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8/4/2019 59184000 Financial Markets Snapshot
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Financial Markets
1
Anil Suvarna
Study Material on
Financial Markets
Compiled by
Prof. Anil Suvarna
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Syllabus
No. Contents
Section 1: Introduction to Equities
1.1 Indian Financial Markets: An Overview
1.2 Classification of Financial Markets
1.3 Evolution of Stock Markets in India
1.4 History of Stock Exchanges in India
1.5 Management of Stock Markets
Section 2: Equities
2.1 Equities: History, Meaning and Definition
2.2 Types of Trading
2.3 Trading Mechanism and its Modernization
2.4 Clearing and Settlement
Section 3: Derivatives
3.1 Derivatives: History, Meaning and Definition
3.2 Classification of Derivatives
3.3 Features, Types and Players in Derivatives
3.4 Forwards: Meaning, Definition & Limitations
Section 4: Futures
4.1 Meaning
4.2 Terminologies
4.3 Payoff Profile
4.4 Numericals
Section 5: Options
5.1 Meaning
5.2 Terminologies
5.3 Payoff Profile
5.4 Numericals
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Section 1: Introduction to Equities
1.1 Financial Markets: An Overview
Financial markets are an integral part of the economy of any nation. They play a key role
in the development of the economy. In simple words financial markets facilitate the
reallocation of savings from savers to entrepreneurs. In India the financial markets and
institutions have, in recent years, undergone significant changes keeping in pace with the
changing needs of market participants. Also the market has gone through various stages
of liberalization that has increased its degree of integration with the global markets.
In the financial markets savings are linked to investments by a variety of intermediaries
through a range of complex financial products called securities. Securities are defined in
the Securities Contracts (Regulation) Act, 1956 to include shares, bond, scrip, stocks, or
other marketable securities of like nature in or of any incorporate company or body
corporate, government securities, derivatives of securities, units of collective investment
scheme, interest and rights in securities, security receipt or any other instruments so
declared by the Central Government.
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1.2 Classification of Financial Markets
The Financial Market Comprises Of Two Broad Groups
Money market
The money market is concerned with the borrowing and lending of short- term funds. It
deals with near substitutes for money like trade bills, promissory notes and government
papers drawn for a short period not exceeding one year. These, short term instruments
can be converted into cash readily without any loss and at low transaction cost. This
market supplies funds for financing current business operations, working capital
requirements, and short period requirements of the Government.
Capital Market
Gilt-edged Securities
MarketSecurities Market
Primary Market
Money Market
Financial Market
Secondary Market
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Capital market
Capital market is concerned with the borrowing and lending of long-term funds. The
capital markets mobilize the savings of the households and of the industrial concerns,
provide them with excellent investment opportunities thus facilitating capital formation
in the country. The capital market makes available funds for various projects in the
private sector as well as public sector. Also institutions raise funds for projects in the
backward areas, which in turn lead to development of the backward areas. A healthy
capital market is an indication of a tremendous economic growth and development of a
country.
Evolution of capital markets
In India the current structure of capital market has evolved over the years due to constant
improvement measures and modifications. A major reason behind this is the growth of
Stock Exchanges in India. Due to this it has become possible for many people to be a part
of the capital market as they have a medium via which they can buy and sell the
securities. The stock exchanges act as a connecting link between the potential demand
and supply.
Setting up of the most important regulatory body in the context of a primary market, i.e.
Securities and Exchange Board of India (SEBI) way back in the year 1988, definitely played
a crucial role in the development of the capital market.
Besides these, the growth of financial institutions such as State Finance Corporations
(SFC’), Industrial Finance Corporation of India (IFCI), State Industrial Development
Corporations (SIDC), a major spurt in the mutual funds industry, development of creditrating industries have also provided a boost to the capital market in India. These
institutions actively participate in the securities market.
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As a result of these significant moves, today our market is rated third in the entire world.
Absence of capital market acts as a deterrent factor to capital formation and economic
growth. Resources would remain idle if finance is not funneled through capital market.
Thus as mentioned earlier it is evident that capital market facilitates increase in
production and productivity in the economy and thus enhances the economic welfare of
the society.
Gilt-edged securities market
This market deals with the securities such as bonds issued by Central Government, State
Government, and All India Financial Institutions like IDBI, State Finance Corporations,
SIDC’s and other government bodies. The securities are issued in the forms of bonds and
credit notes. The buyers of such securities are banks, insurance companies, employee’s
provident funds, RBI and even individuals. These securities are fully backed by the
Government.
Securities Market
This market deals with equities, bonds and derivatives. The securities market has
essentially three categories of participants, namely the issuer of securities, investors insecurities and the intermediaries. The issuers and investors are consumers of services
rendered by the intermediaries. While the investors are consumers of securities issued by
the issuers as they subscribe for and trade in those securities. The Securities Market has
two independent and inseparable segments: The Primary Market and The Secondary
Market.
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Primary Market
The primary market provides the channel for creation of new securities through issuance
of financial instruments by public companies as well as Governments and Government
agencies and bodies. This market provides both existing quoted companies and new
companies with the facility for raising new capital. In India a secondary offering is also
done in a primary market. The primary market issuance is done through: -
Public Issue
Offer for sale
Right Issues
Private Placement
Secondary Market
The secondary market is the place for sale and purchase of existing securities. It enables
an investor to adjust his holdings of securities in response to changes in his assessment
about risk and return. It also enables him to sell securities for cash to meet his liquidity
needs. It essentially comprises of the stock exchanges which provide platform for trading
of securities and a host of intermediaries who assist in trading of securities and clearing
and settlement of trades. The securities are traded, cleared and settled as per prescribedregulatory framework under the supervision of the exchanges and the oversight of SEBI.
The secondary market has further two components, namely:
The Over-The-Counter (OTC) Market
OTC is different from market place provided by the Over The Counter Exchange of
India Limited (OTCEIL). OTC markets are essential informal markets where trade dealsare negotiated. Most of the traders in government securities are in the OTC market.
All the spot trades where securities are traded for immediate delivery and payment
take place in OTC market.
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The Exchange-Trade Market
Trades taking place over a trading cycle, i.e., a day under a rolling settlement, are
settled together after a certain time (currently 2 working days). All the 23 stock
exchanges in the country provide facilities for trading of equities. Traders executed on
the leading exchange (National Stock Exchange of India Limited (NSE) are cleared and
settled by a clearing corporation that provides notations and settlement guarantee.
Alternative Sources of Finance
The selection of alternative sources of capital depends on the urgency of the financial
need, corporate and shareholder objectives, the amount of capital needed, the use to
which the proceeds will be applied, and the relative size and maturity of the company.
Commercial Lenders and Lessors
Strategic Partnerships
Government Loans and Guarantees
Venture Capitalists
Sale or Merger Initial Public Offering
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1.3 Evolution of Stock Market in India
India has a two hundred year old trading in securities. Infact, the first Indian stock
exchange established in Bombay is the oldest exchange in Asia. The pace of growth of stock exchanges was slow till 80’s. After that, there was a capital market revolution in the
country. This was due to gradual liberalization of economic and industrial policies. The
shift from command economy to a market economy brought the importance of stock
exchanges into limelight.
The origin of stock market in India can be traced to the later part of the eighteenth
century. The earliest security dealings were transactions in loans securities of the East
India Company, the dominant institute of those days. Corporate shares came into the
picture by 1830’s, and assumed significance with the enactment of the Companies Act in
1850. The introduction of limited liability marked the beginning of the era of the modern
joint stock enterprises. This was followed by the American civil war in 1860 – 1865.
However, the bubble burst with the end of the civil war and a disastrous slump followed.
It lasted for a long time. It also resulted in complete ostracism of the broker community.
The tremendous social pressure on the brokers led to their forming an informal
association which later gave birth to, ‘The Native Share and Stock Brokers Association’,
(now known as the Bombay stock exchange) in 1887. . This stock exchange played a major
role during the phase of recovery from the seven year depression. It continued to grow in
stature and the size of operations and became the nerve centre of all financial activity
and the first to be recognized by the government of India.
This was followed by the formation of association/exchanges in:-
Ahmedabad (1894)
Calcutta (1908)
Madras (1937)
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The Second World War resulted in a sharp boom and growth in the number stock
exchanges. However, most of the stock exchanges languished till 1956, when the
government came out with a comprehensive legislation called ‘The Securities Contract
(Regulation) Act’, to regulate the functioning of stock exchanges and to check the
performance and promote a more orderly development of the stock market. This
legislation made it mandatory on the part of the stock exchanges to secure recognition
from central government. Only the established stock exchanges were recognised under
the act. Under this legislation it is mandatory on the part of stock exchanges to seek
governmental recognition.
After this the trading on the stock exchanges in India used to take place without use of
information technology for immediate matching or recording of trades. This was time
consuming and inefficient and also imposed limits on trading volumes and efficiency. In
order to provide efficiency, liquidity and transparency, NSE introduced a nation-wide on-
line fully automated screen based trading system (SBTS) where a member can punch into
the computer quantities of securities and the prices at which he likes to transact and the
transaction is executed as soon as it finds a matching sale or buy order from a counter
party. This allowed faster incorporation of price sensitive information into prevailingprices, thus increasing the informational efficiency of markets.
Owing to development of stock markets in India, this attracted the various foreign players
to invest in the Indian stock market. Various FII’s came to India and got them registered
themselves with SEBI and started investing in Indian stock market. During that time
market also had a variety of deferral products like modified carry forward system, which
encouraged leveraged trading by enabling postponement of settlement. The deferralproducts have been banned and in their place came the existence of Derivative trading in
securities though at the beginning it dint take of well because there was no suitable
regulatory framework to govern the trades.
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So SCRA was amended in December 1999 to expand the definition of securities to include
derivatives so that the whole regulatory framework governing trading of securities could
e applied to derivatives also. Then derivative trading took of in June 2000 on two
exchanges. Now in all there are 23 stock exchange in the country where trading in
equities is carried. This all changes have led to development of stock market in India.
1.4 History of Stock Exchanges in India
In 1860, the exchange flourished with 60 brokers. In fact the 'Share Mania' in India began
when the American Civil War broke and the cotton supply from the US to Europe
stopped. Further the brokers increased to 250. At the end of the war in 1874, the market
found a place in a street (now called Dalal Street). In 1887, "Native Share and Stock
Brokers' Association" was established. In 1895, the exchange acquired a premise in the
street which was inaugurated in 1899.
The stock exchanges are the exclusive centres for trading of securities. Stock exchange
means anybody or individual whether incorporated or not, constituted for the purpose of
assisting, regulating or controlling the business of buying, selling or dealing in securities. It
is an association of member brokers for the purpose of self-regulation and protecting the
interest of the members. It can operate only if it is registered under the Securities
Contracts (Regulation) Act 1956.
The SCRA was made in order to regulate certain matters of stock exchanges which include
opening / closing of the stock exchanges, timing of trading, regulation of bank transfers,
regulation of badla or carry over business, control of the settlement and other activities
of the stock exchange like: -
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Margin regulation, regulation of brokers, broker charges, trading rules on the exchange
and settlement and clearing of the trading, at the end March 2003, there were 23
operative stock exchanges with 9,413 securities listed. On the same date, there were
9,519 registered brokers and 13,291 registered sub – brokers trading on these exchanges
in the listed companies.
Functions of the Stock Exchange:
To Ensure A Measure of Safe Dealing: - The stock exchange operates under a
regulatory framework which favours them heavily by almost banning trading of
securities outside exchanges resulting to protect the interest of the investors. The
rules, regulations of a stock exchange approved by the government are made to
ensure that a reasonable measure of safety is provided to investors and transactions
take place in competitive conditions and no malpractices are to be involved.
Directing the Flow of Capital in The Most Profitable Channels: - Companies which
have more profitable investment opportunities are normally able to generate more
funds through this market, whereas companies which do not have such opportunitiesare not able to do so. In this way stock exchange facilitates the direction of flow of
capital in most profitable channels.
Motivates The Company To Raise Its Standard Of Performance: - When the company
is listed on the stock exchange, the performance of the company is reflected in the
market price of the equity stock, which is readily available for public consumption.
When the companies make profit then the public will invest in the shares of thatcompany resulting to profitability of that company. Such a public exposure induces
companies to raise their standard of performance.
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Providing Liquidity To The Listed Companies: - The stock exchange helps the
companies in raising their funds. The savings of investors flow in the stock exchange
there by resulting in trading in securities. This provides liquidity to the listed
companies.
Recognized Stock Exchanges of India
No. Name Of Exchange Date Of Initial
Recognition
1. The Bombay Stock Exchange 31.03.1957
2. The Ahmedabad Stock Exchange 16.09.1957
3. The Calcutta Stock Exchange 10.10.1957
4. The Madras Stock Exchange 15.10.1957
5. The Delhi Stock Exchange 09.1.1957
6. The Hyderabad Stock Exchange 29.09.1958
7. The Madhya Pradesh Stock Exchange 24.12.1958
8. The Banglore Stock Exchange 16.02.1963
9. The Cochin Stock Exchange 10.05.1979
10. The Uttar Pradesh Stock Exchange 03..6.1982
11. The Pune Stock Exchange 02.09.1982
12. The Ludhiana Stock Exchange 29.04.1983
13. The Gauhati Stock Exchange 01.05.1984
14. The Kanara Stock Exchange 09.09.1985
15. The Magadha Stock Exchange 11.12.1980
16. The Jaipur Stock Exchange 09.01.1989
17. The Bhubaneswar Stock Exchange 05.06.1989
18. The Saurashtra Kutch Stock Exchange 10.07.1989
19. The Vadodra Stock Exchange 05.01.1990
20. The Coimbatore Stock Exchange 18.09.1991
21. The Meerut Stock Exchange 20.09.1991
22. The National Stock Exchange 26.04.1993
23. Over The Counter Exchange of India 23.08.1994
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1.5 Management of Stock Exchanges
The Indian stock exchanges are regulated by the Ministry of Finance, The Securities and
Exchange Board of India (SEBI), and the governing boards of the stock exchanges within
the legal framework provided by the securities contracts (Regulations) Act, 1956, and the
Securities and Exchange Board of India Act, 1992. The internal governance of the stock
exchange is done through the framework of Rules, Bye-laws and Regulations, duly
approved by the government of India.
The securities markets in India are governed under 4 main legislations:
The Securities Contracts (Regulation) Act, 1956: - This prevents undesirable
transaction in the securities by regulating the business of dealing in securities.
The Companies Act, 1956: - Which is a uniform law relating to companies throughout
India.
The SEBI Act, 1992: - For protection of interest of investors and for promoting
development of and regulating the securities market.
The Depositories Act, 1996: - Which provides for electronic maintaince and transfer
of ownership of dematerialised securities.
Besides, the Ministry of Finance, through the stock exchange division, administers the
SCRA, 1956. It has the powers to apply the provisions of the said Act, provide licenses to
dealers, grant recognition to the stock exchanges and regulate their operations.
Further, it has the appellate and supervisory powers over the SEBI. The Ministry of
Finance has the power to nominate the Presidents and Vice-Presidents and also theapproval on appointment of various representatives of the stock exchanges.
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SEBI - Securities and Exchange Board of India
The Securities and Exchange Board of India (SEBI) was set up on April 12, 1988. To start
with, SEBI was set up as a non-statutory body. It took almost four years for the
government to bring about a separate legislation in the name of SEBI conferring statutory
powers. The Act charged to SEBI with comprehensive powers over practically all aspects
of capital market operations.
SEBI has two Advisory Committees, one each for primary and secondary market. The
committees are constituted from among the market players, recognized investor
associations and eminent persons associated with the capital market. They provide
advisory inputs in framing policies and regulations. These committees are non statutory
in nature and SEBI is not bound by the committees.
Objectives
According to the preamble of the SEBI Act, the primary objective of the SEBI is to promote
healthy and orderly growth of the securities market and secure investor protection. For
this purpose, the SEBI monitors the activities of not only stock exchange but also
merchant bankers etc. The objectives of SEBI are as follows: -
To protect the interest of investors so that there is a steady flow of savings into the
capital market.
To regulate the securities market and ensure fair practices by the issuers of securities
so that they can raise resources at minimum cost.
To promote efficient services by brokers, merchant bankers and other intermediaries
so that they become competitive and professional.
Simultaneously SEBI which came into existence in 1992 was regarded as the capital
market regulator in India. SEBI was given the full authority and jurisdiction over the
securities market under the act.
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Roles
The various roles of SEBI are as follows:-
To ensure better disclosure norms
Introducing free pricing of Public Issues
Establishing the new norms for issue of stock investment
Framing rules for various market participants (bankers, portfolio managers and
brokers)
To protect the interest of the investors in the securities market, promoting the
development of securities market and even regulating the stock market
Setting up advisory panel for primary and secondary markets
Registering brokers and levying appropriate fees to the brokers
Framing rules for Foreign Institutional Investors (FII’s)
Developing a specific code for mergers and takeovers
To collect information and advise the government on matters relating to the stock
and capital markets
Developing norms for insider trading
Powers:
SEBI has been vested with the following powers: -
Power to call periodical returns from recognized stock exchanges
Power to call any information or explanation from recognized stock exchanges or
their members.
Power to direct enquiries to be made in relation to affairs of stock exchanges or
their members.
Power to grant approval to byelaws of recognized stock exchanges.
Power to make or amend byelaws of recognized stock exchanges.
Power to compel listing of securities by public companies.
Power to control and regulate stock exchanges.
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Power to grant registration to market intermediaries.
Power to levy fees or other charges for carrying out the purpose of regulation.
Power to declare applicability of Sec 17 of Securities Contract (Regulation) Act in
any state or area to grant licenses to dealers in securities.
Operational Review of SEBI:
I. The Securities and Exchange Board of India Act, 1992 provides for the establishment
of the Board to: -
Protect the interest of the investors in securities
Promote the development of, and
Regulate the securities market and matters connected therewith or incidental to.
II. The Securities and Exchange Board of India (SEBI) has chalked out a vision of
becoming the "Most Dynamic and Respected Regulator-Globally".
III. SEBI has drawn a comprehensive Strategic Action Plan in order to realize this vision.
The Plan envisages achievement of strategic aims laid down for : -
Investors (Consumers): Investors are enabled to make informed choices and
decisions and achieve fair deals in their financial dealings’
Firms (Corporate): Regulated firms and their senior management understand and
meet their regulatory obligations’
Financial Markets (Exchanges, Intermediaries): Consumers and other participants
have confidence that markets are efficient, orderly and clean’
Regulatory Regime: An appropriate, proportionate and effective regulatory
regime is established in which all the ‘stakeholders’ have confidence’.
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Section 2: Equities
2.1 Equities: History, Meaning and Definition
History
The Indian Equity Market is also the other name for Indian share market or Indian stock
market. Indian Equity Market at present is a lucrative field for the investors and investing
in Indian stocks are profitable for not only the long and medium-term investors, but also
the position traders, short-term swing traders and also very short term intra-day traders.
Foreign investment in general enjoys a majority share in the Indian Equity Market.
Foreign Institutional Investors (FII) need to register themselves with the SEBI and the RBI
for operating in Indian stock exchanges. In fact from the Indian equity market analysis it is
known that in some specific industries foreigners can have even 100% shares. In the last
few years with the facility of the Online Stock Market Trading in India, it has been very
convenient for the FIIs to trade in the Indian equity market.
Thus, the growing financial capital markets of India being encouraged by domestic and
foreign investments is becoming a profitable business more with each day.
Meaning
The market in which shares are issued and traded, either through exchanges or over-the-
counter markets equity market, also known as the stock market, it is one of the most vital
areas of a market economy because it gives companies access to capital and investors a
slice of ownership in a company with the potential to realize gains based on its future
performance. This market can be split into two main sectors: the primary and secondary
market. The primary market is where new issues are first offered. Any subsequent trading
takes place in the secondary market.
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Definition
Equity market or stock market is a system through which company shares are traded. The
equity market offers investors an opportunity to participate in a company's success
through an increase in its stock price. With enhanced opportunity, however, the equity
market usually carries greater risk than debt markets. The worldwide equity market
benefited from freer markets, government privatizations, and companies seeking an
alternative to debt.
2.2 Types of Trading, Types of Traders and Styles of Trading
Types of Trading can be divided into long term and short term. For long term trading we
have delivery trading and for short term trading we have intra-day trading.
1. Delivery Trading:
• This type of trading is done by investors who want to invest their money from
a long term perspective say for more than 1 year.
• Under delivery trading one actually becomes the owner of the share as he
pays full amount for buying the same.
• The investor has full right on the share purchased and can hold it in his demat
a/c forever, in-short he has got no obligations to be fulfilled once have bought
the share.
• Settlement happens on T+2 days and one gets the actually delivery of shares
in his demat a/c.
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2. Intra-day Trading:
• This type of trading is done only by traders; one has complete his trading
activities in the same trading day.
• Under intra-day trading one doesn’t become the owner of the share as he
pays only the margin amount for buying or selling the same.
• The trader has the obligation to square off the position before the closing bell
as he is not allowed to carry forward the position under intra-day.
• Settlement has to be compulsorily done on the same trading day, since intra-
day is cash settled there is no delivery happening.
Types of Traders The stock market also provides opportunities for short-term traders.
When the price starts to fall or rise, other investors will jump on the bandwagon, causing
an even faster acceleration in price. Eventually the market will correct itself, but for savvy
short-term traders who watch the market closely, these price changes can offer
opportunities for profitable trading.
Short term traders are divided into 3 categories: Position Traders, Swing Traders, and Day
Traders.
1. Position Traders - Position trading is the longest term trading style of the three.
Stocks could be held for a relatively long period of time compared with the other
trading styles. Position traders expect to hold on to their stocks for anywhere from
5 days to 3 or 6 months. Position traders are watching for fundamental changes in
value of a stock. This information can be gleaned from financial reports and
industry analyses. Position trading does not require a great deal of time. An
examination of daily reports is enough to plan trading strategies. This type of
trading is ideal for those who invest in the stock market to supplement their
income. The time needed to study the stock market can be as little as 30 minutes
a day and can be done after regular work hours.
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2. Swing Traders - Swing traders hold stocks for shorter periods than position traders
- generally from one to five days. The swing trader is looking for changes in the
market that are driven more by emotion than fundamental value. This type of
trading requires more time than position trading but the payback is often greater.
Swing traders usually spend about 2 hours a day researching stocks and executing
orders. They need to be able to identify trends and pick out trading opportunities.
They usually rely on daily and intraday charts to plot stock movements.
3. Day Traders - Day trading is commonly thought of as the most risky way to play
the stock market. This may be true if the trader is uneducated, but those who
know what they are doing know how to limit their risk and maximize their profit
potential. Day trading refers to buying and selling stock in very short periods of
time - less than a day but often as short as a few minutes. Day traders rely on
information that can influence price moves and have to plot when to get in and
out of a position. Day traders need to be rational and analytical. Emotional buyers
will quickly lose money in this type of trading. Because of the close attention
needed to market conditions, day trading is a full-time profession.
Styles of Trading
1. Scalping - The scalper is an individual who makes dozens or hundreds of
trades per day, trying to "scalp" a small profit from each trade by exploiting
the bid-ask spread.
2. Momentum Trading - Momentum traders look to find stocks that are moving
significantly in one direction on high volume and try to jump on board to ride
the momentum train to a desired profit.
3. Technical Trading - Technical traders are obsessed with charts and graphs,
watching lines on stock or index graphs for signs of convergence
or divergence that might indicate buy or sell signals.
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4. Fundamental Trading - Fundamentalists trade companies based on
fundamental analysis, which examines things like corporate events such as
actual or anticipated earnings reports, stock splits, reorganizations or
acquisitions.
5. Swing Trading - Swing traders are really fundamental traders who hold their
positions longer than a single day. Most fundamentalists are actually swing
traders since changes in corporate fundamentals generally require several
days or even weeks to produce a price movement sufficient enough for the
trader to claim a reasonable profit.
2.3 Trading Mechanism and its Modernization
Securities Trading Cycle
Decision
to TradePlanning
Order
Trade
Execution
Clearing
of Trades
Funds /
Securities
Settlement
of Trades
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The above figure is a conceptual model of securities trading cycle. A person holding /
having some amount of securities / funds when either to meet his liquidity needs or to
reshuffle his holdings in response to changes in his perception about risk and return of
the assets, decides to buy / sell the securities. Therefore, the person also influenced by
the marketing activity is influenced to make a decision to either increase or decrease his
share holdings. Then on that basis he contacts the broker and communicates his order i.e.
places his order. Then the order is executed by the broker at the price and quantity of
shares quoted by the investor. The order when matches sell / buy order is converted to
trade. The trades then have to be sent for clearing in order to determine the obligations
of counter parties to deliver securities as per schedule. Next the necessary formalities are
conducted. Finally, the buyer / seller delivers funds / securities and receives securities /
funds and acquires ownership them. So, this was the core concept on which the entire
trading system was based upon which has been evolved from the traditional method to
the computerized method but the transaction cycle hasn’t changed. In the following
pages it may be noticed that with the use of technology how the ill effects of traditional
trading methods has been warded off order to evolve computerized system of trading for
facilitating efficient trading for investors.
Traditional Trading Mechanism
The traditional trading method of stock exchanges dates back at the time of inception of
the stock exchanges wherein, rudimentary techniques of trading were applied. The
trading on stock exchanges in India use to take place through open outcry without the use
of information technology for immediate matching / recording of trades. This type of
trading was called Ring trading / Pit trading.
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Ring trading bares its name due to the brokers trading activities used to be conducted in a
ring or pit. The broker use to shout and quote their prices. The entire transaction was
verbal trading and was a community driven market, mainly dominated by the Gujurathis.
Also the market in the old trading system was location specific i.e. the trading could be
done only in the stock market / exchange. The entire market was not representative as it
was manipulated by few individuals.
The main aspect in the traditional trading mechanism was that of the brokers wherein
they delt with the stock markets as per their Whims and Fancies and many a times
manipulated the prices for their own personal benefit. Hence, the traditional trading
mechanism was time consuming, inefficient and not secure.
Modern Trading Mechanism
As analyzed the traditional trading mechanism had become obsolete because of many
reasons such as increased volume in trade, opening up trade and susceptibility of markets
to scams and manipulations. Therefore, on 14th
March, 1995 history was created by
introducing the Screen Based Trading System (SBTS).
The screen based trading system gave in an accurate and timely statistics on market
activity. Also host of electronic devices such as Tickers, Monitors, Boards and Computer
Terminals had been provided. The endeavour was to set up right kind of user friendliness
performance and functionality.
The main objective of Modern Trading Mechanism was: - Lead to Transparent deals in the market
Improvement in Liquidity in the market
Increase the market depth through quote continuity
Eliminate mismatches and mitigate settlement risks
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Instantaneous dissemination of information through various data-feed channels
Structured MIS reports for analysis
Provide a robust and scalable trading system for growing volumes
The aim of the new system was to provide the accurate information at a faster rate for
the benefit of the traders.
The various benefits of Modern Trading Mechanism were: -
It makes trading accessible--anywhere and at anytime
The pace of communication facilitates a fast response time
Dissemination of data is done at a faster rate
Technology also provides the freedom to create-new systems, new products
It also facilitates transparency of information
Provides global connectivity
It increases awareness of market participants through provision of information
Screen Based Trading System (SBTS)
The Screen Based Trading System provides seamless information flow of the variousscrips which is available to everyone and anyone interested in the markets. The main aim
of the technology was used to carry the trading platform from trading hall of stock
exchanges to premises of broker / investor. The Screen Based Trading System operates on
strict time, price and priority. The order that has been placed by the broker on behalf of
investors via satellite through his computer is registered. The orders are started with best
price order getting the first priority. The orders are matched automatically by the
computer keeping the system transparent, objective and fair. Where an order doesnotfind a match, it remains in the system and is displayed to the whole market, till a fresh
order comes in or the earlier order is cancelled or modified. Also the trading provides
tremendous flexibility to the users in terms of kinds of orders that can be placed on the
system.
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The SBTS has two terminals viz.
1. BOLT
2. NEAT
1. BOLT - BSE ON LINE TRADING SYSTEM
BSE's On Line Trading System, popularly known as the BOLT system took its genesis in the
year 1994, as part of the four phase computerization program to create an automated
trading environment. BOLT system aimed at converting the Open Outcry system of
trading to a screen-based trading system. BSE had the requisite knowledge base and by
virtue of the 125 year track record in the capital markets, BSE embarked on the specified
project in 1991 and seamlessly completed the fourth phase in March 1995.
With the interest of BOLT it helped the performance and response time increase to very
extent. Also there was continuos availability for reliable and continuos information. The
data integrity is restored which inturn guarantee the security of the distributed data
enabling others to access it from anywhere in the network. With the creation of BOLT
accurate and timely statistics was available. Through networking, software and hardware
an open interface specification was available. Through this members had the flexibility touse their own developed application. BOTL also is interfaced with various information
vendors including Bloomberg, Bridge, Reuters and others. Market information is fed to
news agencies to in real time. BOLT plans to enhance the capabilities further to have an
integrated two way information flow.
2. NEAT - National Exchange For Automated Trading
The National Stock Exchange (NSE) is India's leading stock exchange covering 364 citiesand towns across the country. NSE was set up by leading institutions to provide a modern,
fully automated screen-based trading system with national reach. The Exchange has
brought about unparalleled transparency, speed & efficiency, safety and market integrity.
It has set up facilities that serve as a model for the securities industry in terms of systems,
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Issuer
NSDL
VSAT Link
R & T Agent
Clearing
CorporationHouse
VSAT Link
Clearing
MemberVSAT Link
DP
Investor
VSAT Link
DP
Investor
practices and procedures. NSE introduced for the first time in India, fully automated
screen based trading. It uses a modern, fully computerised trading system designed to
offer investors across the length and breadth of the country a safe and easy way to invest.
The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a fully
automated screen based trading system, which adopts the principle of an order driven
market.
On – Line Trading Mechanism: A Conceptual Model
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Electronic Linkage Model
The above figure is a conceptual model of trading of securities through electronic linkage.
The main aspect that needs to be considered is that the entire process has to be
electronically networked on every aspect. This electronic network helps in accurate and
fast exchange of information and dealings in order to facilitate the investor. In the above
figure the issuer registers his shares with Registrar & Transfer agent electronically, and
then the DPs trade in the shares on behalf of the investors either by buying or selling of
shares. DPs can be termed as small terminals of NSDL (National Securities Depositaries
Limited) which have electronic link with NSDL and the exchanges. In this system the
investor or the broker either places an order of buy / sell of shares. The NSDL then
connects to the mainframe server of the exchanges and matches the orders with the best
buy and best sell technique. Now let’s get a brief perspective of NSDL.
2.4 Clearing and Settlement
Clearing and settlement is a post trade activity. Clearing Agencies ensures trading
members meet their fund/security obligations. It acts as a legal counter party to all trades
and guarantees settlement for all members. The original trade between the two parties is
cancelled and clearing corporation acts as counter party to both the parties, thus
manages risk and guarantees settlement to both the parties. This process is called
novation.
It determines fund/security obligations and arranges for pay-in of the same. It collects
and maintains margins, processes for shortages in funds and securities. It takes help of
clearing members, clearing banks, custodians and depositories to settle the trades.
The settlement cycle in India is T+2 days i.e. Trade + 2 days. T+2 means the transactions
done on the Trade day, will be settled by exchange of money and securities on the second
business day (excluding Saturday, Sundays, Bank and Exchange Trading Holidays). Pay-in
and Pay-out for securities settlement is done on a T+2 basis.
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The following is the summary of trading and settlement process in India.
• Investors place orders from their trading terminals.
• Broker houses validate the orders and routes them to the exchange (BSE or NSE
depending on the client’s choice)
• Order matching at the exchange.
• Trade confirmation to the investors through the brokers.
• Trade details are sent to Clearing Corporation from the Exchange.
• Clearing Corporation notifies the trade details to clearing Members/Custodians who
confirm back. Based on the confirmation, Clearing Corporation determines
obligations.
• Download of obligation and pay-in advice of funds/securities by Clearing Corporation.
• Clearing Corporation gives instructions to clearing banks to make funds available by
pay-in time.
• Clearing Corporation gives instructions to depositories to make securities available
by pay-in-time.
• Pay-in of securities: Clearing Corporation advises depository to debit pool account of
custodians/Clearing members and credit its (Clearing Corporation’s) account and
depository does the same.
• Pay-in of funds: Clearing Corporation advises Clearing Banks to debit account of
Custodians/Clearing members and credit its account and clearing bank does the
same.
• Payout of securities: Clearing Corporation advises depository to credit pool accounts
of custodians/Clearing members and debit its account and depository does the
same.• Payout of funds: Clearing Corporation advises Clearing Banks to credit account of
custodians/ Clearing members and debit its account and clearing bank does the
same. Note: Clearing members for buy order and sell order are different and Clearing
Corporation acts as a link here.
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• Depository informs custodians/Clearing members through Depository Participants
about pay-in and pay-out of securities.
• Clearing Banks inform custodians/Clearing members about pay-in and pay-out of
funds.
• In case of buy order by normal investors Clearing members instruct his DP to credit
the client’s account and debit its account. The money will be debited (Total settled
amount - margins paid at the time of trade) from the client’s account.
• In case of sell order by normal investors Clearing members instruct his DP to debit
the client’s account and credit its account. The money will be credited to the client’s
account.
BSE Settlement Cycle:
Day Activity T Trading through BOLT (BSE Online Trading)
System, downloading of statements
showing details of transactions and
margins at the end of the day.
Downloading of provisional securities and
funds obligation statements by member-
brokers.
6A/7A entry by the member-brokers/
confirmation by the custodians.
6A/7A: A mechanism whereby the
obligation of settling the transactions done
by a member-broker on behalf of a client is
passed on to a custodian based on
confirmation of latter. The custodian canconfirm the trades done by the member-
brokers on-line and up to 11 a.m. on the
next trading day. The late confirmation of
transactions by the custodian after 11:00
a.m. up to 12:15 p.m., on the next trading
day is, however, permitted subject to
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payment of charges for late confirmation
@ 0.01% of the value of trades confirmed
or Rs. 10,000/-, whichever is less.
Day Activity T +1 Confirmation of 6A/7A data by the
Custodians up to 11:00 a.m. Downloading
of final securities and funds obligationstatements by members.
Day Activity T +2 T+2 - Pay-in of funds and securities by
11:00 a.m. and pay-out of funds and
securities by 1:30 p.m. The member-
brokers are required to submit the pay-in
instructions for funds and securities to
banks and depositories respectively by 10:
30 a.m.
Day Activity T +3 Auction on BOLT at 11.00 a.m.
Day Activity T +4 Auction pay-in and pay-out of funds andsecurities by 12:00 noon and 1:30 p.m.
respectively.
NSE Settlement Cycle:
Day Type of Activity Activity
T Trading Rolling Settlement Trading
T+1 working days Clearing Custodial Confirmation
T+1 working day Delivery Generation
T+2 working day Settlement Securities and Funds pay in
T+2 working daySecurities and Funds pay
out
T+2 working day Valuation Debit
T+3 working day Post Settlement Auction
T+4 working day Bad Delivery Reporting
T+5 working day Auction settlement
T+6 working dayRectified bad delivery pay-
in and pay-out
T+8 working dayRe-bad delivery reporting
and pickup
T+9 working daysClose out of re-bad delivery
and funds pay-in & pay-out
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Functions of Custodian and Depository
Custodian:
A custodian is an entity which holds the documentary evidence of the title to property
belonging like share certificates, etc for safekeeping. In Clearing Corporation, custodian is
a clearing member but not a trading member. He settles trades assigned to him by trading
members. He is required to confirm whether he is going to settle a particular trade or not.
If it is confirmed, the Clearing Corporation assigns that obligation to that custodian and
the custodian is required to settle it on the settlement day. If the custodian rejects (if
there are mismatches due to errors in the system) the trade, the obligation is assigned
back to the trading member. Only on receipt of the rejection message, the broker shall
cancel the rejected contract note and issue a fresh contract note bearing a new number.
Depository:
A depository is an entity where the securities of an investor are held in electronic form.
Depositories help in the settlement of the dematerialized securities. Each
custodian/clearing member is required to maintain a clearing pool account with the
depository. He is required to make available the required securities in the designated
account on settlement day.
The depository runs an electronic file to transfer the securities from accounts of the
custodians/clearing member to that of Clearing Corporation. As per the schedule of
allocation of securities determined by the Clearing Corporation, the depositories transfer
the securities on the payout day from the account of the Clearing Corporation to those of
members/custodians.
Every investor who wants to hold securities in dematerialized form must open an account
with a depository participant (DP) of his choice. Usually this is done by your broker on
behalf of you. Depository Participants (DPs) hold accounts with depositories.
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Just as one can hold funds in a bank account and transfer funds across accounts without
actually handling cash; one can hold securities in a depository account and transfer
securities across depository accounts without actually handling share certificates.
There are two main depositories in India.
1. National Securities Depository Ltd (NSDL)
2. Central Depository Services Ltd (CDSL)
Functions of Clearing Banks
Clearing Bank acts as an important intermediary between clearing member and clearing
corporation. Every clearing member needs to maintain an account with clearing bank. It’s
the clearing member’s function to make sure that the funds are available in his account
with clearing bank on the day of pay-in to meet the obligations. In case of a pay-out
clearing member receives the amount on pay-out day.
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Section: 3 Derivatives
Introduction: Indian Financial Markets: Where does derivative fall?
From the above chart we can see that derivatives fall under secondary market channel.
3.1 Derivatives History, Meaning and Definition
History
Derivatives have been a recent development in the Indian financial markets. But there
have been derivatives in the commodities market. There are Cotton and Oilseed futures
in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin, Coffee futures in Bangalore
etc. But the players in these markets are restricted to big farmers and industries, who
need these as an input to protect themselves from the vagaries of agriculture sector.
Globally too, the first derivatives started with the commodities, way back in 1894.
Financial derivatives are a relatively late development, coming into existence only in the
1970’s. The first exchange where derivatives were traded is the Chicago Board of Trade
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(CBOT).
In India, the first derivatives were introduced by National Stock Exchange (NSE) in June
2000. The first derivatives were index futures. The index used was Nifty. Option trading
was started in June 2001, for index as well as stocks. In November 2001, futures on stocks
were allowed. Currently, there are 275 stocks on which derivative trading are allowed.
Meaning
Derivate – “Derives its value from an asset” - What the phrase means is that the
derivative on its own does not have any value. It is considered important because of the
importance of the underlying. When we say an Infosys future or an Infosys option, these
carry a value only because of the value of Infosys.
Definition
A derivative is a financial instrument that derives its value from an underlying asset. This
underlying asset can be stocks, bonds, currency, commodities, metals and even
intangible, pseudo assets like stock indices.
3.2 Classification of Derivatives
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Financial Derivatives
Financial derivatives are instruments that derive their value from financial assets. These
assets can be stocks, bonds, currency etc. These derivatives can be forward rate
agreements, futures, options swaps etc. As stated earlier, the most traded instruments
are futures and options.
3.3 Features of Derivatives
Hedging: To minimize risk arising due to volatility of the market.
Price Discovery: To have better price discovery in terms of huge no. of players.
Liquidity Function: To infuse liquidity in the market by way of lot size trading.
Trading Volumes: To generate huge trading volumes by way of mass trading.
Types of Derivatives
The most commonly used derivatives contracts are forwards, futures and options. Lets
take a brief look at various derivatives contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed price.
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. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
Options: 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 buyer 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.
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Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.
Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.
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Players in Derivatives
Hedgers: Hedgers face risk associated with the price of an asset they own. They
use derivatives to reduce or eliminate risk.
Speculators: Speculators bet on future movements in the prices of an asset.
Derivatives give them an extra leverage, by which they can increase both the
potential gains and losses.
Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two
different markets.
Jobbers: Jobbers take advantage from the spread between the Bid and Ask price.
3.4 Forwards: Meaning, Definition, Features, Players & Limitations
Meaning
A forward contract is a private contract between a buyer and a seller in which the buyer
agrees to buy and the seller agrees to sell a specific quantity of a certain security or
commodity (known as the underlying instrument ) at the price specified in the contract.
The difference between a forward contract and most other sales contracts is that with the
forward contract, the delivery and payment of the underlying instrument occurs at a
specified future date instead of immediately.
Definition
A forward contract is a customized contract between two parties, where settlement takes
place on a specific date in future at a price agreed today.
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Features of Forwards
The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
Players in Forwards
Hedgers: The one who intends to minimize this risk which respect to price
fluctuations
Speculators: The one who speculates / anticipates the price movement in order to
make maximum profits.
Limitations of Forwards
Lack of centralization of trading
Illiquidity
Counter party risk
In the first two of these, the basic problem is that of too much flexibility and generality.
The forward market is like a real estate market in that any two consenting adults can form
contracts against each other. This often makes them design terms of the deal which are
very convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the other
suffers. Even when forward markets trade standardized contracts, and hence avoid the
problem of illiquidity, still the counterparty risk remains a very serious issue.
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Section 4: Futures
4.1 Meaning
Future contracts is an agreement made and traded on the exchange between two parties
to buy or sell a commodity at a particular time in the future for a pre-defined price. Since
both the parties are unaware of each other, the exchange provides a mechanism to give
the party assurance of honored contract. The exchange specifies standardized features of
the contract. The risk to the holder is unlimited, and because the pay off pattern is
symmetrical, the risk to the seller is unlimited as well.
Money lost and gained by each party on a futures contract are equal and opposite. In
other words, futures trading are a zero-sum game. These are basically forward contracts,
meaning they represent a pledge to make a certain transaction at a future date. The
exchange of assets occurs on the date specified in the contract. These are regulated by
overseeing agencies, and are guaranteed by clearing houses. Hedgers often trade futures
for the purpose of keeping price risk in check.
Future contracts are often used by commercial enterprises as ‘hedging tools’ to reduce
the risk of expected future purchases or sales of the underlying asset. If used to
speculate, risk increases. So risk depends on the underlying instrument and the use of the
future.
Advantages of Futures Contracts
•
If price moves are favourable, the producer realizes the greatest return with this
marketing alternative.
• No premium charge is associated with futures market contracts.
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Disadvantages of Future Contracts
• Subject to margin calls
• Unable to take advantage of favourable price moves
• Net price is subject to Basis change
Futures contracts are similar to Options. Both represent actions that occur in future. But
Options are contract on the underlying futures contract where as futures are either to
accept or deliver the actual physical commodity. To make a decision between using a
futures contract or an options contract, producers need to evaluate both alternatives.
4.2 Terminologies
• 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.
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• 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 timea 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.
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Propose of Futures
Hedging: Hedging is a mechanism to reduce price risk. Price Risk can be reduced
by taking an opposite position in futures market. Hedging can be initiated by
Selling Nifty Futures or a stock ….hedge can be for 20%, 50% or 100% based on
view. Ideally 25 – 35% hedge is kept at all times, then based on view, its increased
or decreased.
Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two
different markets.
Eg. Buy L&T in cash market @ Rs. 800/- sell in future market @ Rs .840/- thereby
profit Rs. 40/-
Jobbing: Jobbing is nothing but taking advantage from the spread between the Bid
and Ask price.
Eg. Powergrid
4.3 Payoff Profile
A payoff is the likely profit or loss that would accrue to a market participant with
change in the price of the underlying asset
Futures have a linear payoff, i.e. the losses as well as profits for the trader of
futures contract are unlimited
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250
1,000 1,100 1,200 1,300 1,400 1,500
-250
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-50
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250
1, 000 1,100 1,200 1,300 1,400 1,500
Payoff for Futures Buyer
Payoff for Futures Seller
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4.4 Numericals
Q.1. Krishna Seth sold a January Nifty futures contract for Rs.240,000 on 15th
January.
Each Nifty futures contract is for delivery of 100 Nifties. On 25th
January, the index closed
at 2350. How much profit/loss did she make?
a. -7,000
b. -5,000
c. +5,000
d. +7,000
Solution: Krishna Seth sold one futures contract costing her Rs.240,000. At a market lot of
100, this works out to be Rs.2400 per Nifty future. On the futures expiration day, the
futures price converges to the spot price. If the index closed at 2350, this must be the
futures close price as well. Hence she will have made of profit of (2400 - 2350)*100. The
correct answer is number 3.
Q.2. Santosh is bullish about Company XYZ and buys ten one- month XYZ futures contracts
at Rs.2,96,000. On the last Thursday of the month, XYZ closes at Rs.271. He makes a ___
a. profit of Rs. 15000
b. profit of Rs.25000
c. loss of Rs.15000
d. loss of Rs.25000
Solution: At Rs.2,96,000 per futures contract, it costs him Rs.296 per unit of futures, i.e.
2,96,000/(10 * 100). On expiration day the spot and futures converge. Therefore he
makes a loss of (296 - 271) * 1000 = 25000. The correct answer is number 4.
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Q.3. Rajiv is bearish about Company ABC and sells twenty one- month ABC futures
contracts at Rs.3,04,000. On the last Thursday of the month, ABC closes at Rs.134. He
makes a _____.
a. profit of Rs. 18000
b. profit of Rs.36000
c. loss of Rs. 18000
d. loss of Rs.36000
Solution: At Rs.3,04,000 per futures contract, it costs him Rs.152 per unit of futures, i.e.
3,04,000/(20 * 100). On expiration day the spot and futures converge. Therefore his profit
is (152-134) * 2000 = 36000. The correct answer is number 2.
Q.4. Ms. Sweta is short on NTPC; the details of her position are as follows:
Lot size: 1625 Shares
Net Future Value: Rs. 2, 59,431.25/-
Initial Margin: 33.95%Span Margin / Maintenance Margin: 23.95%
At what price will she get the margin call and what is the Margin Amount she has to bring
in if she gets a margin call from her broker?
a. Price Rs. 172.55/- and Amount Rs. 22350.50/-
b. Price Rs. 175.62/- and Amount Rs. 25,943.13/-
c. Price Rs. 181.13/- and Amount Rs. 30,056.25/-d. Price Rs. 180.00/- and Amount Rs. 29,596.50/-
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Q.5. Mr. Ankit is long on BHEL, the details of her position are as follows:
Lot size: 75 Shares
Price: Rs. 1355/- per share
Initial Margin: 34.26%
Span Margin / Maintenance Margin: 24.26%
At what price will she get the margin call and what is the Margin Amount she has to bring
in if she gets a margin call from her broker?
a. Price Rs. 1219.50/- and Amount Rs. 10,162.50/-
b. Price Rs. 1220.50/- and Amount Rs. 10,262.50/-
c. Price Rs. 1221.50/- and Amount Rs. 10,362.50/-
d. Price Rs. 1222.50/- and Amount Rs. 10,462.50/-
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Section 5: Options
5.1 Meaning
Options give the buyer the right not the obligation to buy or sell a specified underlying at a
set price, on or before a specified date
5.2 Terminologies
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.
Buyer 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.
There are two basic types of options, call options and put options.
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.
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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.
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 options contract is known as the strike price or the
exercise price.
American options: American options are options that can be exercised at any time upto
the expiration date. Most exchange-traded options are American.
European options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options, andproperties of an American option are frequently deduced from those of its European
counterpart.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cash flow to the holder if it were exercised immediately. A call option on the
index is said to be in-the-money when the current index stands at a level higher than the
strike price (i.e. spot price > strike price). If the index is much higher than the strike price,the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the
strike price.
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At-the-money option: An at-the-money (ATM) option is an option that would lead to zero
cashflow if it were exercised immediately. An option on the index is at-the-money when
the current index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would
lead to a negative cashflow if it were exercised immediately. A call option on the index is
out-of-the-money when the current index stands at a level which is less than the strike
price (i.e. spot price < strike price). If the index is much lower than the strike price, the call
is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike
price.
Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the amount the
option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when theoption is ATM. The longer the time to expiration, the greater is an option's time value, all
else equal. At expiration, an option should have no time value.
ITM-OTM-ATM – Thumb Rule
Market Scenario Call Option Put Option
Market Price > Strike Price ITM OTM
Market Price < Strike Price OTM ITM
Market Price = Strike Price ATM ATM
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Trading Strategies
Strategy 1:
Strategy: 2
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5.3 Payoff Profile
Payoff Profile of a Call Buyer:
The maximum loss for a call optionbuyer is the premium paid by him,
while maximum gains are
unlimited.
Payoff Profile of a Call Seller:
The maximum gain for a seller of the
call option is premium
Payoff Profile of a Put Buyer:
The maximum loss for a buyer of
the put option is the premium paid
by him, while maximum gains are
unlimited.
Payoff Profile of a Put Seller:
The maximum gain for a seller of
the put option is premium.
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1,000 1,100 1,200 1,250 1,350 1,450 1,550
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1,000 1,100 1,200 1,2 50 1 ,3 50 1 ,4 50 1 ,550
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950 1050 1150 1250 1350 1450 1550
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950 1050 1150 1250 1350 1450 1550
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Payoff Profile for Options – Thumb Rule
Call
Buyer • Profits unlimited
• Losses limited to the extend premium paid
Seller • Profits limited to the extend premium
received
• Losses unlimited
Put
Buyer • Profits unlimited
• Losses limited to the extend premium paid
Seller • Profits limited to the extend premium
received
• Losses unlimited
PCR – Put Call Ratio
Put Call Ratio means, the Volume of Put Options to the Volume of Call of Options.
As you may know, Put option indicates, the Price of the Stock is going to fall and a Call
Option buyer anticipates the Stock is going to rise.
When calls are more than Puts, means the anticipation of market moving up is more.
(Bullish Sentiment) When puts are more than calls, means it is a sentiment of Bearish
Market. At the end of the day, when Put to call ratio is taken; the overall market
sentiment can be captured.
• When Put - call ratio is Low, That means, Calls are more than Puts - BullIish Market
Sentiment.
• When Put - Call Ratio is high, that means, puts are more than calls, Bearish Market
Sentiment.
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PCR – Thumb Rule
PCR Higher Puts Are More Than Calls Bearish
PCR Lower Calls Are More Than Puts Bullish
Open Interest
Open Interest is the number of Outstanding Shares (yet to be settled), in the Futures and
Options trading. If you buy 2 futures from me, the Open Interest is 2. If I in turn buy 4
futures from C, the open interest is 6. These are un-setlled contracts. Thus to analyseOpen Interest, it needs to be analyzed along with Price of the Shares.
These are the 4 common analysis parameters:
Open Interest Analysis – Thumb Rule
Contract Increases Price Increases Bullish
Contract Increases Price Decreases Bearish
Contract Decreases Price Increases Bullish
Contract Decreases Price Decreases Bearish
Thus PCR needs to be studied in co-relation with Open Interest for a complete analysis.
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5.4 Numericals
Q.1. Chetan is bullish about the index. Spot nifty stands at 2200. He decides to buy one 3
month nifty call option contract with a strike of 2260 @ Rs. 60 a call. Three months
later the index closes at 2240. His payoff on the position is (Lot Size = 100)a. -7000
b. -4000
c. -12000
d. -6000
Solution: The call expires out of the money, so he simply loses the call premium he
paid, i.e 60 * 100 = Rs.6, 000. The correct answer is d.
Q.2. On 1st April, Ms. Sapna has bought 400 calls (1 Lot) on Cipla at a strike price of Rs200/- for a premium of Rs 20 per call. On expiry Cipla closes at Rs. 240/-. What is net
payoff in terms of profit / loss?
a. Profit of Rs. 16000
b. Profit of Rs. 8000
c. Loss of Rs. 16000
d. Loss of Rs. 8000
Solution: On the 400 calls sold by her, she receives a premium of Rs.8000. However
on the calls assigned to her, she loses Rs. 16,000(400 * (240-200)). Her payin
obligation is Rs.8000. The correct answer is b.
Q.3. Miss Manisha has sold 800 calls on Dr. Reddys Lab at a strike price of Rs. 882 at a
premium of Rs 25 per call on Jan 1st
. The closing price of equity shares on Dr. Reddys
lab is Rs. 884 on that day. If the call option is assigned to her on that day, what is her
net obligation on Jan 1st
?
a. Pay out of Rs. 18300
b. Pay in of Rs. 18300
c. Pay in of Rs 13800
d. Pay out of Rs. 18400
Solution: She will receive the premium amount of Rs. 20,000/- (i.e.800*25). Since she is an
option writer her max. profit is Rs. 20,000/- wherein losses can be unlimited. Now if the
price goes above 882 she stands to loose and if it remains @ 882 or goes below 882 she
stands to gain Rs. 20,000/-. As prices move up from 882 to 884 i.e. diff of Rs.2/- she stands
to loose Rs. 1600/- (800*2). Her profit amount has gone down by 1600, thus she will
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receive the payout from the exchange of Rs. 18400/- instead of Rs. 20,000/-. The correct
answer in d.
Q.4. Miss Shweta has sold 600 calls on DLF at a strike price of Rs. 1403 for a premium of Rs. 30 per call on March 1
st. The closing price of equity shares of DLF is Rs. 1453 on
that day. If the call option is assigned against her on that day, what is her net
obligation on March 1st
?
a. Pay out of Rs. 21600
b. Pay in of Rs 15000
c. Pay out of Rs 13400
d. Pay in of Rs 12000
Solution: She will receive the premium amount of Rs. 18,000/- (i.e.600*30). Since she is an
option writer her max. Profit is Rs. 18,000/- wherein losses can be unlimited. Now if the
price goes above 1403 she stands to loose and if it remains @ 1403 or goes below 1403
she stands to gain Rs. 18,000/-. As prices move up from 1403 to 1453 i.e. diff of Rs.50/-
she stands to loose Rs. 30,000/- (600*50). Now over here her entire profit amount of Rs.
18,000/- has got eroded but on top of that she has made a loss of 12,000/- (i.e. 30000 –
18000) thus she will have to pay in Rs. 12000 to the exchange. The correct answer in d.
Q.5. The May futures contract on XYZ Ltd. closed at Rs.3940 yesterday. It closes today at
Rs.3898.60. The spot closes at Rs.3800. Raju has a short position of 3000 in the May
futures contract. He sells 2000 units of May expiring put options on XYZ with a strike
price of Rs.3900 for a premium of Rs.110 per unit. What is his net obligation to/fromthe clearing
corporation today?
a. Payin of Rs.344200
b. Payout of Rs.640000
c. Payout of Rs.344200
d. Payin of Rs.95800
Solution: On the short position of 3000 May futures contract, he makes a profit of
Rs.124200 (i.e. 3000 * (3940 - 3898.60)). He receives Rs.220000 on the put options sold by
him. Therefore his net obligation from the clearing corporation is Rs.344200. The correct answer in c.