DERIVATIVES THE GLOBAL CASINO

Prepared by:
Name : Jai Kumar Dungarwal
Roll No. : 190
Room No. : 11
Registration No. : A01-1112-1079-12
Session : 2012-2015
Under the supervision of :
Prof. Abhinab Ghosh, Faculty,
Accounting & Finance, St. Xaviers College

(Space for project completion certificate)

Jai Kumar Dungarwal

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DECLARATION
I, the undersigned, Jai Kumar Dungarwal, student of B.Com. (Honours)
at St. Xaviers College (Autonomous), Kolkata declare that I have
completed this Project on Derivatives The Global Casino in the
Academic Year 2014-2015.

Date:
Place: Kolkata
Jai Kumar Dungarwal
Roll No. : 0190

(Signature)

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ACKNOWLEDGEMENT
I would like to express my sincere gratitude to St. Xaviers College for
providing me an opportunity to present this project. A very sincere thank
you to our vice principal Fr. Dominic Savio for constantly motivating
and encouraging us and giving the students an opportunity to indulge
ourselves in this informative, resourceful and learning process of Project
Preparation and Research Work. I would like to extend a deep gratitude
towards my project guide, Prof. Abhinab Ghosh, for always being there
for help, providing me with valuable inputs, patiently removing any
scope of doubt and helping me with his valuable suggestions.
I would like to thank my parents, without whose blessings and
motivation this project would be possible to complete.
Finally, I would like to thank all my friends who have constantly helped
me during the course of this project work.

Jai Kumar Dungarwal

Roll No. : 0190

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Jai Kumar Dungarwal

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TABLE OF CONTENTS
Sl. no.
1
1.1
1.2
1.3
1.4

2
2.1
2.2
2.3

3
3.1
3.2

4
4.1

5
6
7
7.1
7.1.1
7.1.2
7.1.3
7.1.4
7.1.5
7.1.6
7.1.7
7.1.8
7.1.9

8
8.1
8.2
8.3
8.4

9
10
11
11
12

PARTICULARS
INTRODUCTION
OBJECTIVES
RESEARCH METHODOLOGY
LIMITATIONS OF THE STUDY
SCOPE OF THE STUDY
DERIVATIVES
TYPES OF DERIVATIVES
RISK CHARACTERISTICS OF DERIVATIVES
FACTORS FOR THE GROWTH OF THE DERIVATIVES
FUTURES
FUTURES IN INDIA
PAYOFF FOR FUTURES
OPTIONS
OPTIONS PAYOFF
HEDGING
HEDGING USING FUTURES
HEDGING USING OPTIONS
STRATEGIES UNDER OPTIONS
LONG CALL
SYNTHETIC LONG CALL
SHORT PUT
LONG COMBO
COVERED CALL
LONG STRADDLE
COLLAR
BULL CALL SPREAD
SHORT CALL BUTTERFLY
DERIVATIVES IN INDIA
EQUITY DERIVATIVES IN INDIA
OPERATORS OF DERIVATIVES MARKET
REGULATION OF DERIVATIVES TRADING IN INDIA
INDIAN DERIVATIVES VIS--VIS GLOBAL DERIVATIVES
QUESTIONNAIRE
ANALYSIS
FINDINGS & SUGGESTIONS
CONCLUSIONS
BIBLIOGRAPHY

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9-13
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31
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1. Introduction
A Derivative is a financial instrument whose value depends on other, more basic, underlying
variables. The variables underlying could be prices of traded securities and stock, prices of
gold or copper.
Derivatives have become increasingly important in the field of finance, Options and Futures
are traded actively on many exchanges, Forward contracts, Swap and different types of
options are regularly traded outside exchanges by financial institutions, banks and their
corporate clients in what are termed as over-the-counter markets in other words, there is no
single market place or organized exchanges.

1.1 OBJECTIVES OF THE STUDY

To understand the concept of derivatives and insight view of Indian derivatives
market.

To understand the scope of derivatives market in India.

To understand equity derivatives from the view point of futures and options in the Indian
market and various strategies that can be applied by traders and investors.

To study how hedging is an effective tool of derivatives market and various risk and
return appetites under various strategies that can be used for hedging.

1.2 RESEARCH METHODOLOGY

The Research is Descriptive, Exploratory and Analytical in nature. An attempt has been made to
collect the maximum facts and figures available on Derivatives.
Method of data collection:Primary Data A sample survey was done based on a set of questionnaire given to some
students of Accounting & Finance Department.
Secondary sources:The data for study has been collected from various sources:
Books
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Journals
Internet sources
Statistical Tools Used:

Simple tools like bar graphs, tabulation, line diagrams have been used.

1.3 LIMITATIONS:
LIMITED TIME:
Time is a major constraint, as research type in depth study of each instrument under
derivatives and each strategy under various instruments cannot be done.

VOLATILITY:
Stock market is so much volatile and it is difficult to forecast anything about it
whether you trade through online or offline.

ASPECTS COVERAGE:
Some of the aspects may not be covered and hypothetical cases are taken for
understanding various strategies applicable for hedging.

PRIMARY DATA COLLECTION:

The primary data could not be collected from fund managers and those trading
regularly in the derivatives market as the concerned persons did not want to disclose
anything about the strategy that they follow.

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1.4 SCOPE OF THE STUDY

As derivatives are a very vast & huge subject the scope of research is limited to the
financial derivatives viz. futures & options
.

The period covered is 2001-02 to 2013-14.

Forward have been kept out of scope of research as they are not used as effective tool
for hedging in equity derivatives market.

2. DERIVATIVES:
Risk is an inseparable part of investing in financial and capital markets. Various instruments
engaged in financial and capital markets come with different risk attached to it. It is the existence
of risk coupled with various sentiments of investors and their risk taking abilities that has given
rise to Derivatives market. The emergence of the market for derivative products can be traced to
the willingness of the risk-averse economic agents to guard themselves against uncertainties
arising out of fluctuations in asset prices.
Derivatives are a product whose value is derived from one or more variable of an underlying
asset in a contractual manner. The underlying asset may be in the form of equity, commodity,
foreign exchange, interest rate, bonds and various other assets.
The origin of derivatives can be traced back to the need of farmers to protect themselves against
fluctuations in the price of their crop. From the time it was sown to the time it was ready to
harvest, farmers would face price uncertainty. Through the use of simple derivative products, it
was possible for the farmer to partially or fully transfer price risks by locking-in asset prices.
These were simple contracts developed to meet the needs of farmers and were basically a mean
of reducing risk.
In recent years, the market for financial derivatives has grown tremendously both in terms of
variety of instruments available, their complexity and also turnover. In the class of equity
derivatives, futures and options on stock indices have gained more popularity than on individual
stocks, especially among institutional investors, who are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular indices with various
portfolios and ease of use. The lower costs associated with index derivatives vis-a-vis derivative
products based on individual securities is another reason for their growing use.

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In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines equity
derivative to include
A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
A contract, which derives its value from the prices, or index of prices, of underlying securities.
The derivatives are securities under the SC(R) A and hence the trading of derivatives is governed
by the regulatory framework under the SC(R) A.
There are two distinct groups of Derivative:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate agreements and exotic options are
almost always traded in this way. The OTC derivatives market is huge.
Exchange-traded derivatives are those derivatives products that are traded via
Derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions,
and takes Initial margin from both sides of the trade to act as a guarantee.

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2.1 TYPES OF DERIVATIVES

CLASSIFICATION OF DERIVATIVES

Exchange Traded Derivatives

Over The Counter Derivatives

Swaps
National Stock Exchange

Bombay Stock Exchange

National Commodity &

Derivative Exchange

Index Future Index option

Stock option Stock future Interest rate future

The most commonly used derivatives contracts are forwards, futures and options which would
are discussed in detailed later. Various types of commonly traded derivatives are:

Forwards: A forward contract is basically contract between two entities at some future
date, at an agreed price and quantity today. The contract price is generally traded over the
counter and is not available in public domain and contract is settled by physical delivery
of asset on some future date.

Futures: Futures contracts are type of forward contracts between two parties to buy or
sell an asset in certain future agreed date and price. The primary difference between
futures and forwards are former is traded over the counter whereas latter are exchange
traded contracts.

Options: Options are the contracts between two parties at certain future agreed price
where the buyer of the contract have the right but not obligation to exercise the contract
at the date of expiration of contract or before that. Options are exchange latter traded
contracts. Two main types of options are call option and put option.

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Swaps: Swaps are a popular financing tool, a contract between two parties (counter
parties) to exchange two streams of payment for an agreed period of time. Various
variants of swaps are currency, interest rate, commodities, etc. The two commonly used
swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.

2.2 RISK CHARACTERISTICS OF DERIVATIVES

There are various risks attached in financial transactions and derivatives are used for separate
risks from traditional instruments. Various risks attached with derivatives are:

Credit risk: It is mainly concerned with counterparty on non performance of contract
which is also known as default or credit party risk.

Market risk: This type of risk is concerned with various price movements taking place
in stock market.

Liquidity risk: The inability of a firm to arrange a transaction at prevailing market prices
is termed as liquidity risk and is mainly related to liquidity of separate products and
funding of activities of the firm including derivatives.

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Legal risk: Derivatives are traded not only within the jurisdiction of the country but also
with other countries and hence legal aspects associated with various deals should be
looked in carefully.

2.3 FACTORS CONTRIBUTING FOR THE GROWTH OF

DERIVATIVES

PRICE VOLATILITY :Prices are generally determined by market forces. In a market, consumers have demand and
producers or suppliers have supply, and the collective interaction of demand and supply in
the market determines the price. These factors are constantly interacting in the market
causing changes in the price over a short period of time. Such change in the price is known as
price volatility. This has three factors: the speed of price changes, the frequency of price
changes and the magnitude of price changes.

GLOBALISATION OF MARKETS :Earlier, managers had to deal with domestic economic concerns; what happened in other part
of the world was mostly irrelevant. Now globalization has increased the size of markets and
as greatly enhanced competition .it has benefited consumers who cannot obtain better quality
goods at a lower cost. It has also exposed the modern business to significant risks and, in
many cases, led to cut profit margins. Globalization of industrial and financial activities
necessitates use of derivatives to guard against future losses. This factor alone has
contributed to the growth of derivatives to a significant extent.

TECHNOLOGICAL ADVANCES :A significant growth of derivative instruments has been driven by technological
breakthrough. Advances in this area include the development of high speed processors,
network systems and enhanced method of data entry. Improvement in communications allow
for instantaneous worldwide conferencing, Data transmission by satellite. These facilitated
the more rapid movement of information and consequently its instantaneous impact on
market price.

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ADVANCES IN FINANCIAL THEORIES :Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed
by Black and Scholes in 1973 were used to determine prices of call and put options. In
late 1970s, work of Lewis Edeington extended the early work of Johnson and started the
hedging of financial price risks with financial futures. The work of economic theorists
gave rise to new products for risk management which led to the growth of derivatives in
financial markets.

3. FUTURES
The futures markets were designed to solve the problem that exists in the forward market. Unlike
forward contracts, the future contracts are standardized and exchange traded. It is a standardized
contract with standard underlying instrument, a standard quantity and quality of the underlying
instrument that can be delivered and a standxard timing of such settlement. A futures contract
may be exercised prior to maturity by entering in to equal and opposite transaction.
BASIC FEATURES OF FUTURES CONTRACT

1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a short term
interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the notional
amount of bonds, a fixed number of barrels of oil, units of foreign currency, the
notional amount of the deposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds can be
delivered. In case of physical commodities, this specifies not only the quality of the
underlying goods but also the manner and location of delivery. The delivery month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:
Although the value of a contract at time of trading should be zero, its price constantly
fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk
to the exchange, who always acts as counterparty. To minimize this risk, the exchange
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demands that contract owners post a form of collateral, commonly known as Margin
requirements are waived or reduced in some cases for hedgers who have physical ownership
of the covered commodity or spread traders who have offsetting contracts balancing the
position.
Initial margin: is paid by both buyer and seller. It represents the loss on that contract, as
determined by historical price changes, which is not likely to be exceeded on a usual day's
trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may exhaust the initial
margin, a further margin, usually called variation or maintenance margin, is required by the
exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each
day, called the "settlement" or mark-to-market price of the contract.
To understand the original practice, consider that a futures trader, when taking a position,
deposits money with the exchange, called a "margin". This is intended to protect the
exchange against loss. At the end of every trading day, the contract is marked to its present
market value. If the trader is on the winning side of a deal, his contract has increased in value
that day, and the exchange pays this profit into his account. On the other hand, if he is on the
losing side, the exchange will debit his account. If he cannot pay, then the margin is used as
the collateral from which the loss is paid.

3. Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as
specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the buyers
of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled
out by purchasing a covering position - that is, buying a contract to cancel out an earlier
sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a
long).

Cash settlement - a cash payment is made based on the underlying reference rate, such
as a short term interest rate index such as Euribor, or the closing value of a stock market
index. A futures contract might also opt to settle against an index based on trade in a
related spot market.

Expiry is the time when the final prices of the future are determined. For many equity index
and interest rate futures contracts, this happens on the Last Thursday of certain trading
month. On this day the t+2 futures contract becomes the t forward contract.
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3.1 FUTURES IN INDIA

The National Stock Exchange commenced trading in Index Futures on 12 June, 2000. The
NIFTY futures contracts are based on the popular market benchmark S&P CNX NIFTY Index.
S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near
month (one), the next month (two) and the far month (three). A new contract will be
introduced on the trading day following the expiry of the near month contract.
S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the
last Thursday is a trading holiday, the contracts shall expire on the previous trading day
& the permitted lot size of S&P CNX NIFTY contracts is 200 and multiples.
BSE SENSEX FUTURES
The underlying for the Sensex Futures is the BSE Sensitive Index of 30 scripts, popularly called
the Sensex. The contract multiplier is 50 which mean the Rupee notional value of a futures
contract would be 50 times the contracted value.

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Top 20 Futures contracts according to number of contracts 2013-14

Sl.No.

Name of the
Contract

Number
of
Contracts
(crores)

Turnover
(crores)

Percentage
of contracts
to Top 20
contracts

NIFTY August 2013

252,498

9,065,745

8.99

NIFTY September 2013

245,614

8,596,843

8.74

NIFTY October 2013

231,426

7,645,028

8.24

NIFTY January 2014

191,815

6,131,913

6.83

NIFTY June 2013

189063

6492384

6.73

NIFTY November 2013

188152

6106099

6.70

NIFTY May 2013

181338

6019855

6.46

NIFTY July 2013

167505

5687503

5.96

NIFTY December 2013

164155

5253648

5,.84

10

NIFTY March 2014

159345

4931435

5.67

11

NIFTY February 2014

140617

4595362

5.01

12

NIFTY April 2013

118765

4188277

4.23

13

BANKNIFTY August 2013

84724

3484170

3.02

14

BANKNIFTY October 2013

78292

2966124

2.79

15

BANKNIFTY September 2013

74222

3001290

2,64

16

BANKNIFTY January 2014

73103

2646175

2.60

17

BANKNIFTY March 2014

72452

2458223

2.58

18

BANKNIFTY May 2013

66726

2102706

2.38

19

BANKNIFTY November 2013

66,070

23,88,079

2.35

20

BANKNIFTY December 2013

63,236

2,208,378

2.25

95,969,251

100.00

TOTAL

2,809,119

(Source: NSE Factbook 2014 issue)

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FUTURES TERMINOLOGIES

SPOT PRICE: The price at which an asset trades in the spot market.

FUTURES PRICE: The price at which the futures contracts trade in the futures market.

3.2 Payoff for futures

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits
for the buyer and the seller of a futures contract are unlimited.
These linear payoffs are fascinating as they can be combined with options and the underlying to
generate various complex payoffs.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who
holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty
stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up,
the long futures position starts making profits, and when the index moves down it starts making
losses. Below Figure A shows the payoff diagram for the buyer of a futures contract.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty
stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves
down, the short futures position starts making profits, and when the index moves up, it starts
making losses. Figure B shows the payoff diagram for the seller of a futures contract.

Figure A: Payoff for a buyer of Nifty futures

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The figure below shows the profits/losses for a long futures position. The investor bought futures
when the index was at 1220. If the index goes up, his futures position starts making profit. If the
index falls, his futures position starts showing losses.

Profit

1220

Nifty
Loss

Figure B: Payoff for a seller of Nifty futures

The figure shows the profits/losses for a short futures position. The investor sold futures when
the index was at 1220. If the index goes down, his futures position starts making profit. If the
index rises, his futures position starts showing losses.
Profit

1220
0
Nifty

Loss

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4. OPTIONS:
Options are fundamentally different from forward and futures contracts. An option gives the
holder of the option the right to do something. The holder does not have to exercise this right. In
contrast, in a forward or futures contract, the two parties have committed themselves to doing
something.
Popular basic equity instruments/variables underlying options are:
Index options
Options on individual stocks.
Two basic types of options are:
Call options: A call option gives the right but not obligation to buy underlying asset in a future
date at a certain price. For example Mr. A purchases a call option from Mr. B of ABC ltd. it
means Mr. B gives the right to purchase ABC ltd at a fix strike price with agreed period.
Put options: As compared to call option put option gives the holder the right but not the
obligation to sell an asset at a certain agreed period at a fix strike price.

OPTIONS TERMINOLOGIES

INDEX OPTION: These options have stock index as the underlying. In India index
options are European. Like index futures contracts, index option contracts are also cash
settled.
STOCK OPTION: These options are options on individual stocks and a contract gives
the holder to buy or sell shares at specific price. In India stock options are American
options.
BUYER OF AN OPTION: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise the option contract.

WRITER OF AN OPTION: The writer of a call/put option is the one who receives
premium and is thereby obliged to sell/buy asset if the buyer wishes to exercise his
option.

AMERICAN OPTION: American options are options that can be exercised at any time
upto the expiration date.

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EUROPEAN OPTION: European options are options that can be exercised only on the
date of expiry itself.

IN THE MONEY OPTION: A call option on the index is said to be in-the-money

when the current market value is higher than strike price. (spot price>strike price)

AT THE MONEY OPTION: An at-the-money option is an option that would lead to

zero cash flow if exercised immediately. It is said to be at-the-money when current spot
price is equal to strike price. (spot price=strike price)

OUT-OT-THE-MONEY OPTION: A call option is said to be out-of-the-money when

the
current
spot
price
is
lesser
than
strike
price.(
spot price<strike price)

4.1 Options payoffs

The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited; however the profits are
potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to
the option premium; however his losses are potentially unlimited.

These non-linear payoffs are fascinating as they lend themselves to be used to generate various
payoffs by using combinations of options and the underlying. We look here at the six basic
payoffs.

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4.1.1 Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and
sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be long the
asset. Figure A shows the payoff for a long position on the Nifty.1
Figure A Payoff for investor who went Long Nifty at 1220

The figure shows the profits/losses from a long position on the index. The investor bought the
index at 1220. If the index goes up, he profits. If the index falls he loses.

Profit
+60

1160

1220

1280
Nifty

Loss -60

4.1.2 Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and
buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be
short the asset. Figure B shows the payoff for a short position on the Nifty.

Figure B Payoff for investor who went Short Nifty at 1220

The figure shows the profits/losses from a short position on the index. The investor sold the
index at 1220. If the index falls, he profits. If the index rises, he loses.

Source: NSE Derivatives Core Module

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Profit

+60

1160 1220 1280

Nifty

-60

Loss

4.1.3 Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher
the spot price, more is the profit he makes. If the spot price of the underlying is less than the
strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid
for buying the option. Figure C gives the payoff for the buyer of a three month call option (often
referred to as long call) with a strike of 1250 bought at a premium of 86.60.

4.1.4 Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/loss that
the buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyers profit is the sellers loss. If upon expiration, the spot price exceeds the strike price, the
buyer will exercise the option on the writer. Hence as the spot price increases the writer of the
option starts making losses. Higher the spot price more is the loss he makes. If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium. Figure D gives the payoff for the writer of a

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three month call option (often referred to as short call) with a strike of 1250 sold at a premium of
86.60.
Figure C shows Payoff for buyer of call option
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. As can
be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes
above the strike of 1250, the buyer would exercise his option and profit to the extent of the
difference between the Nifty-close and the strike price. The profits possible on this option are
potentially unlimited. However if Nifty falls below the strike of 1250, he lets the option expire.
His losses are limited to the extent of the premium he paid for buying the option.

Profit

1250
0

Nifty

86.60

Loss

Figure D Payoff for writer of call option

The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. As the
spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon
expiration, Nifty closes above the strike of 1250, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the Nifty-close and the
strike price. The loss that can be incurred by the writer of the option is potentially unlimited,
whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60
charged by him.

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Profit

86.60
1250
0

Nifty

Loss

4.1.5 Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in
the option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower
the spot price, more is the profit he makes. If the spot price of the underlying is higher than the
strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid
for buying the option. Figure E gives the payoff for the buyer of a three month put option (often
referred to as long put) with a strike of 1250 bought at a premium of 61.70.

Figure below shows Payoff for buyer of put option

The figure below shows the profits/losses for the buyer of a three-month Nifty 1250 put option.
As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty
closes below the strike of 1250, the buyer would exercise his option and profit to the extent of
the difference between the strike price and Nifty-close. The profits possible on this option can be
as high as the strike price. However if Nifty rises above the strike of 1250, he lets the option
expire. His losses are limited to the extent of the premium he paid for buying the option.

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Profit

1250
0

Nifty

61.70

Loss

4.1.6 Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/loss that
the buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyers profit is the sellers loss. If upon expiration, the spot price happens to be below the strike
price, the buyer will exercise the option on the writer. If upon expiration the spot price of the
underlying is more than the strike price, the buyer lets his option expire un-exercised and the
writer gets to keep the premium. Below figure gives the payoff for the writer of a three-month
put option (often referred to as short put) with a strike of 1250 sold at a premium of 61.70.

Figure below shows Payoff for writer of put option

The figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. As the
spot Nifty falls, the put option is in-the-money and the writer starts making losses . If upon
expiration, Nifty closes below the strike of 1250, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the strike price and Niftyclose. The loss that can be incurred by the writer of the option is a maximum extent of the strike
price(Since the worst that can happen is that the asset price can fall to zero) whereas the
maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by
him.
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Profit

61.70
1250
0

Nifty

Loss

5. HEDGING
Hedging is a mechanism to reduce the risk or minimize losses that are inherent in open positions.
Derivatives like futures, options and swaps are widely used as a tool for hedging. Primary
purpose of hedging is to reduce volatility thereby reducing the risk of a portfolio. Hedge can help
lock in existing profits. Hedging does not mean maximization of profits/returns but it only means
reduction in variation of return.
In a simple example Mr. ABC buys wheat which is to be converted in to flour. At the same time,
the miller will contract to sell an equal amount of wheat, which the miller does not presently
own, to another trader. The miller agrees to deliver the second lot of wheat at the time the flour is
ready from market and at the price current at the time of the agreement. If the price of wheat
declines during the period between the millers purchase of the grain and the flours entrance
onto the market, there will also be a resulting drop in the price of flour. That loss must be
sustained by the miller. However, since the miller has a contract to sell wheat at the older, higher
price, the miller makes up for this loss on the flour sale by the gain on the wheat sales.

Hedge ratio: It is defined as the number of contracts required to buy or sell so as to provide
maximum reduction in the risk of portfolio. This depends on :
Value of futures contract.
Sensitivity of the movement of portfolio with that of the index. (called Beta)
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Portfolio to be hedged.
Risk appetite of the investor.
Hedging only makes an outcome more certain. It does not necessarily lead to a better
outcome.
Various terms under hedging are:

Long Hedge: Long hedge is a transaction when we hedge our position in cash market by
going long in derivatives markets. For example let us assume that we are going to receive funds
in the near future and we are bullish about the market but we are required to invest more money
which is not desirable. The risk can be hedged by investing in Futures & options of derivatives
market

Short Hedge: It is a transaction accomplished by going short in the derivatives market.

For example prices of the stocks which we have invested are continuously going down or are
highly volatile, then in order to protect our portfolio we can go short in the derivative market.

Cross hedge: when derivatives of the underlying assets that we have, are not available,
we use some other related underlying, that are available. This is called cross hedge.
Equity derivatives are the financial derivatives whose values are derived from underlying
securities. These are primarily based on various underlying stocks and stock indices and
performance are closely linked with the underlying securities.
Futures and Options are the most common type of equity derivatives and are used as an
effective tool for hedging.

6. HEDGING WITH FUTURES:

Buying stock futures contract is similar to that of buying number of shares for number of
underlying stock but without taking delivery for the same. Hedger enters the futures market in
order to protect himself from the risk of an adverse price movement.
If the hedger wants to increase value of his portfolio or if he wants to maintain same value for his
portfolio which consists of variety of blue chip stocks he may consider selling the futures or
purchasing it as the case may be in the market. Although hedger may be bullish about the market
still he may have some fear about the negative movement in the market. Let us make a
hypothetical case study under certain assumptions for more clear view of utilizing futures as a
hedging tool:

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Mr. ABC has a portfolio of 9 lakhs and 1 lakh is invested in cash market which is in various
blue chip companies in nifty index. Following are the assumptions for hedging the portfolio
Assumptions:

Futures are purchased in a lot size of 50.

10% margin is required to be paid while entering in to futures contract.

As per the risk appetite of the investor he would be hedging his portfolio.

Valuations of the portfolio should not be shrinked.
Two types of scenario that are taken in to account are:
1. Simple hedging which has beta of 1
2. Hedging for new investors which has beta of more than 1
In the bullish market although investor wants to stick out with his portfolio for two years but he
may still have some fear as it is not possible that his each invested stock would rise and hence he
enters in to contract to protect his portfolio.

First Scenario:Say your equity portfolio has a beta of 1 and the Nifty is at 3500. Over the next two weeks, the
nifty grinds down to 2700. Your portfolio is now worth Rs 810,000 plus Rs210, 000 i.e. Rs
1,020,000. Your decision dilemma is - should I sell or buy more to average out? No its better to
opt for hedging your portfolio against the market movements.
To hedge Rs 900,000 of equity portfolio, we require Rs 900,000 in futures. i.e. 6 lots of Nifty
Futures of Rs 150,000 each. If you short these 6 lots at Nifty 3000, your total margin requirement
say approximately Rs 210,000 as shorting futures has more margin requirements as compared to
that of going long in the futures market.. So that is where you deploy your surplus cash. So in the
event the Nifty tanks to 2700, your equity portfolio would be worth Rs 810,000 while 6 lots of
50 Nifty each will fetch you Rs 90,000 (6 x 50 x 300). No profit, no loss, despite a 10% fall in
market. Now thats a simple hedge in futures.

Second Scenario:With the same amount of above mentioned investment say your Beta is 1.25 of the portfolio
which includes various aggressive and non-aggressive stocks. So instead going short of 6 lots go
short for 7 lots to protect the downside risk of the investor and what if the market moves up at
the same point of time.
Say the market moves up five percent from 4000 in a day. Your mark to market losses would be
150x50x6 = 4500. The same amount that your portfolio would gain. So what is the fun investing
if the portfolio is not giving any good returns. Thus the concept of a stop loss can be used, say at
3% above the market price. So the downside is fully protected but the cost is - a small fall in
profit. In the current market conditions, that is a small price to pay.
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Another variation to the strategy - if over a period of time the equity portfolio value falls
substantially ( and that seems to be the case for most of us!) and you find yourself over hedged,
book your profit in a lot or two and use the cash to buy your favorite stock.
Although investment in the equities are and should be for a long term horizon there are time in
the markets when it deeps to extremely low levels. The capital gains in a year or so is wiped off
in a week or so. The best way to save your money is by keeping your portfolio hedged. The
simplest way to hedge your portfolio is by selling index futures. This essentially means that you
sell index futures of the amount of the portfolio you have taking into consideration the beta of
your portfolio.

7. HEDGING USING OPTIONS:

The only thing that is certain about the market is uncertainty. In recent months due to various
reasons we have seen volatility at its best. As every portfolio is linked with some risk, it
immediately reacts with the trend of the market.
In such volatile market conditions investor has two of the possibility availed:
1. He will sell the stock or
2. Remain invested and bear the brunt of volatility.
The third possible way to protect his portfolio can be over longer time of frame, he can use
options.
Two simple techniques of using derivatives to deal with range bound or volatile markets are call
option and put options which are explained above. Now option contracts are not only available
for hedging risk against fluctuations of the market but also to increase the value of their
portfolios and take opportunity of variety of investments available.
Buying a put option is the best strategy for the retail investors to hedge their portfolio against
downside risk. As compared to same call option can again be used as strategy if the investor is
bullish about the market but again he has to protect himself against downside risk so he can use
both combinations to increase the value of portfolio or hedge himself against the market
volatility.
A key question that might arise is how many NIFTY puts or calls one should buy or short.
Assuming portfolio in line with NIFTY the ideal combination is one lot for every two lakhs of
investment. It also depends on the risk appetite of the investor how much he wants to hedge his
position in the market from the value of his portfolio.

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Hedging should not be considered as a tool for making money. The best it can achieve is
minimizing the risk. Alternatively there might even be instances where the hedged position
incurs a loss. One should avoid the temptation to try and hedge 100% possible draw down in
portfolio as this would mean incurring higher cost, sometimes even 10 to 20% of portfolio value
and may result in heavy loss if the market does not move down as expected.
Below given are some of the tools and strategies that can be used in the bullish market by the
new investors as well as current players having their portfolios.

7.1 STRATEGIES UNDER OPTIONS

7.1.1 LONG CALL:
Although long call is not a pure hedging strategy it can be used as one of the tool for hedging.
Buying a call is the most basic of all options strategies. It is used by aggressive investors who are
very bullish about the prospects of the stock/index, as the strategy has upside potential with
limited downside risk. The primary motivation for such an investor is to realize financial reward
from an increase in price of the underlying security. In general, the more out-of-the-money the
call is the more bullish the strategy, as bigger increases in the underlying stock price are required
for the option to reach the break-even point.
BENEFIT:
A long call option offers a leveraged alternative to a positioning the stock. As the contract
becomes more profitable, increasing leverage can result in large percentage profits because
purchasing calls generally requires lower investment of capital as compared to purchase of
underlying stock. Long call contracts offer the investor a pre-determined risk.
RISK:

Risk is limited to the amount of premium paid for purchasing number of unit of shares which is
downside risk.
REWARD:
Profit that can be earned is unlimited.
EXAMPLE:
Mr. ABC is bullish about the market as on 8th May, 2009 who is new in the market and wants to
make fresh investment but is not ready to take risk with his new investment. Thus he is ready to
take the risk but only to the extent of Rs.5000 as explained in the below example. Lets say
NIFTY is trading at 3600. As he is bullish about the market he decides to purchase 100 units of
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CA NIFTY options for the strike price of 3800 by paying the premium of Rs.50 for the same,
contract of which expires on 30th June. Thus it can be summarized as:

Strike price: 3800

Premium paid: 100*50=5000
Break Even Point: (Strike price + Premium) 3800+50=3850 Per Unit.
Thus we can say that as and when market surpasses 3850 mark Mr. ABC would start earning
profits and if market goes against the expectations of the investor he may not exercise the option
and thus his loss would be limited to the extent of amount of premium paid but the profits earned
can be unlimited. The payoff for the same can made as follows:

Nifty on expiry
3600
3700
3800
3850
4000
4100
4200

Payoff
from
option (Rs.)
-50
-50
-50
0
150
250
350

7.1.2 SYNTHETIC LONG CALL:

This investment strategy is used when an investor is desired to have a stock for the long run yet
investor is concerned about the short term downside risk of the stock. As we are bullish about the
stock in the long run investor will purchase underlying stock from the cash market. Now to
insure against short term downside risk he will purchase a put option of the stock which gives
him right to sell the stock at the strike price which can be price at which you bought or slightly
below then strike price.

BENEFIT:
In case the price of the stock rises he can reap the benefit from the stock which he has purchased
from the cash market. In case price of the stock falls, exercise the put option. As price of the
stock decreases he can minimize the loss by adopting put option. Thus it is a strategy with a
limited loss and unlimited profit which is arrived at after deducting the put premium and from
the stock rise respectively.
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RISK:
It is only to the extent of premium paid for the put option for the near term downside risk.
REWARD:
In case the stock price rises then investor can earn unlimited profits as he is having underlying
stock and in case if the stock price falls then he can earn profits by exercising the put option
which gives him the right to sell the stock.

EXAMPLE:
Mr. ABC who is having a portfolio of Rs.10 lakhs and is bullish about the market but in order to
protect himself against the downside risk uses this strategy to protect the value of his portfolio.
He is having RIL which is currently trading at Rs. 1900 in the cash market. In order to protect
against downside risk he purchases put option for the same stock for strike price of Rs.1850 by
paying the premium of Rs.75. it can summarized as follows:
Strike price: 1850 at premium of Rs.75
Break Even Point: Rs.1775 (Rs.1850-Rs75 premium paid). Amount is deducted from the strike
price as it is a put option which gives right to sell the stock.
Thus we can say that this strategy can be utilized when investor wants to earn in the long run as
well as to minimize losses against the fall in the price of the stock. The payoff chart can be made
as follows:
RIL prices
1650
1700
1775
1850
1900
2000

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Payoff from the

option
+125
+75
0
-75
-75
25

Page 33

7.1.3 SHORT PUT:

This strategy can be used by investors when he is bullish about the market expects the stock
price to rise or stay sideways at the minimum. The primary motive is to earn short term income
by selling the put option. This strategy can be used as a hedging tool by the new investors in the
market.
BENEFIT:
As and when you sell the put you earn a premium from the buyer of the put option. If the stock
price increases beyond the strike price and as it is a put option, the short put position will make
profit for the seller of the put option as the buyer of the option is not going to exercise the put
option and premium amount is retained by the seller of the put option.
RISK
If the stock price reduces beyond the strike price and gets reduced by amount of premium then
buyer of the put option will start making the profit and hence downside risk involved for seller of
the put option is very high.
REWARD:
Potential loss is very high and reward is limited to the price of the premium of the put option.
EXAMPLE:
Mr. ABC is bullish about the market and is positive about RIL stock which is currently trading at
Rs.1900 in the market. He sells the put option at a strike price of 1800 for a premium of Rs.60.
Breakeven point from the point of view of buyer will come as and when price goes beyond
premium. It can be summarized as:
Strike price: Rs. 1800
Premium received: Rs.60
Breakeven Point: Rs.1740 (1800-60) from the view point of the buyer.
Thus we can say that this strategy can be adopted by the investors in the range bound or rising
markets to earn short term profits from the stock but investor has to be meticulous while
selecting the stock as downside risk involved in the same is very high. Net payoff is as follows
RIL prices
1900
1850
1840
1800
1750
1700
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Net payoff from the

option
60
60
0
-40
-90
-140

Page 34

7.1.4 LONG COMBO: SELL A PUT, BUY A CALL:

The long combo is variation of a long synthetic future. The only difference in this strategy is that
we sell Over The Money (OTM) puts and buy OTM higher strike call. This strategy is adopted
when the investor is bullish about the market and expects the stock price to rise in the future but
does not want to make higher investment in the stock.

BENEFIT:
As the strategy involves selling over the money put option and buying higher strike call as he is
bullish about the market investor will start making the money when it goes above the strike price
and net premium investor will start getting benefit from the investment.
RISK:
When put option is sold downside risk increases as price goes beyond strike price and beyond
premium and as he buys a call option risk is limited only to the price of the premium paid if the
price does not go beyond the strike price.
REWARD:
Investor can make the money as and when price of the stock goes beyond the net premium and
reward is unlimited to the extent of the increase in the price of the stock.
EXAMPLE:
Mr. ABC is bullish about ICICI which is currently trading at Rs.600 in the cash market. But he
does not want to make investment of 600. Hence by adopting this strategy he sells a put option
with a strike price of 500 at a premium of Rs. 50 and buys a call option with a call option of
Rs.700 at a premium of Rs.60. Hence net cost for the strategy would be Rs.10. it can be
summarized as follows:
Strike price: Rs.500 OTM higher strike price for put option
Premium received: Rs.50
Strike price: Rs. 700 OTM higher strike price for call option
Premium paid: Rs.60
Breakeven Point: Rs.710 (Rs.700 for call option + Rs.10 net premium investment)
Thus we can say that this strategy can be used when investors wants to make less investment and
is bullish about the market and can earn huge profits but only if the stock moves up. Otherwise

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potential losses can be very high in this strategy. The net payoff by adopting this strategy can be
calculated as follows:
ICICI price
850
800
750
710
650
600
550
500
450

Net payoff from put

sold
50
50
50
50
50
50
50
50
0

Net payoff from call

option
90
40
-10
-60
-60
-60
-60
-60
-60

Net payoff
140
90
40
-10
-10
-10
-10
-10
-60

7.1.5 COVERED CALL:

The covered call is a strategy adopted by the investor when he is neutral or moderately bullish
about certain stock which he holds but not much in a near term and still wants to earn income
from the shares. In this strategy investor sells a call option on a stock he owns and earns a
premium on it. Its attractive to sell an Over the Money or At the Money call while you already
own the stock. In such cases, the premium you collect will he higher as will the likelihood of
exercise, meaning youll end up delivering the stock at the strike price of the sold call. Since the
stock is purchased simultaneously with writing (selling) the call, the strategy is commonly
referred as buy-write.
BENEFIT:
As investor already owns the shares of the company and sells an OTM call option he can earn
premium as part of benefit from the strategy. The option would be exercised by the purchaser of
the call if the price level goes beyond sum of strike price and premium. Here he can be benefited
in a manner that he already owns the stock of the company and can sell if the price rises beyond
the call option.

RISK:
Downside risk involved is in this strategy is very low as compared to other strategies as investor
purchases the shares of the company. But if the stock price goes against the expectations of
investor he will lose the entire value of the stock except the premium received for the call option.
So maximum risk is the difference between price at which stock is purchased and premium
received against call option.

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REWARD:
Benefit under this strategy is limited to the extent of difference of call strike price and stock price
paid for purchasing the stock and premium received against sell of call option.
EXAMPLE:
Mr. ABC who is new investor wants to invest in the market and is bullish about the market
purchases the stock ICICI for 600 but as he wants to protect himself against the downside risk he
simultaneously sells the call option for Rs 700 for premium of Rs.60. Therefore net investment
becomes 540 for Mr. ABC. Call option would be exercised only if it goes beyond Rs.760 and if
goes beyond that then he has make the payment of the price which goes beyond 760. But again
he can make profits from the stock which he has already purchased from the cash market. It can
be summarized as follows:
Purchase price of stock: Rs.600
Strike price: Rs.700
Premium received: Rs.60
Breakeven point: Rs.540 (600-60)
Now if the price reaches to 800 still investor can make profits. It can be explained as follows:
As buyer of the option will exercise option, Mr. ABC has to pay him difference between strike
price and rise in price that is Rs.100 (800-700). But against that he will exercise the stock which
he has purchased from the cash market for Rs.600 and hence if the stock price reaches Rs.800
then he makes profit of Rs. 200 (800-600). Thus net effect would be
Rs.200 Profit made by selling security + Rs.60 premium received by selling a call option
Rs.100 paid for exercising the call option
= Rs.160 profit.
If the stock price stays beyond Rs.700 then Mr. ABC can retain the premium earned against the
call option. The net payoff can be calculated as follows:
ICICI Stock price
450
500
540
600
800

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Net payoff
-90
-40
0
60
160

Page 37

7.1.6 LONG STRADDLE

A straddle is basically a volatility strategy and it can be used by investors when certain stocks are
showing high volatility of large sideways movements. The strategy involves in purchasing call
option as well as selling put option for the same maturity and strike price to take advantage of a
certain volatile market.
BENEFIT:
As strategy involves purchasing call option as well as shorting put option at certain strike price to
be exercised on the same date an investor can be benefited through this strategy in both types of
market, it may be bear market or bull market. Thus this strategy can be opted when investor is
expecting higher movements in the market.

RISK:
Downside risk involved in such strategy is limited to the price of premium purchased for both
types of option i.e. call and put.
REWARD:
Reward is unlimited as soon as the price crosses the strike price in either of the options. The
option would be exercised if an option crosses the price of premium paid for it.
EXAMPLE:
Mr. ABC who is having a portfolio Rs.10 lakhs and expects markets to move either side and
wants to hedge himself in the market he purchases nifty futures which are currently trading at
3,800 and purchases call option for a strike price of 3,900 and put option for strike price of 3,700
for premium of Rs.80 and Rs.90 respectively. Hence it can be summarized as:
Strike price: 3,900 for call option and 3700 for put option.
Premium paid: Rs.80 for call option and Rs.90 for put option.
Breakeven point: Rs.3980 (strike price + premium paid) for call option and Rs.3610 for put
option.
In case the market goes up investor would exercise the option if it reaches beyond 3980 and in
case market falls he will exercise option if market falls below 2610. If the market does not reach
either upward limit of 3980 or downward limit of 3610 Mr. ABC would not exercise the option
and would have loss to the extent of premium paid that is of Rs.170 in the above case. The net
payoff for the same can be calculated as below:

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On expiration price of
nifty futures
4200
4100
4000
3980
3800
3700
3610
3500
3400
3300

Payoff from call

option
220
120
20
0
-80
-80
-80
-80
-80
-80

Payoff from put

option
-90
-90
-90
-90
-90
-90
0
110
210
310

Net payoff
130
30
-70
-90
-170
-170
80
30
130
230

7.1.7 COLLAR:
A collar strategy is similar to that of covered call where investor is neutral to moderately bullish
about the market. Only addition in collar strategy is it involves purchasing of another put option
and hence it is a covered call with limited risk. Although investor is neutral to bullish still he
wants to earn the income and hence can use this strategy. This strategy can be used by new
investors as well as to hedge the existing portfolio of the investor.
BENEFIT:
Collar strategy is buying a particular stock and the same is insured against the downside by
buying a put and selling a call. Hence benefit involved in this strategy is limited since the put
prevents the downside risk and selling a call option prevents that risk. Hence this strategy is
adopted when the investor is conservatively bullish.

RISK:
Risk is very limited in this strategy as investor gets covered by purchasing a put option against a
stock and selling a call which protects him from downside risk.
REWARD:
Reward is very limited in this strategy as this strategy involves a very low risk taken by the
investor. Generally in this strategy put option is ATM and call option is OTM.
EXAMPLE:
Mr. ABC holds the stock of XYZ ltd. which is currently trading at 3600 and he decides to adopt
collar strategy by writing a call of 3800 for Rs.40 premium and purchasing put option 3500 for
Rs.30 premium. Here the net investment would be for Mr. ABC would be 3590 as he receives
Rs, 40 for call option and Rs.30 premium for put option. It can be summarized as:
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Strike price: 3800 for writing a call and 3500 for put option.
Premium: Rs.40 for writing call option and Rs.30 for put option.
Breakeven point: Rs.3590 (purchase price of stock + premium for call premium for put)
In case market moves up as investor has sold call option then he has to pay to the seller of the
call option but can earn the profits by selling the underlying stock. In case the market starts
coming down then he gets protected against downside movement of the market by exercising the
put option after it goes above the strike price. Hence he can earn two ways income from put
option as well as premium received against writing the call option. Hence the net payoff can be
explained as below:

Closing price of
XYZ ltd
3300
3400
3500
3600
3700
3800
3900

Payoff from call

sold
40
40
40
40
40
40
-60

Payoff from put

purchased
170
70
-30
-30
-30
-30
-30

Payoff from
underlying stock
-300
-200
-100
0
100
200
300

Net payoff
-90
-90
-90
10
110
210
210

7.1.8 BULL CALL SPREAD STRATEGY:

This strategy is adopted by the investor when he wants to bring down the cost and breakeven on
a buy call (Long call) strategy by creating a spread by purchasing in-the-money (ITM) call
option and selling out-of-the-money (OTM) call option. Hence this strategy effectively deals
with purchasing and selling call options and can be used by investor when he is moderately
bullish to bullish about the market. This strategy can be utilized by the new investors where
although he is bullish about the market as strategy brings down investment and can hedge him
against the downside risk in the market with limited investment.
BENEFIT:
Investor can be benefited if the market moves as per his expectations and will make profit when
the market rises. The biggest benefit that an investor gets by this strategy is he can bring down
his cost of investment and still can earn huge profits with limited downside risk.
RISK:
The risk involved in this strategy is limited to the extent of premium paid for establishing the
positions in the market. Maximum loss occurs where the underlying falls to the level of the lower
strike or below.
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REWARD:
Maximum profit is limited to difference between the two strike prices less the net debit premium
paid for call options. However strategy also has limited gains and hence is ideal for investor
when he is moderately bullish to bullish about the market.
EXAMPLE:
Mr. ABC purchases nifty call which is currently trading at 3000 and purchases call of 2900 by
paying premium of Rs.100. he writes the call option of 3200 for premium of Rs. 60. Hence his
net investment would be Rs.40 i.e. difference between two premiums. It can be summarized as:
Strike price: Rs.2900 for purchasing call and Rs.3200 for writing a call option.
Premium: Rs.100 for ITM call option and Rs.60 OTM writing call option.
Breakeven Point: 2900 + 40 = 2940 (strike price of purchased call + net premium)
Hence we can say that this strategy can be applied to reduce the investment and can be helpful
for new investors in the market. He can make the profits as soon as investment crosses the
breakeven point. The net payoff chart can be prepared as follows:
Closing price of Nifty
on expiry

Net payoff from call

option

Net payoff from

written call option

Net payoff

2800
2900
3000
3100
3200
3300
3400

-100
-100
0
100
200
300
400

60
60
60
60
60
-40
-140

-40
-40
60
160
260
260
260

7.1.9 SHORT CALL BUTTERFLY:

This is a strategy that can be generated in the range bound and volatile markets. The Short Call
Butterfly can be constructed by Selling one lower striking in-the-money Call, buying two at-themoney Calls and selling another higher strike out-of-the-money Call, giving the investor a net
credit (therefore it is an income strategy). It is just opposite of long call butterfly strategy. There
should be equal distance between each strike. This strategy should be used when investor is
neutral on market conditions and bullish on volatility of the stock.

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BENEFIT:
As the strategy involves selling and purchasing of call options it gives the investor a benefit of
premium that can be received by writing of the call options of various strike price involved. This
strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and
collect an income.
RISK:
The maximum risk involved in this strategy is to the extent of difference between the strike
prices less net credit received for variety of call options purchased and sold at different strike
price. The maximum risk occurs if the stock / index is at the middle strike at expiration.
REWARD:
The maximum profit occurs if the stock finishes on either side of the upper and lower strike
prices at expiration. However, this strategy offers very small returns when compared to straddles,
strangles with only slightly less risk.

EXAMPLE:
This strategy purchasing 2 ATM call option, sell 1 ITM call option and 1 OTM call option. Mr.
ABC purchases 2 ATM call option which is currently trading at Rs.1000 for which he pays a
premium of Rs. 60 per option, sells call option of 900 for 80 premiums and sells 1300 strike
price call option for Rs. 70 premium. Thus net credit would be Rs.30. it can be summarized as
follows:
Strike price: Rs.1000 for 2 call options purchased, 900 for ITM option & 1300 for OTM option.
Premium: Rs.120 for purchasing call option and Rs. 150 for selling call options.
Breakeven point: Upper breakeven point is 1270 and lower breakeven point would be 930.
Hence we can say that by using this strategy can be used by such an investor who is feared about
the market and wants to minimize the losses of his portfolio by making less investment and
limited downside risk as well as profit. The net payoff can be calculated as below:

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Price on expiry
700
800
900
1000
1100
1200
1300
1400
1500

Payoff from 2
purchase call
option
-120
-120
-120
-120
-20
160
360
560
760

Payoff from ITM

sold call option
80
80
80
-20
-120
-220
-320
-420
-520

Payoff from
OTM sold call
option
70
70
70
70
70
70
70
-70
-170

Net payoff
30
30
30
-70
-70
10
110
70
70

8. DERIVATIVES IN INDIA
The introduction of risk management instruments in India gained momentum in the last few
years due to liberalisation process and Reserve Bank of Indias (RBI) efforts in creating currency
forward market. Exchange traded financial derivatives were introduced in India in June 2000 at
the two major stock exchanges, NSE and BSE. There are various contracts currently traded on
these exchanges. National Commodity & Derivatives Exchange Limited (NCDEX) started its
operations in December 2003, to provide a platform for commodities trading. Below is the
chronology of the instrument which discloses the various steps for development of derivatives in
India;

Chronology of instruments
1991

Liberalization process initiated

14 December 1995

NSE asked SEBI for permission to trade index futures.

18 November 1996

SEBI setup L.C.Gupta Committee to draft a policy framework for

Index futures.

11 May 1998

L.C.Gupta Committee submitted report.

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7 July 1999

RBI gave permission for OTC forward rate agreements (FRAs)

Interest rate swaps.

24 May 2000

SIMEX chose Nifty for trading futures and options on an Indian

Index.

25 May 2000

SEBI gave permission to NSE and BSE to do index futures trading.

9 June 2000

Trading of BSE Sensex futures commenced at BSE.

12 June 2000

Trading of Nifty futures commenced at NSE.

25 September 2000
2 June 2001
July 2001

Nifty futures trading commenced at SGX.

Individual Stock Options & Derivatives
Trading at Stock Options at NSE

9th July 2001

Stock Options launched at BSE

1st Nov 2001

Stock futures launched at BSE

Dec 2006
1st Oct 2008

Derivative exchange of the year by Asia risk magazine

Currency Derivatives introduced (currency futures on US Dollar)

Feb 2010

Launch of Currency future on additional currency pairs at NSE

Apr 2010

Financial Derivatives exchange award of the year by Asian Banker to NSE

30th March 2012

Launched BRICSMART indices derivatives

8.1 EQUITY DERIVATIVES IN INDIA:The opening of Indian economy has precipitated the process of integration of Indias financial
markets with the international financial markets. After revolutionary changes of 1990s , the new
institutional arrangements, coupled with the wide spread knowledge and orientation towards
equity investment and speculation, have combined to provide an environment where the equity
spot market is now Indias most sophisticated financial market. One aspect of the sophistication
of the equity market is seen in the levels of market liquidity that are now visible.
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The trading in BSE Sensex options commenced on June 2, 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on individual stocks were
launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty
Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and
trading in options on individual securities commenced on July 2, 2001. Single stock futures were
launched on November 9, 2001. The index futures and options contract on NSE are based on
S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules,
byelaws, and regulations of the respective exchanges and their clearing house/corporation duly
approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are
permitted to trade in all Exchange traded derivative products.

Growth of equity derivatives with reference to futures and options in India is as shown in the
below chart and diagram:

Total
Year

No. of contracts

Turnover (Rs. cr.)

2005-06

58537886

1513755

2006-07

81487424

2539574

2007-08

156598579

3820667

2008-09

210428103

3570111

2009-10

178306889

3934388

2010-11

165023653

4356755

2011-12

146188740

3577998

2012-13

96100385

2527131

2013-14

105252983

3083103

2014-15

125977607

4019431

Source: NSE website

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250,000,000
200,000,000
150,000,000
100,000,000

Turnover in Crores

No. of contracts

5,000,000
4,500,000
4,000,000
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
-

50,000,000
-

Years
No. of contracts

Turnover (Rs. cr.)

Thus the graph clearly indicates the way equity derivatives that is individual futures and options
as well as index options and futures that have exponentially grown in the country and more
awareness among the investors.
Growth of Derivatives Market in India
Equity derivatives market in India has registered an "explosive growth" (see Fig. 1) and is
expected to continue the same in the years to come. Introduced in 2000, financial derivatives
market in India has shown a remarkable growth both in terms of volumes and numbers of traded
contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The
introduction of derivatives has been well received by stock market players. Trading in
derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE
derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the
value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE
cash markets was only Rs. 35,51,038 Cr. If we compare the trading figures of NSE and BSE,
performance of BSE is not encouraging both in terms of volumes and numbers of contracts
traded in all product categories.
Among all the products traded on NSE in F& O segment, single stock futures also known as
equity futures, are most popular in terms of volumes and number of contract traded, followed by
index futures with turnover shares of 52 percent and 31 percent, respectively. In case of BSE,
index futures outperform stock futures. An important feature of the derivative segment of NSE
which may be observed is the huge gap between average daily transactions of its derivatives
segment and cash segment. In sharp contrast to NSE, the situation at BSE is just the opposite: its
cash segment outperforms the derivatives segment.
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Figure 1: Business Growth of Derivatives at NSE from 2000-2009

Source: NSE fact book 2008 issue

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The following is a tabular representation of the turnover of different segments in the

derivatives market:
Business Growth in Derivatives segment

Year

Index Futures
No. of
contracts

2014-15
2013-14
2012-13
2011-12
2010-11
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01

Stock Futures

Turnover (Cr.)

No. of
contracts

Index Options

Turnover (Cr.)

Stock Options

No. of
contracts

Turnover (Cr.)

No. of
contracts

Turnover (Cr.)

21866521

781940.72

48415080

1789643.7

158734718

5696734.03

17604910

666655.38

105270529

3085296.5

170414186

4949281.7

928565175

27767341.2

80174431

2409488.6

96100385

2527130.8

147711691

4223872

820877149

22781574.1

66778193

2000427.3

146188740

3577998.4

158344617

4074670.7

864017736

22720031.6

36494371

977031.13

165023653

4356754.5

186041459

5495756.7

650638557

18365365.8

32508393

1030344.2

178306889

3934388.7

145591240

5195246.6

341379523

8027964.2

14016270

506065.18

210428103

3570111.4

221577980

3479642.1

212088444

3731501.84

13295970

229226.81

156598579

3820667.3

203587952

7548563.2

55366038

1362110.88

9460631

359136.55

81487424

2539574

104955401

3830967

25157438

791906

5283310

193795

58537886

1513755

80905493

2791697

12935116

338469

5240776

180253

21635449

772147

47043066

1484056

3293558

121943

5045112

168836

17191668

554446

32368842

1305939

1732414

52816

5583071

217207

2126763

43952

10676843

286533

442241

9246

3523062

100131

1025588

21483

1957856

51515

175900

3765

1037529

25163

90580

2365

Source: NSE fact book 2014 issue

8.2 OPERATORS OF DERIVATIVES MARKET

Broadly operators of derivatives are divided in three categories i.e. arbitrageurs, hedgers and
speculators.

Arbitragers: They are operators who are involved in business to take advantage of
differential pricing in two different markets. If, for instance they see the future price of an
asset getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.

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Hedgers: They are the operators who want to transfer a risk component in their portfolio
by minimizing losses. They are mainly engaged in futures & options market to minimize
their risk and thereby minimizing losses.
Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices
go up. For protection against higher prices of the produce, he hedges the risk exposure by
buying enough future contracts of the produce to cover the amount of produce he expects
to buy. Since cash and futures prices do tend to move in tandem, the futures position will
profit if the price of the produce raise enough to offset cash loss on the produce.

Speculators: They are basically engaged in speculating or betting future price

movements of the asset. Futures and options contracts give them extra leverage and they
may earn huge profits and probability of potential losses is also higher. They are the
second major group of futures players. These participants include independent floor
traders and investors. They handle trades for their personal clients or brokerage firms.
Buying a futures contract in anticipation of price increases is known as going long.
Selling a futures contract in anticipation of a price decrease is known as going short.

8.3 REGULATION OF DERIVATIVES TRADING IN INDIA

The regulatory framework in India is based on L.C. Gupta committee report and J.C. Varma
committee report. It is most consistent with the International Organization of Securities
Commission (IUSCO). The L.C. Gupta committee report provides a perspective on division of
regulatory responsibility between the exchange and SEBI. It recommends that SEBIs role
should be restricted to approving rules, bye laws and regulations of a derivatives exchange as to
approving the proposed derivatives contracts before commencement of their trading. It
emphasizes the supervisory and advisory role of SEBI. It also suggests establishment of a
separate clearing corporation.

8.4 INDIAN DERIVATIVES VIS--VIS GLOBAL

DERIVATIVES:
The derivative segment has expanded in the recent years in substantial way both globally as well
as in the Indian capital market. The Indian segment has grown phenomenally as compared to the
global segment. The Notional value of NSE option was 354648.91 lakhs USD and the number of
contracts were 67458468 and the notional value at NSE futures was 39228.38563 lakh USD and
the number of contracts were 7815624 in 2013 which are much more than it was in preceding
years.

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Though the derivatives market in India is nascent as compared to the U.S. and European markets,
yet the pace with which it is growing is far more as compared to its counterparts and thus the
future prospects of the Indian derivatives market is bright.

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9. QUESTIONNAIRE
ST. XAVIERS COLLEGE
DERIVATIVES THE GLOBAL CASINO
Name ---

1) Are you aware about the Meaning of Derivatives?

a) Yes

b)

No

2) Are you trading in the Derivative market?

a) Yes

b) No

3) If not, reasons for not investing in the derivatives market?

a) Lack of Knowledge
b) Very Risky
c) Huge amount of investment
d) Other

4) Which of the following Derivatives instrument have you heard

about?
a) Stock Futures
b) Stock index futures
c) Stock options
d) Stock index options
e) Swaps
f) Currency
g) None
5) Do you think the Indian Derivative market is matured enough as
compared to the U.S. market?
a) Yes

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b) No

c) Cant say

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6) Are necessary steps being taken to make people aware about

the Derivatives market?
a) Hedger

b) No

7) Do you think that awareness programmes about Derivatives

should be initiated at college level?
a) Yes

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b) No

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10. ANALYSIS

1) Are you aware about the Meaning of Derivatives?

a) Yes

b)

No

40%
60%
Aware
Unaware

Comment:
Of the survey taken around 40% of the respondents were unaware of derivatives. Out of the 60%,
only about 75% were totally sure of what a derivative actually is.. Thus, even though in
accounting and finance, 40% are yet to know about derivatives and its use.

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2) Are you trading in the Derivative market?

a) Yes

b) No

6.67%

Yes

93.33%
No

Comment:
Almost a negligible
le percentage of the respondent
respondents trade in the Derivatives market.
market When further
questioned, a vast majority of them do not trade in the market. A reason could be unawareness
about this market and therefore risk averseness is natural.

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3) If not, reasons for not investing in the derivatives market?

a) Lack of Knowledge
b) Very Risky

c) Huge amount of investment

d) Other

60%
50%
40%
30%
20%
10%
0%
Lack of Knowledge

Very Risky

Huge Amount of
Investment

Other

Comment:
A vast majority do not trade in the derivatives market because of lack of knowledge. Also people
believe that it is very risky and thus often link derivatives trading to gambling. Some of the
respondents who were aware said that huge amount of investment is required for trading in the
derivatives market which is evident from the fact that futures and wide variety of options are
standardized contracts and thus requires trading in lot
lots.

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4) Which of the following Derivatives instrument have you heard

about?
a) Stock Futures
b) Stock index futures
c) Stock options
d) Stock index options
e) Swaps
f) Currency
g) None

30%
25%
20%
15%
10%
5%
0%

Comment:
Stock futures emerged as the most popular as compared to the other instruments followed by
Stock Options and then followed by the others. Surprisingly, none among the respondents had
heard about Currency derivatives in practice.

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5) Do you think the Indian Derivative market is matured enough as

compared to the U.S. market?
a) Yes

b) No

c) Cant say

20%

Yes

No

50%

30%
Can't say

Comment:
Half the respondents were not aware about the status of the Indian Derivatives Market and thus
could not answer this question. 20% believed the Indian Derivative market to be at par with the
U.S. market while 30% said that Indian Derivative market is not as matured as the U.S.
derivative market. Clearly it reflects on the unawareness of this market among the respondents.

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6) Are necessary steps being taken to mak

make
e people aware about the
Derivatives market?
a) Yes

b) No

80%
70%
60%
50%
40%
30%
20%
10%
0%
Yes

No

Comment:
Majority believe that necessary steps are not being taken to make people informed about the
concept of Derivatives and trading of Derivatives in India. Thus, need arises for making people
informed about derivatives. A lot of wealth is amassed by few people aware about Derivatives
and who frequently trade in the derivatives market and get a handsome return.

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7) Do you think that awareness programmes about Derivatives should

be initiated at college level?
a) Yes

b) No

80
70
60
50
40
30
20
10
0
Yes

No

Comment:
Majority believed that as steps are not being taken to make people aware about Derivatives,
awareness programmes and seminars should be conducted at college level so that there is
adequate idea about Derivatives.

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11. FINDINGS & SUGGESTIONS:

FINDINGS:

The result of the study is a good understanding of different strategies in derivatives. These
strategies are effectively used for hedging loss or gaining risk-free returns by arbitrage and
provide good knowledge of when to use these strategies in most effective way according to
different market situation. The understanding of payoff patterns of futures and options has
contributed to knowledge of implementation of strategies.

From the turnover of the derivative market we can find that Derivative market is
growing at a higher pace in India and is increasing year by year. Derivative Market are
more regulated & standardized so in this way it provides a more controlled environment.
It encourages the investor to take more risk & earn more return.

Investors can use equity derivatives instruments to hedge themselves against the losses
of their portfolio as per the risk appetite of the investor and hence they decide the hedge
ratio i.e. whether they want to hedge the whole portfolio or part of the portfolio. They
can hedge their position in the market by various put and options involved strategies as
well as futures.

Thus in outline, project report establishes knowledge of different strategies and how
hedging can be used as an effective tool for investors.

SUGGESTIONS:

After the study it is clear that Derivative influence our Indian Economy up to much
extent. So, SEBI should take necessary steps for improvement in Derivative Market so
that more investors can invest in Derivative market.

There should be the rapid development of derivatives products in financial markets all
over the world but with some consciousness. Few developments may be like this:

Introducing more types of risk hedging contracts.

Introducing adequate risk management and internal monitoring techniques to curb

unnecessary speculation so as to protect the interest of small investors.

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More awareness must be created among the investors about various derivatives so
that investors can enter in to derivatives contract and can make profits by less
investment.

Derivatives can find its use in many areas:

In the Airline Industry, there is always a risk of the rise in the prices of Airline
Turbine Fuel (ATF). Airline Companies can hedge themselves by using futures to
mitigate risk of risk in ATF Prices.
A speculator who believes that Gold is overvalued can short Gold and thus gain if
his belief turns out to be true.
Entering into commodities trading is expensive but through the use of futures and
options, easy trading can be done in the commodities segment without incurring
storage costs.

Awareness programmes must be initiated at college levels and also through seminars and
through newspapers. As the growth of Derivatives contributes significantly to the
economic growth of a nation, Indians should be made more informed about this market
and thus it shall lead to the growth of both this market as well as the growth of Indian
Economy.

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11. CONCLUSIONS

The Indian Capital Market has undergone qualitative changes in the last decade due to
phenomenal growth of derivatives. Derivatives are used for variety of purposes, but most
important are hedging and arbitrage.

This study attempts to simplify the concept of these basis strategies with the knowledge
of market condition and payoff strategies so that investor can make out opportunities for
reducing the loss and gain fair returns.

Financial Derivatives have earned a well-deserved and extremely significant place among
all the financial instruments due to innovation and landscape.

Derivatives has grown in India at a far greater pace than the growth of its counterparts
globally but although the growth of Derivatives in India is at a rapid pace, yet there is
unequitable distribution of information regarding this market.

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12. BIBLIOGRAPHY
Study of derivatives and various instruments has been done with the help of websites,
books and reports.

Websites:
www.nseindia.com/content/ncfm/sm_otsm.pdf
www.sebi.gov.in
www.derivativesindia.com
www.equitymaster.com
www.sharekhan.com
www.appliedderivatives.com
Search engine google.com and Wikipedia.

Books:
John C. Hull, Future and Options markets, 2nd edition., PHI Learning Private
Ltd., New Delhi, 2009, PP. 1-169.
N.P. Tripathy, Financial Services, 3rd Pr., PHI Learning Pvt. Ltd., New Delhi,
PP. 261-282
NCFM Derivatives Dealers module.

Reports Studied:
Nath Golaka C, (2004), "Behavior of Stock Market Volatility after Derivatives",
<www.nseindia.com>.
Shenbagaraman, Premlata, (2003), "Do Futures and Options Trading contributes to
Stock Market growth? <www.nseindia.com>.
Thenmojhi M, "Futures and Option Trading, Hedging with Index Futures Contract",
NSE

Working Paper, 2002. <www.nseindia.com>.

A. Vashishtha, S. Kumar, Development of financial derivatives market in India a case

study, <www.eurojournals.com>.

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