i Cici Stock Tutorial

Chapter 1Module 1 - New to investing!

Investing !! What's that?

Why should you invest?

When to invest?

How much money do you need to invest ?

What can you invest in ?

Investing !! What's that?

Judging by the fact that you've taken the trouble to navigate to the Learning Center of ICICIDirect, our guess is that you don't need much convincing about the wisdom of investing. However, we hope that your quest for knowledge/information about the art/science of investing ends here. Sink in. Knowledge is power. It is common knowledge that money has to be invested wisely. If you are a novice at investing, terms such as stocks, bonds, badla, undha badla, yield, P/E ratio may sound Greek and Latin. Relax. It takes years to understand the art of investing. You're not alone in the quest to crack the jargon. To start with, take your investment decisions with as many facts as you can assimilate. But, understand that you can never know everything. Learning to live with the anxiety of the unknown is part of investing. Being enthusiastic about getting started is the first step, though daunting at the first instance. That's why our investment course begins with a dose of encouragement: With enough time and a little discipline, you are all but guaranteed to make the right moves in the market. Patience and the willingness to pepper your savings across a portfolio of securities tailored to suit your age and risk profile will propel your revenues at the same time cushion you against any major losses. Investing is not about putting all your money into the "Next Infosys," hoping to make a killing. Investing isn't gambling or speculation; it's about taking reasonable risks to reap steady rewards. Investing is a method of purchasing assets in order to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and appreciation over the long term.

Why should you invest?

Simply put, you should invest so that your money grows and shields you against rising inflation. The rate of return on investments should be greater than the rate of inflation, leaving you with a nice surplus over a period of time. Whether your money is invested in stocks, bonds, mutual funds or certificates of deposit (CD), the end result is to create wealth for retirement, marriage, college fees, vacations, better standard of living or to just pass on the money to the next generation. Also, it's exciting to review your investment returns and to see how they are accumulating at a faster rate than your salary.

When to Invest?

The sooner the better. By investing into the market right away you allow your investments more time to grow, whereby the concept of compounding interest swells your income by accumulating your earnings and dividends. Considering the unpredictability of the markets, research and history indicates these three golden rules for all investors 1. Invest early 2. Invest regularly 3. Invest for long term and not short term While it’s tempting to wait for the “best time” to invest, especially in a rising market, remember that the risk of waiting may be much greater than the potential rewards of participating. Trust in the power of compounding Compounding is growth via reinvestment of returns earned on your savings. Compounding has a snowballing effect because you earn income not only on the original investment but also on the reinvestment of dividend/interest accumulated over the years. The power of compounding is one of the most compelling reasons for investing as soon as possible. The earlier you start investing and continue to do so consistently the more money you will make. The longer you leave your money invested and the higher the interest rates, the faster your money will grow. That's why stocks are the best long-term investment tool. The general upward momentum of the

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economy mitigates the stock market volatility and the risk of losses. That’s the reasoning behind investing for long term rather than short term.

How much money do I need to invest?

There is no statutory amount that an investor needs to invest inorder to generate adequate returns from his savings. The amount that you invest will eventually depend on factors such as:

Your risk profile

Your Time horizon

Savings made

All the above three factors will be discussed in brief in the latter part of the course.

What can you invest in?

The investing options are many, to name a few

Stocks

Bonds

Mutual funds

Fixed deposits

Others

Read about them in detail in module 2 of the course.

Chapter 1Module 2 - Savings & investment vechicles available.

Personal Finances. What are those to be bothered about?

Different investment options and their current market rate of returns.

Personal finances.Why bother?

There is always a first time for everything so also for investing. To invest you need capital free of any obligation. If you are not in the habit of saving sufficient amount every month, then you are not ready for investing. Our advice is :-

Save to atleast 4-5 months of your monthly income for emergencies. Do not invest from savings made for this



purpose. Hold them in a liquid state and do not lock it up against any liability or in term deposits.

Save atleast 30-35 per cent of your monthly income. Stick to this practice and try to increase your savings.

Avoid unnecessary or lavish expenses as they add up to your savings. A dinner at Copper Chimney can always be avoided, the pleasures of avoiding it will be far greater if the amount is saved and invested.

Try gifting a bundle of share certificates to yourself on your marriage anniversary or your hubby’s birthday instead of spending your money on a lavish holiday package.

Clear all your high interest debts first out of the savings that you make. Credit card debts (revolving credits) and loans from pawnbrokers typically carry interest rates of between 24-36% annually. It is foolish to pay off debt by trying to first make money for that cause out of gambling or investing in stocks with whatever little money you hold. Infact its prudent to clear a portion of the debt with whatever amounts you have.

Retirement benefits is an ideal savings tool. Never opt out of retirement benefits in place of a consolidated pay cheque. You are then missing out on a substantial employer contribution into the fund.

Different investment options and their current market rate of returns.

The investment options before you are many. Pick the right investment tool based on the risk profile, circumstance, time zone available etc. If you feel market volatility is something which you can live with then buy stocks. If you do not want to risk the volatility and simply desire some income, then you should consider fixed income securities. However, remember that risk and returns are directly proportional to each other. Higher the risk, higher the returns. A brief preview of different investment options is given below:

Equities: Investment in shares of companies is investing in equities. Stocks can be bought/sold from the exchanges (secondary market) or via IPOs – Initial Public Offerings (primary market). Stocks are the best long-term investment options wherein the market volatility and the resultant risk of losses, if given enough time, is mitigated by the general upward momentum of the economy. There are two streams of revenue generation from this form of investment.

1. Dividend: Periodic payments made out of the company's profits are termed as dividends.

2. Growth: The price of a stock appreciates commensurate to the growth posted by the company resulting in capital appreciation.

On an average an investment in equities in India has a return of 25%. Good portfolio management, precise timing may ensure a return of 40% or more. Picking the right stock at the right time would guarantee that your capital gains i.e. growth in market value of your stock possessions, will rise.

Catch ICICIDirect’s ‘Tips for Stock Picks’ and ‘Portfolio Management’ Chapter II / Module 9 & 10 respectively.

Bonds: It is a fixed income(debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with fixed rate of interest on a specified date, called as the maturity date. Other fixed income instruments include bank fixed deposits, debentures, preference shares etc.

The average rate of return on bonds and securities in India has been around 10 - 12 % p.a.

Certificate of Deposits : These are short - to-medium-term interest bearing, debt instruments offered by banks.

These are low-risk, low-return instruments. There is usually an early withdrawal penalty. Savings account, fixed deposits, recurring deposits etc are some of them. Average rate of return is usually between 4-8 %, depending on which instrument you park your funds in. Minimum required investment is Rs. 1,00,000.

Mutual Fund : These are open and close ended funds operated by an investment company which raises money from the public and invests in a group of assets, in accordance with a stated set of objectives. It’s a substitute for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints. Benefits include diversification and professional money management. Shares are issued and redeemed on demand, based on the fund's net asset value, which is determined at the end of each trading session. The average rate of return as a combination of all mutual funds put together is not fixed but is generally more than what earn in fixed deposits. However, each mutual fund will have its own average rate of return based on several schemes that they have floated. In the recent past, MFs have given a return of 18 – 30 %.

Cash Equivalents: These are highly liquid and safe instruments which can be easily converted into cash, treasury bills and money market funds are a couple of examples for cash equivalents.

Others : There are also other saving and investment vehicles such as gold, real estate, commodities, art and crafts, antiques, foreign currency etc. However, holding assets in foreign currency are considered more of an hedging tool (risk management) rather than an investment.

Chapter 1Module 3 - Why Invest In Equities ?

Introduction to Equity Investing.

Many investors go about their investing in an irrational way:1. They are tipped of a 'news'/'rumor' in a 'hot stock' from their broker.2. They impulsively buy the scrip.3. And after the purchase wonder why they bought the stock.He is a fool to act in such an irrational manner. We suggest a three-step approach to investing in equities.

The moment you get a tip on any stock, get the first hand news immediately. You'll find information on the following sites: www.icicidirect.com www.nse-index.com www.bseindex.com

The news, if any, will be on the sites. Be it announcements earnings, dividend payoffs, corporate move to buy another company, flight of top management to another company, these sites should be your first stop.

Do some number crunching. Check out the growth rate of the stock's earnings, as shown in a percentage and analyze those graphs shown on your broker’s site. You will learn to do it in Chapter II of our learning center under the module named ‘Technical tutorials’. Learn more about the P/E ratio (price-to-earnings ratio), earning per share (EPS), market capitalization to sales ratio, projected earnings growth for the next quarter and some historical data, which will tell what the company has done in the past. Get the current status of the stock movement such as real-time quote, average


trades per day, total number of shares outstanding, dividend, high and low for the day and for the last 52 weeks. This information should give you an indication of the nature of the company’s performance and stock movement. Also its ideal that you be aware of the following terms:-

High (high) : The highest price for the stock in the trading day.

Low (low) : The lowest price for the stock in the trading day.

Close (close) : The price of the stock at the time the stock market closes for the day.

Chg (Change) : The difference between two successive days' closing price of the stock.

Yld (Yield) : Dividend divided by price Bid and Ask (Offer) Price

When you enter an order to buy or sell a stock, you will essentially see the “Bid” and “Ask” for a stock and some numbers. What does this mean?

The ‘Bid’ is the buyer’s price. It is this price that you need to know when you have to sell a stock. Bid is the rate/price at which there is a ready buyer for the stock, which you intend to sell.

The ‘Ask’ (or offer) is what you need to know when you're buying i.e. this is the rate/ price at which there is seller ready to sell his stock. The seller will sell his stock if he gets the quoted “Ask’ price.

Bid size and Ask (Offer) size

If an investor looks at a computer screen for a quote on the stock of say ABC Ltd, it might look something like this:

What this means is that there is total demand for 40,000 shares of company ABC at Rs 3550 per share. Whereas the supply is only of 20,000 shares, which are available for sale at a price of Rs 3595 per share. The law of demand and supply is a major factor, which will determine which way the stock is headed.

Armed with this information, you've got a great chance to pick up a winning stock. Again don’t be in a hurry, ferret out some more facts, try to find out as to who is picking up the stock (FIIs, mutual funds, big industrial houses? The significance of which you will learn in section II of our learning center). Watch for the daily volume in a day: is it more/less than the average daily volume? If it's more, maybe some fund is accumulating the stock.

Next time you hear or read a 'hot tip': do some research; try to know all you can about the stock and then shoot your investing power into the stock. With practice, you'll be hitting a bull’s eye more often than not.

ICICIDirect recommends investors to be aware of the technical tools of measuring stock performances before investing. Learn to identify the signals that the market emits. The Chapter II of the learning center of ICICI Direct will help you in this effort.

Chapter 1

Bid Price : 3550Offer Price : 3595 Bid Qty : 40T Offer Qty : 20T

Module 4 - Basics On The stock Market.

Working of Stock Market.

Indian Stock Market Overview.

Rolling Settlements.

Concept of Buying Limits.

What is Dematerializtion ?

Going Short.

Concept of Margin Trading.

Types of orders.

Circuits Filters & Trading bands.

India's Unique - Badla.

Securities Lending.

Insider Trading.

Working of a stock market

To learn more about how you can earn on the stock market, one has to understand how it works. A person desirous of buying/selling shares in the market has to first place his order with a broker. When the buy order of the shares is communicated to the broker he routes the order through his system to the exchange. The order stays in the queue exchange's systems and gets executed when the order logs on to the system within buy limit that has been specified. The shares purchased will be sent to the purchaser by the broker either in physical or demat format

Indian Stock Market Overview.

The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are the two primary exchanges in India. In addition, there are 22 Regional Stock Exchanges. However, the BSE and NSE have established themselves as the two leading exchanges and account for about 80 per cent of the equity volume traded in India. The NSE and BSE are equal in size in terms of daily traded volume. The average daily turnover at the exchanges has increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further to Rs 2,273 crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a total market capitalization of around Rs 9,21,500 crore (Rs 9215-bln). The BSE has over 6000 stocks listed and has a market capitalization of around Rs 9,68,000 crore (Rs 9680-bln). Most key stocks are traded on both the exchanges and hence the investor could buy them on either exchange. Both exchanges have a different settlement cycle, which allows investors to shift their positions on the bourses. The primary index of BSE is BSE Sensex comprising 30 stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty stocks. The BSE Sensex is the older and more widely followed index. Both these indices are calculated on the basis of market capitalization and contain the heavily traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both the exchanges have switched over from the open outcry trading system to a fully automated computerized mode of trading known as BOLT (BSE On Line Trading) and NEAT (National Exchange Automated Trading) System. It facilitates more efficient processing, automatic order matching, faster execution of trades and transparency. The scrips traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares represent those, which are in the carry forward system (Badla). The 'F' group represents the debt market (fixed income securities) segment. The 'Z' group scrips are the blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual Funds, FIIs and other participants in Indian secondary and primary market is the Securities and Exchange Board of India (SEBI) Ltd.













Rolling Settlement Cycle :

In a rolling settlement, each trading day is considered as a trading period and trades executed during the day are settled based on the net obligations for the day. At NSE and BSE, trades in rolling settlement are settled on a T+3 basis i.e. on the 3rd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE/BSE holidays, Saturdays and Sundays are excluded. Typically trades taking place on Monday are settled on Thursday, Tuesday's trades settled on Friday and so on.

Concept Of Buying Limit

Suppose you have sold some shares on NSE and are trying to figure out that if you can use the money to buy shares on NSE in a different settlement cycle or say on BSE. Due to different settlement cycles and different payment schedules, it may take a clear understanding of settlement mechanism and calendars on your part to figure this out. To simplify things for ICICI Direct customers, we have introduced the concept of Buying Limit (BL). Buying Limit simply tells the customer what is his limit for a given settlement for the desired exchange. The concept is fairly simple to understand, if deals only on one exchange say NSE weekly settlement cycle. Assume that you have enrolled for a ICICI Direct account, which requires 100% of the money required to fund the purchase, be available. Suppose you have Rs 1,00,000 in your Bank A/C and you set aside Rs 50,000 for which you would like to make some purchase. Your Buying Limit is Rs 50,000. Assume that you sell shares worth Rs 1,00,000 on the NSE on Wednesday, which is day 1 of the NSE weekly settlement cycle. The BL therefore for the NSE weekly settlement cycle goes upto Rs 1,50,000. This means you can buy shares upto Rs 1,50,000 on NSE. If you buy shares with Rs 75,000 on Friday on NSE your BL will naturally reduce to Rs 75,000. As long as you deal on one exchange and the concept is fairly simple to understand. Hence your BL is simply the amount set aside by you from your bank account and the amount realized from the sale of any shares you have made less any purchases you have made. The things become more involved if you want to simultaneously deal in more than one exchange. At this point of time please keep in mind the settlement cycles for NSE and BSE, which is the day 1 of the NSE weekly settlement cycle.

On Wednesday your BL of Rs 50,000, which is the amount set aside by you from your Bank account for purchase is available for BSE and NSE. As you have made the sale of shares on NSE on Wednesday, the BL for NSE rises to 1,50,000 but the BL for BSE will still remain at the same level of Rs. 50,000 till start of the next settlement cycle. The amount from sale of shares in NSE will not be available for purchase on BSE for the days of Wednesday, Thursday and Friday but will be available on Monday, which is the first day of the next settlement cycle in BSE. This example shows that BL will depend on the exchange and settlement cycle. ICICI Direct makes it very easy for its customers to know their BL on the click of a mouse. You just have to specify the Exchange and settlement cycle and on a click of your mouse, the BL will be known to you.

What Is Dematerialization?

Dematerialization in short called as 'demat is the process by which an investor can get physical certificates converted into electronic form maintained in an account with the Depository Participant. The investors can dematerialize only those share certificates that are already registered in their name and belong to the list of securities admitted for dematerialization at the depositories.Depository : The organization responsible to maintain investor's securities in the electronic form is called the depository. In other words, a depository can therefore be conceived of as a "Bank" for securities. In India there are two such

organizations viz. NSDL and CDSL. The depository concept is similar to the Banking system with the exception that banks handle funds whereas a depository handles securities of the investors. An investor wishing to utilize the services offered by a depository has to open an account with the depository through a Depository Participant.Depository Participant : The market intermediary through whom the depository services can be availed by the investors is called a Depository Participant (DP). As per SEBI regulations, DP could be organizations involved in the business of providing financial services like banks, brokers, custodians and financial institutions. This system of using the existing distribution channel (mainly constituting DPs) helps the depository to reach a wide cross section of investors spread across a large geographical area at a minimum cost. The admission of the DPs involve a detailed evaluation by the depository of their capability to meet with the strict service standards and a further evaluation and approval from SEBI. Realizing the potential, all the custodians in India and a number of banks, financial institutions and major brokers have already joined as DPs to provide services in a number of cities.

Advantages of a depository services : Trading in demat segment completely eliminates the risk of bad deliveries. In case of transfer of electronic shares, you save 0.5% in stamp duty. Avoids the cost of courier/ notarization/ the need for further follow-up with your broker for shares returned for company objection No loss of certificates in transit and saves substantial expenses involved in obtaining duplicate certificates, when the original share certificates become mutilated or misplaced. Increasing liquidity of securities due to immediate transfer & registration Reduction in brokerage for trading in dematerialized shares Receive bonuses and rights into the depository account as a direct credit, thus eliminating risk of loss in transit. Lower interest charge for loans taken against demat shares as compared to the interest for loan against physical shares. RBI has increased the limit of loans availed against dematerialized securities as collateral to Rs 20 lakh per borrower as against Rs 10 lakh per borrower in case of loans against physical securities. RBI has also reduced the minimum margin to 25% for loans against dematerialized securities, as against 50% for loans against physical securities. Fill up the account opening form, which is available with the DP. Sign the DP-client agreement, which defines the rights and duties of the DP and the person wishing to open the account. Receive your client account number (client ID). This client id along with your DP id gives you a unique identification in the depository system. Fill up a dematerialization request form, which is available with your DP. Submit your share certificates along with the form; (write "surrendered for demat" on the face of the certificate before submitting it for demat) Receive credit for the dematerialized shares into your account within 15 days.

Procedure of opening a demat account:Opening a depository account is as simple as opening a bank account. You can open a depository account with any DP convenient to you by following these steps: Fill up the account opening form, which is available with the DP. Sign the DP-client agreement, which defines the rights and duties of the DP and the person wishing to open the account. Receive your client account number (client ID). This client id along with your DP id gives you a unique identification in the depository system. There is no restriction on the number of depository accounts you can open. However, if your existing physical shares are in joint names, be sure to open the account in the same order of names before you submit your share certificates for demat

Procedure to dematerialize your share certificates: Fill up a dematerialization request form, which is available with your DP. Submit your share certificates along with the form; (write "surrendered for demat" on the face of the certificate before submitting it for demat) Receive credit for the dematerialized shares into your account within 15 days. In case of directly purchasing dematerialized shares from the broker, instruct your broker to purchase the dematerialized shares from the stock exchanges linked to the depositories. Once the order is executed, you have to instruct your DP to receive securities from your broker's clearing account. You have to ensure that your broker also gives a matching instruction to his DP to transfer the shares purchased on your behalf into your depository account. You should also ensure that your broker transfers the shares purchased from his clearing account to your depository account, before the book closure/record date to avail the benefits of corporate action.

Stocks traded under demat:Securities and Exchange Board of India (SEBI) has already specified for settlement only in the dematerialized form in for 761 particular scripts. Investors interested in these stocks receive shares only in demat form without any instruction to your broker. While SEBI has instructed the institutional investors to sell 421 scripts only in the demat form. The shares by

non institutional investors can be sold in both physical and demat form. As there is a mix of both form of stocks, it is possible if you have purchased a stock in this category, you may get delivery of both physical and demat shares.

Opening of a demat account through ICICI Direct : Opening an e-Invest account with ICICI Direct, will enable you to automatically open a demat account with ICICI, one of the largest DP in India, thereby avoiding the hassles of finding an efficient DP. Since the shares to be bought or sold through ICICI Direct will be only in the demat form, it will avoid the hassles of instructing the broker to buy shares only in demat form. Adding to this, you will not face problems like checking whether your broker has transferred the shares from his clearing account to your demat account.

Going Short:

If you do not have shares and you sell them it is known as going short on a stock. Generally a trader will go short if he expects the price to decline. In the NSE Settlement if you are short you will have to cover your short position by Tuesday (last day of settlement cycle) and in BSE by Friday. In a rolling settlement cycle you will have to cover by end of the day on which you had gone short.

Concept Of Margin Trading:

Normally to buy and sell shares, you need to have the money to pay for your purchase and shares in your demat account to deliver for your sale. As explained in the settlement cycles, because of the weekly nature of the settlement cycles on the BSE and the NSE, it is possible to buy / sell shares in the beginning of a settlement cycle without having the full amount or shares to deliver. However as you do not have the full amount to make good for your purchases or shares to deliver for your sale you have to cover (square) your purchase/sale transaction by a sale/purchase transaction before the close of the settlement cycle. In case the price during the course of the settlement cycle moves in your favor (risen in case of purchase done earlier and fallen in case of a sale done earlier) you will make a profit and you receive the payment from the exchange. In case the price movement is adverse, you will make a loss and you will have to make the payment to the exchange. Margins are thus collected to safeguard against any adverse price movement. Margins are quoted as a percentage of the value of the transaction.

Important facts for NRI customers:

Buying and selling on margin in India is quite different than what is referred to in US markets. There is no borrowing of money or shares by your broker to make sure that the settlement takes place as per SE schedule. In Indian context, buying/selling on margin refers to building a leveraged position at the beginning of the settlement cycle and squaring off the trade before the settlement comes to end. As the trade is squared off before the settlement cycle is over, there is no need to borrow money or shares.

Buying On Margin : Suppose you have Rs 1,00,000 with you in your Bank account. You can use this amount to buy 10 shares of Infosys Ltd. at Rs 10,000. In the normal course, you will pay for the shares on the settlement day to the exchange and receive 10 shares from the exchange which will get credited to your demat account. Alternatively you could use this money as margin and suppose the applicable margin rate is 25%. You can now buy upto 40 shares of Infosys Ltd. at Rs 10,000 value Rs 4,00,000, the margin for which at 25% i.e. Rs 1,00,000. Now as you do not have the money to take delivery of 40 shares of Infosys Ltd. you have to cover (square) your purchase transaction by placing a sell order by end of the settlement cycle. Now suppose the price of Infosys Ltd rises to Rs. 11000 before end of the settlement cycle. In this case your profit is Rs 40,000 which is much higher than on the 10 shares if you had bought with the intent to take delivery. The risk is that if the price falls during the settlement cycle, you will still be forced to cover (square) the transaction and the loss would be adjusted against your margin amount. Selling On Margin : You do not have shares in your demat account and you want to sell as you expect the prices of share to go down. You can sell the shares and give the margin to your broker at the applicable rate. As you do not have the shares to deliver you will have to cover (square) your sell transaction by placing a buy order before the end of the settlement cycle. Just like buying on margin, in case the price moves in your favor (falls) you will make profit. In case price goes up, you will make loss and it will be adjusted against the margin amount.

Types Of Orders:

There are various types of orders, which can be placed on the exchanges:

Limit Order : The order refers to a buy or sell order with a limit price. Suppose, you check the quote of Reliance Industries Ltd.(RIL) as Rs. 251 (Ask). You place a buy order for RIL with a limit price of Rs 250. This puts a cap on your purchase price. In this case as the current price is greater than your limit price, order will remain pending and will be executed as soon as the price falls to Rs. 250 or below. In case the actual price of RIL on the exchange was Rs 248, your order will be executed at the best price offered on the exchange, say Rs 249. Thus you may get an execution below your limit price but in no case will exceed the limit buy price. Similarly for a limit sell order in no case the execution price will be below the limit sell price. Market Order : Generally a market order is used by investors, who expect the price of share to move sharply and are yet keen on buying and selling the share regardless of price. Suppose, the last quote of RIL is Rs 251 and you place a market buy order. The execution will be at the best offer price on the exchange, which could be above Rs 251 or below Rs 251. The risk is that the execution price could be substantially different from the last quote you saw. Please refer to Important Fact for Online Investors. Stop Loss Order : A stop loss order allows the trading member to place an order which gets activated only when the last traded price (LTP) of the Share is reached or crosses a threshold price called as the trigger price. The trigger price will be as on the price mark that you want it to be. For example, you have a sold position in Reliance Ltd booked at Rs. 345. Later in case the market goes against you i.e. go up, you would not like to buy the scrip for more than Rs.353. Then you would put a SL Buy order with a Limit Price of Rs.353. You may choose to give a trigger price of Rs.351.50 in which case the order will get triggered into the market when the last traded price hits Rs.351.50 or above. The execution will then be immediate and will be at the best price between 351.50 and 353. However stock movements can be so violent at times. The prices can fluctuate from the current level to over and above the SL limit price, you had quoted, at one shot i.e. the LTP can move from 350…351…and directly to 353.50. At this moment your order will immediately be routed to the Exchange because the LTP has crossed the trigger price specified by you. However, the trade will not be executed because of the LTP being over and above the SL limit price that you had specified. In such a case you will not be able to square your position. Again as the market falls, say if the script falls to 353 or below, your order will be booked on the SL limit price that you have specified i.e. Rs. 353. Even if the script falls from 353.50 to 352 your buy order will be booked at Rs. 353 only. Some seller, somewhere will book a profit in this case form your buy order execution. Hence, an investor will have to understand that one of the foremost parameters in specifying on a stop loss and a trigger price will have to be its chances of executionability as and when the situation arises. A two rupee band width between the trigger and stop loss might be sufficient for execution for say a script like Reliance, however the same band hold near to impossible chances for a script like Infosys or Wipro. This vital parameter of volatility bands of scrips will always have to be kept in mind while using the Stop loss concept.

Circuit Filters And Trading Bands:

In order to check the volatility of shares, SEBI has come with a set of rules to determine the fixed price bands for different securities within which they can move in a day. As per Sebi directive, all securities traded at or above Rs.10/- and below Rs.20/- have a daily price band of ±25%. All securities traded below Rs. 10/- have a daily price band of ± 50%. Price band for all securities traded at or above Rs. 20/- has a daily price band of ± 8%. However, the now the price bands have been relaxed to ± 8% ± 8% for select 100 scrips after a cooling period of half an hour. The previous day's closing price is taken as the base price for calculating the price. As the closing price on BSE and NSE can be significantly different, this means that the circuit limit for a share on BSE and NSE can be different.

Badla financing

In common parlance the carry-forward system is known as 'Badla', which means something in return. Badla is the charge, which the investor pays for carrying forward his position. It is a hedge tool where an investor can take a position in a scrip without actually taking delivery of the stock. He can carry-forward his position on the payment of small margin. In the case of short-selling the charge is termed as 'undha badla'. The CF system serves three needs of the stock market :

Quasi-hedging: If an investor feels that the price of a particular share is expected to go up/down, without giving/taking delivery of the stock he can participate in the volatility of the share. ? Stock lending: If he wishes to short sell without owning the underlying security, the stock lender steps into the CF system and lends his stock for a charge. ? Financing mechanism: If he wishes to buy the share without paying the full consideration, the financier steps into the CF system and provides the finance to fund the purchase The scheme is known as "Vyaj Badla" or "Badla" financing. For example, X has bought a stock and does not have the funds to take delivery, he can arrange a financier through the stock exchange 'badla' mechanism. The financier would make the payment at the prevailing market rate and would take delivery of the shares on X's behalf. You will only have to pay interest on the funds you have borrowed. Vis-à-vis, if you have a sale position and do not have the shares to deliver you can still arrange through the stock exchange for a lender of securities. An investor can either take the services of a badla financier or can assume the role of a badla financier and lend either his money or securities. On every Saturday a CF system session is held at the BSE. The scrips in which there are outstanding positions are listed along with the quantities outstanding. Depending on the demand and supply of money the CF rates are determined. If the market is over bought, there is more demand for funds and the CF rates tend to be high. However, when the market is oversold the CF rates are low or even reverse i.e. there is a demand for stocks and the person who is ready to lend stocks gets a return for the same. The scrips that have been put in the Carry Forward list are all 'A' group scrips, which have a good dividend paying record, high liquidity, and are actively traded. The scrips are not specified in advance because it is then difficult to get maximum return. All transactions are guaranteed by the Trade Guarantee Fund of BSE, hence, there is virtually no risk to the badla financier except for broker defaults. Even in the worst scenario, where the broker through whom you have invested money in badla financing defaults, the title of the shares would remain with you and the shares would be lying with the "Clearing house". However, the risk of volatility of the scrip will have to be borne by the investor.

Securities lending

Securties lending program is from the NSE. It is similar to the Badla from the BSE, only difference being the carry forward system not being allowed by the NSE. Meaning this is a where in a holder of securities or their agent lends eligible securities to borrowers in return for a fee to cover short positions.

Insider trading:

Insider trading is illegal in India. When information, which is sensitive in the form of influencing the price of a scrip, is procured or/and used from sources other than the normal course of information output for unscrupulous inducement of volatility or personal profits, it is called as Insider trading. Insider trading refers to transactions in securities of some company executed by a company insider. Although an insider might theoretically be anyone who knows material financial information about the company before it becomes public, in practice, the list of company insiders (on whom newspapers print information) is normally restricted to a moderate-sized list of company officers and other senior executives. Most companies warn employees about insider trading. SEBI has strict rules in place that dictates when company insiders may execute transactions in their company's securities. All transactions that do not conform to these rules are, in general, prosecutable offenses under the relevant law.

Chapter 1Module 5 - Set your goals right, right at the beginning.

Investment Goals

Is time on Your Side?

Mobilizeable Resources.




Investment Goals.

Investment avenues should always be treated as tools which will generate good returns over a period of time. To take a short term view would be fatal. In the stock markets, prices fluctuate very fast for the lay investor. To get the maximum returns begin with a two-year perspective.

Begin with an understanding of yourself.

What do you want from your investments? It could be growth, income or both.

How comfortable are you to take risks?It's only human if your first reaction on an adverse market movement is to sell and run away. To shield yourself against short term trading risks one has to take a long-term view. Renowned experts such as Benjamin Graham and Warren Buffet rarely shuffle their portfolio unless there is some change in the fundamentals of a company. Once you see the kind of returns you can generate over time, you'll come to realize that it really doesn't matter if your stock drops or rises over the course of a few hours or days or weeks or even months. Mutual funds are a good way to begin investing in the stock market. Funds render investment services with professionalism and give a good diversification over many sectors. If volatility is not your cup of tea, then you might consider buying fixed income securities.

Planning and Setting Goals: Investment requires a lot of planning. Decide on your basic framework of investments and chart your risk profile.

Ask yourself: What is the investment "time horizon"? Time horizon is the time period between the age at which you would like to start investing and at the age by which you would need a consolidated amount of money for any said purpose of yours.

One should also find out if there are there any short-term financial needs?

Will be a need to live off the investment in later years? Your investments could be for retirement, a down payment for a house, your child's education, a second home or just for incremental income to take up a better standard of living.

Make clear-cut, measurable and reasonable goals. Be more specific when you decide your goals. For example you must reasonably predict how much amount of money would require and at what time inorder to satisfy any of the above stated needs? If arriving at these figures looks cumbersome or daunting, our online interactive calculators will help you figure out your future money requirements. The answers to the above will lead you directly to “The type of investments will you make”.

Is time on Your side ?

The time frame you seek to invest on, your investment profile and the moblizable resources are interdependent and are not mutually exclusive.

How much time do you want to spend on investing?You can be active, allocate an hour every day or just spend a few hours every month.

Another important factor is when do you need the money?To help put all of this into context, you also need to look at how various types of investments have performed historically. Bonds and stocks are the two major asset classes that have been used by investors over the past century. Knowing the total return on each of the above and the associated volatility is crucial in deciding where you should put your money.

Moblizable Resources

After you zero in on your investments its time to decide on how much money you want to invest. Setting investment goals and checking out on allocable monetary resources go hand in hand. It is necessary to fix your monetary considerations as soon as you decide on the basic investment framework.

Some of your basic monetary considerations could be:-

The amount of initial investments that you can pump in. The sources for the money that you need for investments. The foreseeable bulk expense which prevents you from saving or which may force you to liquidate your existing

portfolio (this expense itself may be your investment goal). Money that you need to have as back up for emergencies. The amount of savings that you can afford to allocate every month on a continual basis for such number of year that

you may desire.

Answers to all or atleast the most important of these would logically lead you to where you ideally have to invest your money in, can it be equity, mutual funds or bonds.

Chapter 1Module 6 - Can an individual investor match upto market experts.

Can an individual investor match upto market experts?

Singing to the market’s tune. Not always. Be a contrarian !

Power of the World Wide Web (www).

Forming Investment clubs.

How else can we help ?

Can an individual investor match upto market experts?

Yes, he can. The popular opinion is that an investor has no chance in today's volatile markets. The methodology used by professionals, investment strategies and links to worldwide happenings imply that there is no scope for the individual investor in today's institutionalized markets. Nothing could be further away from the truth. E-broking is one solution to the lay investor as these websites provide online information from wire agencies such as Reuters, expert investment advice, research database which is available with the institutions. The advent of online broking has bridged the gap between institutions and the retail investor.

A fund manager is faced with many disadvantages. Typically, a fund manager will not buy high-growth stocks, which are available in small volumes. In some cases an attractive position cannot be capitalized by a fund as the situation might be ultra vires to the fund’s objectives. Sometimes, the fund manager’s risk exposure is high in particular scrips and volumes held, high too. Hence his liquidity is curbed while smaller volumes give the individual investor a higher level of liquidity. A researched view can tilt the scales in favour of the small investor.

http://content.icicidirect.com/learning/LearningCenter/Module6.htm#5





Singing the market’s tune. Not always. Be a contrarian!

When markets start rising, more people step aboard. And when the indices start falling there is panic selling. Most of the times new investors are late in identifying a rally and are late entrants, leaving them with high-priced stocks.

Contrarians buy on bad news, and sell on good news. “Buy low, sell high” is a well-known cliché. That’s how an investor must think in order to profit from stock investing. All stock-market investors embrace the motto "Buy low, sell high." But few act accordingly. The herd mentality restricts us from pursuing a contrarian investment strategy, though it consistently beats the market. There are proven techniques for selecting undervalued stocks which are rarely followed.

The contrarian strategy advises you to pay a cursory look at a company's business fundamentals, stocks trading at below-market multiples of EPS, cash flow, book value, or dividend yield before taking an investment decision. Historically, stocks that are cheap by any of the above measures tend to outperform the market. To do contrary, you would require to go against the crowd, buying stocks that are out of favour and sell a few of Dalal Street’s darlings. This requires overriding powerful instincts.

Power of the World Wide Web (www)

Internet has changed the way the retail investor invests. Stock prices, volume information, investment tools, technical analysis is at his fingertips. Many sites offer Spot Reviews of news breaks and result analysis, which help investors to from an opinion on a particular stock. As the world is networked with the Web you can consult with experts from across cities states. As the internet is flooded with information, an overload, its imperative that you learn to figure out which information is useful and which is not.

Forming Investment Clubs:

If you as an individual investor do not have enough money to invest, or know not enough about investing and do not have the time to learn too. Well, a perfect solution then will be to join or form an investment club.

Investment clubs are formed by people who pool in their money to invest in stocks, bonds, mutual funds and other investments. The appeal is simple: A club has the funds to diversify its investments better than an individual and the knowledge base is wider. Investment clubs can be formed between family, friends and people who work together. However, forming a club with co-workers is a lot easier. But bear in mind that the biggest complaint among club members is finding a convenient time and place to meet each month. Forget not, you can talk about club news over the water cooler or canteen too. To form a club

First step, send out a memo or email asking select members to come to an introductory meeting. During that first meeting, discuss monthly dues. How much can people afford?

Secondly, give members a profile personality test to see where everyone stands. Are they risk takers or conservative investors? Club members should be compatible when it comes to investment goals.

Make sure you recruit people who are truly committed, which means meeting once a month and sharing the workload when it comes to researching companies, picking stocks and reviewing the club's portfolio.

It's common for members to get impatient and to jump ship shortly after the club's formation. Alternatively, member participation tends to drag due to a personal or financial crisis arises. The first few years are the crucial building blocks of a club. Members who survive the two-year hump tend to hang on for the long haul -- 20 years or more. Still, every club must prepare in its bylaws how to bring in new recruits and handle departing members who want to cash out.

Finally, once you have hammered out the goals and operation of the proposed club, if a sufficient number -- around 10 -- are still interested, then you are ready to forge ahead.

How else can we at ICICIDirect help?

ICICIDirect from its end offers virtually everything within the ambit of research tools. Investors has option of using technical analysis, fundamental research, database of over 5000 companies, key ratios, analysts recommendations of future earnings, interviews, company presentations, features, news from the country's leading business daily Business Standard and worldwide wire agency Reuters, which assist our investors to make their investment decisions.

Chapter 2Module 7 - Do it yourself - Basic investment strategies

A few benchmarks for stocks - A quick and easy measuring tool.

The P/E ratio as a guide to investment decisions

Fundamental Analysis

Value, Growth and Income

Keep investing, panic not on your existing stocks.

Go for quality stocks and not quantity

Some more stock tips

A few benchmarks for stocks - A quick and easy measuring stick.

These are a few benchmarks that can help you decide if you should spend more time on a stock or not. They are easily available and can be of great use in screening good stocks.

Revenues/Sales growth. Revenues are how much the company has sold over a given period. Sales are the direct performance indicators for companies. The rate of growth of sales over the previous years indicates the forward momentum of the company, which will have a positive impact on the stock's valuation.

Bottom line growthThe bottom-line is the net profit of a company. The growth in net profit indicates the attractiveness of the stock. The expected growth rate might differ from industry to industry. For instance, the IT sector's growth in bottom-line could be as high as 65-70% from the previous years whereas for the old economy stocks the range could be anywhere in range of 10- 15%.

ROI - Return on InvestmentROI in layman terms is the return on capital invested in business i.e. if you invest Rs 1 crore in men, machines, land and material to generate 25 lakhs of net profit , then the ROI is 25%. Again the expected ROI by market analysts could differ form industry to industry. For the software industry it could be as high as 35-40%, whereas for a capital intensive industry it could be just 10-15%.








Volume Many investors look at the volume of shares traded on a day in comparison with the average daily volume. The investor gets an insight of how active the stock was on a certain day as compared with previous days. When major news are announced, a stock can trade tens of times its average daily volume.Volume is also an indicator of the liquidity in a stock. Highly liquid stocks can be traded in large batches with low transaction costs. Illiquid stocks trade infrequently and large sales often cause the price to rise/fall dramatically. Illiquid stocks tend to carry large spreads i.e. the difference between the buying price and the selling price. Volume is a key way to measure supply and demand, and is often the primary indicator of a new price trend. When a stock moves up in price on unusually high volumes it could indicate that big institutional investors are accumulating the stock. When a stock moves down in price on unusually heavy volume, major selling could be the reason.

Market Capitalization. This is the current market value of the company's shares. Market value is the total number of shares multiplied by the current price of each share. This would indicate the sheer size of the company, it's stocks' liquidity etc.

Company management The quality of the top management is the most important of all resources that a company has access to. An investor has to make a careful assessment of the competence of the company management as evidenced by the dynamism and vision. Finally, the results are the single most important barometer of the company's management. If the company's board includes certain directors who are well known for their efficiency, honesty and integrity and are associated with other companies of proven excellence, an investor can consider it as favourable. Among the directors the MD (Managing Director) is the most important person. It is essential to know whether the MD is a person of proven competence.

PSR (Price-to-Sales Ratio)This is the number you want below 3, and preferably below 1. This measures a company's stock price against the sales per share. Studies have shown that a PSR above 3 almost guarantees a loss while those below 1 give you a much better chance of success.

Return on EquitySupposedly Warren Buffet's favorite number, this measures how much your investment is actually earning. Around 20% is considered good.

Debt-to-Equity RatioThis measures how much debt a company has compared to the equity. The debt-to-equity ratio is arrived by dividing the total debt of the company with the equity capital. You're looking for a very low number here, not necessarily zero, but less than .5. If you see it at 1, then the company is still okay. A D/E ratio of more than 2 or greater is risky. It means that the company has a high interest burden, which will eventually affect the bottom-line. Not all debt is bad if used prudently. If interest payments are using only a small portion of the company's revenues, then the company is better off by employing debt pushing growth. Also note capital intensive industries build on a higher Debt/Equity ratio, hence this tool is not a right parameter in such cases.

Beta The Beta factor measures how volatile a stock is when compared with an index. The higher the beta, the more volatile the stock is. (A negative beta means that the stock moves inversely to the market so when the index rises the stock goes down and vice versa).

Earnings Per Share (EPS)This ratio determines what the company is earning for every share. For many investors, earnings is the most important tool. EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. Thus, if AB ltd has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an EPS of Rs 2. EPS Rating factors the long-term and short-term earnings growth of a company as compared with other firms in the segment. Take the last two quarters of earnings-per-share increase and combine that with the three-to-five-year earnings growth rate. Then compare this number for a company to all other companies in your watch list within each sector and rate the results on

how it outperforms all other companies in your watch list in terms of earnings growth. Its advisable to invest in stocks that rank in the top 20% of companies in your watch list. This is based on the assumption that your portfolio of stocks in the "Watch List" have been selected by using some basic screening tools so as to include the best of the stocks as perceived and authenticated by the screening tools that you had used.

Price / Earnings Ratio (P/E).

Read about this most important investor tool in the next part of this module.

The P/E ratio as a guide to investment decisions

Earnings per share alone mean absolutely nothing. In order to get a sense of how expensive or cheap a stock is, you have to look at earnings relative to the stock price and hence employ the P/E ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. If AB ltd is currently trading at Rs. 20 a share with Rs. 4 of earnings per share (EPS), it would have a P/E of 5. Big increase in earnings is an important factor for share value appreciation. When a stock's P-E ratio is high, the majority of investors consider it as pricey or overvalued. Stocks with low P-E's are typically considered a good value. However, studies done and past market experience have proved that the higher the P/E, the better the stock.

A Company that currently earns Re 1 per share and expects its earnings to grow at 20% p.a will sell at some multiple of its future earnings. Assuming that earnings will be Rs 2.50 (i.e Re 1 compounded at 20% p.a for 5 years). Also assume that the normal P/E ratio is 15. Then the stock selling at a normal P/E ratio of 15 times of the expected earnings of Rs 2.50 could sell for Rs 37.50 (i.e rs 2.5*15) or 37.5 times of this years earnings.

Thus if a company expects its earnings to grow by 20% per year in the future, investors will be willing to pay now for those shares an amount based on those future earnings. In this buying frenzy, the investors would bid the price up until a share sells at a very high P/E ratio relative to its present earnings.

First, one can obtain some idea of a reasonable price to pay for the stock by comparing its present P/E to its past levels of P/E ratio. One can learn what is a high and what is a low P/E for the individual company. One can compare the P/E ratio of the company with that of the market giving a relative measure. One can also use the average P/E ratio over time to help judge the reasonableness of the present levels of prices. All this suggests that as an investor one has to attempt to purchase a stock close to what is judged as a reasonable P/E ratio based on the comparisons made. One must also realize that we must pay a higher price for a quality company with quality management and attractive earnings potential.

Fundamental Analysis

Fundamental Analysis is a conservative and non-speculative approach based on the "Fundamentals". A fundamentalist is not swept by what is happening in Dalal street as he looks at a three dimensional analysis.

The Economy

The Industry

The Company

All the above three dimensions will have to be weighed together and not in exclusion of each other. In this section we would give you a brief glimpse of each of these factors for an easy digestion

The Economy Analysis

In the table below are some economic indicators and their possible impact on the stock market are given in a nut shell.

Economic indicators Impact on the stock market

1. GNP -Growth -Decline

-Favourable -Unfavourable

2. Price Conditions - Stable - Inflation


3. Economy - Boom - Recession


4. Housing Construction Activity - Increase in activity - Decrease in Activity


5. Employment - Increase - Decrease


6. Accumulation of Inventories - Favourable under inflation - Unfavourable under deflation

7. Personal Disposable Income - Increase - Decrease


8. Personal Savings - Favourable under inflation - Unfavourable under deflation

9. Interest Rates - low - high


10. Balance of trade - Positive - Negative


11. Strength of the Rupee in Forex market - Strong - Weak


12. Corporate Taxation (Direct & Indirect - Low - High


The Industry AnalysisEvery industry has to go through a life cycle with four distinct phasesi) Pioneering Stageii) Expansion (growth) Stageiii) Stagnation (mature) Stageiv) Decline Stage

These phases are dynamic for each industry. You as an investor is advised to invest in an industry that is either in a pioneering stage or in its expansion (growth) stage. Its advisable to quickly get out of industries which are in the stagnation stage prior to its lapse into the decline stage. The particular phase or stage of an industry can be determined in terms of sales, profitability and their growth rates amongst other factors.

The Company Analysis

There may be situations were the industry is very attractive but a few companies within it might not be doing all that well; similarly there may be one or two companies which may be doing exceedingly well while the rest of the companies in the industry might be in doldrums. You as an investor will have to consider both the financial and non-financial aspects so as to form a qualitative impression about a company. Some of the factors are

History of the company and line of business Product portfolio's strength Market Share Top Management Intrinsic Values like Patents and trademarks held Foreign Collaboration, its need and availability for future Quality of competition in the market, present and future Future business plans and projects Tags - Like Blue Chips, Market Cap - low, medium and big caps Level of trading of the company's listed scripts EPS, its growth and rating vis-à-vis other companies in the industry. P/E ratio Growth in sales, dividend and bottom line

Value, Growth and Income

Growth, Value, Income and GARP are one of the most rational ways of stock analysis. A brief on each of them is given here for your understanding.

Growth Stocks The task here is to buy stock in companies whose potential for growth in sales and earnings is excellent. Companies growing faster than the rest of the stocks in the market or faster than other stocks in the same industry are the target i.e the Growth Stocks. These companies usually pay little or no dividends, since they prefer to reinvest their profits in their business. Individuals who invest in growth stocks should make up their portfolio with established, well-managed companies that can be held onto for many, many years. Companies like HLL, Nestle, Infosys, Wipro have demonstrated great growth over the years, and are the cornerstones of many portfolios. Most investment clubs stick to growth stocks, too.

Value StocksThe task here is to look for stocks that have been overlooked by other investors and that which may have a "hidden value." These companies may have been beaten down in price because of some bad event, or may be in an industry that's looked down upon by most investors. However, even a company that has seen its stock price decline still has assets to its name-buildings, real estate, inventories, subsidiaries, and so on. Many of these assets still have value, yet that value may not be reflected in the stock's price. Value investors look to buy stocks that are undervalued, and then hold those stocks until the rest of the market (hopefully!) realizes the real value of the company's assets. The value investors tend to purchase a company's stock usually based on relationships between the current market price of the company and certain business fundamentals. They like P/E ratio being below a certain absolute limit; dividend yields above a certain absolute limit; Total sales at a certain level relative to the company's market capitalization, or market value. Templeton Mutual funds are one of the major practitioners of this strategy.

Growth is often discussed in opposition to value, but sometimes the lines between the two approaches become quite fuzzy in practice.

Income.

Stocks are widely purchased by people who expect the shares to increase in value but there are still many people who buy stocks primarily because of the stream of dividends they generate. Called income investors, these individuals often entirely forego companies whose shares have the possibility of capital appreciation for high-yielding dividend-paying companies in slow-growth industries.

Keep investing, panic not on your existing stocks

Here's the best tip we can give you if the volatility in the market has spooked you or if you had seen a large profit wash away in the falling market: ignore your stocks right now and keep your investing attention to something else.

Focus all your efforts and time on the company your stock represents. That's because there are really two elements at work when investing: the stock, which is part of the stock market, and the company, something the stock is supposed to represent. But the company works in a different universe from the stock market, involved more in the real world of profits and losses rather than the emotional tide of fear and greed, the two major forces behind the stock market. With the uncertainty prevailing in the market, fear is rampant and some of it is justified, but there are lots of good companies that might be hammered by that emotion. That's why you'll do better if you research your companies in depth rather than trying to figure out if the morning sell off is the beginning of the end or just a hick up on the road to true wealth. But let's say you've done all your numbers, and everything looks great. You've checked for the latest news and you still can't tell why your stock is down. Then you might want to call the company directly and ask for the Investor Relations department. Don't expect the investor relations person to tell you any secrets or unpublished information but you can ask a few questions and get a better feeling about the company:

1. Why is the stock down so dramatically? Are there rumors the company has heard? If so, what is the company's response to them.2. Is there anything the company can say about the stock being down? 3. Are the officers of the firm buying or selling the stock?4. Is the company buying its own shares right now?

You will hence get a sense of how the company is responding to its stock being down, and maybe hear about news that has just been published but you haven't read. Then, when you've done all you can to determine that the company in which you've invested is indeed doing everything well, you can ignore the stock and be assured that this too shall pass. If you determine that the stock is down for a good reason and seems to be going lower, then you can sell it and move on to another company. In either case, you can make a decision based on the company and not the stock.

Go for quality stocks and not quantity

New investors often want to make a quick buck (some old investors do, too). Sometimes you can do that if you get lucky. But the really big money in investing is made from holding quality stocks a long time. Many investors ask for information on cheap stocks. The usual premise is that they don't have much money, and they want to own thousands of shares of something, that way when it goes up, they'll make big money. The problem is these stocks don't go up. They're a scam for the brokers, and the spread between the bid and the ask on these stocks is enormous, making it impossible to sell them at a profit. Instead of trying to buy thousands of shares of a worthless stock for Rs 10000, let's see what else you can do with it. These examples are all split adjusted and show what that Rs. 10000 can do when you buy the right stocks.

If you had bought Infosys in 1991 for Rs share (split adjusted), you would own n shares

Obviously it's easy to look back to find great stocks. And you had to hold onto these volatile issues to reap these rewards. But the point is that quality stocks are worth holding. In the above examples, the owners have paid no taxes because there have not been any gains taken. The only commission paid was the original one. And as long as the stocks continue to produce good earnings, there's no reason to sell them. Again, it's easy to pick the good ones looking back, going forward, which stocks are the best ones to own?

Do your research thoroughly. Build a portfolio of stocks, one stock at a time, even with Rs 10000. Be sure to diversify

over several industries over time. And only buy the best, no matter how few shares that might be. Then be patient, keep up with the news on the stock, and let the stock grow. That's the way the big money is made.

How many stocks should you own?

Buying a large number of stocks is time-consuming and will distract you from focusing on the absolute best stocks. Most investors simply cannot keep track of a large number of stocks, so concentrate on just a few of the best. Use this simple guideline to determine the number of stocks to own:

Less than Rs. 20,000 1 or 2 stocks

Rs. 20,000 to Rs. 50,000 2 or 3 stocks

Rs. 50,000 to Rs. 2,00,000 3 to 5 stocks

Rs. 2,00,000 to Rs. 5,00,000 5 to 7 stocks

Rs. 5,00,000 or more 7 to 10 stocks

Some more Stock tips

1. New products, services or leadership. If a company has a dynamic new product or service, or is capitalizing on new conditions in the economy, this can have a dramatic impact on the price of a stock.

2. Leading stock in a leading industry group. Nearly 50% of a stock's price action is a result of its industry group's performance. Focus on the top industry groups, and within those groups select stocks with the best price performance. Don't buy laggards just because they look cheaper.

3. High-rated institutional sponsorship. You want at least a few of the better performing mutual funds owning the stock. They're the ones who will drive the stock up on a sustained basis.

4. New Highs. Stocks that make new highs on increased volume tend to move higher. Outstanding stocks usually form a price consolidation pattern, and then go on to make their biggest gains when their price breaks above the pattern on unusually high volume.

5. Positive market. You can buy the best stocks out there, but if the general market is weak, most likely your stocks will be weak also. You need to study our "The market talks. Listen, to spot the best." - Module 8 and learn how to interpret shifts in the market's trend.

6. You should not buy on dips. This is a strategy that doesn't give you a strong probability of making a profit. Remember a stock that has dipped 25% needs to rise 33% to recover the loss and a stock that has dipped 50% needs to double to get back to its old high.

Chapter 2Module 8 - The market Talks. Listen to Spot the best.

Market Direction

Buying Volatile Stocks.

Caution Signals from Market!!!




Market Direction.

Is the Market Heading South?

Check out the NSE Nifty and BSE Sensex charts on ICICIDirect every day. Observe the price and volume changes, there may be some selling on a rising day. The key is that volumes may increase on a day as the index closes lower or is range-bound. Studying the general market averages is not the only tool. There are other indicators to spot a topping market: A number of the market's leading stocks will show individual selling signals. In a falling market start selling your worst performing stocks first. If the market continues to do poorly, consider selling more of your stocks. You may need to sell all your stocks if the market doesn't turn around. If any stocks fall 8% below your purchase price, sell immediately. However, if you have tremendous confidence on the company stick to your pick.

Is theMarket Turning Upwards?

After a prolonged fall, the market will try to bounce back and try to rally from the low levels. However, you can't tell on the first or second day if the rally is going to last, so, as ICICI Direct’s Wise investor, you don't buy on the first or second day of a rally. You can afford to wait for a second confirmation that the market has really turned and a new uptrend or bull market has begun. A follow-through will occur if the market rallies for the second time, showing overwhelming strength by closing higher by one per cent with the volume higher than the day's volume. A strong rebound usually occurs between the fourth and seventh session of an attempted rally. Sometimes, it can be as late as the 10th or 15th day, but this usually shows the turn is not as powerful. Some rallies will fail even after a follow-through day. Confirmed rallies have a high success rate, but those that fail usually do so within a few days of the follow-through. Usually, the market turns lower on increasing volume within a few days.

When the market begins a new rally, stocks from all sectors don't rush out of the gates at the same time. The leading industry groups usually set the pace, while laggards trail behind. After a while, the top sprinters may slow down and pass the baton to other strong groups who lead the market still higher.

Investors improve their chances of success by homing in on these leading groups. Investors should be wary of stocks that are far beyond their initial base consolidated point/stage. After the market has corrected and then turns around, stocks will begin shooting out of bases. Count that as a first-stage of a breakout. Most investors are wary of jumping back into the market after a correction. Plus, the stock hasn't done much lately; so many investors won't even notice the breakout. But the fund managers would take buy positions at this stage.

After a stock has run up 25 per cent or more from its pivot point, it may begin to consolidate and form a second-stage base. A four-week or other brief pause doesn't count. A stock should form a healthy base, usually at least seven weeks before it qualifies. Also, when a stock consolidates after rising around 10 per cent, it's forming a base on top of a base. Don't count that it as a second stage.

When the stock breaks out of the second-stage base, a few more investors see this as a powerful move. But the average investor doesn't spot it. By the time the stock breaks out of the third-stage base, a lot of people see what's going on and start jumping in.

When a stock looks obvious to the investment community, it's usually a bad sign. The stock market tends to disappoint most investors. About 50-60% of third-stage bases fail.

But some stocks keep going and eventually form a fourth-stage base. At this point, everybody and their sisters know about this stock. The company's beaming CEO shows up on the cover of business publications. But while thousands of small investors rush into this "sure thing," the top mutual funds may quietly trim or liquidate their holdings.

Most fourth-stage breakouts fail, though not necessarily right way. Some will rise 10% or so before reversing. Fourth-

stage failures usually undercut the lows of their old bases.

But a stock can be reborn and begin a new four-base life cycle all over again. All it takes is a sizable correction.

How Do You Define A Bear Market?

Typically, market averages falling 15% to 20% or more.

Buying Volatile Stocks.

Buying at the right moment is the best defense against a volatile market. When the stock of a top-class company rises out of a sound price base on heavy volume, don't chase it more than five per cent past its buy point. Great stocks can rise 20-25% in a few days or weeks. If you purchase at those extended levels, what may turn out to be a normal pullback could shake you out. That risk rises with a more volatile stock.

Caution Signals from the Market!!!

There are several signs in the stock market that suggest caution, even though they're all very bullish. Here are some of them and what they might mean, based on past experience. First, everybody's bullish. If everyone's bullish, that means they've already bought their stock and are hoping more people will follow their enthusiasm. Most individual investors are fully invested. And as long as large inflows are still going into equity mutual funds, everything's fine. Watch out when the flows turn into trickles. There won't be buying power to keep boosting stocks.

Second, fear of the Economy/Political scenario. This is an initial indicator, which would pull of sporadic selling that could eventually mount into an outright bear market.

Third, new records for the SEBI week after week. That’s exuberance and won't continue. The technology sector is leading this market, and there's plenty of growth ahead for the group, but the pricing for many of the tech stocks is way ahead of the earnings. Most of the tech stocks are priced to perfection, meaning that if they don't report earnings above the analysts' expectations, they'll be in for a bashing. Too much good is already priced into many of these stocks. Fourth, a record season for IPOs. While there's always been a push to get financing done when the market is upbeat, this last penultimate (second last) season had been one for the records. Records never last. That's not how the market works. The penultimate season saw IPOs such as Hughes Software, HCL Technologies being subscribed several times over, with premium listings as they opened. This was followed by dismal erosion of value for those IPOs. What followed is issues such as Ajanta Pharma, Cadilla etc, opened at deep discounts. Two emotions drive markets: fear and greed. Usually there is some fear and some greed. Markets usually do best when they climb a wall of fear, meaning that every one expresses fear of investing but stocks continue to go higher. When that sentiment changes to bullish, the market roars ahead. Because the market is depressed, the next psychological state will be fear, and there will be a pull back, nothing severe. This great economy isn't going to stop growing, but many stocks are too far ahead of their numbers and will be pulling back when the market has a bad day.

Chapter 2Module 9 - What To Buy? When To Sell?

Sky rocketing stocks -- What is the right price?

Discount sales in most sectors – Buy at a bargain.

Should you buy more if the stock you own keeps climbing.

Winning buying points.

Winning selling points.

Sky rocketing stocks -- What is the right price?

Investors' dilemma is that they want to participate in the tech rally but the numbers look too high. While many of these gravity-defying stocks aren't worth their current prices, a few are. Here's how to tell the difference and when to buy them.

First, when a stock has stratospheric valuations, there's a reason: extremely high expectations. Investors expect the company to perform in an exceptional way in two areas: growth in revenues and growth in earnings. The challenge for investors is to discern which of these high-flying stocks deserve their attention.

Look for a stock that is essential, better performing. Does that mean you just buy the stock and hope? Definitely not. It does mean you start to monitor it and when the stock misses an earnings report or doesn't grow revenues fast enough, you look to buy. That takes patience. There's also the risk that the company won't make a misstep, and you won't buy it. If it happens that way, it will be the first company in history to do so. Granted the level may be much higher than the current one when you finally buy it, but the value of the stock may be much better. In other words, the P/E would be lower than the current levels.

The characteristics of the stocks you want to focus on are:

Market leaders who dominate their niche. The big tend to get bigger, win more contracts and have the largest R&D budgets.

Earnings that are growing, at an increasing rate, every year.

Revenue growth that exceeds the industry average.

Strong management.

Competing in an high and long-term growth oriented industry sector.

When you find all of these factors in a stock, it won't be a cheap one. But if you want to own it, sometimes you have to pay more than you would like. Currently, that's the entry fee for owning the best stocks in the technology areas. If you are patient and wait for some time you can pick some scrips at a relatively good price.

The key to making the big money with these stocks is to own them for a long time, letting them continue to grow. Even if you buy only a few shares, over time you can do very well as the stock grows, splits, and grows again. Many Infosys shareholders started with 10 shares and






now own hundreds. When you buy a great company, you own part of it, so having a small piece of a great one is much better than owning a lot of shares in a loser. If you're interested in making the big bucks, add some sky-rocketting stocks to your portfolio.

Discount sales in most sectors – Buy at a bargain.

There are lot of good stocks available at bargain prices. There are ways of finding the stocks, which are currently out of favor.

First, look for stocks that are out of favor for a temporary reason.

Second, look for stocks within sectors that are currently out of favor.

Third, use the tight screening methods to bring stock into your “Watch List” Here are some of the parameters to use and benchmarks to begin your search:

P/E ratio: Use a minimum of 10 and a maximum of 30. With current P/E ratios closer to 30, stocks with low P/Es can sometimes signal out of favor stocks. When you find these, make sure you're reading all the latest news items and check the analysts' thinking at ICICIDirect.

Price-to-Sales Ratio: Also called PSR. This is a macro way of looking at a stock. Many investors like to find stocks with a PSR below 1. It's a good number to start with, so put in .5 as a maximum and leave the minimum open. Be careful though, because many stocks will always carry a low PSR. You're looking for the stocks that have historically been high and are temporarily low.

Earnings growth: Look for atleast 20 per cent. If you can find a stock that has its earnings growing at 20% and its P/E at 10, you've got something worth investigating further. This is known as the PEG or P/E-to-Growth ratio. Sharp investors are looking for a ratio well below 1. In this example, the stock would have had a PSR of .5 (10/20).

Return on Equity: Start at 20% as the minimum and see who qualifies. The return on equity tells you how much your invested rupee is earning from the company. The higher the number, the better your investment should do.

By using just this combination of variables, you can find some interesting stocks. Try to squeeze your search each time you screen by tightening your numbers on each variable. And when you do find a stock, make sure you read all the relevant information from all the stock resources on the Web.

Should you buy more if the stock you own keeps climbing?

You can buy additional shares if your stock advances 20% to 25% or more in less than eight weeks, provided the stock still shows signs of strength

Cracking Buying Points

Here are some buying points for your reference

1. Strong long-term and short-term earnings growth. Look for annual earnings growth for the last three years of 25% or greater and quarterly earnings growth of at least 25% in the most recent quarter.

2. Impressive sales growth, profit margins and return on equity. The latest three-quarters of sales growth should be a minimum of 25%, return on equity at least 15%, and profit margins should be increasing.

3. New products, services or leadership. If a company has a dynamic new product or service or is capitalizing on new conditions in the economy, this can have a dramatic impact on the price of a stock.

4. Leading stock in a leading industry group. Nearly 50% of a stock's price action is a result of its industry group's performance. Focus on the top industry groups and within those groups select stocks with the best price performance. Don't buy laggards just because they look cheaper.

5. High-rated institutional sponsorship. You want at least a few of the better performing mutual funds owning the stock. They're the ones who will drive the stock up on a sustained basis. 6. New Highs. Stocks that make new highs on increased volume tend to move higher. Outstanding stocks usually form a price consolidation pattern, and then go on to make their biggest gains when their price breaks above the pattern on unusually high volume.

7. Positive market. You can buy the best stocks out there, but if the general market is weak, most likely your stocks will be weak also.

Cracking Selling Point

The decision of when and how much to buy is a relatively easy task as against when and what to sell. But then here are some pointers, which will assist you in deciding when to sell. Keep in mind that these parameters are not independent pointers but when all of them scream together then its time to step in and sell.

1. When they no longer meet the needs of the investor or when you had bought a stock expecting a specific announcement and it didn't occur. Most Pharma stocks fall into this category. Sometimes when they are on the verge of medical breakthroughs as they so claim, in reality if doesn’t materialize into real medicines; the stock will go down because every one else is selling. It's then time to sell yours too immediately, as it didn’t meet your need.

2. When the price in the market for the securities is an historical high. It's done even better than you initially imagined, went up five or ten times what you paid for it. When you get such a spectacularly performing stock, the last thing you should do is to sell all of it. Don't be afraid of making big money. While you liquidate a part of your holding in the stock to get back your principal and some neat profit, hold on to the rest to get you more money; unless there is some fundamental shift necessitating to sell your whole position. To repeat do not sell your whole position.

3. When the future expectations no longer support the price of the stock or when yields fall below the satisfactory level. You need to constantly monitor the various ratios and data points over time, not just when you buy the stock but also when you sell. When most ratios suggest the stock is getting expensive, as determined by your initial evaluation, then you need to sell the stock. But don't sell if only one of your variables is out of track. There should be a number

of them screaming that the stock is fully valued.

4. When other alternatives are more attractive than the stocks held, then liquidate your position in a stock which is least performing and reinvest the same in a new buy.

5. When there is tax advantage in the sale for the investor. If you have made a capital gain somewhere, you can safely buy a stock before dividend announcements i.e. at cum-interest prices and sell it after dividend pay out at ex-interest prices, which will be way below the price at which you had bought the stock. This way the capital loss that you make out of the buy and sell can be offset against the capital gain that you had made elsewhere and will hence cut your taxes on it.

6. Sell if there has been a dramatic change in the direction of the company. Its usually a messy problem when a company successful in one business decides to enter another unrelated venture. Such a decision even though would step up the price initially due to the exuberant announcements, it would begin to fall heavily after a short span. This is because the new venture usually squeezes the successful venture of its reserves and reinvesting capability, thus hurting its future earnings capability.

7. If the earnings and if they aren't improving over two to three quarters, chuck out the stock from your portfolio. To get a higher price on a stock, it needs to constantly improve earnings, not just match past quarters. However, as an investor, you need to read the earnings announcements carefully and determine if there are one-time charges that are hurting current earnings for the benefit of future earnings.

8. Cut losses at the right level. But do not sell on panic. The usual rule for retail investor is to sell if a stock falls 8% below the purchase price. If you don't cut losses quickly, sooner or later you'll suffer some very large losses. Cutting losses at 8% will always allow investors to survive to invest another day.

However, this is not exactly the right way to do it. Some investors have certain disciplines: take only a 10% or 20% loss, then get out. Cut your losses, let your winners ride, etc. The only problem with that is that you often get out just as the stock turns around and heads up to new highs. If you have done your homework on a stock, you will experience a great deal of volatility and a 5 to 8 % move in the stock is part of the trading day. To simply get out of a stock that you've worked hard to find because it goes down, especially without any news attached to it, only guarantees you'll get out and lose money. Stay with a good stock. Keep up with the news and the quarterly reports. Know your stock well, and the fluctuations every investor must endure won't trouble you as much as the uninformed investor. In fact, many of these downdrafts are great opportunities to buy more of a good stock at a great price, not a chance to sell at a loss and miss out on a winner

Chapter 2Module 10 - Learn To Manage Your Portfolio.

Importance of diversification.

Portfolio – Age relationship.



Review of portfolio.

Look analyze and do some adjusting.

Sector rotation.

Measuring portfolio performance

Importance of diversification.

Diversification helps you protect your investments from market fluctuations. Diversifying means allocating your money to different investments avenues and shields you from price risks. As you pick the best stocks from the hottest sectors, the fluctuation risk of the stock eroding your investment rises correspondingly. Since some stocks in the IT and media sectors are highly volatile, you need to protect your portfolio by investing in some defensive stocks or other industry groups. It would also be wise to diversify your investments into bonds or FDs as these are low risk - fixed income avenues.

The primary objectives of any Portfolio management are

Security of principal amount invested

Stability of income

Capital growth

Liquidity – nearness to money to take up any new buy opportunities thrown open by the market

Diversification

Diversifying means buying stocks belonging to different industries with very low correlation i.e to find securities that do not have tendencies to increase or decrease in price at the same time.

What you're working towards should be at least five industries for the stock portion of the portfolio with each stock being the best stock, in your opinion, in their respective industry group. There should still be money invested in a money market fund (the equivalent of cash) as well as some in fixed income.

On the flip side, a diversified portfolio is unlikely to outperform the market by a big margin for exactly the same reason.

Portfolio – Age relationship.

Your age will help you determine what is a good mix / portfolio is

Age Portfolio





below 3080% in stocks or mutual funds 10% in cash10% in fixed income

30 t0 4070% in stocks or mutual funds 10% in cash20% in fixed income

40 to 5060% in stocks or mutual funds 10% in cash 30% in fixed income

50 to 6050% in stocks or mutual funds10% in cash40% in fixed income

above 6040% in stocks or mutual funds 10% in cash 50% in fixed income

These aren't hard and fast allocations, just guidelines to get you thinking about how your portfolio should look. Your risk profile will give you more equities or more fixed income depending on your aggressive or conservative bias. However, it's important to always have some equities in your portfolio (or equity funds) no matter what your age. If inflation roars back, this will be the portion of your investments that protects you from the damage, not your fixed income.

Also, the fixed income of your portfolio should be diversified. If you buy bonds and debentures directly or if you invest in FDs, then make sure you have at least five different maturities to spread out the interest rate risk.

Diversifying in equities and bonds means more than buying a number of positions. Each position needs to be scrutinized as to how it fits into the stocks or bonds that already are in your portfolio, and how they might be affected by the same event such as higher interest rates, lower fuel prices, etc. Put your portfolio together like a puzzle, adding a piece at a time, each one a little different from the other but achieving a uniform whole once the portfolio is complete.

Review of portfolio

Portfolio Management is an incomplete exercise without a periodic review. Every security should be subject to severe scrutiny and a case made out for its continuation or disposal. The frequency of review will depend on the size, amount involved and the kind of securities held in the portfolio. Spend a bit of time; you'll get a little bit of results. If you spend more time, your results should improve. We would suggest you spend a minimum of one hour a day during normal times while on the days of high volatility, its suggested that the investor monitor the situation closely.

Look analyze and do some adjusting

Look at your portfolio and do some adjustments. But don't just sell the losers (or the winners) randomly. There are several consequences of any action whether it's the taxes, the asset allocation, or the timing of the transaction. Here are a few things to consider.

If you liked a stock because of its earnings and it continues to deliver, hang on even if the price has not moved up. It will because earnings are the engine of any stock's price. As always, patience is heavily rewarded in the market because it is the rarest commodity.

As for selling a stock and then thinking you can buy it back after some days. There are two problems with that type of thinking. One, you generate two rounds of commissions (sell, then buy) and two, you may not get to buy the stock back at a decent price because the stock might have run dramatically in the month you did not own it. If you sell a stock, do it with finality and move on. Don't try to time the market. No one can do that with perfection.

Another aspect: look at your portfolio allocation. Are you tech heavy? At the moment that's the place to be. But that changes, quickly as we had seen in the month of May 2000. Put your portfolio in shape by allocating your investments evenly over at least five different industry groups and 10 stocks. That way you won't feel the full impact of any one sector getting hit hard.

Sector Rotation

You've probably noticed that tech stocks are hot, financials are not. Neither are the Consumer durables or some of the large-cap FMCG or Pharmaceuticals. If you're thinking about jumping onto tech stocks now because that's where all the action is, think again. While traders can bounce in and out of stocks several times a day, an investor should look to where the action isn’t much, meaning less of “Extreme Volatility”.

Sector rotation happens all the time in the market. Several groups are hot (like ICE – Infotech, Communication and Entertainment Stocks) while other groups are getting dumped (names like Gujarat Ambuja, Grasim, Tata steel are examples). As an investor, you should look at taking profits from stocks that are fully valued and re-investing in stocks that have a big 'Buy' sign written all over them. In other words, dump some of the winners and buy some of the losers who are not down because of major problems that look to be insurmountable but because of temporary concerns that can be closely scrutinized.

Sector rotation occurs because of fear and greed, the two emotions that run markets. The real challenge for an investor is to determine what the right entry price is and what is out of favor at the moment. Some of the Technology stocks such as Infosys have PE multiples of over 100 times. Whereas some of the fundamentally sound stocks such as Tata Steel whose stocks can be bought for less than 10 times earnings.

The very bullish will point out that tech is where the growth is while financials are always hurt in an upward moving interest rate environment. They're right on both counts. However, the tech stocks are priced to perfection. If any of them don't deliver earnings at or better than expected, they're going to get hammered. And the financials are priced for interest rates going up dramatically from here, not another 25 basis points or so.

The point here is not to recommend financial stocks (or non-durables or drug stocks) but to make investors aware of this sector rotation phenomenon. Take the time to build separate portfolios in each of the sectors you have an interest. It becomes very obvious where the money is flowing and where it's coming from. As an investor the challenge is to wait for prices that you can't believe in quality stocks, and then make your move. You will not catch the bottom of the stock (OK, maybe a few of you will). But you will own a stock that will come back into favor whenever the current troubles have passed and sector rotation occurs once again. Only this time, you'll be riding the hot stocks.

Measuring Portfolio Performance

The performance of a portfolio has to be measured periodically – preferably once a month. The performance of the individual will have to be compared against the overall performance of the market as indicated by various indices such as the Sensex or Nifty. This way a relative comparison of performance can be developed.

Lets now learn to compute the “Total Yield”. For example if the portfolio value of Mr. X is Rs 2,00,000 at the beginning of this month. During the month he added Rs 8000 to the fund. During this month he also received a dividend income of Rs 1000. Assuming the value of the portfolio at the end of this month is Rs 2,20,000.

The total yield will be = ((220000 – (2,00,000 + 9000)) / ( 2,00,000 + (1/2 * 9000)) ) *100 = 5.38% per month

To elaborate, in the numerator we are trying to find out the increase in value of portfolio after deducting the extra amount of Rs 8000 and the income of Rs 1000. It is assumed that this sum of Rs 9000 is put to use somewhere in the middle of the month and hence only half of Rs 9000 is added to the value of the fund at the beginning. The denominator can be adjusted as per the amount that you reinvest (part or fully) out of dividend income and what point of time during the period do you actually plough back such part of the money.

Beta Factor “Beta” indicates the proportion of the yield of a portfolio to the yield of the entire market (as indicated by some index). If there is an increase in the yield of the market, the yield of the individual portfolio may also go up. If the index goes up by 1.5% and the yield of your portfolio goes up by 0.9%, the beta is 0.9/1.5 i.e 0.6. in other words, beta indicates that for every 1 % increase in the market yield, the yield of the portfolio goes up by 0.6%. High beta shares do move higher than the market when the market rises and the yield of the fund declines more than the yield of the market when the market falls. In the Indian context a beta of 1.2% is considered very bullish.

You can be indifferent to market swings if you know your stocks well. Or you can put your portfolio into neutral or bias for the upside if you're bullish or a little for the downside if you're bearish. One way to do that is to have a mix of stocks that have certain betas in your portfolio. When investors are bullish on the market, they like to have high beta stocks in their portfolios because if they're right, then their stocks go up faster than the market in general, and their performance is better than the market. If investors are bearish on the market, then they use the low beta or negative beta stocks because their portfolios will go down less than the market and their performance will be better than the general market. And if they want to be neutral, they can then make sure that they have stocks with a beta of 1 or develop a portfolio that has stocks with betas greater than 1 and less than 1 so that they have the whole portfolio with an average beta of 1.

A beta for a stock is derived from historical data. This means it has no predictive value for the future, but it does show that if the stock continues to have the same price patterns relative to the market in general as it has in the past, you've got a way of knowing how your portfolio will perform in relation to the market. And with a portfolio with an average beta of 1, you can create your own index fund since you'll move more or less in tandem with the market.

Chapter 2Module 11 - Learn from others mistakes. Common pitfalls to be avoided

1. Not being disciplined and failing to cut losses at 8% below the purchase price A strategy of selling while losses are small is a lot like buying an insurance policy. You may feel foolish selling a stock for a loss -- and downright embarrassed if it recovers. But you're protecting yourself from devastating losses. Once you've sold, your capital is safe.The 7%-8% sell rule is a maximum, not an average. Time your buys right, and if the market goes against you the average loss might be limited to only 3% or 4%.

Again its to be kept in mind, do not to sell a winning stock just because it pulls back a little bit.

2. Do not purchase low-priced, low quality stocks.

3. One should follow a system or set of rules.

4. Do not let emotions or ego get in the way of a sound investing strategy You may feel foolish buying a stock at 60, selling at 55, only to buy it back at 65. Put that aside. You might have been too early before, but if the time is right now, don't hesitate. Getting shaken out of a stock should have no bearing on whether you buy it at a later date. It's a new decision every time

5. Invest in equities for long term and not short term

6. Do not make unplanned investing and starting without setting clear investment objectives and time frame for achieving the same.

7. Not having an eye on what the big players / mutual funds buy & sell is a pitfall and an opportunity lost to pick the right stocks. It takes big money to move markets, and institutional investors have the cash. But how do you find out where the smart money is going? Make sure the stock you have your eye on is owned by at least one top-rated fund. If the stock has passed muster with leading portfolio managers and analysts, it's a good confirmation its business is in order. Plus, mutual funds pack plenty of buying power, which will drive the stock higher

8. Patience is a virtue in investing. Do not panic on your existing stocks. It's so important, we repeat: Be patient for your stocks to reap rewards.

9. Do not be unaware of what is happening around in the market. As always, knowledge is power and in investing, it's also a comfort. Dig for more information other than just the top stories that are flashed.

10. Do not put all your money on the same horse. Diversify your portfolio ideally into five industries and ten stocks.

11. Margin is not a luxury, it is a deep-seated risk, know your risk profile and use margin trading sparingly. You as an investor might lose control of your investments if you borrow too much.

12. Greed is dangerous; it may wipe out the gains already made. Once a reasonable profit is made the investor should get out of the market quickly.

ICICIdirect University – Futures

Overview

Derivatives have made the international and financial headlines in the past for mostly with their association with spectacular losses or institutional collapses. But market players have traded derivatives successfully for centuries and the daily international turnover in derivatives trading runs into billions of dollars.

Are derivative instruments that can only be traded by experienced, specialist traders? Although it is true that complicated mathematical models are used for pricing some derivatives, the basic concepts and principles underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and individual investors.

Indian scenario

While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock markets have been largely slow to these global changes. However, in the last few years, there has been substantial improvement in the functioning of the securities market. Requirements of adequate capitalization for market intermediaries, margining and establishment of clearing corporations have reduced market and credit risks. However, there were inadequate advanced risk management tools. And after the ICE (Information, Communication, Entertainment) meltdown the market regulator felt that in order to deepen and strengthen the cash market trading of derivatives like futures and options was imperative.

Why have derivatives?

Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset.

A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly.

The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives.

We will try and understand

What are derivatives? Why have derivatives at all? How are derivatives traded and used?

In subsequent lessons we will try and understand how exactly will an underlying asset effect the movement of a derivative instrument and how is it traded and how one can profit from these instruments.

What are forward contracts?

Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few ‘smart finance professionals’. In reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor, can benefit immensely.

A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities.

Let us take an example of a simple derivative contract:

Ram buys a futures contract. He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000. If the price is unchanged Ram will receive nothing. If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty.Derivatives and futures are basically of 3 types:

Forwards and Futures Options Swaps

Forward contractA forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into.Illustration 1:Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.Illustration 2: Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency.The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contract.

What is an Index?

To understand the use and functioning of the index derivatives markets, it is necessary to understand the underlying index. A stock index represents the change in value of a set of stocks, which constitute the index. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivative instruments such as index futures.

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has 30 stocks comprising the index which are selected based on market capitalization, industry representation, trading frequency etc. It represents 30 large well-established and financially sound companies. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Then there is a BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex.

While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of shares of 50 companies with each having a market capitalization of more than Rs 500 crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the composition of indexes is essential. Choosing the right index is important in choosing the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index.

Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes.

Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. We shall learn in subsequent lessons how one can leverage ones position by taking position in the futures market.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday

of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.

Example:

Futures contracts in Nifty in July 2001

Contract month Expiry/settlement

July 2001 July 26

August 2001 August 30

September 2001 September 27

On July 27

Contract month Expiry/settlement

August 2001 August 30

September 2001 September 27

October 2001 October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.

The index futures symbols are represented as follows:

BSE NSE

BSXJUN2001 (June contract) FUTDXNIFTY28-JUN2001

BSXJUL2001 (July contract) FUTDXNIFTY28-JUL2001

BSXAUG2001 (Aug contract) FUTDXNIFTY28-AUG2001

In subsequent lessons we will learn about the pricing of index futures

Hedging

We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example.

Illustration:

Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

Cost (Rs) Selling price Profit

1000 4000 3000

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.

Shyam defaults Shyam honours

1000 (Initial Investment) 3000 (Initial profit)

1000 (penalty from Shyam) (-1000) discount given to Shyam

- (No gain/loss) 2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment.

The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario.

Stocks carry two types of risk – company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta.

Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us study the impact on the overall gain/loss that accrues:

Index up 10% Index down 10%

Gain/(Loss) in PortfolioRs 120,000 (Rs 120,000)

Gain/(Loss) in Futures(Rs 120,000) Rs 120,000

Net EffectNil Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase. The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market. Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.

Speculation

Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.

Illustration:

Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position.

Selling Price : 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000

Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a long-term view of the market up to atleast 3 months.

Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit. Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market.

Take the case of the NSE Nifty.

Assume that Nifty is at 1200 and 3 month’s Nifty futures is at 1300.

The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account.

If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.Sale = 1070Cost= 1000+30 = 1030Arbitrage profit = 40These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast.

Pricing of Index Futures

The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market.

How many times have you felt of making risk-less profits by arbitraging between the underlying and futures markets. If so, you need to know the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.

The cost of carry model

The cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage.

If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.

Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit 40

However, one has to remember that the components of holding cost vary with contracts on different assets.

Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns.

Example:

Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs 100 + Rs 100 * (0.10 – 0.03)

Futures price = Rs 107

If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of Rs 10.

The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.

Thus, we can arrive at the fair value in the case of dividend yield.

Trading strategies

Speculation

We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. In this module we will see one can trade in index futures and use forward contracts in each of these instances.

Taking a view of the market

Have you ever felt that the market would go down on a particular day and feared that your portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

The problem in both the above cases is that it would be very cumbersome and costly to sell all the stocks in the index. And in the process one could be vulnerable to company specific risk. So what is the option? The best thing to do is to sell index futures.

Illustration:

Scenario 1:

On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an expiry date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.

‘X’ makes a profit of Rs 15,600 (200*78)

Scenario 2:

On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an expiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.

‘X’ makes a profit of Rs 13,400 (200*67).

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of profiting from an anticipated price change.

Hedging

Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stock’s Beta. The Beta of stocks are available on the www.nseindia.com.

While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.

Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks?

Have you ever been a ‘stockpicker’ and carefully purchased a stock based on a sense that it was worth more than the market price?

A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:

1. His understanding can be wrong, and the company is really not worth more than the market price or

2. The entire market moves against him and generates losses even though the underlying idea was correct.

Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.

Let us see how one can hedge positions using index futures:

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.

On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs 13,389.

Let us take another example when one has a portfolio of stocks:

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk

If the index is at 1200 * 200 (market lot) = Rs 2,40,000

The number of contracts to be sold is:

a. 1.19*10 crore = 496 contracts

2,40,000

If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged.Thus, we have seen how one can hedge their portfolio against market risk.

Margins

The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

The computation of initial margin on the futures market is done using the concept of Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front.

The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.

A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500. The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)Initial margin (15%) = Rs 45,000Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:Position on Day 1Close Price Loss Margin released Net cash outflow

1400*200 =2,80,000 20,000 (3,00,000-2,80,000) 3,000 (45,000-42,000) 17,000 (20,000-3000)

Payment to be made (17,000)

New position on Day 2Value of new position = 1,400*200= 2,80,000Margin = 42,000Close Price Gain Addn Margin Net cash inflow

1510*200 =3,02,000 22,000 (3,02,000-2,80,000) 3,300 (45,300-42,000) 18,700 (22,000-3300)

Payment to be recd 18,700

Position on Day 3Value of new position = 1510*200 = Rs 3,02,000Margin = Rs 3,300

Close Price Gain Net cash inflow

1600*200 =3,20,000 18,000 (3,20,000-3,02,000) 18,000 + 45,300* = 63,300

Payment to be recd 63,300

Margin account*Initial margin = Rs 45,000Margin released (Day 1) = (-) Rs 3,000 Position on Day 2 Rs 42,000Addn margin = (+) Rs 3,300 Total margin in a/c Rs 45,300* Net gain/lossDay 1 (loss) = (Rs 17,000)Day 2 Gain = Rs 18,700

Day 3 Gain = Rs 18,000Total Gain = Rs 19,700The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.

Settlements

All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement price.

The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical futures contract.

In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference between the contract value and closing index value is paid.

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for anyone planning to venture in futures trading. Economic dailies and exchange websites www.nseindia.com and www.bseindia.com are some of the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries end of day derivatives summary alongwith the quotes.

The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices.

The following table shows how futures data will be generally displayed in the business papers daily.

Series First Trade

High Low Close

Volume (No of contracts)

Value (Rs in lakh)

No of trades

Open interest (No of contracts)

BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 51

BSXJUL2000 4900 4900 4800 4830.8 12 28.98 10 2

BSXAUG2000 4800 4870 4800 4835 2 4.84 2 1

Total 160 38252 116 54

Source: BSE

The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract.

The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades.

http://www.bseindia.com/

http://www.nseindia.coma/

One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs. 2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts.The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract. A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of outstanding long or short positions – not both. Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts. Action Resulting open interest

New buyer (long) and new seller (short) Trade to form a new contract.

Rise

Existing buyer sells and existing seller buys –The old contract is closed.

Fall

New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer.

No change – there is no increase in long contracts being held

Existing seller buys from new seller. The Existing seller closes his position by buying from new seller.

No change – there is no increase in short contracts being held

Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge market signals. The following chart may help with these signals.

Price

Open interest Market

Strong

Warning signal

Weak

Warning signal

The warning sign indicates that the Open interest is not supporting the price direction.

Selecting the right index

In selecting the index and contract month one should consider the following points.

Expiration date: If the investor has a month or two’s view about the market then he should choose that index futures which has a similar time left for expiry.

Liquidity: The index and the contract month, which is the most liquid must be used. This will save cost because of the low bid-ask spread. This also saves hedging costs.

Stock should be correlated to the index: The stock to be hedged should have a correlation with the index selected.

Potential mispricing: One should sell index futures contract which is overpriced. In such an event one can not only hedge but also earn some profit in selling high.

In a nutshell, one should hedge by using the most popular and fairly priced index and delivery month should not be very far since liquidity and predictability of very few contracts are low.

Glossary

Backwardation: A market where future prices of distant contract months are lower than the near months.

Basis: The difference between the Index and the respective contract is the basis i.e. cash netted for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is the strengthening and weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means increasing short positions.

Basis Point: It is equal to one hundredth of a percentage point

Contango market: This is a market where futures prices are higher for distant contracts than for nearby delivery months.

Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically means the annualized interest cost players decide to pay (receive) for buying (selling) a respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is more interpretable being an annualized figure, as compared to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and Open Interest in highlighting the market trend.

Delivery month: Is the month in which delivery of futures contracts need to be made.

Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price.

Derivative: A financial instrument designed to replicate an underlying security for the purpose of transferring risk.

Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation.

Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the

Value of a Futures contract; Value of the portfolio to be Hedged; and Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.

Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day.Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.Futures contract: A futures contract is similar to a forward contract in terms of its working. The difference is that contracts are standardized and trading is centralized. Futures markets are highly liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes the counterparty to both sides of each transaction and guarantees the trade. Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.Speculation: Trading on anticipated price changes, where the trader does not hold another position which will offset any such price movements.Spread ratio: The number of futures contracts bought, divided by the number of futures contracts sold.VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence. Strike Price: The price at which an option holder may buy or sell the underlying asset, which is specified in an option contract.

Futures QuizThe quiz has been designed based on the course material. It is advised to go through the material before taking the test.

Progress Indicator: Question 1 of 10

1. In India,futures contracts have an expiry period of

Choices: A. One month B. Two months C. Three months D. All of the above

ICICIdirect University – Options

Options

Stock markets by their very nature are fickle. While fortunes can be made in a jiffy more often than not the scenario is the reverse. Investing in stocks has two sides to it –a) Unlimited profit potential from any upside (remember Infosys, HFCL etc) or b) a downside which could make you a pauper.

Derivative products are structured precisely for this reason -- to curtail the risk exposure of an investor. Index futures and stock options are instruments that enable you to hedge your portfolio or open positions in the market. Option contracts allow you to run your profits while restricting your downside risk.

Apart from risk containment, options can be used for speculation and investors can create a wide range of potential profit scenarios.

http://content.icicidirect.com/learning/futures/quiz.asp?qid=1&sa=3




We have seen in the Derivatives School how index futures can be used to protect oneself from volatility or market risk. Here we will try and understand some basic concepts of options.

What are options?

Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance.

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.

‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or if he chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.

When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.

Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.

We will dwelve further into the mechanics of call/put options in subsequent lessons.

Call option

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract.

There are two types of options:

Call Options Put Options

Call optionsCall options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date.Illustration 1:Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares).The buyer of a call has purchased the right to buy and for that he pays a premium.Now let us see how one can profit from buying an option.Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better.Nifty is at 1310. The following are Nifty options traded at following quotes.

Option contract Strike price Call premium

Dec Nifty 1325 Rs 6,000

1345 Rs 2,000

Jan Nifty 1325 Rs 4,500

1345 Rs 5000

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish. When you expect prices to fall, then you take a short position by selling calls. You are bearish.

Put Options

A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time.

eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200

This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro.Quotes are as under:Spot Rs 1040Jan Put at 1050 Rs 10Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below. 1. Jan Spot price of Wipro = 1020 2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000. In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish. When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

CALL OPTIONS PUT OPTIONS

If you expect a fall in price(Bearish) Short Long

If you expect a rise in price (Bullish) Long Short

SUMMARY:

CALL OPTION BUYER CALL OPTION WRITER (Seller)

Pays premium Right to exercise and buy the shares Profits from rising prices

Limited losses, Potentially unlimited gain

Receives premium Obligation to sell shares if exercised Profits from falling prices or remaining neutral

Potentially unlimited losses, limited gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium Right to exercise and sell shares Profits from falling prices

Limited losses, Potentially unlimited gain

Receives premium Obligation to buy shares if exercised Profits from rising prices or remaining neutral

Potentially unlimited losses, limited gain

Option styles

Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:

European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European in nature.

eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.

American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are "American Options".

eg: Sam purchases 1 ACC SEP 145 Call --Premium 12

Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.

American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.

Option Class & Series

Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying.

eg: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.

Calls Puts

.JUL AUG SEP JUL AUG SEP

Wipro 1300 45 60 75 15 20 28

1400 35 45 65 25 28 35

1500 20 42 48 30 40 55

eg: Wipro JUL 1300 refers to one series and trades take place at differentpremiumsAll calls are of the same option type. Similarly, all puts are of the same option type. Options of the same type that are also in the same class are said to be of the same class. Options of the same class and with the same exercise price and the same expiration date are said to be of the same series

Concepts

Important Terms

(Strike price, In-the-money, Out-of-the-Money, At-the-Money, Covered call and Covered Put)

Strike price: The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 20. If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.

In-the-money: A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.

eg: Raj purchases 1 SATCOM AUG 190 Call --Premium 10

In the above example, the option is "in-the-money", till the market price of SATCOM is ruling above the strike price of Rs 190, which is the price at which Raj would like to buy 100 shares anytime before the end of August.

Similary, if Raj had purchased a Put at the same strike price, the option would have been "in-the- money", if the market price of SATCOM was lower than Rs 190 per share.

Out-of-the-Money: A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.

eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150

In the above example, the option is "out-of- the- money", if the market price of INFTEC is ruling below the strike price of Rs 3500, which is the price at which SAM would like to buy 100 shares anytime before the end of August.

Similary, if Sam had purchased a Put at the same strike price, the option would have been "out-of-the-money", if the market price of INFTEC was above Rs 3500 per share.

At-the-Money: The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money.

eg: Raj purchases 1 ACC AUG 150 Call or Put--Premium 10

In the above case, if the market price of ACC is ruling at Rs 150, which is equal to the strike price, then the option is said to be "at-the-money".

If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering that the underlying is at 1410. Similarly in-the-money strike prices will be 1,370 and 1,390, which are lower than the underlying of 1,410.

At these prices one can take either a positive or negative view on the markets i.e. both call and put options will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be

available and considering that there are three series a total number of 30 options will be available to take positions in.

Covered Call Option

Covered option helps the writer to minimize his loss. In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in price of the stock. Further, he is able to bring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected).

eg: Raj believes that HLL has hit rock bottom at the level of Rs.182 and it will move in a narrow range. He can take a long position in HLL shares and at the same time write a call option with a strike price of 185 and collect a premium of Rs.5 per share. This will bring down the effective cost of HLL shares to 177 (182-5). If the price stays below 185 till expiry, the call option will not be exercised and the writer will keep the Rs.5 he collected as premium. If the price goes above 185 and the Option is exercised, the writer can deliver the shares acquired in the cash market.

Covered Put Option

Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). The effective selling price will increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will be left only with the premium amount. The loss in the option exercised will be equal to the gain in the short position of the asset.

Pricing of options

Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying

And two less important factors: Short-Term Interest Rates Dividends

Review of Options Pricing Factors

The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market. For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic

value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value. Price of underlyingThe premium is affected by the price movements in the underlyinginstrument. For Call options – the right to buy the underlying at a fixed strikeprice – as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For Put options – the right to sell the underlying at a fixed strikeprice – as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.The following chart summarises the above for Calls and Puts.

Option Underlying price Premium cost

Call

Put

The Time Value of an Option Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Option Time to expiry Premium cost

Call

Put

Volatility Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.Higher volatility=Higher premiumLower volatility = Lower premium

Option Volatility Premium cost

Call

Put

Interest ratesIn general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on

some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.

Option Interest rates Premium cost

Call

Put

How do we measure the impact of change in each of these pricing determinants on option premium we shall learn in the next module.

Greeks

The options premium is determined by the three factors mentioned earlier – intrinsic value, time value and volatility. But there are more sophisticated tools used to measure the potential variations of options premiums. They are as follows:

Delta Gamma Vega Rho

DeltaDelta is the measure of an option’s sensitivity to changes in the price of the underlying asset. Therefore, its is the degree to which an option price will move given a change in the underlying stock or index price, all else being equal. Change in option premiumDelta = -------------------------------- Change in underlying price For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index. Illustration:A trader is considering buying a Call option on a futures contract, which has a price of Rs 19. The premium for the Call option with a strike price of Rs 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs 20 – a rise of Re 1 – then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or cheap. An at-the-money call would have a delta of 0.5 and a deeply in-the-money call would have a delta close to 1. While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stock price are inversely related. This is because if you buy a put your view is bearish and expect the stock price to go down. However, if the stock price moves up it is contrary to your view therefore, the value of the option decreases. The put delta equals the call delta minus 1.

It may be noted that if delta of your position is positive, you desire the underlying asset to rise in price. On the contrary, if delta is negative, you want the underlying asset’s price to fall.Uses: The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies. The delta is often called the hedge ratio. e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the delta gives you the number of calls you would need to be short (i.e. need to write) to create a riskless hedge – i.e. a portfolio which would be worth the same whether the stock price rose by a very small amount or fell by a very small amount.In such a "delta neutral" portfolio any gain in the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa.Note that as the delta changes with the stock price and time to expiration the number of shares would need to be continually adjusted to maintain the hedge. How quickly the delta changes with the stock price is given by gamma, which we shall learn subsequently.

Gamma

This is the rate at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument.

Change in an option deltaGamma =------------------------------------- Change in underlying price

For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of ±1 in the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall. Gamma is rather like the rate of change in the speed of a car – its acceleration – in moving from a standstill, up to its cruising speed, and braking back to a standstill. Gamma is greatest for an ATM (at-the-money) option (cruising) and falls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-money) (standstill).

If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will want to keep gamma as small as possible as the smaller it is the less often you will have to adjust the hedge to maintain a delta neutral position. If gamma is too large a small change in stock price could wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using options -- unlike delta, it can't be done by buying or selling the underlying asset as the gamma of the underlying asset is, by definition, always zero so more or less of it won't affect the gamma of the total portfolio.

Theta

It is a measure of an option’s sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio.

Change in an option premiumTheta = -------------------------------------- Change in time to expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases.

Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to 2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of the underlying stock will alter the premium. Theta is only concerned with the time value. Unfortunately, we cannot predict with accuracy the change’s in stock market’s value, but we can measure exactly the time remaining until expiration.

Vega

This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change – typically 1% – in the underlying volatility.

Change in an option premiumVega = ----------------------------------------- Change in volatility

If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor increased by 1% to 31%. As the stock becomes more volatile the changes in premium will increase in the same proportion. Vega measures the sensitivity of the premium to these changes in volatility.

What practical use is the vega to a trader? If a trader maintains a delta neutral position, then it is possible to trade options purely in terms of volatility – the trader is not exposed to changes in underlying prices.

Rho

The change in option price given a one percentage point change in the risk-free interest rate. Rho measures the change in an option’s price per unit increase –typically 1% – in the cost of funding the underlying.

Change in an option premiumRho = --------------------------------------------------- Change in cost of funding underlying

Example:

Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the price of the option will move by Rs 0.14109. To put this in another way: if the risk-free interest rate changes by a small amount, then the option value should change by 14.10 times that amount. For example, if the risk-free interest rate increased by 0.01 (from 10% to 11%), the option value would change by 14.10*0.01 = 0.14. For a put option the relationship is inverse. If the interest rate goes up the option value decreases and therefore, Rho for a put option is negative. In general Rho tends to be small except for long-dated options.

Options Pricing Models

There are various option pricing models which traders use to arrive at the right value of the option. Some of the most popular models have been enumerated below. The Binomial Pricing Model The binomial model is an options pricing model which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing models which differ according to their hypotheses or

the underlying instruments upon which they are based (stock options, currency options, options on interest rates). The Black & Scholes ModelThe Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular options pricing models. It is noted for its relative simplicity and its fast mode of calculation: unlike the binomial model, it does not rely on calculation by iteration. The intention of this section is to introduce you to the basic premises upon which this pricing model rests. A complete coverage of this topic is material for an advanced courseThe Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate.The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:S = stock priceX = strike pricet = time remaining until expiration, expressed as a percent of a yearr = current continuously compounded risk-free interest ratev = annual volatility of stock price (the standard deviation of the short-term returns over one year).ln = natural logarithmN(x) = standard normal cumulative distribution functione = the exponential functionLognormal distribution: The model is based on a lognormal distribution of stock prices, as opposed to a normal, or bell-shaped, distribution. The lognormal distribution allows for a stock price distribution of between zero and infinity (ie no negative prices) and has an upward bias (representing the fact that a stock price can only drop 100 per cent but can rise by more than 100 per cent). Risk-neutral valuation: The expected rate of return of the stock (ie the expected rate of growth of the underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the Black-Scholes model (or any other model for option valuation). The important implication is that the price of an option is completely independent of the expected growth of the underlying asset. Thus, while any two investors may strongly disagree on the rate of return they expect on a stock they will, given agreement to the assumptions of volatility and the risk free rate, always agree on the fair price of the option on that underlying asset. The key concept underlying the valuation of all derivatives -- the fact that price of an option is independent of the risk preferences of investors -- is called risk-neutral valuation. It means that all derivatives can be valued by assuming that the return from their underlying assets is the risk free rate. Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widely used adaptations to the original formula, which I use in my models, which enable it to handle both discrete and continuous dividends accurately. However, despite these adaptations the Black-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time -- at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option. As all exchange traded equity options have American-style exercise (ie they can be exercised at any time as opposed to European options which can only be exercised at expiration) this is a significant limitation.

The exception to this is an American call on a non-dividend paying asset. In this case the call is always worth the same as its European equivalent as there is never any advantage in exercising early. Advantage: The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large number of option prices in a very short time. Since, high accuracy is not critical for American option pricing (eg when animating a chart to show the effects of time decay) using Black-Scholes is a good option. But, the option of using the binomial model is also advisable for the relatively few pricing and profitability numbers where accuracy may be important and speed is irrelevant. You can experiment with the Black-Scholes model using on-line options pricing calculator. The Binomial ModelThe binomial model breaks down the time to expiration into potentially a very large number of time intervals, or steps. A tree of stock prices is initially produced working forward from the present to expiration. At each step it is assumed that the stock price will move up or down by an amount calculated using volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying stock prices. The tree represents all the possible paths that the stock price could take during the life of the option. At the end of the tree -- ie at expiration of the option -- all the terminal option prices for each of the final possible stock prices are known as they simply equal their intrinsic values.Next the option prices at each step of the tree are calculated working back from expiration to the present. The option prices at each step are used to derive the option prices at the next step of the tree using risk neutral valuation based on the probabilities of the stock prices moving up or down, the risk free rate and the time interval of each step. Any adjustments to stock prices (at an ex-dividend date) or option prices (as a result of early exercise of American options) are worked into the calculations at the required point in time. At the top of the tree you are left with one option price.Advantage: The big advantage the binomial model has over the Black-Scholes model is that it can be used to accurately price American options. This is because, with the binomial model it's possible to check at every point in an option's life (ie at every step of the binomial tree) for the possibility of early exercise (eg where, due to eg a dividend, or a put being deeply in the money the option price at that point is less than the its intrinsic value).Where an early exercise point is found it is assumed that the option holder would elect to exercise and the option price can be adjusted to equal the intrinsic value at that point. This then flows into the calculations higher up the tree and so on. Limitation: As mentioned before the main disadvantage of the binomial model is its relatively slow speed. It's great for half a dozen calculations at a time but even with today's fastest PCs it's not a practical solution for the calculation of thousands of prices in a few seconds which is what's required for the production of the animated charts in my strategy evaluation model

Bull Market Strategies

Calls in a Bullish Strategy Puts in a Bullish Strategy

Bullish Call Spread Strategies Bullish Put Spread Strategies

Calls in a Bullish Strategy

http://content.icicidirect.com/learning/options/#bullputspread

http://content.icicidirect.com/learning/options/#bullcallspread

http://content.icicidirect.com/learning/options/#putbull

http://content.icicidirect.com/learning/options/#callbull

An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the the market price less the exercise price less the premium. The greater the increase in price of the underlying, the greater the investor's profit.The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless.The investor breaks even when the market price equals the exercise price plus the premium. An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- the-money, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase.A simple example will illustrate the above:Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid. The profit can be derived as follows Profit = Market price - Exercise price - PremiumProfit = Market price – Strike price – Premium. 2200 – 2000 – 100 = Rs 100

Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless. By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received. However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines.

The break-even point occurs when the market price equals the exercise price: minus the premium. At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable.An increase in volatility will increase the value of your put and decrease your return. As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date , lower is the return.

Bullish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices. To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position. To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position. An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread. The cost of Putting on this position will be the difference between the premium paid for the low strike call and the premium received for the high strike call.The investor's profit potential is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

The investors's potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call.The investor breaks even when the market price equals the lower exercise price plus the net premium. At the most, an investor can lose is the net premium paid. To recover the premium, the market price must be as great as the lower exercise price plus the net premium.An example of a Bullish call spread: Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread. Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first position established in the spread is the long lower strike price call option with unlimited profit potential. At the same time to reduce the cost of puchase of the long position a short position at a higher call strike price is established. While this not only reduces the outflow in terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:Maximum profit = Higher strike price - Lower strike price - Net premium paid = 110 - 90 - 10 = 10Maximum Loss = Lower strike premium - Higher strike premium = 14 - 4 = 10Breakeven Price = Lower strike price + Net premium paid = 90 + 10 = 100

Bullish Put Spread Strategies

A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a lower exercise price. The trader pays a net premium for the position. To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position. An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put. The bull spread can be created by buying the lower strike and selling the higher strike of either calls or put. The difference between the premiums paid and received makes up one leg of the spread.The investor's profit potential is limited. When the market price reaches or exceeds the higher exercise price, both options will be out-of-the-money and will expire worthless. The trader will realize his maximum profit, the net premium

The investor's potential loss is also limited. If the market falls, the options will be in-the-money. The puts will offset one another, but at different exercise prices.The investor breaks-even when the market price equals the lower exercise price less the net premium. The investor achieves maximum profit i.e the premium received, when the market price moves up beyond the higher exercise price (both puts are then worthless).An example of a bullish put spread.Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of Rs 110 at a premium of Rs 15. The first position is a short put at a higher strike price. This has resulted in some inflow in terms of premium. But here the trader is worried about risk and so caps his risk by buying another put option at the lower strike price. As such, a part of the premium received goes off and the ultimate position has limited risk and limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:Maximum profit = Net option premium income or net credit = 15 - 5 = 10Maximum loss = Higher strike price - Lower strike price - Net premium received = 110 - 90 - 10 = 10Breakeven Price = Higher Strike price - Net premium income = 110 - 10 = 100

Bear Market Strategies

Puts in a Bearish Strategy Calls in a Bearish Strategy

Bearish Put Spread Strategies Bearish Call Spread Strategies

Puts in a Bearish Strategy

When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits. The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option.The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option.An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option.Calls in a Bearish StrategyAnother option for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position.For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.

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The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option.Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised, he will be exposed to potentially large losses if the market rises against his position.The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even.An increase in volatility will increase the value of your call and decrease your return. When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls.Bearish Put Spread StrategiesA vertical put spread is the simultaneous purchase and sale of identical put options but with different exercise prices. To "buy a put spread" is to purchase a put with a higher exercise price and to write a put with a lower exercise price. The trader pays a net premium for the position. To "sell a put spread" is the opposite. The trader buys a put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position. To put on a bear put spread you buy the higher strike put and sell the lower strike put. You sell the lower strike and buy the higher strike of either calls or puts to set up a bear spread.An investor with a bearish market outlook should: buy a put spread. The "Bear Put Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.

The investor's profit potential is limited. When the market price falls to or below the lower exercise price, both options will be in-the-money and the trader will realize his maximum profit when he recovers the net premium paid for the options.The investor's potential loss is limited. The trader has offsetting positions at different exercise prices. If the market rises rather than falls, the options will be out-of-the-money and expire worthless. Since the trader has paid a net premiumThe investor breaks even when the market price equals the higher exercise price less the net premium. For the strategy to be profitable, the market price must fall. When the market price falls to the high exercise price less the net premium, the trader breaks even. When the market falls beyond this point, the trader profits.An example of a bearish put spread.Lets assume that the cash price of the scrip is Rs 100. You buy a November put option on a scrip with a strike price of Rs 110 at a premium of Rs 15 and sell a put option with a strike price of Rs 90 at a premium of Rs 5. In this bearish position the put is taken as long on a higher strike price put with the outgo of some premium. This position has huge profit potential on downside. If the trader may recover a part of the premium paid by him by writing a lower strike price put option. The resulting position is a mildly bearish position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a bearish position, he has also capped the profit portential as well. The maximum profit, maximum loss and breakeven point of this spread would be as follows:Maximum profit = Higher strike price option - Lower strike price option - Net premium paid = 110 - 90 - 10 = 10Maximum loss = Net premium paid = 15 - 5 = 10Breakeven Price = Higher strike price - Net premium paid = 110 - 10 = 100

Bearish Call Spread StrategiesA vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices. To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position. To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position. To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread.An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.

The investor's profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price.Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium.The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.

An example of a bearish call spread.Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15. In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit startegy. The final position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows:Maximum profit = Net premium received = 15 - 5 = 10Maximum loss = Higher strike price option - Lower strike price option - Net premium received = 110 - 90 - 10 = 10Breakeven Price = Lower strike price + Net premium paid = 90 + 10 = 100

Volatile Market Strategies

Straddles in a Volatile Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile.

A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put.

To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date.

To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as volatile, should buy option straddles. A "straddle purchase" allows the trader to profit from either a bull market or from a bear market.

Here the investor's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option while letting the other option expire worthless. (Bull market, exercise the call; bear market, the put.)While the investor's potential loss is limited. If the price of the underlying asset remains stable instead of either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the options.In this case the trader has long two positions and thus, two breakeven points. One is for the call, which is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the premiums paid.Strangles in a Volatile Market OutlookA strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money.

To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices. A trader, viewing a market as volatile, should buy strangles. A "strangle purchase" allows the trader to profit from either a bull or bear market. Because the options are typically out-of-the-money, the market must move to a greater degree than a straddle purchase to be profitable.The trader's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option, and letting the other expire worthless. (In a bull market, exercise the call; in a bear market, the put).The investor's potential loss is limited. Should the price of the underlying remain stable, the most the trader would lose is the premium he paid for the options. Here the loss potential is also very minimal because, the more the options are out-of-the-money, the lesser the premiums.Here the trader has two long positions and thus, two breakeven points. One for the call, which breakevens when the market price equal the high exercise price plus the premium paid, and for the put, when the market price equals the low exercise price minus the premium paid.Pic:Opt35The Short Butterfly Call SpreadLike the volatility positions we have looked at so far, the Short Butterfly position will realize a profit if the market makes a substantial move. It also uses a combination of puts and calls to achieve its profit/loss profile - but combines them in such a manner that the maximum profit is limited.You are short the September 40-45-50 butterfly with the underlying at 45. You: you are neutral but want the market to move in either direction. The position is a neutral one - consisting of two short options balanced out with two long ones. Which of these positions is a short butterfly spread? The graph on the left. The profit loss profile of a short butterfly spread looks like two short options coming together at the center Calls.

The spread shown above was constructed by using 1 short call at a low exercise price, two long calls at a medium exercise price and 1 short call at a high exercise price.Your potential gains or losses are: limited on both the upside and the downside. Say you had build a short 40-45-50 butterfly. The position would yield a profit only if the market moves below 40 or above 50. The maximum loss is also limited.The Call Ratio Backspread The call ratio backspread is similar in contruction to the short butterfly call spread you looked at in the previous section. The only difference is that you omit one of the components (or legs) used to build the short butterfly when constructing a call ratio backspread. When putting on a call ratio backspread, you are neutral but want the market to move in either direction. The call ratio backspread will lose money if the market sits. The market outlook one would have in putting on this position would be for a volatile market, with greater probability that the market will rally.To put on a call ratio backspread, you sell one of the lower strike and buy two or more of the higher strike. By selling an expensive lower strike option and buying two less expensive high strike options, you receive an initial credit for this position. The maximum loss is then equal to the high strike price minus the low strike price minus the initial net premium received.

Your potential gains are limited on the downside and unlimited on the upside. The profit on the downside is limited to the initial net premium received when setting up the spread. The upside profit is unlimited.An increase in implied volatility will make your spread more profitable. Increased volatility increases a long option position's value. The greater number of long options will cause this spread to become more profitable when volatility increases.

The Put Ratio Backspread

In combination positions (e.g. bull spreads, butterflys, ratio spreads), one can use calls or puts to achieve similar, if not identical, profit profiles. Like its call counterpart, the put ratio backspread combines options to create a spread which has limited loss potential and a mixed profit potential. It is created by combining long and short puts in a ratio of 2:1 or 3:1. In a 3:1 spread, you would buy three puts at a low exercise price and write one put at a high exercise price. While you may, of course, extend this position out to six long and two short or nine long and three short, it is important that you respect the (in this case) 3:1 ratio in order to maintain the put ratio backspread profit/loss profile.When you put on a put ratio backspread: are neutral but want the market to move in either direction. Your market expectations here would be for a volatile market with a greater probability that the market will fall than rally.How would the profit/loss profile of a put ratio backspread differ from a call ratio backspread?Unlimited profit would be realized on the downside. The two long puts offset the short put and result in practically unlimited profit on the bearish side of the market. The cost of the long puts is offset by the premium received for the (more expensive) short put, resulting in a net premium received.To put on a put ratio backspread, you: buy two or more of the lower strike and sell one of the higher strike. You sell the more expensive put and buy two or more of the cheaper put. One usually receives an initial net premium for putting on this spread. The Maximum loss is equal to: High strike price - Low strike price - Initial net premium received.For eg if the ratio backspread is 45 days before expiration. Considering only the bearish side of the market, an increase in volatility increases profit/loss and the passage of time decreases profit/loss.The low breakeven point indicated on the graph is equal to the lower of the two exercise prices... minus the call premiums paid, minus the net premiums received. The higher of this position's two breakeven points is simply the high exercise price minus the net premium.

Stable Market Strategies

Straddles in a Stable Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile. This market outlook is also referred to as "neutral volatility."

A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put.

To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date.

To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as stable, should: write option straddles. A "straddle sale" allows the trader to profit from writing calls and puts in a stable market environment.

The investor's profit potential is limited. If the market remains stable, traders long out-of-the-money calls or puts will let their options expire worthless. Writers of these options will not have be called to deliver and will profit from the sum of the premiums received.The investor's potential loss is unlimited. Should the price of the underlying rise or fall, the writer of a call or put would have to deliver, exposing himself to unlimited loss if he has to deliver on the call and practically unlimited loss if on the put.The breakeven points occur when the market price at expiration equals the exercise priceplus the premium and minus the premium. The trader is short two positions and thus, two breakeven points; One for the call (common exercise price plus the premiums paid), and one for the put (common exercise price minus the premiums paid). Strangles in a Stable Market OutlookA strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money. To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. Usually the call strike price is higher than the put strike price. To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices. A trader, viewing a market as stable, should: write strangles. A "strangle sale" allows the trader to profit from a stable market.The investor's profit potential is: unlimited. If the market remains stable, investors having out-of-the-money long put or long call positions will let their options expire worthless.The investor's potential loss is: unlimited. If the price of the underlying interest rises or falls instead of remaining stable as the trader anticipated, he will have to deliver on the call or the put.The breakeven points occur when market price at expiration equals...the high exercise price plus the premium and the low exercise price minus the premium. The trader is short two positions and thus, two breakeven points. One for the call (high exercise price plus the premiums paid), and one for the put (low exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle? The risk is lower with a strangle. Although the seller gives up a substantial amount of potential profit by selling a strangle rather than a straddle, he also holds less risk. Notice that the strangle requires more of a price move in both directions before it begins to lose money.Long Butterfly Call Spread Strategy The long butterfly call spread is a combination of a bull spread and a bear spread, utilizing calls and three different exercise prices. A long butterfly call spread involves:

Buying a call with a low exercise price,

Writing two calls with a mid-range exercise price,

Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell two 45 strikes. This spread is put on by purchasing one each of the outside strikes and selling two of the inside strike. To put on a short butterfly, you do just the opposite.The investor's profit potential is limited. Maximum profit is attained when the market price of the underlying interest equals the mid-range exercise price (if the exercise prices are symmetrical).

The investor's potential loss is: limited. The maximum loss is limited to the net premium paid and is realized when the market price of the underlying asset is higher than the high exercise price or lower than the low exercise price.The breakeven points occur when the market price at expiration equals ... the high exercise price minus the premium and the low exercise price plus the premium. The strategy is profitable when the market price is between the low exercise price plus the net premium and the high exercise price minus the net premium.

Key Regulations

In India we have two premier exchanges The National Stock Exchange of India (NSE) and The Bombay Stock Exchange (BSE) which offer options trading on stock indices as well as individual securities.

Options on stock indices are European in kind and settled only on the last of expiration of the underlying. NSE offers index options trading on the NSE Fifty index called the Nifty. While BSE offers index options on the country’s widely used index Sensex, which consists of 30 stocks.

Options on individual securities are American. The number of stock options contracts to be traded on the exchanges will be based on the list of securities as specified by Securities and Exchange Board of India (SEBI). Additions/deletions in the list of securities eligible on which options contracts shall be made available shall be notified from time to time.

Underlying: Underlying for the options on individual securities contracts shall be the underlying security available for trading in the capital market segment of the exchange.

Security descriptor: The security descriptor for the options on individual securities shall be:

Market type - N Instrument type - OPTSTK Underlying - Underlying security Expiry date - Date of contract expiry Option type - CA/PA Exercise style - American Premium Settlement method: Premium Settled; CA - Call

American PA - Put American.

Trading cycle: The contract cycle and availability of strike prices for options contracts on individual securities shall be as follows:Options on individual securities contracts will have a maximum of three-month trading cycle. New contracts will be introduced on the trading day following the expiry of the near month contract. On expiry of the near month contract, new contract shall be introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. (See Index futures learning centre for further reading) Strike price intervals: The exchange shall provide a minimum of five strike prices for every option type (i.e call & put) during the trading month. There shall be two contracts in-the-money (ITM), two contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike price interval for options on individual securities is given in the accompanying table.

New contracts with new strike prices for existing expiration date will be introduced for trading on the next working day based on the previous day's underlying close values and as and when required. In order to fix on the at-the-money strike price for options on individual securities contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike price interval. The in-the-money strike price and the out-of-the-money strike price shall be based on the at-the-money strike price interval.Expiry day: Options contracts on individual securities as well as index options shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day. Order type: Regular lot order, stop loss order, immediate or cancel, good till day, good till cancelled, good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order. Permitted lot size: The value of the option contracts on individual securities shall not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on individual securities shall be in multiples of 100 and fractions if any, shall be rounded off to the next higher multiple of 100. Price steps: The price steps in respect of all options contracts admitted to dealings on the exchange shall be Re 0.05. Quantity freeze: Orders which may come to the exchange as a quantity freeze shall be the lesser of the following: 1 per cent of the marketwide position limit stipulated of options on individual securities as given in (h) below or Notional value of the contract of around Rs 5 crore. In respect of such orders, which have come under quantity freeze, the member shall be required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the exchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc. Base price: Base price of the options contracts on introduction of new contracts shall be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. However in such of those contracts where orders could not be placed because of application of price ranges, the bases prices may be modified at the discretion of the exchange and intimated to the members. Price ranges: There will be no day minimum/maximum price ranges applicable for the options contract. The operating ranges and day minimum/maximum ranges for options contract shall be kept at 99 per cent of the base price. In view of this the members will not be able to place orders at prices which are beyond 99 per cent of the base price. The base prices for option contracts may be modified, at the discretion of the exchange, based on the request received from trading members as mentioned above. Exposure limits: Gross open positions of a member at any point of time shall not exceed the exposure limit as detailed hereunder:

Index Options: Exposure Limit shall be 33.33 times the liquid networth.

Option contracts on individual Securities: Exposure Limit shall be 20 times the liquid networth.

Memberwise position limit: When the open position of a Clearing Member, Trading Member or Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore, whichever is higher, in all the option contracts on the same underlying, at any time, including during trading hours. For option contracts on individual securities, open interest shall be equivalent to the open positions multiplied by the notional value. Notional Value shall be the previous day's closing price of the underlying security or such other price as may be specified from time to time. Market wide position limits: Market wide position limits for option contracts on individual securities shall be lower of: *20 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange or, 10 per cent of

the number of shares held by non-promoters in the relevant underlying security i.e. 10 per cent of the free float in terms of the number of shares of a company. The relevant authority shall specify the market wide position limits once every month, on the expiration day of the near month contract, which shall be applicable till the expiry of the subsequent month contract. Exercise settlement: Exercise type shall be American and final settlement in respect of options on individual securities contracts shall be cash settled for an initial period of 6 months and as per the provisions of National Securities Clearing Corporation Ltd (NSCCL) as may be stipulated from time to time.

Reading Stock Option Tables

In India, option tables published in business newspapers and is fairly similarto the regular stock tables.

The following is the format of the options table published in Indian business news papers:

NIFTY OPTIONS

Contracts Exp.Date Str.Price Opt.Type Open High Low Trd.Qty No.of.Cont. Trd.Value

RELIANCE 7/26/01 360 CA 3 3 2 4200 7 1512000

RELIANCE 7/26/01 360 PA 29 39 29 1200 2 432000

RELIANCE 7/26/01 380 CA 1 1 1 1200 2 456000

RELIANCE 7/26/01 380 PA 35 40 35 1200 2 456000

RELIANCE 7/26/01 340 CA 8 9 6 11400 19 3876000

RELIANCE 7/26/01 340 PA 10 14 10 13800 23 4692000

RELIANCE 7/26/01 320 CA 22 24 16 11400 19 3648000

RELIANCE 7/26/01 320 PA 4 7 2 29400 49 9408000

RELIANCE 8/30/01 360 PA 31 35 31 1200 2 432000

RELIANCE 8/30/01 340 CA 15 15 15 600 1 204000

RELIANCE 8/30/01 320 PA 10 10 10 600 1 192000

RELIANCE 7/26/01 300 CA 38 38 38 600 1 180000

RELIANCE 7/26/01 300 PA 2 2 2 1200 2 360000

RELIANCE 7/26/01 280 CA 59 60 53 1800 3 504000

The first column shows the contract that is being traded i.e Reliance.

The second coloumn displays the date on which the contract will expire i.e. the expiry date is the last Thursday of the month. Call options-American are depicted as 'CA' and Put options-American as 'PA'. The Open, High, Low, Close columns display the traded premium rates.

Advantages of option trading

Risk management: Put options allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.

Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.

Speculation: The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.

Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.

We can see below how one can leverage ones position by just paying the premium.

Option Premium Stock

Bought on Oct 15 Rs 380 Rs 4000

Sold on Dec 15 Rs 670 Rs 4500

Profit Rs 290 Rs 500

ROI (Not annualised) 76.3% 12.5%

Income generation: Shareholders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price.

Strategies: By combining different options, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies.

Barings episode—Learnings from the market

With the introduction of index options, the derivatives market is all set to shift to a multi-product environment from a single-product market. Options like futures are leveraged products used by participants to manage the risk in the underlying market. Many people perceive options to be very risky. Debacles like the Barings episode are responsible for this misconception.

At this juncture, when options are being introduced in the Indian capital market, it would be prudent to understand what happened in the Barings case to prevent similar incidents from occurring here.

The episode

The man behind the widely-reported debacle, Nicholas Leeson, had an established track record of being a savvy operator in the derivatives market and was the darling of the top management at the Barings headquarters in London.

As head of derivatives trading, Leeson was responsible for both the trading and clearing functions of Barings Futures Singapore (BFS), a subsidiary of London-based Barings Plc.

Leeson engaged himself in proprietary trading on the Japanese stock exchange index Nikkei 225. He operated simultaneously on the Singapore Exchange – Derivatives Trading Ltd., (SGX – DT) (erstwhile Singapore International Monetary Exchange, SIMEX), Singapore and Osaka Securities Exchange (OSE), Japan in Nikkei 225 futures and options.

A major part of Leeson's trading strategy involved the sale of options on the Nikkei 225 index futures contracts. He sold a large number of option straddles (a strategy that involves simultaneous sale of both call and put options) on Nikkei 225 index futures.

Without going into the intricacies, it may be understood that straddle results in a loss, if the market moves in either direction (up or down) drastically. His strategy amounted to a bet that the Japanese stock market would neither fall nor rise substantially.

But events took an unexpected and dramatic turn. The news of a killer earthquake in Kobe sent the Japanese stock markets tumbling. The futures on the Nikkei 225 started declining and Leeson's straddle position started incurring losses.

Desperate to make some profit from his straddles, he started supporting the index by building up extraordinarily huge long positions in Nikkei 225 futures on both exchanges - SGX – DT and OSE.

However, the Barings management was made to understand that Leeson was trying to arbitrage between the SGX-DT and OSE with the Nikkei 225 index futures.

When OSE authorities warned Leeson about his huge long positions on the exchange in Nikkei 225 futures, the trader claimed that he had built up exactly the opposite positions in the Nikkei 225 on SGX - DT. He wanted to suggest that if his positions in the Nikkei 225 at the OSE suffered losses, they would be made up by the profits by his position in the SGX - DT.

A similar impression was given to SGX - DT authorities, when they inquired about Leeson's positions. While Leeson misled both exchanges with wrong information, neither exchanges bothered to cross-check the trader's positions on the other exchanges because they were competing for the same business.

Both exchanges were more concerned about protecting their financial integrity and in doing so, allowed the continuation of the exceptionally-large positions of Leeson after securing adequate margins.

We all know the consequences. A single operator couldn't take the market in the desired direction and the market crashed drastically.

Consequently, Barings registered losses on Leeson's futures and straddle positions. But, we must note that the flames of the Leeson disaster did not singe the financial integrity of either market. This was because the markets were protected with proper margins.

The lessons

A single operator can't move the market: Leeson was trying to drive up prices by buying index futures on the Nikkei 225 but could not succeed as the market was gripped by pessimism emanating from the devastating Kobe earthquake.

The point is that, a single operator cannot change the direction of the market and it is always prudent to live with the market movement strategically. In this instance, a better strategy for Leeson would have been the dynamic management of his portfolio.

For example, with the falling value of the index, his put leg of the straddle started incurring losses (call was to expire worthless), and he had the choice to square his put options off at the pre-determined level (cut-off loss strategy).

But Leeson, instead of squaring off his short put option position, chose to support the index price by buying futures on the Nikkei 225 and failed.

Traders should have clearly defined and well-communicated position limits: Position limits mean the limits set by top management for each trader in the trading organisation. These limits are defined in various forms with regard to product, market or trader's total market exposure etc.

Any laxity on this front may result in unbearable consequences to the trading organisation. These limits should be clearly defined and well communicated to all traders in the organisation.

Meticulous monitoring of position limits is a must: We may note that Leeson, too, had position limits set by top management, but, he exceeded all of them.

This attempt at crossing limits did not come to the notice of the top brass at Barings as Leeson himself was in charge of supervising back office operations at BFS.

It is understood that he had sent fictitious reports about his trading activities to the Barings' headquarters in London. Had the top management been aware of the real situation, the disaster could probably have been avoided.

Therefore, scrupulous monitoring of the position limits is as important as setting them. The top management's job of monitoring the positions of each dealer in the dealing room may be facilitated by bifurcating the front and back office operations.

Different people should be in charge of front and back-office operations so that any exposure by dealers, over and above the limits set, can be detected immediately. It means having proper checks and balances at various levels to ensure that everyone in the organisation has the disciplinary approach and works within set limits.

In fact, trading systems should be capable enough to automatically disallow traders any increase in exposures as soon as they touch pre-determined limits.

Exchanges should compete professionally: Both the competing exchanges, SGX – DT and OSE, were unconcerned about checking Barings' position at the other exchange.

While both the exchanges were safeguarded through margins, people must appreciate the fact that the effect of a big failure like Barings goes much beyond the financial integrity of a system.

The point to be noted is that exchanges can compete, but at the same time, must co-operate and share information. It could also help in deterring efforts at price manipulation.

Big institutions are as prone to risk as individuals: One broad issue from an overall market perspective is that big institutions are as prone to incurring losses in the derivatives market as is any other individual.

Therefore, irrespective of the entity, margins should be collected by the clearing corporation/ house and/ or exchange on time. Only timely collection of margins can protect the financial integrity of the market as we have seen in the Barings case.

The above-mentioned points are relevant to trading organisations in derivatives market. They have to intelligently work in-house to avoid any mishaps like the Barings episode at any point in time.

SEBI has done a good job in the Indian derivatives market by making margins universally applicable to all categories of participants including institutions. This provision will go a long way in creating a financially-safe derivatives market in India.

Conclusion

Clearly, the failure of Barings was not a 'derivatives' failure' but a failure of management. After the investigations were through in the Barings case, the Board of Banking Supervision's report also placed responsibility on poor operational controls at Barings rather than the use of derivatives.

An important lesson from the entire episode is that we all need a disciplinary and self-regulatory approach. The moment we go against this fundamental rule, this leveraged market is capable of threatening our very existence

Source: Bombay Stock Exchange.

Glossary

American style: Type of option contract which allows the holder to exercise at any time up to and including the Expiry Day.

Annualised return: The return or profit, expressed on an annual basis, the writer of the option contract receives for buying the shares and writing that particular option.

Assignment: The random allocation of an exercise obligation to a writer. This is carried out by the exchanges.

At-the-money: When the price of the underlying security equals the exercise price of the option.

Buy and write: The simultaneous purchase of shares and sale of an equivalent number of option contracts.

Call option: An option contract that entitles the taker (buyer) to buy a fixed number of the underlying shares at a stated price on or before a fixed Expiry Day.

Class of options: Option contracts of the same type – either calls or puts - covering the same underlying security.

Delta: The rate in change of option premium due to a change in price of the underlying securities.

Derivative: An instrument which derives its value from the value of an underlying instrument (such as shares, share price indices, fixed interest securities, commodities, currencies, etc.). Warrants and options are types of derivative.

European style: Type of option contract, which allows the holder to exercise only on the Expiry Day.

Exercise price: The amount of money which must be paid by the taker (in the case of a call option) or the writer (in the case of a put option) for the transfer of each of the underlying securities upon exercise of the option.

Expiry day: The date on which all unexercised options in a particular series expire.

Hedge: A transaction, which reduces or offsets the risk of a current holding. For example, a put option may act as a hedge for a current holding in the underlying instrument.

Implied volatility: A measure of volatility assigned to a series by the current market price.

In-the-money: An option with intrinsic value.

Intrinsic value: The difference between the market value of the underlying securities and the exercise price of the option. Usually it is not less than zero. It represents the advantage the taker has over the current market price if the option is exercised.

Long-term option: An option with a term to expiry of two or three years from the date the series was first listed. (This is not available in currently in India)

Multiplier: Is used when considering index options. The strike price and premium of an index option are usually expressed in points.

Open interest: The number of outstanding contracts in a particular class or series existing in the option market. Also called the "open position".

Out-of-the-money: A call option is out-of-the-money if the market price of the underlying securities is below the exercise price of the option; a put option is out-of-the-money if the market price of the underlying securities is above the exercise price of the options.

Premium: The amount payable by the taker to the writer for entering the option. It is determined through the trading process and represents current market value.

Put option: An option contract that entitles the taker (buyer) to sell a fixed number of underlying securities at a stated price on or before a fixed Expiry Day.

Random selection: The method by which an exercise of an option is allocated to a writer in that series of option.

Series of options: All contracts of the same class having the same Expiry Day and the same exercise price.

Time value: The amount investors are willing to pay for the possibility that they could make a profit from their option position. It is influenced by time to expiry, dividends, interest rates, volatility and market expectations.

Underlying securities: The shares or other securities subject to purchase or sale upon exercise of the option.

Volatility: A measure of the expected amount of fluctuation in the price of the particular securities.

Writer: The seller of an option contract.

Options QuizThe quiz has been designed based on the course material. It is advised to go through the material before taking the test.

Progress Indicator: Question 1 of 20

1. A call option:

Choices: A. gives the option holder the right - not the obligation - to buy the underlying asset at a

specified price. B. gives the option holder the right - not the obligation - to sell the underlying asset at a

specified price. C. gives the option writer the right - not the obligation - to sell the underlying asset at a

specified price.

http://content.icicidirect.com/learning/options/quiz.asp?qid=1&sa=2






ICICIdirect University - Technical Analysis

What is Technical Analysis ?

Technical Analysis is basically the study of Price Chart, undertaken to get an idea about future price action of any traded stock. A Price Chart plots the quotes of a stock traded on a stock market. All past\present\future news relating to a stock, together with investors' opinion about it, determine the price of the stock on the trading floor. The "Price" discounts everything. Therefore, study of anything else is unnecessary. Technical Anlysis comprise of various techniques to study such price action over a period, as shown in the price chart.

How is it Different from Fundamental Analysis ?

Fundamentalists study the cause, while technicians study the effect. "Price" is the final result of all forces that can affect a stock. Price even discount the future, unknown news, while Fundamentals reflect the past. It is because of this reality, we often see tops being made on good news and bottoms being made on bad news.

How Technical Analysis helps an investors and traders?

With the help of Technical Analysis, the Investors and traders can enter the stock (long or short) when it starts trending, instead of locking their money during the periods of consolidation. Traders may look for such trending moves in Daily (or shorter) charts, while the investors may look for such trending moves in weekly/monthly charts.

Types of Charts

Price Style

Charts are displayed in three styles -- Bar,line and candlestick.

Candlestick

A candlestick is black if the closing price is lower than the opening price. A candlestick is white if the closing price is higher than the opening price.

Line

A line chart simply connects the closing prices from one period to the next. This type of chart is ideal for securities with no high or low price data (i.e., mutual funds).

Price Pattern

Head & Shoulders

The Head-and-Shoulders price pattern is the most reliable and well-known chart pattern. It gets its name from the resemblance of a head with two shoulders on either side. The reason this reversal pattern is so common is due to the manner in which trends typically reverse.

A up-trend is formed as prices make higher-highs and higher-lows in a stair-step fashion. The trend is broken when this upward climb ends. As you can see in the illustration (Intel, INTC), the "left shoulder" and the "head" are the last two higher-highs. The right shoulder is created as the bulls try to push prices higher, but are unable to do so. This signifies the end of the up-trend. Confirmation of a new down-trend occurs when the "neckline" is penetrated.

During a healthy up-trend, volume should increase during each rally. A sign that the trend is weakening occurs when the volume accompanying rallies is less than the volume accompanying the preceding rally. In a typical Head-and-Shoulders pattern, volume decreases on the head and is especially light on the right shoulder.

Following the penetration of the neckline, it is very common for prices to return to the neckline in a last effort to continue the up-trend. If prices are then unable to rise above the neckline, they usually decline rapidly on increased volume.

An inverse (or upside-down) Head-and-Shoulders pattern often coincides with market bottoms. As with a normal Head-and-Shoulders pattern, volume usually decreases as the pattern is formed and then increases as prices rise above the neckline.

DOUBLE TOP

A double top occurs when prices rise to a resistance level on significant volume, retreat, and subsequently return to the resistance level on decreased volume. Prices then decline marking the beginning of a new down-trend.

DOUBLE BOTTOM

A double bottom has the same characteristics as a double top except it is upside-down displays a potential upside.

Rounding Tops and Bottoms

Rounding tops occur as expectations gradually shift from bullish to bearish. The gradual, yet steady shift forms a rounded top. Rounding bottoms occur as expectations gradually shift from bearish to bullish.

Volume during both rounding tops and rounding bottoms often mirrors the bowl-like shape of prices during a rounding bottom. Volume, which was high during the previous trend, decreases as expectations shift and traders become indecisive. Volume then increases as the new trend is established.

TRIANGLES

A triangle occurs as the range between peaks and troughs narrows. Triangles typically occur as prices encounter a support or resistance level which constricts the prices.

A "symmetrical triangle" occurs when prices are making both lower-highs and higher-lows.

An "ascending triangle" occurs when there are higher-lows (as with a symmetrical triangle), but the highs are occurring at the same price level due to resistance. The odds favor an upside breakout from an ascending triangle.

A "descending triangle" occurs when there are lower-highs (as with a symmetrical triangle), but the lows are occurring at the same price level due to support. The odds favor a downside breakout from a descending triangle.

Just as pressure increases when water is forced through a narrow opening, the "pressure" of prices increases as the triangle pattern forms. Prices will usually breakout rapidly from a triangle. Breakouts are confirmed when they are accompanied by an increase in volume.

The most reliable breakouts occur somewhere between half and three-quarters of the distance between the beginning and end (apex) of the triangle. There are seldom many clues as to the direction prices will break out of a symmetrical triangle. If prices move all the way through the triangle to the apex, a breakout is unlikely.

Studies and Indicators

Trendlines

In the preceding section, we saw how support and resistance levels can be penetrated by a change in investor expectations (which results in shifts of the supply/demand lines). This type of a change is often abrupt and "news based."

In this section, we'll review "trends." A trend represents a consistent change in prices (i.e., a change in investor expectations). Trends differ from support/resistance levels in that trends represent change, whereas support/resistance levels represent barriers to change.

As shown in the following chart, a rising trend is defined by successively higher low-prices. A rising trend can be thought of as a rising support level--the bulls are in control and are pushing prices higher.

As shown in the next chart, a falling trend is defined by successively lower high-prices. A falling trend can be thought of as a falling resistance level--the bears are in control and are pushing prices lower.

Support and Resistance

The foundation of most technical analysis tools is rooted in the concept of supply and demand. There is nothing mysterious about support and resistance--it is classic supply and demand. Remembering "Econ 101" class, supply/demand lines show what the supply and demand will be at a given price.

Resistance is equivalent to a "supply" line. When prices increase, the quantity of sellers also increases as more investors are willing to sell at these higher prices. When too much selling occurs, however, prices retreat. When this happens repeatedly near a specific price level, resistance forms at that price level.

Support is equivalent to a "demand" line. When prices decrease, the quantity of buyers increases as more investors are willing to buy at lower prices. When too much buying occurs, however, prices rise. When this happens repeatedly near a specific price level, support forms at that price level.

Following the penetration of a support/resistance level, it is common for traders to question the new price levels. For example, after a breakout above a resistance level, buyers and sellers may both question the validity of the new price and may decide to sell. This creates a phenomena referred to as "traders' remorse" where prices return to a support/resistance level following a price breakout.

The price action following this remorseful period is crucial. One of two things can happen. Either the consensus of expectations will be that the new price is not warranted and prices will move

back to their previous level; or investors will accept the new price and prices will continue to move in the direction of the penetration.

When a resistance level is successfully penetrated, that level becomes a support level. Similarly, when a support level is successfully penetrated, that level becomes a resistance level.

Accumulation/Distribution

The Accumulation/Distribution is a momentum indicator that associates changes in price and volume. The indicator is based on the premise that the more volume that accompanies a price move, the more significant the price move.

Interpretation

The Accumulation/Distribution is really a variation of the more popular On Balance Volume indicator. Both of these indicators attempt to confirm changes in prices by comparing the volume associated with prices.

When the Accumulation/Distribution moves up, it shows that the security is being accumulated as most of the volume is associated with upward price movement. When the indicator moves down, it shows that the security is being distributed as most of the volume is associated with downward price movement.

Divergences between the Accumulation/Distribution and the security's price imply a change is imminent. When a divergence does occur, prices usually change to confirm the Accumulation/Distribution. For example, if the indicator is moving up and the security's price is going down, prices will probably reverse.

Bollinger Bands

Bollinger Bands are similar to moving average envelopes. The difference between Bollinger Bands and envelopes is envelopes are plotted at a fixed percentage above and below a moving average, whereas Bollinger Bands are plotted at standard deviation levels above and below a moving average. Since standard deviation is a measure of volatility, the bands are self-adjusting: widening during volatile markets and contracting during calmer periods.

Bollinger Bands were created by John Bollinger.

Interpretation

Bollinger Bands are usually displayed on top of security prices, but they can be displayed on an indicator. These comments refer to bands displayed on prices.

As with moving average envelopes, the basic interpretation of Bollinger Bands is that prices tend to stay within the upper- and lower-band. The distinctive characteristic of Bollinger Bands is that the spacing between the bands varies based on the volatility of the prices. During periods of extreme price changes (i.e., high volatility), the bands widen to become more forgiving. During periods of stagnant pricing (i.e., low volatility), the bands narrow to contain prices.

Mr. Bollinger notes the following characteristics of Bollinger Bands.

Sharp price changes tend to occur after the bands tighten, as volatility lessens. When prices move outside the bands, a continuation of the current trend is implied. Bottoms and tops made outside the bands followed by bottoms and tops made inside the

bands call for reversals in the trend.

A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.

MACD

The MACD ("Moving Average Convergence/Divergence") is a trend following momentum indicator that shows the relationship between two moving averages of prices. The MACD was developed by Gerald Appel, publisher of Systems and Forecasts.

The MACD is the difference between a 26-day and 12-day exponential moving average. A 9-day exponential moving average, called the "signal" (or "trigger") line is plotted on top of the MACD to show buy/sell opportunities. (Appel specifies exponential moving averages as percentages as explained on page 170. Thus, he refers to these three moving averages as 7.5%, 15%, and 20% respectively.)

Interpretation

The MACD proves most effective in wide-swinging trading markets. There are three popular ways to use the MACD: crossovers, overbought/oversold, and divergences.

Crossovers

The basic MACD trading rule is to sell when the MACD falls below its signal line. Similarly, a buy signal occurs when the MACD rises above its signal line. It is also popular to buy/sell when the MACD goes above/below zero.

Overbought/Oversold Conditions.

The MACD is also useful as an overbought/oversold indicator. When the shorter moving average pulls away dramatically from the longer moving average (i.e., the MACD rises), it is likely that the security price is overextending and will soon return to more realistic levels. MACD overbought and oversold conditions exist vary from security to security.

Divergences.

A indication that an end to the current trend may be near occurs when the MACD diverges from the security (page 32). A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows. A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs. Both of these divergences are most significant when they occur at relatively overbought/oversold levels.

Oscillators

An oscillator is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period.

Relative Strength Index (RSI)

RSI: The Relative Strength Index is a price-following oscillator that ranges between 0 and 100. A popular method of analyzing the Relative Strength Index is to look for a divergence in which the security is making a new high, but the Relative Strength Index is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the Relative Strength Index then turns down and falls below its most recent trough, it is said to have completed a "failure swing." The failure swing is considered a confirmation of the impending reversal.

Tops and Bottoms: The Relative Strength Index usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.

Chart Formations: The Relative Strength Index often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart.

Failure Swings: (also known as support or resistance penetrations or breakouts). This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough).

Support and Resistance: The Relative Strength Index shows, sometimes more clearly than price themselves, levels of support and resistance.

Divergences: As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index. Prices usually correct and move in the direction of the Relative Strength Index.

Rate of Change (ROC)

The Price Rate-of-Change ("ROC") indicator displays the difference between the current price and the price x-time periods ago. The difference can be displayed in either points or as a percentage. The Momentum indicator displays the same information, but expresses it as a ratio.

Interpretation

It is a well recognized phenomenon that security prices surge ahead and retract in a cyclical wave-like motion. This cyclical action is the result of the changing expectations as bulls and bears struggle to control prices.

The ROC displays the wave-like motion in an oscillator format by measuring the amount that prices have changed over a given time period. As prices increase, the ROC rises; as prices fall, the ROC falls. The greater the change in prices, the greater the change in the ROC.

The 12-day ROC is an excellent short- to intermediate-term overbought/oversold indicator. The higher the ROC, the more overbought the security; the lower the ROC, the more likely a rally. However, as with all overbought/oversold indicators, it is prudent to wait for the market to begin to correct (i.e., turn up or down) before placing your trade. A market that appears overbought may remain overbought for some time. In fact, extremely overbought/oversold readings usually imply a continuation of the current trend.

The 12-day ROC tends to be very cyclical, oscillating back and forth in a fairly regular cycle. Often, price changes can be anticipated by studying the previous cycles of the ROC and relating the previous cycles to the current market.

Japanese Candlesticks

Japanese Candlesticks

Overview

In the 1600s, the Japanese developed a method of technical analysis to analyze the price of rice contracts. This technique is called candlestick charting. Steven Nison is credited with popularizing candlestick charting and has become recognized as the leading expert on their interpretation.

Candlestick charts display the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a manner that extenuates the relationship between the opening and closing prices. Candlestick charts are simply a new way of looking at prices, they don't involve any calculations.

Each candlestick represents one period (e.g., day) of data. Figure 45 displays the elements of a candle.

Interpretation

I have met investors who are attracted to candlestick charts by their mystique--maybe they are the "long forgotten Asian secret" to investment analysis. Other investors are turned-off by this mystique--they are only charts, right? Regardless of your feelings about the heritage of candlestick charting, I strongly encourage you to explore their use. Candlestick charts dramatically illustrate changes in the underlying supply/demand lines.

Because candlesticks display the relationship between the open, high, low, and closing prices, they cannot be displayed on securities that only have closing prices, nor were they intended to be displayed on securities that lack opening prices. If you want to display a candlestick chart on a security that does not have opening prices, I suggest that you use the previous day's closing prices in place of opening prices. This technique can create candlestick lines and patterns that are unusual, but valid.

The interpretation of candlestick charts is based primarily on patterns. The most popular patterns are explained below.

Long white (empty) line. This is a bullish line. It occurs when prices open near the low and close significantly higher near the period's high.

Hammer. This is a bullish line if it occurs after a significant downtrend. If the line occurs after a significant up-trend, it is called a Hanging Man. A Hammer is identified by a small real body (i.e., a small range between the open and closing prices) and a long lower shadow (i.e., the low is significantly lower than the open, high, and close). The body can be empty or filled-in.

Piercing line. This is a bullish pattern and the opposite of a dark cloud cover. The first line is a long black line and the second line is a long white line. The second line opens lower than the first line's low, but it closes more than halfway above the first line's real body.

Bullish engulfing lines. This pattern is strongly bullish if it occurs after a significant downtrend (i.e., it acts as a reversal pattern). It occurs when a small bearish (filled-in) line is engulfed by a large bullish (empty) line.

Morning star. This is a bullish pattern signifying a potential bottom. The "star" indicates a possible reversal and the bullish (empty) line confirms this. The star can be empty or filled-in.

Bullish doji star. A "star" indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the morning star, above) before trading a doji star. The first line can be empty or filled in.

Long black (filled-in) line. This is a bearish line. It occurs when prices open near the high and close significantly lower near the period's low.

Hanging Man. These lines are bearish if they occur after a significant uptrend. If this pattern occurs after a significant downtrend, it is called a Hammer. They are identified by small real bodies (i.e., a small range between the open and closing prices) and a long lower shadow (i.e., the low was significantly lower than the open, high, and close). The bodies can be empty or filled-in.

Dark cloud cover. This is a bearish pattern. The pattern is more significant if the second line's body is below the center of the previous line's body (as illustrated).

Bearish engulfing lines. This pattern is strongly bearish if it occurs after a significant up-trend (i.e., it acts as a reversal pattern). It occurs when a small bullish (empty) line is engulfed by a large bearish (filled-in) line.

Evening star. This is a bearish pattern signifying a potential top. The "star" indicates a possible reversal and the bearish (filled-in) line confirms this. The star can be empty or filled-in.

Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the evening star illustration) before trading a doji star.

Shooting star. This pattern suggests a minor reversal when it appears after a rally. The star's body must appear near the low price and the line should have a long upper shadow.

Long-legged doji. This line often signifies a turning point. It occurs when the open and close are the same, and the range between the high and low is relatively large.

Dragon-fly doji. This line also signifies a turning point. It occurs when the open and close are the same, and the low is significantly lower than the open, high, and closing prices.

Gravestone doji. This line also signifies a turning point. It occurs when the open, close, and low are the same, and the high is significantly higher than the open, low, and closing prices.

Star. Stars indicate reversals. A star is a line with a small real body that occurs after a line with a much larger real body, where the real bodies do not overlap. The shadows may overlap.

Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the evening star illustration) before trading a doji star.

Spinning tops. These are neutral lines. They occur when the distance between the high and low, and the distance between the open and close, are relatively small.

Doji. This line implies indecision. The security opened and closed at the same price. These lines can appear in several different patterns.

Double doji lines (two adjacent doji lines) imply that a forceful move will follow a breakout from the current indecision.

Harami ("pregnant" in English). This pattern indicates a decrease in momentum. It occurs when a line with a small body falls within the area of a larger body.

In this example, a bullish (empty) line with a long body is followed by a weak bearish (filled-in) line. This implies a decrease in the bullish momentum.

Harami cross. This pattern also indicates a decrease in momentum. The pattern is similar to a harami, except the second line is a doji (signifying indecision).

ICICIdirect University - Mutual Fund

Introduction

The Mutual Fund Industry

The genesis of the mutual fund industry in India can be traced back to 1964 with the setting up of the Unit Trust of India (UTI) by the Government of India. Since then UTI has grown to be a dominant player in the industry. UTI is governed by a special legislation, the Unit Trust of India Act, 1963.

The industry was opened up for wider participation in 1987 when public sector banks and insurance companies were permitted to set up mutual funds. Since then, 6 public sector banks have set up mutual funds. Also the two Insurance companies LIC and GIC have established mutual funds. Securities Exchange Board of India (SEBI) formulated the Mutual Fund (Regulation) 1993, which for the first time established a comprehensive regulatory framework for the mutual fund industry. Since then several mutual funds have been set up by the private and joint sectors.

Growth of Mutual Funds

The Indian Mutual fund industry has passed through three phases.The first phase was between 1964 and 1987 when Unit Trust of India was the only player.By the end of 1988,UTI had total asset of Rs 6,700 crores. The second phase was between 1987 and 1993 during which period 8 funds were established (6 by banks and one each by LIC and GIC).This resulted in the total assets under management to grow to Rs 61,028 crores at the end of 1994 and the number of schemes were 167.

The third phase began with the entry of private and foreign sectors in the Mutual fund industry in 1993. Several private sectors Mutual Funds were launched in 1993 and 1994. The share of the private players has risen rapidly since then. Currently there are 34 Mutual Fund organisations in India. Kothari Pioneer Mutual fund was the first fund to be established by the private sector in association with a foreign fund.

This signaled a growth phase in the industry and at the end of financial year 2000, 32 funds were functioning with Rs. 1,13,005 crores as total assets under management. As on August end 2000, there were 33 funds with 391 schemes and assets under management with Rs. 1,02,849 crores. The Securities and Exchange Board of India (SEBI) came out with comprehensive regulation in 1993 which defined the structure of Mutual Fund and Asset Management Companies for the first time.

What is a Mutual Fund

Like most developed and developing countries the mutual fund cult has been catching on in India. There are various reasons for this. Mutual funds make it easy and less costly for investors to satisfy their need for capital growth, income and/or income preservation.

And in addition to this a mutual fund brings the benefits of diversification and money management to the individual investor, providing an opportunity for financial success that was once available only to a select few.

Understanding Mutual funds is easy as it's such a simple concept: a mutual fund is a company that pools the money of many investors -- its shareholders -- to invest in a variety of different securities. Investments may be in stocks, bonds, money market securities or some combination of these. Those securities are professionally managed on behalf of the shareholders, and each investor holds a pro rata share of the portfolio -- entitled to any profits when the securities are sold, but subject to any losses in value as well.

For the individual investor, mutual funds provide the benefit of having someone else manage your investments and diversify your money over many different securities that may not be available or affordable to you otherwise. Today, minimum investment requirements on many funds are low enough that even the smallest investor can get started in mutual funds.

A mutual fund, by its very nature, is diversified -- its assets are invested in many different securities. Beyond that, there are many different types of mutual funds with different objectives and levels of growth potential, furthering your chances to diversify.

Why invest in Mutual Funds.

Investing in mutual has various benefits which makes it an ideal investment avenue. Following are some of the primary benefits.

Professional investment management

One of the primary benefits of mutual funds is that an investor has access to professional management. A good investment manager is certainly worth the fees you will pay. Good mutual fund managers with an excellent research team can do a better job of monitoring the companies they have chosen to invest in than you can, unless you have time to spend on researching the companies you select for your portfolio. That is because Mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. The managers have real-time access to crucial market information and are able to execute trades on the largest and most cost-effective scale. When you buy a mutual fund, the primary asset you are buying is the manager, who will be controlling which assets are chosen to meet the funds' stated investment objectives.

Diversification

A crucial element in investing is asset allocation. It plays a very big part in the success of any portfolio. However, small investors do not have enough money to properly allocate their assets. By pooling your funds with others, you can quickly benefit from greater diversification. Mutual

funds invest in a broad range of securities. This limits investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund unit-holders can benefit from diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities.

Low Cost

A mutual fund let's you participate in a diversified portfolio for as little as Rs.5,000, and sometimes less. And with a no-load fund, you pay little or no sales charges to own them.

Convenience and Flexibility

Investing in mutual funds has it’s own convenience. While you own just one security rather than many, you still enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide what securities to trade, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. It also uses the services of a high quality custodian and registrar. Another big advantage is that you can move your funds easily from one fund to another within a mutual fund family. This allows you to easily rebalance your portfolio to respond to significant fund management or economic changes.

Liquidity

In open-ended schemes, you can get your money back promptly at net asset value related prices from the mutual fund itself.

Transparency

Regulations for mutual funds have made the industry very transparent. You can track the investments that have been made on you behalf and the specific investments made by the mutual fund scheme to see where your money is going. In addition to this, you get regular information on the value of your investment.

Variety

There is no shortage of variety when investing in mutual funds. You can find a mutual fund that matches just about any investing strategy you select. There are funds that focus on blue-chip stocks, technology stocks, bonds or a mix of stocks and bonds. The greatest challenge can be sorting through the variety and picking the best for you.

Types of Mutual Funds

Getting a handle on what's under the hood helps you become a better investor and put together a more successful portfolio. To do this one must know the different types of funds that cater to investor needs, whatever the age, financial position, risk tolerance and return expectations. The mutual fund schemes can be classified according to both their investment objective (like income, growth, tax saving) as well as the number of units (if these are unlimited then the fund is an open-ended one while if there are limited units then the fund is close-ended).

This section provides descriptions of the characteristics -- such as investment objective and potential for volatility of your investment -- of various categories of funds. These descriptions are organized by the type of securities purchased by each fund: equities, fixed-income, money market instruments, or some combination of these.

Open-ended schemes

Open-ended schemes do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund on any business day. These schemes have unlimited capitalization, open-ended schemes do not have a fixed maturity, there is no cap on the amount you can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange.

Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over close-ended are as follows:

Any time exit option, The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries. Any time entry option, An open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.

Close ended schemes

Close-ended schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. After that such schemes can not issue new units except in case of bonus or rights issue. However, after the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors’ expectations and other market factors

Classification according to investment objectives

Mutual funds can be further classified based on their specific investment objective such as growth of capital, safety of principal, current income or tax-exempt income.

In general mutual funds fall into three general categories:

1] Equity Funds are those that invest in shares or equity of companies.

2] Fixed-Income Funds invest in government or corporate securities that offer fixed rates of return are

3] While funds that invest in a combination of both stocks and bonds are called Balanced Funds.

Growth Funds

Growth funds primarily look for growth of capital with secondary emphasis on dividend. Such funds invest in shares with a potential for growth and capital appreciation. They invest in well-established companies where the company itself and the industry in which it operates are thought to have good long-term growth potential, and hence growth funds provide low current income. Growth funds generally incur higher risks than income funds in an effort to secure more pronounced growth.

Some growth funds concentrate on one or more industry sectors and also invest in a broad range of industries. Growth funds are suitable for investors who can afford to assume the risk of potential loss in value of their investment in the hope of achieving substantial and rapid gains.

They are not suitable for investors who must conserve their principal or who must maximize current income.

Growth and Income Funds

Growth and income funds seek long-term growth of capital as well as current income. The investment strategies used to reach these goals vary among funds. Some invest in a dual portfolio consisting of growth stocks and income stocks, or a combination of growth stocks, stocks paying high dividends, preferred stocks, convertible securities or fixed-income securities such as corporate bonds and money market instruments. Others may invest in growth stocks and earn current income by selling covered call options on their portfolio stocks.

Growth and income funds have low to moderate stability of principal and moderate potential for current income and growth. They are suitable for investors who can assume some risk to achieve growth of capital but who also want to maintain a moderate level of current income.

Fixed-Income Funds

Fixed income funds primarily look to provide current income consistent with the preservation of capital. These funds invest in corporate bonds or government-backed mortgage securities that have a fixed rate of return. Within the fixed-income category, funds vary greatly in their stability of principal and in their dividend yields. High-yield funds, which seek to maximize yield by investing in lower-rated bonds of longer maturities, entail less stability of principal than fixed-income funds that invest in higher-rated but lower-yielding securities.

Some fixed-income funds seek to minimize risk by investing exclusively in securities whose timely payment of interest and principal is backed by the full faith and credit of the Indian Government. Fixed-income funds are suitable for investors who want to maximize current income and who can assume a degree of capital risk in order to do so.

Balanced

The Balanced fund aims to provide both growth and income. These funds invest in both shares and fixed income securities in the proportion indicated in their offer documents. Ideal for investors who are looking for a combination of income and moderate growth.

Money Market Funds/Liquid Funds

For the cautious investor, these funds provide a very high stability of principal while seeking a moderate to high current income. They invest in highly liquid, virtually risk-free, short-term debt securities of agencies of the Indian Government, banks and corporations and Treasury Bills. Because of their short-term investments, money market mutual funds are able to keep a virtually constant unit price; only the yield fluctuates.

Therefore, they are an attractive alternative to bank accounts. With yields that are generally competitive with - and usually higher than -- yields on bank savings account, they offer several advantages. Money can be withdrawn any time without penalty. Although not insured, money market funds invest only in highly liquid, short-term, top-rated money market instruments. Money market funds are suitable for investors who want high stability of principal and current income with immediate liquidity.

Specialty/Sector Funds

These funds invest in securities of a specific industry or sector of the economy such as health care, technology, leisure, utilities or precious metals. The funds enable investors to diversify holdings among many companies within an industry, a more conservative approach than investing directly in one particular company.

Sector funds offer the opportunity for sharp capital gains in cases where the fund's industry is "in favor" but also entail the risk of capital losses when the industry is out of favor. While sector funds restrict holdings to a particular industry, other specialty funds such as index funds give investors a broadly diversified portfolio and attempt to mirror the performance of various market averages.

Index funds generally buy shares in all the companies composing the BSE Sensex or NSE Nifty or other broad stock market indices. They are not suitable for investors who must conserve their principal or maximize current income.

Risk vs Reward

Having understood the basics of mutual funds the next step is to build a successful investment portfolio. Before you can begin to build a portfolio, one should understand some other elements of mutual fund investing and how they can affect the potential value of your investments over the years. The first thing that has to be kept in mind is that when you invest in mutual funds, there is no guarantee that you will end up with more money when you withdraw your investment than what you started out with. That is the potential of loss is always there. The loss of value in your investment is what is considered risk in investing.

Even so, the opportunity for investment growth that is possible through investments in mutual funds far exceeds that concern for most investors. Here’s why.

At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward. Or stated in another way, you get what you pay for and you get paid a higher return only when you're willing to accept more volatility.

Risk then, refers to the volatility -- the up and down activity in the markets and individual issues that occurs constantly over time. This volatility can be caused by a number of factors -- interest rate changes, inflation or general economic conditions. It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock we invest in will fall substantially. But it is this very volatility that is the exact reason that you can expect to earn a higher long-term return from these investments than from a savings account.

Different types of mutual funds have different levels of volatility or potential price change, and those with the greater chance of losing value are also the funds that can produce the greater returns for you over time. So risk has two sides: it causes the value of your investments to fluctuate, but it is precisely the reason you can expect to earn higher returns.

You might find it helpful to remember that all financial investments will fluctuate. There are very few perfectly safe havens and those simply don't pay enough to beat inflation over the long run.

Types of risks

All investments involve some form of risk. Consider these common types of risk and evaluate them against potential rewards when you select an investment.

Market Risk

At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk". Also known as systematic risk.

Inflation Risk

Sometimes referred to as "loss of purchasing power." Whenever inflation rises forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns.

Credit Risk

In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?

Interest Rate Risk

Changing interest rates affect both equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can help in offseting these changes.

Exchange risk

A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.

Investment Risks

The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.

Changes in the Government Policy

Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund

Effect of loss of key professionals and inability to adapt business to the rapid technological change.

An industries' key asset is often the personnel who run the business i.e. intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers. Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.

Choosing a fund

Mutual fund is the best investment tool for the retail investor as it offers the twin benefits of good returns and safety as compared with other avenues such as bank deposits or stock investing. Having looked at the various types of mutual funds, one has to now go about selecting a fund suiting your requirements. Choose the wrong fund and you would have been better off keeping money in a bank fixed deposit.Keep in mind the points listed below and you could at least marginalise your investment risk.

Past performance

While past performance is not an indicator of the future it does throw some light on the investment philosophies of the fund, how it has performed in the past and the kind of returns it is offering to the investor over a period of time. Also check out the two-year and one-year returns for consistency. How did these funds perform in the bull and bear markets of the immediate past? Tracking the performance in the bear market is particularly important because the true test of a portfolio is often revealed in how little it falls in a bad market.

Know your fund manager

The success of a fund to a great extent depends on the fund manager. The same fund managers manage most successful funds. Ask before investing, has the fund manager or strategy changed recently? For instance, the portfolio manager who generated the fund’s successful performance may no longer be managing the fund.

Does it suit your risk profile?

Certain sector-specific schemes come with a high-risk high-return tag. Such plans are suspect to crashes in case the industry loses the marketmen’s fancy. If the investor is totally risk averse he can opt for pure debt schemes with little or no risk. Most prefer the balanced schemes which

invest in the equity and debt markets. Growth and pure equity plans give greater returns than pure debt plans but their risk is higher.

Read the prospectus

The prospectus says a lot about the fund. A reading of the fund’s prospectus is a must to learn about its investment strategy and the risk that it will expose you to. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you.

How will the fund affect the diversification of your portfolio?

When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk.

What it costs you?

A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time.

Finally, don’t pick a fund simply because it has shown a spurt in value in the current rally. Ferret out information of a fund for atleast three years. The one thing to remember while investing in equity funds is that it makes no sense to get in and out of a fund with each turn of the market. Like stocks, the right equity mutual fund will pay off big -- if you have the patience. Similarly, it makes little sense to hold on to a fund that lags behind the total market year after year.

Tax aspects of Mutual Funds

Income received from Mutual Funds

According to the latest Budget proposals dividends from Mutual Funds will now be taxed in the hands of the investor. Before the new proposals, dividend from debt funds was subject to a 10 per cent dividend distribution tax plus surcharge. Dividends received from open-ended equity funds were completely tax-free. Now, all mutual funds including equity funds and schemes of UTI will attract a 10 per cent dividend tax. However, dividend upto Rs 1,000 has been exempt under Section 80L.

Capital gains tax

The difference between the sale consideration and the cost of acquisition of the asset is called capital gain. If the investor sells his units and earns capital gains he is liable to pay capital gains tax. Capital gains are of two types: Short term and Long term capital gains.

Short Term Capital Gains

If the units are held for a period of less than one year they will be treated as short-term capital gains and the investor will be taxed depending on the income tax rate applicable to him.

Long Term Capital Gains

All units held for a period of more than 12 months will be classified as long term capital assets. The investor has to pay long-term capital gains on the units held by him for period of more than 12 months. In this case the investor will

1] Pay tax at a flat rate of 10 % (plus surcharge @ 5% of the applicable tax rate) on the capital gains without indexation or

2] Avail cost indexation on capital gains and pay 20 % tax (plus surcharge @ 5% of the applicable tax rate) whichever is lower.

Indexation means that the purchase price is marked up by an inflation index resulting in lower capital gains and hence lower tax.

Inflation index for the year of transfer

Inflation index = ------------------------------------------

Inflation index for the year of acquisition

Wealth tax

Units held by the investor are not treated as assets within the meaning of section 2(ea) of the Wealth Tax act 1957, and therefore not liable for wealth tax.

Gift tax

Units of Mutual Funds may be given as a gift and no gift tax will be payable either by the donor or the donee.

TDS on redemption

No TDS is required to be deducted from capital gains arising at the time of redemptions in case of mutual funds

Section 88 of Income Tax Act

Under Section 88 of the Income Tax Act an investor has some tax benefits if he invests in specified mutual funds (called equity linked savings schemes or ELSS). The tax break is available for a maximum investment of Rs 10,000. However, the deduction will depend on the income tax bracket the investor falls in. For taxable income upto Rs 1.5 lakh the deduction is 20 per cent or Rs 2,000. For taxable income between Rs 1.5 lakh and Rs 5 lakh the deduction is 15 per cent or Rs 1,500. For income above Rs 5 lakh there is no deduction under this section. These funds have a lock-in period of three years.

Risk Tolerance Questionnaire

1 Current vs. Future

Which of the following statements best reflects the manner you wish to invest to achieve your goals?

My investments should be absolutely safe and I just cannot run the risk of losing even a single rupee of principal.

My investments should generate regular income that I can spend.

My investments should generate some current income and also grow in value over time.

I want to create wealth and not current income.

2 Volatility

Depending on the kinds of investments you select, the value of your assets can remain quite stable (increasing slowly but steadily) or may rise and fall in response to market events. With respect to your goals, how much volatility are you willing to accept?

Slight.

Some.

Considerable.

3 Desire for Returns

Investments in which the principal is 100% safe sometimes earn less than the inflation rate. This means that while no money is lost, there is a loss in purchasing power. (To illustrate: If a Rs1000 was locked in a vault 100 years ago and taken out today, it would still be worth Rs 1000 but would buy a great deal less today than when it was put in.) With respect to your goals, which of the following is most true?

My money should be 100% safe, even if it means my returns do not keep pace with inflation.

It is important that the value of my investments keep pace with inflation.

It is important that my investments grow faster than inflation.

4 Extent of Tolerable Loss

The value of my portfolio may fluctuate over time. However, the maximum loss in any one-year period that I would be prepared to accept is approximately:

0%

-5%

-10%

-20%

-30%

5 Allocation Strategy

Consider the following two investments, ABC Limited and XYZ Limited. ABC Limited provides an average annual return of 10% with minimal risk of loss of principal. XYZ Limited provides an average annual return of 20% but carries a potential loss of principal of 30% or more in any year. If I could choose to invest between this two companies to meet my goals, I would invest my money in:

100% in ABC Ltd. and 20% in XYZ Ltd.

80% in ABC Limited and 20% in XYZ Limited.




6 Fluctuation

In case of fluctuations in the value of my investments I would

Immediately sell any investment that loses money on a daily or weekly basis

If my investment loses 5% within three months, I will redeem my investment and not

invest further

If after a year there is a decline in the value of my funds, I will pull out my investment from mutual funds

If my investment has declined in value after a year, I will exchange the mutual fund for another mutual fund

7 Risk-Return Matrix

I am willing to accept these best and worst case scenarios. For an initial investment of Rs10,000 for five years.

Rs 82,000/Rs 2,000

Rs 45,000/Rs 4,000

Rs 27,000/Rs 7,000

Rs 13,000/Rs 9,950

Rs 10,050/Rs 10,000

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