Introduction to Equity Market

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An Introduction to Equity Markets

S. No. Chapter Page No.

1. Equity Market 1

Origin, Definition

2. Exchanges 1

Indian, International, Index trading /formation

3. Indian Stock Market 4

Dynamism, FII flow, Growth

4. Screen Based Trading 5

Online trading mechanism

5. Regulator 6

SEBI, Market Surveillance, Depository, Demat

6. Research Approach 8

Fundamental, Technical, Top down, Bottom up Analysis

7. Terminologies 10

8. Identify Your Clients 14

Arbitrager, Hedger, Speculator, Trader, Investor

9. Derivatives 15


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1. EQUITY OR STOCK MARKET

Are markets in which shares are issued and traded either through exchanges or over-the-counter markets.

Also known as the equity market, it is one of the most vital areas of a market economy as it providescompanies with access to capital and investors with a slice of ownership in the company and the potentialof gains based on the company's future performance.

Stock?

Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on thecompany's assets and earnings. As you acquire more stock, your ownership stake in the company becomesgreater. Whether you say shares, equity, or stock, it all means the same thing. The importance of being ashareholder is that you are entitled to a portion of the companys profits and have a claim on assets.Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion ofthe profits you get.

The securities market has two interdependent segments: the primary (new issues) market and thesecondary market. Primary market is where new issues are first offered, with any subsequent tradinggoing on in the secondary market. The primary market provides the channel for sale of new securities.Secondary market refers to a market where securities are traded after being initially offered to the publicin the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondarymarket. Secondary market comprises of equity markets and the debt markets.

2. ORIGIN & EXCHANGES

Share market in Indian started functioning in 1875. The name of the first share trading association in Indiawas Native Share and Stock Broker's Association, which later came to be known as Bombay Stock Exchange(BSE). This association kicked of with 318 members. Indian Share Market mainly consists of two stockexchanges namely Bombay Stock Exchange (BSE) & National Stock Exchange (NSE)

Bombay Stock Exchange (BSE)

Bombay Stock Exchange is the oldest stock exchange not only in India but in entire Asia. Its history issynonymous with that of the Indian Share Market history. BSE started functioning with the name, TheNative Share and Stock Broker's Association in 1875. It got Government of India's recognition as a stockexchange in 1956 under Securities Contracts (Regulation) Act, 1956. At the time of its origin it was anAssociation of Persons but now it has been transformed to a corporate and demutualised entity. BSE isspread all over India and is present in 417 towns and cities. The total number of companies listed in BSE isaround 3500.

The main index of BSE is called BSE SENSEX or simply SENSEX. It is composed of 30 financially sound

company stocks, which are liable to be reviewed and modified from time-to-time.

Index calculation methodology

SENSEX, first compiled in 1986 was calculated on a "Market Capitalization-Weighted" methodology of 30component stocks representing a sample of large, well established and financially sound companies. Thebase year of SENSEX is 1978-79. From September 2003, the SENSEX is calculated on a free-float marketcapitalization methodology. The "free-float Market Capitalization-Weighted" methodology is a widelyfollowed index construction methodology on which majority of global equity benchmarks are based.


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Launch of Other BSE Indices

The launch of SENSEX in 1986 was later followed up in January 1989 by introduction of BSE NationalIndex (Base: 1983-84 = 100). The BSE National Index was renamed as BSE-100 Index from October 14, 1996 and since then it is

calculated taking into consideration only the prices of stocks listed at BSE. The Exchange launched dollar-linked version of BSE-100 index i.e. Dollex-100 on May 22, 2006. The Exchange constructed and launched on 27th May, 1994, two new index series viz., the 'BSE-200'

and the 'DOLLEX-200' indices. The launch of BSE-200 Index in 1994 was followed by the launch of BSE-500 Index and 5 sectoral

indices in 1999.

In 2001, BSE launched the BSE-PSU Index, DOLLEX-30 and the country's first free-float based index - theBSE TECkIndex. The Exchange shifted all its indices to a free-float methodology (except BSE PSU index) ina pahsed manner.

National Stock Exchange (NSE)

National Stock Exchange (NSE) founded although late than BSE, is currently the leading stock exchange inIndia in terms of total volume traded. It is also based in Mumbai but has its presence in over 1500 townsand cities. In terms of market capitalization, NSE is the second largest bourse in South Asia. National StockExchange got its recognition as a stock exchange in July 1993 under Securities Contracts (Regulation) Act,1956. The products that can be traded in NSE are: - Equity or Share Futures (both index and stock) Options (Call and Put) Wholesale Debt Market

Retail Debt Market

NSE's leading index is Nifty 50 or popularly Nifty and is composed of 50 diversified benchmark Indiancompany stocks. Nifty is constructed on the basis of weighted average market capitalization method.

GLOBAL EXCHANGES

The New York Stock ExchangeThe most prestigious exchange in the world is the New York Stock Exchange (NYSE). The "Big Board" wasfounded over 200 years ago in 1792 with the signing of the Buttonwood Agreement by 24 New York Citystockbrokers and merchants. Currently the NYSE, with stocks like General Electric, McDonald's, Citigroup,Coca-Cola, Gillette and Wal-mart, is the market of choice for the largest companies in America.

American Stock ExchangeThe third largest exchange in the U.S. is the American Stock Exchange (AMEX). The AMEX used to be analternative to the NYSE, but that role has since been filled by the Nasdaq. In fact, the National Associationof Securities Dealers (NASD), which is the parent of Nasdaq, bought the AMEX in 1998.

Nasdaq (History)

The NASDAQ (acronym of National Association of Securities Dealers Automated Quotations) is anAmerican stock exchange. It is the largest electronic screen-based equity securities trading market in theUnited States. It was founded in 1971 by the National Association of Securities Dealers (NASD), who


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divested themselves of it in a series of sales in 2000 and 2001. It is owned and operated by the NASDAQOMX Group. Its main index is the NASDAQ Composite, which has been published since its inception.However, its exchange-traded fund tracks the large-cap NASDAQ 100 index, which was introduced in 1985

alongside the NASDAQ 100 Financial Index.

NASDAQ lists approximately 3,200 securities, of which 335 are non-U.S. companies from 35 countriesrepresenting all industry sectors. To qualify for listing on the exchange, a company must be registered withthe SEC, have at least three market makers (financial firms that act as brokers or dealers for specificsecurities), and meet minimum requirements for assets, capital, public shares, andshareholders.NasdaqOMX now has a dual listing agreement with the Tel Aviv Stock Exchange.Nasdaq istraditionally home to many high-tech stocks, such as Microsoft, Intel, Dell and Cisco.

Dow Jones Industrial Average (DJIA)"The Dow", the DJIA is the oldest and single most watched index in the world. The DJIA includes companieslike General Electric, Disney, Exxon and Microsoft. Charles Dow invented the DJIA back in 1896. The DowJones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York StockExchange and the Nasdaq.

European Market Index - London Stock Exchange (LSE)The primary stock exchange in the U.K. and the largest in Europe, originated in 1773, the regionalexchanges were merged in 1973 to form the Stock Exchange of Great Britain and Ireland, later renamed theLondon Stock Exchange (LSE). The Financial Times Stock Exchange (FTSE) 100 Share Index, or "Footsie", isthe dominant index, containing 100 of the top blue chips on the LSE.

Asian Market Indices

Tokyo Stock Exchange (TSE)

Tokyo Stock Exchange was established on May 15, 1878, and trading began on June 1st.

Japan Stock Exchange: NikkeiJapan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkeiis equivalent to the Dow Jones Industrial Average Index in the U.S. In fact, it was called the Nikkei DowJones Stock Average from 1975 to 1985.

Hong Kong Exchange: Hang Seng Index (HSI)

In Hang Seng index there is market capitalization-weighted index of 40 of the largest companies that tradeon the Hong Kong Exchange. The Index is maintained by a subsidiary of Hang Seng Bank, and has beenpublished since 1969. The index aims to capture the leadership of the Hong Kong exchange, and coversapproximately 65% of its total market capitalization.

3. THE INDIAN STOCK MARKET

With over 25 million shareholders, India has the third largest investor base in the world after USA andJapan. Over 7500 companies are listed on the Indian stock exchanges (more than the number of companieslisted in developed markets of Japan, UK, Germany, France, Australia, Switzerland, Canada and HongKong.). The Indian capital market is significant in terms of the degree of development, volume of trading,transparency and its tremendous growth potential.Indias market capitalisation was the highest among the emerging markets. Total market capitalisation ofThe Bombay Stock Exchange (BSE), which, as on July 31, 1997, was US$ 175 billion has grown by 37.5% per


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cent every twelve months and was over US$ 834 billion as of January, 2007. Bombay Stock Exchanges (BSE),one of the oldest in the world, accounts for the largest number of listed companies transacting their shareson a nation wide online trading system. The two major exchanges namely the National Stock Exchange

(NSE) and the Bombay Stock Exchnage (BSE) ranked no. 3 & 5 in the world, calculated by the number ofdaily transactions done on the exchanges.The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 An increase of 82% fromUS $ 1237 billion in 2004 in a short span of 2 years only. Turnover in the Spot and Derivatives segment bothin NSE & BSE was higher by 45% into 2006 as compared to 2005. With daily average volume of US $ 9.4billion, the Sensex has posted excellent returns in the recent years. The market cap of the sensex as onApril 11th, 2008 was Rs 2,237,540 crore with a P/E of 20.23x.

Sensex Sensex Eps P/E P/E

high low High Low

2002-3 3758 2828 272 13.8 10.4

2003-4 6249 2905 348 18.0 8.3

2004-5 6954 4227 450 15.5 9.42005-6 11356 6118 540 21.0 11.4

2006-7 12671 8800 686 18.5 12.8

2007-8 13950 8799 785 17.8 11.2

SIZE OF EQUITY MARKET, RETURNS (%),P/E

Index CY04 CY05 CY06 CY07

Nifty:

Returns (%) 10.7 36.3 39.8 54.7

End year mcap (Rs crore) 9,02,831 13,50,394 19,75,603 35,22,527

End year P/E 15.32 17.07 21.26 27.62

Bse Sensex

Returns (%) 13.1 42.3 46.7 47.2

End year mcap (Rs crore) 7,35,528 12,13,867 17,58,865 28,61,341

End year P/E 17.1 18.6 22.8 27.7

BSE 500

Returns(%) 17.5 36.6 38.9 63

End year Mcap (Rs crore) 15,80,762 22,81,579 33,36,509 64,70,881

End year P/E 15.2 17.5 20.2 29.1

Trends in Primary MarketsAccording to Sebi data, the average size of IPO has increased from Rs 197 crore in FY06 to Rs 270 crore inFY07 and in FY08 this figure has magnified to 403 crore. Corporates collected Rs.22,131 crore in 2003-04,Rs 25,526 crore in 2004-05, Rs 23,676 crore in 2005-06, Rs 24,993 in 2006-07 and a whopping Rs 51,408crore in 2007-08 (till the end of January 2008).


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FII inflows in India

Net FIIs inflow in India increased steadily through the last decade of the 1990s. The year 2003 was awatershed year for FIIs investments in Indian stock market which reached an annual peak of US$ 10 billionin 2004-2005. This buoyancy continued during 2005-06 and the cumulative FII inflow in 9 months periodending December, 2006 had reached around US$ 10 billion.The cumulative FII inflow till 6th March, 2007 had reached around $ 51.47 billion from $4 million in 1992,reflecting the strong economic fundamentals of the country, as well as confidence of the foreign investorsin the growth and stability of the Indian market.International Corporations which have invested in India include GE, Dupont, Eli Lily, Monsato, Caterpillar,GM, Hewlett Packard, Motorola, Bell Labs, Daimler Chrysler, Intel, Texas Instruments, Cummins, Microsoft,IBM, Honda, Toyota, Mitsubishi, Samsung, LG, Novartis, Bayer, Nestle, Coca Cola and McDonalds To namea few. They have pumped in over US$ 23 billion in the past three years which strengthens Indias position inemerging as a major investment destination for the world investors.Many Japanese and European investors have also started eyeing India, aiming to cash in on the rising equitymarkets. Registrations from non-traditional countries like Denmark, Italy, Belgium, Canada, Sweden andIreland are on the rise. Bill Gates, chairman of Microsoft Corporation, the worlds largest softwarecompany, said that the company will invest US$1.7 billion in India over the next four years to expand itsoperations.

4. INTRODUCTION OF SCREEN-BASED TRADING SYSTEM (SBTS)

Before the NSE was set up, trading on the stock exchanges in India used to take place through open outcrywithout use of information technology for immediate matching or recording of trades. This was timeconsuming and inefficient. The practice of physical trading imposed limits on trading volumes as well as,the speed with which new information was incorporated into prices.

To obviate this, the NSE introduced screen-based trading system (SBTS) where a member can punch into

the computer the quantities of shares and the prices at which he wants to transact. The transaction isexecuted as soon as the quote punched by a trading member finds a matching sale or buys quote fromcounterparty. SBTS electronically matches the buyer and seller in an order-driven system or finds thecustomer the best price available in a quote-driven system, and hence cuts down on time, cost and risk oferror as well as on the chances of fraud.

SBTS enables distant participants to trade with each other, improving the liquidity of the markets. The highspeed with which trades are executed and the large number of participants who can trade simultaneouslyallows faster incorporation of price-sensitive information into prevailing prices.

This increases the informational efficiency of markets. With SBTS, it becomes possible for marketparticipants to see the full market, which helps to make the market more transparent, leading to increasedinvestor confidence. The NSE started nation-wide SBTS, which have provided a completely transparenttrading mechanism. Regional exchanges lost a lot of business to NSE, forcing them to introduce SBTS.

Online Trading Mechanism:

Bombay Stock Exchange's trading system is popularly known as BOLT (BSE's Online Trading System). The BSEhas deployed an OnLine Trading system (BOLT) on March 14, 1995. BOLT has a two-tier architecture. The


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trader workstations are connected directly to the backend server, which acts as a communication serverand a Central Trading Engine (CTE). Other services like information dissemination, index computation, andposition monitoring are also provided by the system. Access to market related information through the

trader workstations is essential for the market participants to act on real-time basis and take immediatedecisions. BOLT has been interfaced with various information vendors like Bloomberg, Bridge, and Reuters.Market information is fed to news agencies in real time. It makes the trade efficient, transparent and timesaving.

NSE provides its customers with a fully automated screen based trading system known as NEAT system, inwhich a member can punch into the computer quantities of securities and the prices at which he likes totransact and the transaction is executed as soon as it finds a matching sale or buy order from a counterparty. It electronically matches orders on a price/time priority and hence cuts down on time, cost and riskof error, as well as on fraud, resulting in improved operational efficiency. It allows faster incorporation ofprice sensitive information into prevailing prices, thus increasing the informational efficiency of markets.The stocks are hold in a demutualised format helping in fast, transparent and efficient preservation andtransactions.

5. REGULATORS OF SECURITIES MARKET

The responsibility for regulating the securities market is shared by Department of Economic Affairs (DEA),Department of Company Affairs (DCA), Reserve Bank of India (RBI) and Securities and Exchange Board ofIndia (SEBI).

Securities and Exchange Board of India (SEBI)

SEBI or Securities and Exchange Board of India is entitled to protect the investors' interests, regulate anddevelop securities market in India. The Securities and Exchange Board of India (SEBI) is the regulatoryauthority in India established under Section 3 of SEBI Act, 1992. SEBI Act, 1992 provides for establishmentof Securities and Exchange Board of India (SEBI) with statutory powers for (a) protecting the interests ofinvestors insecurities (b) promoting the development of the securities market and (c) regulating thesecurities market. Its regulatory jurisdiction extends over corporates in the issuance of capital and transferof securities, in addition to all intermediaries and persons associated with securities market. It passes lawsfor streamlining the Indian share market for efficient outcomes.

Role of SEBI

SEBI has been obligated to perform the aforesaid functions by such measures as itthinks fit. In particular, it has powers for: Regulating the business in stock exchanges and any other securities markets Registering and regulating the working of stock brokers, subbrokers etc. Promoting and regulating self-regulatory organizations Prohibiting fraudulent and unfair trade practices Calling for information from, undertaking inspection, conducting inquiries and audits of the stock

exchanges, intermediaries, self regulatory organizations, mutual funds and other persons associatedwith the securities market.

Market Surveillance Mechanism

In order to ensure investor protection and to safeguard the integrity of the markets, it is imperative tohave in place an effective market surveillance mechanism. The surveillance function is an extremely vital


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link in the chain of activities performed by the regulatory agency for fulfilling its avowed mission ofprotection of investor interest and development and regulation of capital markets.

The surveillance system adopted by SEBI is two pronged viz.:(1) Surveillance Cell in the stock exchange and(2) The Integrated Surveillance Department in SEBI.

(1) Surveillance Cell in the stock exchange

The stock exchanges as said earlier, are the primary regulators for detection of market manipulation, pricerigging and other regulatory breaches regarding capital market functioning. This is accomplished throughSurveillance Cell in the stock exchanges. SEBI keeps constant vigil on the activities of the stock exchangesto ensure effectiveness of surveillance systems. The stock exchanges are charged with the primaryresponsibility of taking timely and effective surveillance measures in the interest of investors and marketintegrity. Proactive steps are to be taken by the exchanges themselves in the interest of investors andmarket integrity as they are in a position to obtain real time alerts and thus know about any abnormalitiespresent in the market.

Unusual deviations are informed to SEBI. Based on the feedback from the exchanges, the matter isthereafter taken up for a preliminary enquiry and subsequently, depending on the findings gathered fromthe exchanges, depositories and concerned entities, the matter is taken up for full-fledged investigation, ifnecessary.

(2) Integrated Surveillance Department in SEBI

SEBI on its own also initiates surveillance cases based on references received from other regulatoryagencies, other stakeholders (investors, corporates, shareholders) and media reports. Being proactive isone of the necessary features for success in taking surveillance measures. Keeping the same in mind, theIntegrated Surveillance Department of SEBI keeps tab on the news appearing in print and electronic media.News and rumours appearing in the media are discussed in the weekly surveillance meetings with the stock

exchanges and necessary actions are initiated.

Integrated Market Surveillance System:In order to enhance the efficacy of the surveillance function, SEBI has decided to put in place a world-classcomprehensive Integrated Market Surveillance System (IMSS) across stock exchanges and across marketsegments (cash and derivative markets).

Depository System

The erstwhile settlement system on Indian stock exchanges was also inefficient and increased risk, due tothe time that elapsed before trades were settled. The transfer was by physical movement of papers. Therehad to be a physical delivery of securities -a process fraught with delays and resultant risks. The secondaspect of the settlement relates to transfer of shares in favour of the purchaser by the company. The

system of transfer of ownership was grossly inefficient as every transfer involves physical movement ofpaper securities to the issuer for registration, with the change of ownership being evidenced by anendorsement on the securitycertificate. In many cases the process of transfer would take much longer than the two months stipulatedin the Companies Act, and a significant proportion of transactions would end up as bad delivery due tofaulty compliance of paper work. Theft, forgery, mutilation of certificates and other irregularities wererampant. In addition, the issuer has the right to refuse the transfer of a security. All this added to costsand delays in settlement, restricted liquidity and made investor grievance redressal time consuming and, attimes, intractable.


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To obviate these problems, the Depositories Act, 1996 was passed. It provides for the establishment ofdepositories in securities with the objective of ensuring free transferability of securities with speed,

accuracy and security. It does so by (a) making securities of public limited companies freely transferable,subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providingfor maintenance of ownership records in a book entry form. In order to streamline both the stages ofsettlement process, the Act envisages transfer ownership of securities electronically by book entry withoutmaking the securities move from person to person. The Act has made the securities of all public limitedcompanies freely transferable, restricting the company's right to use discretion in effecting the transfer ofsecurities, and the transfer deed and other procedural requirements under the Companies Act have beendispensed with. Two depositories, viz., NSDL and CDSL, have come up to provide instantaneous electronictransfer of securities.

In any stock exchange, trades or transactions have to be settled by either squaring up the carrying forwardpositions or settling by payment of net cash or net delivery of securities. This account settlement period, ifit is long leads to several price distortions and allows for market manipulation. It increases the chances ofspeculation resulting in volatility, which hurts the small investors. With the application of IT in thesecurities market - screen-based trading and trading through the Internet - it has been possible to reducethis settlement period.

Dematerialization

Dematerialization or "Demat" is a process whereby your securities like shares, debentures etc, areconverted into electronic data and stored in computers by a Depository.It is safe, secure and convenient buying, selling and transacting stocks without suffering endless paperworkand delays. You can convert your securities to electronic format with a Demat Account.

There are many advantages of holding a demat account. A few important ones' are as below. Shorter settlements thereby enhancing liquidity No stamp duty on transfer of securities held in demat form. No concept of Market Lots. Change of name, address, dividend mandate, registration of power of attorney, transmission etc. can

be effected across companies held in demat form by a single instruction to the DP. A few features of a Demat account are: Dematerialisation of Securities Settlement of Securities traded on the exchange as well as off market transactions Pledging and Hypothecation of Dematerialised Securities Electronic credit in public issue Receipt of non-cash benefits in electronic form

8. METHODS USED TO ANALYZE SECURITIES

The methods used to analyze securities fall into two very broad categories: fundamental analysis and

technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order toestimate its value. Technical analysis takes a completely different approach; it doesn't care one bit aboutthe "value" of a company or a commodity.

Technical Analysis

A method of evaluating securities by analyzing statistics generated charts by market activity, such as pastprices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead


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use charts and other tools to identify patterns that can suggest future activity. Technical analysts believethat the historical performance of stocks and markets are indications of future performance.

Fundamental Analysis

A method of evaluating a security by attempting to measure its intrinsic value by examining relatedeconomic, financial and other qualitative and quantitative factors.

Fundamental analysts attempt to study everything that can affect the security's value, includingmacroeconomic factors (like the overall economy and industry conditions) and individually specific factors(like the financial condition and management of companies).

The biggest part of fundamental analysis involves delving into the financial statements. Also known asquantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the otherfinancial aspects of a company. Fundamental analysts look at this information to gain insight on acompany's future performance. The various fundamental factors can be grouped into two categories:quantitative and qualitative. The financial meaning of these terms isnt all that different from their regulardefinitions.

Quantitative capable of being measured or expressed in numerical terms. Qualitative related to or based on the quality or character of something, often as opposed to its

size or quantity.

Quantitative fundamentals are numeric, measurable characteristics about a business.Qualitative fundamentals, these are the less tangible factors surrounding a business - things such as thequality of a companys board members and key executives, its brand-name recognition, patents orproprietary technology.

Research Approach

Top Down Approach Understanding economy and tracking economic trends to forecast future Top down investors are generally growth investors As emphasis is on economic conditions and market movement, changes contrary to expectations may havea larger impact on the portfolio

Bottom-up Approach Starts with micro analysis at company level Typically look at under-researched companies that have potential to unlock value in LT. Finds favor with value investors In the process of focusing on individual companies, industries and sectors with promising outlook maybe left out


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7. TERMINOLOGIES

Equity/Share

Total equity capital of a company is divided into equal units of small denominations, each called a share.For example, in a company the total equity capital of Rs 2,00,00,000 is divided into 20,00,000 units of Rs10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is said to have 20,00,000 equityshares of Rs 10 each. The holders of such shares are members of the company and have voting rights.

Warrants Certificate issued along with a bond or preferred stock Entitles holder to buy specific no. of securities at a specific price

Convertible Debentures Can be converted in stock at specified date in future At the discretion of either the issuer/lender Issuer can borrow at lower cost if the lender has convertibility option

Rights Issue/ Rights Shares: The issue of new securities to existing shareholders at a ratio to those alreadyheld, at a price. For e.g. a 2:3 rights issue at Rs. 125, would entitle a shareholder to receive 2 shares forevery 3 shares held at a price of Rs. 125 per share.

Bonus Shares: Shares issued by the companies to their shareholders free of cost based on the number ofshares the shareholder owns.

Preference shares: Owners of these kind of shares are entitled to a fixed dividend or dividend calculated ata fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoypriority over the equity shareholders in payment of surplus. But in the event of liquidation, their claimsrank below the claims of the companys creditors, bondholders/debenture holders.

Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remainedunpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares.

Cumulative Convertible Preference Shares: A type of preference shares where the dividend payable on thesame accumulates, if not paid. After a specified date, these shares will be converted into equity capital ofthe company.

IPO (Initial Public Offer)The first issue by a company to public investors

Public IssueAny issue by a company to public investors

Bonus Issue of securities to existing investors in a specific ratio without any consideration being received by theissuer

Rights Issue of securities to existing investors in a specific ratio for a consideration received by the issuer

GDR / ADR (Global Depository Receipt/ American Depository Receipt) Issue of securities that are listed in an international stock exchange; each security representing aspecified number of securities listed in the local stock exchange


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Buyback Acquisition of securities by the issuer from existing investors, through a public offer or purchases in the

secondary market.

Face ValueThe nominal or stated amount (in Rs.) assigned to a security by the issuer. For shares, it is the original costof the stock shown on the certificate; for bonds, it is the amount paid to the holder at maturity. Alsoknown as par value or simply par. For an equity share, the face value is usually a very small amount (Rs. 5,Rs. 10) and does not have much bearing on the price of the share, which may quote higher in the market,at Rs. 100 or Rs. 1000 or any other price. For a debt security, face value is the amount repaid to theinvestor when the bond matures (usually, Government securities and corporate bonds have a face value ofRs. 100). The price at which the security trades depends on the fluctuations in the interest rates in theeconomy.

Dividendis a percentage of the face value of a share that a company returns to its shareholders from its annualprofits. Compared to most other forms of investments, investing in equity shares offers the highest rate ofreturn, if invested over a longer duration.

Market Capitalization

Number of equity shares outstanding x market value per equity share. Represents the market value of theentire company

Enterprise Value

Enterprise value is a figure that, in theory, represents the entire cost of a company if someone were toacquire it. Enterprise value is a more accurate estimate of takeover cost than market capitalizationbecause it takes a number of important factors such as preference shares, debt and cash that are excluded

from the latter matrix.Enterprise value = Mkt cap + preference shares + outstanding debt - cash and cash equivalentMarket capitalization =Number of outstanding shares * CMP

Intrinsic ValueIt is discounted value of cash that can be taken out of a business during its remaining life. It is an estimaterather than a precise figure, and it is additionally an estimate that must be changed if interest rates moveor forecasts of future cash flows are revised. Two people looking at same set of facts will come up withdifferent intrinsic value figures.

Beta

A measure of the volatility of a stock relative to the overall market. A beta of less than one indicates lower

volatility than the market; a beta of more than one indicates higher volatility than the market. GenerallyConsumer and utility stocks have low beta compared to cyclicals and industrials.

Book Value

It shows the historic cost of the assets as reduced by the depreciation. It is significant forevaluating Banking company stocks. Stocks of companies holding large blocks of land and other hiddenassets are evaluated on this basis. It does not make sense to look at book value for companies in highgrowth businesses. BV = Shareholders funds / No. Of Equity shares


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Cost of Capital

This is the cost of borrowing funds from the market.The ROE and the ROCE should be more then the costof capital or else it would make little sense for the company to borrow funds. For stocks in the emergingmarkets the cost of capital should be 300 to 400 basis points above the risk free rate of return.COC = Riskfree rate of return + Equity risk premium.

Debt Equity Ratio

Long-term debt divided by shareholders' equity, showing relationship between long-term funds provided bycreditors with respect to the Shareholders funds. A high Debt Equity ratio indicates high risk while a lowerratio may indicates lower risk. Short-term debt is not included as long as cash is greater then short-termdebt. As equity increases relative to debt, the company becomes a more attractive investment. Finally,bonddebt is preferred to bank debt because bank debt is due on demand. Companies that repay back debtexperience PE expansion compared to companies that take on debt.DER = Long term loans / Shareholders Funds

Dividend yield

This is the current yield on a stock. Dividend paying companies have in built bottoms. When the stockprices fall too much their dividend yield becomes attractive enough for existing investors to hold on as wellas for new investors to get in. This is a basic criterion for a value investorStocks that pay dividends areobviously favored over stocks that don't . Dividend paying stocks are likely to fall less in an economicdownturn As stock prices fall with no fall in dividends, the dividend yield rises attracting new investors.Finally, if you do buy a stock for dividend , you should make sure that the company has a history of payingthe dividendin both good times and bad. DY = Dividend per share / Market Price

Discounted cash flow statement

Discounted Value of free cash flow that a business generates during a particular period of time. Companiesembarking on a major Capital expenditure program will experience reduced free cash flow and lowervaluations. A rise in interest rates increases the cost of capital and also reduces valuations Most of theanalyst fraternity uses this concept. The risk free rate is used as the discount rate. This evaluation tool ishelpful only for evaluating stable businesses rather then high growth businesses

Earning per share (EPS):

This is the net income divided by the number of shares outstanding however; both the numerator anddenominator can change depending on how you define "earnings" and "shares outstanding. The E.PS as anabsolute figure means nothing and is significant only when viewed in relation to the price of the stock. EPS= Net Profits / No. Of Equity Shares

Enterprise Value

EV = Market Capitalization + Debt.Enterprise value for cash rich companies is market cap as reduced by cash. During bear markets smartInvestors are able to spot a number of companies that are available at zero or negative enterprise value. In2002 Trent was available at Rs 60 when it had Rs 100 as cash on its balance sheet. The stock has been amultibagger since.


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EVA

Economic Value added is the excess of ROCE over the cost of capital . Companies with higher EVA's are ableto generate higher PE's and are generally wealth creators compared to companies that have a low ornegative EVA.EVA = (ROCE Cost of capital) Capital employed

Free Cash flowsThe amount of cash left in a company after all expenditure both revenue and capital has been accountedfor. This is also known as net addition to cash. Free cash flow per share = Cash earnings - capital spending.Companies that generate substantial free cash flows make for very good investments.

Growth in Stock Price vs. Growth in earningsA dangerous signal is generated when the stock price of a company increases faster than its earnings.Invariabily this wleads to a higher PE multiple and makes the stocks liable for decline. Generally it isbetter to ivest into businesses their earnings growing at an equal pace to their stock prices.

Market Capitalization

The market cap is the amount of money that the acquirer would need to buy back all the outstandingshares. In case of absurd valuations the market cap reaches stupid levels. During the 2000 tech boomHimachal Futuristic sold at a market cap of Rs 20,000 crores. Multibaggers (stocks that go up a number oftimes) generally have a very small market cap to start with. Companies with a market cap of more then US$ 1 billion are classified as large caps, between US $ 250 million to 1 $billion as mid caps and less then 250million as small caps.Market price x No. Of Equity shares

Market Cap to Sales

It is the number of times the sales exceeds the market cap. For companies in growth businesses the marketcap to sales could be about 3 times whereas for companies in low growth businesses it should be equal to1. The sales number is the most difficult to fudge and therefore the market cap to sales is a more reliableindicator in corporate analysis. In the 2000 technology bubble Infosys traded at a market cap to sales ofmore then 100!Market Cap / Sales

PEG

This is known as the Price earnings to growth ratio. It should be less then equal to 1 Growth in Earnings vs.the P/E Ratio. The ratio will be lower for slow growers and higher for fast growers.PEG = PE / Sustainable Growth

Price Earnings (PE)

This is one of the most widely used tools in sizing up stocks. Simply put, it is how much investors are willingto pay for a rupee of the company's earnings. It is also termed as referred to as a "multiple." When youcalculate a P/E based on the past year's earnings, the P/E is called "trailing." Another way to determine aP/E is to substitute future earnings projections. This is the "forward" P/E (also referred to as the


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"anticipated" P/E). Another way of looking at the PE This as the number of years it will take to earn backthe initial investment.PE = Market price / EPS

Price to BookValue

This is used mainly for Banking (where the book value is adjusted for Non performing assets) and oldeconomy stocks. It is defined as the number of times the market price equals the book value of the stocks.PBV = Market Price / Book Value

Return on Equity (RoE)

Return on Equity (RoE) is an indicator of how efficiently the shareholders funds (Equity) are being used .Companies having a higher RoE tend to be wealth creators and companies having an RoE of less then 15%tend to be wealth destroyers . Normally higher the RoE higher the PE . Companies that are engaged intocommodity businesses have lower RoE's compared to the ones that are engaged into high growthbusinesses. As with the PE Companies that are in the initial stages of growth and are available at smallmarket caps or the ones, which are yet to see the earnings hit a peak, can be bought in spite of having alow RoE. Commodity companies exhibiting very high RoE's are a sign of danger since that would encouragenew entrants to rush in and push prices down.RoE = EPS / Book Value

Return on Market Cap

The percentage that profits that can be earned if an investor buys all the shares from the market. It istheoretically equal to the inverse of the PE (1/PE)

8. IDENTIFY YOUR CLIENTS

HedgersExecuting equal and opposite positions to manage the adversity of price movement in same or differentassets is hedging. In equity hedgers use futures for protection against adverse future price movements inthe underlying cash. The rationale of hedging is based upon the demonstrated tendency of cash prices andfutures values moving in tandem. The hedgers are very often businesses or individuals who at one point oranother deal in the underlying cash script.

SpeculatorsSpeculators are the second major group of futures players. They benefit from price variations and serve ascounter-parties to hedgers. In fact, they accept the risk offered by the hedgers in a bid to gain fromfavourable price changes.

For speculators, futures have a number of advantages over other investments.o They need to invest less capital in futures than in the cash market since they are required to pay only a

fraction of the value of the underlying contract (usually around 30 per cent) as margin.o Further, commission/brokerage charges on futures traders are small compared to what they are in case

of cash trades and other investments.


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ArbitragersArbitragers work at making profits by taking advantage of discrepancy between prices of the same script.If, for example, they see the futures price of an asset getting out of line with the cash price, they would

take offsetting positions in the two markets to lock in the profit.

Funds

There are two types of funds operating in the matured and ideal market, Hedge funds and Trading funds.These funds help investors to make money irrespective of their domain knowledge. They take pool of fundsfrom the investors and trade on informed decisions in the market betting on their experience team.

InvestorInvestors are typically people with having long term prospective in mind. They take usually informeddecisions. Once research is done fully they take positions and provides comfortable time for management,economy and industry before booking their profits.

HNIHigh Networth Investors are people having huge wealth with them and are return chasing or speculativeinvestors. They can some times surpass the trading volumes of the corporates. In general the individualstrading in his/her account with huge volumes and having significant Networth is brought under thiscategory. The definition of HNI varies from broker to brokers depending on the entry-level marginrequirement of the particular brokerage houses.

RetailsThis segment comprises of all other small and marginal investors, which has not been covered in HNIcategory.

Punters/ JobbersPunter and Jobbers are those who operate in very thin margins and bank on their number or volume oftrades to generate revenues. These set of people are suppose to bring high liquidity in the exchange-tradedcontracts.

8. DERIVATIVES

Derivatives are assets, which derive their values from an underlying asset. These underlying assets are ofvarious categories like

Commodities including grains, coffee beans, etc. Precious metals like gold and silver.

Foreign exchange rate. Bonds of different types, including medium to long-term negotiable debt securities issued by

governments, companies, etc. Short-term debt securities such as T-bills. Over-The-Counter (OTC) money market products such as loans or deposits. Equities


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For example, a dollar forward is a derivative contract, which gives the buyer a right & an obligation to buydollars at some future date. The prices of the derivatives are driven by the spot prices of these underlyingassets.

However, the most important use of derivatives is in transferring market risk, called Hedging, which is aprotection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a veryimportant tool of risk management.

There are various derivative products traded. They are;

1. Forwards2. Futures3. Options4. Swaps

To understand these products better lets take an example:

A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of aspecific quality and quantity of asset usually a commodity at a specified future date. The price maybe agreed on in advance or in future.

Forward A contract to buy / sell underlying on future date at price that is determined today Outside the framework of stock exchanges. Therefore

Illiquid No transparent pricing Trades not guaranteed by any stock exchange Futures

Like a forward, but traded in exchange on the basis of standard contracts Regulations permit upto 12 month futures. Now available for 1,2 and 3 months India:

Index Futures (June 2000); Stock Futures (Nov 2001)

Forward contracts are being used in India on large scale in the foreign exchange market to cover thecurrency risk. Forward contracts, being negotiated by the parties on one to one basis, offer thetremendous flexibility to the parties concerned to articulate the contract in terms of the price, quantity,quality (in case of commodities), delivery time and place.

Forward contracts however have poor liquidity and default risk (credit risk). Let us understand it in detail:

Liquidity risk:

Liquidity is generally defined as the ability of the operator to buy or sell the asset whenever he/she wantsto do so. Now, these forward contracts, being traded on one to one basis, are tailor made contractscatering to the specific needs of the parties involved and so are not listed and traded on the exchanges. Incase of change of perception of either of the parties after entering into contract but before contractsmaturity, if he/she wants to come out of the contract, he/she has the necessarily to go to the same party,who being in a monopoly situation can exploit a weak counter party. Therefore, liquidity of these contractsis poor.


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Default risk/credit risk/counter-party risk:

Forward contracts, as defined above are traded on one to one basis and so each party is exposed to

counter-partys credit risk i.e. the risk of default exists in case of forward contracts.

FUTURE CONTRACT

A Future contract is a firm contractual agreement between a buyer and seller for a specified as on afixed date in future. The contract price will vary according to the market place but it is fixed whenthe trade is made. The contract also has a standard specification so both parties know exactly whatis being done.

These contracts are traded on the exchanges. Futures markets are the extension of the forward markets.These markets being organized/ standardized are very liquid by their own nature. Therefore, liquidityproblem, which persists in the forward market, does not exist in the futures market.

In these markets, clearing corporation/house becomes the counter-party to all the trades or providesunconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the wholesystem. In other words, we may say that the credit risk of the system is eliminated by the exchangethrough the clearing corporation/ house.

Major distinction between forward and future contract is summarized below

Features Forward Contract Future Contract

Operational Mechanism Not traded on exchange Traded on exchange

Contract Specifications Differs from trade to trade. Contracts are standardized

contracts.

Counter party Risk Exists Exists, but assumed by

Clearing Corporation/ house.

Liquidation Profile Poor Liquidity as contracts

are tailor maid contracts.

Very high Liquidity as

contracts are standardized

contracts.


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Price Discovery Poor; as markets are

fragmented.

Better; as fragmented

markets are brought to the

common platform.

OPTIONS

An Options contractconfers the right but not the obligation to buy (call option) or sell (put option) aspecifiedunderlying instrument or asset at a specified price the Strike or Exercisedprice up until oran specified future date the Expiry date. The Price is called Premium and is paid by buyer of theoption to the seller or writerof the option.

Option Unlike a future, in an option, only one party is committed, the other has an option i.e. a right, but not anobligation The party that has the option is the option buyer The party that is committed is the option writer. Earns a premium for taking such a position Price at which the option buyer can exercise the right is the exercise price / strike price Date on which contract would lapse is theexpiration date The option can be to buy (call option) or to sell (put option) India:

Index Options (June 2001); Stock Options (July 2001))

Understand that option buyer has the right and option seller has the obligation i.e. option buyer may ormay not exercise the option given, but, if option buyer decides to exercise the option, option seller has no

choice but to honor the obligation.

A call option gives the holder the right to buy an underlying asset by a certain date for a certainprice. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called "thecall option premium or call option price".

A put option, on the other hand gives the holder the right to sell an underlying asset by a certaindate for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this,which is called "the put option premium or put option price".

For Instance,

Suppose Mr. Dhiraj is bullish and feels that the share price of Reliance will rise in future. Thereforehe buys Out of money Reliance capital call at 350. Spot price is 330 at a premium outflow of Rs. 20/-. Lotsize of reliance capital is 1100. Eventually he lands out paying Rs.22000/- and leveraged his position. If themarket goes up from Rs. 350, he makes profit. However if his expectation proves wrong and reliancecapital slides down. His loss is limited to his premium amount. Thus premium is a sunk cost for optionbuyer.


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KEY TERMS IN OPTIONS

Before diving deep in the option market lets understand the key term in option trading, which are

repeatedly used and also the factors that influence the option price.

Strike Price: - The stated price per share for which underlying stock may be purchased(for a call) or sold (for a put) by option holder upon exercise of the option contract. (ExReliance capital call at 350)

Expiration Date: - The date on which option expires is expiration date, the Exercised date, thestrike date or the maturity date. It is the last day on which option can be exercised. Optionnormally has a month and/or quarterly expiration cycle.

Option Price: - Option price is the price, which the option buyer pays to the option seller. It isalso referred to as option premium. The Premium depend on various factors like strike price,Stock price, Expiration date, Volatility, Interest rate. The buyer pays premium to seller. Onreceiving the premium seller has the obligation to exercised the option when assigned to him

American option: - American options are option that can be exercised any time upon theexpiration date. Most exchange-traded option is American. Options on individual stocks areAmerican. Ex. Reliance. CA, Tisco .PA, SBI. CA

European option: - European options are option that can be exercised only on the expirationdate itself. Index based option are European option. Ex. NIFTY CE

Where;

CA: Call American

PA: Put American

CE: Call European

PE: Put European

In the money: An in the money (ITM) option is an option that would lead to positivecash flows to the holder if it was exercised immediately. A call option is ITM when spot price isgreater than strike price. If the difference is huge it is called deep in the money

At-the-money: An at the money (ATM) option will lead to zero cash flow if exercisedimmediately. Option is at the money if strike price is equal to spot price.

Out-of-the-money: An out of money (OTM) option will lead negative cash flow ifexercised immediately. In case of call option if strike price is greater than spot price than it is

OTM. Whereas in case of put option if strike price is less than spot price it is OTM

Example:


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Stock: INFOSYS

Spot Price (S): 2300

Strike Price(K): 2200 2300 2400

Intrinsic Value of an option: Option premium has two parts in it, i.e. Intrinsic value and Timevalue.

Intrinsic value means how much is option ITM. Deeper is the option in the money moreis the intrinsic value of an option. If the option is Out of the money or at the money itsintrinsic value is zero.

For a call option intrinsic value is

Max (0, (St K)) and

For a put option intrinsic value is

Max (0, (K - St ))

In other words Intrinsic value can only be positive or zero.

ITM ATM OTM

CALL S > K

2300 > 2200

S = K

2300 = 2300

S < K

2300 < 2400

PUT S < K

2300 < 2400

S = K

2300 = 2300

S > K

2300 > 2200


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Time Value of an option: Time value of option is difference between Premium andIntrinsic value. Both call and put have time value. ATM and OTM option only have timevalue and no Intrinsic value.

The portion of the option premium that is attributable to the amount of time remaining untilthe expiration of the option contract. ATM option has the highest time value. It is probabilityof option going ITM. Generally as there is more time to expiration greater is the Time Value.As the time remaining to maturity reduces time value decreases and becomes zero onmaturity .

Example;

ONGC Spot ( S ): 960

ONGC Strike ( K ): 940 960 980

EXPIRY : 28th July 2005

Fundamental Understanding of Derivatives

Derivatives provide platform to investor to make huge profit by leveraging their position. Howeverit is double edge sword if not handled properly may result in huge losses too. So as a prudent and smartinvestor one must look at the signal that markets continuously provides to make a right decision by takingcalculative risk.

CALLSTRIKE PREMIUM

940 35960 12980 4

FUT/OPT

EXPIRY

CALL

/PUT

STRIKE SPOTTYPE OFOPTION

PREMIUM

INTRINSIC

VALUE

TIME

VALUEOPTSTK 28JUL2005 CA 940 960 ITM 35 (960-940) = 20 15

OPTSTK 28JUL2005 CA 960 960 ATM 12

(960-960) =

0

12

OPTSTK 28JUL2005 CA 980 960 OTM 4

(960-980) =

(-20) so 0

4


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The most important parameter to judge the performance of stock in Future and Option market isOPENINTEREST

OPEN INTEREST:

Open interest and volumes are very close to each other. However Volumes considered total tradecarried out whereas open interest is number of outstanding contracts at a particular time. It is morerelevant as it considers number of contract which are outstanding and not squared off by the investor.

Further Open interest increases only when new contract is traded i.e when existing parties (Buyeror seller) enters in fresh position and not square of or when new parties enter into a contract whereas

Open interest decreases when existing parties i.e. Buyer as well as seller square off their position.

Buyer of the contract sells it

Seller of the contract buys it

Example:

Suppose trade is taking place in Infy Futures on 1st July 2005

Time Trader Trade Change Net openInterest

10.55 A.M.s Mr. Subhash

Mr. Ankit

Buy 2 Futures

Sells 2 Future

2

12.00 Noon Mr. Ankit

Ms. Seema

Buy 2 Futures

Sells 2 Futures

=

2

2:30 P.M. Ms. Dhiraj

Mr. Sunil

Sells 4 Futures

Buys 4 Futures

6

3:25 P.M Mr. Subhash

Ms. Seema

Sells 2 Futures

Buys 2 Futures

4

Open Interest along with Price movement is consider a good indicator of market trend

OPEN INTEREST PRICE OUTLOOKPOSITIVE

NEGATIVE

POSITIVE

NEGATIVE


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PUT-CALL RATIO

While most options traders are familiar with the leverage and flexibility that options offer, noteverybody is aware of their value as predictive tools. Yet one of the most reliable indicators of futuremarket direction is a contrarian sentiment measure known as the Put/Call options volume ratio.

Put option gives the right to sell the option at a predetermined price whereas call option givesright to sell. While too many put buyer usually signals that market bottom is nearby while too many callbuyer indicates market top is making.

Put call ratio is simply number of put contracts divided by number of call contracts traded duringthe particular day. Higher put call ratio signifies market player are bearish and feel stock may fall whereaslower put call ratio tells the opposite story.

However signals thrown by market player contradicts the real outcome. Higher PCR portrays thatthe stock is oversold and reversal is on the way .Its right time to get in. whereas Lower PCR portrays thatthe stock is over bought and downward trend is soon expected.

The Put/call ratio is yet another solid weapon within a speculator's arsenal to trade and give clearpicture many time that when to exit or when to enter the market but then also one cannot rely only onPut/call ratio to survive in the market and earn money. This fact also cannot be ignored that it is a verypowerful tool, which help speculator up to a great extent to prejudge the market movement and investaccordingly.

Volatility

Volatility is a statistical measure of the amount of fluctuation in a stocks price within a period of time. Astock with high volatility would have rapid up and down movements in its stock price. A stock with verylittle movement in its price would constitute low volatility. There are two main measures of Volatility:Historical Volatility & Implied Volatility. Historical volatility will be discussed in this report whereasimplied volatility will be explained in the subsequent report.

Historical Volatility is a statistical measure of the volatility of a futures contract, security, or otherinstrument over a specified number of past trading days

Historical volatility is the measure of a stocks price movement based on historical prices. It measures how

active a stock price typically is over a certain period of time. Usually, historical volatility is measured bytaking the daily (close-to-close) percentage price changes in a stock and calculating the average over agiven time period. The average is then expressed as an annualized percentage. Historical volatility is oftenreferred to as actual volatilityor realized volatility.

Short-term or more active traders tend to useshorter time periods for measuring historical volatility, themost common being 5-day, 10-day, 20-day and 30-day. Intermediate-term and long-term investors tend touse longer time periods, most commonly 60-day, 180-day and 360-day.


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Implied Volatility can be defined as the volatility of an instrument as implied by the prices of an option onthat instrument, calculated using an options pricing model. An options value consists of severalcomponents The strike price, expiration date, the current stock price, dividends paid by the stock (if

any), the implied volatility of the stock and interest rates.

Instead of substituting a volatility parameter into an option model (e.g. Black-Scholes) to determine anoption's fair value, the calculation can be turned round, where the actual current option price is input andthe volatility is output. Therefore implied volatility is that level of volatility that will calculate a fair valueactually equal to the current trading option price.

This calculation can be very useful when comparing different options on the same underlying & differentstrike prices. The implied volatility can be regarded as a measure of an option's "expensiveness" in themarket, and is used by traders setting up combination strategies, where they have to identify relativelycheap and expensive option contracts.

As there are many options on a stock, with different strike prices and expiration dates, each option can,and typically will, have a different implied volatility. Even within the same expiration, options withdifferent strike prices will have different implied volatilities.

FUTURES ARBITRAGE

Arbitrage is the act of simultaneously buying and selling assets or commodities in an attempt to exploit aprofitable opportunity.

Arbitrage is done between two related instruments that are temporarily mis-priced. For example, thefutures price and spot price are related by the interest rate, time to maturity and corporate benefit, ifany, in the interregnum.

If the two prices do not move in tandem, then it throws up arbitrage opportunity. An arbitrageur will buy

what is cheap and sell what is costly and lock in profits without any risk.

INDEX ARBITRAGE

Index Arbitrage is the basis between the Index (Nifty) futures and its constituents (Basket).

Nifty future is in discount to Nifty spot Buy Nifty Futures and Sell Basket.

Nifty future is in premium to Nifty spot Buy Basket and Sell Nifty Futures.

As we cant trade in Nifty spot, we have to create Basket of Nifty components either with underlying stockor stock futures.

PROCESS

If Nifty is in discount (as quite often), then you have to sell basket.

As you cannot short sell in cash, we will be creating basket using stock futures.

Advantage of using stock futures is only margin money will be deployed.

We will be creating Basket based on the weight of the constituents in the Nifty.(Market CapitalizationMethod)


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We have to make portfolio - Perfect Hedge.

HEDGING

Protecting the value of an asset against risk arising out of fluctuations in price is known as hedging.Technically hedging means transfer of risk from the asset holder to another person who is willing to carryrisk.

When an investor is bearish on market, he can hedge his position by taking countervailing position againsthis portfolio, say, selling Nifty futures.

If the market falls, the fall in portfolio value will be compensated by the gains on the Nifty futures. But ifthe market rises, the rise in the portfolio value would be offset against the futures loss.

The same concept can be applied to any stocks which have a presence in futures market. The result of anyPerfect Hedge contract is No Profit and No Loss

PORTFOLIO HEDGING

To hedge portfolio, we need to calculate the Beta of the Portfolio and then hedge the Portfolio against theprice risk.

Beta measures the sensitivity of the stock to the broad market index. So if the beta of the stocks Portfoliois 1.05, and if the markets rise by 1%, then the Portfolio is likely to go up 1.05% and same goes for negativemovement too.

Calculate the number of Nifty contracts needed for Hedging. We can use the formula (Portfolio Beta x

Portfolio Value) / Futures Value.

e.g.:- Portfolio value = Rs. 1,00,00,000, Nifty value = 4,50,000(4500*100) and Beta of Portfolio =1.05No. of contracts = (1,00,00,000*1.05)/4,50,000

= 24 contractsSo we need to sell 24 contracts of Nifty to hedge the Long Portfolio.

Greeks

The Greeks are various functions that show the sensitivity of Fair Value of an option to changes in marketconditions. These functions are very helpful in assessing and comparing various option positions. They showwhat effect different variables will have on the fair value price of an option. There are ways of estimatingthe risks associated with options, such as the risk of the stock price moving up or down, implied volatility


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moving up or down, or how much money is made or lost as time passes. They are numbers generated bymathematical formulas. Collectively, they are known as the "Greeks", because most use Greek letters asnames. Each greek estimates the risk for one variable: delta measures the change in the option price due

to a change in the stock price, gamma measures the change in the option delta due to a change in thestock price, theta measures the change in the option price due to time passing, Vega measures the changein the option price due to volatility changing, and Rho measures the change in the option price due to achange in interest rates.

Delta

The first and most commonly used greek is "delta". For the record, and contrary to what is frequentlywritten and said about it, delta is NOT the probability that the option will expire ITM. Simply, delta is anumber that measures how much the theoretical value of an option will change if the underlying stockmoves up or down Rs.1.00. Positive delta means that the option position will rise in value if the stock pricerises, and drop in value if the stock price falls. Negative delta means that the option position willtheoretically rise in value if the stock price falls, and theoretically drop in value if the stock price rises.

The delta of a call can range from 0.00 to 1.00; the delta of a put can range from 0.00 to 1.00. Long callshave positive delta; short calls have negative delta. Long puts have negative delta; short puts have positivedelta. Long stock has positive delta; short stock has negative delta. The closer an option's delta is to 1.00or 1.00, the more the price of the option responds like actual long or short stock when the stock pricemoves.

So, if the IFCI Mar 50 call has a value of Rs.2.00 and a delta of +.45 with the price of IFCI at Rs.48, if IFCIrises to Rs.49, the value of the IFCI Mar 50 call will theoretically rise to Rs.2.45. If IFCI falls to Rs.47, thevalue of the IFCI Mar 50 call will theoretically drop to Rs.1.55.

If the IFCI Mar 50 put has a value of Rs.3.75 and a delta of -.55 with the price of IFCI at Rs.48, if IFCI risesto Rs.49, the value of the IFCI Mar 50 put will drop to Rs.3.20. If IFCI falls to Rs.47, the value of the IFCI

Mar 50 put will rise to Rs.4.30.

An ATM option has a delta close to .50. The more ITM an option is, the closer its delta is to 1.00 (for calls)or 1.00 (for puts). The more OTM and option is, the closer its delta is to 0.00.

The delta of an option depends largely on the price of the stock relative to the strike price. Therefore,when the stock price changes, the delta of the option changes.

Gamma

Gamma is an estimate of how much the delta of an option changes when the price of the stock movesRs.1.00. As a tool, gamma can tell you how "stable" your delta is. A big gamma means that your delta can

start changing dramatically for even a small move in the stock price.

Long calls and long puts both always have positive gamma. Short calls and short puts both always havenegative gamma. Stock has zero gamma because its delta is always 1.00 it never changes. Positive gammameans that the delta of long calls will become more positive and move toward +1.00 when the stock pricesrises, and less positive and move toward 0.00 when the stock price falls. It means that the delta of longputs will become more negative and move toward 1.00 when the stock price falls, and less negative andmove toward 0.00 when the stock price rises. The reverse is true for short gamma.


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For example, the IFCI Mar 50 call has a delta of +.45, and the IFCI Mar 50 put has a delta of -.55, with theprice of IFCI at Rs.48.00. The gamma for both the IFCI Mar 50 call and put is .07. If IFCI moves up Rs.1.00to Rs.49.00, the delta of the IFCI Mar 50 call becomes +.52 (+.45 + (Rs.1 * .07), and the delta of the IFCI

Mar 50 put becomes -.48 (-.55 + (Rs.1 * .07). If IFCI drops Rs.1.00 to Rs.47.00, the delta of the IFCI Mar 50call becomes +.38 (+.45 + (-Rs.1 * .07), and the delta of the IFCI Mar 50 put becomes -.62 (-.55 + (-Rs.1 *.07).

Gamma measures how much the delta of a position changes when the stock price moves Rs.1.00. At-the-money options have the highest Gammas. Gamma decreases as you go in-the-money or out-of-the-money.Gamma is sometimes used as a risk management tool to manage a large portfolio, because it tends toreflect the speed of an option. Options with high gamma are the most responsive to price movements, sothey provide the most help in covering directional exposure

Theta

Theta, a.k.a. time decay, is an estimate of how much the theoretical value of an option decreases when 1

day passes and there is no move in either the stock price or volatility. Theta is used to estimate how muchan option's extrinsic value is whittled away by the always-constant passage of time.

Long calls and long puts always have negative theta. Short calls and short puts always have positive theta.Stock has zero theta its value is not eroded by time. All other things being equal, an option with moredays to expiration will have more extrinsic value than an option with fewer days to expiration. Thedifference between the extrinsic value of the option with more days to expiration and the option withfewer days to expiration is due to theta. Therefore, it makes sense that long options have negative thetaand short options have positive theta. If options are continuously losing their extrinsic value, a long optionposition will lose money because of theta, while a short option position will make money because of theta.

But theta doesn't reduce an option's value in an even rate. Theta has much more impact on an option withfewer days to expiration than an option with more days to expiration. For example, the IFCI Oct 75 put is

worth Rs.3.00, has 20 days until expiration and has a theta of -.15. The IFCI Dec 75 put is worth Rs.4.75,has 80 days until expiration and has a theta of -.03. If one day passes, and the price of IFCI stock doesn'tchange, and there is no change in the implied volatility of either option, the value of the IFCI Oct 75 putwill drop by Rs.0.15 to Rs.2.85, and the value of the IFCI Dec 75 put will drop by Rs.0.03 to Rs.4.72.

Theta is highest for ATM options, and is progressively lower as options are ITM and OTM. This makes sensebecause ATM options have the highest extrinsic value, so they have more extrinsic value to lose over timethan an ITM or OTM option. The theta of options is higher when either volatility is lower or there are fewerdays to expiration. The longer the stock price does not move big, the more theta will hurt your position.

Vega

Vega (the only greek that isn't represented by a real Greek letter) is an estimate of how much thetheoretical value of an option changes when volatility changes 1.00%. Higher volatility means higher optionprices. The reason for this is that higher volatility means a greater price swings in the stock price, whichtranslates into a greater likelihood for an option to make money by expiration.

Long calls and long puts both always have positive vega. Short calls and short puts both always havenegative vega. Stock has zero vega it's value is not affected by volatility. Positive vega means that thevalue of an option position increases when volatility increases, and decreases when volatility decreases.


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Negative vega means that the value of an option position decreases when volatility increases, and increaseswhen volatility decreases.

Let's look at the IFCI Mar 50 call again. It has a value of Rs.2.00 and a vega of +.20 with the volatility ofIFCI stock at 30.00%. If the volatility of IFCI rises to 31.00%, the value of the IFCI Mar 50 call will rise toRs.2.20. If the volatility of IFCI falls to 29.00%, the value of the IFCI Mar 50 call will drop to Rs.1.80.

Vega is highest for ATM options, and is progressively lower as options are ITM and OTM. This means that thevalue of ATM options changes the most when the volatility changes. The vega of ATM options is higher wheneither volatility is higher or there are more days to expiration.

Rho

Rho is an estimate of how much the theoretical value of an option changes when interest rates move1.00%. The rho for a call and put at the same strike price and the same expiration month are not equal.Rho is one of the least used greeks. When interest rates in an economy are relatively stable, the chance

that the value of an option position will change dramatically because of a drop or rise in interest rates ispretty low.

Long calls and short puts have positive rho. Short calls and long puts have negative rho. How does thishappen? The cost to hold a stock position is built into the value of an option.

The more expensive it is to hold a stock position, the more expensive the call option. An increase ininterest rates increases the value of calls and decreases the value of puts. A decrease in interest ratesdecreases the value of calls and increases the value of puts.

Back to the IFCI Mar 50 calls. They have a value of Rs.2.00 and a rho of +.02 with IFCI at Rs.48.00 andinterest rates at 5.00%. If interest rates increase to 6.00%, the value of the IFCI Mar 50 calls would increase

to Rs.2.02. If interest rates decrease to 4.00%, the value of the IFCI Mar 50 calls would decrease to Rs.1.98.

STRATEGYOption is used as a hedging tool

HEDGING represents a strategy, which aims at limiting the loss in one position by taking a off-setting position in same securities or another security. Hedging does not completely eliminate the lossesbut it just minimizes it.

Very often option is used for hedging in combination with having a long/ short position inunderlying. Its done when volatility seems to be high and thus to minimize the downward risk.

Strategies:

Hedging by buying option

Long position, buy put

Short position, buy call

Hedging by selling option


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Long position, sell call (Covered Call)

Short position, sell put

(I) Long position, buy put

Suppose there is a small retail investor Mr. Sharma who is holding the 1000 Essar Oil stock at aprice of RS. 290. Having seen large movement in January month he still feels that the stock is goodand its potential to rise further is intact. However a small sceptism arise as nifty is currently trailingat 5200 level and correction is possible at any time and so stock price may come down. Being a smartinvestor he limits his downward risk by buying 1000 OTM put at 280 at premium outflow of Rs. 14. Hispayoff at various spot prices would be

Thus Mr. Sharma has hedged his downward risk to the extent of Rs. 2400/-(24*1000). But hisprofit potential is unlimited ones the stock price crosses 304 where it breaks even. Thus he hashedged his downward risk instead of just holding a naked position.

Summary:

Profit: Unlimited aboveBreakeven

Loss: Limited (X-S) + (P)= (280-290)+(-14)= -24

Break even: S+(S-X)+(P)=290+(290-280)+14= 304

SharePrice

ExercisePrice

PREMIUMOutflow

Profit onExercise (i)

Profit / Loss onShare Held (ii)

Net Profit(i) + (ii)

260 280

14

6 -30 -24

270 28014

-4 -20 -24

280 28014

-14 -10 -24

290 280 14 -14 0 -14

300 280 14 -14 10 -4

304 28014

-14 14 0

310 280 14 -14 20 6

320 280 14 -14 30 16

350 280 14 -14 60 46


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Covered CALL

METHODOLOGY: Buying a stock, Writing a call

One can hedge its long position in stock by writing a option. Writer of a option has a limited profit to theextent of premium received, however loss is unlimited. . As an example, suppose that Mr. Mehta holdshares of a stock, which he expect will experience small changes in the short term, then he may write acall on these. This is known as coveredcalls. By writing covered call options, you tend to raise the short-term returns. Of course, you will not derive any benefit if large price changes occur because then theoption will be exercised or, else, you would have to make a reversing transaction.

Suppose Mr. Mehta has 300 stocks of ONGC bought at 980. He feels that ONGC will rise in future. Howeverin the worst scenario when market turns around and losses are huge Mehtaji writes a call at 1020 with thepremium inflow of 20.

When share price are expected to remain flat, the writing calls can be used to generate income, while alsoproviding some protection against an unexpected fall in the market. In the above case Mr. Mehta hashedged its naked position by selling OTM call. However if the share price rises above 1040, call buyer willexercised and he should be ready to deliver the share.

Summary:

Profit: Limited to (X-S) + P i.e. (1020-980) +20 = 60

Loss: Unlimited if market moves downwards

Breakeven: S-P = 980-20 =960

SharePrice

Exerciseprice

Premium P/L onexercise ofcall

Profit onExerciseoption

(I)

P/L on sharesheld(II)

Net profit+(II)

920 1020 20 0 20 -60 -40

940 1020 20 0 20 -40 -20

960 1020 20 0 20 -20 0

980 1020 20 0 20 0 20

1000 1020 20 0 20 20 40

1020 1020 20 0 20 40 60

1040 1020 20 -20 0 60 60


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Reverse of Covered Call:

This strategy is reverse of writing a covered call. It is applied by taking a long position or buying a calloption and selling the stocks. Example:

Mr. Prashant enters into buying a call option on one lot of Rel. Petro. At a strike price of Rs.60 and apremium of Rs.6 per share. The maturity date is two months from now and along with this option he/shesells a share of Rel. Petrol. in the spot market at Rs. 58 per share.

The payoff chart describes the payoff of buying the call option at the various spot rates and the profit fromselling the share at Rs.58 per share at various spot prices. The thick line shows the net profit.

Thus Mr. Prashant is safeguard from future losses if share price goes up by buying call option o

Summary

SPREADS

In the above strategies only one option was traded. Spread involves taking a position in two ormore option of the same type (i.e. Two or more call or two or more put)

Bull Call Spread:

BUYING A REVERSE COVERED CALL OPTION

S Xt cProfit frombuying calloption

Net Profit fromCall Buying

Spot Price ofSelling thestock

Profit fromstock

Total Profit

46 60 -6 0 -6 58 12 6

48 60 -6 0 -6 58 10 4

50 60 -6 0 -6 58 8 2

52 60 -6 0 -6 58 6 0

54 60 -6 0 -6 58 4 -2

56 60 -6 0 -6 58 2 -4

58 60 -6 0 -6 58 0 -6

60 60 -6 0 -6 58 -2 -8

62 60 -6 2 -4 58 -4 -8

Profit: Unlimited profit if market moves below 52 unlimited

Breakeven: X- net P 60-8= 58

Loss: Limited to net premium i.e. (X-S)+(P) 60-58 +6 =8


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When the investor is bullish that the stock price will rise further he goes for creating a spread. The spreadhas the advantage of being cheaper to establish than the purchase of a single call, as the premium receivedfrom the sold call reduces the overall cost. The spread offers a limited profit potential if the underlying

rises and a limited loss if the underlying falls.

Example:

Ms. Kiran is very bullish on steel sector and feels that the prices of Tisco will move aheadtherefore she buys one ATM call at350 with premium outgo of Rs. 11 and sells one OTM Call at 380 at Rs. 3

If the stock price rules between the strike prices of the two calls, the purchased call is In-the-money whilethe call sold expires unexercised. Thus, the payoff equals the difference between the stock price and the(lower) exercise price. If the stock price is greater than higher exercise price, both options are In-the-

money and the payoff equals the difference between the exercise prices of the two options.

Summary:

Profit: Limited to the difference between the two strikes minus net premium cost. Maximum profitoccurs where the underlying rises to the level of the higher strike (2) or above.

Loss: Limited to any initial premium paid in establishing the position. Maximum loss occurs wherethe underlying falls to the level of the lower strike (1) or below.

PAYOFF FROM BULL SPREAD (CALL)

Priceofstock(S)

Strikeprice ofcallbought(X1)

Strikepriceof callSold(X2)

PremiumFor1st call(P1)


Netpremiumcost

Profitfrom1st call

Profitfrom2nd call

Total Profit

340 350 380 11 3 8 0 0 -8

350 350 380 11 3 8 0 0 -8

358 350 380 11 3 8 8 0 0

360 350 380 11 3 8 10 0 2

370 350 380 11 3 8 20 0 12380 350 380 11 3 8 30 0 22


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Break-even: Reached when the underlying is above strike (1) by the same amount as the net cost ofestablishing the position.

Bull Spread by entering in a put option

Suppose Ms. Kiran trade in two put option (Put option gives the right to sell the option at a determinedprice). She buys one OTM option of TISCO at 330 at 3.5 and sells one ITM option at 360 at 17. TotalPremium inflow is 17-3.5 =13.5.

PAYOFF TABLE

Summary

Profit: Limited to the net premium credit. Maximum profit occurs where underlying rises to the level of the

higher strike B or above.

Loss: Maximum loss occurs where the underlying falls to the level of the lower strike A or below.

PRICE OFSTOCK

PAYOFFFROMLONG PUT

PAYOFFFROMSHORT PUT

TOTALPAYOFF

NET PROFIT WHICH OPTIONIS EXERCISED

S1 > X2 0 0 0 X2-X1 NONEX1 < S1


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Break-even: Reached when the underlying is below strike B by the same amount as the net credit ofestablishing the position

BEAR SPREAD

An investor who enters in bear spread is bearish and feels that stock price will decline. In adeclining market too investor can make profit both by using call and put. However this strategy is oppositeof that of Bull spread. Investor buys higher strike call and sells lower strike call. Thus there is a netpremium inflow.

For Instance Mr. Rakesh is bearish about nifty and feels that market will correct from here.He buys Nifty call at 2260 at premium of Rs.27 and sells lower strike call at 2230 at 40. Spot Nifty is trailingat 2226. Prudent investor Mr. Rakesh receives net premium of Rs. 13. Lot size of nifty is 100.

Payoff Table

Summary:

Profit: Limited to the net premium credit. Maximum profit occurs where underlying falls to the level ofthe lower strike or below X1. i.e. = 13

Loss: Limited to the difference between the two strikes minus the net credit received in establishing theposition. Maximum loss occurs where the underlying rises to the level of the higher strike B orabove. i.e. = (2260-2230) 13 = 17

PAYOFF FROM BEAR SPREAD (CALL )

Price ofstock(S)

Srikeprice ofcallSold(X1)

Srikeprice ofcallBought(X2)



Netpremiumcredit

Lossfrom 1stcall

Profitfrom2nd call

TotalProfit

2200 2230 2260 40 -27 13 0 0 13

2210 2230 2260 40 -27 13 0 0 13

2220 2230 2260 40 -27 13 0 0 13

2230 2230 2260 40 -27 13 0 0 13

2240 2230 2260 40 -27 13 -10 0 3

2243 2230 2260 40 -27 13 -13 0 0

2250 2230 2260 40 -27 13 -20 0 -7

2260 2230 2260 40 -27 13 -30 0 -17

2270 2230 2260 40 -27 13 -40 10 -17


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Break-even: Reached when the underlying is above strike price X1 by the same amount as the net credit ofestablishing the position. i.e. = 2230+ 13 = 2243

Combo Strategy:

Option strategies not only include trading in same option. In fact we can have combo strategy i.e. tradingboth in call as well as put. The strategy to be used depends upon market outlook:

Bearish outlook: Long Combo: Sell a higher strike call

Buy a lower strike put

Bullish outlook: Short Combo: Buy a higher strike call

Sell a lower strike put

A) Short Combo:

Suppose Mr. Vinay is bullish on Information Technology sector and feels that Infosys will ride up. Howeverto reduce its cost he buys one option and sells another. Currently spot Infy stands at 2400. He buys a OTMcall at 2460 at Rs.50 and sells ITM put at 2370 at 75. Thus he has net premium credit of Rs. 25/-. ShortCombo is used when investor is bullish, however when volatility is uncertain is advisable to go for ShortCombo.

In this strategy investor is taking advantage of both the option simultaneously.

Documents

Introduction to Equity Market