DERIVATIVES MARKET

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As with any of the previous modules in Varsity, we will again make the same old assumption that you are new to options and therefore know nothing about options. For this reason we will start from scratch and slowly ramp up as we proceed. Let us start with running through some basic background information. The options market makes up for a significant part of the derivative market, particularly in India. Internationally, the option market has been around for a while now, here is a quick background on the same —.

Clearly the international markets have evolved a great deal since the OTC days. However in India from the time of inception, the options market was facilitated by the exchanges. The badla system no longer exists, it has become obsolete. Here is a quick recap of the history of the Indian derivative markets —. Though the options market has been around sinceoptions trading in derivatives india present scenario real liquidity in the Indian index options was seen only in !

I remember trading options around that time, the spreads were high and getting fills was a big deal. However inthe Ambani brothers formally split up and their respective companies were listed as separate entities, thereby unlocking the value to the shareholders. In my opinion this particular corporate event triggered vibrancy in the Indian markets, creating some serious liquidity. However if you were to compare the liquidity in Indian stock options with the international markets, we still have a long way to catch up.

There are two types of options — The Call option and the Put option. You can be a buyer or seller of these options. In fact the best way to understand the call option is to first deal with a tangible real world example, once we understand this example we will extrapolate the same to stock markets. Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns.

If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay options trading in derivatives india present scenario benefit from the investment he would make today. So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is uncertain whether to buy the land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay is willing to buy.

Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details of the arrangement is as follows —. So what do you think about this special agreement?

Who do you think is smarter here — Is it Ajay for proposing such a tricky agreement or Venu for accepting such an agreement? Well, the answer to these options trading in derivatives india present scenario is not easy to answer, unless you analyze the details of the agreement thoroughly. I would suggest you read through the example carefully it also forms the basis to understand options — Ajay has plotted an extremely clever deal here! Options trading in derivatives india present scenario fact this deal has many faces to it.

Now, after initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what would actually happen. However irrespective of what happens to the highway, there are only three possible outcomes —. Remember as per the agreement, Ajay has the right to call off the deal at the end of 6 months. Now, with the increase in the land price, do you think Ajay will options trading in derivatives india present scenario off the deal? This means Ajay now enjoys the right to buy a piece of land at Rs.

Clearly Ajay is making a steal deal here. Venu is obligated to sell him the land at a lesser value, simply because he had accepted Rs. Another way to look at this is — For an initial cash commitment of Rs. Venu even though very clearly knows that the value of the land is much higher in the open market, is forced to sell it at a much lower price to Ajay. The profit that Ajay makes Rs. It options trading in derivatives india present scenario out that the highway project was just a rumor, and nothing really is expected to come out of the whole thing.

People are disappointed and hence there options trading in derivatives india present scenario a sudden rush to sell out the land. As a result, the price of the land goes down to Rs. So what do you think Ajay will do now? Clearly it does not make sense to buy the land, hence he would walk away from the deal.

Here is the math that explains why it does not make sense to buy the land —. Remember the sale price is fixed at Rs. Hence if Ajay has to buy the land he has to shell out Rs. Which means he is in effect paying Rs. Clearly this would not make sense to Ajay, since he has the right to call of the deal, he would simply walk away from it and would not buy the land.

However do note, as per the agreement Ajay has to let go of Rs. For whatever reasons after 6 months the price stays at Rs. What do you think Ajay will do? Well, he will obviously walk away from the deal and would not buy the land. Why you may ask, well here is the math —. Clearly it does not make sense to buy a piece of land at Rs. Do note, since Ajay has already committed 1lk, he could still buy the land, but ends up paying Rs 1lk extra in this process. For this reason Ajay will call off the deal and in the process let go of the agreement fee of Rs.

I hope you have understood this transaction clearly, and if you have then it is good news as through the example you already know how the call options work! But let us not hurry to extrapolate this to the stock markets; we will spend some more options trading in derivatives india present scenario with the Ajay-Venu transaction. I would suggest you be absolutely thorough with this example. If not, please go through it again to understand the dynamics involved.

Also, please remember this example, as we will revisit the same on a few occasions in the subsequent chapters. Do note, I will deliberately skip the nitty-gritty of an option trade at this stage. The idea is to understand the bare bone structure of the call option contract. Assume a stock is trading at Rs. You are given a right today to buy the same one month later, at say Rs. Obviously you would, as this means to say that after 1 month even if the share is trading at 85, you can still get options trading in derivatives india present scenario buy it at Rs.

In order to get this right you are required to pay a small amount today, say Rs. If the share price moves above Rs. If the share price stays at or below Rs. All you lose is Rs. After you get into this agreement, there are only three possibilities that can occur. Case 1 — If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs. Case 2 — If the stock price goes down to say Rs. Case 3 — Likewise if the stock stays flat at Rs. This is simple right? If you have understood this, you have essentially understood the core logic of a call option.

What remains unexplained is the finer points, all of which we will learn soon. At this stage what you really need to understand is this — For reasons we have discussed so far whenever you expect the price of a stock or any asset for that matter to increase, it always makes sense to buy a call option!

Now that we are through with the various concepts, let us understand options and their associated terms. Hi Sir, Options is like greek and latin options trading in derivatives india present scenario me.

Thanks for the analogies. No, all derivative contracts are routed via options trading in derivatives india present scenario exchanges. You cannot enter into an OTC arrangement, even if you do, it would not be regulated hence quite dangerous.

What benefit would Ajay get by calling off the deal before the expiry of 6 months? He will instead wait for the whole 6 months for any chance of the highway project. My first question Karthik is this: The dropdown value on the NSE website does not contain all months expiries — after 18th May we have 25th June followed by 24th Sept and then 31st Dec What happened to the other months? For to only June and Dec contracts are available.

What happened to the remaining? Saurabh, options trading in derivatives india present scenario you noticed it! For all stocks options the expiry is very similar to futures. Hence we have current month, mid month, and far month contracts. However for Nifty there are several different expiry options. Leaps are good if you have a super long term view on markets.

However the problem with leaps in India is that they are not liquid, there are hardly any trading activity here.

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The computation of risk arrays for Stock option contract is done only at discrete time points each day and the latest available risk arrays is applied to the portfolios on a real time basis. The risk arrays is updated 5 times in a day taking the closing price of the previous day at the start of trading and taking the last available traded prices at A portfolio based margining model is adopted which will take an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all the derivatives contract traded on Derivatives Segment.

The parameters for such a model are as follows: The initial margin or the worst scenario loss is adjusted against the available liquid net worth of the Member. The Members in turn will collect the initial margin from their clients on an up front basis. The scenarios to be used for this purpose are: However, the Derivatives Segment may specify a higher price scan range than the said 3.

The price scan range shall be linked to liquidity, measured in terms of impact cost for an order size of Rs. The Black-Scholes model is used for valuing options. The notional value of option positions is calculated by applying the last closing price of the underlying stock.

Thus mark-to-market gains and losses on option positions will be adjusted against the available liquid net worth of the Clearing Member.

Since the options are premium style, there will be no mark-to-market profit or loss. However, the premium is deducted only for those portfolios where open position is long for a particular series. For the purpose of computing 1. This value shall be applicable for the next month and shall be re-calculated at the end of the month by once again taking the price data on a rolling basis for the past six months.

However, BSE may specify higher exposure margin for better risk management. Position Limits a Market Level: A market wide limit on the open position in terms of the number of underlying stock on stock options and futures contract of a particular underlying stock is: The limit would be applicable on all open positions in all futures and option contracts on a particular underlying stock.

The Market Wide limit is enforced in the following manner: Though the action is taken only at the end of the day, the real time information about the market wide-open interest as a percentage of the market wide position limits is disclosed to the market participants. At the end of each day during which the ban on fresh positions is in force for any scrip, BSE tests whether any Member or client has increased his existing positions, or has created a new position in that scrip. The penalty is recovered along with the Mark-to-Market on the next day.

Once a Member reaches the position limit in a particular underlying, he is permitted to take only offsetting positions which results in lowering the open position of 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 of the Trading Member.

Members are advised to disclose the position of the clients in case the client crosses the aforesaid limits. Members are also advised to inform their clients about the disclosure requirement to BSE on part of the client. The gross open position across all derivative contracts on a particular underlying stock of a sub-account of a FII should not exceed the higher of: Exercise Limits At present, there is no exercise limit for trading in Stock Option contracts.

However, the Derivatives Segment may specify such limit as it may deem fit from time to time. Assignment of Options On exercise of 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 of assignment of Stock Option Contracts. Final settlement for Stock options Exercise of all open positions for single stock options will be solely at the discretion of the buyer on last trading day.

In other words, there will be no automatic exercise of stock options contracts on expiry day. All outstanding positions at expiry for which exercise notices have been received by the Exchange will be settled by delivery of the underlying stock at the respective strike prices. The risk management framework of the equity cash segment shall be applicable to all such delivery based derivatives positions w.

The settlement of such net outstanding delivery based derivatives positions would be settled separately as per the settlement calendar issued for the said Delivery Based Stock Derivatives Segment and as per the delivery mechanism prevalent in the cash segment.