CONTINUING PROFESSIONAL EDUCATION (CPE)

PROGRAM
FOR

EQUITY DERIVATIVES

(Version: 4.0)

1
About NISM CPE
 NISM Continuing Professional Educational Program aims at:
 updating certificate holders with recent changes in market and
regulations
 introduce new topics that may add value
 The CPE Program is of one day duration and the candidate can
attend it anytime during the last year of the validity of his/her
certificate.
 At the end of the day there will be an evaluation based on the topics
covered in the CPE Program.
 Participants will be considered eligible for revalidation/ issue of
certificate once they have successfully completed the related CPE
Program of NISM.
 Please see the CPE Guidelines available on NISM website
(www.nism.ac.in)
Instructions
 For successfully completing CPE Program:
 Please make the complete payment towards CPE fee
 Please submit all the required proofs and photographs
 Please attend the complete CPE Program
 Please remember to sign on the attendance sheet at the
beginning and at the end of the program
 Please switch off your mobiles
 Please keep all your questions for the end of each session
Disclaimer
 This presentation is made for the purpose of use by our
trainers for the sessions and for the benefit of participants
 NISM does not endorse the views and opinions expressed
by the trainers
 NISM will not be held responsible for any personal
opinions expressed by the trainers
Agenda
 A recap of Futures and Options (45 minutes)
 Option Trading Strategies (90 minutes)
 Option Pricing and Option Greeks (60 minutes)
 Trading, Clearing and Settlement of Derivatives (90 minutes)
 Key element of Derivatives Taxation (45 minutes)
 Evaluation Test (30 minutes)
Session 1
Duration: 45 minutes
Linear Derivatives
 Forward - It is a contractual agreement between two parties to
buy/sell an underlying asset at a certain future date for a
particular price that is pre-decided on the date of contract. These
are OTC contracts.
 Futures - A futures contract is similar to a forward, except that
the deal is made through an organized and regulated exchange
rather than being negotiated directly between two parties.
Indeed, we may say futures are exchange traded forward
contracts.
 Two types of Futures Positions:
 Long Futures
 Short futures
Long and Short Futures
Long Futures
Right Entitlement to receive
the underlying at
predetermined price
Obligation Accept underlying at
contract price/ Pay
settlement difference.
Margin Requirement Yes
Risk Profile Unlimited*, when prices
go down
Profit Potential Unlimited, if prices go up
* In practice, it is limited to the extent of underlying’s price reaching to zero
(as equity prices cannot go below zero)
Short Futures
Entitlement to force
delivery of the underlying
at contract price
Deliver underlying at
contract price/ Pay
settlement difference.
Yes
Unlimited, when prices go
up
Unlimited*, if prices go
down
Payoff – Long Futures
 If we buy XYZ stock futures at INR 100, its payoff profile would be as follows:
Payoff – Short Futures
 If we sell XYZ stock futures at INR 100, its payoff profile would be as follows:
Non-Linear Derivatives
 Options - An Option is a contract that gives the right, but not an
obligation, to buy/sell the underlying on or before a stated date
and at a stated price. While buyer of option pays the premium
and buys the right, writer (seller) of option receives the premium
with an obligation to sell/buy the underlying asset, if the buyer
exercises his right.
 Swaps - A swap is an agreement made between two parties to
exchange cash flows in the future according to a prearranged
formula. Swaps are series of forward contracts. Swaps help
market participants manage risk associated with volatile interest
rates, currency exchange rates and commodity prices.
Types of Options & Positions
 Call Option : Option, which gives buyer a right to buy the
underlying asset.
 Put Options : Option, which gives buyer a right to sell the
underlying asset.

 Buyer of an option: Buyer of an option is one who has a right

but not the obligation in the contract. He pays a price to the
seller for this option (right), which is called ‘option premium’.
 Writer of an option: Writer of an option is one who receives the
option premium and is thereby obliged to sell*/buy** the
underlying asset if the buyer of the option exercises his right.

* Sell in case of Call option

** Buy in case of Put option
Moneyness of options
 In the money (ITM) option: This option would give holder a
positive cash flow, if it were exercised immediately. A call option is
said to be ITM, when spot price is higher than strike price. And, a
put option is said to be ITM when spot price is lower than strike
price.
 At the money (ATM) option: At the money option would lead to
zero cash flow if it were exercised immediately. Therefore, for both
call and put ATM options, strike price is equal to spot price.
 Out of the money (OTM) option: Out of the money option is one
with strike price worse than the spot price for the holder of option.
In other words, this option would give the holder a negative cash
flow if it were exercised immediately. A call option is said to be
OTM, when spot price is lower than strike price. And, a put option
is said to be OTM when spot price is higher than strike price.

* Close to money (CTM) will be discussed in session 4

Moneyness of options - Example
 If the spot price of ABC Ltd is INR 102.50 and the strike price
difference is INR 2.50, then moneyness of option contracts of
different strikes is as follows:
Position of Buyer and Seller of Call Option and Put Option
Unlike futures (with linear payoffs), options result in non-linear payoffs.
Long Call Short Call Long Put Short Put
Buy underlying Sell underlying at
Right Nil Nil
at strike price strike price
Sell underlying at Buy underlying at
Obligation Nil Nil
strike price strike price
Premium Paid Received Paid Received
Unlimited (if
Limited (to the Limited (to the
Unlimited (if prices prices go down)
Risk extent of extent of [but in effect, it is limited
go up)
premium paid) premium paid) as asset price can not go
below zero]

Unlimited (if
Limited (to the Limited (to the
Profit Unlimited (if prices go down)
extent of premium [but in effect, it is limited extent of premium
Potential prices go up)
received) as asset price can not go received)
below zero]

Breakeven Strike price + Strike price + Strike price - Strike price -

Point Premium Premium Premium Premium
Example – Long Call
 Mr. X buys a call option at a strike price of INR 500 and pays a premium
of INR 20.
 Payoff (profit and loss) of this Long Call position on the expiration date
under different scenarios:
Payoff of Long Call
 Payoff diagram of this Long Call option would look like this:
Example – Short Call
 Mr. X sells (writes) a call option at a strike price of INR 500 and receives
a premium of INR 20.
 Payoff (profit and loss) of this Short Call position on the expiration
date under different scenarios:
Payoff of Short Call
 Payoff diagram of this Short Call option would look like this:
Example - Long Put
 Mr. X buys a Put option at a strike price of INR 300 and pays a premium
of INR 10.
 Payoff (profit and loss) of this Long Put position on the expiration date
under different scenarios:
Payoff of Long Put
 Payoff diagram of this Long Put option would look like this:
Example - Short Put
 Mr. X sells (writes) a Put option at a strike price of INR 300 and receives
a premium of INR 10.
 Payoff (profit and loss) of this Short Put position on the expiration date
under different scenarios:
Payoff of Short Put
 Payoff diagram of this Short Put option would look like this:
Strategies

 Arbitrage: Arbitrage is a deal that produces profit by

exploiting the price difference in a specific product or of a
same product or identical products in two different
markets.

 Hedging: Hedging is the process of managing the risk

associated with fluctuations in underlying.

 Speculation: Taking positions in derivatives contracts,

without any underlying exposure, with an aim to make
profit.
Arbitrage & Types
 Arbitrage involves making purchases and sales simultaneously in
two different markets to profit from the price differences
prevailing in those markets.

 Cash and Carry arbitrage: It is created by buying in Equity shares

and selling (Short) the Futures contract.

 Reverse cash and carry arbitrage: It is created by Selling the

Equity shares (spot holding) and buying (Long) the Futures
contract.
Cash and Carry Arbitrage
 Cash-and-carry arbitrage refers to buying the stock with
borrowed funds and simultaneously selling the futures contract.
 The futures position is physically settled on the expiration day.
 The opportunity arises when the futures price of the commodity
is more than the sum of spot price and the cost of carrying it till
the expiry date.
Example – Cash and Carry Arbitrage
 In May, Mr. X buys 5000 Shares of ABC Ltd at the spot price of Rs. 100
per share by borrowing Rs. 5,00,000 at the rate of 12 percent per annum
for two months (at simple interest) and simultaneously sells a July
futures contract of 5000 shares at a price of Rs. 103.
 He keeps possession of Shares for two months. He closes out the
futures position on the contract expiry day when the spot and futures
prices converged, by giving delivery of the Shares purchased in May.
 The transaction yields a profit of INR Rs. 15,000 ( = Rs. 515,000 – Rs. 500,000).
 From the amount of Rs. 515,000, Mr. X returns the borrowed amount of
Rs. 500,000 along with an interest of Rs. 10,000.
 Mr. X earns an arbitrage profit of Rs. 5,000 after payment of interest.
Practice For Participants
 Suppose that :
 The spot price of a stock is INR 10,000
 The quoted 3-month futures price is INR 10,212.50
 Lot size is 50
 The 1 year interest rate is 4.5% per annum
 Is there any arbitrage opportunity here?
Reverse Cash and Carry Arbitrage
 Reverse cash and carry arbitrage opportunity works for those
who have Equity shares with them.
 The arbitrage opportunity can be explored when futures price of
the stock is less than the spot price + cost of carry.
 It is initiated by lending funds released from selling the equity
shares in the spot market and buying futures simultaneously.
 After receiving the interest income and the original funds which
were lent, the equity shares are bought back to finally settle the
transaction.
Hedging
 Hedging means taking a position in the derivatives market that is opposite of a
position in the cash / spot market with the objective of reducing or limiting
risks associated with the price changes.
 Hedging is a process designed to reduce or remove the risk of a position in an
asset or a derivative product.
 A hedger enters into the derivatives contract to mitigate the risk of adverse
price fluctuation in his existing position.
 Hedgers may have an underlying exposure in the equity cash market and use
derivatives market to insure themselves against adverse price fluctuations.
 Hedgers include everyone who is exposed towards price risk and wants to
minimize it.
 Hedging is based on the principle that the spot / cash market prices and
futures market prices tends to move in tandem and the price movement is close
enough even though it may not necessarily be exactly identical. Therefore, it is
possible to mitigate the risk of a loss in the spot market by taking an opposite
position in the futures market. Taking opposite positions in the spot and
futures market allows losses in one market to be offset by gains in the other.
Types of Hedgers
 Broadly, there are two types of hedgers: Long hedgers and short
hedgers.

 Short hedgers are those who are long in stock (spot position) and a
decline in stock price is a risk to them. They use derivatives to manage
risk associated with bearish movement in stock price.

 Long hedgers are those who wants to lock-in buying price of the shares
for a forward date. An increase in price is a risk to them and they
manage their risk by buying futures.
Hedging using Futures: Long Hedge & Short Hedge
 In the case of a long hedge, the hedger does not own the
underlying asset, but he needs to acquire it in the future.
 He can lock-in the price that he will be paying in the future by
going long in futures contracts.
 In effect, he is already naturally short on the underlying stock
because he must buy it in future and he offsets this naturally
short position by taking a long position in futures.
 Similarly, short hedge involves sale of futures to offset potential
loss from the falling price of underlying.
Cross hedge
 When futures contract on an asset is not available, market
participants search for an asset that is closely associated with their
underlying asset and trades in the futures market of that closely
associated asset, for hedging purpose (i.e., to protect the value of
their spot market position).
 For example, United Bank stock derivatives are not available in the
F&O segment as it does not qualify the selection criteria of the
exchange but it may have good correlation with PNB derivatives or
with derivatives on Banking sectoral indices such as Bank Nifty.
 Hence, investors holding United Bank stock may set up a cross
hedge for their underlying position using PNB derivatives or Bank
Nifty derivatives.
Example – Hedging using Futures
 Mr. X buys 5000 shares of ABC Ltd at a price of INR 100 per share.
Though he is optimistic about the long-term prospects of ABC Ltd, he
is concerned about some of the near-term events in ABC Ltd and their
potential adverse impact on the share price of ABC Ltd.
 These near-term events are expected to be played out in the next three
months. Therefore, he decided to manage this risk by going short on
futures contracts of three-months duration on the same underlying.
 During this three month period, if the stock price goes down, then this
adverse movement in stock price will give losses on his spot position
but his futures position will compensate for this loss.
 However, if the stock price goes up during this period, then the profits
in his spot position are offset by the losses in his futures position.
 Therefore, it is to be noted that hedging will not always lead to
favourable outcome but what it provides is the certainty of outcome.
Hedging using Options
 Hedgers can use options to manage price risk and protect themselves
against the possibility that the market prices may go against them.
Both calls and puts can be used for hedging.
 Benefits:
 Hedging using Long Put option provides protection from any price
decline in the spot market below the strike price of the option
contract. In case of a price fall in spot market, the loss is
compensated by hedging gains.
 Hedging using Long Call option provides protection from any price
appreciation in the spot market above the strike price of the option
contract. In case of a price increase in spot market, the loss is
compensated by hedging gains.
 Disadvantage: Buyer has to pay an upfront premium. This may
decrease his realized profit (in case of hedging using long put) or
increase his cost of acquisition (in case of hedging using long call).
 Example - Hedging using call option
 Mr. X wants to buy equity shares of ABC Ltd (Current Market Price: INR 2000) after three
months, but if the stock price increase during this period, then he has to buy shares at a
higher price. To manage this risk, he decided to buy a call option of three-months
validity on ABC Ltd at a strike price of INR 2000 by paying a premium of INR 100.
 Case 1: If spot price closes above INR 2000 on expiration (at INR 2300), then he will
exercise his Call option. As he has a right to buy the equity shares of ABC Ltd at a price of
INR 2000, Mr. X will take delivery of shares from the Call option writer by paying INR
2000 per share. Therefore, his cost of acquisition of ABC Ltd shares will be INR 2100.
 Case 2: If spot price closes below INR 2000 on expiration (at INR 1700), then he will not
exercise his Call option. As ABC’s shares are available in the spot market at a cheaper
price, he will directly buy those from spot market and book a loss on his options position
(i.e., the amount of premium paid by him). Therefore, his cost of acquisition of ABC Ltd
shares in this scenario will be INR 1800.
 Case 3: If spot price closes at INR 2000 on expiration, then he may not exercise his Call
option (actually, he is indifferent to exercise or not to exercise this option). He can let his
option expire and can directly buy the shares from the spot market at INR 2000. Here, his
cost of acquisition of ABC Ltd shares will be INR 2100.
 In all these scenarios, the call option hedging allowed him to buy the shares of ABC Ltd
at or below INR 2100 (i.e., at or below the Strike Price + Premium).
Benefits and Limitations of Hedging
 Benefits of Hedging:
 Price risk is minimized
 Facilitates production/business planning and cash flow management
 Limitations of Hedging:
 Price risk cannot be totally eliminated
 Transaction cost is to be incurred
 Margins are to be maintained leading to cash flow pressures
 If hedging is selectively carried out only on a few positions based on
one’s view and not with a holistic hedging strategy, it may so happen that
the hedging transaction leg itself may lead to losses.
 This is because selective hedging with the choice to hedge or not to hedge is as
good as speculation or trading.
 Speculation / trading has payoffs on both the sides – gains as well as losses.
 Hence, an entrepreneur who wants to focus on his core competency in his
business, avoids selective hedging and implement the policy of hedging
incidental risks at all times.
Leverage
 Leverage is a strategy of using borrowed funds to trade or invest in
capital markets.
 It is done to increase the potential return from an investment asset.
 But it also increases the risk many fold.
 Derivative products have an inherent leverage built-in and therefore
can lead to faster profits and also to devastating losses.
 Advantages of Leverage:
 It can accelerate the return on the base capital deployed
 Lower capital outflow by the trader for higher exposure
 Helps in achieving financial objectives quickly
 Works as supplementary capital while investing
 Disadvantages of Leverage:
 When the investment idea goes wrong, leveraging leads to huge losses
 Capable of destroying the complete capital of the trader swiftly
Open Interest
 Open Interest is the total number of contracts outstanding for an
underlying asset (i.e., contracts that are yet to be settled).
 In the market, No. of Long futures = No. of Short futures
 Open interest is measured by counting either all the open buy
positions (long positions), or by counting all the open sell
positions (short positions), but not both.
 Open Interest indicates market depth
 Increase in Open Interest: New positions are created
 Decrease in Open Interest: Existing positions are squared-off
 Open Interest is Constant: When new positions created are
equal to squared off positions
 Example - Open Interest
OI Increase / Decrease /
Time Participant A Participant B Participant C Participant D Participant E Open Interest
Constant

10 Contracts 10 Contract
9:15 AM 10 Contracts
Bought Sold
OI Increasing as
20 Contracts 20 Contracts 10 + 20 = 30
9:18 AM new positions are
Bought Sold Contracts
created
OI Increasing as
5 Contracts 5 Contracts 30+ 5 = 35
9:21 AM new positions are
Bought Sold Contracts
created
OI Decreasing as
10 Contracts 10 Contracts 35-10 = 25
9:24 AM exisitng postions
Sold Bought Contracts
are sqaured off

OI Decreasing as
10 Contracts 10 Contracts 25 - 10 = 15
9:27 AM existing positions
Sold Bought Contracts
are squared off
OI is Constant, as
New positions
10 Contracts 10 Contracts
9:30 AM 15 contracts created are equals
Bought Sold
to square off of
existing positions
Volume
 Volume shows the amount of trading activity in a given
market (i.e., in a specific stock or in a specific futures
contract or in a specific options contract) on any given day.
 An increase in volume means that there was more trading
activity and more contracts were traded than on the
previous day.
 For an ongoing market trend, high and rising volume is
interpreted as trading activity supports the current
(ongoing) trend and assumed that a trend continuation is
likely because more traders / investors (or more contracts
traded) support current price movement.
Price, Volume and Open Interest – General Interpretation
Many traders in the derivatives market believes in the existence of the
following relationship between Price, Volume and Open Interest and
use these signals while executing their trading strategies:

Price Volume Open Interest General Interpretation

Rising Rising Rising Market is Strong
Rising Falling Falling Market is weakening
Falling Rising Rising Market is weak
Falling Falling Falling Market is Strengthening
Open Interest (OI) life cycle
 Thin OI - At the start of the contract
 Increase in OI – When the contract becomes the near month
 Decrease in OI – When the contract is close to expiration
Know your Client
 KYC is an acronym for “Know Your Client”, a term commonly
used for Customer Identification Process.
 The regulatory body has prescribed certain requirements
relating to KYC norms for Financial Institutions and Financial
Intermediaries including Mutual Funds and Stock Brokers to
‘know’ their clients.
 This entails verification of identity and address, financial status,
occupation and such other personal and financial information as
may be prescribed by the guidelines, rules and regulation.
Understanding risk profile of the investors
 First prudent exercise for a broker should be to profile its clients/customers.
 People invest in various investment products that generally comprise of:
 Fixed Income Instruments, and
 Market oriented investments.
 There is need to understand risk tolerance for a variety of reasons, some of
which are specified below:
 To achieve level of financial independence that allows them to meet not
only their basic human needs, but also higher level needs for self
development and self improvement in their life.
 Willingness to accept a certain smaller return rather than a large but
uncertain profit from their financial decisions.
 Individual’s evaluations of their self-worth and their levels of self-esteem
are related to their levels of satisfaction with their financial situation.
 Individuals need to appreciate their personal comfort zone when they
trade-off what they are willing to accept in terms of possible losses versus
possible gains.
Understanding risk profile of the investors […continued]
 Investor’s objectives are often poorly developed and unrealistic in terms of
investments.
 It is often difficult for people to describe in their own words their attitudes
about risk.
 There is a good chance that new investors in particular will not understand
many of the financial and risk concepts presented by broker.
 Some of the key parameters on which one’s risk tolerance may depend
are: age, personal income, combined family income, gender, number of
dependents, occupation, marital status, education, access to other
inherited sources of wealth, etc.
Risk Disclosure Document
 Document detailing risks associated with dealing in the securities
market.
 It is imperative to discuss the risks associated with derivatives
trading.
 Copy of signed risk disclosure document to be handed over to the
client for his future reference.
 Three major risk categories defined in risk disclosure document
are as follows:
 Basic risks including Volatility risk, Liquidity risk, Risk related to Bid-
Ask spreads, risk related to non-execution of stop loss order, Risk related
to rumors, etc.
 Risks related to derivatives segment: Being leveraged instruments, risk
related to leverage, risk of option holder, risk to option writer, etc.
 Risks related to Technology: System / network congestion risk, risk
related to wireless technology, system failure, etc.
Session 2
Duration: 90 minutes
Option Trading Strategies
 An option trading strategy is a set of option positions to achieve a
desired risk-return profile.
 Option strategies are used to minimize or offset the price risk by
Investors and Hedgers.
 The strategy could vary depending on the market outlook as per the
view of trader.
 Combination strategies mean use of multiple options with same or
different strikes and maturities to implement a view.
 Combination strategies are more suitable when the market view is
moderately bullish or moderately bearish, range bound or uncertain
and the transaction objective is to also reduce the overall payout of
options premium.
 Numerous strategies can be worked out depending on the view on the
market, risk appetite of the trader and his objective.
Types of Option Strategies
 Options combined with Futures / Spot
 Protective Put
 Covered call
 Options combined with options
 Bull Call spread
 Bear Call spread
 Bull Put spread
 Bear Put spread
 Straddle
 Strangle
 Butterfly spread
 And many such combinations
Protective Put
 Any investor, long in the spot market, always runs the risk
of a fall in prices and thereby reduction of portfolio value
and MTM losses. The protective Put strategy is one of the
solution to this problem.
 An investor who holds the stock fears decrease in price and
buys a put options to negate the losses arising out from
his/her stock holdings.
 For Example:
 An investor buys a stock in the spot market at INR 1600 and at
the same time buys a put option with strike price of INR 1600
by paying a premium of INR 20.
 Lets understand how this strategy works under different
market scenarios.
 Protective Put - Example
Long Cash 1600 Combined position Profit / loss
Strike Price 1600 Long
Premium 20 CMP Long Cash Put Net
1500 -100 80 -20
1510 -90 70 -20
1520 -80 60 -20
1530 -70 50 -20
1540 -60 40 -20
1550 -50 30 -20
1560 -40 20 -20
1570 -30 10 -20
1580 -20 0 -20
1590 -10 -10 -20
1600 0 -20 -20
1610 10 -20 -10
1620 20 -20 0
1630 30 -20 10
1640 40 -20 20
1650 50 -20 30
1660 60 -20 40
1670 70 -20 50
1680 80 -20 60
1690 90 -20 70
1700 100 -20 80
The maximum loss is the amount of premium paid.
Maximum profit is substantial (if the stock price goes down significantly).
The breakeven point is: strike price plus premium paid.
Protective Put - Payoff diagram
Covered call
 A strategy which can be used to generate extra income
from existing stock holdings to reduce the cost of
acquisition.
 Covered call strategy is created by buying the shares in
cash markets and writing an OTM call option.
 For example:
 An investor buys a stock in the cash market at INR 1590
and at the same time he writes a call option with a strike
price of INR 1600.
 Lets understand how this strategy works under different
market scenarios.
 CMP Stock Call Net
Covered Call - Example 1490 -100 10 -90
1500 -90 10 -80
Long Stock 1590
Strike Price 1600 1510 -80 10 -70
Premium 10 1520 -70 10 -60
1530 -60 10 -50
1540 -50 10 -40
1550 -40 10 -30
1560 -30 10 -20
1570 -20 10 -10
1580 -10 10 0
1590 0 10 10
1600 10 10 20
1610 20 0 20
1620 30 -10 20
1630 40 -20 20
1640 50 -30 20
1650 60 -40 20
1660 70 -50 20
1670 80 -60 20
1680 90 -70 20
1690 100 -80 20
The maximum loss can be substantial (if the stock price goes significantly down)
Maximum profit is INR 20 (premium received plus the difference between stock price and strike price)
The breakeven point is: Strike price minus Maximum profit.
Covered Call – Payoff diagram
Spread Strategies – A snapshot
Bull Call Bear Call Bull Put Bear Put
Spread Spread Spread Spread
Moderately Moderately Moderately Moderately
Market view
Bullish Bearish Bullish Bearish
Buy lower Sell Lower Buy lower Sell Lower
Strategy strike and sell strike and buy strike and sell strike and buy
higher strike Higher strike higher strike Higher strike
Net
Paid out Received Received Paid Out
Premium
Difference in Difference in
strike prices strike prices
Maximum Net Premium Net Premium
less net less net
Risk paid paid
premium premium
received received
Difference in Difference in
Maximum Net premium Net premium
strike less net strike less net
Reward received received
premium paid premium paid
Options Spreads and Types of Options Spreads
 An options spread is a strategy that involves the
simultaneous buying and selling of options on the
same underlying asset.
 A debit spread involves purchasing a high-premium
option while selling a low-premium option, resulting
in a debit from the trader's account.
 A credit spread involves selling a high-premium option
while purchasing a low-premium option, resulting in a
credit to the trader's account.
Bull Call Spread
 It comes under the umbrella of Debit spread and
categorised as vertical spread
 It is created by buying call option of ITM / ATM strike
price and writing a call option of higher strike price
(OTM)
 The view point of creating Bull call spread is
moderately bullish till stock / index rises to higher
strike price level
 It is a limited loss and a limited profit strategy
Bull Call Spread - Example
Option Call Call
Long/Short Long Short CMP Long Call Short Call Net Flow
Strike 10200 10800 9500 -350 140 -210
Premium 350 140
Spot 10500 9600 -350 140 -210
9700 -350 140 -210
9800 -350 140 -210
9900 -350 140 -210
10000 -350 140 -210
10100 -350 140 -210
10200 -350 140 -210
10300 -250 140 -110
10400 -150 140 -10
10500 -50 140 90
10600 50 140 190
10700 150 140 290
10800 250 140 390
10900 350 40 390
11000 450 -60 390
11100 550 -160 390
11200 650 -260 390
11300 750 -360 390
11400 850 -460 390
11500 950 -560 390
Bull Call Spread – Payoff diagram
Bull Call Spread - P/L details
 Net premium paid = Premium of Lower strike price – Premium
of Higher strike price
 Breakeven point = Lower strike price + Net premium paid
 Maximum loss = Net premium paid
 Maximum profit = Strike price difference - Net premium paid
Bear Put Spread
 It comes under the umbrella of Debit spread and
categorised as vertical spread
 It is created by buying a put option of ITM / ATM
strike price and writing a put option of lower strike
price (OTM)
 The view point of creating Bear put spread is
moderately bearish till it falls to an extent of lower
strike price
 It is a limited loss and a limited profit strategy
Bear Put Spread - Example
Option Put Put
Long/Short Short Long CMP Short Put Long Put Net Flow
Strike 10500 10800
Premium 130 300 9500 -870 1000 130
Spot 10500 9600 -770 900 130
9700 -670 800 130
9800 -570 700 130
9900 -470 600 130
10000 -370 500 130
10100 -270 400 130
10200 -170 300 130
10300 -70 200 130
10400 30 100 130
10500 130 0 130
10600 130 -100 30
10700 130 -200 -70
10800 130 -300 -170
10900 130 -300 -170
11000 130 -300 -170
11100 130 -300 -170
11200 130 -300 -170
11300 130 -300 -170
11400 130 -300 -170
11500 130 -300 -170
Bear Put Spread – Payoff diagram
Bear Put Spread - P/L details
 Net premium paid = Premium of Higher strike price – Premium
of Lower strike price
 Breakeven point = Higher strike price - Net premium paid
 Maximum loss = Net premium paid
 Maximum profit = Strike price difference - Net premium paid
Bear Call Spread
 It comes under the umbrella of credit spread and
categorised as vertical spread
 It is created by writing a call option of ITM / ATM
strike price and buying a call option of higher strike
price (OTM)
 The view point of creating bear call spread is bearish
 It is a limited loss and a limited profit strategy
Bear Call Spread - Example
Option Call Call
Long/Short Long Short
CMP Long Call Short Call Net Flow
Strike 10800 10200
Premium 140 350 9500 -140 350 210
Spot 10500 9600 -140 350 210
9700 -140 350 210
9800 -140 350 210
9900 -140 350 210
10000 -140 350 210
10100 -140 350 210
10200 -140 350 210
10300 -140 250 110
10400 -140 150 10
10500 -140 50 -90
10600 -140 -50 -190
10700 -140 -150 -290
10800 -140 -250 -390
10900 -40 -350 -390
11000 60 -450 -390
11100 160 -550 -390
11200 260 -650 -390
11300 360 -750 -390
11400 460 -850 -390
11500 560 -950 -390
Bear Call Spread - Payoff diagram
Bear Call Spread - P/L details
 Net premium received = Premium of Lower strike price –
Premium of Higher strike price
 Breakeven point = Lower strike price + Net premium paid
 Maximum profit = Net premium received
 Maximum loss = Strike price difference - Net premium received
Bull Put Spread
 It comes under the umbrella of credit spread and
categorised as vertical spread
 It is created by writing a put option of ITM / ATM
strike price and buying a put option of lower strike
price (OTM)
 The view point of creating Bear put spread is bearish
 It is a limited loss and a limited profit strategy
Bull Put Spread - Example
Option Put Put
Long/Short Short Long
CMP Short Put Long Put Net Flow
Strike 10800 10500
Premium 300 130 9500 -1000 870 -130
Spot 10500 9600 -900 770 -130
9700 -800 670 -130
9800 -700 570 -130
9900 -600 470 -130
10000 -500 370 -130
10100 -400 270 -130
10200 -300 170 -130
10300 -200 70 -130
10400 -100 -30 -130
10500 0 -130 -130
10600 100 -130 -30
10700 200 -130 70
10800 300 -130 170
10900 300 -130 170
11000 300 -130 170
11100 300 -130 170
11200 300 -130 170
11300 300 -130 170
11400 300 -130 170
11500 300 -130 170
Bull Put Spread - Payoff diagram
Bull Put Spread - P/L details
 Net premium received = Premium of Higher strike price –
Premium of Lower strike price
 Breakeven point = Higher strike price - Net premium Received
 Maximum profit = Net premium received
 Maximum loss = Strike price difference - Net premium received
Practice for Participants
 Spot price: INR 2000
 Mr. X writes (sell) a Put option at a strike price of INR 1950 and
Receives a premium of INR 40
 He also buys a Put option at a strike price of INR 1900 and Pays a
premium of INR 25
 Lot size: 250

 Which type of spread it is?

 Is Mr. X Bullish or Bearish?
 Calculate Maximum loss, Maximum profit, Breakeven point,
Maximum profit point and Maximum loss point?
Straddle and Strangle
 One of the major strategies in option trading involves
simultaneous purchase of calls/puts with a view to profit from a
change in the volatility of the underlying stock.
 Volatility refers to the range to which the price of a stock may
increase or decrease.
 Investors with Long options anticipate an increase in volatility
and they are long on vega.*
 Similarly, investors with short positions anticipate a decrease in
volatility and they are short on vega.*

* Vega (measure of volatility) will be discuss in the next session

Straddle and Strangle [continued]
 Straddles and Strangles are the two major strategies in this
category.
 Long Straddle: A long straddle is an option strategy where the
trader buys a call and a put with the same strike price and same
expiry date.
 Short Straddle: A short straddle is an option strategy where the
trader sells a call and a put with the same strike price and same
expiry date.
 Long Strangle: A long strangle involves the purchase of a call and a
put with the same expiry date but with different strike prices.
 Short Strangle: A short strangle involves the sale of a call and a put
with the same expiry date but with different strike prices.
Summary of Straddles and Strangles
Long Straddle Short Straddle Long Strangle Short Strangle
Investor is unsure
Investor is of the
about direction of
view that the price
movement of price. Investor expects
will not move too far Investor expects more
Rationale Good news will push lesser volatility in
away from the volatility in the prices.
the price higher and the prices.
current market
bad news will bring
price.
down the price.
An increase in A decrease in A large increase in Large decrease in
Market View
volatility volatility volatility volatility
Sell a call and a put
Buy a call and a put
Buy a call and put Sell a call and put with same expiry
with same expiry
Methodology with the same strike with the same strike dates but with
dates but with
price and expiry date price and expiry date different strike
different strike prices
prices
Maximum
Total Premiums paid Unlimited Total Premium paid Unlimited
Risk

Limited to the sum

Maximum Total Premiums
Unlimited of the premiums Unlimited
Returns received
received
Long straddle
 Long straddle is a neutral trading strategy which is created by
buying an ATM call option and an ATM put option together
 Long straddle is created with a view that stock price will be
volatile and expected to either move up or down soon
 The profit from long straddle will accumulate if the stock move
up or goes down (i.e., if the stock price moves in either of the
directions)
 The loss from the strategy only comes if the stock price goes into
consolidation (i.e., it doesn’t move below or beyond BEP on
expiration day)
 There are two breakeven points for this strategy:
 Strike price + Total premium paid
 Strike price – Total premium paid
 It is a limited loss and unlimited profit strategy
Long Straddle - Example
Option Call Put
Long/Short Long Long CMP Long Call Long Put Net Flow
Strike 6000 6000 5000 -257 864 607
Premium 257 136 5100 -257 764 507
Spot 6000
5200 -257 664 407
5300 -257 564 307
5400 -257 464 207
5500 -257 364 107
5600 -257 264 7
5700 -257 164 -93
5800 -257 64 -193
5900 -257 -36 -293
6000 -257 -136 -393
6100 -157 -136 -293
6200 -57 -136 -193
6300 43 -136 -93
6400 143 -136 7
6500 243 -136 107
6600 343 -136 207
6700 443 -136 307
6800 543 -136 407
6900 643 -136 507
7000 743 -136 607
Long Straddle - Payoff diagram
Short straddle
 Short straddle is a is a neutral trading strategy which is created
by selling an ATM call option and an ATM put option together
 Short straddle is created with a view that the underlying will not
be volatile
 The profit from short straddle will accumulate if the stock
doesn’t move up or goes down (i.e., if the stock price doesn’t
move in any of the direction)
 The loss from the strategy only comes if the stock price becomes
volatile
 There are two breakeven points for this strategy:
 Strike price + Total premium received
 Strike price – Total Premium received
 It is a unlimited loss and limited profit strategy
Short Straddle - Example
Option Call Put
Long/Short Short Short CMP Short Call Short Put Net Flow
Strike 6000 6000
Premium 257 136 5000 257 -864 -607
Spot 6000 5100 257 -764 -507
5200 257 -664 -407
5300 257 -564 -307
5400 257 -464 -207
5500 257 -364 -107
5600 257 -264 -7
5700 257 -164 93
5800 257 -64 193
5900 257 36 293
6000 257 136 393
6100 157 136 293
6200 57 136 193
6300 -43 136 93
6400 -143 136 -7
6500 -243 136 -107
6600 -343 136 -207
6700 -443 136 -307
6800 -543 136 -407
6900 -643 136 -507
7000 -743 136 -607
Short Straddle - Payoff diagram
Long strangle
 Long strangle is a neutral market strategy created by buying an
OTM Call option and an OTM Put option simultaneously
 Long strangle is created with a view that the stock price is
expected to give substantial move in any of the direction (i.e.,
either up or down)
 The profit from long strangle will accumulate if the stock price
either moves up or down significantly
 The loss from the strategy only comes if the stock price goes into
consolidation (i.e., does not move significantly)
 The breakeven point for this strategy:
 Higher strike price of Call OTM option + Total premium paid
 Lower strike price of Put OTM option – Total premium paid
 It is a limited loss and unlimited profit strategy
Long Strangle - Example
Option Call Put
CMP Long Call Long Put Net Flow
Long/Short Long Long
Strike 6200 6000 5100 -145 760 615
Premium 145 140 5200 -145 660 515
Spot 6100 5300 -145 560 415
5400 -145 460 315
5500 -145 360 215
5600 -145 260 115
5700 -145 160 15
5800 -145 60 -85
5900 -145 -40 -185
6000 -145 -140 -285
6100 -145 -140 -285
6200 -145 -140 -285
6300 -45 -140 -185
6400 55 -140 -85
6500 155 -140 15
6600 255 -140 115
6700 355 -140 215
6800 455 -140 315
6900 555 -140 415
7000 655 -140 515
7100 755 -140 615
Long Strangle - Payoff diagram
Short Strangle
 Short strangle is a neutral trading strategy which is created by
writing an OTM call option and an OTM put option
simultaneously
 Short strangle is created with a view that stock price will not be
volatile and expected to be in a range till expiration
 The profit from short strangle will accumulate if the stock price
doesn’t move up or doesn’t goes down much (i.e., it remains
within a range)
 The loss from the strategy only comes if the stock price move
below or beyond BEP on expiration day
 There are two breakeven points for this strategy:
 Higher strike price of call option + Total premium received
 Lower strike price of put option – Total premium received
 It is a limited profit and unlimited loss strategy
Short Strangle - Example
Option Call Put
Long/Short Short Short CMP Short Call Short Put Net Flow
Strike 6200 6000
5100 145 -760 -615
Premium 145 140
Spot 6100 5200 145 -660 -515
5300 145 -560 -415
5400 145 -460 -315
5500 145 -360 -215
5600 145 -260 -115
5700 145 -160 -15
5800 145 -60 85
5900 145 40 185
6000 145 140 285
6100 145 140 285
6200 145 140 285
6300 45 140 185
6400 -55 140 85
6500 -155 140 -15
6600 -255 140 -115
6700 -355 140 -215
6800 -455 140 -315
6900 -555 140 -415
7000 -655 140 -515
7100 -755 140 -615
Short Strangle - Payoff diagram
Butterfly Spread
 Butterfly spread is a three leg and four position based strategy
 Butterfly spread can be created with only calls, only puts or
combinations of both calls and puts
 It is created by writing two ATM options and buying one ITM
option and one OTM option respectively
 This strategy is created with a view that stock will remain in a
range, particularly near to the ATM option strike price on
expiration day
 The cost of creating butterfly spread is calculated by summing
up the premiums paid and premiums received for all four
positions
 The two breakeven points for butterfly spread with calls are:
 Lower strike price + Net premium paid
 Higher strike price – Net premium paid
Butterfly Spread - Example
Option Call Call Call Call
Long/Short Long Short Long Short
Strike 6000 6100 6200 6100
Premium 230 150 100 150
Spot 6100

CMP Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
5100 -230 150 -100 150 -30
5200 -230 150 -100 150 -30
5300 -230 150 -100 150 -30
5400 -230 150 -100 150 -30
5500 -230 150 -100 150 -30
5600 -230 150 -100 150 -30
5700 -230 150 -100 150 -30
5800 -230 150 -100 150 -30
5900 -230 150 -100 150 -30
6000 -230 150 -100 150 -30
6100 -130 150 -100 150 70
6200 -30 50 -100 50 -30
6300 70 -50 0 -50 -30
6400 170 -150 100 -150 -30
6500 270 -250 200 -250 -30
6600 370 -350 300 -350 -30
6700 470 -450 400 -450 -30
6800 570 -550 500 -550 -30
6900 670 -650 600 -650 -30
7000 770 -750 700 -750 -30
7100 870 -850 800 -850 -30
Butterfly Spread - Payoff
Session 3
Duration: 60 minutes
Options Pricing Models - The Binomial Pricing Model
 The binomial option pricing model was developed by William
Sharpe in 1978. It has proved over time to be the most flexible,
intuitive and popular approach for options pricing.
 The binomial model represents the price evolution of the
option’s underlying asset as the binomial tree of all possible
prices at equally-spaced time steps from today under the
assumption that at each step, the price can only move up and
down at fixed rates and with respective simulated probabilities.
 This is an intuitive way to price options but also very lengthy and
time consuming model.
Options Pricing Models - The Black & Scholes Model
 The Black & Scholes model was published in 1973 by Fisher
Black and Myron Scholes. It is one of the most popular, relatively
simple and fast modes of calculation.
 This model is used to calculate the theoretical price of options
using the five key determinants of an option’s price:
 Underlying’s price
 Strike price
 Volatility
 Time to expiration
 Short-term risk-free interest rate
 It is widely used Option Pricing Model.
Black & Scholes Options Pricing Model - Formulae
c  S 0 N (d1 )  K e  rT N (d 2 )
p  K e  rT N ( d 2 )  S 0 N ( d1 )
ln( S 0 / K )  (r   2 / 2)T
where d1 
 T
ln( S 0 / K )  (r   2 / 2)T
d2   d1   T
 T

 c: European call option price  D : Present value of dividends

 p : European put option price during option’s life
 S0 : Stock price today  r : Risk-free rate for maturity T
 K : Strike price
with continuous compounding
 T : Life of option
  : Volatility of stock price
Volatility
 Volatility is the standard deviation of the continuously
compounded rate of return in one year
 It is a statistical measure of the dispersion of returns for a given
security or market index.
 The higher the volatility, the riskier the security.
 The two types of Volatility which are widely used in Derivatives:
 Historical Volatility
 Implied Volatility
Historical Volatility (HV)
 Historical volatility (HV) is a statistical measure of the
dispersion of returns for a given security or market
index over a given period of time
 Calculation of HV:
 Calculate volatility based on Historical data with
following formula for all data points:  Si 
Si is Spot price today ui  ln 
S i 1 is the spot price yesterday
 S i 1 

 Then calculate the standard deviation of the series u

and multiply it with the square root of time (i.e., with
the square root of No. of trading days)
Implied Volatility (IV)
 The implied volatility of an option is the volatility for which the
Black-Scholes price equals the market price of the option.
 Implied Volatility is the expected volatility of a stock over the
life of the Option.
 It is the market's forecast of a likely movement in a stock price.
 Supply, Demand related to the option premium and Time value
are major determinants of Implied Volatility.
 Higher the IV, Higher will be the Premiums and vice versa.
 Usually it has a negative relationship with underlying price.
Implied Volatility (IV) [continued]
 Traders uses historical IV levels to forecast major turning
(reversal) points as it moves with a negative correlation with
stock prices.
 Participants in the derivatives markets considers that, if IVs are
high, then it is expensive to buy options, as premiums are high
and vice versa.
 Usually when IVs are high (i.e., Options are expensive), then
traders prefers to write options to take advantage of falling IVs
and vice versa.
 However, please note that IVs tend to be high for reasons such as
higher uncertainty (higher risk) due to an uncertain outcome of
an upcoming major event, or during / expected economic or
political turmoil, etc., which means higher probability for the
options to get exercised.
Volatility Index
 Volatility Index is a measure of market’s expectation of volatility
over the near term.
 The Volatility index measures the expected market volatility over
the next 30 calendar days.
 Volatility Index is computed using the order book of the
underlying index options and is denoted as an annualized
percentage.
 India VIX is often called the "fear gauge“ for the Indian markets.
 A higher India VIX need not necessarily be bearish for stocks.
Instead, the India VIX is a measure of market’s perceived
volatility in either direction, including to the upside.
Implied Volatility from market prices using Black-Scholes model
 IV Computation - Explained
 Step 1 : Assuming that the risk free rate of return is 10%, enter the values of
underlying price, exercise price, today’s date and expiry date and risk free
rate of return in their respective cells
 Step 2 : Set the initial value of the implied volatility at 25% for calculating
Theoretical price of options (i.e., call option premium here)
 Step 3 : Calculate the options premium for these inputs using B&S model
 Step 4 : Now use the “Goal Seek” function of MS-Excel as follows:
 Map Set cell to the cell where option’s theoretical price was computed in Step 3.
 Now set this variable’s value to actual premium of this option contract in the
market using To value box
 By changing cell is the variable cell which we want the “Goal Seek” to compute
by trying out different values for this variable cell in order to identify that
specific value of this cell for which the computed option premium (Set cell)
matches the market’s option premium (To value). That specific value where
these two premiums are equal is the Implied Volatility
 Click OK to get the results
Introduction to option Greeks
 Delta (δ or ∆): Delta measures the sensitivity of the option value to a
given small change in the price of the underlying asset.
 Delta = Change in option premium / Unit change in price of the underlying
 Delta for call option buyer is positive. Delta for call option seller will be
same in magnitude but with the opposite sign (i.e., negative).
 Delta for put option buyer is negative. Delta for put option seller will be
same in magnitude but with the opposite sign (i.e., positive).
 Gamma (γ): Gamma measures change in delta with respect to change
in price of the underlying asset.
 Gamma = Change in an option delta / Unit change in price of underlying
 Gamma signifies the speed with which an option will go either in-the-
money or out-of-the-money due to a change in price of the underlying asset.
 Theta (θ): Theta is the change in option price given one-day decrease in
time to expiration. It is a measure of time decay.
 Theta = Change in an option premium / Change in time to expiry by one day
 Theta is negative for a long option, whether it is a call or a put.
 Theta is positive for a short option, whether it is a call or a put.
Introduction to option Greeks (…continued)
 Vega (ν): Vega is a measure of the sensitivity of an option price to
changes in market volatility. It is the change of an option premium for a
given change (typically 1%) in the underlying volatility.
 Vega = Change in an option premium / Change in volatility
 Vega is positive for a long option positions.
 Vega is negative for short option positions.
 Rho (ρ): Rho is the change in option price given a one percentage point
change in the risk-free interest rate.
 Rho = Change in an option premium / Change in cost of funding the
underlying
 Rho measures the change in an option’s price per unit increase/decrease in
the cost of funding the underlying.
Theta - Application
 Theta measures the rate at which the options lose their value to
time. It is the daily decay of the option’s extrinsic (time) value.
 It is expressed as a negative number and conveys how much an
option buyer will get impacted if he holds the position.
 For the option writer, longer he holds his position, bigger the
amount of theta he gains (and vice-versa for option buyer).
 From the options buyers perspective the theta value is less
negative when the contract is a far month contract and once it
become the near month contract, then theta value starts to
become more negative. That means, option premium will start
decaying faster during the near month than in the far month,
holding other parameters constant.
 Theta value starts decaying exponentially when the contract is
close to expiration. (Please refer to the snapshots in next slide)
Theta with passage of time
Theta - Graphical Representation
Representative Image of Theta movement (by keeping everything else constant)
Session 4
Duration: 90 minutes
Weekly Options Contract
 A significant development regarding investment/trading happened
after weekly contracts were launched in May 2016
 From operations perspectives, all the existing clearing and settlement
procedures along with the extant risk management measures adopted
for monthly option contracts (such as initial margins, minimum
margins, position limits, etc., including the right of Clearing
Corporation to close out positions) shall apply to weekly contracts also.
However a brief of weekly options contracts are as follows:
 Trading
 Risk management
 Clearing
 Settlement
Weekly Options Contracts - Snapshot
Particulars NIFTY 50 Nifty Bank Sensex 50
Symbol NIFTY BANKNIFTY IN50
Contract cycle 7 Weekly expiry 7 Weekly expiry 7 Weekly expiry
contracts contracts contracts
Expiry date Every Thursday of Every Thursday of Every Monday of
the week the week the week
Lot size 75 25 75
Margins SPAN + Exposure SPAN + Exposure SPAN + Exposure
Price bands A contract specific A contract specific A contract specific
price range based price range based price range based
on its delta value is on its delta value is on its delta value is
computed and computed and computed and
updated on a daily updated on a daily updated on a daily
basis. basis. basis.
Price step 0.05 0.05 0.05
Weekly Options Contracts - Snapshot [continued]
Particulars NIFTY 50 NIFTY BANK Sensex 50
Position Limits As prescribed in As prescribed in As prescribed in
(Category wise) NIFTY monthly NIFTY BANK Sensex 50 monthly
options contract monthly options options contract
contract
Settlement T+1 T+1 T+1
schedule
Settlement price Closing price of Closing price of Closing price of
the relevant the relevant the underlying
underlying index underlying index index on the last
in the Capital in the Capital trading day
Market segment of Market segment of
NSE, on the last NSE, on the last
trading day of the trading day of the
options contract. options contract.
Entities Engaged in Clearing & Settlement
 The complete clearing & settlement is executed with
an engagement of :
 Clearing corporation
 Clearing banks
 Clearing members
 Depositories
Clearing and Settlement: Overview
Pay-in / Pay- out
of Funds and Decision to
Delivery of goods / trade
cash settlement (1)
(6)

Settlement Placing
of Buy or Sell
trades Order
(5) (2)

Clearing
Trade
of
Execution
Trades
(3)
(4)
Clearing and Settlement: Overview
 Clearing refers to the process of accounting to update and reconcile
obligations/payments of the parties involved in the trade.
 Settlement refers to the process of adjusting financial positions of
the parties to the trade transactions to reflect the net amounts due
to them or due from them.
 Settlement process involves matching the outstanding buy and sell
instructions, by transferring the equity shares against funds
between buyer and seller.
 Transactions involving transfer of equity shares are settled by
netting at a client level and grossing up at the member level,
whereas fund obligations are netted at the member level to reduce
the number of settlement transactions as part of the clearing
process.
Clearing and Settlement: Overview […continued]
 Clearing and settlement process has been automated at all the
derivatives exchanges and broadly involves the following steps:
 Trade details are transmitted from exchange to clearing corporation on a
real-time basis.
 The trade details are notified by the clearing corporation to compute
obligations of trading members.
 Obligation and pay-in advice of funds are communicated to clearing
members.
 Instructions are issued to clearing banks to make funds available by the
pay-in time.
 Pay-in of funds for the executed trades are carried out by clearing banks by
debiting the account of the clearing members and crediting clearing
corporation account for the amount due to them.
 Pay-out of funds is done based on the instruction of the clearing
corporation to clearing banks to credit account of clearing members by
debiting its account, wherever applicable.
Settlement Mechanism of Equity Derivatives
 Types of settlement
 Cash settlement
 Physical settlement
 All index based products are essentially cash settled.
 Individual stock futures and options are compulsorily settled
physically.
 At present, all single stock derivative contracts are Physically
(delivery) settled.
Settlement mechanism of Futures contract on
Index and Stocks
Futures contract have two types of settlements:
 The mark-to-market (MTM) settlement which happens on a
continuous basis at the end of each day, and
 The final settlement which happens on E+2 day of the futures
contract.
Mark to Market (MTM) Settlement
 Mark to Market is a process of arriving at daily profit/loss on the
positions and is computed as the difference between:
 The trade price and the day's settlement price for contracts executed
during the day but not squared-off.
 The previous day's settlement price and the current day's settlement
price for brought forward contracts.
 The buy price and the sell price for contracts executed and also
squared-off during the same day.
 MTM losses are to be paid in cash on T+1 basis.
 After completing day’s settlement process, all the open positions
are reset to the daily settlement price. These positions become
the open positions for the next day.
 MTM - Example
 Mr. X buys a stock futures on 23rd day of the month at INR 100 per
share, The lot size is 5000 shares and contract is going to mature on
31st day of the month. Lets understand how the MTM will be
calculated during the life of the contract.
Final Settlement
 For Index derivatives:
 On expiration of futures and options contract, all open positions are
Marked to Market (MTM) to the final settlement price and the
resulting profit/loss is settled in cash.
 Final settlement loss/profit amount is debited/credited to the
relevant clearing member’s clearing bank account on the day
following the expiry day of the contract (i.e., on T+1 basis).
 For Stock derivatives for Futures:
 On expiration day, all open positions are Marked to Market (MTM)
to the final settlement price and the resulting profit/loss is settled
in cash.
 The open positions in stock futures are marked for compulsory
physical settlement after expiration of futures contract and then
settlement process is initiated.
Settlement Prices for futures and options
 Daily settlement price of futures contracts on a trading day is the
closing price of the respective contracts on such day.
 The closing price for a futures contract is currently calculated as
the last half an hour weighted average price of the contract in the
F&O Segment of exchanges.
 Final settlement price is the closing price of the relevant
underlying index/security in the Capital Market segment of
exchange, on the last trading day of the Contract.
 The closing price of the underlying Index/security is currently its
last half an hour weighted average value in the Capital Market
Segment of exchange.
Physical settlement of Stock Futures - Example

• Funds pay-in: Mr. X pays INR 5,10,000 (settlement price multiplied with No. of
shares in lot size) = 102 * 5000 to clearing corporation via clearing member
through clearing bank.
• Security pay-in: Mr. Y has to give delivery of shares to the clearing corporation
(Depository) via Clearing members through Demat pool account.
• Security pay-out: Mr. X receives shares in his Demat account from clearing
corporation (Depository) via Clearing members through Demat pool account.
• Funds pay-out: Mr. Y receives the amount INR 5,10,000 from clearing
corporation via clearing member through clearing bank.
Settlement mechanism of Option contract on
Index and Stocks
 Option contracts have two types of settlements: the premium
settlement which happens on T+1 basis and the final settlement
which happens on the E+2 after maturity of option contract.
 Index options are settled in cash.
 Stock options are settled through compulsory physical delivery.
Premium Settlement of Option contract on Index
and Stocks
 At the end of each day, the amount payable and receivable as
premium are netted to compute the net premium payable or
receivable amount for each client for each option contract.
 Pay-in and pay-out of the premium settlement is done on T+1 day.
 The premium payable amount and premium receivable amount
are directly debited/credited to the clearing member’s clearing
bank account.
Final Settlement of Option contract on Index
 All the in the money index options contracts get automatically
exercised on the expiry day for index:
 The details of exercise are as follows:
 The holder of ITM call options will receive the difference of strike
price and final settlement price
 The writer of ITM call needs to pay the difference of strike price and
final settlement price
 The holder of ITM put option will receive the difference of strike
price and final settlement price
 The writer of ITM put options to pay the difference of strike price
and final settlement price
Final Settlement of Option contract on Stocks
 All the in-the-money (ITM) stock options contracts get
automatically exercised on the expiry day except Close to Money
(CTM) options where the holder hold a right to give explicit
instruction of “DO NOT EXERCISE”.
 The details of exercise are as follows:
 At the money (ATM) and out of money (OTM) options expire worthless
and are not considered for settlement.
 The holder of ITM call options is engaged to pay funds and receive shares
 The writer of ITM call options is engaged to give shares and receive Funds
 The holder of ITM put option is engaged to give shares and receive Funds
 The writer of ITM put options is engaged to pay funds and receive shares
Final Settlement of Option contract on Stocks [continued]
 The immediate three strike price which are in the money for call and put
are considered as Close to money option (CTM)
 If the holder of a CTM option decides to exercise then writer is under
obligation to settle the options contract but if the holder decides not to
exercise then it expires worthless (as in the case of ATM and OTM options)
 The communication by the member to the exchange on CTM options are
sent at the stipulated time on expiration day as an explicit instruction
under: “DO NOT EXERCISE”
 In case the “DO NOT EXERCISE” option is availed, it simply means that the
option buyer has forfeited his right to exercise the contract and on account
of this forfeiture, he is not eligible to receive the settlement difference.
 The CTM strikes range shall be arrived as under:
 For Call Options: 3 ITM options strikes immediately below the final settlement
price shall be considered as ‘CTM’
 For Put Options: 3 ITM options strikes immediately above the final settlement
price shall be considered as ‘CTM’.
Potential reasons for someone opting for “Do Not Exercise”
 The closing prices on maturity date is derived by calculating last
30 minutes of weighted average price of spot market which may
be different from the last traded price on expiration date.
 So, it is quite possible that settlement price may bring a strike
price ITM by a few ticks and the options holder may not be
interested to go for physical settlement.
 Hence, an option is given to the option holder to choose the “DO
NOT EXERCISE” option for the CTM options.
Settlement process for Call options
 For In the money call options including CTM which are
exercised:
 The writer of call options is under obligation to give delivery of
shares
 The holder of call options is under obligation to transfer funds on
E+2 against his exercised right to buy
 The holder of call options will receives the shares in his Demat
account
 The writer will receive the amount of funds pay out
Settlement process for Put options
 For In the money put options including CTM which are
exercised:
 The writer of put options is under obligation to take delivery of
shares
 The holder of put options is under obligation to transfer shares on
E+2 against his exercised right to sell
 The holder of put options will receives the amount of funds pay out
 The writer will receive the shares in his Demat account
CTM options (If not exercised) - Example
 Mr. X buys a call option at a strike price of INR 1000 by paying a
premium of INR 20 at the time of initiating the contract. The
strike price difference in the stock is INR 25. On the maturity
date, the spot closing price (i.e., the Final settlement price) is INR
1030 and Mr. X gives explicit instructions of “Do Not Exercise” as
strike prices 1025, 1000 and 975 will be considered as close to
money (CTM) strike prices.
 In this case, Mr. X will not be liable to pay funds against his right
to buy shares and it is considered as option buyer has forfeited his
right to exercise the contract and on account of this forfeiture, he
is not liable for physical settlement and his position will be closed
without any further obligation/settlement requirement.

 Same is applicable for CTM put options also.

Settlement of Options for stocks
(including CTM options which are exercised)
 Mr. X buys a call option from Mr. Y at a strike price of INR 1000 by
paying a premium of INR 20 at the time of initiating the contract.
Lot size is 500 shares.
 Initial outflow from Mr. X is INR 10,000 (= 20 * 500) i.e., premium
multiplied by lot size.
 Mr Y will receive the amount of INR 10,000 (= 20 * 500) i.e., premium
multiplied by lot size.
 However he is required to pay (block) margin as he is exposed for
unlimited loss. The amount of margin is equal to the margin in
Futures contract of same underlying.
 The amount of mark to market will be additionally blocked or
released every day from writer’s account i.e., Mr. Y’s (same as in case
of futures contract) as per risk management practices by the exchange
as he is exposed for substantial loss on the short option position.
Steps in physical settlement post expiration
 On the expiration of options contract the final settlement price in the
spot market is INR 1100.
 The strike price of INR 1000 will be considered as In-the-money (ITM)
and will be exercised for physical settlement.
 Mr. X who holds the right to exercise will pay an amount of INR
5,00,000 (i.e., lot size * strike price = 500 * 1000 = INR 5,00,000). The
amount will be credited to clearing corporation via clearing member by
debiting the account of the option holder.
 Mr. Y who was under obligation to sell shares due to his short position
in the Call options contract will give the delivery of 500 shares to the
clearing corporation (Depository) via clearing member.
 Mr. X will receive a credit of 500 shares in his Demat account by
clearing corporation via clearing member.
 Mr. Y will get a credit of INR 5,00,000 (i.e., lot size * strike price = 500 *
1000 = INR 5,00,000) by clearing corporation via clearing member.
 The clearing corporation will release the margin amount of Mr. Y.
Delivery quantity
 The deliverable quantity is computed as follows:
 Unexpired Futures
 Long futures shall result in a buy (security receivable) position
 Short futures shall result in a sell (security deliverable) position
 In-the-money Call options
 Long call exercised shall result in a buy (security receivable) position
 Short call assigned shall result in a sell (security deliverable) position
 In-the-money Put options
 Long put exercised shall result in a sell (security deliverable) position
 Short put assigned shall result in a buy (security receivable) position
Interoperability
 Interoperability is a mechanism that allows market participants
to choose any clearing corporation to settle their trades,
irrespective of the exchange where they executed their trades.
 Prior to the implementation of interoperability, participants who
trade on multiple exchanges had to necessarily arrange for
margin and capital separately at each of the three stock exchanges
and their respective clearing corporations.
 This led to a practice wherein members had to keep margins with
each clearing corporation as all equity and derivative brokers are
members of multiple exchanges and trade in all these exchanges
on a regular basis. This stringent arrangement for clearing trades
resulted in inefficient use of capital and higher costs.
 To bridge this, interoperability was allowed by the regulator and
the same was implemented from 1st July 2019.
Benefits of Interoperability
 Significant reduction in margin requirements is bringing down
overall trading costs.
 It will save participants from glitches in case of issues in a
particular exchange, or at the broker level.
 It will separate the execution risk from the settlement risk and
allow market participants to seamlessly square-off their positions
in case of outages of exchanges.
New Margin Framework
Sr. Particulars New framework Implication
No.
1 EWMA Volatility calculation Lambda value Volatility will have
changed from 0.94 longer memory
to 0.995
2 Volatility multiplier Margin based on Margins becomes
six sigma more
conservatives
3 Extreme loss rate Approximately Reduction in
halved notional
component of
margin
4 Hedged positions in options 60% reduction in Better for investor
margins to create hedge
positions such as
spreads
Client Level Position Limits
 The gross open position for each client, across all the derivative
contracts on a underlying, should not exceed:
 1% of the free float market capitalization (in terms of number of shares), or
 5% of the open interest in all derivative contracts in the same underlying
stock (in terms of number of shares)
 whichever is higher
 Client level position limits, underlying-wise, are made available
on the exchanges’ website.
 Any person or persons acting in concert who together own 15% or
more of the open interest on a particular underlying index, is
required to report this fact to the Exchange/Clearing Corporation.
Failure to do so shall be treated as a violation and shall attract
appropriate penal and disciplinary action in accordance with the
Rules, Byelaws and Regulations of the Clearing Corporation.
Trading Member wise Position Limit
Index Futures : Higher of Rs 500 crores or 15% of the total open
interest in the market. This limit would be applicable on open
positions in all futures contracts on a particular underlying index.
Index Options : Higher of Rs 500 crores or 15% of the total open
interest in the market. This limit would be applicable on open
positions in all option contracts on a particular underlying index.
Futures and Option contracts on individual securities: It is
related to the market-wide position limit for the individual stocks:
• For stocks having applicable market-wide position limit (MWPL) of Rs
500 crores or more, the combined futures and options position limit is
20% of applicable MWPL or Rs 300 crores, whichever is lower and within
which stock futures position cannot exceed 10% of applicable MWPL or Rs
150 crores, whichever is lower.
• For stocks having applicable market-wide position limit (MWPL) of less
than Rs 500 crores, the combined futures and options position limit is
20% of applicable MWPL and futures position cannot exceed 20% of
applicable MWPL or Rs 50 crore which ever is lower.
Market Wide Position Limit
• There is no market wide position limits specified for index futures
and index options contracts.
• The market wide position limit for single stock futures and stock
option contracts is linked to the free float market capitalization
and shall be equal to 20% of the number of shares held by non-
promoters in the relevant underlying security (i.e., free-float
holding). This limit would be applicable on aggregate open
positions in all futures and all option contracts on a particular
underlying stock.
Market Wide Position Limit - Monitoring
• At the end of each day, Exchange disseminates the aggregate open
interest across all Exchanges in the futures and options on individual
security along with the market wide position limit for that security and
tests whether the aggregate open interest for any security exceeds 95%
of the market wide position limit for that security.
• If yes, the Exchange takes note of open positions of all client/TMs as at
the end of that day in that security and from next day onwards the
client/TMs should trade only to decrease their positions through
offsetting positions till the normal trading in the security is resumed.
• The normal trading in the security is resumed only after the aggregate
open interest across Exchanges comes down to 80% or below of the
market wide position limit.
• A facility is available on the trading system to display an alert once the
open interest in the futures and options contract in a security exceeds
60% of the market wide position limit specified for such security. Such
alerts are presently displayed at time intervals of 10 minutes.
 Effects of non-payment of margins
 In case of any shortfall in margin:
 The members shall not be permitted to trade with immediate effect.
 There is a penalty for margin violation on amount of shortfall.

Instances of Penalty to be levied

disablement

1st instance 0.07% per day

2nd to 5th 0.07% per day +Rs.5000/- per instance from 2nd to 5th instance
instance of
disablement

6th to 10th 0.07% per day+ Rs. 20000 ( for 2nd to 5th instance) +Rs.10000/- per
instance of instance from 6th to 10th instance
disablement

11th instance 0.07% per day +Rs. 70,000/- (for 2nd to 10th instance) +Rs.10000/- per
onwards instance from 11th instance onwards. Additionally, the member will be
referred to the Disciplinary Action Committee for suitable action
Session 5
Duration: 45 minutes
Securities Transaction Tax
 STT is levied on transactions involving equity, derivatives and
equity oriented mutual funds.
 In case of derivatives transactions, the exchange on which the
transaction took place is required to collect (deduct) the STT
and remit the same to the Government.

Taxable securities
STT rate Payable by
transaction

Sale of an option in securities 0.05 per cent Seller

Sale of an option in securities,

0.125 per cent Purchaser
where option is exercised

Sale of a futures in securities 0.01 per cent Seller

Update regarding STT on ITM options
 STT on exercised contracts from September 1, 2019 will be
charged at the rate of 0.125% of intrinsic value (how much in-the-
money the option is) and not on the total contract value like it
used to be done earlier. Intrinsic value for OTM options is always
zero, so there is no STT for OTM options.
 So if you hold 1 lot of call at a strike price of 11,000 and if market
expires at 11,050. You will pay STT of 0.125% of (11050 - 11000 = 50)
multiplied by lot size 75, which is around Rs 5. Earlier you would
have paid around Rs 1000 (= 11050 x 75 x 0.125%).
Securities Transaction Tax [continued]
 Exchanges adopt the following procedure in respect of the
calculation and collection of Securities Transaction Tax:
 STT is applicable on all sell transactions for both futures and
options contracts.
 For the purpose of STT, each futures trade is valued at the actual
traded price and option trade is valued at premium.
 On this value, the STT rate as prescribed is applied to determine the
STT liability.
 In case of voluntary or final exercise of an option contract, STT is
levied on settlement price on the day of exercise if the option
contract is in the money (ITM).
 STT payable by the clearing member is the sum total of STT payable
by all trading members clearing through him.
 The trading member’s liability is the aggregate STT liability of all
clients trading through him.
Derivatives as a Business Income
 As per Amendment in finance Act 2005, a derivatives transaction
which is carried out in a “recognized stock exchange” is not taxed
as speculative income or loss.
 It is treated as “Business Income”.
 As a non-speculative Business Income, loss on derivative
transactions can be set-off against any other income during the
year (except salary income).
 The loss can be carried forward to subsequent assessment year
but can be set-off only against non-speculative business income
of the subsequent year.
 Such losses can be carried forward for a period of 8 assessment
years.
Taxation aspects - ITR
 ITR 3 to be used:
 when you have a salary, interest income, income from house property, income
from capital gains, and income from business/profession,
 If you are an individual who is declaring trading as a business income
 If you are an investor in equity shares and a derivatives trader too, then you can
show income arising out of investments under capital gains and if you are
actively participating in derivative market, then income will be considered
under business income.
 Anyone having income from following sources are eligible to file ITR 3:
 Carrying on a business or profession
 If you are an Individual Director in a company
 If you have had investments in unlisted equity shares at any time during the
financial year
 Return may include income from House property, Salary/Pension and Income
from other sources
 Income of a person as a partner in the firm
 As Derivatives is treated under Business Income, derivatives traders are
to use ITR 3
Taxation aspects – ITR [continued]
 ITR 4 is similar to ITR 3 but with a presumptive scheme, if section
44AD and 44AE are used for computation of business income.
 ITR 4 cannot be used to declare any capital gains or if losses have to be
carried forward. So you can use ITR 4 only if you have business income
which is not to be carry forwarded (speculative + non-speculative)
 Who cannot use ITR 4?
 If your total income exceeds Rs 50 lakh
 Having income from more than one house property
 If you have any brought forward loss or loss to be carried forward under any
head of income
 Owning any foreign asset
 Having income from any source outside India
 If you are a Director in a company
 If you have had investments in unlisted equity shares at any time during the
financial year
 Having foreign assets or foreign income
Important dates for traders’ for income tax
 15th June – First installment of Advance tax
 15th September – Second installment of advance tax
 15th December – Third installment of advance tax
 15th March – Fourth installment of advance tax
 31st July – Annual return of Income tax incase of Non tax audit
 30th Sep – Annual return of Income tax incase of Tax audit
Session 6
Duration: 30 minutes
Information
 For more details, please visit: www.nism.ac.in
 For queries: cpe@nism.ac.in
 Board Numbers (NISM): 8080806476