THE VALUATION SCHOOL | PARTH VERMA

NISM VIII
EQUITY DERIVATIVES

NOTES
Parth Verma / The Valuation School

NISM VIII
CHAPTER 2: UNDERSTANDING INDEX

LEARNING OBJECTIVES
The Index and its significance
Different types of stock market indices
Index management and maintenance
Applications of indices

2.1 & 2.6 INTRODUCTION TO AN INDEX

What is an Index?
Collection of securities (shares, bonds, etc) representing a
particular market segment.
Helps in measuring the changes in an economy or specific sectors.

To know more about various broad market indices CLICK HERE

Calculation-
Each index has its own calculation & methodology, usually
expressed in terms of a change from a base value.
If the base value is 100 and the index value today is 110, the index
has increased by 10%.
2.2 SIGNIFICANCE OF THE STOCK INDEX

Role of an index

Measurement: Tracks price movements of stocks, bonds, etc.

Benchmarking: Used by investors to compare performance.
Market Sentiment: Reflects the overall market behaviour.
Underlying for derivatives: Used as the foundation/base for
creating derivatives

2.3 TYPES OF STOCK MARKET INDICES

Market capitalization weighted index

Weight of each stock based on the market capitalization

Higher the market capitalization of stock higher its weight
Market capitalization = Total outstanding shares * price per share

Example -

Parth Verma / The Valuation School

Parth Verma / The Valuation School

EXAMPLE OF MARKET CAPITALIZATION WEIGHTED INDEX

Index value on start date Index value today
(1st April, 2023) (1st April, 2024)

Shares Market Cap Shares Market Cap

Stock Price (Rs) Stock Price (Rs)
(Lakhs) (Rs Lakhs) (Lakhs) (Rs Lakhs)

AZ 100 10 1000 AZ 400 10 4000

BY 200 15 3000 BY 600 15 9000
CX 150 20 3000 CX 500 20 10000
DW 50 25 1250 DW 300 25 7500
EU 80 10 800 EU 250 10 2500
Total - - 9050 Total - - 33000

NEW INDEX VALUE CALCULATION

Old Market Cap: 9050 lakhs
New Market Cap: 33000 lakhs
New Index Value 33,000/9,050 = 364.64
% return = (364.64-100)/100(base at the start) x 100% = 264.64%

Free Float weighted Index

Free Float - Excludes shares held by promoters, institutions, etc.,
focusing only on shares available for trading
Calculations similar to the Market cap method - the only change is free
float market cap is considered
Index is computed based on weights of each security’s free float
market cap
Price weighted Index
Such an index where each stock's impact on the index is proportional to
its price. Higher-priced stocks have more influence on the index's
performance
Calculation Method
Add the prices of all stocks in the index.
Divide the sum by the total number of stocks in the index.

Examples: Dow Jones Industrial Average (DJIA), Nikkei 225

EXAMPLE OF PRICE WEIGHTED INDEX

Old Index (April 1st, 2023) Index today (April 1st, 2024)

Stock Price (Rs) Shares (Lakhs) Stock Price (Rs) Shares (Lakhs)

AZ 150 20 AZ 650 20

BY 300 12 BY 450 12

CX 450 16 CX 600 16

DW 100 30 DW 350 30

EU 250 8 EU 500 8

Total - - Total - -

Old Index Value: Current Index Value:

(150 + 300 + 450 + 100 + 250)/5 (650 + 450 + 600 + 350 + 500)/5
= 1250/5 = 250 = 2550/5 = 510

Percentage change
= (510 - 250)/250 * 100= 104%

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Equal weighted Index

Regardless of its market price or market capitalization
Each stock in the index is assigned the same weight.
The index requires periodic rebalancing to maintain equal weights.
Stocks that increase in price are sold, and stocks that decrease in price
are bought.

EXAMPLE OF EQUAL WEIGHTED INDEX

Consider an index constructed on April 2023 , with four stocks (P, Q, R, S).
Each stock has the same initial value.

START OF INDEX

PRICE (RS) - VALUE(RS) = PRICE * WEIGHT - APRIL

STOCK QUANTITY
APRIL 2023 QUANTITY 2023

P 120 250 30,000 0.25

Q 140 214 30,000 0.25

R 160 188 30,000 0.25

S 180 167 30,000 0.25

Total - - 1,20,000 1.00

POST 1 YEAR
RETURN = PRICE
PRICE (RS) - QUANTITY CURRENT VALUE(RS) WEIGHT - PRICE CHANGES * OLD
STOCK
APRIL 2024 (SAME) = QTY* PRICE APRIL 2023 CHANGES WEIGHT

P 170 250 42,500 0.325 41.67% 10.42%

Q 110 214 23,540 0.18 -21.43% -5.36%

R 210 188 39,480 0.305 31.25% 7.81%

S 150 167 25,050 0.19 -16.67% 4.17%

Total - - 1,30,570 1.00 - 8.70%

Index Value Calculation

Old Index Value: Set to 100.
New Index Value= (130570/120000) * 100 = 108.81

Rebalancing
Increased Weight: Stocks P and R have weights greater than 25%
due to price increases.
Decreased Weight: Stocks Q and S have weights less than 25% due
to price decreases.
Action: Sell quantities of stocks P and R, and buy quantities of
stocks Q and S to restore equal weights.

Example - U.S. businesses - Equal-Weighted Wilshire Large-Cap Index

Want to learn more on Equal weighted Index funds (Indian Context) - CLICK HERE

Parth Verma / The Valuation School

Parth Verma / The Valuation School

2.4 ATTRIBUTES OF AN INDEX

Reflect the tageted market behaviour

Should be bias free & computed by independent third party

Impact Cost - additional cost incurred when executing large

orders due to price changes from the ideal price.

1. Ideal Price: The average of the best buy and sell prices. For example, if
the best bid is Rs. 4.00 and the best offer is Rs. 4.50, the ideal price is
Rs. 4.25.

ORDER BOOK
BID PRICE OFFER PRICE
QUANTITY SELL QUANTITY SR. NO.
(IN RS) (IN RS.)

1000 4.00 4.50 2000 5

1000 3.90 4.55 1000 6

2000 3.80 4.70 500 7

1000 3.70 4.75 100 8

2. Actual Price: The price at which a transaction occurs. When buying,

it's higher than the ideal price; when selling, it's lower.

3. Impact Cost Calculation:

Ideal price: (Best Buy + Best Sell) / 2

Actual Price: Weighted average of prices for the order size.
Impact Cost = (Actual Price - Ideal Price)/ideal price ×100
2.5 INDEX MANAGEMENT
Index Construction: Choosing stocks for the index and deciding the
calculation methodology.

Index Maintenance: Adjusting the index for corporate actions like

bonus issues, rights issues, stock splits, consolidations, and mergers.

Index Revision: Replacing existing stocks with new ones due to

changes in trading patterns or market interest.

All 3 activites done by agencies - BSE indices are managed by Asia

Index Pvt Ltd and NSE indices are managed by NSE Indices Limited.

2.6 APPLICATION OF INDICES

Apart from measuring the market sentiments Index is used for
these purposes -

Index Funds
Aim to generate returns equivalent to a specific index by investing
in the same stocks in the same proportions as the index.
(Example - UTI Nifty 50 Index fund)
Funds experience slight deviations known as "tracking errors" due
to fund management expenses and cash holdings for redemptions.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Index Derivatives
Derivative contracts with an index as the underlying
asset, used for hedge/ speculating
Example - S&P BSE SENSEX 50

ETF
Replicate index return & trade like individual stocks on exchanges.
Allow for intraday trading.
Offer smaller denominations and low transaction costs.
Parth Verma / The Valuation School

NISM VIII
CHAPTER 4: INTRODUCTION TO OPTIONS

LEARNING OBJECTIVES
Concept of Options
Payoffs in case of option contracts
Difference between futures and options
Fundamentals relating to option pricing
Option Greeks and Implied volatility
Analysis of options from the perspective of option buyers and
sellers

4.1 BASICS OF OPTION

What is an option?

An option is a financial contract that lets you buy or sell an

asset at a fixed price before a specific date.

You pay a fee for this right, but you're not obligated to use it.
Example -
You buy an option to purchase a stock for ₹100 (the strike
price) within the next month by paying ₹5 for this option.

If the stock price rises to ₹120, you can still buy it for ₹100,
making a profit.

If the stock price doesn’t go up, you can let the option expire,
losing only the ₹5 you paid for the option.

Bought an option for Rs 5 to

purchase a stock for Rs 100

stock price
stock price rises
doesn’t go up

Made a profit Lose just Rs 5

Option Premium: Cost of buying the option.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Buyer of an Option:

Has the right but not the obligation.

Pays an option premium to the seller.
Can buy (call option) or sell (put option) the underlying
asset.
Buys the option.

Writer of an Option:
Receives the option premium.
Obliged to sell or buy the asset if exercised.
Sells the option.

Payment:

The buyer pays the premium to the seller upfront.

TYPES OF OPTIONS

Mainly there are 2 types

1. Call option - Buyer of Option gets the Right to BUY
2. Put Option - Buyer of Option gets the Right to SELL
OPTION TERMINOLOGY
Types of Options:

Index Option: Underlying asset is a stock index

(e.g. Nifty, Sensex).
Stock Option: Underlying asset is an individual stock
(e.g. ONGC, NTPC).

Option Styles:

American Option: Can be exercised anytime on or before

expiry.
European Option: Can be exercised only on expiry date.
(Followed in India)

Key Terms:

Option Premium: Price paid by the buyer to the seller.

Spot Price (S): Current price of the underlying asset in the
spot market.
Strike Price or Exercise Price (X): Price at which the asset
can be bought (call) or sold (put).
Open Interest: Total number of outstanding option
contracts.

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Parth Verma / The Valuation School

Assignment of Options:
Allocation of exercised options to one or more option
sellers.

Opening a Position:
Opening Purchase (Long on Option): Creating or
increasing a long position.
Opening Sale (Short on Option): Creating or increasing a
short position.

Closing a Position:

Closing Purchase: Reducing or eliminating a short position.

Closing Sale: Reducing or eliminating a long position.

4.2 CONTRACT SPECIFICATIONS OF

EXCHANGE-TRADED OPTIONS

1. Contract Size or Lot Size:

Number of units in a contract.

Varies by stock/index.
Example: Nifty options have a contract size of 50
2. Contract Trading Cycle:
Period during which the option is traded.
Stock options on NSE: three-month trading cycle (e.g., May,
June, July). with monthly expiry
Index options: weekly and monthly expiries.

3. Expiration Date:
Last trading day of the contract.
Nifty and Bank Nifty options expire on the last Thursday of
the month.
Weekly options expire on the Thursday of each week.

4. Tick Size:
Minimum price movement.
Set at 5 paisa for stock and index options.

5. Final Settlement Price:

No daily settlement for options.
Final settlement on expiration date.
Based on the closing price of the underlying asset.

6. Trading Hours:
9:15 am to 3:30 pm, Monday to Friday.
Exchange publishes annual trading holidays.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

BSE OPTIONS SLIGHLTY DIFFERENT

Features Details

Underlying asset BSE Sensex

Contract size 10

Tick size Rs.0.05

Contract cycle 7 serial weekly, 3 monthly, 3 quarterly and 8 semi-annually

maturing contracts

Trading hours 9:15 a.m. to 3:30 p.m.

Exercise style European

Monthly, Quarterly and Semi-annually – last Friday of the

Expiration day
contract; Weekly contracts – Friday expiry

Cash settlement based on the closing price of the

Final settlement
underlying index on the expiration day

4.3 MONEYNESS OF AN OPTION

In-the-Money (ITM) Option:

An option is considered in-the-money if exercising it would

result in a positive cash flow for the holder.

Call Option: ITM when the spot price is higher than the
strike price.
Put Option: ITM when the spot price is lower than the
strike price.
Example: If the spot price of an asset is ₹185 and the strike
price of a call option is ₹180, the call option is ITM because
you can buy the asset for ₹180 (lower than the market
price) and sell it at ₹185, making a profit.

At-the-Money (ATM) Option:

An option is at-the-money if exercising it would result in zero

cash flow, meaning the strike price is equal to the spot price.

Call and Put Options: Both are ATM when the strike price
is equal to the spot price.
Example: If the index is at ₹18400 and the strike prices
available are ₹18350, ₹18400, and ₹18450, the option with
the strike price of ₹18400 is the ATM option.

Out-of-the-Money (OTM) Option:

An option is out-of-the-money if exercising it would result
in a negative cash flow for the holder.

Call Option: OTM when the spot price is lower than the
strike price.
Put Option: OTM when the spot price is higher than the
strike price.
Example: If the spot price of an asset is ₹175 and the strike
price of a call option is ₹180, the call option is OTM because
you would have to buy the asset for ₹180 (higher than the
market price) and sell it at ₹175, resulting in a loss.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

4.4 INTRINSIC VALUE AND TIME VALUE

OF AN OPTION

Option Premium, Consists of two components: intrinsic value

and time value.

Intrinsic Value:

It is the amount by which an option is in-the-money (ITM).

Call Option: Intrinsic value = Spot price (S) - Strike price (X).
Put Option: Intrinsic value = Strike price (X) - Spot price (S).
Only ITM options have intrinsic value; ATM and OTM options
have zero intrinsic value.
Intrinsic value can never be negative as the option holder
won't exercise it at a loss.

Example:

Put Option (ITM): Strike price (X) = ₹18400,

Spot price (S) = ₹18315.10

Intrinsic value = ₹18400 - ₹18315.10 = ₹84.90

Call Option (OTM): Strike price (X) = ₹18400,

Spot price (S) = ₹18315.10

Intrinsic value = ₹0
(since the spot price is lower than the strike price).
Time Value:
Difference between the option premium and intrinsic value.
ATM and OTM Options: Entire premium is the time value as
intrinsic value is zero.

Example:

Put Option: Premium = ₹177.60, Intrinsic value = ₹84.90

Time value = ₹177.60 - ₹84.90 = ₹92.70

Call Option: Premium = ₹124.50, Intrinsic value = ₹0

Time value = ₹124.50

4.5 PAYOFF CHARTS FOR OPTIONS

Long Option

Long the option: Buyer has the right but not the
obligation to buy/sell the underlying asset.

When you are long an equity option contract:

You have the right to exercise that option.
Your potential loss is limited to the premium amount
you paid.
Profit depends on the asset price at exercise/expiry.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Short Option

Short the option: Seller has the obligation to sell/buy the

underlying asset.

When you are short an equity option contract:

Your maximum profit is the premium received.
You can be assigned an exercised option at any time
during the life of the option contract (in the case of
American options).
Your potential loss is theoretically unlimited.

Now, let us understand each of these positions in detail:

1) Long Call:

Long Call Option: A long call option gives the buyer the right,
but not the obligation, to buy the underlying asset at a
specified strike price before or at expiration.

Example:
Stock index: 17562
Call option strike price: 17500
Premium paid: Rs. 95

Right to Buy:
You can buy the index at 17500 on the expiration date.
If the index is above 17500, exercise the option; if it is
below, let it expire.
Break-Even Point (BEP)

BEP Formula: Strike Price + Premium = 17500 + 95 = 17595

At BEP (17595):
Payoff = 17595 - 17500 = Rs. 95
Net Profit = Payoff - Premium = 95 - 95 = 0

Outcome at Various Levels:

Index at 17400: Do not exercise; loss = Rs. 95

(premium paid).
Index at 17595: Exercise; receive Rs. 95
(break-even point, no profit or loss).
Index at 18000: Exercise; receive Rs. 500.
Profit = Rs. 500 - Rs. 95 = Rs. 405.

Payoff Table:
A payoff table shows the profit or loss for an option at various
levels of the underlying asset's price at expiration.

Index Value at The payoff on Profit on Expiry

Premium Paid (A)
Expiry Expiry (B) (A+B)

17400 -95 0 -95

17500 -95 0 -95
17600 -95 100 5
17700 -95 200 105
18000 -95 500 405

Parth Verma / The Valuation School

Parth Verma / The Valuation School

The chart above shows some of the possible closing levels

of the index on the expiration date on the X-axis.

The Y-axis shows the net profit on the long call position at
various closing levels of Nifty on the expiration date.

Key Points: Contract value: 17500 * 50 = Rs. 8,75,000

Maximum loss: Rs. 95 * 50 = Rs. 4,750
Profit starts when the index closes above 17595.
Loss limited to Rs. 4,750 with potentially unlimited profit.
No margin is required since loss is limited to the
premium paid.
2) Short Call:

Short Call Option: A short call option obligates the seller to

sell the underlying asset at a specified strike price if the
buyer chooses to exercise the option.

Example:
Stock index: 17562
Call option strike price: 17500
Premium received: Rs. 95

Obligation to Sell:
You must sell the index at 17500 if the
option is exercised.
If the index is above 17500, the buyer will exercise the
option; if below, the option expires worthless.

Break-Even Point (BEP)

BEP = 17595

Outcome at Various Levels:

Index at 17400: Option expires worthless;
profit = Rs. 95 (premium received).
Index at 17595: No profit or loss;
profit = Rs. 95 - Rs. 95 = 0.
Index at 18000: Must sell at 17500;
loss = Rs. 500 - Rs. 95 = Rs. 405.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Payoff Table:
Index Value at The payoff on Profit on Expiry
Expiry Premium Paid (A)
Expiry (B) (A+B)

17400 95 0 95
17500 95 0 95
17600 95 -100 -5
17700 95 -200 -105
17800 95 -300 -205
18000 95 -500 -405

The short call payoff chart is just a mirror image of the

long call payoff.

Key Points:
Contract value: 17500 * 50 = Rs. 8,75,000
Maximum gain: Rs. 95 * 50 = Rs. 4,750
(premium received)
Potential losses: Unlimited above the BEP (17595)
Margin required: Due to the potential for unlimited
losses, the exchange requires a margin from the seller.
3) Long Put:

Long Put Option:

A put option gives the buyer the right, but not the obligation,
to sell the underlying asset at a specified strike price before
or at expiration.

Example:
Stock index: 17562
Put option strike price: 17500
Premium paid: Rs. 150

Right to Sell:
You can sell the index at 17500 on the expiration date.
If the index is below 17500, exercise the option;
if above, let it expire.

Break-Even Point (BEP)

BEP Formula: Strike Price - Premium = 17500 - 150 = 17350
At BEP (17350):
Payoff = 17500 - 17350 = Rs. 150
Net Profit = Payoff - Premium = 150 - 150 = 0

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Outcome at Various Levels:

Index at 17100:
Exercise; profit = Rs. 400 - Rs. 150 = Rs. 250.
Index at 17350:
Exercise; no profit or loss (Breakeven Point)
Index at 17600:
Do not exercise; loss = Rs. 150 (premium paid).

Payoff Table:

Index Value at The payoff on Profit on Expiry

Expiry Premium Paid (A)
Expiry (B) (A+B)

17100 -150 400 250

17300 -150 200 50
17400 -150 100 -50
17500 -150 0 -150
17600 -150 0 -150
The X-axis of the chart above shows the different possible
closing levels of the index on the expiration date while the
Y-axis shows the net profit on the long-put position
corresponding to each closing level of the index.

Key Points:
Contract value: 17500 * 50 = Rs. 8,75,000
Maximum loss: Rs. 150 * 50 = Rs. 7,500
Profit starts when the index closes below 17350.
Loss limited to Rs. 7,500 with potentially high profit
(maximum profit at index zero: Rs. 17,350).
No margin is required since the loss is limited to the
premium paid.

4) Short Put:

Short Put Option:

A short put option obligates the seller to buy the underlying
asset at a specified strike price if the buyer chooses to
exercise the option.

Example:
Stock index: 17500
Put option strike price: 17500
Premium received: Rs. 150

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Obligation to Buy:
You must buy the index at 17500 if the buyer exercises the
option.
If the index is above 17500, the option expires worthless; if
below, you incur losses.

Break-Even Point (BEP)

BEP = 17350

Outcome at Various Levels:

Index at 17100:
Option exercised; loss = Rs. 400 - Rs. 150 = Rs. 250.
Index at 17350: Option exercised; no profit or loss
(Breakeven Point)
Index at 17600: Option expires; profit = Rs. 150 (premium
received).

Payoff Table:

Index Value at Premium Received The payoff on Profit on Expiry

Expiry (A) Expiry (B) (A+B)

17100 150 -400 -250

17300 150 -200 -50
17400 150 -100 50
17500 150 0 150
17600 150 0 150
The X-axis of the chart above shows the different possible
closing levels of the index on the expiration date while the
Y-axis shows the net profit on the short put position
corresponding to each closing level of the index.

Key Points:
Contract value: 17500 * 50 = Rs. 8,75,000
Maximum profit: Rs. 150 (premium received)
Potential loss: Large, increasing as the index falls below
17350
Margin required due to the potential for significant
losses.

RISK AND RETURN PROFILE OF OPTION CONTRACTS

A long option position has limited risk (premium paid) and
unlimited profit potential.
A short option position has unlimited downside risk, but
limited upside potential (to the extent of the premium
received).

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Risk Return
Long Premium paid Unlimited

Short Unlimited Premium received

4.6 DISTINCTION BETWEEN FUTURES

AND OPTIONS CONTRACTS

Asymmetric Risk and Leverage in Options vs. Futures

Asymmetric Risk:
Options: Gains and losses are unequal. For example, a
call option buyer's loss is limited to the premium paid,
but gains are unlimited if the stock price rises.
Futures: Gains and losses are equal, resulting in
symmetric risk exposure.

Leverage:
Options: A small premium relative to contract value allows
for high leverage. This can lead to large percentage gains
from small favorable moves in the underlying asset.
Downside: Leverage can also magnify losses if the
underlying asset's price doesn't move as expected. If
options expire worthless, the premium paid is lost.
FEW MAIN DIFFERENCES BETWEEN FUTURES
AND OPTIONS CONTRACTS

Futures Contracts Options Contracts

Symmetric risk. Both Asymmetric risk. Limited

parties can have loss to premium paid;
Risk Exposure
unlimited gains or losses. potential for unlimited
gains.
Margin payments are A small premium for
Leverage required by both buyer market exposure leads to
and seller. high leverage.

Both buyer and seller Buyer has the right (no

Rights & have obligations to obligation) to buy/sell;
Obligations buy/sell the underlying seller has an obligation if
asset. exercised.
Both parties pay the
Buyer pays a premium;
initial margin and are
Payments seller deposits margin
subject to daily margin
with exchanges.
(MTM) payments.
Buyer: Unlimited gains,
Gains and Both parties can have limited loss (premium
Losses unlimited gains or losses. paid). Seller: Limited
gains, unlimited losses.

Both buyer and seller are Only the seller is subject

Daily Margins subject to daily MTM to daily MTM margins.
margins.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

4.7 OPTION PRICING FUNDAMENTALS

Components of Option Premium:

1. Intrinsic Value: Value if the option is exercised now (ITM,

ATM, OTM).
2. Time Value: Remaining time until expiration and
underlying asset volatility.

Option Premium is determined by market participants through

price discovery, not fixed by stock exchanges or SEBI.

There are five fundamental parameters on which the

option price depends:

1. Spot Price:
Call options increase in value as the underlying asset
price rises.
Put options decrease in value as the underlying asset
price rises.

2. Strike Price:
A higher strike price decreases call option value.
A higher strike price increases the put option value.
3. Volatility:
Higher volatility increases both call and put option
premiums.
Lower volatility decreases premiums.

4. Time to Expiration:
Longer time to expiration generally increases
premiums.
Time decay reduces the premium as expiration
approaches.

5. Interest Rates:
Higher interest rates increase call option value.
Higher interest rates decrease put option value.

Option Greeks:

Option premiums change with changes in the factors that

determine option pricing i.e., factors such as strike price,
volatility, term to maturity, etc.

The sensitivities most commonly tracked in the market are

known collectively as “Greeks”.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

DIFFERENT TYPES OF OPTION GREEKS:

1) Delta (Δ):

Measures the sensitivity of an option's value to a small change

in the price of the underlying asset.

Change in option premium

Formula: Δ =
Change in price of the underlying asset

Call Options:
Buyer: Positive Delta (value increases as underlying
price rises).
Seller: Negative Delta (value decreases as underlying
price rises).

Put Options:
Buyer: Negative Delta (value increases as underlying
price falls).
Seller: Positive Delta (value decreases as underlying
price falls).

Example: If a call option has a Delta of 0.60, a Rs.1 increase in

the underlying asset's price will increase the option's price by
60 paise.

Importance: Heavily used in margining and risk management

strategies; often called the hedge ratio.
2) Gamma (γ):

Measures the rate of change of Delta with respect to the price

of the underlying asset.
Change in Delta
Formula: γ =
Change in price of the underlying asset

Example: If a call option has a Delta of 0.50 and Gamma of

0.08, a Rs.1 increase in the underlying asset's price will change
the Delta to 0.58.

Importance: Indicates how fast an option will go in-the-

money or out-of-the-money.

3) Theta (θ):
Measures an option’s sensitivity to time decay.
Change in option premium
Formula: θ =
Change in time to expiry

Example: If a call option with 5 days to expiry has a Theta of

1.2, the option price will decline by Rs.1.20 per day.

Importance: Reflects how time decay affects option positions;

typically negative for long options.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

4) Vega (ν):

Measures the sensitivity of an option's price to changes in

market volatility.
Change in option premium
Formula: ν =
Change in volatility

Example: If a call option has a Vega of 0.80, a 1% increase in

volatility will change the option's premium by 0.80%.

Importance: Indicates how changes in volatility affect option

prices; positive for both long calls and long puts.

5) Rho (ρ):

Measures the sensitivity of an option's price to changes in

the risk-free interest rate.
Change in option premium
Formula: ρ =
Change in cost of funding the underlying

Importance: Reflects the impact of interest rate changes

on option prices.
4.8 OPTION PRICING MODELS

1) The Binomial Pricing Model

Developed by: William Sharpe in 1978.
Key Features:
Price Evolution: Represents the price evolution of the
underlying asset as a binomial tree.
Assumptions: At each step, the price can move up or
down at fixed rates with respective probabilities.
Accuracy: Very accurate due to its iterative nature.
Complexity: Implementation is complex and time-
consuming.

2) The Black & Scholes Model

Published by: Fisher Black and Myron Scholes in 1973.

Key Features:
Simplicity: Relatively simple and fast calculation.
Non-iterative: Unlike the binomial model, it does not
rely on iterative calculations.
Dividends: Ignores dividends paid during the option's
life.
Key Determinants: Stock price, strike price, volatility,
time to expiration, and risk-free interest rate.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

CALL OPTION PRICE FORMULA:

PUT OPTION PRICE FORMULA:

Where:

S = stock price
X = strike price
t = time remaining until expiration, expressed in years
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of
the short-term returns over one year)
In = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function
4.9 IMPLIED VOLATILITY OF AN OPTION

Types of Volatility:
1. Historical Volatility:
Measured using past price changes.
Example: Calculate the standard deviation of weekly
percentage changes in Nifty over the past year.
Reflects past market behavior.

2. Implied Volatility:
Expected future volatility over the option's life.
Derived from current option prices using models like
Black-Scholes.
Reflects market expectations and sentiment.

Factors Influencing Implied Volatility:

Major events (e.g., court verdicts, earnings reports).
Market sentiment and expectations.
Overall market conditions.

Benefits for Options Traders:

Helps determine the fair value of options.
Informs buy/sell decisions based on market conditions.
Provides insight into market expectations and potential
price movements.
Parth Verma / The Valuation School
Parth Verma / The Valuation School

4.10 ANALYSIS OF OPTIONS FROM THE

PERSPECTIVES OF BUYER AND SELLER

Analysis of Call Option Trading from Buyer’s Perspective

Scenario:
Index Price: 17562
Strike Prices and Premiums:
17300: Rs. 327
17400: Rs. 250
17500: Rs. 185
17600: Rs. 130

Intrinsic Value:
Deep ITM (17300 strike): 17562 - 17300 = 262
(Intrinsic Value), Time Value = 327 - 262 = 65
OTM (17600 strikes): No intrinsic value, entire
premium is time value.

Break-Even Points (BEP):

17300 Strike: 17627
17400 Strike: 17650
17500 Strike: 17685
17600 Strike: 17730
PROFIT/LOSS ANALYSIS AT EXPIRY:
Index Closing Profit for Profit for Profit for Profit for
Value 17300 17400 17500 17600

17300 -327 -250 -185 -130

17400 -227 -250 -185 -130
17500 -127 -150 -185 -130
17600 -27 -50 -85 -130
17700 73 50 15 -30
17800 173 150 115 70

Max Loss: Equal to the premium paid.

Max Profit: Potentially unlimited as the index rises.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

RETURN ON INVESTMENT (ROI) AT INDEX VALUE 17800:

Strike Price Profit ROI Calculation ROI

17300 173 173/327 53%

17400 150 150/250 60%
17500 115 115/185 62%
17600 70 70/130 54%

Analysis:
ITM Options: Higher intrinsic value, higher premium, lower
ROI but more stable.
ATM Options: Balanced premium, higher uncertainty,
moderate ROI.
OTM Options: Lower premium, higher risk, potentially high
ROI if the index moves significantly.

Conclusion:
Choice of Option:
Bullish Traders: Prefer ATM or slightly OTM options
for higher ROI.
Conservative Traders: Prefer ITM options for more
stability and lower risk.
Time to expiry, volatility, and market outlook are crucial
in deciding the best strike price to trade.
Analysis of Call Option Trading from Seller’s
Perspective

Scenario:
Neutral to Bearish Outlook: The seller expects the
underlying asset price to remain stable or decline.

PROFIT/LOSS ANALYSIS AT EXPIRY:

Index Closing Profit for Profit for Profit for Profit for
Value 17300 17400 17500 17600

17300 327 250 185 130

17400 227 250 185 130
17500 127 150 185 130
17600 27 50 85 130
17700 -73 -50 -15 30
17800 -173 -150 -115 -70

Maximum Profit: Equal to the premium received.

Profit: When the index closes below the strike price, the
seller keeps the entire premium.
Loss: When the index closes above the strike price, the
seller starts incurring losses.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Conclusion:
Risk:
The seller's profit is capped at the premium received.
Potential losses are unlimited as the index price rises.

Strategy:
Selling call options is advantageous when expecting
neutral to bearish market conditions.
Risk management is crucial due to the potential for
unlimited losses.
Analysis of Put Option Trading from a
Buyer’s Perspective

Scenario:
Index: 17562
Strike Prices and Premiums:
17300: Rs. 65
17400: Rs. 91
17500: Rs. 121
17600: Rs. 167

Intrinsic Value:
ITM (17600 strike): 17600 - 17562 = 38,
Time Value = 167 - 38 = 129
OTM (17300 strikes): No intrinsic value, entire
premium is time value.

Break-Even Points (BEP):

17300: 17235
17400: 17309
17500: 17379
17600: 17433

Parth Verma / The Valuation School

Parth Verma / The Valuation School

PROFIT/LOSS ANALYSIS AT EXPIRY:

Index Closing Profit for Profit for Profit for Profit for
Value 17300 17400 17500 17600

17200 35 109 179 233

17300 -65 9 79 133
17400 -65 -91 -21 33
17500 -65 -91 -121 -67
17600 -65 -91 -121 -167

Max Loss: Equal to the premium paid.

Profit: When the index closes below the strike price, the
buyer makes a profit.
Loss: When the index closes above the strike price, the
buyer loses the premium paid.

RETURN ON INVESTMENT (ROI) AT INDEX VALUE 17000:

Strike Price Profit ROI Calculation ROI

17300 235 235/65 362%

17400 309 309/91 340%
17500 379 379/121 313%
17600 433 433/167 259%
Conclusion:

ITM Options:
Higher intrinsic value, higher premium.
Lower ROI compared to OTM options but more stable.

ATM/OTM Options:
Lower premium, higher risk.
Higher potential ROI if the index drops significantly.

Strategy:
For a bearish outlook, buying put options can be
profitable.
OTM options provide higher ROI if the index falls
drastically.
ITM options offer more stability with lower ROI.

Analysis of Put Option Trading from Seller’s

Perspective

Scenario:
Neutral to Bullish Outlook: The seller expects the
underlying asset price to remain stable or rise.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

PROFIT/LOSS ANALYSIS AT EXPIRY:

Index Closing Profit for Profit for Profit for Profit for
Value 17300 17400 17500 17600

17200 -35 -109 -179 -233

17300 65 -9 -79 -133
17400 65 91 21 -33
17500 65 91 121 67
17600 65 91 121 167

Maximum Profit: Equal to the premium received.

Profit: When the index closes above the strike price, the
seller keeps the premium.
Loss: The seller starts incurring losses when the index
closes below the strike price.
Conclusion:

Risk:
The seller's profit is capped at the premium received.
Potential losses are significant as the index price falls.

Strategy:
Selling put options is advantageous when expecting
neutral to bullish market conditions.
Risk management is crucial due to the potential for
significant losses.

Parth Verma / The Valuation School

Parth Verma The Valuation School

NISM VIII
CHAPTER 5: STRATEGIES USING EQUITY FUTURES
AND EQUITY OPTIONS

LEARNING OBJECTIVES
To know various hedging, arbitrage and trading strategies using equity futures and
options. In this chapter we’re going to use the features of the future and options
using different strategies.

5.1 FUTURES CONTRACTS FOR HEDGING

SPECULATION AND ARBITRAGE:
Futures and options were created to help manage risk.

One common strategy is using stock futures to protect against

the risk of stock prices changing. Here's how it works:

Long Hedge Using Stock Futures:

Imagine you want to buy 1500 shares of ABC Ltd., which are
currently priced at Rs. 455 each, but you don't have the
money to buy them until June 20, 2023, when one of your
bank deposits matures.

You are worried the price might increase by then, so you

decide to hedge this risk using stock futures.
Process
Current Situation (May 10, 2023):
Current share price of ABC Ltd.: Rs. 455
You plan to buy 1500 shares on June 20, 2023
You take a long position in a futures contract expiring
on June 29, 2023, which is priced at Rs. 457.30
The lot size of the futures contract is 1500 shares

Hedging:
You buy one lot of the futures contract (1500 shares)
at Rs. 457.30 to lock in the price

Case 1: Stock Price Increases

June 20, 2023:

Stock price rises to Rs. 520
You buy 1500 shares at Rs. 520, costing you Rs.
780,000
Futures price also rises to Rs. 521.20
Gain on futures position: (Rs. 521.20 - Rs. 457.30) *
1500 = Rs. 95,850

Net Cost Calculation:

Total cost in cash market: Rs. 780,000
Subtract gain from futures: Rs. 95,850
Net cost: Rs. 684,150
Net cost per share: Rs. 684,150 / 1500 = Rs. 456.10
Parth Verma The Valuation School
Parth Verma The Valuation School

Case 2: Stock Price Decreases

June 20, 2023:

Stock price drops to Rs. 390
You buy 1500 shares at Rs. 390, costing you Rs.
585,000
Futures price also drops to Rs. 391.10
Loss on futures position: (Rs. 457.30 - Rs. 391.10) * 1500
= Rs. 99,300

Net Cost Calculation:

Total cost in cash market: Rs. 585,000
Add loss from futures: Rs. 99,300
Net cost: Rs. 684,300
Net cost per share: Rs. 684,300 / 1500 = Rs. 456.20

Whether the stock price goes up or down, the net cost per
share stays close to the futures price you locked in initially
(around Rs. 457.30).

This strategy, called a "long hedge," helps you manage the risk
of price changes by effectively locking in a purchase price for
the future.

This way, you can plan your stock purchase without worrying
about significant price fluctuations.

Parth Verma The Valuation School

Parth Verma The Valuation School

1. Short hedge using stock future:

Imagine you plan to sell 1200 shares of PQR Ltd. on July

10, 2023, to pay off a personal loan.

Today is May 10, 2023, and the shares are currently

priced at Rs. 1690 each.

The July futures contract for PQR Ltd. shares is priced at

Rs. 1706.

You're worried the price might drop by July 10, so you

decide to hedge this risk using stock futures.

Process:

Current Situation (May 10, 2023):

Current share price of PQR Ltd.: Rs. 1690
You plan to sell 1200 shares on July 10, 2023
July futures contract price for PQR Ltd.: Rs. 1706
The lot size of the futures contract is 600 shares
To hedge 1200 shares, you need to short (sell) 2
futures contracts (600 shares each)

Hedging:
You sell 2 lots of the July futures contract at Rs. 1706
to lock in the price
Case 1: Stock Price Falls

July 10, 2023:

Stock price drops to Rs. 1440
You sell 1200 shares at Rs. 1440, receiving Rs. 17,28,000
Futures price also drops to Rs. 1441
Gain on futures position: (Rs. 1706 - Rs. 1441) * 600 * 2 =
Rs. 3,18,000

Net Amount Calculation:

Amount from selling shares: Rs. 17,28,000
Add gain from futures: Rs. 3,18,000
Net amount received: Rs. 20,46,000
Effective selling price per share: Rs. 20,46,000 / 1200 =
Rs. 1705

Case 2: Stock Price Rises

July 10, 2023:

Stock price rises to Rs. 1800
You sell 1200 shares at Rs. 1800, receiving Rs. 21,60,000
Futures price also rises to Rs. 1802
Loss on futures position: (Rs. 1706 - Rs. 1802) * 600 * 2
= Rs. 1,15,200

Parth Verma The Valuation School

Parth Verma The Valuation School

Net Amount Calculation:

Amount from selling shares: Rs. 21,60,000
Subtract loss from futures: Rs. 1,15,200
Net amount received: Rs. 20,44,800
Effective selling price per share: Rs. 20,44,800 / 1200 =
Rs. 1704

Whether the stock price goes up or down, the net selling

price per share stays close to the futures price you initially
locked in (around Rs. 1706).

This strategy, called a "short hedge," helps you manage the

risk of price changes by effectively locking in a selling price
for the future.

This way, you can plan your stock sale without worrying
about significant price fluctuations.

Hedging a portfolio using index futures:

Imagine you have a well-diversified portfolio of 15 large-cap

stocks from different sectors, worth Rs. 90,00,000.

This means your specific risk (the risk from individual stocks)
is minimal, but you still face systematic or market risk (the
risk that the whole market might go down).
The Problem:

You're worried about a potential market crash

in the next month. You have two options:

1. Sell Your Portfolio: Sell all your stocks and hold cash, but this
might not be ideal if you believe in the long-term value of your
investments.
2. Hedge with Index Futures: Use index futures to protect
against market risk without selling your stocks.

How to Hedge with Index Futures

1. Take a Short Position: You will sell index futures contracts.

If the market crashes, the loss in your portfolio will be offset
by the gain in your short futures position.

2. Calculate the Hedge Ratio: This ratio helps you determine

how many index futures contracts you need to sell to hedge
your portfolio.

STEPS:
1. Portfolio Value: Rs. 90,00,000
2. Portfolio Beta: 1.3 (Beta measures how much your portfolio
moves compared to the market. A beta of 1.3 means your
portfolio is 30% more volatile than the market.)
3. Index Futures Price: 17700
4. Index Futures Lot Size: 25
Parth Verma The Valuation School
Parth Verma The Valuation School

The hedge ratio formula is:

(Portfolio Beta×Portfolio Value)

Hedge Ratio =
(Index Futures Price×Lot Size)

(1.3 * 90,00,000)
=
(17700 * 25)

= 26.44

So, you need to take a short position in approximately 26

index futures contracts to hedge your portfolio.

By shorting 26 index futures contracts, you can protect your

portfolio from market downturns. If the market crashes and
your portfolio loses value, the profit from your short futures
position will offset the loss.

This strategy allows you to manage the systematic

risk while still holding onto your portfolio.

Using futures for trading or speculation:

Futures contracts are not only used for hedging risks but also
for trading and speculation. Let's break down how they work
for these purposes in simple terms.
Basics of Trading with Futures

Bullish View (Expecting Prices to Rise): Investors who

expect the price of a stock or index to go up take a "long
position" in futures contracts.

Bearish View (Expecting Prices to Fall): Investors who

expect the price to go down take a "short position" in
futures contracts.

Bullish view: Long futures:

Let's say a trader expects the stock price of XYZ Ltd to

increase from Rs. 1298 to Rs. 1350 in the next week. The
current near-month futures contract for XYZ is trading at Rs.
1300.

Strategy

Since the trader expects the stock price to rise, he can:

1. Buy the stock directly.

2. Go long (buy) a futures contract for XYZ.

Futures contracts allow traders to control a large number of

shares with a smaller amount of money. This is known as
leverage.
Parth Verma The Valuation School
Parth Verma The Valuation School

Example:

Stock Price Now: Rs. 1300

Lot Size: 850 shares (one futures contract represents
850 shares)
Contract Value: Rs. 1300 x 850 = Rs. 11,05,000
Margin Required: Rs. 2,21,000 (20% of contract value)

The margin is the amount of money the trader needs to

pay upfront to hold the futures position.

Case 1: Buying the Stock Directly

If the trader buys 850 shares directly at Rs. 1300, the total
investment is Rs. 11,05,000.

Case 2: Taking a Long Position in Futures

Initial Position: Buy one futures contract at Rs. 1300.

Investment (Margin): Rs. 2,21,000

Suppose a week later, the stock price rises to Rs. 1345 and
the futures contract rises to Rs. 1346.
Calculating Returns

Direct Stock Purchase:

New Stock Price: Rs. 1345
Profit per Share: Rs. 1345 - Rs. 1300 = Rs. 45
Total Profit: 45 x 850 = Rs. 38,250
Return on Investment: (Rs. 38,250 / Rs. 11,05,000) x 100
≈ 3.46%

Futures Position:
New Futures Price: Rs. 1346
Profit per Share: Rs. 1346 - Rs. 1300 = Rs. 46
Total Profit: 46 x 850 = Rs. 39,100
Return on Investment: (Rs. 39,100 / Rs. 2,21,000) x 100
= 17.7%

(a) Purchase of 850 (b) Long position in XYZ

shares of XYZ Ltd futures contract (lot size: 850)

Cash outflow is the cost of buying

Cash outflow is the margin on
these shares: 850 x Rs.1298
the futures position: Rs.2,21,000
= Rs. 11,03,300

Profit on selling the shares Profit on squaring-off of futures

= Rs.39,950 i.e., (1345-1298) * 850 position = Rs.39,100, i.e.
(1346-1300) * 850

Return on investment: 3.62% Return on investment: 17.69%

(39950/11,03,300) (39100/2,21,000)

Parth Verma The Valuation School

Parth Verma The Valuation School

By using futures contracts, the trader achieves a

much higher return on investment (17.7%) compared
to directly buying the shares (3.46%).

This is due to the leverage effect, where the initial cash

margin is much smaller in the futures market than in the
cash market, allowing for potentially greater returns.

However, it's important to remember that leverage can

also amplify losses, so it's crucial to manage risks carefully.

Bearish view: Short futures:

Expecting Stock Price to Fall

Stock: ABC LTD.
Current Stock Price: Rs. 1595
Expected Future Stock Price: Rs. 1520
Current Futures Price: Rs. 1602

Two Options for the Trader

1. Sell Shares Now, Buy Back Later:

Requires owning the shares in a demat account.

Sell shares today at Rs. 1595 and buy back at Rs.1520 later.
2. Short Futures Contract:
Doesn't require owning the actual shares.
Short (sell) ABC LTD. futures at Rs. 1602 and cover (buy
back) at a lower price.

Shorting a futures contract allows traders to bet on price

declines without owning the stock.

This method requires a margin deposit but not the full

value of the stock.

Example Calculation

Lot Size of ABC LTD. Futures: 550 shares

Contract Value: Rs. 1602 x 550 = Rs. 8,81,100
Margin Requirement: 20% of Rs. 8,81,100 = Rs. 1,76,220

Process:

1. Initial Short Position:

Short 1 futures contract at Rs. 1602.
Margin required: Rs. 1,76,220.

2. Price Movement:
Stock price falls to Rs. 1525.
Futures price falls to Rs. 1527.

3. Closing the Position:

Square off (buy back) the futures position at Rs. 1527.

Parth Verma The Valuation School

Parth Verma The Valuation School

Calculating the Profit

Initial Short Price: Rs. 1602

Cover Price: Rs. 1527
Price Difference (Profit per Share): Rs. 1602 - Rs. 1527 = Rs.
75
Total Profit: Rs. 75 x 550 = Rs. 41,250

Return on Investment (ROI)

Initial Cash Outlay (Margin): Rs. 1,76,220

Profit: Rs. 41,250
ROI: (Rs. 41,250 / Rs. 1,76,220) x 100 = 23.41%

By shorting the futures contract, the trader:

Initial Action: Sells futures at Rs. 1602.
Outcome: Buys back at Rs. 1527 after the price falls.
Profit: Rs. 41,250 on a Rs. 1,76,220 margin.
ROI: 23.41%

Shorting futures allows traders to profit from falling prices

without needing to own the actual shares, requiring only a
margin deposit.

This makes it a flexible and powerful tool for expressing

bearish views in the market.
Using futures for arbitrage:

Arbitrage involves exploiting price differences between

markets to make a risk-free profit.

Let's break down how traders use futures contracts for

arbitrage with a simple example.

Key Points:

1. Fair Futures Price: The theoretical price of a futures

contract, considering the cost of carrying the underlying asset.

2. Actual Futures Price: The price at which the futures

contract is currently trading in the market.

3. Cost of Carry: Includes interest costs, storage costs, and

other costs associated with holding the underlying asset.

Types of Arbitrage

Cash-and-Carry Arbitrage: Profitable when the traded

futures price is higher than the fair futures price.

Reverse Cash-and-Carry Arbitrage:

Profitable when the traded futures price is lower than the
fair futures price.

Parth Verma The Valuation School

Parth Verma The Valuation School

Cash and Carry Arbitrage:

Given Data:
Cash Market Price of Stock A: Rs. 1500
3-month Futures Price of Stock A: Rs. 1550
Contract Multiplier: 100 shares
Cost of Carry: 9% per annum (approx. 0.75% per month)

Calculate Fair Futures Price:

Formula: Fair Futures Price = Spot Price * e (Cost of
Carry∗Time)
Fair Futures Price: 1500 * e0.00753 or 1500 * e0.093/12
= 1534.13

Since the traded futures price Rs. 1550 is higher than the fair
futures price Rs. 1534.13, the futures contract is overvalued.

Arbitrage Strategy

1. Buy 100 shares of Stock A at Rs. 1500.

2. Sell 1 futures contract of Stock A at Rs. 1550.

Profit Calculation

Difference between Actual and Fair Futures Prices:

Difference per Share: Rs. 1550 - Rs. 1534.13 = Rs. 15.87
Total Arbitrage Profit: Rs. 15.87 * 100 shares = Rs. 1587
On Expiry Day:

Case I: Stock Price Rises to Rs. 1580

Profit on Shares: (1580−1500)×100=Rs.8000

Loss on Futures: (1580−1550)×100=Rs.3000
Gross Gain from Arbitrage: Rs. 5000
Cost of Arbitrage: Rs. 3413
Net Gain: 5000−3413= Rs.1587

Case II: Stock Price Falls to Rs. 1480

Loss on Shares: (1500−1480)×100= Rs.2000

Profit on Futures: (1550−1480)×100= Rs.7000
Gross Gain from Arbitrage: Rs.5000
Cost of Arbitrage: Rs. 3413
Net Gain: 5000−3413= Rs.1587

In both scenarios, the net gain remains Rs. 1587, which implies
how arbitrage can lock in risk free profits by exploiting the
difference between the actual futures price and the fair
futures price.

This example illustrates the concept of arbitrage using stock

futures in a simplified manner.

Parth Verma The Valuation School

Parth Verma The Valuation School

Reverse cash and carry arbitrage:

Reverse cash-and-carry arbitrage involves taking

advantage of futures contracts trading at a discount to the
cash market price. Here’s a simplified explanation using a
practical example.

Example:

Given Data:
Cash Market Price of Stock B: Rs. 100
One-month Futures Price of Stock B: Rs. 90
Contract Multiplier: 200 shares
Cost of Carry: 9% per annum (.75% per month)

Arbitrage Strategy

1. Buy 1 Futures Contract: at Rs. 90.

2. Sell 200 Shares of Stock B: at Rs. 100 in the cash market.

Initial Arbitrage Profit Calculation:

Difference per Share: Rs. 100 (cash) - Rs. 90 (futures)

= Rs. 10
Total Arbitrage Profit: Rs. 10 * 200 shares = Rs. 2000
On Expiry Day:

Case I: Stock Price Rises to Rs. 110

Loss on Cash Market Position: (110−100)×200=Rs.2000

Profit on Futures Position: (110−90)×200=Rs.4000
Net Gain: Rs. 2000 (Rs. 4000 - Rs. 2000)

Case II: Stock Price Falls to Rs. 85

Profit on Cash Market Position: (100−85)×200=Rs.3000

(100 - 85) \times 200 = Rs.3000(100−85)×200= Rs.3000
Loss on Futures Position: (90−85)×200=Rs.1000(90 - 85)
\times 200 = Rs. 1000(90−85)×200= Rs.1000
Net Gain: Rs. 2000 (Rs. 3000 - Rs. 1000)

Adding Interest Earned

Assuming you can invest the proceeds from selling the

200 shares at 9% per annum:

Interest for One Month:

Formula: (2000*e0.09*1/12) - 2000 = Rs.150.56

Total Gain for Each Case:

Case I: Rs. 2000 + Rs. 150.56 = Rs. 2150.56
Case II: Rs. 2000 + Rs. 150.56 = Rs. 2150.56

Parth Verma The Valuation School

Parth Verma The Valuation School

Mid-Month Position Reversal

If the arbitrageur decides to reverse the positions before

expiry (say, on the 15th of the month):

New Market Prices:

Spot Price: Rs. 130
Futures Price: Rs. 135

Profit Calculation:
Loss on Cash Market Position: (130−100) × 200= Rs.6000
Profit on Futures Position: (135−90) × 200 = Rs.9000
Net Gain: Rs. 3000 (Rs. 9000 - Rs. 6000)

Interest Earned for 15 Days:

Formula: 20000×e (0.09×15/365) − 20000 = Rs.74.11
Total Gain: Rs. 3000 + Rs. 74.11 = Rs. 3074.11

Reverse cash-and-carry arbitrage allows traders to profit

from futures contracts trading at a discount to cash prices.

The strategy involves buying futures contracts and selling

the underlying stock in the cash market, then reversing the
positions at favorable prices.

This example illustrates how the strategy works in different

market scenarios and includes the effect of interest earned
on the proceeds from the stock sale.
Calendar spread:

Calendar spread arbitrage involves trading futures contracts

of the same stock but with different expiration months.
The goal is to exploit price differences between these
contracts to make a profit.

Key Points

1. Futures Contracts: Agreements to buy or sell a stock at a

predetermined price at a specified future date.
2. Near-Month Futures: Contracts that expire soon.
3. Mid-Month Futures: Contracts that expire later than near-
month futures.
4. Fair Price: The theoretically correct price of a futures
contract, considering factors like the current stock price and
interest rates.

Example:

Given Data:
Current Stock Price: Rs. 120
Near-Month Futures Price: Rs. 121.30
Mid-Month Futures Price: Rs. 121.50
Interest Rate: 8% per annum

Calculate Fair Prices:

Fair Price of Near - Month Futures: 120×e (0.08/12) = 120.80
Fair Price of Mid - Month Futures: 120×e (0.08×2/12) = 121.61
Parth Verma The Valuation School
Parth Verma The Valuation School

Arbitrage Opportunity:

The fair price difference between the two futures should

be about 81 paise (121.61 - 120.80), but the current
difference is only 20 paise (121.50 - 121.30).

Which means the near-month futures contract is

overpriced compared to the mid-month futures contract.

Arbitrage Strategy:
Short the Near-Month Futures: Sell at Rs. 121.30.
Long the Mid-Month Futures: Buy at Rs. 121.50.

On Expiry Day:

Case 1: Stock Price Rises to Rs. 122

Near-Month Futures Price: Rs. 122
Loss on Near-Month Futures: 121.30−122=−0.70
Mid-Month Futures Price: Rs. 122.82
Gain on Mid-Month Futures: 122.82−121.50=1.32
Net Gain on Calendar Spread: 1.32−0.70=0.62

Case 2: Stock Price Falls to Rs. 120

Near-Month Futures Price: Rs. 120
Gain on Near-Month Futures: 121.30−120=1.30
Mid-Month Futures Price: Rs. 120.80
Loss on Mid-Month Futures: 121.50−120.80=−0.70
Net Gain on Calendar Spread: 1.30−0.70=0.60
Calendar Spread Advantage:

1. Non-Directional Bet: No need to predict stock price

direction.
2. Opposite Positions: Short one contract and long another,
balancing risks.
3. Low Returns: Profits come from small price differences.

Practical Considerations:

Market Efficiency: Mispricing is rare and quickly corrected

by other traders.
Execution Timing: Must enter and exit both positions
simultaneously to lock in profits and avoid losses.

Calendar spread arbitrage allows traders to profit from small

discrepancies between futures contracts of different
expiration months.

It’s a low-risk, low-return strategy that doesn’t depend on

market direction.

Efficient execution is crucial to capture profits, as market

conditions and prices can change rapidly.

Parth Verma The Valuation School

Parth Verma The Valuation School

5.2 USE OF OPTIONS FOR TRADING AND HEDGING

Trading strategies using options:

There are mainly 3 categories for strategies using options:

Vertical spread Horizontal spread Diagonal spread

1. Vertical spread:
They are formed by using options of same expiry but
different strike price

Classification:
Bullish Vertical Spread
1. Using Calls 2. Using Puts

Bearish Vertical Spread

1. Using Calls 2. Using Puts

Bullish Vertical Spread using Calls:

A bull call spread is an options trading strategy used when
you expect the market to rise (bullish), but you also want to
reduce your initial cost. It involves two steps:

Buy a Call Option at a lower strike price.

Sell a Call Option at a higher strike price.
Why Bull Call Spread?

Lower Cost: Buying a call option costs money (premium).

By selling a call option at a higher strike price, you receive
some premium, reducing the overall cost.
Limited Risk: Your potential loss is limited to the net
premium paid.
Limited Profit: Your profit is capped because any gain
beyond the higher strike price is offset by the loss on the
sold call.

Example:

1. Bullish View: You expect the market to go up.

2. Strike Prices:
Buy a call option with a strike price of 17500.
Sell a call option with a strike price of 17800.

Premiums:
Buy 17500 Call Option: Costs Rs 185.
Sell 17800 Call Option: Receive Rs 61.

Net Cost (Initial Cash Outflow):

Cost of 17500 Call: Rs 185.
Premium Received for 17800 Call: Rs 61.
Net Premium Paid: Rs 124 (185 - 61).

Parth Verma The Valuation School

Parth Verma The Valuation School

Payoff and Profit Calculation

1. Maximum Profit: Limited to the difference between the

two strike prices minus the net premium paid.
Strike Price Difference: 17800 - 17500 = 300.
Net Premium Paid: Rs 124.
Maximum Profit: 300 - 124 = Rs 176.

2. Maximum Loss: Limited to the net premium paid.

Maximum Loss: Rs 124.

3. Break-Even Point: The stock price at which you neither

make a profit nor a loss.
Break-Even Price: Lower strike price + net premium paid.
Break-Even Point: 17500 + 124 = 17624.

A bull call spread is a way to profit from a moderate rise in

the market while keeping your risk and costs under control.

Option Call Call

Long/Short Long Short
Strike 17500 17800
Premium 185 61
Spot 17500
Index value at expiry P&L long call P&L short call Net gain

17100 -185 61 -124

17200 -185 61 -124
17300 -185 61 -124
17400 -185 61 -124
17500 -185 61 -124
17600 -85 61 -24
17700 15 61 76
17800 115 61 176
17900 215 -39 176
18000 315 -139 176

Parth Verma The Valuation School

Parth Verma The Valuation School

Bullish Vertical Spread using Puts:

A bull put spread is an options trading strategy used when

you expect the market to rise (bullish). It involves two steps:

1. Sell a Put Option at a higher strike price.

2. Buy a Put Option at a lower strike price.

Why Bull Put Spread?

Income Generation: You receive a net premium by selling

a put option and buying a cheaper one.
Limited Risk: Buying the lower strike put limits your
potential losses.
Limited Profit: Your maximum profit is the net premium
received.

Example:

1. Bullish View: You expect the market to go up.

2. Strike Prices:
Sell a put option with a strike price of 17500.
Buy a put option with a strike price of 17000.

Premiums:
Sell 17500 Put Option: Receive Rs 125.
Buy 17000 Put Option: Pay Rs 34.
Net Premium Received (Initial Cash Inflow):
Premium Received for 17500 Put: Rs 125.
Premium Paid for 17000 Put: Rs 34.
Net Premium Received: Rs 91 (125 - 34).

Payoff and Profit Calculation

1. Maximum Profit: Limited to the net premium received.

Maximum Profit: Rs 91.

2. Maximum Loss: Limited to the difference between the

strike prices minus the net premium received.
Strike Price Difference: 17500 - 17000 = 500.
Net Premium Received: Rs 91.
Maximum Loss: 500 - 91 = Rs 409.

3. Break-Even Point: The index level at which you neither

make a profit nor a loss.
Break-Even Point: Higher strike price - net premium
received.
Break-Even Point: 17500 - 91 = 17409.

A bull put spread is a way to profit from a moderate rise in the

market while keeping your risk and potential losses limited

Parth Verma The Valuation School

Parth Verma The Valuation School

Option Call Call

Long/Short Short Long

Strike 17500 17000

Premium 125 34
Spot 17500

Index value at expiry P&L short put P&L long put Net gain

16800 -575 166 -409

16900 -475 66 -409
17000 -375 -34 -409
17100 -275 -34 -309
17200 -175 -34 -209
17300 -75 -34 -109
17400 25 -34 -9
17500 125 -34 91
17600 125 -34 91
17700 125 -34 91
17800 125 -34 91
Bearish Vertical Spread using calls:

A bear call spread is an options trading strategy used when

you expect the market to fall (bearish). It involves two steps:

Sell a Call Option at a lower strike price with a higher

premium.
Buy a Call Option at a higher strike price with a lower
premium.

Why Bear Call Spread?

Income Generation: You receive a net premium by selling a

call option and buying a cheaper one.
Limited Risk: Buying the higher strike call limits your
potential losses.
Limited Profit: Your maximum profit is the net premium
received.
Parth Verma The Valuation School
Parth Verma The Valuation School

Example:

1. Bearish View: You expect the market to go down.

2. Strike Prices:
Sell a call option with a strike price of 17500 and receive
a high premium.
Buy a call option with a strike price of 17800 and pay a
lower premium.

Premiums:
Sell 17500 Call Option: Receive Rs 185.
Buy 17800 Call Option: Pay Rs 61.

Net Premium Received (Initial Cash Inflow):

Premium Received for 17500 Call: Rs 185.
Premium Paid for 17800 Call: Rs 61.
Net Premium Received: Rs 124 (185 - 61).

Payoff and Profit Calculation

1. Maximum Profit: Limited to the net premium received.

Maximum Profit: Rs 124.

2. Maximum Loss: Limited to the difference between the

strike prices minus the net premium received.
Strike Price Difference: 17800 - 17500 = 300.
Net Premium Received: Rs 124.
Maximum Loss: 300 - 124 = Rs 176.
3. Break-Even Point: The index level at which you neither
make a profit nor a loss.
Break-Even Point: Lower strike price + net premium
received.
Break-Even Point: 17500 + 124 = 17624.

A bear call spread is a way to profit from a moderate decline in

the market while keeping your risk and potential losses limited.

Option Call Call

Long/Short Long Short
Strike 17800 17500
Premium 61 185
Spot 17500

Parth Verma The Valuation School

Parth Verma The Valuation School

Index value at expiry P&L long call P&L short call Net gain

17100 -61 185 124

17200 -61 185 124
17300 -61 185 124
17400 -61 185 124
17500 -61 185 124
17600 -61 -85 24
17700 -61 -15 -76
17800 -61 -115 -176
17900 39 -215 -176
18000 139 -315 -176
Bearish Vertical Spread using puts:

A bull put spread is an options trading strategy used when you

expect the market to rise (bullish). It involves two steps:

1. Buy a Put Option at a higher strike price and pay a premium.

2. Sell a Put Option at a lower strike price and receive a premium.

Why Bull Put Spread?

Cost Reduction: Selling a put option helps offset the cost of

buying a put option.
Limited Risk and Profit: Both potential profit and loss are
capped.

Example:

1. Bearish View: You expect the market to fall.

2. Strike Prices:
Buy a put option with a strike price of 17500 and pay a
premium.
Sell a put option with a strike price of 17000 and receive
a premium.

Premiums:
Buy 17500 Put Option: Pay Rs 125.
Sell 17000 Put Option: Receive Rs 34.
Parth Verma The Valuation School
Parth Verma The Valuation School

Net Premium Paid (Initial Cash Outflow):

Premium Paid for 17500 Put: Rs 125.
Premium Received for 17000 Put: Rs 34.
Net Premium Paid: Rs 91 (125 - 34).

Payoff and Profit Calculation

1. Maximum Profit: Limited to the difference between the

strike prices minus the net premium paid.
Strike Price Difference: 17500 - 17000 = 500.
Net Premium Paid: Rs 91.
Maximum Profit: 500 - 91 = Rs 409.

2. Maximum Loss: Limited to the net premium paid.

Maximum Loss: Rs 91.

3. Break-Even Point: The index level at which you neither

make a profit nor a loss.
Break-Even Point: Higher strike price - net premium paid.
Break-Even Point: 17500 - 91 = 17409.

A bull put spread is a way to profit from a moderate

decline in the market while keeping your risk and
potential losses limited.
Option Put Put

Long/Short Short Long

Strike 17000 17500

Premium 34 125
Spot 17500

Index value at expiry P&L short put P&L long put Net gain

16800 -166 575 409

16900 -66 475 409
17000 34 375 409
17100 34 275 309
17200 34 175 209
17300 34 75 109
17400 34 -25 9
17500 34 -125 -91
17600 34 -125 -91
17700 34 -125 -91
17800 34 -125 -91

Parth Verma The Valuation School

Parth Verma The Valuation School

Horizontal Spread

This strategy uses options of the same type (either calls or

puts) with the same strike price but different expiration dates.

The goal is to profit from the change in the difference between

the time values of the two options.

Essentially, it's a bet on whether the premium difference will

increase or decrease.

Diagonal Spread

This strategy combines options on the same underlying asset

but with different expiration dates and different strike prices.

It’s a more complex strategy that aims to take advantage of

movements in both time value and strike price differences.
Straddles
This strategy involves buying or selling both a call and a put
option with the same strike price and expiration date.
1. Long Straddle 2.Short Straddle

Let’s understand with the examples:

Suppose, a stock’s CMP = Rs.6,000

ATM Call option = Rs.257
ATM Put option = Rs.136

In Long straddle,
Long Straddle is an options trading strategy where an
investor buys both a call option and a put option for the
same stock, with the same strike price and expiration date.

This strategy is useful when the investor expects the stock

price to move significantly, but is unsure of the direction.

Key Points:

1. Maximum Loss:
The maximum loss is the total amount spent on buying
the call and put options.
In this example, the premiums paid for the call and put
options are Rs 257 and Rs 136, respectively.
Total premium (maximum loss) = Rs 257 + Rs 136 = Rs 393.

Parth Verma The Valuation School

Parth Verma The Valuation School

2. Potential for Profit:

If the stock price moves significantly up or down, the
investor can make a profit.
The profit potential is unlimited in either direction
(up or down), after covering the total premium paid.

Break-Even Points:
The stock price must move beyond a certain range for the
investor to start making a profit.
Break-Even Point 1: Strike Price - Total Premium
6000−393=5607
Break-Even Point 2: Strike Price + Total Premium
6000+393=6393

Example:

1. Stock Price Falls to 5300:

Long Call: Loses Rs 257 (worthless since the stock price

is below the strike price)
Long Put: Gains Rs 700 (since the strike price is 6000
and the stock price is 5300)
Net Gain: 700 (gain from put) −257 (loss from call) −136
(premium for put) = 307
2. Stock Price Rises to 6700:
Long Call: Gains Rs 700 (since the strike price is 6000
and the stock price is 6700).
Long Put: Loses Rs 136 (worthless since the stock price
is above the strike price).
Net Gain: 700 (gain from call) −136 (loss from put)−257
(premium for call) = 307

Loss Zone:
The investor will incur a loss if the stock price remains
between the two break-even points (5607 and 6393).
The maximum loss of Rs 393 occurs if the stock price
stays exactly at the strike price of Rs 6000.

A Long Straddle is a good strategy when you expect the stock

price to make a big move but are unsure of the direction.

The risk is limited to the total premium paid, but the potential
profit is unlimited if the stock price moves significantly in
either direction.

Option Call Put

Long/Short Long Long
Strike 6000 6000
Premium 257 136
Spot 6000 6000

Parth Verma The Valuation School

Parth Verma The Valuation School

Index value at expiry Long Call Long Put Net Flow

5000 -257 864 607

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:

Short Straddle is an options trading strategy where an

investor sells (writes) both a call option and a put option
for the same stock, with the same strike price and
expiration date.

This strategy is used when the investor expects the stock

price to remain stable, not moving much in either direction.

Parth Verma The Valuation School

Parth Verma The Valuation School

Key Points:

1. Maximum Profit:

The maximum profit is the total premiums received from

selling both the call and put options.
For example, if the premiums for the call and put options
are Rs 257 and Rs 136, respectively, then:
Total premium (maximum profit) = Rs 257 + Rs 136
= Rs 393.

2. Risk of Loss:

The potential for loss is unlimited if the stock price

moves significantly up or down.
This strategy should be used with caution because the
losses can be very large if the stock price moves a lot.

Profit and Loss Scenarios:

1. Stock Price Remains Stable:

If the stock price stays close to the strike price, both the
call and put options expire worthless.
The investor keeps the total premiums received as profit.
2. Stock Price Moves Significantly:

If the stock price moves far above the strike price, the
call option will incur a loss because the investor will have
to sell the stock at the lower strike price.
If the stock price moves far below the strike price, the
put option will incur a loss because the investor will
have to buy the stock at the higher strike price.
These losses can be very large and potentially unlimited.

Example:

1. Stock Price Remains at 6000 (Strike Price):

Short Call: Expires worthless, profit is Rs 257 (premium

received).
Short Put: Expires worthless, profit is Rs 136 (premium
received).
Net Profit: 257+136 = 393257 + 136 = 393257+136 = 393

2. Stock Price Falls to 5300:

Short Call: Expires worthless, profit is Rs 257 (premium

received).
Short Put: Loss of Rs 700 (since the strike price is 6000
and the stock price is 5300).
Net Loss: 700 (loss on put) − 393 (total premiums
received) = 307

Parth Verma The Valuation School

Parth Verma The Valuation School

3. Stock Price Rises to 6700:

Short Call: Loss of Rs 700 (since the strike price is 6000

and the stock price is 6700)
Short Put: Expires worthless, profit is Rs 136 (premium
received)
Net Loss: 700 (loss on call) − 393 (total premiums
received) = 307

A Short Straddle is a good strategy when you expect the stock

price to stay stable.

The maximum profit is limited to the total premiums received,

but the potential for loss is unlimited if the stock price moves
significantly in either direction.

This strategy should be used with caution and a good

understanding of the risks involved.

Option Call Put

Long/Short Short Short

Strike 6000 6000

Premium 257 136
Spot 6000 6000
CMP Short Call Short Put Net Flow
5000 257 -864 -607
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

Parth Verma The Valuation School

Parth Verma The Valuation School

Strangles:

Strangle is similar to straddle in terms of catching the market

move but the implementation and approach is different.

It includes a combination of different types of options i.e.call

and put with the same underlying and expiry dates but
different strike price.

There are two types of strangles:

1. Long straddle
2. Short Straddle

Long strangle:

Long Strangle is an options trading strategy similar to a

straddle, but with different strike prices for the call and put
options.

This strategy is used when the investor expects the stock

price to move significantly in either direction (up or down),
but with a lower cost than a straddle since the options are
out-of-the-money.
Key Points:

1. Structure:

Call Option: Strike price above the current stock price.

Put Option: Strike price below the current stock price.
Both options are out of the money, meaning the stock
price is not yet at the strike prices of either option.

2. Cost and Maximum Loss:

The total cost (and maximum loss) is the sum of the

premiums paid for both options.
In this example:
Call premium: Rs 145 (for 6200 strike price).
Put premium: Rs 140 (for 6000 strike price).
Total premium (maximum loss) = Rs 145 + Rs 140 =
Rs 285.

3. Potential for Profit:

The potential profit is unlimited if the stock price moves
significantly beyond the break-even points in either
direction.
Profit starts once the stock price moves past the break-
even points.

Parth Verma The Valuation School

Parth Verma The Valuation School

Break Even Points (BEPs):

Break-Even Point 1: Strike Price of Put - Total Premium

6000−285 = 5715

Break-Even Point 2: Strike Price of Call + Total Premium

6200+285 = 6485

Example:

1. Stock Price Falls to 5700:

Long Call: Loss of Rs 145 (expires worthless since the

stock price is below the strike price).
Long Put: Profit of Rs 300 (6000 strike price - 5700
stock price).
Net Position: 300 (profit from put) − 145 (loss from call)
−140 (premium for put) = 15

2. Stock Price Rises to 6800:

Long Call: Profit of Rs 600 (6800 stock price - 6200
strike price).
Long Put: Loss of Rs 140 (expires worthless since the
stock price is above the strike price).
Net Position: 600 (profit from call) − 140 (loss from put)
− 145 (premium for call) = 315
Loss Zone:
The investor incurs a loss if the stock price remains
between the two strike prices (6000 and 6200).
The maximum loss of Rs 285 occurs if the stock price
stays between 6000 and 6200 at expiration.

A Long Strangle is a good strategy when you expect

significant movement in the stock price but want to pay lower
premiums than with a straddle.

The maximum loss is limited to the total premiums paid, while

the potential profit is unlimited if the stock price moves
significantly beyond the break-even points in either direction.

Option Call Put

Long/Short Long Long

Strike 6200 6000

Premium 145 140
Spot 6100

Parth Verma The Valuation School

Parth Verma The Valuation School

CMP Long Call Long Put Net Flow

5100 -145 760 615
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:

Short Strangle is the opposite of a Long Strangle. In this

strategy, an investor sells (writes) both a call and a put option
with different strike prices and both out of the money.

This strategy is used when the investor expects the stock

price to remain stable.

Key Points:

1. Structure:

Call Option: Strike price above the current stock price.

Put Option: Strike price below the current stock price.
Both options are out-of-the-money.

Parth Verma The Valuation School

Parth Verma The Valuation School

2. Maximum Profit:

The maximum profit is the total premiums received from

selling both options.
In this example:
Call premium: Rs 145 (for 6200 strike price).
Put premium: Rs 140 (for 6000 strike price).
Total premium (maximum profit) = Rs 145 + Rs 140
= Rs 285.

3. Potential for Loss:

The potential loss is unlimited if the stock price moves

significantly in either direction (up or down).

Break-Even Points (BEPs):

Break-Even Point 1: Strike Price of Put - Total Premium
6000−285=5715
Break-Even Point 2: Strike Price of Call + Total Premium
6200+285=6485

Example:

1. Stock Price Falls to 5700:

Short Call: Profit of Rs 145 (expires worthless since the
stock price is below the strike price).
Short Put: Loss of Rs 300 (6000 strike price - 5700
stock price).
Net Position: 145(profit from call)−300(loss from
put)+140(premium from put)=−15
2. Stock Price Rises to 6800:
Short Call: Loss of Rs 600 (6800 stock price - 6200
strike price).
Short Put: Profit of Rs 140 (expires worthless since the
stock price is above the strike price).
Net Position: 140 (profit from put) −600 (loss from call)
+145 (premium from call) = −315

Profit Zone:
The investor makes a profit if the stock price stays
between the two strike prices (6000 and 6200).
The maximum profit of Rs 285 occurs if the stock price
stays between 6000 and 6200 at expiration.

Loss Zone:
The investor incurs a loss if the stock price
moves beyond the break-even points (5715 and 6485).
The potential loss is unlimited in either direction (if the
stock price falls below 5715 or rises above 6485).

A Short Strangle is a good strategy when you expect the

stock price to stay stable.

The maximum profit is limited to the total premiums

received, while the potential loss is unlimited if the stock
price moves significantly beyond the break-even points.
This strategy requires careful risk management due to the
high potential for loss.
Parth Verma The Valuation School
Parth Verma The Valuation School

Option Call Put

Long/Short Short Short
Strike 6200 6000
Premium 145 140
Spot 6100

CMP Long Call Long Put Net Flow

5100 145 -760 -615

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
Parth Verma The Valuation School

6700 -355 140 -215

6800 -455 140 -315
6900 -555 140 -415
7000 -655 140 -515
7100 -755 140 -615

Covered Call:

A Covered Call strategy is used by an investor who owns a

stock and wants to generate extra income from it without
selling the stock.

This is achieved by selling a call option on the stock, earning

a premium that helps reduce the overall cost of holding the
stock.
1. How It Works:
Stock Holding: The investor owns a stock.
Selling Call Option: The investor sells a call option with a
strike price higher than the current stock price.
Earning Premium: The investor earns a premium from
selling the call option.

2. Benefits:
Generates extra income from the premium received.
Reduces the overall cost of holding the stock.

3. Scenarios:

a. Stock Price Rises:

Example: Stock bought at Rs 1590, call option sold with a
strike price of 1600, premium received Rs 10.
Stock Price at 1640:
Profit on Stock: 1640−1590 = 50
Loss on Call Option: −(1640−1600)+10 = −30
Net Profit: 50−30 = 20

b. Stock Price Falls:

Example: Stock bought at Rs 1590, call option sold with a
strike price of 1600, premium received Rs 10.
Stock Price at 1520:
Loss on Stock: 1520−1590=−70
Profit on Call Option: 10 (the call option expires worthless)
Net Loss: −70+10=−60

Parth Verma The Valuation School

Parth Verma The Valuation School

5. Important Considerations:

Strike Price: The strike price of the sold call option is

crucial.
Close to Current Price: Higher premium, but limits
potential gains from the stock.
Far from Current Price: Lower premium, but allows
for more potential gains from the stock.

Decision Making: Choose the strike price based on your

expectations for the stock price and your need for
upfront premium vs. potential stock price gains.

6. Synthetic Short Put:

The covered call strategy is similar to holding a short put

option.
It limits the upside (gains) and leaves
potential for unlimited downside (losses).

7. Arbitrage Opportunity:

If a 1600 strike put option is priced differently than Rs 20,

you can create a synthetic short put and potentially make
a risk-free profit.
Ex: Sell the call option for Rs 20, buy the put option for Rs
17 and make a risk-free profit of Rs 3 (minus transaction
costs).
A Covered Call strategy is a way to earn extra income from
stocks you already own by selling call options.

It provides additional income through premiums but limits the

potential gains if the stock price rises significantly.

Choosing the right strike price is key to balancing immediate

income with potential future gains. This strategy is best used
when you expect the stock price to remain relatively stable or
grow slowly.

Long stock 1590

Strike 1600
Premium 10

Parth Verma The Valuation School

Parth Verma The Valuation School

CMP Stock Call Net Flow

1490 -100 10 -90

1500 -90 10 -80
1510 -80 10 -70
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
Collar:
A Collar Strategy is an extension of the covered call strategy
designed to limit downside risk. It involves holding the stock,
selling a call option, and buying a put option.

This strategy is useful for investors who want to protect

against significant losses while still generating some income.

Key Points:
Structure:
Long Stock: Own the stock.
Short Call: Sell a call option (earns a premium).
Long Put: Buy a put option (pays a premium).

Purpose:
Limit Downside Risk: The put option acts as insurance
against the stock price falling too much.
Generate Income: The call option provides additional
income through the premium received.

Example:
Stock Price: Rs 1590
Short Call: Strike price 1600, premium received Rs 10
Long Put: Strike price 1580, premium paid Rs 7

Break Even Point (BEP):

Calculation: Purchase price of the stock - net premium
received/paid.
BEP in this example: Rs 1590 - (Rs 10 - Rs 7) = Rs 1587
Parth Verma The Valuation School
Parth Verma The Valuation School

Result:

1. Stock Price Falls to 1490:

Long Stock: 1490−1590=−100
Short Call: +10+10+10 (call expires worthless)
Long Put: 1580−1490−7=83
Net Position: −100+10+83=−7

2. Stock Price Rises to 1690:

Long Stock: 1690−1590=100
Short Call: 10−(1690−1600)=−80
Long Put: −7 (put expires worthless)
Net Position: 100−80−7=13

Comparison with Covered Call:

Downside Protection: The collar strategy provides

downside protection, limiting the maximum loss.
Reduced Profit Potential: The addition of the put option
reduces the maximum profit compared to a covered call.
Profit & Loss:

Maximum Loss: Limited to the premium paid for the put

option, minus the premium received from the call option.
Maximum Profit: Capped by the strike price of the call
option minus the initial cost.
Break-Even Point: Adjusted higher by the net
premium paid for the put option.

A Collar Strategy is a prudent choice for investors who want to

protect against significant losses while still earning some
income from the stock.

It effectively limits both the potential loss and the potential

profit, making it a balanced approach for conservative
investors.

Long Stock 1590 Long Put 1580

Short Call 1600 Premium 7

Call Premium 10

Parth Verma The Valuation School

Parth Verma The Valuation School

CMP Long Stock Short Call Long Put Net

1490 100 10 83 -7
1500 90 10 73 -7
1510 80 10 63 -7
1520 70 10 53 -7
1530 60 10 43 -7
1540 50 10 23 -7
1550 40 10 13 -7
1560 30 10 3 -7
1570 20 10 -7 -7
1580 10 10 -7 -7
1590 0 10 -7 3
1600 -10 10 -7 13
1610 -20 0 -7 13
1620 -30 -10 -7 13
1630 -40 -20 -7 13
1640 -50 -30 -7 13
1650 -60 -40 -7 13
1660 -70 -50 -7 13
1670 -80 -60 -7 13
1680 -90 -70 -7 13
1690 -100 -80 -7 13
Butterfly Spread :

A Butterfly Spread is an options strategy designed to limit

both potential profit and potential loss.

It involves combining multiple options positions to create a

payoff that looks like a butterfly's wings.

This strategy is an extension of the short straddle but with

limited risk.

Parth Verma The Valuation School

Parth Verma The Valuation School

Key Points:

1. Structure:
Long Call 1: Buy a call option at a lower strike price.
Short Call 2: Sell two call options at a middle strike price.
Long Call 3: Buy a call option at a higher strike price.

2. Purpose:
Limit Downside Risk: By buying out of the money calls, the
trader limits the risk of significant loss if the stock moves
sharply.
Create a Profit Zone: The strategy aims to profit if the
stock price remains within a specific range at expiration.

3. Example Scenario:
Long Call 1: Strike price 6000, premium paid Rs 230.
Short Call 2: Strike price 6100, premium received Rs 150
(for each of the two options).
Long Call 3: Strike price 6200, premium paid Rs 100.

4. Net Cost:
Total Premium Paid: 230 (LongCall1) + 100 (LongCall3)
= 330
Total Premium Received: 150×2 (ShortCall2) = 300
Net Cost: 330−300 = 30 (This is the maximum possible
loss)
Result:

1. Stock Price at 6000 or Lower:

Long Call 1: Expires worthless, loss = Rs 230.
Short Call 2: Expires worthless, gain = Rs 150 × 2 = Rs 300.
Long Call 3: Expires worthless, loss = Rs 100.
Net Position: −230+300−100 = −30

2. Stock Price at 6100:

Long Call 1: 6100−6000−230 = −130
Short Call 2: 150×2 = 300
Long Call 3: Expires worthless, loss = Rs 100.
Net Position: −130+300−100 = 70 (Maximum Profit)

3. Stock Price at 6200 or Higher:

Long Call 1: 6200−6000−230 = −30
Short Call 2: 150−100 (difference in strike prices) = 50
for each, total = Rs 100.
Long Call 3: 6200−6200−100 = −100
Net Position: −30+100−100 = −30

Break-Even Points (BEPs):

Lower BEP: 6000+30 = 6030
Upper BEP: 6200−30 = 617

Parth Verma The Valuation School

Parth Verma The Valuation School

Alternative Structures:

Using Puts: Buy one put at the highest strike, sell two puts
at the middle strike, and buy one put at the lowest strike.
Combination of Calls and Puts: Buy one call at the lowest
strike, sell one call at the middle strike, buy one put at the
highest strike, and sell one put at the middle strike.

A Butterfly Spread is a limited profit, limited loss strategy

that profits from the stock price staying within a specific
range.

It provides a balanced approach, offering controlled risk

and reward.

This strategy is ideal for traders expecting low volatility in

the stock price.
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

Parth Verma The Valuation School

Parth Verma The Valuation School

Options Call Call Call Call

Long/Short Long Short Long Short
Strike 6000 6100 6200 6100
Premium 230 150 100 150
Spot 6100
Hedging with options:

Hedging with options is like buying insurance for your

investments. It helps protect against unexpected changes
in stock prices.

Key Points:

1. Purpose of Options in Hedging:

Call Options: Protect against unexpected price increases.
Put Options: Protect against unexpected price decreases.

2. How Call Options Work:

Scenario: You plan to buy a stock in the future but worry
the price might go up.
Solution: Buy a call option to lock in a purchase price now.

3. Example:
Current Stock Price: Rs. 463
Call Option: Strike price Rs. 460, premium Rs. 19
Plan: Buy 1500 shares at the end of the month.

Parth Verma The Valuation School

Parth Verma The Valuation School

4. Possible Outcomes:
Stock Price Rises to Rs. 520:
Call Option: Becomes valuable. You can exercise it to
buy at Rs. 460.
Calculation: Market Price: Rs. 520
Call Option Exercise Price: Rs. 460
Benefit: Rs. 520 - Rs. 460 = Rs. 60 gain per share
(minus Rs. 19 premium).
Net Gain: Rs. 60 - Rs. 19 = Rs. 41 per share.
Total Protection: Your effective cost is Rs. 460 + Rs. 19
= Rs. 479 per share, lower than Rs. 520.

Stock Price Falls to Rs. 430:

Call Option: Expires worthless (no need to use it).
Action: Buy stock at the lower market price.
Loss: Only the premium paid, Rs. 19 per share.
Benefit: Stock is cheaper than expected, cost is
Rs. 430 per share.

5. How Put Options Work:

Scenario: You own stock and worry the price might drop.
Solution: Buy a put option to lock in a selling price now.
Using options for hedging is like buying insurance for your
investments. Call options protect against rising prices when
planning to buy stocks, while put options protect against
falling prices when you already own stocks.

This strategy helps manage risk and provides peace of mind

against market volatility.

Protective Put:

A hedged position helps protect an investor’s portfolio from

falling prices while still allowing for profits if prices rise. This is
like buying insurance for your investments.

Key Points:

1. Risk of Falling Prices:

When an investor holds stocks (long position),
they risk losing money if stock prices fall.

2. Hedging Strategy:
To protect against this risk, investors can buy put
options. A put option allows them to sell their stock at
a predetermined price, even if the market price falls.

3. Example:
Stock Price: Rs. 1600
Put Option: Strike price Rs. 1600, premium Rs. 20

Parth Verma The Valuation School

Parth Verma The Valuation School

4. Possible Outcomes:
If Prices Fall to Rs. 1530:
Stock Position: Loss of Rs. 70 (1530 - 1600)
Put Option: Gain of Rs. 50 (1600 - 1530 - 20 premium)
Net Loss: Rs. 20 (loss is limited to the premium paid)

If Prices Rise to Rs. 1660:

Stock Position: Gain of Rs. 60 (1660 - 1600)
Put Option: Loss of Rs. 20 (premium paid)
Net Gain: Rs. 40

5. Why Use Put Options?

Limited Losses: The maximum loss is limited to the
premium paid for the put option (Rs. 20 in this case).
Unlimited Gains: If the stock price rises, the investor can
still profit from the increase in stock value, minus the put
option premium.

6. Protective Put = Synthetic Long Call:

Protective Put: Combining a long stock position with a
long put option.
Synthetic Long Call: This strategy mimics the payoff of a
long call option, offering unlimited potential gains and
limited losses.
Using put options as a hedge ensures that an investor can stay
in the market, reducing losses during price drops and still
benefiting from price increases.

Long Cash 1600

Strike 1600
Premium 20

CMP Long Cash Long Put Net Flow

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

Parth Verma The Valuation School

Parth Verma The Valuation School

1650 50 -20 30
1660 60 -20 40
1670 70 -20 50
1680 80 -20 60
1690 90 -20 70
1700 100 -20 80

5.3 ARBITRAGE USING OPTIONS: PUT-CALL PARITY

Arbitrage is the practice of making risk-free profits by

exploiting price differences in different markets or forms.

Put-call parity is a principle used to identify arbitrage

opportunities between call and put options on the same stock.

Formula:

𝑐 + 𝑋 ∗ 𝑒 −𝑟𝑡 = 𝑝 + 𝑆0

c = Premium of call option

p = Premium of put option
X = Strike price of option
𝑆0 = Current price of the underlying asset (stock)
r = Rate of interest
t = Time to expiry
This formula derives the fair or theoretical price of the put
option of the underlying whose stock price and price of call
option is known with the same strike price and expiry date as
of call option.

When the actual market price of the put option is different

from the price calculated using the formula, we have an
arbitrage opportunity. We can make a risk-free profit by this
price difference.

Note: Put call parity principle is only applicable to

European options and not American

Example:

Case 1:

Stock price (So) = Rs. 1251

Call option price (c) = Rs. 47.50
Strike price (X) = Rs. 1240
Interest rate = 8% per year
Time to expiration (t) = 1 month
Applying the put call parity formula:
Fair price of the put option:
𝑐 + 𝑋 ∗ 𝑒 −𝑟𝑡 = 𝑝 + 𝑆0

Parth Verma The Valuation School

Parth Verma The Valuation School

Rearranging the formula:

𝑝 = 𝑐 + 𝑋 ∗ 𝑒 −𝑟𝑡 - 𝑆0
𝑝 = 47.50 + 1240 * e-.08*1/12 - 1251
𝑝 = Rs.28.26

Suppose the put option is trading at Rs. 23.15, which is lower

than the fair price of Rs. 28.26.
So, arbitrage can be done by:
Buy the put option at Rs. 23.15.
Buy the stock at Rs. 1251.
Sell the call option at Rs. 47.50.
Net cash flow = 1251+23.15-47.50 = Rs.1226.65

Assuming borrowing of Rs. 1226.65 at 8% per year for 1 month.

The amount grows to Rs. 1234.86 by the end of the month.

Case 2:

Stock rises to Rs.1275:

Sell the stock at Rs. 1275.
The put option expires worthless.

The call option incurs a loss of Rs. 35 (since the stock price
is above the strike price).

Repay the borrowed amount (Rs. 1234.86).

Net Profit: 1275 − 35 − 1234.86 = Rs.5.141275 - 35 - 1234.86

= Rs.5.141275 − 35 − 1234.86 = Rs.5.14
Case 3:

Stock falls to Rs.1200:

Sell the stock at Rs. 1200.
The put option pays out Rs. 40 (since the stock price is below
the strike price).

The call option expires worthless.

Repay the borrowed amount (Rs. 1234.86).
Net Profit: 1200 + 40 − 1234.86 = Rs.5.141200 + 40 - 1234.86
= Rs.5.141200 + 40 − 1234.86 = Rs.5.14

Put-call parity provides a theoretical framework to identify

arbitrage opportunities between call and put options.

Understanding this relationship allows traders to potentially

profit from price discrepancies, but requires precise execution
and risk management due to market dynamics and transaction
complexities.

5.4 DELTA-HEDGING:
Delta is a measure of how much the price of an option
changes when the price of the underlying asset changes.

For a call option (which gives the right to buy), a delta of 0.6
means if the stock price goes up by Rs. 1, the option price goes
up by Rs. 0.60.

Parth Verma The Valuation School

Parth Verma The Valuation School

For a put option (which gives the right to sell), a delta of -0.4
means if the stock price goes up by Rs. 1, the option price
goes down by Rs. 0.40.

Suppose,
A stock’s CMP is Rs.100
Trader short 10 ATM call options
Lot size = 50
Delta = 0.5 (50 paise change per Rs. 1 change in stock price).
If stock price rises by Rs. 1, the option price goes up by 0.5 *
50 = Rs. 25/contract.
For 10 contracts, the total loss = 10 * 25 = Rs. 250

To avoid this loss, the trader can buy futures contracts.

Futures contracts have a delta of 1

The trader needs to cover a delta of 250 (since each option

contract has a delta of 0.5 and there are 10 contracts, the
total delta is 0.5 * 10 * 50 = 250).

To hedge, trader buy 5 futures contracts (each covers 50

shares, so 5 * 50 = 250).

=> Combined delta of the short call options is -250.

=> Combined delta of the long futures is +250.

So, the total delta is 0, which is a delta neutral position

If stock price changes, the delta of the options will also
change.

For example, if the stock price goes up to Rs. 110, the delta of
the call options might increase from 0.5 to 0.6.

Traders need to adjust the hedge by buying more futures

contracts to maintain a delta neutral position.

If the delta increases to 0.6, the new total delta for the
options would be 0.6 * 10 * 50 = 300.

The trader would then need a total of 6 futures contracts to

hedge this new delta (300).
5.4 Interpreting open interest and put-call ratio for trading
strategies:

Here are some of the basic terms related to futures and

options:

Open Interest:

This is the total number of open positions in futures or options

that haven't been closed. Ex: If there are 256,000 open
positions in May index futures, it means 256,000 contracts
have been bought or sold and are still active.

Parth Verma The Valuation School

Parth Verma The Valuation School

Total Traded Quantity or Traded Volume:

This is the number of contracts that have been traded during

the day.

Ex: If 200,000 May index futures were traded today, that is the
traded volume for the day.

Put-Call Ratio (PCR):

PCR is the ratio of the trading volume of put options to call

options.

Ex: If the open interest (number of active contracts) for puts is

8,000 and for calls is 12,000, then the PCR = 8000 / 12000
= 0.67.

A PCR < 1 means more call options are being traded than puts,
indicating a bearish trend.
A PCR > 1 means more put options are being traded than calls,
indicating a bullish trend.

Trading Strategies Based on Open Interest and

Futures Prices:
Traders look at how open interest and the price of futures
contracts change to decide their trading strategies. There
are four scenarios:
1. Futures Price Rising and Open Interest Increasing:
Indicates a bullish trend.
Traders typically buy futures.

2. Futures Price Rising and Open Interest Decreasing:

Indicates short covering (traders who had sold futures are
buying them back)
This means existing short positions are being closed.

3. Futures Price Falling and Open Interest Increasing:

Indicates a bearish trend
Traders typically sell (go short) futures contracts.

4. Futures Price Falling and Open Interest Decreasing:

Indicates long positions are being closed (traders who had
bought futures are selling them).
Usually means existing long positions are being squared up.

Using Put-Call Ratio for Trading Decisions

Low PCR (< 1): More call options than put options,
indicating traders expect the market not to rise, which is a
bearish signal.
High PCR (> 1): More put options than call options,
indicating traders expect the market not to fall, which is a
bullish signal.

Parth Verma The Valuation School

Parth Verma / The Valuation School

NISM VIII
CHAPTER 6: TRADING MECHANISM

Learning Objectives
Trading Mechanism for futures and options
Entities involved in the trading of futures and options
Different types of orders and order matching rule
Selection criteria of stocks and index for futures and option trading
Adjustment for Corporate Actions

6.1 TRADING MECHANISM

Types of Market

Open Outcry Market: Electronic Market: Trading is

Trading happens through done through screen-based
shouting or hand signals broker terminals without a
in a trading pit. physical trading pit.

Futures and options trading in India - electronic in nature,

with the bids and offers, and the acceptance being
displayed on the terminal continuously.
Trading systems provide complete transparency in
trading operations.
Trading mechanism is similar to equities in the cash
market segment.

Key Market Participants:

Trading Member: A member of the stock exchange who

can trade for themselves or their clients.

Trading cum Clearing Member: A member who trades

and also handles the settlement of trades for themselves,
their clients, and others.

Professional Clearing Member: A member who settles

trades for other trading members and institutional clients
but does not trade themselves.

Self Clearing Member: A member who settles only their

own trades and their clients' trades & not other trading
member trades.

Participants: Client of a trading member who can trade

through different members but settle through one
clearing member.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Authorized Persons (APs): Individuals who help expand a

broker's network and can act like sub-brokers, but not
independently.

A clearing member is a member of the clearing corporation

who clears and settles deals through the clearing corporation.

Trading on the derivatives segment happens

on all working days from 9:15 am to 3:30 pm.

Corporate Hierarchy

Corporate Manager:
Highest level user in a trading firm.
Can perform all functions like placing orders, viewing
trades, getting reports for all branches and dealers, and
setting exposure limits for branches.

Branch Manager:
Reports to the Corporate Manager.
Can manage orders and trades for all dealers in their branch.

Dealer:
Lowest level user.
Can only view and manage their own orders and trades.
Client Broker Relationship

Handle several compliance activities like:

1. Complete Know Your Client (KYC) forms

2. Execution of Client Broker agreements,
3. Ensure timely pay-in and pay-out of funds

Order Types and Conditions in Trading System

Trading members can customize orders with various
conditions. These conditions are divided into:
1. Time Conditions
2. Price Conditions
3. Combinations of Time and Price Conditions

Time Conditions

Day Order:
Valid for one day.
Automatically cancelled if not executed by the end of
the day.

Immediate or Cancel (IOC) Order:

Must be executed immediately.
Any part of the order that isn't immediately matched is
cancelled.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Price Conditions

Limit Order:
Specify a price to buy or sell.
Executed at the specified price or better.

Market Order:
No specific price mentioned.
Executed at the best available market price.

Stop-Loss Order:
Activated when a specified trigger price is reached.
Converts to a market or limit order once triggered.
Example: Buy shares at Rs 100. Set a stop-loss with a
trigger price of Rs 90 and a limit price of Rs 87. If the
price drops to Rs 90, it sells at Rs 87 or better.

Order Matching Rules

Order Driven Market:

Orders match based on price-time priority.
Best buy order (highest price) matches with the best
sell order (lowest price).
Orders are time-stamped and processed for potential
matches.
Price Band

There are no price limits in derivatives, but measures

exist to prevent errors.
Operating Ranges:
Index Futures: 10% of the base price.
Futures on Individual Securities: 10% of the base price.
Index and Stock Options: Price range based on delta
value, updated daily.
Orders outside these ranges trigger a price freeze at the
Exchange.

Trader Workstation

Market Watch Window:

Displays various windows such as title bar, ticker
windows, toolbar, market watch, inquiry, snap quote,
order/trade, and system messages.
Spend time studying a live screen to get familiar.

Placing Orders

Order Identification:
Proprietary orders: marked as 'Pro'.
Client orders: marked as 'Cli' with client account number.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Futures and Options Market Instruments

Trading Facilities:
Index-based futures.
Index-based options.
Individual stock options.
Individual stock futures.

6.2 ELIGIBILITY CRITERIA FOR SELECTION

OF STOCKS FOR DERIVATIVES TRADING
Stocks that meet certain criteria related to market size,
turnover, and liquidity are only allowed for derivative trading

1. Top 500 Stocks: The stock must be among the top 500
stocks based on average daily market capitalization and
average daily traded value over the last six months.
(rolling basis)

2. Median Quarter-Sigma Order Size (MQSOS): Over the

last six months (rolling basis) must be at least Rs 25 Lakhs.

3. Market Wide Position Limit (MWPL): Should be at least

Rs 500 crores. (rolling basis)
4. Average Daily Delivery Value: The stock must have an
average daily delivery value in the cash market of at least Rs
10 crores over the last six months. (rolling basis)

Criteria for Maintaining Eligibility

If a stock fails to meet the criteria for three consecutive

months, no new contracts will be issued.
Existing contracts can be traded until expiry,
and new strikes can be added.

Re-Eligibility

Excluded stocks can be re-eligible by meeting enhanced

criteria for six consecutive months.

6.3 ELIGIBILITY CRITERIA FOR INDICES

Stock Weightage: At least 80% of index stocks must be

individually eligible for derivatives. No single ineligible stock
can have more than 5% weightage.

Continuous Compliance: Index must meet criteria monthly.

If it fails for three consecutive months, no new contracts are
issued, but existing ones can trade until expiry and new
strikes can be added.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Product Success Framework

Trading Members: 15% of members or 20 members,
whichever is lower, must trade the index derivatives monthly.
Trading Days: Traded on at least 75% of trading days.
Turnover: Average daily turnover of at least INR 10 crore.
Open Interest: Average daily open interest of INR 4 crore.

Re-Eligibility

Excluded indices cannot be reconsidered for six months. Re-

launch is possible after modifications and SEBI approval.

6.4 ADJUSTMENT FOR CORPORATE ACTIONS

Corporate actions such as bonuses, splits or dividends can

affect the price and the characteristics of stock options.

Adjustments ensure that the value of the option position

remains as fair as possible before and after the corporate
action.
Main points for adjustments are as follows:

1. Maintaining Position Value:

The goal is to keep the value of the option position the
same before and after the corporate action.
This ensures that the options remain relatively ITM, ATM
and OTM as they were before the corporate action.

2. Types of Adjustments:

Strike Price: The price at which you can buy (call) or sell
(put) the stock.
Position: The number of options you hold.
Market Lot/Multiplier: The number of shares each option
contract controls.

3. Timing of Adjustments:

Adjustments are made on the last trading day when the

stock trades with the “cum” basis of the corporate action,
after the market closes.

Note: Adjustments for corporate action apply

to all open option positions.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

4. Corporate Actions Categories:

Stock Benefits: Bonus, Rights, Merger/Demerger,
Amalgamation, Splits, Consolidations, Hive-off, Warrants,
Secured Premium Notes (SPNs), Extraordinary Dividends.

Cash Benefits: Dividends.

5. Adjustments for Specific Corporate Actions:

Bonus, Stock Splits, or Consolidations:

Strike Price:
New strike price = Old strike price / Adjustment factor.

Market Lot/Multiplier:
New market lot = Old market lot × Adjustment factor.

Position: New position = Old position × Adjustment factor.

The adjustment factors for corporate actions like bonuses,

stock splits or consolidation are:

1. Bonus:

In a bonus issue, the company issues additional shares to

shareholders for free.
Bonus Ratio: A : B
A: Number of bonus shares
B: Number of existing shares
Adjustment Factor: (A + B) ⁄ B
Example:
Ratio: 1:2 (1 bonus share for every 2 existing shares)
Adjustment Factor: (1 + 2) / 2 = 1.5

2. Stock Splits and Consolidations:

Stock Split: Existing shares are divided into more shares.
Consolidation (Reverse Split): Existing shares are
combined into fewer shares.
Ratio: A : B
A: New number of shares after the split/consolidation
B: Original number of shares
Adjustment Factor: A ⁄ B
Example:
Ratio: 2:1 (2 new shares for every 1 existing share)
Adjustment Factor: 2 ⁄ 1 = 2

3. Right issues:

When a company offers rights to its existing shareholders,

they can buy additional shares at a discounted price.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Here’s how adjustments for rights issues are made:

Existing Shares (A): The number of shares you currently
hold.
Rights Entitlement (B): The number of additional shares
you can buy.
Total Entitlement: A + B (existing shares plus the new
shares you can buy).
Underlying Close Price (P): The stock price on the last day
Issue Price (S): The price at which the new shares are
offered.

Benefit per Right Entitlement: P - S (difference between

the market price and the issue price).
Benefit per Share (E): (P - S) / (A + B) (the benefit
distributed over all the shares).

Adjustment Factor: (P - E) / P (adjusts the strike price and

market lot to reflect the new value after the rights issue).
Example: If a company offers 1 right for every 2 existing
shares (1:2) and the current stock price is Rs. 100 and the
issue price is Rs. 80, then:
A = 2 (existing shares), B = 1 (rights entitlement)
Total Entitlement = A+B = 2 + 1 = 3
P = 100, S = 80
Benefit per Right Entitlement = 100 - 80 = 20
Benefit per Share (E) = 20 / 3 = 6.67
Adjustment Factor = (100 - 6.67) / 100 = 0.9333

To avoid fractions:

1. Compute the position value before adjustment.

2. Apply the exact adjustment factor.
3. Round off the strike price and market lot.
4. Compute the position value after rounding.

4. Dividend Adjustments:

Ordinary Dividends:
Dividends below 2% of the market value of the
underlying stock.
No adjustment in the strike price.

Extraordinary Dividends:
Dividends above 2% of the market value of the
underlying stock.
Strike Price Adjustment: The strike price is adjusted to
reflect the dividend amount.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Key Points:

The market price is determined by the stock's closing price

on the day before the dividend announcement.
The same day's closing price is used if the dividend is
declared after market hours.
If shareholders change the dividend rate at the AGM, the
adjusted rate is used to determine if the dividend is
extraordinary.
Strike Prices are reduced by the total dividend amount and
applied from the ex-dividend date.
All open positions will continue to exist in the newly
adjusted strike prices, and futures contracts will be carried
forward at the daily settlement price minus the dividend
amount.

5. Merger-Demerger:
When a company announces a merger or demerger,
adjustments need to be made to futures and options
contracts to ensure that everything is fair and accurate
for traders.
Here's how it works:

Record Date: When the merger/demerger officially occurs.

Last Cum-Date: Last trading day before the
merger/demerger, determined by the Exchange.
Contract Expiration: Futures and options for the stock
expiring on the last cum-date.
New Contracts: No new contracts introduced post-record
date for the stock.
Settlement: Active contracts on the last cum-date are
settled at the last closing price of that day.

6.5 TRADING COSTS

Broadly classified into:
1. User Charges 2. Statutory Charges 3. Impact Cost

1. User Charges
Brokerage: Commission charged by brokers for placing
orders. Generally lower for intra-day trades.
Stock exchanges also charge transaction fees from brokers.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

2. Statutory Charges

Securities Transaction Tax (STT):

TAXABLE SECURITIES TRANSACTION RATES PAYABLE BY

Sale of an option in Seller – on the option

0.0625%
securities premium
Sale of an option in
Purchaser – on the
securities, where option is 0.125%
settlement price
exercised

Seller – on the price at

Sale of a futures in
0.0125% which such futures is
securities
traded

Goods and Services Tax (GST): 18% on brokerage plus

transaction charges.
Stamp Duty: 0.002% for buyers of equity futures, 0.003%
for buyers of equity options.
SEBI Turnover Fees: Rs. 10 per crore.

3. Bid-ask spread cost

Bid-Ask Spread: The difference between the highest bid

price and the lowest ask price. Larger spreads occur with
less liquidity.
Impact Cost: Difference in cost due to non-execution of
trade on ideal price (Best Bid + Best Ask/2)
Example: Cost of Trading
Position: Short 1 lot of index futures
Futures Price: 17500
Lot Size: 50
Contract Value: Rs. 8,75,000 (1 * 50 * 17500)

Sr No Contract value 8,75,000.00

1 Brokerage @ 0.03% 262.50

2 STT @ 0.0125% 109.38

3 Exchange fees @ 0.002% 17.50

4 GST @ 18% on (1+3) 50.04

5 SEBI charges @ Rs.10 per Cr 0.88

Total trading cost 440.66

6.6 ALGORITHMIC TRADING

Algorithmic trading involves executing orders using
automated and pre-programmed trading instructions
based on variables like price, timing, and volume.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Advantages:

Emotion-Free Trading
Speed: Computers execute orders much faster than
human traders.
High-Frequency Trading: Allows tens of thousands of
trades per second, primarily used by institutional
investors and large brokers.

Usage:

Institutional Investors and Large Brokers: To reduce

trading costs.
Retail Clients: Some large brokers in India offer algo trading
strategies to retail clients in the derivatives market.

Concerns and Regulations:

Unregulated Platforms: Some offer aggressive marketing

of algo strategies promising high returns.

SEBI Guidelines:
Brokers should not reference past or expected returns
from algo strategies.
Brokers should not associate with platforms that make
such claims to protect investors.
Parth Verma / The Valuation School

6.7 TRACKING FUTURES AND OPTIONS DATA

Sources:
Real-time data available on exchange websites and online
trading platforms.

Data Points

1. Date: Trade date.

2. Symbol: Underlying index or stock (e.g., NIFTY, ACC).
3. Instrument: Contract descriptor (e.g., FUTSTK, OPTIDX).
4. Expiry Date: Contract expiration date.
5. Option Type: Type of option (CE: Call European, PE: Put
European, CA: Call American, PA: Put American).
6. Corporate Action Level: Flag indicating corporate actions
like symbol change or dividends.
7. Strike Price: Strike price of the contract.
8. Opening Price: Price at which the contract opened for the
day.
9. High Price: Highest price of the day.
10. Low Price: Lowest price of the day.
11. Closing Price: Price at the end of the day.
12. Last Traded Price: Price at which the last contract of the
day was traded.
13. Open Interest/notional value (options): Open positions
multiplied by the last available closing price (futures) or
14. Total Traded Quantity: Total number of contracts traded.
15. Total Traded Value: Total monetary value of the trades.
16. Number of Trades: Total number of trades executed.

Market Trends Information

Positive Trend: Lists top gainers in the futures market.

Negative Trend: Lists top losers in the futures market.
Futures OI Gainers: Futures with the highest percentage
increase in open interest.
Futures OI Losers: Futures with the highest percentage
decrease in open interest.
Active Calls: Calls with high trading volumes.
Active Puts: Puts with high trading volumes.
Put/Call Ratio (PCR): Ratio of trading volume of put
options to call options. Calculated based on trading
volumes or open interest.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

NISM VIII
Chapter 7

LEARNING OBJECTIVES
Different types of clearing members
Interoperability of clearing corporations and its benefits
Clearing and settlement mechanism for equity derivatives
Risk management in equity derivatives segment
Margining system in equity derivatives segment
Position limits
Settlement Guarantee Fund and Investor Protection Fund

7.1 CLEARING MEMBERS

The Clearing Corporation is a legal counterparty to all trades in this
segment and guarantees their financial settlement.

Main Activities:

Clearing
Settlement
Risk Management

Clearing and settlement in the F&O segment are managed by the Clearing
Corporation with support from Clearing Members and Clearing Banks.
Clearing Members handle clearing and settlement for Trading Members.

Their key functions are:

Clearing: Determine positions to settle.

Settlement: Perform the actual settlement.
Risk Management: Set position limits and monitor continuously.

Clearing Banks:
Fund settlement in the F&O segment occurs through Clearing Banks.
Clearing Members must open a separate bank account with a Clearing
Corporation-designated clearing bank.

Clearing Member Eligibility Norms

1. Net-worth Requirement:
Rs. 300 lakhs for Clearing Members handling deals for others.
Rs. 100 lakhs if only handling their own deals.
2. Security Deposit: Rs. 50 lakhs to the Clearing Corporation.
3. Incremental Deposit: Rs. 10 lakhs for each additional Trading Member
(TM) they clear for.

7.2 CLEARING MECHANISM:

The clearing mechanism involves calculating and aggregating the open
positions of all Trading Members (TMs) and custodial participants under
a Clearing Member (CM).

With proprietary trades netted (buy-sell) and client trades summed per
client.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

For example,

For a CM - XYZ, with TMs clearing through him - ABC

and PQR

Table Details:

Proprietary
Client 1 Client 2
Position
Net Member
TM Security Buy Qty Sell Qty Net Qty Buy Qty Sell Qty Net Qty Buy Qty Sell Qty Net Qty

Nifty 50
ABC 4000 2000 2000 3000 1000 2000 4000 2000 2000 Long 6000
January contract

Nifty 50 Long 1000

PQR 2000 3000 (1000) 2000 1000 1000 1000 2000 (1000)
January contract Short 2000

XYZ’s open position for Nifty 50 January contract:

Member Long Position Short Position

ABC 6000 0

PQR 1000 2000

Total for XYZ 7000 2000

7.3 INTEROPERABILITY AMONG CLEARING
CORPORATIONS

Stock exchanges in India used to have their own clearing corporations.

Traders needed memberships with multiple exchanges and clearing

corporations to trade on different platforms.

This resulted in maintaining collaterals and margins at multiple places,

causing inefficient capital allocation and higher trading costs.

Changes Introduced:
In 2018, SEBI proposed a framework for interoperability among clearing
corporations.
Implemented in 2019, it allows trades on any exchange to be cleared
and settled by any clearing corporation.
Brokers can now choose a single clearing corporation for all their trades.

Advantages
Lower trading costs as traders only need to
maintain margins with one clearing corporation.
Efficient use of capital by consolidating margins and collaterals.
Continuous trading is possible even if one exchange has issues.
Simplified Compliance, follow the rules of just one clearing corporation.
Improved pricing and services due to competition among clearing
corporations.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

7.4 SETTLEMENT MECHANISM

Two Types

(A) Mark-to-market (MTM)

(B) The final settlement

(A) Mark-to-Market
Settlement which happens on a continuous basis at the end of each day.
1. Profits/ losses are calculated as a difference between the trade price and
the day's settlement price.

2. Clearing members are responsible for collecting and settling the daily
MTM profits/losses incurred by the Trading members.

3. The clearing member who suffers a loss is required to pay the MTM loss
amount, which is passed on to the clearing member who has made a MTM
profit.

Next Day is a Fresh Start!

Daily Settlement Price

Futures Contracts: Based on the last 30 minutes volume-weighted

average price across exchanges.
Non-traded Contracts: Calculated using F = S * e^(rt), where S is the
underlying value, r is the interest rate, and t is the time to expiration.

Daily MTM Settlement

Cash-Settled: Daily MTM settlements are done in cash.
Timing: Pay-in and pay-out occur before market hours on the next day
via clearing members' accounts at the clearing bank.
(B) Final Settlement
Happens on the last trading day of the futures contract.

After trading hours, all positions are marked to the final settlement price.
Assignment: Long positions are assigned to short positions with the
same series for either cash or delivery settlement.

Final settlement procedure for

cash-settled futures contracts:
All positions are marked to market at the final settlement price (for final
settlement) and settled.

Settlement obligations for futures contracts are computed at the final

settlement price of the respective futures contract

Funds Pay-in and Pay-out: Members must have sufficient funds in their
accounts by the pay-in time. Pay-out is credited to the receiving
members' accounts afterward.

Final Settlement for Physically Settled Futures

Settlement Procedure: Final settlement is on T+1, the day after the

expiry date. Delivering members must transfer securities to the
Depository pool account by the cut-off time. Depositories credit the
receiving members' accounts as instructed by the clearing corporation.

Settlement Obligation: Long futures result in a buy (security receivable)

position, while short futures result in a sell (security deliverable) position.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Example

Long Position in Stock Futures

Example 1:
Client Mr. XYZ has a long position in one lot of a stock futures contract
on the expiry date.
Lot size: 1500 shares
Final settlement price: Rs. 475
Previous day’s settlement price: Rs. 482

Settlement Obligation:

Since Mr. XYZ has a long position, he must buy 1500 shares at Rs.
475 per share on the T+2 date.
Total amount: 1500 shares × Rs. 475 = Rs. 7,12,500
Mr. XYZ needs to ensure he has Rs. 7,12,500 in his bank account for
this settlement.

Mark to Market (MTM) Settlement:

The difference between the final settlement price (Rs. 475) and the
previous day’s settlement price (Rs. 482) will be settled in cash on T+1 day.
Amount to be paid by Mr. XYZ: (475 - 482) × 1500 = Rs. 10,500

Short Position in Stock Futures

Example 2:
Client Mr. ABC has a short position in one lot of a stock futures contract
on the expiry date.
Lot size: 1500 shares
Final settlement price: Rs. 475
Previous day’s settlement price: Rs. 482
Settlement Obligation:

Since Mr. ABC has a short position, he must deliver 1500 shares at
Rs. 475 per share on T+2 date.
Mr. ABC needs to ensure he has 1500 shares in his Demat account for
delivery.

Mark to Market (MTM) Settlement:

The difference between the final settlement price (Rs. 475) and the
previous day’s settlement price (Rs. 482) will be settled in cash on T+1 day.
Amount to be received by Mr. ABC: (482 - 475) × 1500 = Rs. 10,500

Options contracts involve two types of settlements:

1. Daily Premium Settlement

2. Final Settlement.

1. Daily Premium Settlement

This is the daily process where the buyer of an option pays the premium,
and the seller receives the premium.

How does it work?

The amount each buyer and seller needs to pay or receive is calculated
and netted out.
Clearing members with a payable position pay the amount to the clearing
corporation.
This amount is then distributed to the members with a receivable
position.
This settlement happens on T+1 day (the day after the trade).

Parth Verma / The Valuation School

Parth Verma / The Valuation School

2. Final Exercise Settlement

This happens on the expiry day of the options contract. It involves
settling the contracts that have intrinsic value (In-the-Money contracts).

Types of Final Settlements:

1. Final Settlements of Index Options:

In India, index options are European style options, meaning they can
only be exercised on the expiry day.
All ITM long positions are automatically assigned to short positions
randomly.
Final Settlement Price is the closing price of the index on the expiry day.
Exercise Settlement Value is calculated as:
Call Options: Closing price on expiry day- Strike price
Put Options: Strike price - Closing price on expiry day

This amount represents the intrinsic value of the option at expiration.

The final settlement is done via cash, credited or debited to the clearing
members’ bank accounts on T+1 day.

Example 3:

On the expiry day, if you have an ITM option:

Call Option Example: Strike price: Rs. 17500

Closing price on expiry day: Rs. 17800
Exercise Settlement Value: Rs. 17800 - Rs. 17500 = Rs. 300 per unit.
Lot size: 50
Total settlement amount: Rs. 300 x 50 = Rs. 15,000

This value is settled in cash the next day (T+1).

2. Final Settlements of Stock Options:
In India, stock options are European-style, meaning they can only be
exercised on the expiry day.
Unlike index options, stock options are settled by delivering the
actual shares.
Long ITM Options are automatically assigned to short positions in
the same series by the exchange.

Settlement Obligation

ITM Call Options:

Long Call: Results in buying the shares (receivable position).

Short Call: Results in selling the shares (deliverable position).

ITM Put Options:

Long Put: Results in selling the shares (deliverable position).

Short Put: Results in buying the shares (receivable position).

Settlement Obligation Value: Calculated based on the strike price

of the option contracts.

Example 4: Long Call Option

Client: Mr. AB
Position: Long one lot of a call option on a stock
Strike Price: Rs. 475
Lot Size: 1500 shares
Stock Price on Expiry: Rs. 510

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Calculation of exercise settlement value:

The call option is ITM because Rs. 510 (final price) > Rs. 475 (strike price).
Mr. AB will receive 1500 shares on T+2 (two days after expiry).
Settlement Value: Rs. 475 x 1500 = Rs. 7,12,500.
Mr. AB must ensure he has Rs. 7,12,500 for the physical settlement.

Example 5: Long Put Option

Client: Mr. XY
Position: Long one lot of a put option on a stock
Strike Price: Rs. 475
Lot Size: 1500 shares
Stock Price on Expiry: Rs. 410

Calculation of exercise settlement value:

The put option is ITM because Rs. 410 (final price) < Rs. 475 (strike price).
Mr. XY will need to deliver 1500 shares on T+2.
Settlement Value: Rs. 475 x 1500 = Rs. 7,12,500.
Mr. XY must ensure he has 1500 shares in his demat account for the
physical settlement.

Treatment of Short ITM Options

Short ITM Put Options: Similar to long ITM call options.

The client must have funds equal to the final exercise settlement value.

Short ITM Call Options: Similar to long ITM put options.

The client must have a shareholding equal to the lot size of the
assigned call option.
Net Settlement of cash segment and futures and options
(F&O) segment on expiry:
1. Net Settlement Mechanism: It combines cash and F&O
(Futures & Options) settlements to reduce risk and improve efficiency.

2. Purpose: Aligns cash and derivatives segments, reduces price risk and
allows market participants to net their obligations.

Working:

On the expiry of F&O positions, a client’s obligations from both cash

segment settlements and physical settlement of F&O positions are
settled together.
This means that instead of handling these settlements separately, they
are combined to simplify the process.

Example:

PQR: Holds a long put option on XYZ Ltd with a strike price of Rs. 110.
Shares Purchased: Buys shares of XYZ Ltd at Rs. 101 on expiry day.
Settlement Price: Rs. 100 on expiry day.

According to earlier rule:

PQR had to:

a. Pay Rs. 101 to buy the shares on T+2.

b. Deliver these shares to settle the long put option and receive Rs. 110.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

According to net settlement scheme:

Under the new mechanism, PQR does not need to make the Rs. 101
payment.

Instead, the settlement is netted:

Net Result: Mr. PQR receives the difference between the strike price
(Rs. 110) and the purchase price (Rs. 101).
Net Payout: Rs. 9 (i.e.110 - 101).
No actual transfer of shares or additional payments required.

Facility Available To:

Investors who trade and clear through the same Trading Member-
Clearing Member (TM-CM) combination in both cash and F&O segments.

Facility Not Available To:

Investors using different Clearing Members or Clearing Corporations for
cash and F&O segments.
Institutional investors.

7.5 RISK MANAGEMENT

1. Capital Adequacy: Ensures members have strong financial backing.
2. Initial Margin: Upfront margin based on Value-At-Risk (VaR), and
specified daily.
3. MTM Settlement: Daily settlement of open positions.
4. Real-Time Monitoring: Online system tracks positions and sets limits,
generating alerts as needed.
5. Trading Terminal: Monitors Trading Member's positions and enforces
intra-day limits.

The most critical components are the margining system and online position
monitoring, carried out using the SPAN® (Standard Portfolio Analysis of Risk)
system for real-time margin computation.
7.6 MARGINING AND MARK TO MARKET
UNDER SPAN
Exchanges in India use SPAN (Standard Portfolio Analysis of Risk),
designed by the Chicago Mercantile Exchange, to manage risk and
calculate initial margins.

Objective:
Identify potential risk in a portfolio.
Determine the largest possible loss a portfolio might suffer in one day.
Set initial margins to cover this potential loss.

Risk Array:
Represents the potential gain or loss of a derivative over one trading day
under various market conditions.
Evaluates the maximum likely loss over one day to set margins
accordingly.

Margining system

Initial margin: upfront payment required by the clearing corporation,

calculated using SPAN based on a 99% value at risk over one or two days.

Premium Margin: additional charge at the client level, covering the

premium amount due until the premium settlement is completed.

Assignment Margin: Additional margin required for assigned positions in

options contracts, covering final exercise settlement obligations until fully
paid.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Intra-day Crystallised Losses

Intra-day Crystallised Losses (ICMTM) are losses calculated and levied

by the clearing corporation during the trading day for trades that close
out open futures positions.

Calculation: ICMTM is computed for trades closing out open futures

positions and based on weighted average prices.

Scope: It applies only to futures contracts.

Adjustment: ICMTM is part of the initial margin and adjusted against the
clearing member's liquid assets in real time.

Offsetting: Crystallised losses for a client are offset against any

crystallised profits from other contracts for the same client.

Aggregation: All client-level losses, including trading members'

proprietary losses, are summed up to determine the clearing member's
ICMTM.

Release: The collected ICMTM is released after the daily/final mark-to-

market settlement pay-in is completed.

Delivery margins are additional funds required for positions that will be
delivered, starting four days before the contract's expiry.

Applied to the lower value between potential deliverable positions and

in-the-money long option position

Staggered Collection:
20% on Expiry - 4 EOD
40% on Expiry - 3 EOD
60% on Expiry - 2 EOD
80% on Expiry - 1 EOD
Exposure Margins
Exposure margins are additional funds required, based on Value at Risk
(VaR) and Extreme Loss percentages, updated with every change in the
Capital Market segment's margin rates.

Short Option Minimum Charge

Previously a margin for short option positions in deep-out-of-the-money
strikes, this charge was eliminated by SEBI on February 24, 2020.

Net Option Value

Net Option Value is the difference between long and short option
positions, valued at the last closing price and updated intraday. It is added
to the clearing member's Liquid Net Worth, and mark-to-market gains and
losses are not settled in cash for options positions.

Client Margin Reporting

Clearing Members (CMs) and Trading Members (TMs) must collect upfront
initial and extreme loss margins from their constituents.

CMs must report daily on the margin amounts due and collected from TMs
and their constituents. This reporting covers trades and open positions,
ensuring CMs meet margin requirements paid to NSE CLEARING.

Peak margin obligation

Peak Margins, introduced by SEBI on December 1, 2020, are regulated
margins collected upfront to control leverage and increase trade
transparency. This change reduces excessive speculation by shifting
margin collection from the end of the day to multiple points throughout
the trading day.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Cross margin
Cross margining is a process wherein excess margin in a trader's margin
account is moved to another one in order to satisfy the maintenance
margin requirements.

Early pay-in
Early pay-in refers to when you fulfill your funds and/or securities
obligation for an executed trade to the exchange, before the stipulated
settlement date for the trade.

When members make an early pay-in (EPI) of securities, those positions

are exempt from delivery margins In NSDL, securities are delivered to the
pool account and transferred via irreversible delivery instructions.

In CDSL, securities are transferred to the early pay-in account for the
Capital Market segment.

Mechanism for pledge/repledge of client securities

SEBI introduced a new pledge/repledge mechanism in September 2020 to
prevent brokers from misusing client securities.

Clients now provide collateral only through a 'margin pledge,' not by power
of attorney.

This system ensures that securities are only pledged and not transferred,
reducing misuse risk and maintaining a clear re-pledge trail.
Segregation and Monitoring of Collateral at client collatral:

Trading Member must report to Clearing Member detailed information on

collaterals received, retained, and placed at the client level.

CMs must then report this disaggregated information, including proprietary

collaterals, to the Clearing Corporation daily.

This ensures the Clearing Corporation has a clear view of client-wise

collateral at all levels.

7.7 POSITION LIMITS

These limits restrict the number of derivatives contracts that a trading

member or client can own to prevent market manipulation.

1. Position Limits in Derivatives Exchanges:

Client-Level Position Limits: :
For individual securities, the limit is the higher of 1% of free float
market cap or 5% of open interest.
Clients with 15% or more open interest in an index must report to
the Exchange.

2.Trading Member-Wise Position Limits:

Index Futures/Options: Higher of Rs. 500 crores or 15% of total
market open interest.
Individual Securities: The limit is 20% of the Market Wide Position
Limit (MWPL).

Parth Verma / The Valuation School

Parth Verma / The Valuation School

3.Market-Wide Position Limits (MWPL):

MWPL is 20% of a company's free float.

Alerts at 60% MWPL; no new positions if over 95% until it drops
below 80%.

Penalties apply for exceeding these limits, and brokers must ensure
clients stay within allowable positions.

7.8 VIOLATION AND PENALTIES

Non-compliance by clearing or trading members leads

to penalties. Common lapses include:

Not meeting margin or settlement obligations

Failing securities delivery
Violating exposure or position limits
Misusing client collaterals
Short or non-reporting of client margins
Violating Market Wide Position Limits (MWPL)

Penalties can involve withdrawing trading rights, closing out positions,

and imposing fines.

Additional actions may include collecting deposits, invoking bank

guarantees, and selling securities.
7.9 SETTLEMENT OF RUNNING ACCOUNT OF
CLIENT’S FUNDS LYING WITH THE TRADING
MEMBER:

To prevent misuse of client funds, SEBI mandates brokers to settle client

accounts monthly or quarterly based on the client's choice.

Settlements occur on the first Friday of the quarter or month, after

considering the client's end-of-day obligations across all exchanges.

If the first Friday is a holiday, settlement happens on the previous trading

day.

7.10 SETTLEMENT GUARANTEE FUND

AND INVESTOR PROTECTION FUND:

Clearing corporations must have a Core Settlement Guarantee Fund

(Core SGF) for each segment (e.g., Cash, F&O) to ensure trade
settlements if a clearing member defaults.

Additionally, exchanges have an Investor Protection Fund to

compensate investors when defaulting members' assets are insufficient.

This fund also promotes investor education and awareness. It is managed

by a registered Trust.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

NISM VIII
CHAPTER 8: LEGAL & REGULATORY ENVIRONMENT

Learning Objectives
Definition of securities and derivatives as per the
Securities Contract (Regulation) Act, 1956
Functions of SEBI
Regulatory framework for derivatives market trading,
clearing, settlement and risk management
Eligibility criteria for membership in the derivatives segment

INTRODUCTION

The trading of derivatives is regulated by:

The Securities Contracts (Regulation) Act of 1956,

The Securities Exchange Board of India Act of 1992,
Various rules and regulations are established under
these acts.
Other rules and by laws of stock exchanges.
8.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956

The Act aims to prevent undesirable transactions and

governs securities trading in India.

The term ‘Securities’ includes shares, bonds, derivatives,

units from collective investment schemes and mutual funds,
government securities, and other instruments recognized by
the government.

According to the act “Derivatives” is defined as:‐

They are derived from debt instruments,

shares, loans, or other securities.
Their value depends on the prices or indices
of underlying securities.
Includes commodity derivatives and other
government-designated instruments.
Legally valid if traded and settled on a recognized stock
exchange according to its rules and bylaws.

8.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

1. The SEBI Act, of 1992 establishes the Securities and

Exchange Board of India (SEBI) with statutory powers to
protect investor interests, promote securities market
development, and regulate the market.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Key powers of SEBI include:

Protect investor interests.

Promote and regulate the securities market.
Oversee corporate issuance and transfer of securities,
and all related intermediaries.
Regulate stock exchanges and market participants.
Combat fraudulent practices in securities markets.
Conduct inspections and audits.
Perform functions delegated under the Securities
Contracts (Regulation) Act, 1956.

8.3 REGULATIONS IN TRADING

The SEBI established a committee under Dr. L. C. Gupta

to develop the regulatory framework for derivatives
trading.

On May 11, 1998, SEBI accepted the committee's

recommendations and approved a phased introduction
of derivatives trading, beginning with stock index futures.

The Securities Contract (Regulation) Act (SCRA) was

amended to include derivatives under the definition of
'securities,' allowing derivatives trading within its
framework.
1. Eligibility and Governance for Derivatives Trading:

Any exchange meeting the eligibility criteria from the L.C.

Gupta Committee report can apply to SEBI for recognition
to start derivatives trading under Section 4 of SCRA (1956).
Governance Requirements:
A derivatives segment/exchange should have a separate
governing council.
Trading/clearing members' representation on the council
should be limited to a maximum of 40%.
The exchange must obtain SEBI's prior approval before
starting any derivatives contract trading.
The exchange must have a minimum of 50 members.

2. Membership and Participation Rules:

Members of an existing segment do not automatically become

members of the derivatives segment. They must meet the
eligibility criteria outlined in the L.C. Gupta report

Clearing and Settlement:

Must be conducted through SEBI-approved clearing

corporations.
Clearing corporations must also meet eligibility conditions
and apply to SEBI for approval.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Derivative Brokers/Dealers:

Must register with SEBI separately from their registration as

stock exchange brokers.
Net Worth Requirement: Clearing members must have a net
worth of Rs. 300 Lakhs. This is calculated as:
Net Worth = Capital + Free Reserves - Non-Allowable
Assets, such as:
Fixed assets, pledged securities, unlisted securities,
bad debts, and other non-marketable securities

3. Contract and Margin Requirements:

The minimum contract value for derivatives contracts

must be at least Rs. 5,00,000.
Exchanges must submit contract details to SEBI before
introducing futures contracts.
Initial Margin Requirement and exposure limits are
linked to capital adequacy and risk and are subject to
SEBI/Exchange regulations.
4. Know Your Customer (KYC) and Risk Disclosure:

The KYC rule is strictly enforced.

Clients must be registered with a derivatives broker, and
brokers must provide clients with the Risk Disclosure
Document to inform them of potential risks in derivatives
trading.
Clients are required to sign the Risk Disclosure Document
during the registration process.

5. Collateral and Margin Requirements for Members:

Members and authorized dealers must meet specific

requirements and provide collateral deposits to
participate in the F&O (Futures and Options) segment.

Collateral Types:
Cash component: Includes cash, bank guarantees,
fixed deposit receipts, T-bills, and government
securities.
Non-cash component: Includes approved
demat securities.

The net worth criteria for Clearing Members is set by

SEBI, while that for Trading Members is decided by
stock exchanges.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

6. Inspection and Record Keeping:

Trading members are required to maintain records,

including trade confirmation slips and exercise notices,
for at least 5 years.
All derivative segment member brokers must be
inspected by the exchange at least once a year.
A default by a member in the derivatives segment is
considered a default across all segments and exchanges
where the member operates.

7. Stock Broker Regulations and Penalties:

Recognition: SEBI grants recognition to stock exchanges

under the SCRA, giving the Central Government
jurisdiction over:
Stock exchanges, contracts in securities, and listing of
securities.

Penalties or Suspension of stock brokers' registration

can occur for violations such as:
Breaching provisions of the Act, failing to resolve
investor complaints, engaging in market manipulation,
or substantial financial deterioration.
8. Position Limits:

Position limits refer to maximum exposure levels that can

be taken by an investor or Clearing Member.
These limits are set by SEBI, and once a Trading Member
reaches their position limit, they can only enter transactions
to reduce exposure (i.e., squaring-off existing positions).

8.4 REGULATIONS IN CLEARING AND

SETTLEMENT AND RISK MANAGEMENT

Membership:

F&O segment membership requires membership in "Capital

Market and F&O" or "Capital Market, Wholesale Debt Market
and F&O." Existing cash market members can join.

Margins

Clearing members pay initial margins upfront in the

form of cash, bank guarantees, or approved securities.
Clearing members set maximum collateral limits for
individual trading members.
Non-fulfilling margin obligations lead to penalties and
potential loss of trading privileges.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Clearing Member Requirements:

Maintain adequate liquid assets (cash, guarantees,

securities) to cover margins and net worth. At least 50%
of liquid assets must be cash.

Clearing Corporation Responsibilities:

Collect margins on time.
Ensure smooth daily clearing and settlement.
Act as the legal counterparty for every contract.
Monitor positions in derivatives and cash segments.
Decide daily settlement prices.
Maintain client margin records.
Ensure client margins are not used for broker debts.
Transfer client positions in case of broker default.

Reporting to SEBI:
Derivatives exchanges report to SEBI on:
- Violations of 99% Value at Risk limit.
- Broker member defaults.
- Daily market activity report or Daily market report

Trade Guarantee Fund (TGF):

Protects investors and guarantees settlement of trades.
Funded by initial contributions from exchange members.
8.5 ELIGIBILITY CRITERIA FOR MEMBERSHIP
ON DERIVATIVES SEGMENT

Balance Sheet Net Worth Requirements:

Clearing members: Rs. 3 crore
Self-clearing members: Rs. 1 crore

Liquid Net Worth:

All clearing members (both clearing members and

self-clearing members) must maintain at least Rs 50 lakh
with the exchange/clearing corporation.

Certification:
Members and at least two approved users appointed by
trading members must pass a SEBI-approved certification
program.
Only approved users can operate derivatives trading
terminals.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

8.6 STANDARD OPERATING PROCEDURE IN

THE CASE OF DEFAULT BY TM OR CM

SEBI has mandated that stock exchanges, clearing

corporations, and depositories follow a Standard Operating
Procedure (SOP) upon detecting warning signals of a potential
default by a Trading Member (TM) or Clearing Member (CM).

This SOP aims to protect non-defaulting clients.

Actions include:

1. Interim measures: Settle credit balances of small investors

(less than Rs. 25 lakh) using available unencumbered deposits.

2. Pro-rata payments: Investors with balances exceeding

Rs. 25 lakh are paid proportionately from the remaining funds.
8.7 SOP FOR HANDLING STOCK EXCHANGE
OUTAGE

SEBI has established a Standard Operating Procedure (SOP)

for handling stock exchange outages due to technical
glitches to ensure smooth closure of intraday positions.

Key steps include:

1. Immediate Notification: The affected exchange
must inform SEBI immediately via email.
2. Participant Notification: Market participants and Market
Infrastructure Institutions (MIIs) must be informed within 15
minutes via broadcast message and website.
3. Segment Continuity: Trading can continue in unaffected
segments and on other unaffected exchanges.
4. Restoration Efforts: The affected exchange must quickly
restore operations, including activating its Disaster Recovery
Site.
5. Pre-Resumption Notice: Participants must be informed
at least 15 minutes before trading resumes.
6. Extended Trading Hours: Any extension must be
communicated promptly to participants, MIIs, and SEBI.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

EXTENTION OF TRADING
SCENARIO
HOURS

Resumption of normal
trading atleast 1 hour No change of trading
before scheduled market hours required
closure

Trading does not resume All stock exchanges should

to normalcy within 1 hour extend their trading hours
before the scheduled by one and half hours for
market closure. that day

Outage happens during the

All stock exchanges should
last trading hour of normal
extend their trading hours
operation and latest before
by one and half hours for
15 minutes of normal
that day
scheduled market closure.
Parth Verma / The Valuation School

NISM VIII
CHAPTER 9: ACCOUNTING AND TAXATION

Learning Objectives
Accounting treatment for derivatives contracts
Taxation of derivatives transaction in securities

9.1 ACCOUNTING

When the forward contract is for hedging:

Amortize premium or discount (spot vs. forward rate)

over the contract's life.
Recognize exchange differences (settlement/reporting
date vs. previous date) in the year's P&L.
Recognize profit/loss from forward contract
cancellation/renewal in the year's P&L.

When the forward contract is for trading/speculation:

No premium or discount is recognized.

Recognize gain or loss (difference between
contract/previous year-end forward rate and year-
end forward rate) in the P&L for the period.
Recognize profit/loss from forward contract
cancellation/renewal in the year's P&L.
Accounting of Equity index and Equity stock
futures in the books of the client:

The Institute of Chartered Accountants of India (ICAI)

has issued guidance notes on the accounting of index
futures contracts from the viewpoint of parties who
enter into such futures contracts as buyers or sellers.

For other parties like brokers, trading members, clearing

members, and clearing corporations, a trade-in equity
index futures is similar to a trade-in, say shares, and does
not pose any peculiar accounting problems.

IN THIS CHAPTER MAIN FOCUS ON THE BOOKS OF

CLIENTS ONLY

Accounting at the inception of the contract

(Accounting for Initial Margin)

Clients must pay initial margins as per Exchange

regulations when entering equity index/stock futures
contracts, debited to "Initial Margin - Equity Index/Equity
Stock Futures Account".
Additional margins are recorded in the same account.
No accounting entry for the contract itself at inception,
only for the initial margin.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

At the balance sheet date, initial margin balances are

listed under 'Currency Assets'.
Any payment exceeding the required margins is shown as
a separate deposit under 'Current Assets'.
Non-cash margins (like bank guarantees or securities)
are disclosed in the financial statement notes without an
accounting entry.

THE ACCOUNTING ENTRIES

1. Deposit for Initial Margin Kept:

Deposit for Initial Margin A/c Dr.

To Bank A/c

2. Initial Margin Paid / Adjusted from Deposit

Initial Margin A/c Dr.
To Deposit for Initial Margin A/c

OR if paid directly from the bank:

Initial Margin A/c Dr.
To Bank A/c

3. Initial Margin Returned / Released

Bank A/c Dr.
To Initial Margin A/c
OR If adjusted from margin account
Deposit for Initial Margin A/c Dr.
To Initial Margin A/c

EXAMPLE:
Mr. Y purchased a Futures Contract on April 10, 2023. The
initial margin required, calculated using SPAN, is ₹60,000.
The subsequent margin requirements are as follows:
April 11, 2023: ₹65,000
April 12, 2023: ₹55,000
April 13, 2023: ₹58,000

SOLUTION:
April 10, 2023:
Mr. Y deposits the initial margin of ₹60,000

Initial Margin – Equity Futures A/c Dr ₹60,000

To Bank A/c ₹60,000
(Being initial margin paid on Equity Futures Contracts)

April 11, 2023:

Initial Margin – Equity Futures A/c Dr ₹5,000
To Bank A/c ₹5,000
(Being additional margin paid to the Exchange)

Parth Verma / The Valuation School

Parth Verma / The Valuation School

April 12, 2023:

Bank A/c Dr ₹10,000
To Initial Margin – Equity Futures A/c ₹10,000
(Being margin refunded by the Exchange)

April 13, 2023:

Initial Margin – Equity Futures A/c Dr ₹3,000
To Bank A/c ₹3,000
(Being further margin paid to the Exchange)

ACCOUNTING AT THE TIME OF DAILY SETTLEMENT -

PAYMENT/RECEIPT OF MTM MARGIN

MTM Margin Payments/Receipts:

Daily adjustments based on market movement
for futures contracts.
Losses are debited, and gains are credited to the Mark-to-
Market Margin - Equity Index/Stock Futures Account.

Account Maintenance (Index/Stock-wise):

To track provisions for losses accurately, maintain separate
accounts for each stock or index, such as Nifty Futures or
specific stock futures.
Settlement Methods:
Payments/receipts can be through:
Bank Account (direct payment).
Or from a Deposit for Mark-to-Market Margin
Account (kept with the clearing member or broker).

Year-End Treatment of Deposits:

Any remaining balance in the Deposit for MTM Margin

Account at the year-end is treated as a Current Asset
in the balance sheet.

JOURNAL ENTRIES
1. Deposit for Mark-to-Market Margin Kept:
Deposit for M to M Margin A/c Dr.
To Bank A/c

2. Mark-to-Market Margin Paid/Adjusted from

Deposit:
M to M Margin A/c Dr.
To Bank A/c / Deposit for M to M Margin A/c

3. Mark-to-Market Margin Received:

Bank A/c / Deposit for M to M Margin A/c Dr.
To M to M Margin A/c

Parth Verma / The Valuation School

Parth Verma / The Valuation School

ACCOUNTING FOR OPEN INTERESTS

AS ON THE BALANCE SHEET DATE

1. Debit/Credit Balance in Mark-to-Market (MTM)

Margin Account:
The debit balance shows the net amount paid (loss), and
the credit balance shows the net amount received (profit)
due to price movements in index or stock futures.

2. Anticipated Loss Provision (Prudence Principle):

If there's a debit balance (loss), create a provision by
debiting the Profit & Loss account to reflect the potential
loss.
If there's a credit balance (profit), ignore it, meaning don't
record it as a profit in the P&L as it's just an anticipated
profit.

3. Presentation in the Balance Sheet:

The debit balance (amount paid to the broker) should be

listed under Current Assets, Loans and Advances. The
provision for the loss should be shown as a deduction
from this amount.
The credit balance (amount received from the broker)
should be listed under Current Liabilities and Provisions.
4. Index/Stock-Wise Calculation:
The provision for loss should be calculated separately for
each stock or index, combining all series of the same stock.

PROVISION FOR LOSS ON EQUITY

STOCK/INDEX FUTURES

1. If Provision is Increased (Insufficient Provision):

Profit & Loss A/c Dr
To Provision for Loss on Equity Stock/Index Futures A/c

2. If Provision is Decreased (Excess Provision):

Provision for Loss on Equity Stock/Index Futures A/c Dr

To Profit & Loss A/c

Example:
Suppose Mr. B pays ₹3,000 as Mark-to-Market Margin
due to losses on an Equity Futures Contract:

Profit & Loss A/c Dr ₹3,000

To Provision for Loss on Equity Futures A/c ₹3,000
(Provision made for the loss paid due to price movement
in the futures contract)

Parth Verma / The Valuation School

Parth Verma / The Valuation School

ACCOUNTING AT THE TIME OF FINAL SETTLEMENT

OR SQUARING-UP OF THE CONTRACT

1. Profit/Loss Calculation at Expiry:

When the equity index futures expire, calculate the profit

or loss as the difference between the final settlement
price and the contract price.

2. Recording Profit/Loss:

The profit or loss calculated is recorded in the

Profit & Loss Account with a corresponding
entry in the Mark-to-Market Margin Account.

3. Squaring-up of Contracts:

When a contract is squared-up (closed by entering into

an opposite contract), the same accounting treatment is
applied.

4. Handling Multiple Contracts:

If multiple contracts are outstanding for the same series, use

the weighted average method to calculate the contract
price for determining the profit/loss when squaring up.
5. Release of Initial Margin:
Once the contract is settled, the initial margin that was paid
is released. Credit the Initial Margin Account and debit the
Bank/Deposit Account.

JOURNAL ENTRIES
1. If Profit on Settlement / Squaring off:

Mark-to-Market Margin A/c Dr

To Profit & Loss A/c

2. If Loss on Settlement / Squaring off:

Profit & Loss A/c Dr

To Mark-to-Market Margin A/c

3. Entry for Release of Initial Margin:

Bank A/c / Deposit for Initial Margin A/c Dr

To Initial Margin A/c

Parth Verma / The Valuation School

Parth Verma / The Valuation School

ACCOUNTING IN CASE OF DEFAULT:

1. Client Default:

If a client defaults, the contract is closed out.

2. Margin Adjustment:
Unpaid amount is adjusted against the initial margin.
Excess margin is released.
Shortfall must be paid by the client.

3. Accounting:
Profit/loss is calculated and recorded in the Profit & Loss
Account as usual.

DISCLOSURE REQUIREMENTS:

1. Bank Guarantee & Securities:

Disclose bank guarantee, and book/market value of
securities lodged as margin.

2. Open Interest:

Disclose the number of open contracts, units, and

positions (long/short) for each index/stock futures.
ACCOUNTING FOR EQUITY INDEX OPTIONS IN CASE OF
CASH SETTLED OPTIONS

1. For Seller/Writer:

Initial Margin Paid:

Journal Entry:
Equity Index/Stock Option Margin A/c Dr
To Bank A/c
(Initial margin paid for entering the option contract)

The seller deposits a margin to enter the contract, which

is treated as a Current Asset in the balance sheet.

Premium Received:
Journal Entry:
Bank A/c Dr
To Equity Index/Stock Option Premium A/c
(Premium received from buyer for selling the option)

The seller receives the premium as income for selling

the option.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

2. For Buyer/Holder:

Premium Paid:
Journal Entry:
Equity Index/Stock Option Premium A/c Dr
To Bank A/c
(Premium paid for purchasing the option)

The buyer pays the premium, which is treated as an

expense in their books.

ACCOUNTING AT THE TIME OF

PAYMENT/ RECEIPT OF MARGIN

1. For Seller/Writer - Payment/Receipt of Margin:

Payment of Margin:
Journal Entry:

Equity Index/Stock Option Margin A/c Dr

To Bank A/c
(Being margin payment made by seller for the
option contract)

The margin is paid and debited to the Margin Account,

reducing the bank balance.
Receipt of Margin:
Journal Entry:

Bank A/c Dr
To Equity Index/Stock Option Margin A/c
(Being margin received by seller for the option contract)

When the margin is refunded or received back, it is

credited to the Margin Account and bank balance is
increased.

2. Lump Sum Deposit with Clearing Member:

Payment of Margin from Lump Sum Deposit:

Journal Entry:

Equity Index/Stock Option Margin A/c Dr

To Deposit for Margin A/c
(Being margin paid from deposit held with clearing
member)

Receipt of Margin into Lump Sum Deposit:

Journal Entry:

Deposit for Margin A/c Dr

To Equity Index/Stock Option Margin A/c
(Being margin received and added to deposit with
clearing member)

Parth Verma / The Valuation School

Parth Verma / The Valuation School

If a lump sum deposit is used for margin, the Deposit for

Margin A/c is adjusted accordingly. At year-end, any balance
in the deposit account is shown under Current Assets.

ACCOUNTING FOR OPEN OPTIONS AS ON THE BALANCE

SHEET DATE

Premium Account:
Buyer's Premium: Shown under Current Assets.
Seller's Premium: Shown under Current Liabilities.

For Multiple Options:

Combine all premiums in one account but maintain stock-
wise/index-wise entries for provisions.

FOR BUYER/HOLDER:

Loss Provision:

If premium paid > market premium, create a provision for

the difference:
Profit & Loss A/c Dr
To Provision for Loss on Options A/c

This reduces the value in Current Assets.

FOR SELLER/WRITER:

Loss Provision:

If market premium > premium received, create

a provision for the difference:

Profit & Loss A/c Dr

To Provision for Loss on Options A/c

This adds a liability under Current Liabilities.

Final Adjustments:

Losses are accounted for; profits are ignored (as a

precaution).
Adjust old provisions from previous years against the new
year's calculations.

ACCOUNTING AT THE TIME OF FINAL SETTLEMENT

For the Buyer/Holder:

1. Premium Expense:
The buyer records the premium paid as
an expense in the Profit & Loss Account.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

2. Income on Exercise:
If the option is exercised, the buyer receives the
difference between the final settlement price and
the strike price, recorded as income.

For the Seller/Writer:

1. Premium Income:
The seller records the premium received
as income in the Profit & Loss Account.

2. Loss on Exercise:
If the option is exercised, the seller pays the
difference between the final settlement price and
the strike price, recorded as a loss.

3. Release of Margin:
Once the option is exercised, the margin is released
by the exchange, credited to the Margin Account,
and debited to the Bank Account.

ACCOUNTING FOR SQUARING OFF AN OPTION CONTRACT

1. Premium Difference:
The difference between the premium paid and
premium received when squaring off the option is
recorded as a profit or loss in the Profit & Loss
Account.
2. Release of Margin:
When the option is squared off, any margin held is
released, just like in final settlement. The margin is
transferred back to the Bank Account.

3. Handling Multiple Options:

If there are multiple options with the same stock/index,
strike price, and expiry date, use the weighted
average method to calculate the profit or loss.

ACCOUNTING FOR DELIVERY-SETTLED OPTIONS

For Buyer/Holder:
1. Call Option (Buyer Receives Shares):
The buyer exercises the call option and
receives equity shares by paying cash.

Equity Shares A/c Dr

To Bank/Cash A/c
(Being equity shares received at the strike price on
exercise of call option)

Parth Verma / The Valuation School

Parth Verma / The Valuation School

2. Put Option (Buyer Delivers Shares):

The buyer exercises the put option and delivers
equity shares, receiving cash.

Bank/Cash A/c Dr
To Equity Shares A/c
(Being equity shares delivered at the strike price on
exercise of put option)

For Seller/Writer:

1. Call Option (Seller Delivers Shares):

The seller exercises the call option and delivers
equity shares to the buyer, receiving cash.

Bank/Cash A/c Dr
To Equity Shares A/c
(Being equity shares delivered on exercise of call
option by the buyer)

2. Put Option (Seller Receives Shares):

The seller exercises the put option and receives
equity shares by paying cash.

Equity Shares A/c Dr

To Bank/Cash A/c
(Being equity shares received on exercise of put
option by the buyer)
PREMIUM ENTRIES:
For both buyer and seller, the premium paid/received is
transferred to the Profit & Loss Account.

For Buyer:
Profit & Loss A/c Dr
To Equity Index/Stock Option Premium A/c
(Being premium paid transferred to P&L)

For Seller:
Equity Index/Stock Option Premium A/c Dr
To Profit & Loss A/c
(Being premium received transferred to P&L)

DISCLOSURE REQUIREMENTS:
1. Disclose accounting Policies for equity index/stock
options.
2. Details of Margins such as bank guarantees or securities
lodged.
3. Details of Outstanding Option Contracts at the year-end
for both buyer and seller.

This version includes all necessary journal entries and

summarizes the disclosure requirements as well.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

ACCOUNTING FOR EQUITY STOCK OPTIONS

Cash-Settled Equity Stock Options:

Same accounting as Equity Index Options.

Settlement is done without delivery of the underlying
stock; only cash difference is exchanged.

Delivery-Settled Equity Stock Options:

At Inception, Daily Margin, and Open Options:

Same as cash-settled options (record premium,
margin payments, and adjust balances).

Final Settlement (if Exercised):

Shares are physically delivered (actual transfer of stock

and cash between buyer and seller)
9.2 TAXATION OF DERIVATIVE
TRANSACTION IN SECURITIES

Taxation of Profit/Loss:

Gains or losses from derivatives trading on recognized

stock exchanges (like futures and options) are taxed as
business income under the head ‘Profits and Gains from
Business or Profession’.

This income is treated as non-speculative (ordinary

business income), meaning losses can be set off against
any business income, except salary income.

Changes in Tax Law (Before & After 2005):

Before FY 2005-06, derivative transactions were
considered speculative (like gambling), and losses could
only be set off against speculative gains.

After 2005, the law was changed, and derivative

transactions on recognized exchanges are no longer
treated as speculative. Now, losses can be set off against
other business income or carried forward for up to 8 years.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Conditions for Carry Forward Losses:

To carry forward derivative losses, the income tax return
must be filed on or before the due date.

Securities Transaction Tax (STT):

The Securities Transaction Tax (STT) paid on these
derivative trades can be deducted under the Income
Tax Act.

Taxation for Foreign Portfolio Investors (FPIs):

For FPIs, gains/losses from derivative trading are taxed

as capital gains, mostly as short-term capital gains
since derivative contracts generally have short durations
(up to 3 months).

Presumptive Taxation:
Small traders (with turnover under ₹2 crores) can opt for
presumptive taxation under Section 44AD, where they
are taxed on 6% of their turnover without needing to
maintain detailed records or get their accounts audited.
SECURITIES TRANSACTION TAX (STT)

What is STT:
Securities Transaction Tax (STT) is a tax on the
purchase and sale of securities listed on Indian stock
exchanges.
Applies to equity, derivatives, and equity-oriented
mutual funds.

Who Collects STT:

The stock exchange collects STT on derivative
transactions and pays it to the Government.

STT Rates for Derivatives:

Sale of Options: 0.0625% (paid by seller).
Exercised Options: 0.125% (paid by buyer on
settlement price).
Sale of Futures: 0.0125% (paid by seller).

These are the older rates

→ Got revised in Budget 2024

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Valuation for STT:

For Options:
On sale: STT is applied on the option premium.
When exercised: STT is applied on the settlement
price.
Physical Settlement: STT for delivery-based transactions
is 0.1% (applies to both buyer and seller).

STT Procedure:

Futures: STT is applied on the actual trade price.

Options: STT is applied on the premium.
Exercised Options: STT is applied on the settlement price.

Clearing Member's Role:

STT liability is collected at each trading level:

Clearing members pay the total STT for all trading
members under them.
Trading members pay STT for all their clients.
Parth Verma / The Valuation School

NISM VIII
CHAPTER 10: SALES PRACTICES AND INVESTOR
PROTECTION MEASURES

Learning Objectives
Importance of understanding client risk profile and Risk
Disclosure Document
Client Identification procedure
Due Diligence process for customers
Documents required under KYC process
Suspicious Transaction Reporting
Investor Grievance Redressal Mechanism

The finance sector plays an important role in an economy

ensuring stable markets and supporting the real economy.

Financial institutions must provide sustainable financial services,

good advice, and excellent customer service for long-term
success.

A customer-oriented approach is essential, where product sales

are led by customer needs and accompanied by efficient advice.
Investors need to be cautious of:

High Return" or "Risk-Free" Investments:

Be wary of opportunities promising spectacular or guaranteed returns. All
investments carry risks.

Investment Advisor Services:

Advisors should act in the client's best interest, but investors must review
their statements and plans regularly.

Unsuitable Investment Recommendations:

Be cautious of products that don't match your investment objectives or
risk profile.

Churning:
Watch for excessive trading intended to generate commissions.

Investor Seminars:
At some investor seminars, advisers may pitch unsuitable products.
Investors should avoid rushed decisions and seek third-party advice
before committing their funds.

As sales become an integral part of financial services,

proper advice to the customers is important.

Parth Verma / The Valuation School

While contacting customers sales agents should:

Call only between 9 am and 8 pm unless requested otherwise.

Identify themselves and their purpose promptly.
Respect customers' personal circumstances and diversity obligations.
End discussions immediately if requested by the customer.
Cease contact if the customer indicates it is unwelcome.
Leave a contact number if requested and maintain records of interactions.
Always be courteous, and professional, avoid false assumptions, and refrain
from high-pressure tactics.

10.1 UNDERSTANDING THE RISK PROFILE OF THE CLIENT

In investments, "risk" refers not only to the chance of losing capital but
also to not achieving the desired returns.

Investment products generally include:

Fixed Income Instruments: These have a definite interest rate & minimal
risk of not getting desired returns, though credit or default risk exists.
Market-Oriented Investments: These carry the risk of not achieving
expected returns.

Risk/Return Trade-Off

Higher risk should correlate with higher potential returns.

Risk-Averse Investors: Prefer secure investments like debt and fixed
income.
Less Risk-Averse Investors: Prefer higher exposure to equities and risky
investments.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

There is a need to understand risk tolerance for a variety

of reasons, some of which are specified below:

Achieving financial independence.

Accepting smaller, certain returns over large, uncertain profits.
Evaluating self-worth and satisfaction with financial situations.
Identifying personal comfort zones regarding potential losses versus gains.
Developing realistic investment objectives.
Communicating risk attitudes effectively.
Ensuring new investors grasp financial and risk concepts.
Accurately profiling an investor's risk tolerance.
Avoiding a one-size-fits-all investment approach.

Key parameters affecting risk tolerance include age, personal and family
income, dependents, occupation, marital status, education, liabilities, and
access to inherited wealth.

Financial advisors need to know the investment period and objectives to

provide proper advice for both short-term and long-term needs. Longer
investment horizons allow for more risk in financial planning.

10.2 RISK DISCLOSURE DOCUMENT

Equities as an Asset Class:

Equities generally outperform other asset classes over the long term,
delivering superior returns. However, in the short term, they can
underperform and even yield negative returns.

This unpredictability makes stocks riskier for short-term investments.

Purpose of the Risk Disclosure Document:
This document outlines the risks involved in trading on stock exchanges and
the rights and obligations of brokers and clients.

It emphasizes the need for clients to understand these risks and sign the
document at onboarding.

Risks in Equity Derivatives:

Trading in derivatives such as options and futures,

involves various risks due to their leveraged nature.

1. Market Risk: The possibility of the market moving unfavorably, causing

losses.
2. Liquidity Risk: The difficulty in liquidating positions, especially as contracts
near expiry.
3. Counterparty Risk: The risk of default by a transaction's counterparty,
generally mitigated in exchange-traded derivatives.

Specific Risks in Futures and Options:

Futures Contracts:
Daily Settlement: Futures are marked to market daily. Unfavorable
market movements require additional deposits to cover notional losses.
Increased Margins: Margins can rise suddenly during volatility,
potentially leading to liquidation if not met.
Liquidity Issues: During volatility, liquidity can dry up, making it difficult
to execute trades.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Option Buyers:
Premium Loss: Options are "wasting assets," potentially becoming
worthless if the underlying asset's price doesn't move as expected
before expiry.

Option Sellers:
Unlimited Losses: Unlike buyers, sellers face unlimited
risk if the underlying asset's price moves unfavorably.

Volatility and Execution Risks:

High volatility can cause large price swings which lead to partial or non-
execution of orders, system glitches, or communication failures which
results in substantial losses.

Regulatory Focus and Ethical Practices:

Broker-client relationships and sales practices in derivatives need strict

regulation. Brokers must issue a risk disclosure document, ensuring clients
understand the risks. They must also:

Know their client’s financial capabilities and investment knowledge.

Verify the client’s net worth, income, and investment experience.
Avoid recommending unsuitable derivative products.
Content of the Risk Disclosure Document:
The document should explain:

Mechanics and risks of derivatives trading.

Transaction costs and margin requirements.
Tax consequences of margin trading.

Due to the increasing participation of retail investors in

equity futures and options, informed decision-making is
crucial. Brokers must now:

1. Display key Risk Disclosure facts on their websites, which pop up when
clients log in. Clients must acknowledge these before proceeding.

The facts, based on SEBI's 2023 study are:

1. 9 out of 10 individual traders in the equity Futures and Options

Segment, incurred net losses.
2. On average, loss makers registered net trading losses close to ₹ 50,000.
3. Over and above the net trading losses incurred, loss makers expended
an additional 28% of net trading losses as transaction costs.
4. Those making net trading profits, incurred between 15% to 50% of such
profits as transaction cost.

2. Maintain and retain individual clients' (excluding proprietary traders,

institutions, etc.) profit and loss data in a prescribed format for at least
five years.

Stock exchanges and depositories must also display these

Risk Disclosure facts and provide a link to the SEBI study.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

10.3 WRITTEN ANTI-MONEY LAUNDERING PROCEDURES

The Prevention of Money Laundering Act, 2002 (PMLA) aims to prevent
money laundering and confiscate property derived from such activities.

Financial intermediaries must adopt written procedures to comply with

anti-money laundering (AML) regulations.

These procedures should focus on three main areas related to the Client
Due Diligence Process:

1. Client Acceptance Policy

2. Client Identification Procedure
3. Transaction Monitoring and Reporting
(including Suspicious Transactions Reporting - STR)

Customer Due Diligence (CDD)

CDD measures include:
Identifying and verifying the identity of clients and beneficial owners.
Understanding the ownership and control structure of clients.
Conducting ongoing monitoring of transactions to ensure consistency
with the client's risk profile and source of funds.

Client Acceptance Policy

The following safeguards are to be followed while accepting the clients:
No anonymous or fictitious accounts.
Risk-based classification of clients (low, medium, high risk).
Enhanced due diligence for high-risk clients.
Documentation requirements based on client risk.
Refusal to open accounts if due diligence cannot be completed.
Clear guidelines for clients acting on behalf of others.
Checks to ensure clients do not have a criminal background.
Risk-Based Approach
Clients are categorized into higher or lower risk based on their background
and type of transactions.

Enhanced due diligence is applied to higher-risk clients, while simplified

measures may be used for lower-risk clients.

The type and amount of identification information and documents required

depend on the customer's risk category.

Clients of Special Categories (CSC)

Clients requiring special attention include:
Non-residents.
High net-worth individuals.
Trusts, charities, NGOs.
Companies with family ownership.
Politically exposed persons (PEPs) of foreign origin.
Clients from high-risk countries.
Non-face-to-face clients.
Clients with dubious reputations.

This list is illustrative, and intermediaries should use judgment to identify CSC
clients.

Client Identification Procedure

KYC Policy
The 'Know Your Client' (KYC) policy should detail procedures
for client identification at various stages:
Establishing intermediary-client relationships
Conducting transactions
Addressing doubts about previously obtained client data

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Client Identification
Intermediaries should:

Use reliable sources for client identification, verifying each original

document.
Gather adequate information to establish each client's identity and the
nature of the relationship.
Ensure due diligence to satisfy regulatory authorities.
Report to higher authorities if a client fails to provide satisfactory
evidence of identity.`

Documentation for Customer Identification

Accounts of Individuals
Legal Name & Other Names: Supported by documents such as PAN
card, passport, voter ID, driving license, Aadhaar card, etc.
Permanent Address: Supported by documents such as an Aadhaar card,
passport, driving license, voter ID card, bank statement, utility bills, etc.

Accounts of Companies
Required Information: Company name, principal place of business,
mailing address, telephone/fax number.
Documents: Certificate of incorporation, Memorandum & Articles of
Association, board resolution, Power of Attorney, PAN allotment letter,
telephone bill.

Accounts of Partnership Firms

Required Information: Legal name, address, names and addresses of
partners, telephone numbers.
Documents: Registration certificate, partnership deed, Power of Attorney,
valid documents identifying partners, telephone bill.
In-person Verification
Mandatory for opening trading or demat accounts, which can be done via:
Physical Verification: KYC staff visits the customer's address.
Online Verification: Webcam verification or video call for e-KYC.

Exceptions:
KYC was completed using Aadhaar authentication.
Online submission with verification through DigiLocker or similar sources.

e-KYC Process
The process can be completed offline or online, involving:
Online account opening form submission.
Scanned proof of identity and address.
In-person verification via video call.
Digital signing of documents.

Unique Client Code (UCC)

Post-KYC, clients are given a Unique Client Code (UCC) linked to their PAN.
The UCC is uploaded to stock exchanges and is necessary for activating the
trading account.
SEBI requires UCC to be mapped to demat accounts to prevent securities
misappropriation.

Suspicious Transaction Reporting

Under the Anti-Money Laundering (AML) and Combating of Financial
Terrorism (CFT) regulations, intermediaries must report suspicious
transactions to the Financial Intelligence Unit - India (FIU-IND). Examples of
suspicious transactions include:

Difficulty in verifying a client's identity or lack of cooperation.

Unclear or inappropriate source of funds.
Parth Verma / The Valuation School
Parth Verma / The Valuation School

Sudden substantial increase in business.

Large money transfers to/from overseas with cash payment instructions.
Transfer of investment proceeds to unrelated third parties.

Suspicious transactions must be reported immediately to the Money

Laundering Control Officer.
The client should not be informed about the suspicion or the report. Account
operations may only be suspended in exceptional circumstances.
Compliance and risk management staff should have timely access to all
relevant client and transaction data.

10.4 INVESTOR GRIEVANCE MECHANISM

Dedicated Department:
Each exchange has a dedicated department to handle investor
grievances against Trading Members and Issuers.
These departments are accessible from all exchange offices.
Supervised by the Investor Grievance Redressal Committee (IGRC),
comprising Exchange officials and independent experts approved by SEBI.
SEBI monitors the grievance redressal performance of exchanges.

Process:

Receipt of Complaints:

Investors submit complaints using a prescribed

form with supporting documents.
Exchange reviews and records the complaint, assigns a complaint
number, and acknowledges receipt.
If documents are inadequate, investors are asked to correct the
deficiencies.
Redressal of Complaints:

Exchanges aim to resolve complaints by facilitating communication

between the member and the complainant.
If the member agrees, immediate settlement is advised.
If the member claims settlement, proof is requested and confirmed by
the investor.
If disputes arise, the exchange facilitates discussion and suggests
arbitration if needed.
Members with valid reasons within regulations are clarified.
Dissatisfied parties can opt for arbitration within 3 months of IGRC
recommendations, or as per The Limitation Act, 1963 if bypassing IGRC.

Nature of Complaints Handled:

Non-receipt of corporate benefits (dividend/interest/bonus).
Issues with trading members such as:
Non-issuance of documents.
Non-receipt of funds/securities.
Non-receipt of margin/security deposit.
Disputes over auction/close-out values.
Unauthorized trade execution.
Overcharging of brokerage.
Discrepancies in credit balance.
Non-receipt of funds/securities kept as margin.

Parth Verma / The Valuation School

Parth Verma / The Valuation School

Complaints Not Handled:

Exchanges do not entertain the following types of complaints:
Complaints are already under arbitration proceedings.
Issues involving funds/securities transferred to entities other than the
trading member.
Claims for mental distress, harassment, or expenses related to matters
with the ISC.
Claims for notional or opportunity loss.
Complaints about trades not executed by the complainant on the
exchange.
Claims from authorized persons for private commercial dealings.
Claims related to loan or financing transactions outside the exchange's
defined framework.
Claims related to entities or activities not regulated by the exchange.

Arbitration
Arbitration is a quasi-judicial process used to settle disputes between
trading members, investors, clearing members, and listed companies without
going to court.

Disputes must be filed for arbitration at Regional Arbitration Centres within

three years. The process follows stock exchange rules and SEBI guidelines,
and both sides choose arbitrators from a panel provided by the exchange.

The arbitrator makes a decision within four months of the first hearing, and
it is binding. However, if either party is unhappy with the decision, they can
appeal to an Appellate Bench within 30 days.

The Bench's ruling is enforceable like a court order, but if dissatisfied, the
decision can still be challenged in court.
SEBI Complaints Redress System (SCORES):

SCORES is a web-based system for managing investor grievances with

tracking mechanisms.

Features:

Centralized database of complaints.

Online transfer of complaints to relevant companies or intermediaries.
Online Action Taken Reports (ATRs) and status updates viewable by
investors.

Process:

Registration: Investors register at http://scores.gov.in with the

necessary details.
Complaint Lodging: Submit complaints directly to entities or SEBI.
Follow-Up: Companies must resolve complaints within 30 days;
unresolved issues are forwarded to SEBI.
Escalation: Dissatisfied investors must provide reasons within 15 days
for further review by SEBI officers.

Support:
Assistance available from SEBI-recognized Investor Associations or SEBI’s
helpline.

Parth Verma / The Valuation School

General Do's and Don’ts for Investors

Do’s:

Deal only with SEBI-registered intermediaries.

Perform due diligence before registering with intermediaries.
Collect copies of all executed documents.
Provide clear instructions to brokers/agents.
Insist on contract notes and verify transactions.
Settle dues through formal banking channels.
Follow investment strategies suitable for their risk capacity.
Be cautious of sudden price or trading activity spikes.
Understand there are no guaranteed returns in the stock market.
Keep copies of all investment documentation.
Use reliable modes for sending important documents.
Ensure they have the required funds or securities before trading.

Don’ts:

Avoid unregistered brokers or intermediaries.

Do not execute documents without understanding them.
Do not leave Demat Transaction slip books with intermediaries.
Avoid making payments in cash.
Reject unsigned, duplicate, or incomplete contract notes.
Do not trade based on rumors or tips.
Avoid promises of high or guaranteed returns.
Do not be misled by repayment guarantees or luring advertisements.
Avoid blindly following media reports or imitating others' investment
decisions.
Ensure to obtain all transaction documents, even from known persons.
Do not delay approaching authorities in case of disputes; file complaints
promptly.

Parth Verma / The Valuation School