DerivativesTrading

By CA (Dr.) Alok B. ShahBBA- 13th November, 2013

DERIVATIVES ARE FINANACIAL WEAPONS OF MASS DESTRUCTION

Warren Buffett

Derivative Market consist of Three segments

Forward Futures Option

Execution of Forward contract

Contract

Forward Price

Physical or Cash

Settlement

Two PartiesTransaction

@ Expiry date

Participants in Forward Contract

Money

Delivery of Asset

Seller Takes Short

position

Buyer Takes Long

Position

Execution of Futures contract

1 •Standardize Forward contract.•Contract Between two parties.

2 •Traded on recognized stock exchange.

3 •Traded on future date.•Price Agreed on present date.

4 •Futures Contract requires Clearing House, Margins, Marking to Market, Price Limits.

Participants in Futures Contract

Payment

Buy cont.

Receipt

Sell cont.

Clearing House

Futures Buyer

Futures Seller

Presently Index futures on S&P CNX NIFTY and CNX IT, Stock futures on certain specified Securities and Interest Rate Futures are available for trading at NSE. All the futures contracts are settled in cash.

Points Forward Contract Futures ContractStructure Customized to

customer needsStandardized

Transaction Method

Negotiated directly by the buyer and seller

Quoted and traded on the Exchange

Market Regulation

Not regulated Government regulated market

Institutional Guarantee

The contracting parties

Clearing House

Risk High counterparty risk Low counterparty riskContract Maturity

Delivering the commodity

Delivery of commodity is not necessary

Difference

Option Contract

An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.

Types Option Contract

Call Option

Put Option

Seller Buyer

NSE Futures and Option Trading System

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Index futures & options and Stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism.

Entities in the trading system

Trading members

• They can trade either on their own account or on behalf of their clients including participants.

Clearing members• They carry out risk management activities and

confirmation/inquiry of trades through the trading system.

Professional clearing members

• A professional clearing member is a clearing member who is not a trading member.

Participants

• A participant is a client of trading members like financial institutions.

Entities in the trading system

Basis of trading

Order Driven Market

Security, its Price, Time and Quantity.

Notification of regular lot size and tick size

Passive orders sits into the outstanding order book

Entered order in trading system is active order

Corporate hierarchyCorporate manager

Branch

manager

Dealer

Admin

Order types and conditions

Time conditions

Price conditions

Other conditions

Time conditions

Day order

• A day order, as the name suggests is an order which is valid for the day on which it is entered.

• If the order is not executed during the day, the system cancels the order automatically at the end of the day.

Day order

• An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system.

• Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

Price conditions

Stop-loss

• This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price.

Other conditions

Market price

• Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price.

Trigger price

• Price at which an order gets triggered from the stop-loss book.

Limit price

• Price of the orders after triggering from stop-loss book.

For the hedging or trading purpose: Illustrations of the Futures/Options and Forward Contract.

Of Call Option

Suppose you know that a Farm Land having a current value of Rs. 100,000/- but there is a chance of it

increasing drastically within one year because you know that a hotel chain is thinking of buying the

property for Rs. 200,000/-

So you approaches to the Farm owner and tell him that you want the option to buy the land from him within one year for Rs. 120,000/- and you pay him

Rs. 5,000/- for this right or option.

Rs. 5,000/- or premium, you paid to the owner is his compensation for giving up the right to sell the

property over the next one year to someone else and obligating him to sell it to you for Rs. 120,000/- if you

so choose.

After few months the hotel chain approaches the farmer and tell him they will buy the property for

Rs. 200,000/-Unfortunately, for the farmer he must inform them

that he cannot sell it to them because he had already sold the option to you.

The hotel chain then approaches you and states that they want to buy the land for Rs. 200,000/- since you

have the rights to sale the land.

Now you have two Choices

(Options)

Option one

You can exercise your option and buy the property for Rs.120,000/- from the farmer and turn around and sell it to the hotel chain for Rs.200,000/- for a profit of Rs.75,000/-

Option two

Sell the option directly to the hotel chain for a handsome profit and there after they can exercise the option and buy the land from the farmer.

In both the situations you can get Rs. 75000/- profit.

Put Option

Suppose you bought 100 shares of Reliance Industries at Rs.500 but wanted to make sure you don't lose more

than 10% on this investment.

You could buy Reliance Industries Ltd. put option with a strike of Rs.450. That way if the price drops below

Rs.450 a share you will be able to exercise your put option and sell your stock for Rs.450.

Here you don’t have to compulsorily sell these shares at Rs.450. That is why it is called “Put Option”

- it is a choice to sell and not an obligation.

Forward Contract

Suppose On November 1, 2013 Mr. Birla agrees to buy from Mr. Tata 100 Tones of polyester on April 1, 2014 at

a price of Rs. 10,000 per Tone.

Now, on April 1, 2014 the spot price (also known as the market price) of polyester is greater than

Rs. 10,000, say Rs. 12,000 a tone, the buyer has gained.

Rather than paying Rs.12,000 a tone for polyester, it only needs to pay Rs.2,000.

However, the buyer's gain is the seller's loss. The seller must now sell 100 tones of polyester at only Rs.

10,000 per tone when it could sell it in the open market for Rs.12,000 per tone.

Rather than the buyer giving the seller Rs.10,000 per tone of polyester as he would for physical delivery, the seller simply pays the buyer Rs. 2,000 per tone. Rs.2,000 per ton is the cash difference between the

agreed upon price and the current spot price.

Futures Contract

On November 1, 2013 the jeweler is setting the price of jewelry to be sold in December through the catalog he is printing. His major input expense is the cost of gold, which changes from day to day in the market. Today, the jeweler sees the

following prices:

Spot Price Rs. 30,000 per 10 Gms

Gold Futures for December Rs. 40,000 per 10 Gms

At the expiration of a futures contract, the spot and futures price normally converge, i.e., become the same. On December 1, the futures price (which in this example equals the spot price) can be above, below or the same as the futures price was on November 1.

Now let us take two alternative situations

one

The price in December is Rs. 45,000/- per 10 gms, i.e., higher than it was in November (Rs.40,000/-), In such a case, the jeweler has gained Rs.5,000/- per 10 gms on the futures contract that he can use to decrease the effective cost of the spot gold he is purchasing:from Rs. 45,000/- to Rs.40,000/-.

Two

If the futures price of gold on December 1 were Rs. 25,000, the jeweler could buy spot gold for Rs. 25,000, but he would have had a loss of Rs. 15,000/- per 10 gms. in the futures market, resulting again effective cost of Rs.40,000 per 10 gms of spot gold in December.

In either case, the jeweler's effective cost of gold is Rs.40,000 per 10 gms; i.e., the futures price (December) he "locked in" during November.

Broadly There are Three types of participants

Hedgers

Speculators

Arbitrageurs

Insuring an Investment Against Risk

Bets on Derivative markets

Attempts to get profit from price inefficiencies

How one can start trading in the derivatives market

1. Futures/ Options contracts in both index as well as stocks can be bought and sold through the trading members of NSE/BSE.

2. Some of the trading members also provide the internet facility to trade in the futures and options market.

3. One is required to open an account with one of the trading members.

4. Further complete the related formalities which include KYC, Signing of member-constituent agreement, constituent registration form and risk disclosure document.

5. The trading member will allot a unique client identification number.

6. To begin trading, one must deposit cash and/or other collaterals with their trading member as may be stipulated by him.

Hedgers • Hedgers are those who protect themselves from

the risk associated with the price of an asset by using derivatives.

• A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts.

• In this way he gets an assured fixed price of his produce.

• In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity.

Speculators• Speculators are some what like a middle man.

They are never interested in actual owing the commodity.

• They will just buy from one end and sell it to the other in anticipation of future price movements.

• They actually bet on the future movement in the price of an asset.

• They are the second major group of futures players. These participants include independent floor traders and investors.

• They handle trades for their personal clients or brokerage firms.

Arbitrageurs• As per Dictionary meaning - A person who has

been officially chosen to make a decision between two people or groups who do not agree is known as Arbitrageurs.

• In commodity market Arbitrageurs are the person who take the advantage of a discrepancy between prices in two different markets.

• If he finds future prices of a commodity edging out with the cash price, he will take offsetting positions in both the markets to lock in a profit.

• Moreover the commodity futures investor is not charged interest on the difference between margin and the full contract value.

Overall Benefits to Trade in Derivatives

1. Able to transfer the risk to the person who is willing to accept them,

2. Incentive to make profits with minimal amount of risk capital,

3. Lower transaction costs,4. Provides liquidity, enables price discovery in

underlying market,5. Derivatives market are lead economic indicators,6. Arbitrage between underlying and derivative

market,7. Eliminate security specific risk.

• Even after this lecture • The best way to get a feel of the trading

system, however, is to actually watch the screen and observe trading.