Professional Documents
Culture Documents
Tiauing mechanism
The Iutures and options trading system oI NSE, called NEAT-F&O trading system,
provides a Iully automated screen-based trading Ior Index Iutures & options and
Stock Iutures & options on a nationwide basis and an online monitoring and
surveillance mechanism. It supports an anonymous order driven market which
provides complete transparency oI trading operations and operates on strict price-
time priority. It is similar to that oI trading oI equities in the Cash Market (CM)
segment.
The NEAT-F&O trading system is accessed by two types oI users. The
Trading Members (TM) have access to Iunctions such as order entry, order
Year Index Iuture Index option Stock Iuture Stock
option
11-1
.78 578.45 874..8 77.
1-11
45754.5 855.7 54575.7 44.
9-1
488.7 874. 554.4 55.8
8-9
57.4 75.84 474. .8
7-8
87.7 .88 75485. 5.55
-7
5574 7 87 75
5-
5755 84 77 85
4-5
7747 4 4845 88
matching, order and trade management. It provides tremendous Ilexibility to users
in terms oI kinds oI orders that can be placed on the system. Various conditions like
Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order.
The Clearing Members (CM) use the trader workstation Ior the purpose oI
monitoring the trading member(s) Ior whom they clear the trades. Additionally,
they can enter and set limits to positions, which a trading member can take.
MARKET INDEX
To understand the use and Iunctioning oI the index derivatives markets, it is
necessary to understand the underlying index. In the Iollowing section, we take a
look at index related issues. Traditionally, indexes have been used as inIormation
sources. By looking at an index, we know how the market is Iaring. In recent years,
indexes have come to the IoreIront owing to direct applications in Iinance in the
Iorm oI index Iunds and index derivatives. Index derivatives allow people to
cheaply alter their risk exposure to an index (hedging) and to implement Iorecasts
about index movements (speculation). Hedging using index derivatives has become
a central part oI risk management in the modern economy.
TYPES 0F INBEXES
Most oI the commonly Iollowed stock market indexes are oI the Iollowing
two types: Market capitalization weighted index or price weighted index. In a
market capitalization weighted index, each stock in the index aIIects the index value
in proportion to the market value oI all shares outstanding. A price weighted index
is one that gives a weight to each stock that is proportional to its stock price.
Indexes can also be equally weighted. Recently, major indices in the world
like the S&P 500 and the FTSE-100 have shiIted to a new method oI index
calculation called the "Free Iloat" method. We take a look at a Iew methods oI
index calculation.
Market capitalization weighted index calculation
In the example below we can see that each stock aIIects the index value in
proportion to the market value oI all the outstanding shares. In the present
example, the base index 1000 and the index value works out to be 1002.60
Company Current Market capitalization Base Market capitalization
Grasim Inds 1,668,791.10 1,654,247.50 1,654247.54
Telco 872,686.30 860,018.25 860018.25
SBI 1,452,587.65 1,465,218.80 1,465,218.80
Wipro 2,675,613.30 2,669,339.55 2,669,339.55
Bajaj 660,887.85 662,559.30 666,2559.30
Total 7,330,566.20 7,311,383.40 7,311,383.40
1. Price weighted index. In a price weighted index each stock is given a
weight proportional to its stock price.
2. Market capitali:ation weighted index. In this type oI index, the equity price is
weighted by the market capitalization oI the company (share price * number oI
outstanding shares). Hence each constituent stock in the index aIIects the index
value in proportion to the market value oI all the outstanding shares. This index
Iorms the underlying Ior a lot oI index based products like index Iunds and index
Iutures.
In the market capitalization weighted method,
where:
urrent market capitali:ation Sum oI (current market price * outstanding shares)
oI all securities in the index.
Base market capitali:ation Sum oI (market price * issue size) oI all securities as
on base date.
TBE S&P CNX NIFTY
What makes a good stock market index Ior use in an index Iutures
and index options market? Several issues play a role in terms oI the choice oI index.
We will discuss how the S&P CNX NiIty addresses some oI these issues.
DiversiIication: As mentioned earlier, a stock market index should be well
diversiIied, thus ensuring that hedgers or speculators are not vulnerable to
individual-company or industry risk. Liquidity oI the index: The index should be
easy to trade on the cash market. This is partly related to the choice oI stocks in the
index.
High liquidity oI index components implies that the information in the
index is less noisy. Operational issues: The index should be proIessionally
maintained, with a steady evolution oI securities in the index to keep pace with
changes in the economy. The calculations involved in the index should be accurate
and reliable. When a stock trades at multiple venues, index computation should be
done using prices Irom the most liquid market.
The S&P CNX NiIty is a market capitalization index based upon solid
economic research. It was designed not only as a barometer oI market movement
but also to be a Ioundation oI the new world oI Iinancial products based on the
index like index Iutures, index options and index Iunds. A trillion calculations were
expended to evolve the rules inside the S&P CNX NiIty index.
Beuging effectiveness
Hedging eIIectiveness is a measure oI the extent to which an index correlates
with a portIolio, whatever the portIolio may be. NiIty correlates better with all kinds
oI portIolios in India as compared to other indexes. This holds good Ior all kinds oI
portIolios, not just those that contain index stocks. Similarly, the CNX IT and
BAN NiIty contracts which NSE trades in, correlate well with inIormation
technology and banking sector portIolios.
IT, BAN NiIty, CNX NiIty Junior, CNX 100, NiIty Midcap 50 and
Mini NiIty 50 indices are owned, computed and maintained by India Index Services
& Products Limited NiIty, CNX (IISL), a company setup by NSE and CRISIL with
technical assistance Irom Standard & Poor's.
Inuex ueiivatives
Index derivatives are derivative contracts which have the index as
the underlying. The most popular index derivatives contract the world over are
index Iutures and index options. NSE's market index, the S&P CNX NiIty was
scientiIically designed to enable the launch oI index-based products like index
derivatives and index Iunds. The Iirst derivative contract to be traded on NSE's
market was the index Iutures contract with the NiIty as the underlying. This was
Iollowed by NiIty options, derivative contracts on sectoral indexes like CNX IT and
BAN NiIty contracts. Trading on index derivatives were Iurther introduced on
CNX NiIty Junior, CNX 100, NiIty Midcap 50 and Mini NiIty 50.
Index funds
An index Iund is a Iund that tries to replicate the index returns. It does so by
investing in index stocks in the proportions in which these stocks exist in the index.
The goal oI the index Iund is to achieve the same perIormance as the index it
tracks.
For instance, a NiIty index Iund would seek to get the same return as the NiIty
index. Since the NiIty has 50 stocks, the Iund would buy all 50 stocks in the
proportion in which they exist in the NiIty. Once invested, the Iund will track the
index, i.e. iI the NiIty goes up, the value oI the Iund will go up to the same extent
as the NiIty. II the NiIty Ialls, the value oI the index Iund will Iall to the same
extent as the NiIty. The most useIul kind oI market index is one where the weight
attached to a stock is proportional to its market capitalization, as in the case oI
NiIty. Index Iunds are easy to construct Ior this kind oI index since the index Iund
does not need to trade in response to price Iluctuations. Trading is only required in
response to issuance oI shares, mergers, etc.
!`!.`! !.! !%`
Exchange Traded Funds (ETFs) are innovative products, which Iirst came into
existence in the USA in 1993. They have gained prominence over the last Iew
years with over $300 billion invested as oI end 2001 in about 360 ETFs globally.
About 60 oI trading volume on the American Stock Exchange is Irom ETFs.
Among the popular ones are SPDRs (Spiders) based on the S&P 500 Index, QQQs
(Cubes) based on the Nasdaq-100 Index, iSHARES based on MSCI Indices and
TRAH (Tracks) based on the Hang Seng Index.
ETFs provide exposure to an index or a basket oI securities that trade on the
exchange like a single stock. They have a number oI advantages over traditional
open-ended Iunds as they can be bought and sold on the exchange at prices that are
usually close to the actual intra-day NAV oI the scheme. They are an innovation to
traditional mutual Iunds as they provide investors a Iund that closely tracks the
perIormance oI an index with the ability to buy/sell on an intra-day basis. Unlike
listed closed-ended Iunds, which trade at substantial premia or more Irequently at
discounts to NAV, ETFs are structured in a manner which allows to create new
units and redeem outstanding units directly with the Iund, thereby ensuring that
ETFs trade close to their actual NAVs.
The Iirst ETF in India, "NiIty BeEs" (NiIty Benchmark Exchange Traded Scheme)
based on S&P CNX NiIty, was launched in December 2001 by Benchmark Mutual
Fund. It is bought and sold like any other stock on NSE and has all characteristics
oI an index Iund. It would provide returns that closely correspond to the total
return oI stocks included in NiIty.
Futures markets can be used Ior creating synthetic index Iunds. Synthetic
index Iunds created using Iutures contracts have advantages oI simplicity and low
costs. The simplicity stems Irom the Iact that index Iutures automatically track the
index. The cost advantages stem Irom the Iact that the costs oI establishing and re-
balancing the Iund are substantially reduced because commissions and bid-ask
spreads are lower in the Iutures markets than in the equity markets.
The methodology Ior creating a synthetic index Iund is to combine index
Iutures contracts with bank deposits or treasury bills. The index Iund uses part oI its
money as margin on the Iutures market and the rest is invested at the risk-Iree rate
oI return. This methodology however does require Irequent roll-over as Iutures
contracts expire. Index Iunds can also use the Iutures market Ior the purpose oI
spreading index sales or purchases over a period oI time. Take the case oI an index
Iund which has raised Rs.100 crore Irom the market. To reduce the tracking error,
this money must be invested in the index immediately. However large trades Iace
large impact costs. What the Iund can do is, the moment it receives the
subscriptions it can buy index Iutures. Then gradually over a period oI say a month,
it can keep acquiring the underlying index stocks. As it acquires the index stocks, it
should unwind its position on the Iutures market by selling Iutures to the extent oI
stock acquired. This should continue till the Iund is Iully invested in the index.
Derivatives have become increasingly important in the Iield oI Iinance. While
Iutures and options are now actively traded on many exchanges, Iorward contracts
are popular on the OTC market.
RWARD CNTRACTS
A Iorward contract is an agreement to buy or sell an asset on a speciIied date Ior
a speciIied price. One oI the parties to the contract assumes a long position and
agrees to buy the underlying asset on a certain speciIied Iuture date Ior a certain
speciIied pric e. The other party assumes a short position and agrees to sell the asset
on the same date Ior the same price. Other contract details like delivery date, price
and quantity are negotiated bilaterally by the parties to the contract. The Iorward
contracts are normally traded outside the exchanges.
Tbe solient feotures of forworJ controcts ore:
Foiwaiu contiacts aie veiy useful in heuging anu speculation. The
classic heuging application woulu be that of an expoitei who expects to ieceive
payment in uollais thiee months latei. Be is exposeu to the iisk of exchange
iate fluctuations. By using the cuiiency foiwaiu maiket to sell uollais foiwaiu,
he can lock on to a iate touay anu ieuuce his unceitainty. Similaily an impoitei
who is iequiieu to make a payment in uollais two months hence can ieuuce his
exposuie to exchange iate fluctuations by buying uollais foiwaiu. If a
speculatoi has infoimation oi analysis, which foiecasts an uptuin in a piice,
then he can go long on the foiwaiu maiket insteau of the cash maiket.
The speculatoi woulu go long on the foiwaiu, wait foi the piice to iise,
anu then take a ieveising tiansaction to book piofits. Speculatois may well be
iequiieu to ueposit a maigin upfiont. Bowevei, this is geneially a ielatively
small piopoition of the value of the assets unueilying the foiwaiu contiact.
The use of foiwaiu maikets heie supplies leveiage to the speculatoi.
LINITATI0NS 0F F0RWARB NARKETS
Forward markets world-wide are aIIlicted by several problems:
Lack oI centralization oI trading,
Illiquidity, and
Counterparty risk
In the Iirst two oI these, the basic problem is that oI too much Ilexibility and
generality. The Iorward market is like a real estate market in that any two
consenting adults can Iorm contracts against each other. This oIten makes them
design terms oI the deal which are very convenient in that speciIic situation, but
makes the contracts non-tradable.
Counterparty risk arises Irom the possibility oI deIault by any one party to
the transaction. When one oI the two sides to the transaction declares bankruptcy,
the other suIIers. Even when Iorward markets trade standardized contracts, and
hence avoid the problem oI illiquidity, still the counterparty risk remains a very
serious issue.
INTRDUCTIN T UTURES
Futures markets were designed to solve the problems that exist in Iorward markets.
A Iutures contract is an agreement between two parties to buy or sell an asset at a
certain time in the Iuture at a certain price. But unlike Iorward contracts, the Iutures
contracts are standardized and exchange traded. To Iacilitate liquidity in the Iutures
contracts, the exchange speciIies certain standard Ieatures oI the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality oI the underlying instrument that can be delivered, (or which can be used Ior
reIerence purposes in settlement) and a standard timing oI such settlement. A
Iutures contract may be oIIset prior to maturity by entering into an equal and
opposite transaction.
More than 99 oI Iutures transactions are oIIset this way.
The standardi:ed items in a futures contract are.
I. Quantity oI the underlying.
II. Quality oI the underlying.
III. The date and the month oI delivery
IV. The units oI price quotation and minimum price change
V. Location oI settlement
FUTURES TERMINOLOGY
I. Spot price: The price at which an asset trades in the spot market.
II. Futures price: The price at which the Iutures contract trades in the Iutures
market.
III. o3tract cycle: The period over which a contract trades. The index Iutures
contracts on the NSE have one- month, two-month and three months expiry
cycles which expire on the last Thursday oI the month. Thus a January
expiration contract expires on the last Thursday oI January and a February
expiration contract ceases trading on the last Thursday oI February. On the
Friday Iollowing the last Thursday, a new contract having a three- month
expiry is introduced Ior trading.
IV. Expiry date: It is the date speciIied in the Iutures contract. This is the last day
on which the contract will be traded, at the end oI which it will cease to exist.
V. o3tract size. The amount oI asset that has to be delivered under one
contract. Also called as lot size.
Basis: In the context oI Iinancial Iutures, basis can be deIined as the Iutures
price minus the spot price. There will be a diIIerent basis Ior each delivery
month Ior each contract. In a normal market, basis will be positive. This reIlects
that Iutures prices normally exceed spot prices.
ost of carry: The relationship between Iutures prices and spot prices can be
summarized in terms oI what is known as the cost oI carry. This measures the
storage cost plus the interest that is paid to Iinance the asset less the income earned
on the asset.
3itial mari3: The amount that must be deposited in the margin account at the
time a Iutures contract is Iirst entered into is known as initial margin.
arki3-to-market: In the Iutures market, at the end oI each trading day, the
margin account is adjusted to reIlect the investor's gain or loss depending upon the
Iutures closing price. This is called marking-to-market.
ai3te3a3ce mari3: This is somewhat lower than the initial margin. This is set to
ensure that the balance in the margin account never becomes negative. II the
balance in the margin account Ialls below the maintenance margin, the investor
receives a margin call and is expected to top up the margin account to the initial
margin level beIore trading commences on the next day.
Distinction between Iutures and Iorwards
Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customized contract terms
hence more liquid hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end oI period
Forward contracts are oIten conIused with Iutures contracts. The conIusion is
primarily because both serve essentially the same economic Iunctions oI allocating
risk in the presence oI Iuture price uncertainty. However Iutures area signiIicant
improvement over the Iorward contracts as they eliminate counterparty risk and
oIIer more liquidity.
INTRODUCTION TO OPTIONS
Options are Iundamentally diIIerent Irom Iorward and Iutures contracts. An option
gives the holder oI the option the right to do something. The holder does not have to
exercise this right. In contrast, in a Iorward or Iutures contract, the two parties have
committed themselves to doing something. Whereas it costs nothing (except margin
requirements) to enter into a Iutures contract, the purchase oI an option requires an
up-Iront payment.
OPTION TERMINOLOGY
i. 3dex optio3s. These options have the index as the underlying. Some
options are European while others are American. Like index Iutures
contracts, index options contracts are also cash settled.
ii. Stock optio3s: Stock options are options on individual stoc ks.
Options currently trade on over 500 stocks in the United States. A
contract gives the holder the right to buy or sell shares at the speciIied
price.
iii. Buyer of a3 optio3: The buyer oI an option is the one who by paying
the option premium buys the right but not the obligation to exercise
his option on the seller/writer.
iv. Writer of a3 optio3: The writer oI a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the
asset iI the buyer exercises on him.
There are two basic types of options, call options and put options.
all optio3: A call option gives the holder the right but not the obligation to buy an
asset by a certain date Ior a certain price.
Put optio3: A put option gives the holder the right but not the obligation to sell an
asset by a certain date Ior a certain price.
Optio3 price/premium: Option price is the price which the option buyer pays to the
option seller. It is also reIerred to as the option premium.
Expiratio3 date: The date speciIied in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike price: The price speciIied in the options contract is known as the strike price
or the exercise price.
America3 optio3s: American options are options that can be exercised at any time
up to the expiration date. Most exchange-traded options are American.
Europea3 optio3s: European options are options that can be exercised only on the
expiration date itselI. European options are easier to analyze than American options,
and properties oI an American option are Irequently deduced Irom those oI its
European counterpart.
3-the-mo3ey optio3: An in-the-money (ITM) option is an option that would lead
to a positive cashIlow to the holder iI it were exercised immediately. A call option
on the index is said to be in-the-money when the current index stands at a level
higher than the strike price (i.e. spot price ~ strike price). II the index is much
higher than the strike price, the call is said to be deep ITM. In the case oI a put, the
put is ITM iI the index is below the strike price.
At-the-mo3ey optio3: An at-the-money (ATM) option is an option that would lead
to zero cashIlow iI it were exercised immediately. An option on the index is at-the-
money when the current index equals the strike price (i.e. spot price strike price).
Out-of-the-mo3ey optio3: An out-oI-the-money (OTM) option is an option that
would lead to a negative cashIlow iI it were exercised immediately. A call option on
the index is out-oI-the-money when the current index stands at a level which is less
than the strike price (i.e. spot price strike price). II the index is much lower than
the strike price, the call is said to be deep OTM. In the case oI a put, the put is OTM
iI the index is above the strike price.
3tri3sic ;alue of a3 optio3: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value oI a call is the
amount the option is ITM, iI it is ITM. II the call is OTM, its intrinsic value is zero.
Putting it another way, the intrinsic value oI a call is Max[0, (St K)] which means
the intrinsic value oI a call is the greater oI 0 or (St K). Similarly, the intrinsic
value oI a put is Max[0, K St|,i.e. the greater oI 0 or (K St). is the strike
price and St is the spot price.
%ime ;alue of a3 optio3: The time value oI an option is the diIIerence between its
premium and its intrinsic value. Both calls and puts have time value. An option that
is OTM or ATM has only time value. Usually, the maximum time value exists
when the option is ATM. The longer the time to expiration, the greater is an
option's time value, all else equal. At expiration, an option should have no time
value.
FUTURES AND OPTIONS
An interesting question to ask at this stage is - when would one use options
instead oI Iutures? Options are diIIerent Irom Iutures in several interesting senses.
At a practical level, the option buyer Iaces an interesting situation. He pays Ior the
option in Iull at the time it is purchased. AIter this, he only has an upside. There is
no possibility oI the options position generating any Iurther losses to him (other
than the Iunds already paid Ior the option). This is diIIerent Irom Iutures, which is
Iree to enter into, but can generate very large losses. This characteristic makes
options attractive to many occasional market participants, who cannot put in the
time to closely monitor their Iutures positions
The phenomenal growth oI Iinancial derivatives across the world is
attributed the IulIilment oI needs oI hedgers, speculators and arbitrageurs by these
products. In this chapter we Iirst look at how trading Iutures diIIers Irom trading the
underlying spot. We then look at the payoII oI these contracts, and Iinally at how
these contracts can be used by various entities in the economy.
A payoII is the likely proIit/loss that would accrue to a market participant
with change in the price oI the underlying asset. This is generally depicted in the
Iorm oI payoII diagrams which show the price oI the underlying asset on the X-axis
and the proIits/losses on the Y-axis.
The single stock Iutures market in India has been a great success story
across the world. NSE ranks Iirst in the world in terms oI number oI contracts
traded in single stock Iuture s. One oI the reasons Ior the success could be the ease
oI trading and settling these contracts. To trade securities, a customer must open a
security trading account with a securities broker and a demat account with a
securities depository.
Buying security involves putting up all the money upIront. With the
purchase oI shares oI a company, the holder becomes a part owner oI the company.
The shareholder typically receives the rights and privileges associated with the
security, which may include the receipt oI dividends, invitation to the annual
shareholders meeting and the power to vote.
Selling securities involves buying the security beIore selling it. Even in
cases where short selling is permitted, it is assumed that the securities broker owns
the security and then "lends" it to the trader so that he can sell it. Besides, even iI
permitted, short sales on security can only be executed on an up-tick. To trade
Iutures, a customer must open a Iutures trading account with a derivatives broker.
Buying Iutures simply involves putting in the margin money.
They enable the Iutures traders to take a position in the underlying security
without having to open an account with a securities broker. With the purchase oI
Iutures on a security, the holder essentially makes a legally binding promise or
obligation to buy the underlying security at some point in the Iuture (the expiration
date oI the contract). Security Iutures do not represent ownership in a corporation
and the holder is thereIore not regarded as a shareholder. A Iutures contract
represents a promise to transact at some point in the Iuture. In this light, a promise
to sell security is just as easy to make as a promise to buy security. Selling security
Iutures without previously owning them simply obligates the trader to selling a
certain amount oI the underlying security at some point in the Iuture. It can be done
just as easily as buying Iutures, which obligates the trader to buying a certain
amount oI the underlying security at some point in the Iuture.
Distinction between Iutures and options:
Futures Options
Exchange traded, with novation Same as Iutures.
Exchange deIines the product same as Iutures.
Price is zero, strike price moves Strike price is Iixed, price moves.
Price is zero Price is always positive.
Linear payoII Nonlinear payoII.
Both long and short at risk Only short at risk.
The NiIty index Iund industry will Iind it very useIul to make a bundle oI a NiIty
index Iund and a NiIty put option to create a new kind oI a NiIty index Iund, which
gives the investor protection against extreme drops in NiIty. Selling put options is
selling insurance, so anyone who Ieels like earning revenues by selling insurance
can set himselI up to do so on the index options market.
More generally, options oIIer "nonlinear payoIIs" whereas Iutures only have
"linear payoIIs". By combining Iutures and options, a wide variety oI innovative
and useIul payoII structures can be created.
INDEX DERIVATIVES:
Index derivatives are derivative contracts which derive their value Irom an
underlying index. The two most popular index derivatives are index Iutures and
index options. Index derivatives have become very popular worldwide. Index
derivatives oIIer various advantages and hence have become very popular.
Institutional and large equity-holders need portIolio-hedging Iacility. Index-
derivatives are more suited to them and more cost-eIIective than derivatives based
on individual stocks. Pension Iunds in the US are known to use stock index Iutures
Ior risk hedging purposes.
Index derivatives oIIer ease oI use Ior hedging any portIolio
irrespective oI its composition.
Stock index is diIIicult to manipulate as compared to individual stock prices, more
so in India, and the possibility oI cornering is reduced. This is partly because an
individual stock has a limited supply, which can be cornered.
Stock index, being an average, is much less volatile than individual stock prices.
This implies much lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suIIer Irom settlement delays
and problems related to bad delivery, Iorged/Iake certiIicates.
Understanding beta (Risk) :
The index model suggested by William Sharpe oIIers insights into portIolio
diversiIication. It expresses the excess return on a security or a portIolio as a Iunction oI market
Iactors and non market Iactors are those Iactors that aIIect all stocks and portIolios. These would
include Iactors such as inIlation, interest rates, business cycles etc. Non-market Iactors would be
those Iactors which are speciIic to a company, and do not aIIect the entire market. For example, a
Iire breakout in a Iactory, a new invention, the death oI a key employee, a strike in the Iactory,
etc. The market Iactors aIIect all Iirms.
The unexpected change in these Iactors causes unexpected changes in the rates oI returns
on the entire stock market. Each stock however responds to these Iactors to diIIerent extents. Beta
oI a stock measures the sensitivity oI the stocks responsiveness to these market Iactors. Similarly,
Beta oI a portIolio, measures the portIolios responsiveness to these market movements. Given
stock beta`s, calculating portIolio beta is simple. It is nothing but the weighted average oI the
stock betas.
The index has a beta oI 1. Hence the movements oI returns on a portIolio with a beta oI
one will be like the index. II the index moves up by ten percent, my portIolio value will increase
by ten percent. Similarly iI the index drops by Iive percent, my portIolio value will drop by Iive
percent. A portIolio with a beta oI two, responds more sharply to index movements. II the index
moves up by ten percent, the value oI a portIolio with a beta oI two will move up by twenty
percent.
II the index drops by ten percent, the value oI a portIolio with a beta oI two, will Iall by
twenty percent. Similarly, iI a portIolio has a beta oI 0.75, a ten percent movement in the index
will cause a 7.5 percent movement in the value oI the portIolio. In short, beta is a measure oI the
systematic risk or market risk oI a portIolio. Using index Iutures contracts, it is possible to hedge
the systematic risk. With this basic understanding, we look at some applications oI index Iutures.
We look here at some applications oI Iutures contracts. We reIer to single stock Iutures. However
since the index is nothing but a security whose price or level is a weighted average oI securities
constituting an index, all strategies that can be implemented using stock Iutures can also be
implemented using index Iutures.
Hedi3: Lo3 security, sell futures
Futures can be used as an eIIective risk-management tool. Take the case oI
an investor who holds the shares oI a company and gets uncomIortable with market
movements in the short run. He sees the value oI his security Ialling Irom Rs.450 to
Rs.390. In the absence oI stock Iutures, he would either suIIer the discomIort oI a
price Iall or sell the security in anticipation oI a market upheaval. With security
Iutures he can minimize his price risk. All he need do is enter into an oIIsetting
stock Iutures position, in this case, take on a short Iutures position.
Assume that the spot price oI the security he holds is Rs.390. Two-month
Iutures cost him Rs.402. For this he pays an initial margin. Now iI the price oI the
security Ialls any Iurther, he will suIIer losses on the security he holds. However,
the losses he suIIers on the security, will be oIIset by the proIits he makes on his
short Iutures position. Take Ior instance that the price oI his security Ialls to Rs.350.
The Iall in the price oI the security will result in a Iall in the price oI Iutures.
Futures will now trade at a price lower than the price at which he entered into a
short Iutures position.
Hence his short Iutures position will start making proIits. The loss oI
Rs.40 incurred on the security he holds, will be made up by the proIits made on his
short Iutures position. Index Iutures in particular can be very eIIectively used to get
rid oI the market risk oI a portIolio. Every portIolio contains a hidden index
exposure or a market exposure. This statement is true Ior all portIolios, whether a
portIolio is composed oI index securities or not. In the case oI portIolios, most oI
the portIolio risk is accounted Ior by index Iluctuations (unlike individual securities,
where only 30- 60 oI the securities risk is accounted Ior by index Iluctuations).
Hence a position LONG PORTFOLIO SHORT NIFTY can oIten
become one-tenth as risky as the LONG PORTFOLIO position! Suppose we have a
portIolio oI Rs. 1 million which has a beta oI 1.25. Then a complete hedge is
obtained by selling Rs.1.25 million oI NiIty Iutures.
War3i3:
Hedging does not always make money. The best that can be achieved using
hedging is the removal oI unwanted exposure, i.e. unnecessary risk. The hedged position will
make less proIits than the unhedged position, halI the time. One should not enter into a hedging
strategy hoping to make excess proIits Ior sure; all that can come out oI hedging is reduced risk.
Speculatio3: Bullish security, buy futures
Take the case oI a speculator who has a view on the direction oI the
market. He would like to trade based on this view. He believes that a particular
security that trades at Rs.1000 is undervalued and expect its price to go up in the
next two-three months. How can he trade based on this belieI? In the absence oI a
deIerral product, he would have to buy the security and hold on to it. Assume he
buys a 100 shares which cost him one lakh rupees.
His hunch proves correct and two months later the security closes at
Rs.1010. He makes a proIit oI Rs.1000 on an investment oI Rs. 1,00,000 Ior a
period oI two months. This works out to an annual return oI 6 percent. Today a
speculator can take exactly the same position on the security by using Iutures
contracts.
Let us see how this works. The security trades at Rs.1000 and the two-
month Iutures trades at 1006. Just Ior the sake oI comparison, assume that the
minimum contract value is 1,00,000. He buys 100 security Iutures Ior which he
pays a margin oI Rs.20,000. Two months later the security closes at 1010. On the
day oI expiration, the Iutures price converges to the spot price and he makes a
proIit oI Rs.400 on an investment oI Rs.20,000.
This works out to an annual return oI 12 percent. Because oI the leverage
they provide, security Iutures Iorm an attractive option Ior speculators.
eurlxh xecurlty, xell futurex,
Stock Iutures can be used by a speculator who believes that a
particular security is over-valued and is likely to see a Iall in price. How can he
trade based on his opinion? In the absence oI a deIerral product, there wasn't much
he could do to proIit Irom his opinion. Today all he needs to do is sell stock Iutures.
Let us understand how this works. Simple arbitrage ensures that Iutures on an
individual securities move correspondingly with the underlying security, as long as
there is suIIicient liquidity in the market Ior the security.
II the security price rises, so will the Iutures price. II the security
price Ialls, so will the Iutures price. Now take the case oI the trader who expects to
see a Iall in the price oI ABC Ltd. He sells one two-month contract oI Iutures on
ABC at Rs.240 (each contact Ior A100 underlying shares). He pays a small margin
on the same. Two months later, when the Iutures contract expires, ABC closes at
220. On the day oI expiration, the spot and the Iutures price converges. He has
made a clean proIit oI Rs.20 per share. For the one contract that he bought, this
works out to be Rs.2000.
PRICING OPTIONS;
An option buyer has the right but not the obligation to
exercise on the seller. The worst that can happen to a buyer is the loss oI the
premium paid by him. His downside is limited to this premium, but his upside is
potentially unlimited. This optionality is precious and has a value, which is
expressed in terms oI the option price. Just like in other Iree markets, it is the supply
and demand in the secondary market that drives the price oI an option.
There are various models which help us get close to the true price oI an
option. Most oI these are variants oI the celebrated Black-Scholes model Ior pricing European
options. Today most calculators and spread-sheets come with a built-in Black- Scholes options
pricing Iormula so to price options we don't really need to memorize the Iormula. All we need to
know is the variables that go into the model.
APPLICATION OF OPTIONS-
We look here at some applications oI options contracts. We reIer to single
stock options here. However since the index is nothing but a security whose price or
level is a weighted average oI securities constituting the index, all strategies that
can be implemented using stock Iutures can also be implemented using index
options.
Hedging: Have underlying buy puts
Owners oI stocks or equity portIolios oIten experience discomIort about
the overall stock market movement. As an owner oI stocks or an equity portIolio,
sometimes you may have a view that stock prices will Iall in the near Iuture. At
other times you may see that the market is in Ior a Iew days or weeks oI massive
volatility, and you do not have an appetite Ior this kind oI volatility. The union
budget is a common and reliable source oI such volatility: market volatility is
always enhanced Ior one week beIore and two weeks aIter a budget. Many investors
simply do not want the Iluctuations oI these three weeks. One way to protect your
portIolio Irom potential downside due to a market drop is to buy insurance using
put options.
Index and stock options are a cheap and easily implementable way oI
seeking this insurance. The idea is simple. To protect the value oI your portIolio
Irom Ialling below a particular level, buy the right number oI put options with the
right strike price. II you are only concerned about the value oI a particular stock that
you hold, buy put options on that stock. II you are concerned about the overall
portIolio, buy put options on the index.
When the stoc k price Ialls your stock will lose value and the put options
bought by you will gain, eIIectively ensuring that the total value oI your stock plus
put does not Iall below a particular level. This level depends on the strike price oI
the stock options chosen by you. Similarly when the index Ialls, your portIolio will
lose value and the put options bought by you will gain, eIIectively ensuring that the
value oI your portIolio does not Iall below a particular level. This level depends on
the strike price oI the index options chosen by you.
PortIolio insurance using put options is oI particular interest to mutual
Iunds who already own well-diversiIied portIolios. By buying puts, the Iund can
limit its downside in case oI a market Iall.There are times when investors believe
that security prices are going to rise. For instance, aIter a good budget, or good
corporate results, or the onset oI a stable government.
How does one implement a trading strategy to beneIit Irom an upward movement in
the underlying security? Using options there are two ways one can do this:
1. Buy call options; or
2. Sell put options
We have already seen the payoII oI a call option. The downside to the
buyer oI the call option is limited to the option premium he pays Ior buying the
option. His upside however is potentially unlimited. Suppose you have a hunch that
the price oI a particular security is going to rise in a month`s time. Your hunch
proves correct and the price does indeed rise, it is this upside that you cash in on.
However, iI your hunch proves to be wrong and the security price plunges down,
what you lose is only the option premium.
Bull spreads - Buy a call and sell another,
There are times when you think the market is going to rise over the next
two months, however in the event that the market does not rise, you would like to
limit your downside. One way you could do this is by entering into a spread. A
spread trading strategy involves taking a position in two or more options oI the
same type, that is, two or more calls or two or more puts. A spread that is designed
to proIit iI the price goes up is called a bull spread. How does one go about doing
this? This is basically done utilizing two call options having the same expiration
date, but diIIerent exercise prices.
The buyer oI a bull spread buys a call with an exerc ise price below the
current index level and sells a call option with an exercise price above the current
index level. The spread is a bull spread because the trader hopes to proIit Irom a rise
in the index. The trade is a spread because it involves buying one option and selling
a related option. What is the advantage oI entering into a bull spread? Compared to
buying the underlying asset itselI, the bull spread with call options limits the trader's
risk, but the bull spread also limits the proIit potential.
Bear spreads - sell a call a3d buy a3other;
There are times when you think the market is going to Iall over the
next two months. However in the event that the market does not Iall, you would like
to limit your downside. One way you could do this is by entering into a spread. A
spread trading strategy involves taking a position in two or more options oI the
same type, that is, two or more calls or two or more puts. A spread that is designed
to proIit iI the price goes down is called a bear spread.
How does one go about doing this? This is basically done utilizing two call options
having the same expiration date, but diIIerent exercise prices. How is a bull spread
diIIerent Irom a bear spread? In a bear spread, the strike price oI the option
purchased is greater than the strike price oI the option sold. The buyer oI a bear
spread buys a call with an exercise price above the current index level and sells a
call option with an exercise price below the current index level. The spread is a bear
spread because the trader hopes to proIit Irom a Iall in the index. The trade is a
spread because it involves buying one option and selling a related option. What is
the advantage oI entering into a bear spread? Compared to buying the index itselI,
the bear spread with call options limits the trader's risk, but it also limits the proIit
potential. In short, it limits both the upside potential as well as the downside risk. A
bear spread created using calls involves initial cash inIlow since the price oI the call
sold is greater than the price oI the call purchased. shows the payoII Irom the bear
spread.
Broadly we can have three types oI bear spreads:
1. Both calls initially out-oI-the-money.
2. One call initially in-the-money and one call initially out-oI-the-money, and
3. Both calls initially in-the-money.
The decision about which oI the three spreads to undertake depends upon how
much risk the investor is willing to take. The most aggressive bear spreads are oI
type 1. They cost very little to set up, but have a very small probability oI giving a
high payoII. As we move Irom type 1 to type 2 and Irom type 2 to type 3, the
spreads become more conservative and cost higher to set up. Bear spreads can also
be created by buying a put with a high strike price and selling a put with a low
strike price.
TRADING
In this chapter we shall take a brieI look at the trading system Ior NSE's Iutures and
options market. However, the best way to get a Ieel oI the trading system is to
actually watch the screen and observe trading.
FUTURES AND OPTIONS TRADING SYSTEM;
The Iutures & options trading system oI NSE, called NEAT-F&O trading
system, provides a Iully automated screen-based trading Ior Index Iutures & options
and Stock Iutures & options on a nationwide basis as well as an online monitoring
and surveillance mechanism. It supports an order driven market and provides
complete transparency oI trading operations. It is similar to that oI trading oI
equities in the cash market segment.
The soItware Ior the F&O market has been developed to Iacilitate eIIicient
and transparent trading in Iutures and options instruments. eeping in view the
Iamiliarity oI trading members with the current capital market trading system,
modiIications have been perIormed in the existing capital market trading system so
as to make it suitable Ior trading Iutures and options.
E3tities i3 the tradi3 system
There are Iour entities in the trading system. Trading members, clearing
members, proIessional clearing members and participants.
1) %radi3 members: Trading members are members oI NSE. They can
trade either on their own account or on behalI oI their clients including
participants. The exchange assigns a trading member ID to each
trading member. Each trading member can have more than one user.
The number oI users allowed Ior each trading member is notiIied by
the exchange Irom time to time. Each user oI a trading member
must be registered with the exchange and is assigned an unique user
ID.
2) The unique trading member ID Iunctions as a reIerence Ior all
orders/trades oI diIIerent users. This ID is common Ior all users oI a
particular trading member. It is the responsibility oI the trading
member to maintain adequate control over persons having access to the
Iirm`s User IDs.
2) leari3 members: Clearing members are members oI NSCCL. They carry out
risk management activities and conIirmation/inquiry oI trades through the trading
system.
3) Professio3al cleari3 members: A proIessional clearing members is a clearing
member who is not a trading member. Typically, banks and custodians become
proIessional clearing members and clear and settle Ior their trading members.
) Participa3ts: A participant is a client oI trading members like Iinancial
institutions. These clients may trade through multiple trading members but settle
through a single clearing member Marketed by price in NEAT F&O
Basis of tradi3
The NEAT F&O system supports an order driven market, wherein
ordersmatch automatically. Order matching is essentially on the basis oI security, its
price, time and quantity. All quantity Iields are in units and price in rupees. The
exchange notiIies the regular lot size and tick size Ior each oI the contracts traded
on this segment Irom time to time. When any order enters
the trading system, it is an active order. It tries to Iind a match on the other side oI
the book. II it Iinds a match, a trade is generated. II it does not Iind a match, the
order becomes passive and goes and sits in the respective outstanding order book in
the system.
orporate hierarchy
In the F&O trading soItware, a trading member has the Iacility oI
deIining a hierarchy amongst users oI the system. This hierarchy comprises
corporate manager, branch manager and dealer.
1) orporate ma3aer: The term 'Corporate manager' is assigned to a user placed
at the highest level in a trading Iirm. Such a user can perIorm all the Iunctions such
as order and trade related activities, receiving reports Ior all branches oI the trading
member Iirm and also all dealers oI the Iirm. Additionally, a corporate manager can
deIine exposure limits Ior the branches oI the Iirm. This Iacility is available only to
the corporate manager.
2) Bra3ch ma3aer: The branch manager is a term assigned to a user who is placed
under the corporate manager. Such a user can perIorm and view order and trade
related activities Ior all deale rs under that branch.
3) ealer: Dealers are users at the lower most level oI the hierarchy. A Dealer can
perIorm view order and trade related activities only Ior one selI and does not have
access to inIormation on other dealers under either the same branch or other
branches. Below given cases explain activities possible Ior speciIic user categories:
1) leari3 member corporate ma3aer: He can view outstanding orders, previous
trades and net position oI his client trading members by putting the TM ID (Trading
member identiIication) and leaving the Branch ID and Dealer ID blank.
2) leari3 member a3d tradi3 member corporate ma3aer: He can view:
(a) Outstanding orders, previous trades and net position oI his client trading
members by putting the TM ID and leaving the Branch ID and the Dealer ID blank.
(b) Outstanding orders, previous trades and net positions entered Ior himselI by
entering his own TM ID, Branch ID and User ID. This is his deIault screen.
(c) Outstanding orders, previous trades and net position entered Ior his branch by
entering his TM ID and Branch ID Iields.
(d) Outstanding orders, previous trades, and net positions entered Ior any oI his
users/dealers by entering his TM ID, Branch ID and user ID Iields.
3) leari3 member a3d tradi3 member dealer: He can only view requests
entered by him.
4) %radi3 member corporate ma3aer: He can view:
(a) Outstanding requests and activity log Ior requests entered by him by entering his
own Branch and User IDs. This is his deIault screen.
(b) Outstanding requests entered by his dealers and/or branch managers by either
entering the Branch and/or User IDs or leaving them blank.
5) %radi3 member bra3ch ma3aer: He can view:
(a) Outstanding requests and activity log Ior requests entered by him by entering his
own Branch and User IDs. This is his deIault screen.
(b) Outstanding requests entered by his users either by Iilling the User ID Iield with
a speciIic user or leaving the User ID Iield blank.
6) %radi3 member dealer: He can only view requests entered by him.
lie3t Broker #elatio3ship i3 eri;ati;e Seme3t
A trading member must ensure compliance particularly with relation to the
Iollowing while dealing with clients:
1. Filling oI 'now Your Client' Iorm
2. Execution oI Client Broker agreement
3. Bring risk Iactors to the knowledge oI client by getting acknowledgement oI
client on risk disclosure document
4. Timely execution oI orders as per the instruction oI clients in respective client
codes.
5. Collection oI adequate margins Irom the client
6. Maintaining separate client bank account Ior the segregation oI client money.
7. Timely issue oI contract notes as per the prescribed Iormat to the client
8. Ensuring timely pay-in and pay-out oI Iunds to and Irom the clients
9. Resolving complaint oI clients iI any at the earliest.
10. Avoiding receipt and payment oI cash and deal only through account payee
cheques
11. Sending the periodical statement oI accounts to clients
12. Not charging excess brokerage
13. Maintaining unique client code as per the regulations.
Order types a3d co3ditio3s
The system allows the trading members to enter orders with various conditions
attached to them as per their requirements. These conditions are broadly divided
into the Iollowing categories:
1. Time conditions
2. Price conditions
3. Other conditions
Several combinations oI the above are allowed thereby providing enormous
Ilexibility to the users. The order types and conditions are summarized below.
W Time conditions
- ay order: A day order, as the name suggests is an order which is valid Ior the
day on which it is entered. II the order is not executed during the day, the system
cancels the order automatically at the end oI the day.
- mmediate or a3cel (O: An IOC order allows the user to buy or sell a
contract as soon as the order is released into the system, Iailing which the order is
cancelled Irom the system. Partial match is possible Ior the order, and the
unmatched portion oI the order is cancelled immediately.
W Price condition
- Stop-loss: This Iacility allows the user to release an order into the system, aIter the
market price oI the security reaches or crosses a threshold price e.g. iI Ior stop-loss
buy order, the trigger is 1027.00, the limit price is 1030.00 and the market
(last traded) price is 1023.00, then this order is released into the system once the
market price reaches or exceeds 1027.00. This order is added to the regular lot book
with time oI triggering as the time stamp, as a limit order oI 1030.00. For the stop-
loss sell order, the trigger price has to be greater than the limit price.
W Other conditions
- arket price: Market orders are orders Ior which no price is speciIied at the time
the order is entered (i.e. price is market price). For such orders, the system
determines the price.
- %rier price: Price at which an order gets triggered Irom the stop-loss book.
- Limit price: Price oI the orders aIter triggering Irom stop-loss book.
- Pro: Pro means that the orders are entered on the trading member's own account.
- li: Cli means that the trading member enters the orders on behalI oI a client.
%he market watch wi3dow
The Iollowing windows are displayed on the trader workstation screen:
-Title bar
-Ticker window oI Iutures and options market
-Ticker window oI underlying (capital) market
-Toolbar
-Market watch window
-Inquiry window
-Snap quote
-Order/trade window
-System message window
As mentioned earlier, the best way to Iamiliarize oneselI with the screen
and its various segments is to actually spend some time studying a live screen. In
this section we shall restrict ourselves to understanding just two segments oI the
workstation screen, the market watch window and the inquiry window.
The market watch window is the third window Irom the top oI the screen
which is always visible to the user. The purpose oI market watch is to allow
continuous monitoring oI contracts or securities that are oI speciIic interest to the
user. It displays trading inIormation Ior contracts selected by the user. The user also
gets a broadcast oI all the cash market securities on the screen. This Iunction also
will be available iI the user selects the relevant securities Ior display on the market
watch screen. Display oI trading inIormation related to cash market securities will
be on "Read only" Iormat, i.e. the dealer can only view the inIormation on cash
market but, cannot trade in them through the system. This is the main window Irom
the dealer's perspective.
Inquiry window,
The inquiry window enables the user to view inIormation such as Market by Price
(MBP), Previous Trades (PT), Outstanding Orders (OO), Activity log (AL), Snap
Quote (SQ), Order Status (OS), Market Movement (MM), Market Inquiry (MI), Net
Position, On line backup, Multiple index inquiry, Most active security and so on.
Relevant inIormation Ior the selected contract/security can be viewed. We shall
look in detail at the Market by Price (MBP) and the Market Inquiry (MI) screens.
Market by price (MBP):
The purpose oI the MBP is to enable the user to view passive orders in
the market aggregated at each price and are displayed in order oI best
prices. The window can be invoked by pressing the |F6| key. II a
particular contract or security is selected, the details oI the selected
contract or security can be seen on this screen.
Market inquiry (MI);
The market inquiry screen can be invoked by using the |F11| key. II a
particular contract or security is selected, the details oI the selected contract or
selected security deIaults in the selection screen or else the current position in the
market watch deIaults. The Iirst line oI the screen gives the Instrument type,
symbol, expiry, contract status, total traded quantity, liIe time high and liIe time
low. The second line displays the closing price, open price, high price, low price,
last traded price and indicator Ior net change Irom closing price. The third line
displays the last traded quantity, last traded time and the last traded date.
The Iourth line displays the closing open interest, the opening open
interest, day high open interest, day low open interest, current open interest, liIe
time high open interest, liIe time low open interest and net change Irom closing
open interest. The IiIth line display very important inIormation, namely the carrying
cost in percentage terms.
Placing orders on the trading system,
For both the Iutures and the options market, while entering orders on the
trading system, members are required to identiIy orders as being proprietary or
client orders. Proprietary orders should be identiIied as 'Pro' and those oI clients
should be identiIied as 'Cli'. Apart Irom this, in the case oI 'Cli' trades, the client
account number should also be provided. The Iutures market is a zero sum game i.e.
the total number oI long in any contract always equals the total number oI short in
any contract. The total number oI outstanding contracts (long/short) at any point in
time is called the "Open interest". This Open interest Iigure is a good indicator oI
the liquidity in every contract. Based on studies carried out in international
exchanges, it is Iound that open interest is maximum in near month expiry
contracts.
Basket trading
In order to provide a facility for easy arbitrage between
futures and cash markets, NSE introduced basket-trading facility.
This enables the generation of portfolio offline order files in the
derivatives trading system and its execution in the cash segment.
A trading member can buy or sell a portfolio through a single
order, once he determines its size. The system automatically
works out the quantity of each security to be bought or sold in
proportion to their weights in the portfolio.
FUTURES AND OPTIONS MARET INSTRUMENTS
The F&O segment of NSE provides trading facilities for the
following derivative
Instruments:
. Index based futures
. Index based options
. Individual stock options
4. Individual stock futures
ontract specifications for index futures
NSE trades NiIty, CNX IT, BAN NiIty, CNX NiIty Junior, CNX 100,
NiIty Midcap 50 and Mini NiIty 50 Iutures contracts having one-month, two-month
and three-month expiry cycles. All contracts expire on the last Thursday oI every
month. Thus a January expiration contract would expire on the last Thursday oI
January and a February expiry contract would cease trading on the last Thursday oI
February.
On the Friday Iollowing the last Thursday, a new contract having a three-
month expiry would be introduced Ior trading. Thus, as shown in Figure 5.5 at any
point in time, three contracts would be available Ior trading with the Iirst contract
expiring on the last Thursday oI that month. Depending on the time period Ior
which you want to take an exposure in index Iutures contracts, you can place buy
and sell orders in the respective contracts.
The Instrument type reIers to "Futures contract on index" and Contract
symbol - NIFTY denotes a "Futures contract on NiIty index" and the Expiry date
represents the last date on which the contract will be available Ior trading. Each
Iutures contract has a separate limit order book. All passive orders are stacked in the
system in terms oI price-time priority and trades take place at the passive order
price (similar to the existing capital market trading system). The best buy order Ior
a given Iutures contract will be the order to buy the index at the highest index level
whereas the best sell order will be the order to sell the index at the lowest index
level.
New Products in the F&O Segment ;
The Year 8 witnessed the launch of new products in the F&O
Segment of NSE. The Mini derivative (Futures and Options)
contracts on S&P CNX Nifty were introduced for trading on
January , 8. The mini contracts have smaller contract size
than the normal Nifty contract and extend greater affordability to
individual investors and helps the individual investor to hedge
risks of a smaller portfolio. The Long Term Options Contracts on
S&P CNX Nifty were launched on March , 8. The long term
options have a life cycle of maximum years duration and offer
long term investors to take a view on prolonged price changes
over a longer duration, without needing to use a combination of
shorter term option contracts.
ligibility criteria of stocks,
The stock is chosen Irom amongst the top 500 stocks in terms oI average
daily market capitalization and average daily traded value in the previous six
months on a rolling basis. The stock's median quarter-sigma order size over the last
six months should be not less than Rs. 5 lakhs. For this purpose, a stock's quarter-
sigma order size should mean the order size (in value terms) required to cause a
change in the stock price equal to one-quarter oI a standard deviation.
The market wide position limit in the stock should not be less than Rs.100 crores.
The market wide position limit (number oI shares) is valued taking the closing
prices oI stocks in the underlying cash market on the date oI expiry oI contract in
the month.
The market wide position limit oI open position (in terms oI the number
oI underlying stock) on Iutures and option contracts on a particular underlying stock
shall be 20 oI the number oI shares held by non promoters in the relevant
underlying security i.e. Iree-Iloat holding. For an existing F&O stock, the continued
eligibility criteria is that market wide position limit in the stock shall not be less
than Rs. 60 crores and stock`s median quarter-sigma order size over the last six
months shall be not less than Rs. 2 lakh. II an existing security Iails to meet the
eligibility criteria Ior three months consecutively, then no Iresh month contract will
be issued on that security. However, the existing unexpired contracts can be
permitted to trade till expiry and new strikes can also be introduced in the existing
contract months. Further, once the stock is excluded Irom the F&O list, it shall not
be considered Ior re-inclusion Ior a period oI one year. Futures & Options contracts
may be introduced on (new) securities which meet the above mentioned eligibility
criteria, subject to approval by SEBI.
Eligibility criteria of indices;
The exchange may consider introducing derivative contracts on an
index iI the stocks contributing to 80 weightage oI the index are individually
eligible Ior derivative trading.
However, no single ineligible stocks in the index should have a weightage oI more
than 5 in the index. The above criteria is applied every month, iI the index Iails to
meet the eligibility criteria Ior three months consecutively, then no Iresh month
contract would be issued on that index, However, the existing unexpired contacts
will be permitted to trade till expiry
and new strikes can also be introduced in the existing contracts.
CHARGES
The maximum brokerage chargeable by a trading member in relation to trades
eIIected in the contracts admitted to dealing on the F&O segment oI NSE is Iixed at
2.5 oI the contract value in case oI index Iutures and stock Iutures. In case oI
index options and stock options it is 2.5 oI notional value oI the contract |(Strike
Price Premium) * Quantity)|, exclusive oI statutory levies. The transaction
charges payable to the exchange by the trading member Ior the trades executed by
him on the F&O segment are Iixed at the rate oI Rs. 2 per lakh oI turnover (0.002)
subject to a minimum oI Rs. 1,00,000 per year. However Ior the transactions in the
options sub-segment the transaction charges are levied on the premium value at the
rate oI 0.05 (each side) instead oI on the strike price as levied earlier. Further to
this, trading members have been advised to charge brokerage Irom their clients on
the Premium price(traded price) rather than Strike price. The trading members
contribute to Investor Protection Fund oI F&O segment at the rate oI Re. 1/- per Rs.
100 crores oI the traded value.
MTM settlement:
All Iutures contracts Ior each member are marked-to-market(MTM) to the daily
settlement price oI the relevant Iutures contract at the end oI each day. The
proIits/losses are computed as the diIIerence between:
1. The trade price and the day's settlement price Ior contracts executed during
the day but not squared up.
2. The previous day's settlement price and the current day's settlement
price Ior brought Iorward contracts.
3. The buy price and the sell price Ior contracts executed during the day and
squared up. The CMs who have a loss are required to pay the mark-to-market
(MTM) loss amount in cash which is in turn passed on to the CMs who have made a
MTM proIit. This is known as daily mark-to-market settlement. CMs are
responsible
To collect and settle the daily MTM proIits/losses incurred by the TMs and
their clients clearing and settling through them. Similarly, TMs are responsible to
collect/pay losses/proIits Irom/to their clients by the next day. The pay-in and pay-
out oI the mark-to-market settlement are eIIected on the day Iollowing the trade
day.
$ettlement of options contracts
Options contracts have three types oI settlements, daily premium
settlement, exercise settlement, interim exercise settlement in the case oI option
contracts on securities and Iinal settlement.
Daily premium settlement
Buyer oI an option is obligated to pay the premium towards the options
purchased by him. Similarly, the seller oI an option is entitled to receive the
premium Ior the option sold by him. The premium payable amount and the
premium receivable amount are netted to compute the net premium payable or
receivable amount Ior each client Ior each option contract.
Exercise settlement most option buyers and sellers close out their options
positions by an oIIsetting closing transaction, an understanding oI exercise can help
an option buyer determine whether exercise might be more advantageous than an
oIIsetting sale oI the option. There is always a possibility oI the option seller being
assigned an exercise.
Once an exercise oI an option has been assigned to an option seller, the
option seller is bound to IulIill his obligation (meaning, pay the cash settlement
amount in the case oI a cash-settled option) even though he may not yet have been
notiIied oI the assignment. Interim exercise settlement Interim exercise settlement
takes place only Ior option contracts on securities. An investor can exercise his in-
the-money options at any time during trading hours, through his trading member.
Interim exercise settlement is eIIected Ior such options at the close oI the trading
hours, on the day oI exercise.
Valid exercised option contracts are assigned to short positions in the
option contract with the same series (i.e. having the same underlying, same expiry
date and same strike price), on a random basis, at the client level. The CM who has
exercised the option receives the exercise settlement value per unit oI the option
Irom the CM who has been assigned the option contract.
Final exercise settlement Final exercise settlement is eIIected Ior
all open long in-the-money strike price options existing at the close oI trading
hours, on the expiration day oI
100 an option contract. All such long positions are exercised and automatically
assigned to short positions in option contracts with the same series, on a
Random basis. The investor who has long in-the-money options on
the expiry date will receive the exercise settlement value per unit oI the option Irom
the investor who has been assigned the option contract.
xercise process,
The period during which an option is exercisable depends on the style
oI the option. On NSE, index options are European style, i.e. options are only
subject to automatic exercise on the expiration day, iI they are in-the-money. As
compared to this, options on securities are American style. In such cases, the
exercise is automatic on the expiration day, and voluntary prior to the expiration
day oI the option contract, provided they are in-the-money. Automatic exercise
means that all in-the-money options would be exercised by NSCCL on the
expiration day oI the contract.
The buyer oI such options need not give an exercise notice in such
cases. Voluntary exercise means that the buyer oI an in-the-money option can direct
his TM/CM to give exercise
Instructions to NSCCL. In order to ensure that an option is exercised on a particular
day, the buyer must direct his TM to exercise beIore the cut-oII time Ior accepting
exercise instructions Ior that day. Usually, the exercise orders will be accepted by
the system till the close oI trading hours. DiIIerent TMs may have diIIerent cut -oII
times Ior accepting exercise instructions Irom customers, which may vary Ior
diIIerent options. An option, which expires unexercised, becomes worthless. Some
TMs may accept standing instructions to exercise, or have procedures Ior the
exercise oI every option, which is in the- money at expiration.
Once an exercise instruction is given by a CM to NSCCL, it cannot
ordinarily be revoked. Exercise notices given by a buyer at anytime on a day are
processed by NSCCL aIter the close oI trading hours on that day. All exercise
notices received by NSCCL Irom the NEAT F&O system are processed to
determine their validity. Some basic validation checks are carried out to check the
open buy position oI the exercising client/TM and iI option contract is in-the-
money. Once exercised contracts are Iound valid, they are assigned.
Assignment process,
The exercise notices are assigned in standardized market lots to short
positions in the option contract with the same series (i.e. same underlying, expiry
date and strike price) at the client level. Assignment to the short positions is done
on a random basis. NSCCL determines short positions, which are eligible to be
assigned and then allocates the exercised positions to any one or more short
positions.
Assignments are made at the end oI the trading day on which exercise
instruction is received by NSCCL and notiIied to the members on the same day. It
is possible that an option seller may not receive notiIication Irom its TM that an
exercise has been assigned to him until the next day Iollowing the date oI the
assignment to the CM by NSCCL.
xercise settlement computation,
In case oI index option contracts, all open long positions at in-the-
money strike prices are automatically exercised on the expiration day and assigned
to short positions in option contracts with the same series on a random basis. For
options on securities, where exercise settlement may be interim or Iinal, interim
exercise Ior an open long in-the-money option position can be eIIected on any day
till the expiry oI the contract.
Final exercise is automatically aIIected by NSCCL Ior all open long in-
the-money positions in the expiring month option contract, on the expiry day oI the
option contract. The exercise settlement price is the closing price oI the underlying
(index or security) on the exercise day (Ior interim exercise) or the expiry day oI the
relevant option contract (Iinal exercise).
The exercise settlement value is the diIIerence between the strike price
and the Iinal settlement price oI the relevant option contract. For call options, the
exercise settlement value receivable by a buyer is the diIIerence between the Iinal
settlement price and the strike price Ior each unit oI the underlying conveyed by the
option contract, while Ior put options it is diIIerence between the strike price and
the Iinal settlement price Ior each unit oI the underlying conveyed by the option
contract. Settlement oI exercises oI options on securities is currently by payment in
cash and not by delivery oI securities. It takes place Ior in-the-money option
contracts.
The exercise settlement value Ior each unit oI the exercised contract is computed as
Iollows:
Call options Closing price oI the security on the day oI exercise Strike price
Put options Strike price Closing price oI the security on the day oI exercise
For Iinal exercise the closing price oI the underlying security is taken on the
Expiration day. The exercise settlement value is debited / credited to the relevant
CMs clearing bank account on T 1 day (T exercise date).
Special Iacility Ior settlement oI institutional deals;
NSCCL provides a special Iacility to Institutions/Foreign Institutional
Investors (FIIs)/Mutual Funds etc. to execute trades through any TM, which may be
cleared and settled by their own CM. Such entities are called custodial participants
(CPs). To avail oI this Iacility, a CP is required to register with NSCCL through his
CM. A unique CP code is allotted to the CP by NSCCL. All trades executed by a
CP through any TM are required to have the CP code in the relevant Iield on the
trading system at the time oI order entry.
Such trades executed on behalI oI a CP are conIirmed by their own CM
(and not the CM oI the TM through whom the order is entered), within the time
speciIied by NSE on the trade day though the on-line conIirmation Iacility. Till
such time the trade is conIirmed by CM oI concerned CP, the same is considered as
a trade oI the TM and the responsibility oI settlement oI such trade vests with CM
oI the TM. Once conIirmed by CM oI concerned CP, such CM is responsible Ior
clearing and settlement oI deals oI such custodial clients.
FIIs have been permitted to trade in all the exchange traded derivative
contracts subject to compliance oI the position limits prescribed Ior them and their
subaccounts, and compliance with the prescribed procedure Ior settlement and
reporting. A FII/a sub-account oI the FII, as the case may be, intending to trade in
the F&O segment oI the exchange, is required to obtain a unique Custodial
Participant (CP) code allotted Irom the NSCCL. FII/sub-accounts oI FIIs which
have been allotted a unique CP code by NSCCL are only permitted to trade on the
F&O segment. The FD/sub-account oI FII ensures that all orders placed by them on
the Exchange carry the relevant CP code allotted by NSCCL.
ADJUSTMENTS FOR CORPORATE ACTIONS
The basis Ior any adjustment Ior corporate actions is such that the value oI
the position oI the market participants, on the cum and ex-dates Ior the corporate
action, continues to remain the same as Iar as possible. This Iacilitates in retaining
the relative status oI positions, namely in-the-money, at-the-money and out-oI-
money. This also addresses issues related to exercise and assignments.
Corporate actions can be broadly classiIied under stock beneIits and cash
beneIits. The various stock beneIits declared by the issuer oI capital are bonus,
rights, merger/de- merger, amalgamation, splits, consolidations, hive oII, warrants
and secured premium notes (SPNs) among others. The cash beneIit declared by the
issuer oI capital is cash dividend. Any adjustment Ior corporate actions is carried
out on the last day on which a security is traded on a cum basis in the underlying
equities market, aIter the close oI trading hours. Adjustments may entail
modiIications to positions and/or contract speciIications as listed below, such that
the basic premise oI adjustment
Laid down above is satisIied:
1. Strike price
2. Position
3. Market lot/multiplier
The adjustments are carried out on any or all oI the above, based on the nature oI
the
Corporate action. The adjustments Ior corporate actions are carried out on all
Open, exercised as well as assigned positions.
RIS MANAGEMENT
NSCCL has developed a comprehensive risk containment mechanism Ior
the F&O segment. The salient Ieatures oI risk containment mechanism on the F&O
segment are:
1. The Iinancial soundness oI the members is the key to risk Management.
ThereIore, the requirements Ior membership in terms oI capital adequacy (net
worth, security deposits) are quite stringent.
2. NSCCL charges an upIront initial margin Ior all the open positions oI a CM. It
speciIies the initial margin requirements Ior each Iutures/options contract on a daily
basis. It also Iollows value-at-risk (VaR) based margining through SPAN. The CM
in turn collects the initial margin Irom the TMs and their respective clients.
3. The open positions oI the members are marked to market based on contract
settlement price Ior each contract. The diIIerence is settled in cash on a T1 basis.
4. NSCCL's on-line position monitoring system monitors a CM's open positions on
a real-time basis. Limits are set Ior each CM based on his capital deposits. The on-
line position monitoring system generates alerts whenever a CM reaches a position
limit set up by NSCCL. NSCCL monitors the CMs Ior MTM value violation, while
TMs are monitored Ior contract-wise position limit violation.
5. CMs are provided a trading terminal Ior the purpose oI monitoring the open
positions oI all the TMs clearing and settling through him. A CM may set exposure
limits Ior a TM clearing and settling through him. NSCCL assists the CM to
monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds
the limits, it stops that particular TM Irom Iurther trading.
6. A member is alerted oI his position to enable him to adjust his exposure or bring
in additional capital. Position violations result in withdrawal oI trading Iacility Ior
all TMs oI a CM in case oI a violation by the CM.
7. A separate settlement guarantee Iund Ior this segment has been created out oI the
capital oI members. The most critical component oI risk containment mechanism
Ior F&O segment is the margining system and on-line position monitoring. The
actual position monitoring and margining is carried out on-line through Parallel
Risk Management System (PRISM). PRISM uses SPAN(r) (Standard PortIolio
Analysis oI Risk) system Ior the purpose oI computation oI on-line margins,
based on the parameters deIined by SEBI.
NSCCL-SPAN
The objective oI NSCCL-SPAN is to identiIy overall risk in a
portIolio oI all Iutures and options contracts Ior each member. The system treats
Iutures and options contracts uniIormly, while at the same time recognizing the
unique exposures associated with options portIolios, like extremely deep out-oI-the
money short positions and inter- month risk. Its over-riding objective is to
determine the largest loss that a portIolio might reasonably be expected to suIIer
Irom one day to the next day based on 99 VaR methodology. SPAN considers
uniqueness oI option portIolios. The Iollowing Iactors aIIect the value oI an option:
1. Underlying market price
2. Strike price
3. Volatility (variability) oI underlying instrument
4. Time to expiration
5. Interest rate
As these Iactors change, the value oI options maintained within a
portIolio also changes. Thus, SPAN constructs scenarios oI probable changes in
underlying prices and volatilities in order to identiIy the largest loss a portIolio
might suIIer Irom one day to the next. It then sets the margin requirement to cover
this one-day loss. The complex calculations (e.g. the pricing oI options) in SPAN
are executed by NSCCL
The results oI these calculations are called risk arrays. Riskarrays, and other
necessary data inputs Ior margin calculation are provided to members daily in a Iile
called the SPAN risk parameter Iile. Members can apply the data contained in the
risk parameter Iiles, to their speciIic portIolios oI Iutures and options contracts, to
determine their SPAN margin requirements. Hence, members need not execute
complex option pricing calculations, which are perIormed by NSCCL. SPAN has
the ability to estimate risk Ior combined Iutures and options portIolios, and also re-
value the same under various scenarios oI changing market conditions.
%ypes of mari3s:
The margining system Ior F&O segment is explained below:
Initial margin: Margin in the F&O segment is computed by NSCCL upto client
level Ior open positions oI CMs/TMs. These are required to be paid up-Iront on
gross basis at individual client level Ior client positions and on net basis Ior
proprietary positions. NSCCL collects initial margin
Ior all the open positions oI a CM based on the margins computed by NSE-SPAN.
A CM is required to ensure collection oI adequate initial margin Irom his TMs up-
Iront. The TM is required to collect adequate initial margins up-Iront Irom his
clients.
Premium margin: In addition to initial margin, premium margin is charged at client
level. This margin is required to be paid by a buyer oI an option till the premium
settlement is complete.
Assignment margin for options on securities: Assignment margin islevied in
addition to initial margin and premium margin. It is required to be paid on assigned
positions oI CMs towards interim and Iinal exercise settlement obligations Ior
option contracts on individual securities, till such obligations are IulIilled. The
margin is charged on the net exercise settlement value payable by a CM towards
interim and Iinal exercise settlement.
lient margins : NSCCL intimates all members oI the margin liability oIeach oI
their client. Additionally members are also required to report details oI margins
collected Irom clients to NSCCL, which holds in trust client margin monies to the
extent reported by the member as having been collected Iorm their respective
clients.
ARGINING SYSTE
Derivatives enable traders to take on leveraged positions. This can be very risky
because a small movement in prices oI underlying could result in either big gains or
big losses. Hence the margining system Ior derivatives becomes an important aspect
oI market Iunctioning and determines the integrity oI this market. In this chapter we
look at some margining concepts and the methodology used Ior computing margins.
NSCCL has developed a comprehensive risk containment mechanism Ior the
Futures & Options segment. The most critical component oI a risk containment
mechanism is the online position monitoring and margining system. The actual
margining and position monitoring is done on-line, on an intra-day basis using
PRISM (Parallel Risk Management System) which is the real-time position
monitoring and risk management system. The risk oI each trading and clearing
member is monitored on a real-time basis and alerts/disablementmessages are
generated iI the member crosses the set limits. NSCCL uses the SPAN (Standard
PortIolio Analysis oI Risk) system, a portIolio based margining system, Ior the
purpose oI calculating initial margins.
$! approach of computing initial margins:
The objective oI SPAN is to identiIy overall risk in a portIolio oI Iutures and
options contracts Ior each member. The system treats Iutures and options contracts
uniIormly, while at the same time recognizing the unique exposures associated with
options portIolios like extremely deep out-oI-the-money short positions, inter-
month risk and inter-commodity risk. Because SPAN is used to determine
perIormance bond requirements (margin requirements), its overriding objective is to
determine the largest loss that a portIolio might reasonably be expected to suIIer
Irom one day to the next day. In standard pricing models, three Iactors most directly
aIIect the value oI an option at a given point in time:
1. Underlying market price
2. Volatility (variability) oI underlying instrument
3. Time to expiration
As these Iactors change, so too will the value oI Iutures and options maintained
within a portIolio. SPAN constructs sixteen scenarios oI probable changes in
underlying prices and volatilities in order to identiIy the largest loss a portIolio
might suIIer Irom one day to the next. It then sets the margin requirement at a level
suIIicient to cover this one-day loss. The computation oI worst scenario loss has
two components. The Iirst is the valuation oI each contract under sixteen scenarios.
The second is the application oI these scenario contract values to the actual
positions in a portIolio to compute the portIolio values and the worst scenario loss.
The scenario contract values are updated at least 5 times in the day, which may be
carried out by taking prices at the start oI trading, at 11:00 a.m., at 12:30 p.m., at
2:00 p.m., and at the end oI the trading session.
Mechanics of SPAN:
The complex calculations (e.g. the pricing oI options) in SPAN are executed by
NSCCL. The results oI these calculations are called risk arrays. Risk arrays, and
other necessary data inputs Ior margin calculation are then provided to members on
a daily basis in a Iile called the SPAN Risk Parameter Iile. Members can apply the
data contained in the risk parameter Iiles, to their speciIic portIolios oI Iutures and
options contracts, to determine their SPAN margin requirements. Hence members
do not need to execute complex option pricing calculations. SPAN has the ability to
estimate risk Ior combined Iutures and options portIolios, and re-value the same
under various scenarios oI changing market conditions.
Risk arrays:
The SPAN risk array represents how a speciIic derivative instrument (Ior example,
an option on NIFTY index at a speciIic strike price) will gain or lose value, Irom
the current point in time to a speciIic point in time in the near Iuture, Ior a speciIic
set oI market conditions which may occur over this time duration. The results oI the
calculation Ior each risk scenario i.e. the amount by which the Iutures and options
contracts will gain or lose value over the look-ahead time under that risk scenario -
is called the risk array value Ior that scenario. The set oI risk array values Ior each
Iutures and options contract under the Iull set oI risk scenarios, constitutes the risk
array Ior that contract. In the risk array, losses are represented as positive values,
and gains as negative values. Risk array values are represented in Indian Rupees,
the currency in which the Iutures or options contract is denominated.
Risk scenarios:
The speciIic set oI market conditions evaluated by SPAN, are called the risk
scenarios, and these are denned in terms oI:
1. How much the price oI the underlying instrument is expected to change
over one trading day, and
2. How much the volatility oI that underlying price is expected to change over
one trading day.
SPAN Iurther uses a standardized deIinition oI the risk scenarios, deIined in
terms oI:
1. The underlying price scan range or probable price change over a one day
period, and
2. The underlying price volatility scan range or probable volatility change oI the
underlying over a one day period.
Method of computation of volatility
The exponential moving average method is used to obtain the volatility estimate
every day. The estimate at the end oI day t, t-1 is estimated using the previous day's
volatility estimate t-1 (as at the end oI day t-1), and the return rt observed in the
Iutures market on day t. where is a parameter which determines how rapidly
volatility estimates change. A value oI 0.94 is used Ior SPAN uses the risk arrays to
scan probable underlying market price changes and probable volatility changes Ior
all contracts in a portIolio, in order to determine value gains and losses at the
portIolio level. This is the single most important calculation executed by the
system.
Scanning risk charge
As shown in the table giving the sixteen standard risk scenarios, SPAN starts
at the last underlying market settlement price and scans up and down three
even intervals oI price changes (price scan range). At each price scan point,
the program also scans up and down a range oI probable volatility Irom the
underlying market's current volatility (volatility scan range). SPAN calculates
the probable premium value at each price scan point Ior volatility up and
volatility down scenario. It then compares this probable premium value to the
theoretical premium value (based on last closing value oI the underlying) to
determine proIit or loss.
Deep-out-oI-the-money short options positions pose a special risk identiIication
problem. As they move towards expiration, they may not be signiIicantly
exposed to "normal" price moves in the underlying. However, unusually large
underlying price changes may cause these options to move into-the-money,
thus creating large losses to the holders oI short option positions. In order to
account Ior this possibility, two oI the standard risk scenarios in the risk array,
Number 15 and 16, reIlect an "extreme" underlying price movement, currently
denned as double the maximum price scan range Ior a given underlying.
However, because price changes oI these magnitudes are rare, the system
only covers 35 oI the resulting losses.
AIter SPAN has scanned the 16 diIIerent scenarios oI underlying market price
and volatility changes, it selects the largest loss Irom among these 16
observations. This "largest reasonable loss" is the scanning risk charge Ior the
portIolio.
Calendar spread margin-
A calendar spread is a position in an underlying with one maturity which is
hedged by an oIIsetting position in the same underlying with a diIIerent
maturity: Ior example, a short position in a July Iutures contract on Reliance
and a long position in the August Iutures contract on Reliance is a calendar
spread. Calendar spreads attract lower margins because they are not exposed
to market risk oI the underlying. II the underlying rises, the July contract would
make a proIit while the August contract would make a loss.
As SPAN scans Iutures prices within a single underlying instrument, it assumes
that price moves correlate perIectly across contract months. Since price moves
across contract months do not generally exhibit perIect correlation, SPAN adds
an calendar spread charge (also called the inter-month spread charge) to the
scanning risk charge associated with each Iutures and options contract. To put
it in a diIIerent way, the calendar spread charge covers the calendar basis risk
that may exist Ior portIolios containing Iutures and options with diIIerent
expirations.
For each Iutures and options contract, SPAN identiIies the delta associated each
Iutures and option position, Ior a contract month. It then Iorms spreads using these
deltas across contract months. For each spread Iormed, SPAN assesses
a speciIic charge per spread which constitutes the calendar spread charge.
The margin Ior calendar spread is calculated on the basis oI delta oI the
portIolio in each month. Thus a portIolio consisting oI a near month option
with a delta oI 100 and a Iar month option with a delta oI 100 would bear a
spread charge equivalent to the calendar spread charge Ior a portIolio which is
long 100 near month Iutures contract and short 100 Iar month Iutures
contract. A calendar spread position on Exchange traded equity derivatives may
be granted calendar spread treatment till the expiry oI the near month
contract.
Margin on calendar spreads is levied at 0.5 per month oI spread on the Iar
month contract oI the spread subject to a minimum margin oI 1 and a
maximum margin oI 3 on the Iar month contract oI the spread.
Short option minimum margin
Short options positions in extremely deep-out-oI-the-money strikes may
appear to have little or no risk across the entire scanning range. However, in
the event that underlying market conditions change suIIiciently, these options
may move into-the-money, thereby generating large losses Ior the short
positions in these options. To cover the risks associated with deep-out-oI-themoney
short options positions, SPAN assesses a minimum margin Ior each
short option position in the portIolio called the short option minimum charge,
which is set by the NSCCL. The short option minimum charge serves as a
minimum charge towards margin requirements Ior each short position in an
option contract.
For example, suppose that the short option minimum charge is Rs.50 per short
position. A portIolio containing 20 short options will have a margin
requirement oI at least Rs. 1,000, even iI the scanning risk charge plus the
calendar spread charge on the position is only Rs. 500.
The short option minimum margin equal to 3 oI the notional value oI all
short index options is charged iI sum oI the worst scenario loss and the
calendar spread margin is lower than the short option minimum margin. For
stock options it is equal to 7.5 oI the notional value based on the previous
days closing value oI the underlying stock. Notional value oI option positions is
calculated on the short option positions by applying the last closing price oI
the relevant underlying.
Net option value
The net option value is calculated as the c urrent market value oI the option times
the number oI option units (positive Ior long options and negative Ior short
options) in the portIolio. Net option value is added to the liquid net worth oI the
clearing member. This means that the current market value oI short options are
deducted Irom the liquid net worth and the market value oI long options are added
thereto. Thus mark to market gains and losses on option positions get adjusted
against the available liquid net worth.
Net buy premium
To cover the one day risk on long option positions (Ior which premium
shall be payable on T1 day), net buy premium to the extent oI the net
long options position value is deducted Irom the Liquid Networth oI the
member on a real time basis. This would be applicable only Ior trades
done on a given day. The net buy premium margin shall be released
towards the Liquid Networth oI the member on T1 day aIter the
completion oI pay-in towards premium settlement.
O;erall portfolio mari3 requireme3t
The total margin requirements Ior a member Ior a portIolio oI Iutures and
options contract would be computed by SPAN as Iollows:
1. Adds up the scanning risk charges and the calendar spread
charges.
2. Compares this Iigure to the short option minimum charge and
selects the larger oI the two. This is the SPAN risk requirement.
3. Total SPAN margin requirement is equal to SPAN risk requirement
less the net option value, which is mark to market value oI
diIIerence in long option positions and short option positions.
4. Initial margin requirement Total SPAN margin requirement
Net Buy Premium.
REGULATORY FRAMEWORK
The trading oI derivatives is governed by the provisions contained in the
SC(R)A, the SEBI Act, the rules and regulations Iramed thereunder and the
rules and byelaws oI stock exchanges.
SECURITIES CONTRACTS (REGULATION) ACT, 1956
SC(R)A aims at preventing undesirable transactions in securities by regulating
the business oI dealing therein and by providing Ior certain other matters
connected therewith. This is the principal Act, which governs the trading oI
securities in India. The term 'securities has been deIined in the SC(R)A. As
per Section 2(h), the Securities` include:
1. Shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities oI a like nature in or oI any incorporated
company or other body corporate.
2. Derivative
3. Units or any other instrument issued by any collective investment
scheme to the investors in such schemes.
4. Government securities
5. Such other instruments as may be declared by the Central Government
to be securities.
6. Rights or interests in securities.
'Derivative is deIined to include:
A security derived Irom a debt instrument, share, loan whether secured
or unsecured, risk instrument or contract Ior diIIerences or any other
Iorm oI security.
A contract which derives its value Irom the prices, or index oI prices, oI
underlying securities.
Section 18A provides that notwithstanding anything contained in any other
law Ior the time being in Iorce, contracts in derivative shall be legal and valid
iI such contracts are:
Traded on a recognized stock exchange
Settled on the clearing house oI the recognized stock exchange, in
accordance with the rules and byelaws oI such stock exchanges.
SECURITIES AND EXCHANGE BOARD OF INDIA
ACT, 1992
SEBI Act, 1992 provides Ior establishment oI Securities and Exchange Board
oI India(SEBI) with statutory powers Ior (a) protecting the interests oI
investors in securities (b) promoting the development oI the securities market
and (c) regulating the securities market. Its regulatory jurisdiction extends
over corporates in the issuance oI capital and transIer oI securities, in
addition to all intermediaries and persons associated with securities market.
SEBI has been obligated to perIorm the aIoresaid Iunctions by such measures
as it thinks Iit. In particular, it has powers Ior:
regulating the business in stock exchanges and any other securities
markets.
registering and regulating the working oI stock brokers, subbrokers
etc.
promoting and regulating selI-regulatory organizations.
prohibiting Iraudulent and unIair trade practices.
calling Ior inIormation Irom, undertaking inspection, conducting
inquiries and audits oI the stock exchanges, mutual Iunds and other
persons associated with the securities market and intermediaries and
selIregulatory organizations in the securities market.
perIorming such Iunctions and exercising according to Securities
Contracts (Regulation) Act, 1956, as may be delegated to it by the
Central Government.
REGULATION FOR DERIVATIVES TRADING
SEBI set up a 24- member committee under the Chairmanship oI Dr. L. C.
Gupta to develop the appropriate regulatory Iramework Ior derivatives trading
in India. On May 11, 1998 SEBI accepted the recommendations oI the
committee and approved the phased introduction oI derivatives trading in
India beginning with stock index Iutures.
The provisions in the SC(R)A and the regulatory Iramework developed
thereunder govern trading in securities. The amendment oI the SC(R)A to
include derivatives within the ambit oI securities` in the SC(R)A made trading
in derivatives possible within the Iramework oI that Act.
1. Any Exchange IulIilling the eligibility criteria as prescribed in the L. C.
Gupta committee report can apply to SEBI Ior grant oI recognition
under Section 4 oI the SC(R)A, 1956 to start trading derivatives. The
derivatives exchange/segment should have a separate governing
council and representation oI trading/clearing members shall be limited
to maximum oI 40 oI the total members oI the governing council. The
exchange would have to regulate the sales practices oI its members
and would have to obtain prior approval oI SEBI beIore start oI trading
in any derivative contract.
2. The Exchange should have minimum 50 members.
3. The members oI an existing segment oI the exchange would not
automatically become the members oI derivative segment. The
members oI the derivative segment would need to IulIill the eligibility
conditions as laid down by the L. C. Gupta committee.
4. The clearing and settlement oI derivatives trades would be through a
SEBI approved clearing corporation/house. Clearing
corporations/houses complying with the eligibility conditions as laid
down by the committee have to apply to SEBI Ior grant oI approval.
5. Derivative brokers/dealers and clearing members are required to seek
registration Irom SEBI. This is in addition to their registration as brokers
oI existing stock exchanges. The minimum networth Ior clearing
members oI the derivatives clearing corporation/house shall be Rs.300
Lakh. The networth oI the member shall be computed as Iollows:
Capital Free reserves
Less non-allowable assets viz.,
(a) Fixed assets
119
(b) Pledged securities
(c) Member`s card
(d) Non-allowable securities(unlisted securities)
(e) Bad deliveries
(I) DoubtIul debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30 marketable securities
6. The minimum contract value shall not be less than Rs.2 Lakh.
Exchanges have to submit details oI the Iutures contract they propose
to introduce.
7. The initial margin requirement, exposure limits linked to capital
adequacy and margin demands related to the risk oI loss on the
position will be prescribed by SEBI/Exchange Irom time to time.
8. The L. C. Gupta committee report requires strict enIorcement oI 'now
your customer rule and requires that every client shall be registered
with the derivatives broker. The members oI the derivatives segment
are also required to make their clients aware oI the risks involved in
derivatives trading by issuing to the client the Risk Disclosure
Document and obtain a copy oI the same duly signed by the client.
9. The trading members are required to have qualiIied approved user and
sales person who have passed a certiIication programme approved by
SEBI.
Forms of collateral's acceptable at ASL
Members and dealer authorized dealer have to IulIill certain requirements and
provide collateral deposits to become members oI the F&O segment. All
collateral deposits are segregated into cash component and non-cash
component. Cash component means cash, bank guarantee, Iixed deposit
receipts, T-bills and dated government securities. Non-cash component mean
all other Iorms oI collateral deposits like deposit oI approved demat securities.
#equireme3ts to become authorized / appro;ed user
Trading members and participants are entitled to appoint, with the approval
oI the F&O segment oI the exchange authorized persons and approved users
to operate the trading workstation(s). These authorized users can be
individuals, registered partnership Iirms or corporate bodies.
Authorized persons cannot collect any commission or any amount directly
Irom the clients he introduces to the trading member who appointed him.
However he can receive a commission or any such amount Irom the trading
member who appointed him as provided under regulation.
Approved users on the F&O segment have to pass a certiIication program
which has been approved by SEBI. Each approved user is given a unique
identiIication number through which he will have access to the NEAT system.
The approved user can access the NEAT system through a password and can
change such password Irom time to time.
Positio3 limits
Position limits have been speciIied by SEBI at trading member, client, market
and FII levels respectively.
Trading member position limits
Trading member position limits are speciIied as given below:
1. Trading member position limits in equity index option contracts: The
trading member position limits in equity index option contracts is higher
oI Rs.500 crore or 15 oI the total open interest in the market in
equity index option contracts. This limit is applicable on open positions
in all option contracts on a particular underlying index.
2. Trading member position limits in equity index Iutures contracts: The
trading member position limits in equity index Iutures contracts is higher
oI Rs.500 crore or 15 oI the total open interest in the market in
equity index Iutures contracts. This limit is applicable on open
positions in all Iutures contracts on a particular underlying index.
3. Trading member position limits Ior combined Iutures and options
position:
For stocks having applicable market-wise position limit(MWPL) oI
500 crores or more, the combined Iutures and options
position limit is 20 oI applicable MWPL or Rs.300 crores,
whichever is lower and within which stock Iutures position cannot
exceed 10 oI applicable MWPL or Rs.150 crores, whichever is
lower.
For stocks having applicable market-wise position limit (MWPL)
less than Rs.500 crores, the combined Iutures and options
position limit is 20 oI applicable MWPL and Iutures position
cannot exceed 20 oI applicable MWPL or Rs.50 crore which
ever is lower. The Clearing Corporation shall speciIy the trading
member-wise position limits on the last trading day month
which shall be reckoned Ior the purpose during the next month.
Client level position limits
The gross open position Ior each client, across all the derivative contracts on
an underlying, should not exceed 1 oI the Iree Iloat market capitalization (in
terms oI number oI shares) or 5 oI the open interest in all derivative
contracts in the same underlying stock (in terms oI number oI shares)
whichever is higher.
Market wide position limits
The market wide limit oI open position (in terms oI the number oI underlying
stock) on Iutures and option contracts on a particular underlying stock is 20
oI the number oI shares held by non-promoters in the relevant underlying
security i.e. IreeIloat holding. This limit is applicable on all open positions in
all Iutures and option contracts on a particular underlying stock. The
enIorcement oI the market wide limits is done in the Iollowing manner:
At end oI the day the exchange tests whether the market wide open
interest Ior any scrip exceeds 95 oI the market wide position limit Ior
that scrip. In case it does so, the exchange takes note oI open position
oI all client/TMs as at end oI that day Ior that scrip and Irom next day
onwards they can trade only to decrease their positions through
oIIsetting positions.
At the end oI each day during which the ban on Iresh positions is in Iorce
Ior any scrip, the exchange tests whether any member or client has
increased his existing positions or has created a new position in that
scrip. II so, that client is subject to a penalty equal to a speciIied
percentage (or basis points) oI the increase in the position (in terms oI
notional value). The penalty is recovered beIore trading begins next
day. The exchange speciIies the percentage or basis points, which is set
high enough to deter violations oI the ban on increasing positions.
The normal trading in the scrip is resumed aIter the open outstanding
position comes down to 80 or below oI the market wide position
limit. Further, the exchange also checks on a monthly basis, whether a
stock has remained subject to the ban on new position Ior a signiIicant
part oI the month consistently Ior three months. II so, then the
exchange phases out derivative contracts on that underlying.
FII and sub-account position limits
FII and subaccount position limits are speciIied as given below:
1. The FII position limit in all index options contracts on a particular
underlying index is Rs. 500 crore or 15 oI the total open interest oI
the market in index options, whichever is higher, per exchange. This
limit is applicable on open positions in all option contracts on a
particular underlying index.
2. FII position limit in all index Iutures contracts on a particular
underlying index is the same as mentioned above Ior FII position limits
in index option contracts. This limit is applicable on open positions in
all Iutures contracts on a particular underlying index.
In addition to the above, FIIs can take exposure in equity index derivatives
subject to the Iollowing limits:
1. Short positions in index derivatives (short Iutures, short calls and long
puts) not exceeding (in notional value) the FIIs holding oI stocks.
2. Long positions in index derivatives (long Iutures, long calls and short
puts) not exceeding (in notional value) the FIIs holding oI cash,
government securities, T-bills and similar instruments.
The FIIs should report to the clearing member (custodian) the extent oI the
FIIs holding oI stocks, cash, government securities, T-bills and similar
instruments beIore the end oI the day. The clearing member (custodian) in
turn should report the same to the exchange. The exchange monitors the FII
position limits. The position limit Ior sub-account is same as that oI client level
position limits.
Position limits for mutual funds
Mutual Funds are allowed to participate in the derivatives market at par with
Foreign Institutional Investors (FII). Accordingly, mutual Iunds shall be
treated at par with a registered FII in respect oI position limits in index
Iutures, index options, stock options and stock Iutures contracts. Mutual Iunds
will be considered as trading members like registered FIIs and the schemes oI
mutual Iunds will be treated as clients like sub-accounts oI FIIs.
The position limits Ior Mutual Funds and its schemes shall be as under:
1. Position limit Ior mutual Iunds in index options contracts:
a) The mutual Iund position limit in all index options contracts on a
particular underlying index shall be Rs.500 crore or 15 oI the total
open interest oI the market in index options, whichever is higher, per
stock exchange.
b) This limit would be applicable on open positions in all options
contracts on a particular underlying index.
2. Position limit Ior mutual Iunds in index Iutures contracts:
a) The mutual Iund position limit in all index Iutures contracts on a
particular underlying index shall be Rs.500 crore or 15 oI the
total open interest oI the market in index Iutures, whichever is
higher, per stock exchange.
b) This limit would be applicable on open positions in all Iutures
contracts on a particular underlying index.
3. Additional position limit Ior hedging: In addition to the position limits
above, mutual Iunds may take exposure in equity index derivatives
subject to the Iollowing limits:
a) Short positions in index derivatives (short Iutures, short calls and
long puts) shall not exceed (in notional value) the mutual Fund`s
holding oI stocks.
b) Long positions in index derivatives (long Iutures, long calls and
short puts) shall not exceed (in notional value) the mutual
Fund`s holding oI cash, government securities, TBills and
similar instruments.
4. Foreign Institutional Investors and Mutual Fund Position limits on
individual securities:
a) For stoc ks having applicable market-wide position limit (MWPL)
oI Rs. 500 crores or more, the combined Iutures and options
position limit shall be 20 oI applicable MWPL or Rs. 300
crores, whichever is lower and within which stock Iutures
position cannot exceed 10 oI applicable MWPL or Rs. 150
crores, whichever is lower.
b) For stocks having applicable market-wide position limit (MWPL)
less than Rs. 500 crores, the combined Iutures and options
position limit shall be 20 oI applicable MWPL and stock
Iutures position cannot exceed 20 oI applicable MWPL or Rs.
50 crores, whichever is lower.
5. Position limit Ior each scheme oI a mutual Iund: The position limits Ior
each scheme oI mutual Iund and disclosure requirements shall be
identical to that prescribed Ior a subaccount oI a FII. ThereIore, the
schemewise position limit/disclosure requirements shall be as Iollows:
a) For stock option and stock Iutures contracts, the gross open
position across all derivative contracts on a particular
underlying stock oI a scheme oI a mutual Iund shall not exceed
the higher oI 1 oI the Iree Iloat market capitalisation (number
oI shares) or 5 oI open interest (number oI contracts) in
derivative contracts on a particular underlying stock.
b) This position limits shall be applicable on the combined position
in all derivative contracts on an underlying stock at a stock
exchange.
c) For index based contracts, mutual Iunds shall disclose the total
open interest held by its scheme or all schemes put together in
a particular underlying index, iI such open interest equals to or
exceeds 15 oI the open interest oI all derivative contracts on
that underlying index.
#eporti3 of clie3t mari3
Clearing Members (CMs) and Trading Members (TMs) are required to collect
upIront initial margins Irom all their Trading Members/ Constituents.
CMs are required to compulsorily report, on a daily basis, details in respect oI
such margin amount due and collected, Irom the TMs/ Constituents clearing
and settling through them, with respect to the trades executed/ open
positions oI the TMs/ Constituents, which the CMs have paid to NSCCL, Ior the
purpose oI meeting margin requirements.
Similarly, TMs are required to report on a daily basis details in respect oI such
margin amount due and collected Irom the constituents clearing and settling
through them, with respect to the trades executed/ open positions oI the
constituents, which the trading members have paid to the CMs, and on which
the CMs have allowed initial margin limit to the TMs.
AD1USTMENTS FOR CORPORATE ACTIONS
Adjustments Ior corporate actions Ior stock options would be as Iollows:
The basis Ior any adjustment Ior corporate action shall be such that the
value oI the position oI the market participants on cum and ex-date Ior
corporate action shall continue to remain the same as Iar as possible.
This will Iacilitate in retaining the relative status oI positions namely inthe-
money, at-the-money and out-oI-money. This will also address
issues related to exercise and assignments.
Adjustment Ior corporate actions shall be carried out on the last day on
which a security is traded on a cum basis in the underlying cash
market.
Adjustments shall mean modiIications to positions and/or contract
speciIications namely strike price, position, market lot, multiplier. These
adjustments shall be carried out on all open, exercised as well as
assigned positions.
The corporate actions may be broadly classiIied under stock beneIits and
cash beneIits. The various stock beneIits declared by the issuer oI
capital are bonus, rights, merger/demerger, amalgamation, splits,
consolidations, hiveoII, warrants and secured premium notes and
dividends.
The methodology Ior adjustment oI corporate actions such as bonus,
stock splits and consolidations is as Iollows:
- Strike price: The new strike price shall be arrived at by dividing
the old strike price by the adjustment Iactor as under.
- Market lot/multiplier: The new market lot/multiplier shall be
arrived at by multiplying the old market lot by the adjustment
Iactor as under.
- Position: The new position shall be arrived at by multiplying the
old position by the adjustment Iactor, which will be computed
using the pre-speciIied methodology.
The adjustment Iactor Ior bonus, stock splits and consolidations is arrived at as
Iollows:
- Bonus: Ratio - A:B; Adjustment Iactor: (AB)/B
- Stock splits and consolidations: Ratio - A:B ; Adjustment Iactor:
B/A
- Right: Ratio - A:B
* Premium: C
* Face value: D
* Existing strike price: X
* New strike price: ((B * X) A * (C D))/(AB)
- Existing market lot / multiplier/ position: Y ; New issue size : Y *
(AB)/B
The above methodology may result in Iractions due to the corporate
action e.g. a bonus ratio oI 3:7. With a view to minimizing Iraction
settlements, the Iollowing methodology is proposed to be adopted:
1. Compute value oI the position beIore adjustment.
2. Compute value oI the position taking into account the exact
adjustment Iactor.
3. Carry out rounding oII Ior the Strike Price and Market Lot.
4. Compute value oI the position based on the revised strike price and
market lot.
The diIIerence between 1 and 4 above, iI any, shall be decided in the
manner laid down by the group by adjusting strike price or market lot,
so that no Iorced closure oI open position is mandated.
Dividends which are below 10 oI the market value oI the underlying
stock, would be deemed to be ordinary dividends and no adjustment in
the strike price would be made Ior ordinary dividends. For extra-ordinary
dividends, above 10 oI the market value oI the underlying stock, the
strike price would be adjusted.
The exchange will on a case to case basis carry out adjustments Ior other
corporate actions as decided by the group in conIormity with the above
guidelines.
ACCOUNTING
Accou3ti3 for futures
The Institute oI Chartered Accountants oI India (ICAI) has issued guidance
notes on accounting oI index Iutures contracts Irom the view point oI parties
128
who enter into such Iutures contracts as buyers or sellers. For other parties
involved in the trading process, like brokers, trading members, clearing
members and clearing corporations, a trade in equity index Iutures is similar
to a trade in, say shares, and does not pose any peculiar accounting
problems. Hence in this section we shall largely Iocus on the accounting
treatment oI equity index Iutures in the books oI the client. But beIore we do
so, a quick re-look at some oI the terms used.
1. Clearing corporation/house: Clearing corporation/house means the
clearing corporation/house approved by SEBI Ior clearing and
settlement oI trades on the derivatives exchange/segment. All the
clearing and settlement Ior trades that happen on the NSE`s market is
done through NSCCL.
2. Clearing member: Clearing member means a member oI the clearing
corporation and includes all categories oI clearing members as may be
admitted as such by the clearing corporation to the derivatives
segment.
3. Client: A client means a person, on whose instructions and, on whose
account, the trading member enters into any contract Ior the purchase
or sale oI any contract or does any act in relation thereto.
4. Contract month: Contract month means the month in which the
exchange/clearing corporation rules require a contract to be Iinally
settled.
5. Daily settlement price: Daily settlement price is the closing price oI the
equity index Iutures contract Ior the day or such other price as may be
decided by the clearing house Irom time to time.
6. Derivative exchange/segment: Derivative exchange means an
exchange approved by SEBI as a derivative exchange. Derivative
segment means segment oI an existing exchange approved by SEBI as
derivatives segment.
7. Final settlement price: The Iinal settlement price is the closing price oI
the equity index Iutures contract on the last trading day oI the contract
or such other price as may be speciIied by the clearing corporation, Irom
time to time.
8. Long position: Long position in an equity index Iutures contract means
outstanding purchase obligations in respect oI the equity index Iutures
contract at any point oI time .
9. Open position: Open position means the total number oI equity index
Iutures contracts that have not yet been oIIset and closed by an
opposite position.
10. Settlement date: Settlement date means the date on which the
settlement oI outstanding obligations in an equity index Iutures
contract are required to be settled as provided in the Bye-Laws oI the
Derivatives exchange/segment.
11. Short position: Short position in an equity index Iutures contract means
outstanding sell obligations in respect oI an equity index Iutures
contract at any point oI time.
12. Trading member: Trading member means a Member oI the Derivatives
exchange/segment and registered with SEBI.
Accounting at the inception of a contract
Every client is required to pay to the trading member/clearing member, the
initial margin determined by the clearing corporation as per the byelaws/
regulations oI the exchange Ior entering into equity index Iutures
contracts. Such initial margin paid/payable should be debited to 'Initial
margin - Equity index Iutures account. Additional margins, iI any, should also
be accounted Ior in the same manner. It may be mentioned that at the time
when the contract is entered into Ior purchase/sale oI equity index Iutures, no
entry is passed Ior recording the contract because no payment is made at
that time except Ior the initial margin. At the balance sheet date, the balance
in the Initial margin - Equity index Iutures account` should be shown
separately under the head current assets`. In those cases where any amount
has been paid in excess oI the initial/additional margin, the excess should be
disclosed separately as a deposit under the head current assets`. In cases
where instead oI paying initial margin in cash, the client provides bank
guarantees or lodges securities with the member, a disclosure should be
made in the notes to the Iinancial statements oI the client.
Accounting at the time of daily settlement
This involves the accounting oI payment/receipt oI mark-to-market margin
money. Payments made or received on account oI daily settlement by the
client would be credited/debited to the bank account and the corresponding
debit or credit Ior the same should be made to an account titled as 'Mark-tomarket
margin - Equity index Iutures account.
Some times the client may deposit a lump sum amount with the
broker/trading member in respect oI mark-to-market margin money instead
oI receiving/paying mark-to-market margin money on daily basis. The
amount so paid is in the nature oI a deposit and should be debited to an
appropriate account, say, 'Deposit Ior mark-to-market margin account. The
amount oI 'mark-to-market margin received/paid Irom such account should
130
be credited/debited to 'Mark-to-market margin - Equity index Iutures account
with a corresponding debit/credit to 'Deposit Ior mark-to-market margin
account. At the year-end, any balance in the 'Deposit Ior mark-to-market
margin account should be shown as a deposit under the head 'current
assets.
Accounting for open positions
Position leIt open on the balance sheet date must be accounted Ior.
Debit/credit balance in the 'mark-to-market margin - Equity index Iutures
account, maintained on global basis, represents the net amount
paid/received on the basis oI movement in the prices oI index Iutures till the
balance sheet date. eeping in view prudence` as a consideration Ior
preparation oI Iinancial statements, provision Ior anticipated loss, which may
be equivalent to the net payment made to the broker (represented by the
debit balance in the 'mark-to-market margin - Equity index Iutures account)
should be created by debiting the proIit and loss account. Net amount received
(represented by credit balance in the 'mark-to-market margin - Equity index
Iutures account) being anticipated proIit should be ignored and no credit Ior
the same should be taken in the proIit and loss account. The debit balance in
the said 'mark-to-market margin - Equity index Iutures account, i.e., net
payment made to the broker, may be shown under the head 'current assets,
loans and advances in the balance sheet and the provision created thereagainst
should be shown as a deduction thereIrom. On the other hand, the
credit balance in the said account, i.e., the net amount received Irom the
broker, should be shown as a current liability under the head 'current
liabilities and provisions in the balance sheet.
Accounting at the time of final settlement
This involves accounting at the time oI Iinal settlement or squaring-up oI the
contract. At the expiry oI a series oI equity index Iutures, the proIit/loss, on
Iinal settlement oI the contracts in the series, should be calculated as the
diIIerence between Iinal settlement price and contract prices oI all the
contracts in the series. The proIit/loss, so computed, should be recognized in
the proIit and loss account by corresponding debit/credit to 'mark-to-market
margin - Equity index Iutures account. However, where a balance exists in
the provision account created Ior anticipated loss, any loss arising on such
settlement should be Iirst charged to such provision account, to the extent oI
the balance available in the provision account, and the balance oI loss, iI any,
should be charged to the proIit and loss account. Same accounting treatment
should be made when a contract is squared-up by entering into a reverse
contract. It appears that, at present, it is not Ieasible to identiIy the equity
index Iutures contracts. Accordingly, iI more than one contract in respect oI
the series oI equity index Iutures contracts to which the squared-up contract
pertains is outstanding at the time oI the squaring oI the contract, the
contract price oI the contract so squared-up should be determined using First131
In, First-Out (FIFO) method Ior calculating proIit/loss on squaring-up.
On the settlement oI an equity index Iutures contract, the initial margin paid in
respect oI the contract is released which should be credited to 'Initial margin -
Equity index Iutures account, and a corresponding debit should be given to
the bank account or the deposit account (where the amount is not received).
Accounting in case of a default
When a client deIaults in making payment in respect oI a daily settlement, the
contract is closed out. The amount not paid by the Client is adjusted against
the initial margin. In the books oI the Client, the amount so adjusted should
be debited to 'mark-to-market - Equity index Iutures account with a
corresponding credit to 'Initial margin - Equity index Iutures account. The
amount oI initial margin on the contract, in excess oI the amount adjusted
against the mark-to-market margin not paid, will be released. The accounting
treatment in this regard will be the same as explained above. In case, the
amount to be paid on daily settlement exceeds the initial margin the excess is
a liability and should be shown as such under the head current liabilities and
provisions`, iI it continues to exist on the balance sheet date. The amount oI
proIit or loss on the contract so closed out should be calculated and
recognized in the proIit and loss account in the manner dealt with above.
Disclosure requirements
The amount oI bank guarantee and book value as also the market value oI
securities lodged should be disclosed in respect oI contracts having open
positions at the year end, where initial margin money has been paid by way
oI bank guarantee and/or lodging oI securities.
Total number oI contracts entered and gross number oI units oI equity index
Iutures traded (separately Ior buy/sell) should be disclosed in respect oI each
series oI equity index Iutures.
The number oI equity index Iutures contracts having open position, number oI
units oI equity index Iutures pertaining to those contracts and the daily
settlement price as oI the balance sheet date should be disclosed separately
Ior long and short positions, in respect oI each series oI equity index Iutures.
Accou3ti3 for optio3s
The Institute oI Chartered Accountants oI India issued guidance note on
accounting Ior index options and stock options Irom the view point oI the
parties who enter into such contracts as buyers/holder or sellers/writers.
Following are the guidelines Ior accounting treatment in case oI cash settled
index options and stock options:
Accounting at the inception of a contract
The seller/writer oI the option is required to pay initial margin Ior entering
into the option contract. Such initial margin paid would be debited to Equity
Index Option Margin Account` or to Equity Stock Option Margin Account`, as
the case may be. In the balance sheet, such account should be shown
separately under the head Current Assets`. The buyer/holder oI the option is
not required to pay any margin. He is required to pay the premium. In his
books, such premium would be debited to Equity Index Option Premium
Account` or Equity Stock Option Premium Account`, as the case may be. In the
books oI the seller/writer, such premium received should be credited to Equity
Index Option Premium Account` or Equity Stock Option Premium Account` as
the case may be.
Accounting at the time of payment/receipt of margin
Payments made or received by the seller/writer Ior the margin should be
credited/debited to the bank account and the corresponding debit/credit Ior
the same should also be made to Equity Index Option Margin Account` or to
Equity Stock Option Margin Account`, as the case may be. Sometimes, the
client deposit a lump sum amount with the trading/clearing member in respect
oI the margin instead oI paying/receiving margin on daily basis. In such case,
the amount oI margin paid/received Irom/into such accounts should be
debited/credited to the Deposit Ior Margin Account`. At the end oI the year
the balance in this account would be shown as deposit under Current Assets`.
Accounting for open positions as on balance sheet dates
The Equity Index Option Premium Account` and the Equity Stock Option
Premium Account` should be shown under the head Current Assets` or
Current Liabilities`, as the case may be.
In the books oI the buyer/holder, a provision should be made Ior the amount
by which the premium paid Ior the option exceeds the premium prevailing on
the balance sheet date. The provision so created should be credited to
Provision Ior Loss on Equity Index Option Account` to the Provision Ior Loss
on Equity Stock Options Account`, as the case may be. The provision made as
above should be shown as deduction Irom Equity Index Option Premium` or
Equity Stock Option Premium` which is shown under Current Assets`.
In the books oI the seller/writer, the provision should be made Ior the amount
by which premium prevailing on the balance sheet date exceeds the premium
received Ior that option. This provision should be credited to Provision Ior
Loss on Equity Index Option Account` or to the Provision Ior Loss on Equity
Stock Option Account`, as the case may be, with a corresponding debit to
proIit and loss account. Equity Index Options Premium Account` or Equity
Stock Options Premium Account` and Provision Ior Loss on Equity Index
Options Account` or `Provision Ior Loss on Equity Stock Options Account`
should be shown under Current Liabilities and Provisions`.
In case oI any opening balance in the Provision Ior Loss on Equity Stock
Options Account` or the Provision Ior Loss on Equity Index Options Account`,
the same should be adjusted against the provisio n required in the current year
and the proIit and loss account be debited/credited with the balance provision
required to be made/excess provision written back.
Accounting at the time of final settlement
On exercise oI the option, the buyer/holder will recognize premium as an
expense and debit the proIit and loss account by crediting Equity Index
Option Premium Account` or Equity Stock Option Premium Account`. Apart
Irom the above, the buyer/holder will receive Iavorable diIIerence, iI any,
between the Iinal settlement price as on the exercise/expiry date and the strike
price, which will be recognized as income. On exercise oI the option, the
seller/writer will recognize premium as an income and credit the proIit and loss
account by debiting Equity Index Option Premium Account` or Equity Stock
Option Premium Account`. Apart Irom the above, the seller/writer will pay the
adverse diIIerence, iI any, between the Iinal settlement price as on the
exercise/expiry date and the strike price. Such payment will be recognized as
a loss.
As soon as an option gets exercised, margin paid towards such option would
be released by the exchange, which should be credited to Equity Index Option
Margin Account` or to Equity Stock Option Margin Account`, as the case may
be, and the bank account will be debited.
Accounting at the time of squaring off an option contract
The diIIerence between the premium paid and received on the squared oII
transactions should be transIerred to the proIit and loss account. Following are
the guidelines Ior accounting treatment in case oI delivery settled index
options and stock options: The accounting entries at the time oI inception,
payment/receipt oI margin and open options at the balance sheet date will be
the same as those in case oI cash settled options. At the time oI Iinal
settlement, iI an option expires un-exercised then the accounting entries will
be the same as those in case oI cash settled options. II the option is exercised
then shares will be transIerred in consideration Ior cash at the strike price.
For a call option the buyer/holder will receive equity shares Ior which the call
option was entered into. The buyer/holder should debit the relevant equity
shares account and credit cash/bank. For a put option, the buyer/holder will
deliver equity shares Ior which the put option was entered into. The
buyer/holder should credit the relevant equity shares account and debit
cash/bank. Similarly, Ior a call option the seller/writer will deliver equity
shares Ior which the call option was entered into. The seller/writer should
credit the relevant equity shares account and debit cash/bank. For a put
option the seller/writer will receive equity shares Ior which the put option was
entered into. The seller/writer should debit the relevant equity shares account
and credit cash/bank. In addition to this entry, the premium paid/received will
be transIerred to the proIit and loss account, the accounting entries Ior which
should be the same as those in case oI cash settled options.
TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES
%axatio3 of Profit/Loss o3 deri;ati;e tra3sactio3 i3 securities
Prior to Financial Year 200506, transaction in derivatives were considered as
speculative transactions Ior the purpose oI determination oI tax liability under
the Income -tax Act. This is in view oI section 43(5) oI the Income -tax Act
which deIined speculative transaction as a transaction in which a contract Ior
purchase or sale oI any commodity, including stocks and shares, is
periodically or ultimately settled otherwise than by the actual delivery or
transIer oI the commodity or scrips. However, such transactions entered into
by hedgers and stock exchange members in course oI jobbing or arbitrage
activity were speciIically excluded Irom the purview oI deIinition oI speculative
transaction.
In view oI the above provisions, most oI the transactions entered into in
derivatives by investors and speculators were considered as speculative
transactions. The tax provisions provided Ior diIIerential treatment with
respect to set oII and carry Iorward oI loss on such transactions. Loss on
derivative transactions could be set oII only against other speculative income
and the same could not be set oII against any other income. This resulted in
payment oI higher taxes by an assessee.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in
derivatives carried out in a 'recognized stock exchange Ior this purpose. This
implies that income or loss on derivative transactions which are carried out in
a 'recognized stock exchange is not taxed as speculative income or loss.
Thus, loss on derivative transactions can be set oII against any other income
during the year. In case the same cannot be set oII, it can be carried Iorward to
subsequent assessment year and set oII against any other income oI the
subsequent year. Such losses can be carried Iorward Ior a period oI 8
assessment years. It may also be noted that securities transaction tax paid on
such transactions is eligible as deduction under Income-tax Act, 1961.
Securities tra3sactio3 tax o3 deri;ati;es
tra3sactio3s
As per Chapter VII oI the Finance (No. 2) Act, 2004, Securities Transaction
Tax (STT) is levied on all transactions oI sale and/or purchase oI equity
shares and units oI equity oriented Iund and sale oI derivatives entered into
in a recognized stock exchange.
Derivative Report
ndia Research
July 11, 2011 NFTY vs Openinterest
C0HHFtTS
The NiIty Iutures` open interest increased by 0.18 while MiniIty Iutures` open
interest decreased by 21.41 as market closed at 5660.65 levels.
- The NiIty July Iuture closed at a premium oI 16.65 points, against a
premium oI 15.65 points in the last trading session, while the Aug Iutures
closed at a premium oI 28.55 points.
- The Implied Volatility oI at the money options decreased Irom 17.20 to
16.80.
- The PCR-OI decreased Irom 1.34 to 1.25 points.
- The total OI oI the market is `121,352cr and the stock Iutures OI is
`33,617cr.
- Few liquid stocks where CoC is positive are MTNL, 3IINFOTECH,
NATIONALUM, GTLINFA. FA.
F Statistics for 08-July-2011
Detail Buy Sell Net Open interest
Contacts Value(in
crore)
Change
in
Index
Iuture
1251.26
1813.39 562.13 448602 12711.70 1.11
Index
option
8263.84 7377.77 886.07 1249661 35368.77 6.00
Stock
Iuture
1147.09 1845.84 (698.75) 1099522 31264.96 1.40
Stock
option
431.62 372.20 59.42 27775 779.9 8.21
Total 11093.81 11409.20 315.39 2825560 80125.43 16.72
From the above Iacts and Iigures, it is obvious that Derivative market is highly
speculative and volatile but as well as lucrative. Every day astonishing volumes oI
trade is being happening in derivative markets. With well known market
knowledge , daily news updates and some commonsense one can conIidently enter
into derivative market to try their luck in the the global open gambling game i.e,
the derivative market.
Risk management
Relation between expected return and risk Ior portIolio consisting oI one unit oI
asset and nf Iutures contracts.
As we continue to sell more Iutures (i.e., nf 1), risk starts to increase, but, as
long as oH oS, we are hedging. Where nf 2, we are speculating in that the
L
x
p
e
c
L
e
d
r
e
L
u
r
1oLal 8lsk
%
beJqeJ portfolios nf=-
% nf=
nf=-%
%
nf=- nf=- speculotive portfolios
-% nf=-%
-
4 %
portIolio risk level exceeds the risk level oI the asset held in isolation. The same
applies where we buy Iutures (i.e., nf ~ 0) rather than sell. Thus , where 2 nf
0, we hold a hedged portIolio, and, where nf 2 and nf ~ 0, we hold a speculative
portIolio.
Risk Management In Derivatives
E"UITY DERIVATIVES
Stock Futures
A portIolio based margining model is adopted by BSE which takes an integrated
view oI the risk involved in the portIolio oI each individual client comprising oI
his positions in all the derivatives contract traded on Derivatives Segment. The
parameters Ior such a model are as Iollows:
I)Initial Margin or Worst Case Scenario Loss:
The initial Margin requirement is based on the worst-case loss oI
portIolio at client level to cover 99 VaR over one day horizon. The
initial margin requirement is net at the client level and is on a gross
basis at the Trading/Clearing Member level. The initial margin
requirement Ior the proprietary position oI Trading / Clearing
Members is also on net basis.
a) orst Scenario oss
The worst-case loss oI a portIolio is calculated by valuing the
portIolio under several scenarios oI changes in the respective stock
prices. The scenarios to be used Ior this
purpose are:
Risk Scenario
Number
Price Move in
Multiples of Price
Range
Fraction of Loss to
be Considered
1. 0 100
2. 0 100
3. 1/3 100
4. 1/3 100
5. -1/3 100
6. -1/3 100
7. 2/3 100
8. 2/3 100
9. -2/3 100
10. -2/3 100
11. 1 100
12. 1 100
13. -1 100
14. -1 100
15. 2 35
16. -2 35
The price scan range is taken at three and a halI standard deviations
(3.5 ) where is daily volatility oI respective underlying stock. The
price scan range shall be linked to liquidity, measured in terms oI
impact cost Ior an order size oI Rs.5 lakhs, calculated on the basis oI
order book snapshots in the previous six months. Accordingly, iI the
mean value oI impact cost exceeds 1, the price scanning range is
scaled up by square root oI three. This is in addition to the
requirement oI scaling up Ior the look-ahead period i.e. the time in
which mark to market margin is collected. However, the Derivatives
Segment may speciIy a higher price scan range than the said 3.5
values Ior better risk management.
To cover a 99 VaR over 'T' day`s horizon, the price scan range is
based on 3.5 T where T is number oI days.
The computation oI risk arrays Ior various stock Iuture contracts is
done only at discrete time points each day and the latest available risk
arrays is applied to the portIolios on a real time basis. The risk arrays
is updated 5 times in a day taking the closing price oI the previous day
at the start oI trading and taking the last available traded prices at
11:00 a.m., 12:30 p.m., 2:00 p.m., and at the end oI the trading session
taking closing price oI the day.
b) Minimum Margin
The minimum initial margin equal to 7.5 oI the notional value oI the
contract based on the last available price oI the Iutures contract is
applied at all times. To achieve the same, the price scan range is
adjusted to ensure that the minimum margin collected doesn`t Iall
below 7.5 at any time.
The Minimum Initial Margin Ior Stock Futures Contract shall Iurther
be scaled up by square root oI three in respect oI stocks which have a
mean value oI impact cost oI more than 1. This would be in addition
to the look ahead period.
c) alendar Spread
The margin on calendar spread is calculated and beneIit is given to the
Members Ior such position. The calendar-spread margin is charged in
addition to worst-scenario loss oI the portIolio. A calendar spread is
treated as a naked position in the Iar month contract as the near month
contract approaches expiry. A calendar spread will be treated as naked
positions in the Iar month contract three trading days beIore the near
month contract expires.
The margin on calendar spread is calculated on the basis oI delta oI
the portIolio consisting oI Iutures and option contracts in each month.
Thus, a portIolio consisting oI a near month contract with a delta oI
100 and a Iar month contract with a delta oI 100 will attract a spread
charge equal to the spread charge Ior a portIolio, which is long 100
near month Iutures and short 100 Iar month Iutures. The spread charge
is speciIied as 0.5 per month Ior the diIIerence between the two legs
oI the spread subject to minimum 1 and maximum 3 as speciIied
in the J. R. Varma Committee report. While calculating the spread
charge, the last available closing price oI the Iar month contract is
used to determine the spread charge.
II) Exposure Limits/Second Line of Defense
In case oI stock Iutures contracts, the notional value oI gross open positions
at any point in time should not exceed 20 times the available liquid networth
oI a Member, i.e. 5 oI the notional value oI gross open position in single
stock Iutures or 1.5 oI the notional value oI gross open position in single
stock Iutures, whichever is higher, would be collected / adjusted Irom the
liquid networth oI a Member on a real time basis.
This is calculated as Iollows:
4 Long /Short Stock Futures
Last available closing price oI the Iuture series * No. oI
Market lots * x .
Where "x" is the higher oI 5 or 1.5 .
For the purpose oI computing 1.5 , the oI daily logarithmic returns oI
prices in the underlying stock in the cash market in the last six months shall
be computed. This value shall be applicable Ior a month and shall be re-
calculated at the end oI the month by once again taking the price data on a
rolling basis Ior the past six months.
However, BSE may speciIy higher exposure margin Ior better risk
management.
In case oI a calendar spread contracts, the calendar spread is regarded as an
open position oI one third (1/3rd) oI the Iar month contract. As the near
month contract approaches expiry, the spread shall be treated as a naked
position in the Iar month contract three days prior to the expiry oI the near
month contract.
III) Mark-to-Market Margin
The clients` positions are marked-to-market on a daily basis at the
portIolio level. However, Ior payment oI mark-to-market margin to
BSE, the same are netted out at the Member level.
a) Collection / Payment : The mark-to-market margin is
paid in / out in cash on T1 day.
b) Methodology Ior calculating Closing Price Ior mark-
to-market: The daily closing price oI the stock Iutures
contract Ior mark-to-market settlement is arrived at using
the Iollowing algorithm:
4 Weighted average price oI all the trades in last halI an hour oI the
continuous trading session.
4 II there are no trades during the last halI an hour, then the theoretical
price is taken as the oIIicial closing price.
The theoretical price is arrived at using Iollowing algorithm:
Theoretical price losing value of underlying stock
]closing value of underlying stock * No. of days to expiry * risk
free interest rate (at present 7) / 365}
The Bank Rate 1 would be taken as risk Iree interest
rate percentage and dividend yield is taken as zero Ior
simplicity.
IV) Final Settlement
On the expiry oI a stock Iutures contract, the contract is settled in cash
at the Iinal settlement price. However, the proIit /loss is paid in /paid
out in cash on T1 basis. The Iinal settlement price oI the expiring
Iutures contract is taken as the closing price oI the underlying stock.
The Iollowing algorithm is presently being used Ior calculating
closing value oI the underlying scrips (including other scrips) in the
Cash Segment oI BSE:
4 Weighted average price oI all the trades in the last thirty minutes oI
the continuous trading session.
4 II there are no trades during the last thirty minutes, then the last traded
price in the continuous trading session would be taken as the oIIicial
closing price.
V) Position Limits
a) Market Level
A market wide limit on the open position (in terms oI the number oI
underlying stock) on stock options and Iutures contract oI a particular
underlying stock is
20 oI the number oI shares held by non-promoters i.e. 20 oI the Iree
Iloat, in terms oI number oI shares oI a company.
The limit would be applicable on all open positions in all Iutures and option
contracts on a particular underlying stock.
The Market Wide limit is enIorced in the Iollowing manner:
At the end oI the day, BSE tests whether the market wide-open interest Ior
any scrip exceeds 95 oI the market wide position limit Ior that scrip. II so,
BSE takes note oI open position oI all client/Trading Members as at the end
oI that day in that scrip and Irom next day onwards the Members / clients are
required to trade only to decrease their positions through oIIsetting positions.
Though the action is taken only at the end oI the day, the real time
inIormation about the market wide-open interest as a percentage oI the
market wide position limits is disclosed to the market participants.
At the end oI each day during which the ban on Iresh positions is in Iorce Ior
any scrip, BSE tests whether any member or client has increased his existing
positions, or has created a new position in that scrip. II so, the client shall be
subject to a penalty equal to a speciIied oI the increase in the position.
The penalty is recovered along with the Mark-to-Market on the next day.
The normal trading in the scrip is resumed aIter the open outstanding
position comes down to 80 or below oI the market wide position limit.
b) Trading Member Level
For stocks having applicable market-wide position limit (MWPL) oI Rs. 500
crores or more, the combined Iutures and options position limit shall be 20
oI applicable MWPL or Rs. 300 crores, whichever is lower and within which
stock Iutures position cannot exceed 10 oI applicable MWPL or Rs. 150
crores, whichever is lower.
For stocks having applicable market wide position limit (MWPL) less than
Rs. 500 crores, the combined Iutures and options position limit would be
20 oI applicable MWPL and Iutures position cannot exceed 20 oI
applicable MWPL or Rs. 50 crores whichever is lower.
Once a Member reaches the position limit in a particular underlying, he is
permitted to take only oIIsetting positions (which results in lowering the
open position oI the member) in derivative contracts on that underlying. The
position limit at trading Member level is computed on a gross basis across
all clients oI the trading Member.
c) Client Level
The client's gross open position across all derivative contracts on a particular
underlying shall not exceed higher of-
1 oI the Iree Iloat market capitalization (in terms oI number oI shares)
or
5 oI the open interest in the underlying stock (in terms oI number oI
shares).
The position is applicable on the combined positions in all derivatives
contracts on an underlying stock. Members are advised to disclose the
position oI the clients in case the client crosses the aIoresaid limits.
Members are also advised to inIorm their clients about the disclosure
requirement to BSE on part oI the client.
d) FII Level
For stocks having applicable market-wide position limit (MWPL) oI Rs. 500
crores or more, the combined Iutures and options position limit shall be 20
oI applicable MWPL or Rs. 300 crores, whichever is lower and within which
stock Iutures position cannot exceed 10 oI applicable MWPL or Rs. 150
crores, whichever is lower.
For stocks having applicable market wise position limit (MWPL) less than
Rs. 500 crores, the combined Iutures and options position limit would be
20 oI applicable MWPL and Iutures position cannot exceed 20 oI
applicable MWPL or Rs. 50 crores whichever is lower.
e) Sub Account Level
Each sub-account oI a FII would have the Iollowing position limits:
The gross open position across all derivative contracts on a particular
underlying stock oI a sub-account oI a FII should not exceed the higher of:
1 of the free float market capitalisation (in terms of number of shares).
or
5 of the open interest in the derivative contracts on a particular
underlying stock (in terms of number of contracts).
This position limits would be applicable on the combined position in all
derivative contracts on an underlying stock at an exchange.
I) NRI Level
For stock option and single stock Iutures contracts, the gross open position
across all derivative contracts on a particular underlying stock oI a NRI shall
not exceed the higher of:
1 of the free float market capitali:ation (in terms of number of shares).
or
5 of the open interest in the derivative contracts on a particular
underlying stock (in terms of number of contracts).
This position limits would be applicable on the combined position in all
derivative contracts on an underlying stock at an exchange.
g) Mutual Fund Level
For stocks having applicable market-wide position limit (MWPL) oI Rs. 500
crores or more, the combined Iutures and options position limit shall be 20
oI applicable MWPL or Rs. 300 crores, whichever is lower and within which
stock Iutures position cannot exceed 10 oI applicable MWPL or Rs. 150
crores, whichever is lower.
For stocks having applicable market wide position limit (MWPL) less than
Rs. 500 crores, the combined Iutures and options position limit would be
20 oI applicable MWPL and Iutures position cannot exceed 20 oI
applicable MWPL or Rs. 50 crores whichever is lower.
h) Limits oI each scheme oI Mutual Fund
For Stock Futures and Option Contracts, the gross open position across all
derivative contracts on a particular underlying stock oI a scheme oI mutual
Iund shall not exceed the higher oI:
1 oI the Iree Iloat market capitalisation (in terms oI number oI shares)
or
5 oI the open interest in the derivative contracts on a particular underlying
stock (in terms oI number oI contracts)
This position limits is applicable on the combined position in all derivative
contracts on an underlying stock.
STOCK OPTIONS
A portIolio based margining model is adopted which will take an
integrated view oI the risk involved in the portIolio oI each individual
client comprising oI his positions in all the derivatives contract traded
on Derivatives Segment. The parameters Ior such a model are as
Iollows:
I) Initial Margin or Worst Case Scenario Loss:
The initial Margin requirement is based on the worst-case loss oI
portIolio at client level to cover 99 VaR over one day horizon. The
initial margin requirement is net at the client level and is on a gross
basis at the Trading/Clearing Member level. The initial margin
requirement Ior the proprietary position oI Trading / Clearing Member
is also on net basis. The initial margin (or the worst scenario loss) is
adjusted against the available liquid net worth oI the Member. The
Members in turn will collect the initial margin Irom their clients on an
up Iront basis.
a) orst Scenario oss
The worst-case loss oI a portIolio is calculated by valuing the
portIolio under several scenarios oI changes in the underlying stock
price and also the changes in the volatility oI the underlying stocks.
The scenarios to be used Ior this purpose are:
Risk
Scenario
Number
Price Move in
Multiples of
Price Range
Volatility
Move in
Multiples of
Volatility
Range
Fraction of
Loss to be
Considered
1. 0 1 100
2. 0 -1 100
3. 1/3 1 100
4. 1/3 -1 100
5. -1/3 1 100
6. -1/3 -1 100
7. 2/3 1 100
8. 2/3 -1 100
9. -2/3 1 100
10. -2/3 -1 100
11. 1 1 100
12. 1 -1 100
13. -1 1 100
14. -1 -1 100
15.
16.
2
-2
0
0
35
35
The price scan range is taken at three and a halI standard deviations
(3.5 ) where is daily volatility oI respective stocks. However, the
Derivatives Segment may speciIy a higher price scan range than the
said 3.5 values Ior better risk management. The price scan range
shall be linked to liquidity, measured in terms oI impact cost Ior an
order size oI Rs.5 lakh, calculated on the basis oI order book
snapshots in the previous six months. Accordingly, iI the mean value
oI impact cost exceeds 1, the price scanning range is scaled up by
square root oI three. The value oI is computed in line with the
guidelines speciIied under J.R. Varma Committee report. The
volatility scan range is levied at 10. The Black-Scholes model is
used Ior valuing options.
The computation oI risk arrays Ior Stock option contract is done only
at discrete time points each day and the latest available risk arrays is
applied to the portIolios on a real time basis. The risk arrays is
updated 5 times in a day taking the closing price oI the previous day at
the start oI trading and taking the last available traded prices at 11:00
a.m., 12:30 p.m., 2:00 p.m., and at the end oI the trading session
taking closing price oI the day.
b) Short Option Minimum Margin
The short option minimum margin equal to 7.5 oI the notional value
oI all short stock options shall be charged iI sum oI the worst-scenario
loss and the calendar spread margin is lower than the short option
minimum margin. The notional value oI option positions is calculated
by applying the last closing price oI the underlying stock.
The Short Option Minimum Charge Ior Stock Options Contract, shall
be scaled up by square root oI three in respect oI stocks which have a
mean value oI impact cost oI more than 1.
c) Net Option Jalue (NOJ)
The net option value shall be calculated as the current market value oI
the option times the number oI options (positive Ior long options and
negative Ior short options) in the portIolio. This NOV is added to the
liquid networth oI the Clearing Member i.e. the value oI short options
will be deducted Irom the liquid networth and the value oI long
options will be added thereto. Thus mark-to-market gains and losses
on option positions will be adjusted against the available liquid
networth oI the Clearing Member. Since the options are premium
style, there will be no mark-to-market proIit or loss.
d) ash Settlement of Premium
The premium is paid in by the buyers in cash and paid out to the
sellers in cash on T1 day.
e) Unpaid Premium
Until the buyer pays in the premium, the premium due shall be
deducted Irom the available liquid networth on a real-time basis.
However, the premium is deducted only Ior those portIolios where
open position is long Ior a particular series.
II) Exposure Limits/Second Line of Defense
In case oI stock options contracts, the notional value oI gross short
open positions at any point in time would not exceed 20 times the
available liquid networth oI a Member, i.e. 5 oI the notional value
oI gross short open position in single stock options or 1.5 oI the
notional value oI gross short open position in single stock options,
whichever is higher, will be collected / adjusted Irom the liquid
networth oI a Member on a real time basis over and above the margin
calculated by SPAN.
This is calculated as Iollows:
Long Call / Put Options:
No capital adequacy required
Short Call / Put Options:
Last available closing price oI underlying stock* No. oI
Market lots * x.
Where "x" is the higher oI 5 or 1.5 .
For the purpose oI computing 1.5 , the oI daily logarithmic
returns oI prices in the underlying stock in the cash market in the last
six months shall be computed. This value shall be applicable Ior the
next month and shall be re-calculated at the end oI the month by once
again taking the price data on a rolling basis Ior the past six months.
However, BSE may speciIy higher exposure margin Ior better risk
management.
III) Position Limits
a) Market Level:
A market wide limit on the open position (in terms oI the number oI
underlying stock) on stock options and Iutures contract oI a particular
underlying stock is :-
20 oI the number oI shares held by non-promoters i.e. 20 oI the
Iree Iloat, in terms oI number oI shares oI a company. The limit would
be applicable on all open positions in all Iutures and option contracts
on a particular underlying stock.
The Market Wide limit is enIorced in the Iollowing manner:
At the end oI the day, BSE tests whether the market wide-open
interest Ior any scrip exceeds 95 oI the market wide position limit
Ior that scrip. II so, the Exchange takes note oI open position oI all
client/Trading Members as at the end oI that day in that scrip and
Irom next day onwards the Members / client are required to trade only
to decrease their positions through oIIsetting positions. Though the
action is taken only at the end oI the day, the real time inIormation
about the market wide-open interest as a percentage oI the market
wide position limits is disclosed to the market participants.
At the end oI each day during which the ban on Iresh positions is in
Iorce Ior any scrip, BSE tests whether any Member or client has
increased his existing positions, or has created a new position in that
scrip. II so, the client shall be subject to a penalty equal to a speciIied
oI the increase in the position. The penalty is recovered along with
the Mark-to-Market on the next day.
The normal trading in the scrip is resumed aIter the open outstanding
position comes down to 80 or below oI the market wide position
limit.
b) Trading Member Level
For stocks having applicable market-wide position limit (MWPL) oI
Rs. 500 crores or more, the combined Iutures and options position
limit shall be 20 oI applicable MWPL or Rs. 300 crores, whichever
is lower and within which stock Iutures position cannot exceed 10
oI applicable MWPL or Rs. 150 crores, whichever is lower.
For stocks having applicable market wide position limit (MWPL) less
than Rs. 500 crores, the combined Iutures and options position limit
would be 20 oI applicable MWPL and Iutures position cannot
exceed 20 oI applicable MWPL or Rs. 50 crores whichever is lower.
Once a Member reaches the position limit in a particular underlying,
he is permitted to take only oIIsetting positions (which results in
lowering the open position oI the Member) in derivative contracts on
that underlying. The position limit at Trading Member level will be
computed on a gross basis across all clients oI the Trading Member.
c) Client Level
The client's gross open position across all derivative contracts on a
particular underlying shall not exceed higher of-
1 oI the Iree Iloat market capitalization (in terms oI number oI
shares)
or
5 oI the open interest in the underlying stock (in terms oI number oI
shares).
The position is applicable on the combined positions in all derivatives
contracts on an underlying stock. Members are advised to disclose the
position oI the clients in case the client crosses the aIoresaid limits.
Members are also advised to inIorm their clients about the disclosure
requirement to BSEon part oI the client.
d) FII Level
For stocks having applicable market-wide position limit (MWPL) oI
Rs. 500 crores or more, the combined Iutures and options position
limit shall be 20 oI applicable MWPL or Rs. 300 crores, whichever
is lower and within which stock Iutures position cannot exceed 10
oI applicable MWPL or Rs. 150 crores, whichever is lower.
For stocks having applicable market wide position limit (MWPL) less
than Rs. 500 crores, the combined Iutures and options position limit
would be 20 oI applicable MWPL and Iutures position cannot
exceed 20 oI applicable MWPL or Rs. 50 crores whichever is lower
e) Sub Account Level
Each sub-account oI a FII would have the Iollowing position limits:
The gross open position across all derivative contracts on a particular
underlying stock oI a sub-account oI a FII should not exceed the
higher of:
1 of the free float market capitalisation (in terms of number of
shares).
or
5 of the open interest in the derivative contracts on a particular
underlying stock (in terms of number of contracts).
This position limits would be applicable on the combined position in
all derivative contracts on an underlying stock at an exchange.
I) NRI Level
For stock option and single stock Iutures contracts, the gross open
position across all derivative contracts on a particular underlying
stock oI a NRI shall not exceed the higher of:
1 of the free float market capitalisation (in terms of number of
shares).
or
5 of the open interest in the derivative contracts on a particular
underlying stock (in terms of number of contracts).
This position limits would be applicable on the combined position in
all derivative contracts on an underlying stock at an exchange.
g) Mutual Fund Level
For stocks having applicable market-wide position limit (MWPL) oI
Rs. 500 crores or more, the combined Iutures and options position
limit shall be 20 oI applicable MWPL or Rs. 300 crores, whichever
is lower and within which stock Iutures position cannot exceed 10
oI applicable MWPL or Rs. 150 crores, whichever is lower.
For stocks having applicable market wide position limit (MWPL) less
than Rs. 500 crores, the combined Iutures and options position limit
would be 20 oI applicable MWPL and Iutures position cannot
exceed 20 oI applicable MWPL or Rs. 50 crores whichever is lower.
h) Limits oI each scheme oI Mutual Fund
For Stock Futures and Option Contracts, the gross open position
across all derivative contracts on a particular underlying stock oI a
scheme oI mutual Iund shall not exceed the higher oI:
1 oI the Iree Iloat market capitalisation (in terms oI number oI
shares)
or
5 oI the open interest in the derivative contracts on a particular
underlying stock (in terms oI number oI contracts)
This position limits is applicable on the combined position in all
derivative contracts on an underlying stock.
IV) Exercise Limits
At present, there is no exercise limit Ior trading in Stock Option
contracts. However, the Derivatives Segment may speciIy such limit
as it may deem Iit Irom time to time.
V) Assignment of Options
On exercise oI an Option by an option holder, it will be assigned to
the option writer on random basis at client level. The system will use
the same algorithm as in case oI assignment oI Stock Option
Contracts.
VI) Settlement of Options
On exercise/ assignment oI options, the settlement will take place on
T1 basis. The settlement shall take place on the closing price oI the
underlying in the Cash Segment.
INDEX DERIVATIVES
INDEX FUTURES
A portIolio based margining model is adopted which will take an integrated view
oI the risk involved in the portIolio oI each individual client comprising oI his
positions in all the derivatives contract traded on Derivatives Segment. The
parameters Ior such a model are as Iollows:
I) Initial Margin or Worst Case Scenario Loss
The Initial Margin requirement is based on the worst-case loss oI
portIolio at client level to cover 99 VaR over one day horizon. The
initial margin requirement is net at the client level and is on gross
basis at the Trading/Clearing Member level. The initial margin
requirement Ior the proprietary position oI Trading / Clearing Member
is also be on net basis.
a) orst Scenario oss
The worst-case loss oI a portIolio is calculated by valuing the
portIolio under several scenarios oI changes in the respective Index
prices. The scenarios to be used Ior this purpose are:
Risk Scenario
Number
Price Move in
Multiples of Price
Range
Fraction of Loss to
be Considered
1. 0 100
2. 0 100
3. 1/3 100
4. 1/3 100
5. -1/3 100
6. -1/3 100
7. 2/3 100
8. 2/3 100
9. -2/3 100
10. -2/3 100
11. 1 100
12. 1 100
13. -1 100
14. -1 100
15. 2 35
16. -2 35
The price scan range is taken at three standard deviations (100*e
(3o-1)
)
where beta is daily volatility oI respective underlying Index or Index
Futures whichever is higher. However, the Derivatives Segment may
speciIy a higher price scan range than the said 3 values Ior better
risk management.
To cover a 99 VaR over 'T' day`s horizon, the price scan range is
based on 3beta T where T is number oI days.
The computation oI risk arrays Ior various Index Iuture contracts is
done only at discrete time points each day and the latest available risk
arrays is applied to the portIolios on a real time basis. The risk arrays
is updated at 5 times in a day taking the closing price oI the previous
day at the start oI trading and taking the last available traded prices at
11.00 am, 12.30 pm, 2.00 pm, and at the end oI the trading session
taking closing price oI the day.
b) Minimum Margin
The minimum initial margin equal to 5 oI the notional value oI the
contract based on the last available price oI the Iutures contract is
applied at all times. To achieve the same, the price scan range is
adjusted to ensure that the minimum margin collected doesn`t Iall
below 5 at any time. In addition the minimum margin shall also be
scaled up by the look ahead point.
c) alendar Spread
The margin on calendar spread is calculated and beneIit is given to the
Members Ior such position. The calendar-spread margin is charged in
addition to worst-scenario loss oI the portIolio. A calendar spread is treated
as a naked position in the Iar month contract as the near month contract
approaches expiry. A calendar spread will be treated as naked positions in
the Iar month contract three trading days beIore the near month contract
expires.
The spread charge is speciIied as 0.5 per month Ior the diIIerence between
the two legs oI the spread subject to minimum 1 and maximum 3 as
speciIied in the J. R. Varma Committee report. While calculating the spread
charge, the last available closing price oI the Iar month contract is used to
determine the spread charge.
II) Exposure Limits/Second Line of Defense:
In case oI Index Iutures & Index options contracts, the notional value oI
gross open positions at any point in time would not exceed 33 1/3 times the
available liquid networth oI a Member. In case oI Index Iutures contract, 3
oI the notional value oI gross open position in Index Iuture contract would
be collected / adjusted Irom the liquid networth oI a Member on a real time
basis.
This is calculated as Iollows:
4 Long /Short Index Futures:
Last available closing price oI the Iuture series *
Quantity * 3
However, BSE may speciIy higher exposure margin Ior better risk
management.
In case oI a calendar spread contracts, the calendar spread is regarded as an
open position oI one third (1/3rd) oI the Iar month contract. As the near
month contract approaches expiry, the spread shall be treated as a naked
position in the Iar month contract three days prior to the expiry oI the near
month contract.
III) Mark-to-Market Margin
The clients` positions are marked-to-market on a daily basis at the
portIolio level. However, Ior payment oI mark-to-market margin to
BSE, the same is netted out at the Member level.
a) Collection / Payment : The mark-to-market margin is
paid in / out in cash on T1 day.
b) Methodology Ior calculating Closing Price Ior mark-
to-market: The daily closing price oI the Index Iutures
contract Ior mark-to-market settlement is arrived at using
the Iollowing algorithm:
4 Weighted average price oI all the trades in last halI an hour oI the
continuous trading session.
4 II there were no trades during the last halI an hour, then the theoretical
price is taken as the oIIicial closing price.
The theoretical price is arrived at using Iollowing algorithm:
Theoretical price Closing value oI underlying Index
closing value oI underlying Index * No. oI days to expiry *
risk Iree interest rate (at present 7) / 365}
The Bank Rate 1 would be taken as risk Iree interest
rate percentage and dividend yield is taken as zero Ior
simplicity.
IV) Final Settlement
On the expiry oI an Index Iutures contract, the contract is settled in
cash at the Iinal settlement price. However, the proIit /loss is paid in
/paid out in cash on T1 basis. The Iinal settlement price oI the
expiring Iutures contract is taken as the closing price oI the underlying
Index. The Iollowing algorithm is presently being used Ior calculating
closing value oI the (individual scrips including the scrips constituting
the Index) in the equity segment oI BSE:
4 Weighted average price oI all the trades in the last thirty minutes oI
the continuous trading session.
4 II there are no trades during the last thirty minutes, then the last traded
price in the continuous trading session would be taken as the oIIicial
closing price.
V) Position Limits
a) Trading Member Level:
The Trading Member position limits in equity index Iutures contracts shall
be higher oI:
O Rs.500 crore
or
O 15 oI the total open interest in the market in equity index Iutures
contracts.
This limit would be applicable on open positions in all Iutures contracts on a
particular underlying index as prescribed by SEBI.
b) Client Level
Any person or persons acting in concert who hold 15 or more oI the open
interest in all derivatives contracts on the Index shall be required to report
the Iact to BSE and Iailure to do so shall attract a penalty as laid down by
BSE / clearing corporation / SEBI.
c) FII position limits in Index Futures Contracts.
FII position limits in equity index Iutures contracts shall be higher oI:
O Rs.500 crore
or
O 15 oI the total open interest in the market in equity index Iutures
contracts.
This limit would be applicable on open positions in all Iutures contracts on a
particular underlying index as prescribed by SEBI.
In addition to the above, FIIs can take exposure in equity index derivatives
subject to the Iollowing limits
O Short positions in Index Derivatives (Short Futures, Short Calls and
Long puts) not exceeding (in notional value) the FIIs holding oI
stocks. The stocks shall be valued at the closing price in the cash
market as on the previous trading day.
O Long positions in Index Derivatives (long Iutures, long alls and short
puts) not exceeding (in notional value) the FIIs holding oI cash,
government securities, T-Bills and similar instruments. The
government securities and T-Bills are to be valued at book value.
Money Market Mutual Funds and Gilt Funds shall be valued at Net
Asset Value (NAV).
d) Sub-account Level
Each sub-account oI a FII would have the Iollowing position limits: A
disclosure requirement Ior any person or persons acting in concert who
together own 15 or more oI the open interest oI all derivative contracts on
a particular underlying index.
e) NRI Level
The position limits Ior NRIs shall be the same as the client level position
limits speciIied above. ThereIore, the NRI position limits shall be For
Index based contracts, a disclosure requirement Ior any person or persons
acting in concert who together own 15 or more oI the open interest oI all
derivative contracts on a particular underlying index.
I) Mutual Fund Level
Mutual Fund position limits in equity index Iutures contracts shall be higher
oI:
O Rs.500 crore
or
O 15 oI the total open interest in the market in equity index Iutures
contracts.
This limit would be applicable on open positions in all Iutures contracts on a
particular underlying index as prescribed by SEBI.
In addition to the above, Mutual Funds can take exposure in equity index
derivatives subject to the Iollowing limits:
O Short positions in Index Derivatives (Short Futures, Short Calls and
Long puts) not exceeding (in notional value) the Mutual Fund holding
oI stocks. The stocks shall be valued at the closing price in the cash
market as on the previous trading day.
O Long positions in Index Derivatives (long Iutures, long alls and short
puts) not exceeding (in notional value) the Mutual Fund holding oI
cash, government securities, T-Bills and similar instruments. The
government securities and T-Bills are to be valued at book value.
Money Market Mutual Funds and Gilt Funds shall be valued at Net
Asset Value (NAV).
g) Limits oI each scheme oI Mutual Fund
For Index based Contracts, Mutual Funds are required to disclose the total
open interest held by its scheme or all schemes put together in a particular
underlying index, iI such open interest equals to or exceeds 15 oI the open
interest oI all derivative contracts on that underlying index.
SWAN Ana|ys|s
S Strengths
W Weaknesses
A : Achlevementx
N : Next xtep,Next lnltlutlve
Strengthx
Service
Distribution
Marketing
Products
Flexibility in trading
Low brokerage charges
Weuknexx
Customer SatisIaction
Branding
t0t6S
In my analysis I have Iound that, in derivative market the concept oI
volatility is the most observable part, since risk situations are most prevailing in
the market. The derivative market is an open gambling platIorm where people can
make money and lose money. Mostly 90 oI participants in derivative markets
lose their money because oI high speculations.
The average percentage companies which suIIered losses with an impact oI
derivative markets is 45. The Global economies will have a considerable impact
on them Irom share markets especially Irom derivative markets.
Angel stock broking Iirm abodes Ior most hardworking and skillIul
workIorce along with latest technologies and runs with customer satisIaction
motive. Apart Irom their technically analysed suggestions to the customers , the
overall proIit making clients are Iew because high market Iluctuations.
Suggestions
As quoted earlier, the derivative market is highly volatile. No one can predict the
market and many people do mistakes in investing. The right time to buy any share
is when the market Ialls down. That means one should buy share when the price oI
the share Ialls down considerably. And should sell them when the share price
increases.
Investing money through portIolios is the best investing strategy. Because iI
we are investing in 10 companies , the share value oI all the companies will not go
down at a time. So iI three companies are on the verge oI Ialling ,we will have
saIe shares oI 7 companies in our hand.
Risk covering is also an important activity in derivative market because oI
its virtue. Market players should cover their risk to a maximum extent through
hedging, paying oI Var margins. Above all having general awareness about day-
to-day markets , minimum knowledge in share markets is also important. One must
not be greedy to get huge amounts oI money in single punch.
Next Step]next |n|t|at|ve
The people have proposed a number oI recommendations to improve the product
oI ANGEL BROING. Though the present product caters to the interests oI its
customers to a certain extents, it could attract more iI the proposed suggestions are
taken into account. Some oI the most Ieasible suggestions are given below:
The documentation process should be made a bit easy, so that the account
can be opened without much diIIiculty.
The services provided by company are still not up to that mark, the working
oI back oIIice is very slow, due to which account opening time takes too
much time. This service could be made Iast.
The company could make their approach more eIIicient. The executives
could be trained very well Ior at least a week and in the beginning, beIore
independently going to any customer the executives should go with their
team leaders.
Angel Stock Broking could make a diIIerent service department, which will
work Ior the customer to solve all their problems related to Angels product
The image oI Angel Stock Broking could be made through eIIective
advertisement in print & electronic media.
onc|us|on
In online trading 'Angel Broking have mainly competition with Religare, ICICI-
Direct, Indiabulls. Angel Broking has an advantage oI being in this industry Ior
more than 8 decades. It has launched its website in 2000 and was among the Iirst
player in the online share trading. The ~ANGEL BROKING has decided to
spend its advertisement budget through Iour media i.e. Television, Print, Web and
Outlets. ANGEL BROING is only broker in which no margin needs to keep.
1. Derivatives serve a highly useIul risk-management role Ior both Iinancial and
non-Iinancial Iirms.
2. It is not necessary to impose Iederal prudential regulation on nonbank
derivatives dealers. There is no evidence that the activities oI these dealers pose a
signiIicant systemic risk. In addition, we see no reason to impose the same
regulatory structure on nonbank dealers as on bank derivatives dealers. As
recipients and beneIiciaries oI government-insured deposits, banks are the proper
concern oI government and should be subject to diIIerent regulation.
3. Although some major end-users, mutual Iunds, hedge Iunds, securities Iirms,
and even banks have incurred derivatives-related losses, most oI these losses have
been due to inadequate risk-management systems and poor operations control and
supervision. These losses have not threatened the stability and eIIiciency oI
Iinancial markets, and, by encouraging the development oI better risk-management
and operational controls, they have had a salutary eIIect. The best discipline
against systemic risk in any market, including derivatives, is to Ioster a market in
which participants have an incentive to manage themselves prudently and can
respond quickly and innovatively to market conditions.
Bibliography
1. Introduction to Derivatives --- R S Srishan.
2. Book on Derivative markets Ashwini Gujaral.
3. www.mcx-sx.com
4. www.nseindia.com
5. www.Angelbroking.com
6. Capital Market magazine
7. Daily news Irom various sources.