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8/9/2019 Stock Market Operations and Derivative Trading
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STOCK MARKET OPERATIONS:
CASH MARKET &DERIVATIVE
TRADING Dr.B.L.GUPTA
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The selection of any investment proposal
is largely dependent upon the followingfeatures :
1. Safety,
2. Liquidity, and3. Return.
Essential Features of an Investment
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N o one in the world ever became richwithout taking any risk.
The ships are safe in the harbour but theyare not built for this purpose.
Taking no risks may also mean forgoingrewards
In fact, everyone in this World is aspeculator and every thing we do is aspeculation.
INV ESTME N T RISK
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Risk ManagementRisk can be defined as the
combination of the probability of an event and its consequences.
Risk management is a rapidlydeveloping discipline in business
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The focus of good risk
management is the identificationand treatment of risks.Its objective is to add maximum
sustainable value to all theactivities of the organisation.
Risk Management
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SPECULATI V E V/ S I NV ESTME N T OBJECTI V ES
S peculation is related with the trading insecurities for the primary purpose of realisingcapital gains.Investment is related to the putting money intothe asset for certain regular income and gains in
the long run.There is no water-tight compartment betweenspeculation and investment objectives particularlyin the securities market.
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Essential Requirements of Trading
1.Broker Client Agreement2.Opening of a Dematerlised Account.3. S igning of Non-revocable Power of attorney.4.Opening of a Bank Account
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The payoff of a BOUGHT S HARE S is directly proportional to the spotprice of the security. As the spot price increases the profit from the boughtshares also increases or as the spot price decreases the loss from thebought share is also increases.
Profit
Loss
0Spot Price
Payoff profile of a bought share
BUYING IN CASH
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Profit
Loss
0 Spot Price
SELLI NG IN CASH
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Derivatives are financialinstruments that derive their value from an underlying asset.
The underlying assets may beequity, currency or a
commodity.
DERI VATIV ES
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Derivatives are those financial instruments which provides theample scope of trading in the market without holding a large
quantity of stock i.e. without high investment. Derivativeinstruments also protects the portfolio of the investor by paying asmall premium amount. It gives the significant scope of makingprofits with minimum amount of risk involved. The advantage of derivative trading can be summarised as follows :
(1) Advantage of Leverage2) Advantage of Hedging
(3) Advantage of Arbitrage(4) Power to Defer
Benefits of Derivative Trading
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Contract Specifications
1.Trading Cycle Maximum of 3 month
(a) Current Month
(b) Near Month(c) Far month
2.Expiration Day Last Thursday of the expirymonth
3. S ettlement Price Closing value of the underlyingsecurity.
4. S ettlement Mode No physical delivery is allowed.
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Margin RequirementInitial Margin Payable at the time of
execution of the contract.
Mark to Market Margin Payable on dailybasis to cover price fluctuations
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The payoff of a futures contract is directly proportional to the spot price of the underlying. As the spot price increases the profit from the boughtfuture also increases or as the spot price decreases the loss from thebought future also increases.
Profit
Loss
0Spot Price
Payoff profile of a bought future
FUTURE
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P r fit
ss
t P rice
Payoff profile of a sold future
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Call option
Profit
Loss
0Spot PricePremium = Max
Loss
Strike PriceBEP
Payoff profile of a buyer of a call
It is an option to buy an asset at a strike price without any obligati
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Let S = S pot PriceX = S trike priceP = Premium; then
S cenario 1: S > (X + P) = Profit = S (X + P)
S cenario 2: S = (X + P) =BEPS cenario 3: X < S < (X + P) = Loss = (X + P) SS cenario 4: S < X = Max. Loss = P
Pay-off of a call option
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P r fit
ss
t P rice
P remium = MaxP r fit
trike P rice
BEP
Payoff profile for a seller of a call
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Payoff profile for a seller of a call
S cenario 1: S < X = Max. Profit = P
S cenario2: X< S < (X + P) =Profit = X + P S
S cenario 3: S = (X + P)= BEP
S cenario 4: S > (X + P) = Loss = S (X + P)
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P r fit
ss
t P rice P remium = Max ss
trike P riceBEP
Put OptionPut option is an option to sell an underlying asset at the strike pricewithout any obligation.
Payoff profile for a buyer of a put
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Payoff profile for a buyer of a put
S cenario 1: S < (X P) =Profit = X (S + P)
S cenario 2: S = (X P) =BEP
S cenario3:(X P)< S < X= Loss = P (X S )
S cenario 4 : X < S =Max Loss = P
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Profit
Loss
0 SpotPrice
Premium = Max Profit
Strike Price
BEP
Payoff profile for a seller of a put
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Payoff profile for a seller of a put
S cenario 1: X > S = Max. Profit = P
S cenario2: X> S > (X P)= Profit = S (X P)
S cenario 3: S = (X P) =BEP
S cenario 4: S < (X P) = Loss = S (X P)
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Hedging
Hedging is a strategy in which two simultaneouspositions are adopted by the trader in order to protect
any possible lossProfit
Loss
0 Spot Price Premium on Buying put
Strike Price
Payoff of put option
Payoff of BuyFuture
Buy future and buy put
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P r fit
ss
t P riceP remium nBuying Call
trike P rice
P ay ff f ellFuture
P ay ff f BuyCall
S elling future and buy Call
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Straddle
S traddle is a combination strategy of buyingsimultaneously call as well as put with the same
strike price and maturityProfit
Loss
0Spot Price
Premium on Buying Call
Premium on Buying put
Loss Loss
Profit Profit
Strike price minus
premiumStrike
price
Strike price plus premium
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Pro f
oss
0SpotPrice
Premium onSelling a put
Premium onSelling a Call
LossLoss
Pro f it Pro f itStrike price
minus premium
Strike price
Strike price plus premium
Straddle
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S PREAD ST RA T EGIE S
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A spread is the difference between premium received onselling an option and premium paid on buying on option.
It is a simultaneous purchase and sale of option contractsi.e. put or call on the same underlying security.
T he objective of spread strategy is to benefit fromfavourable movement in market price of a security alongwith the restriction of downside.
S pread
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A bull spread is established when an investor expects an increase in prices of the underlying
security.
A bull call can be created by buying a call at lower strike price and selling a call at higher strike price.
The price of the bull spread in the premium paid onbought call and the premium received on sold call.
Bu ll Spread :
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1 . Max. Loss = Difference in premium i.e. premium paid Premium received.
2. Max. Gain = [(Strike price on short position) + (OptionPremium Received)] [(Strike Price on Long position) +(Option Premium Paid)] Or Diff in strike price Max.Loss.
3. 3. EP = Strike Price at bought option + Max. Loss
Payoff Profile of a bull spread
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A bear call is established when an investor
desires a down trend in the price of theunderlying security.
A bear call is created by buying a call at ahigher strike price and selling a call at lower strike price.
Bear Spread :
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1 . Max Profit = Difference in option premiums i.e.Premium received Premium paid.
2. Max. Loss = Difference in exercise price MaxProfit
2. 3. EP = Strike price of the option sold+ Max.Profit.
The payoff of this strategy
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The box spread also requires execution of 4 trades related
to options. The strategy is as follows :
(I) Buy a bull call spread i.e. buying a call at lower strike price and selling a call at higher strike price.
(ii) Buy a put bear spread : Buying a put at higher strike price and selling a put at lower strike price.
Box Spread :
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T he payoff position of the box spread is as follows :
1 . ost of the ox = ost of ull all Spread + ost of bear
put spread2. Profit = Diff in Strike price ost of the ox
3. T he box spread is established to take advantage of
insufficient pricing of bull and bear spread. I f thedifference in strike price is higher then the cost of box, aguaranteed profit opportunity exists provided that all tradesare executed simultaneously at the specified prices.
The Payoff Position
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T he butterfly spread is useful to a trader who expects thatthe price of the underlying will remain range bound.
T he butterfly spread can be created by adopting thefollowing strategies :
(i) T wo call short position on mid strike price.
(ii) One call long position at lower striking price;and
(iii) One call long position at the higher striking
price.
Bu tterfly Spread :
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Trading in derivatives is highly risky unless it isprotected by certain strategy. The minimum contract size
and the market lot of derivative trading are very high for a small investor to deal in. the volatility of the underlyingand the premium/discount on the market price alsoeffects the future price. High open-interest on a
particular expiry date also increases the volatility of themarket. It is therefore required to give close look on thevarious factors of derivative trading.
Risk In Trading
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Trading strategies in derivatives should be framedwith utmost care and caution
Words of Caution
1. Investor's experience in the capital market.2. Investor's willingness to accept risk.3. Age and health of investor.4. Financial strength of the investor.5. Nature of job and family responsibilities.6. Availability of liquid reserves.
7. Investor's devotion towards the market
Following points should be considered carefullybefore making any attempt in the derivativemarket :
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Forward Contracts (Regulation) Act (FCRA), 1952defines goods as every kind of movable property.
All goods and products of agricultural (includingplantation), mineral and fossil origin are allowed for commodity trading .The national commodity exchanges, recognized by the
Central Government, permits commodities which includeprecious (gold and silver) and all metals; cereals andpulses; cotton; oilseeds, oils and raw jute and jutegoods; sugar; coffee and tea; rubber and spices and
many more products..
COMMODITY FUTURE
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Government of India has allowed forward transactions in commoditiesthrough the following Online Commodity Exchanges
National Commodity & DerivativesExchange Limited (N CDEX)
Multi Commodity Exchange of India
Limited (MCX)N ational Multi-Commodity Exchangeof India Limited (N MCEIL)
CURRENCY FUTURE
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Hedgers: :Hedgers are those who protect themselves
from the risk associated with the price of anasset by using derivatives. A person keepsa close watch upon the prices discovered in
trading and when the comfortable price isreflected according to his wants, he sellsfutures contracts. In this way he gets an
assured fixed price of his produce .
Types of Trades in
Commodity Derivatives
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Speculators: :S peculators are some what like a middleman. They are never interested in actualowing the commodity. They will just buyfrom one end and sell it to the other inanticipation of future price movements.They actually bet on the futuremovement in the price of an asset.
COMMODITY FUTURE
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Arbitrators: :
Arbitrators are the person who take theadvantage of a discrepancy between pricesin two different markets trades or products.If he finds future prices of a commodityedging out with the cash price, he will takeoffsetting positions in both the markets tolock in a profit .
COMMODITY FUTURE
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Margin RequirementInitial Margin Payable at the time of
execution of the contract.
Mark to Market Margin Payable on dailybasis to cover price fluctuations
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The payoff of a futures contract is directly proportional to the spot price of the underlying. As the spot price increases the profit from the boughtfuture also increases or as the spot price decreases the loss from the
bought future also increases.Profit
Loss
0 Spot Price
Payoff profile of a bought future
COMMODITY FUTURE
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Payoff profile of asold future
COMMODITY FUTUREProfit
Loss
0 Spot Price
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Details of Contract Specificationof US D /IN R futures
S YMBOL : U S DINR
UNIT OF TRADING : 1000 U S D
TRADING HOUR S : MONDAY- FRIDAY
(9.00am to 5.00 pm)
TRADING CYCLE : 12 MONTH S
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Initial margin:Nearly 3% of the value of the Contract
Mark To Market As per the marketcondition
Calendar spreads:
Minimum Rs. 250/- per
contract for all months of spread
MARGIN
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Daily /Final :
Daily settlement :
on average prices.
F inal settlement :on RBI referencerate.
Mode of settlementCash settled inIndian Rupees
Settlement
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TRADING S PREAD
S PREAD : I t is a simultaneous purchase andsale of futures contracts on the sameunderlying security.
T he objective of spread strategy is to benefit
from favourable movement in market price of a security along with the restriction of downside
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TRADING CALENDER S PREAD
S TRATEGY :
BUYING NEAR MONTH CONTRACT
AND SIMULTANEOUSLY
S ELLING FAR MONTH CONTRACT
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DERIVATIVES ARE THEFINANCIAL WEAPON OF
MASS PROTECTION AND AN
EXCELLENT VEHICLE FOR
ACCUMULATING WEALTH
Dr.B.L.GUPTA
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