technical and derivative .. project report

8/2/2019 technical and derivative .. project report

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Technical analysis & Derivatives trading strategy

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Table of Contents

Contents Page No.

1. Introduction to AnandRathi Financial Services Ltd. 3-4

2. Technical Analysis 5-6

A. Introduction 5B. Assumptions of Technical analysis 6

3. Support and Resistance 7-10

A. Introduction 7B. Round Numbers and Support and Resistance 8C. Role Reversal 8

D. The Importance of Support and Resistance 10

4. Importance of Trend 11-13

A. Types of trends 11B. Trend Lengths 13

5. Types of Charts 14-17

A. Line Chart 14B. Bar Chart 15C. Candlestick Charts 15

D. Point and Figure Charts 16

6. Chart Patterns 18-25

7. Moving Averages 26-28

8. Indicators and Oscillators 29-33

9. Derivatives 34-34

10. The Scenario In India 35-37

A. Need for Derivatives in India 36

B. Factors Driving The Growth Of Derivates 37


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11. Derivative Products 38-40

A. Introduction 38B. Economic Function Of Derivative Market 39

12. Derivatives Terminologies 41-44

13. Options 45-77

A. Introduction 45B. Options Terminologies 45C. Options Trading Strategies 48

14. Conclusions 78-79

15.Limitation 80

Bibliography 81


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Introduction to AnandRathi Financial Services Ltd.

AnandRathi is a leading full service investment bank founded in 1994 offering a wide range

of financial services and wealth management solutions to institutions, corporations, highnet

worth individuals and families. The firm has rapidly expanded its footprint to over 350

locations across India with international presence in Hong Kong, Dubai & London. Founded

by Mr. Anand Rathi and Mr. Pradeep Gupta, the group today employs over 2,500

professionals throughout India and its international offices.

The firms philosophy is entirely client centric, with a clear focus on providing long term

value addition to clients, while maintaining the highest standards of excellence, ethics andprofessionalism. The entire firm activities are divided across distinct client groups:

Individuals, Private Clients, Corporates and Institutions. AnandRathi has been named The

Best Domestic Private Bank in India by Asiamoney in their Fifth Annual Private Banking

Poll 2009. The firm provides Private Banking service from Mumbai, Delhi, Bangalore &

Hyderabad. The firm has emerged a winner across all key segments in Asiamoneys largest

survey of high net worth individuals in India.

In year 2007 Citigroup Venture Capital International joined the group as a financial partner .

Breadth of services:

In line with its client-centric philosophy, the firm offers to its clients the entire spectrum of

financial services ranging from brokerage services in equities and commodities, distribution

of mutual funds, IPOs and insurance products, investment banking, merger and acquisitions,

corporate finance and corporate advisory.

Management Team

AnandRathi has a highly professional core management team that comprises of individuals

with extensive business as well as industry experience. Some of them are:

1. Mr. Anand Rathi, Founder & Chairman2. Mr. Amit Rathi, Managing Director3. Mr. Pradeep Gupta, Managing Director


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Vision statement:

To be a shining example as a leader of innovation and first choice for clients and

employees.

In-Depth Research:

Anand Rathis research expertise is at the core of the value proposition that they offer to their

clients. Research teams across the firm continuously track various markets and Products. The

aim is however common - to go far deeper than others, to deliver incisive insights and ideas

and be accountable for results.


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Technical Analysis

Introduction:

It is a method of evaluating securities by analysing statistics and data such as historical prices

and trading volumes. Technical analysts do not attempt to measure a security's intrinsic value

but instead use charts, graphs, and other analytic tools to identify patterns that they believe

will help predict future activity.

Technical charting analysis is a way of gathering and processing price and volume

information of a particular security by applying mathematical equations and then plotting the

resulting data onto graphs in order to predict future price movements. Unlike the

fundamental analysis, where the economic, geo political factors or the financial health of a

company is under scrutiny, technical analysis is only concerned with the price and trading

volume of a security. In essence, technical analysis focuses on the effect of the previous

price movements while fundamental analysis studies the causes that could affect the market.

Charting analysis involves the manipulation of data relating to price and trading volume that

occur with respect to time. The resulting information are then used to generate visual displays

that can help the investor uncover price patterns and trends. These patterns are more

commonly known as indicators and depending on the additional variables used in the

mathematical formulation; the indicators can be further classified as either leading or lagging

indicators. Typical leading indicators are the Williams%R, the stochastic, momentum, and

the Relative Strength Index (RSI). Typical lagging indicators are the Moving Average

Convergence/Divergence (MACD), the simple and exponential moving averages, and the

Chaiken Oscillator. Beyond the indicators, technical analysis also consists of the utilization of

number theories such as the Fibonacci sequence calculations, the Gann numbers and the

Elliot wave theory. These number theories are used for the most part to help forecast

resistance and support levels of a security's price.


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Assumptions of Technical Analysis:

1. Market action discounts everything: This means that the actual price is a reflectionof everything that is known to the market that could affect it, for example, supply anddemand, political factors and market sentiment. The pure technical analyst is only

concerned with price movements, not with the reasons for any changes.

2. Prices move in trends: Technical analysis is used to identify patterns of marketbehaviour that have long been recognized as significant. For many given patterns

there is a high probability that they will produce the expected results. Also there are

recognized patterns that repeat themselves on a consistent basis.

3. History repeats itself: Chart patterns have been recognized and categorized for over100 years and the manner in which many patterns are repeated leads to the conclusion

that human psychology changes little with time.

4. Self-fulfilling prophecy: Enough people seeing the same pattern will take actions thatforce the prediction to occur. While this is positive if you are on the right side of the

trade, it presents a major weakness when everyone attempts to exit at the same time.

5. Momentum reverses: When a trade becomes very crowded with everyone assumingthe same position, unexpected surprises can drive prices. If the exit becomes crowded,

what first looked promising quickly becomes a nightmare.


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Support and Resistance

Introduction:

Support:

Support is the price level at which demand is thought to be strong enough to prevent the price

from declining further. The logic dictates that as the price declines towards support and gets

cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the

time the price reaches the support level, it is believed that demand will overcome supply and

prevent the price from falling below support.

Resistance:

Resistance is the price level at which selling is thought to be strong enough to prevent the

price from rising further. The logic dictates that as the price advances towards resistance,

sellers become more inclined to sell and buyers become less inclined to buy. By the time the

price reaches the resistance level, it is believed that supply will overcome demand and

prevent the price from rising above resistance.

Figure 1

As you can see in Figure 1, support is the price level through which a stock or market seldom

falls (illustrated by the blue arrows). Resistance, on the other hand, is the price level that a

stock or market seldom surpasses (illustrated by the red arrows)


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Why does it happen?

These support and resistance levels are seen as important in terms of market psychology and

supply and demand. Support and resistance levels are the levels at which a lot of traders are

willing to buy the stock (in the case of a support) or sell it (in the case of resistance). Whenthese trendiness are broken, the supply and demand and the psychology behind the stock's

movements is thought to have shifted, in which case new levels of support and resistance will

likely be established.

Round Numbers and Support and Resistance:

One type of universal support and resistance that tends to be seen across a large number of

securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and 1,000 tend be

important in support and resistance levels because they often represent the major

psychological turning points at which many traders will make buy or sell decisions. Buyers

will often purchase large amounts of stock once the price starts to fall toward a major round

number such as $50, which makes it more difficult for shares to fall below the level. On the

other hand, sellers start to sell off a stock as it moves toward a round number peak, making it

difficult to move past this upper level as well. It is the increased buying and selling pressure

at these levels that makes them important points of support and resistance and, in many cases,

major psychological points as well.

Role Reversal:

Once a resistance or support level is broken, its role is reversed. If the price falls below a

support level, that level will become resistance. If the price rises above a resistance level, it

will often become support. As the price moves past a level of support or resistance, it is

thought that supply and demand has shifted, causing the breached level to reverse its role. For

a true reversal to occur, however, it is important that the price make a strong move through

either the support or resistance.


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Figure 2

For example, as you can see in Figure 2, the dotted line is shown as a level of resistance that

has prevented the price from heading higher on two previous occasions (Points 1 and 2).

However, once the resistance is broken, it becomes a level of support (shown by Points 3 and

4) by propping up the price and preventing it from heading lower again.

Many traders who begin using technical analysis find this concept hard to believe and don't

realize that this phenomenon occurs rather frequently, even with some of the most well-

known companies. For example, as you can see in Figure 3, this phenomenon is evident on

the Wal-Mart Stores Inc. (WMT) chart between 2003 and 2006. Notice how the role of the

$51 level changes from a strong level of support to a level of resistance.

In almost every case, a stock will have both a level of support and a level of resistance and

will trade in this range as it bounces between these levels. This is most often seen when a

stock is trading in a generally sideways manner as the price moves through successive peaks

and troughs, testing resistance and support.

Figure 3


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The Importance of Support and Resistance:

Support and resistance analysis is an important part of trends because it can be used to make

trading decisions and identify when a trend is reversing. For example, if a trader identifies an

important level of resistance that has been tested several times but never broken, he or she

may decide to take profits as the security moves toward this point because it is unlikely that it

will move past this level.

Support and resistance levels both test and confirm trends and need to be monitored by

anyone who uses technical analysis. As long as the price of the share remains between these

levels of support and resistance, the trend is likely to continue. It is important to note,however, that a break beyond a level of support or resistance does not always have to be a

reversal. For example, if a price moved above the resistance levels of an upward trending

channel, the trend has accelerated, not reversed. This means that the price appreciation is

expected to be faster than it was in the channel.

Being aware of these important support and resistance points should affect the way that you

trade a stock. Traders should avoid placing orders at these major points, as the area around

them is usually marked by a lot of volatility. If you feel confident about making a trade near a

support or resistance level, it is important that you follow this simple rule: do not place orders

directly at the support or resistance level. This is because in many cases, the price never

actually reaches the whole number, but flirts with it instead. So if you're bullish on a stock

that is moving toward an important support level, do not place the trade at the support level.

Instead, place it above the support level, but within a few points. On the other hand, if you are

placing stops or short selling, set up your trade price at or below the level of support.


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Importance of Trend

One of the most important concepts in technical analysis is that of trend. The meaning in

finance isn't all that different from the general definition of the term - a trend is really nothing

more than the general direction in which a security or market is headed. Take a look at the

chart below:

Figure 1

It isn't hard to see that the trend in Figure 1 is up. However, it's not always this easy to see a

trend

Types of trends:

1. Uptrends:An uptrend is classified as a series of higher highs and higher lows, while a downtrend is one

of lower lows and lower highs. Figure 3 is an example of an uptrend. Point 2 in the chart is

the first high, which is determined after the price falls from this point. Point 3 is the low that

is established as the price falls from the high. For this to remain an uptrend each successive

low must not fall below the previous lowest point or the trend is deemed a reversal.


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Figure 3

2. Downtrends:It describes the price movement of a financial asset when the overall direction is downward.

A formal downtrend occurs when each successive peak and trough is lower than the ones

found earlier in the trend.

Notice how each successive peak and trough is lower than the previous one. For example, the

low at Point 3 is lower than the low at Point 1. The downtrend will be deemed broken once

the price closes above the high at Point 4.Downtrend is the opposite of uptrend

3. Sideways/Horizontal Trends:

As the names imply, when each successive peak and trough is higher, it's referred to as an

upward trend. If the peaks and troughs are getting lower, it's a downtrend. When there is little

movement up or down in the peaks and troughs, it's a sideways or horizontal trend. If you

want to get really technical, you might even say that a sideways trend is actually not a trend


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on its own, but a lack of a well-defined trend in either direction. In any case, the market can

really only trend in these three ways: up, down or nowhere.

Trend Lengths:

Along with these three trend directions, there are three trend classifications. A trend of any

direction can be classified as a long-term trend, intermediate trend or a short-term trend. In

terms of the stock market, a major trend is generally categorized as one lasting longer than a

year. An intermediate trend is considered to last between one and three months and a near-

term trend is anything less than a month. A long-term trend is composed of several

intermediate trends, which often move against the direction of the major trend. If the major

trend is upward and there is a downward correction in price movement followed by a

continuation of the uptrend, the correction is considered to be an intermediate trend. The

short-term trends are components of both major and intermediate trends. Take a look a Figure

4 to get a sense of how these three trend lengths might look

Figure 4

When analysing trends, it is important that the chart is constructed to best reflect the type of

trend being analysed. To help identify long-term trends, weekly charts or daily charts

spanning a five-year period are used by chartists to get a better idea of the long-term trend.

Daily data charts are best used when analysing both intermediate and short-term trends. It is

also important to remember that the longer the trend, the more important it is; for example, aone-month trend is not as significant as a five-year trend.


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Types of Charts

There are four main types of charts that are used by investors and traders depending on theinformation that they are seeking and their individual skill levels. The chart types are: the line

chart, the bar chart, the candlestick chart and the point and figure chart. In the following

sections, we will focus on the S&P 500 Index during the period of January 2006 through May

2006. Notice how the data used to create the charts is the same, but the way the data is plotted

and shown in the charts is different.

1. Line Chart

The most basic of the four charts is the line chart because it represents only the closing prices

over a set period of time. The line is formed by connecting the closing prices over the time

frame. Line charts do not provide visual information of the trading range for the individual

points such as the high, low and opening prices. However, the closing price is often

considered to be the most important price in stock data compared to the high and low for the

day and this is why it is the only value used in line charts.

Figure 1: A line chart
http://www.investopedia.com/terms/s/sp500.asphttp://www.investopedia.com/terms/s/sp500.asp


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2. Bar Charts

The bar chart expands on the line chart by adding several more key pieces of information to

each data point. The chart is made up of a series of vertical lines that represent each datapoint. This vertical line represents the high and low for the trading period, along with the

closing price. The close and open are represented on the vertical line by a horizontal dash.

The opening price on a bar chart is illustrated by the dash that is located on the left side of the

vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the

left dash (open) is lower than the right dash (close) then the bar will be shaded black,

representing an up period for the stock, which means it has gained value. A bar that is colored

red signals that the stock has gone down in value over that period. When this is the case, the

dash on the right (close) is lower than the dash on the left (open).

Figure 2: A bar chart

3. Candlestick Charts

The candlestick chart is similar to a bar chart, but it differs in the way that it is visually

constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the

period's trading range. The difference comes in the formation of a wide bar on the vertical

line, which illustrates the difference between the open and close. And, like bar charts,


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candlesticks also rely heavily on the use of colours to explain what has happened during the

trading period.

Figure 3: A candlestick chart

4. Point and Figure Charts

The point and figure chart is not well known or used by the average investor but it has had a

long history of use dating back to the first technical traders. This type of chart reflects price

movements and is not as concerned about time and volume in the formulation of the points.

The point and figure chart removes the noise, or insignificant price movements, in the stock,

which can distort traders' views of the price trends. These types of charts also try to neutralize

the skewing effect that time has on chart analysis.

When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs

represent upward price trends and the Os represent downward price trends. There are also

numbers and letters in the chart; these represent months, and give investors an idea of the

date. Each box on the chart represents the price scale, which adjusts depending on the price of

the stock: the higher the stock's price the more each box represents. On most charts where the

price is between $20 and $100, a box represents $1, or 1 point for the stock. The other critical

point of a point and figure chart is the reversal criteria.


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Figure 4: A point and figure chart

This is usually set at three but it can also be set according to the chartist's discretion. The

reversal criteria set how much the price has to move away from the high or low in the price

trend to create a new trend or, in other words, how much the price has to move in order for a

column of Xs to become a column of Os, or vice versa. When the price trend has moved from

one trend to another, it shifts to the right, signalling a trend change.


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Chart Patterns

A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a signof future price movements. Chartists use these patterns to identify current trends and trend

reversals and to trigger buy and sell signals.

Basically there are two types of chart patterns Reversal and Continuation

Reversal:

It is a change in the direction of a price trend. On a price chart, reversals undergo a

recognizable change in the price structure. An uptrend, which is a series of higher highs andhigher lows, reverses into a downtrend by changing to a series of lower highs and lower lows.

A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by

changing to a series of higher highs and higher lows.

It also referred to as a "trend reversal", "rally" or "correction".

Continuation:

A technical analysis pattern that suggests a trend is exhibiting a temporary diversion in

behaviour, and will eventually continue on its existing trend. The symmetrical triangle charts

displayed below are both exhibiting a continuation pattern. Notice how the chart extends

above (below) its existing pattern.


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Head and Shoulders:

This is one of the most popular and reliable chart patterns in technical analysis. Head and

shoulders is a reversal chart pattern that when formed, signals that the security is likely to

move against the previous trend. As you can see in Figure 1, there are two versions of the

head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern

that is formed at the high of an upward movement and signals that the upward trend is about

to end. Head and shoulders bottom, also known as inverse head and shoulders (shown on the

right) is the lesser known of the two, but is used to signal a reversal in a downtrend.

Figure 1: Head and shoulders top is shown on the left. Head and shoulders bottom, or

inverse head and shoulders, is on the right.

Both of these head and shoulders patterns are similar in that there are four main parts: two

shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of a


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high and a low. For example, in the head and shoulders top image shown on the left side in

Figure 1, the left shoulder is made up of a high followed by a low. In this pattern, the

neckline is a level of support or resistance. Remember that an upward trend is a period of

successive rising highs and rising lows. The head and shoulders chart pattern, therefore,illustrates a weakening in a trend by showing the deterioration in the successive movements

of the highs and lows.

Cup and Handle

A cup and handle chart is a bullish continuation pattern in which the upward trend has paused

but will continue in an upward direction once the pattern is confirmed.

Figure 2

As you can see in Figure 2, this price pattern forms what looks like a cup, which is precededby an upward trend. The handle follows the cup formation and is formed by a generally

downward/sideways movement in the security's price. Once the price movement pushes

above the resistance lines formed in the handle, the upward trend can continue. There is a

wide ranging time frame for this type of pattern, with the span ranging from several months

to more than a year.
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Double Tops and Bottoms

This chart pattern is another well-known pattern that signals a trend reversal - it is considered

to be one of the most reliable and is commonly used. These patterns are formed after asustained trend and signal to chartists that the trend is about to reverse. The pattern is created

when a price movement tests support or resistance levels twice and is unable to break

through. This pattern is often used to signal intermediate and long-term trend reversals.

Figure 3: A double top pattern is shown on the left, while a double bottom pattern is shown

on the right.

In the case of the double top pattern in Figure 3, the price movement has twice tried to move

above a certain price level. After two unsuccessful attempts at pushing the price higher, the

trend reverses and the price heads lower. In the case of a double bottom (shown on the right),

the price movement has tried to go lower twice, but has found support each time. After the

second bounce off of the support, the security enters a new trend and heads upward.

Triangles:

Triangles are some of the most well-known chart patterns used in technical analysis. The

three types of triangles, which vary in construct and implication, are the symmetrical triangle,

ascending and descending triangle. These chart patterns are considered to last anywhere from

a couple of weeks to several months.


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Figure 4

The symmetrical triangle in Figure 4 is a pattern in which two trendline converge toward

each other. This pattern is neutral in that a breakout to the upside or downside is a

confirmation of a trend in that direction. In an ascending triangle, the upper trendline is flat,

while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern

in which chartists look for an upside breakout. In a descending triangle, the lower trendline is

flat and the upper trendline is descending. This is generally seen as a bearish pattern where

chartists look for a downside breakout.

Gaps:

A gap in a chart is an empty space between a trading period and the following trading period.

This occurs when there is a large difference in prices between two sequential trading periods.

For example, if the trading range in one period is between $25 and $30 and the next trading

period opens at $40, there will be a large gap on the chart between these two periods. Gap

price movements can be found on bar charts and candlestick charts but will not be found on


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point and figure or basic line charts. Gaps generally show that something of significance has

happened in the security, such as a better-than-expected earnings announcement.

There are three main types of gaps, Breakaway, Runaway (measuring) and Exhaustion. A

breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trendand an exhaustion gap forms near the end of a trend.

The image shows a gap at the beginning of a large upward movement.

Runaway gap on a price chart that occurs during strong bull or bear movements characterized

by an abrupt change in price and appearing over a range of prices. They are best described asgaps caused by a sudden increase/decrease in interest for a stock.

The image shows a gap in the middle of a large upward movement.

Exhaustion gap is the one that occurs after the rapid rise in a stock's price begins to tail off.

An exhaustion gap usually reflects falling demand for a particular stock


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The image shows a gap at the end of a large upward movement, signalling a reversal

Triple tops and Triple bottoms

Triple tops and triple bottoms are another type of reversal chart pattern in chart analysis.

These are not as prevalent in charts as head and shoulders and double tops and bottoms, but

they act in a similar fashion. These two chart patterns are formed when the price movementtests a level of support or resistance three times and is unable to break through; this signals a

reversal of the prior trend.

Figure 7


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Confusion can form with triple tops and bottoms during the formation of the pattern because

they can look similar to other chart patterns. After the first two support/resistance tests are

formed in the price movement, the pattern will look like a double top or bottom, which could

lead a chartist to enter a reversal position too soon.

Rounding Bottom:

A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that

signals a shift from a downward trend to an upward trend. This pattern is traditionally thought

to last anywhere from several months to several years.

Figure 8


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Moving Averages

An indicator frequently used in technical analysis showing the average value of a security'sprice over a set period. Moving averages are generally used to measure momentum and

define areas of possible support and resistance.

Types of Moving Averages:

There are a number of different types of moving averages that vary in the way they are

calculated, but how each average is interpreted remains the same. The calculations only differ

in regards to the weighting that they place on the price data, shifting from equal weighting of

each price point to more weight being placed on recent data. The three most common types of

moving averages are simple, linear and exponential.

1. Simple Moving Average (SMA)

This is the most common method used to calculate the moving average of prices. It simply

takes the sum of all of the past closing prices over the time period and divides the result by

the number of prices used in the calculation. For example, in a 10-day moving average, the

last 10 closing prices are added together and then divided by 10. As you can see in Figure 1, a

trader is able to make the average less responsive to changing prices by increasing the

number of periods used in the calculation. Increasing the number of time periods in the

calculation is one of the best ways to gauge the strength of the long-term trend and thelikelihood that it will reverse.


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Many individuals argue that the usefulness of this type of average is limited because each

point in the data series has the same impact on the result regardless of where it occurs in the

sequence. The critics argue that the most recent data is more important and, therefore, itshould also have a higher weighting. This type of criticism has been one of the main factors

leading to the invention of other forms of moving averages.

Figure 1

2. Linear Weighted Average

This moving average indicator is the least common out of the three and is used to address the

problem of the equal weighting. The linear weighted moving average is calculated by taking

the sum of all the closing prices over a certain time period and multiplying them by the

position of the data point and then dividing by the sum of the number of periods. Forexample, in a five-day linear weighted average, today's closing price is multiplied by five,

yesterday's by four and so on until the first day in the period range is reached. These numbers

are then added together and divided by the sum of the multipliers.


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3. Exponential Moving Average (EMA)

This moving average calculation uses a smoothing factor to place a higher weight on recent

data points and is regarded as much more efficient than the linear weighted average. Havingan understanding of the calculation is not generally required for most traders because most

charting packages do the calculation for you. The most important thing to remember about

the exponential moving average is that it is more responsive to new information relative to

the simple moving average. This responsiveness is one of the key factors of why this is the

moving average of choice among many technical traders. As you can see in Figure 2, a 15-

period EMA rises and falls faster than a 15-period SMA.


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Indicators and Oscillators

Indicator: Statistics used to measure current conditions as well as to forecast financial oreconomic trends. Indicators are used extensively in technical analysis to predict changes in

stock trends or price patterns. In fundamental analysis, economic indicators that quantify

current economic and industry conditions are used to provide insight into the future

profitability potential of public companies

Oscillator: It is a technical analysis tool that is banded between two extreme values and built

with the results from a trend indicator for discovering short-term overbought or oversold

conditions. As the value of the oscillator approaches the upper extreme value the asset is

deemed to be overbought, and as it approaches the lower extreme it is deemed to be oversold.

Average Directional Index: The average directional index (ADX) is a trend indicator that is

used to measure the strength of a current trend. The indicator is seldom used to identify the

direction of the current trend, but can identify the momentum behind trends.

The ADX is a combination of two price movement measures: the positive directional

indicator (+DI) and the negative directional indicator (-DI). The ADX measures the strength

of a trend but not the direction. The +DI measures the strength of the upward trend while the

-DI measures the strength of the downward trend. These two measures are also plotted along

with the ADX line. Measured on a scale between zero and 100, readings below 20 signal a

weak trend while readings above 40 signal a strong trend.

Accumulation/Distribution Line: The accumulation/distribution line is one of the more

popular volume indicators that measures money flows in a security. This indicator attempts to

measure the ratio of buying to selling by comparing the price movement of a period to the

volume of that period.

Calculated:

Acc/Dist = ((Close - Low) - (High - Close)) / (High - Low) * Period's Volume


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This is a non-bounded indicator that simply keeps a running sum over the period of the

security. Traders look for trends in this indicator to gain insight on the amount of purchasing

compared to selling of a security. If a security has an accumulation/distribution line that is

trending upward, it is a sign that there is more buying than selling

Moving Average Convergence:

The moving average convergence divergence (MACD) is one of the most well-known and

used indicators in technical analysis. This indicator is comprised of two exponential moving

averages, which help to measure momentum in the security. The MACD is simply the

difference between these two moving averages plotted against a centerline. The centerline is

the point at which the two moving averages are equal. Along with the MACD and the

centerline, an exponential moving average of the MACD itself is plotted on the chart. The

idea behind this momentum indicator is to measure short-term momentum compared to

longer term momentum to help signal the current direction of momentum.

MACD= shorter term moving average - longer term moving average

When the MACD is positive, it signals that the shorter term moving average is above the

longer term moving average and suggests upward momentum. The opposite holds true when

the MACD is negative - this signals that the shorter term is below the longer and suggest

downward momentum. When the MACD line crosses over the centerline, it signals a crossing

in the moving averages. The most common moving average values used in the calculation are

the 26-day and 12-day exponential moving averages. The signal line is commonly created by

using a nine-day exponential moving average of the MACD values. These values can be

adjusted to meet the needs of the technician and the security. For more volatile securities,

shorter term averages are used while less volatile securities should have longer averages.

As you can see in Figure 2, one of the most common buy signals is generated when the

MACD crosses above the signal line (blue dotted line), while sell signals often occur when

the MACD crosses below the signal.


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Figure 2

Relative Strength Index:

The relative strength index (RSI) is another one of the most used and well-known momentum

indicators in technical analysis. RSI helps to signal overbought and oversold conditions in a

security. The indicator is plotted in a range between zero and 100. A reading above 70 is used

to suggest that a security is overbought, while a reading below 30 is used to suggest that it is

oversold. This indicator helps traders to identify whether a securitys price has been

unreasonably pushed to current levels and whether a reversal may be on the way.

Figure 3


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Stochastic Oscillator:

The stochastic oscillator is one of the most recognized momentum indicators used in

technical analysis. The idea behind this indicator is that in an uptrend, the price should beclosing near the highs of the trading range, signaling upward momentum in the security. In

downtrends, the price should be closing near the lows of the trading range, signaling

downward momentum.

The stochastic oscillator is plotted within a range of zero and 100 and signals overbought

conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two

lines. The first line is the %K, which is essentially the raw measure used to formulate the idea

of momentum behind the oscillator. The second line is the %D, which is simply a moving

average of the %K. The %D line is considered to be the more important of the two lines as it

is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading

periods in its calculation but can be adjusted to meet the needs of the user.

Figure 4

Price rate of change (ROC):

It is a technical indicator that measures the percentage change between the most recent price

and the price "n" periods in the past. It is calculated by using the following formula:

(Closing Price Today - Closing Price "n" Periods Ago) / Closing Price "n" Periods Ago

ROC is classed as a price momentum indicator or a velocity indicator because it measures the

rate of change or the strength of momentum of change.


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Fibonacci Retracement:

A term used in technical analysis that refers to areas of support (price stops going lower) or

resistance (price stops going higher). The Fibonacci retracement is the potential retracement

of a financial asset's original move in price. Fibonacci retracements use horizontal lines to

indicate areas of support or resistance at the key Fibonacci levels before it continues in the

original direction. These levels are created by drawing a trendline between two extreme

points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%,

50%, 61.8% and 100%.


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Derivatives

Introduction:

The emergence of the market for derivative products, most notably forwards, futures and

options, can be traced back to the willingness of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. By their very

nature, the financial markets are marked by a very high degree of volatility. Though the use

of derivative products, it is possible to partially or fully transfer price risks by locking-in asset

prices. As instruments of risk management, these generally do not influence the fluctuations

in the underlying asset prices. However, by locking-in asset prices, derivative products

minimize the impact of fluctuations in asset prices on the profitability and cash flow situation

of risk-averse investors.

Definition:

Derivative is a product whose value is derived from the value of one or more basic variables,

called bases (underlying asset, index, or reference rate), in a contractual manner. The

underlying asset can be equity, forex, commodity or any other asset. For example, wheat

farmers may wish to sell their harvest at a future date to eliminate the risk of a change in

prices by that date. Such a transaction is an example of a derivative. The price of this

derivative is driven by the spot price of wheat which is the underlying.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines

derivatives to include-

1.

A security derived from a dept instrument, share, loan whether secured or unsecured,risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlyingsecurities.

Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed

by the regulatory framework under the SC(R)A.


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The Scenario in India

After deregulation, freeing of the exchange rate and removal of price and trade controls are

measures that are increasing the volatility of prices of various goods and services in India toproducers and consumers alike. Gyrations of stock market prices (and market-determined

interest and exchange rates) also create instability in portfolio values for mutual funds and

unit trusts. Hedging through derivatives can mitigate these risks.

The 1960s marked a period of great decline in futures trading in India. Market after market

was closed, normally because commodity price rises were attributed to speculation on these

markets.

There are signs that the late 1990s may be marked by exactly the opposite trend-a large-scale

revival of futures markets in India.

The trend is not confined to the commodity markets. RBI recommended major liberalisation

of the forward exchange market and had urged the setting up of rupee-based derivatives in

financial instruments.

In a momentous and far reaching decision, SEBI gave the go-ahead for stock index futures in

May 1998, ushering a new era in Indian financial markets.

Derivative trading started with the introduction of Index (Sensex) Futures at the NSE and the

BSE in June 2000. The exchanges have the Futures and Options Trading System which

provides a fully automated trading environment. A committee was setup under the

chairmanship of Prof. J.R. Varma along with others to provide the guidelines for derivative

trading in India. The first of the 5 contracts of the June series was done on June 9, 2000

between M/s Kaji & Maulik Securities Pvt. Ltd. and M/s Emkay Share & Stock Brokers Ltd.

at the rate of 4755.

This marked the beginning of exchange traded financial derivatives trading in India. We have

a strong dollar-rupee forward market with contracts being traded for one to six months. As of

now there is very little trading in futures and options in India. Trades are settled on a weekly

basis due to low volumes and volatilities.


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Need for Derivatives in India:

Derivatives came into being primarily for the reason of the need to eliminate price risk.

Risk is a characteristic feature of all commodity and capital markets. Prices of all

commodities-whether agricultural like wheat, cotton, rice, coffee or tea, or non-agricultural

like silver, gold, etc. are subject to fluctuation over time in keeping with prevailing demand

and supply conditions. Producers or possessors of these commodities obviously cannot be

sure of the prices that their produce or possession may fetch when they have to sell them, in

the same way as the buyers and the processors are not sure what they would have to pay for

their buy.

Similarly, prices of shares and debentures or bonds and other securities are also subject to

continuous change. Owners of shares of a company face the risk that the market price of thatshare may fall below the price at which they were purchased. In the same way, the foreign

exchange rates are also subject to continuous change. Thus, an importer of a certain piece of

machinery is not sure of the amount he would have to pay in rupee terms when the payments

become due.

While examples where risk is seen to exist, can be multiple, it may be observed that parties

involved in all such cases may see the benefits of, and are likely to desire, having some

contract from which forward prices may be fixed and the price risk facing them is eliminated

and therefore to reduce the risk, derivatives was introduced.

Milestones in the development of Indian derivative market

Year Developments

November 18, 1996 L.C. Gupta Committee set up to draft a policy framework for

introducing derivatives

May 11, 1998 L.C. Gupta committee submits its report on the policy framework.

May 25, 2000 SEBI allows exchanges to trade in index futures

June 12, 2000 Trading on Nifty futures commences on the NSE

June 4, 2001 Trading for Nifty options commences o n the NSE

July 2, 2001 Trading on Stock options commences on the NSE

November 9, 2001 Trading on Stock futures commences on the NSE

August 29, 2008 Currency derivatives trading commences on the NSE

August 31, 2009 Interest rate derivatives trading commences on the NSE


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Factors Driving the Growth of Derivates:

1. Increased volatility in asset prices in financial markets. 2. Increased integration of national financial markets with the international markets.3. Marked improvement in communication facilities and sharp decline in their costs. 4. Development of more sophisticated risk management tools, providing economic

agents.

5. A wider choice of risk management strategies, and Innovations in the derivativesmarkets, which optimally combine the risks and returns. Over a large number of

financial assets leading to higher returns, reduced risk as well.

6. Transactions costs as compared to individual financial assets.


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Derivative Products

Introduction:

Derivative contracts have several variants. The most common variants are forwards, futures,

options and swaps. We take a brief look at various derivatives contracts that have come to be

used.

Forward contract: It is a non-standardized contract between two parties to buy or sell an

asset at a specified future time at a price agreed today. This is in contrast to a spot contract,

which is an agreement to buy or sell an asset today. It costs nothing to enter a forward

contract. The party agreeing to buy the underlying asset in the future assumes a long position,

and the party agreeing to sell the asset in the future assumes a short position. The price agreed

upon is called the delivery price, which is equal to the forward price at the time the contract is

entered into.

Futures: A future contract is an agreement between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contract are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two typescalls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset, at a given price on or before a

given future date. Puts give the buyer the right, but not the obligation to sell a given quantity

of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of options traded on options exchanges having a

maximum maturity of nine months. Longer-dated options are called warrants and are

generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-term Equity Anticipation Securities. These are

options having a maturity of upto three years.


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Baskets: Basket options are options on portfolios of underlying assets. The underlying asset

is usually a moving average of a basket of assets. Equity index options are a form of basket

options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flowsbetween the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between theparties, with the cash flows in one direction being in a different currency than those in

the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaptions is an option on a forward swap. Rather than have

calls and puts, the Swaptions market has receiver swaptions and payer swaptions. A receiver

swaptions is an option to receive fixed and pay floating. A payer swaptions is an option to

pay fixed and receive floating.

Economic Function of Derivative Market:

1. Prices in an organized derivatives market reflect the perception of market participantsabout the future and lead the prices of underlying to the perceived future level. The

prices of derivatives converge with the prices of the underlying at the expiration of the

derivative contract. Thus derivatives help in discovery of future as well as current

prices.

2. The derivatives market helps to transfer risks from those who have them but may notlike them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets.With the introduction of derivatives, the underlying market witnesses higher trading

volumes because of participation by more players who would not otherwise

participate for lack of an arrangement to transfer risk.

4.

Speculative trades shift to a more controlled environment of derivatives market. In theabsence of an organized derivatives market, speculators trade in the underlying cash


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markets. Margining, monitoring and surveillance of the activities of various

participants become extremely difficult in these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as acatalyst for new entrepreneurial activity. The derivatives have a history of attractingmany bright, creative, well-educated people with an entrepreneurial attitude. They

often energize others to create new businesses, new products and new employment

opportunities, the benefit of which are immense.


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Derivatives Terminologies

Delta: The ratio comparing the change in the price of the underlying asset to the

corresponding change in the price of a derivative. Sometimes referred to as the "hedge ratio". For example, with respect to call options, a delta of 0.7 means that for every $1 the

underlying stock increases, the call option will increase by $0.70. Put option deltas, on the

other hand, will be negative, because as the underlying security increases, the value of the

option will decrease. So a put option with a delta of -0.7 will decrease by $0.70 for every $1

the underlying increases in price. As an in-the-money call option nears expiration, it will

approach a delta of 1.00, and as an in-the-money put option nears expiration, it will approach

a delta of -1.00. The Delta of a call is always positive and the Delta of a put is always

negative.

Gamma: Gamma is the rate of change of the option's Delta with respect to the price of the

underlying asset. In other words, it is the second derivative of the option price with respect to

price of the underlying asset.

Theta: Theta of a portfolio of options is the rate of change of the value of the portfolio with

respect to the passage of time with all else remaining the same. Theta is also referred to as the

time decay of the portfolio. Theta is the change in the portfolio value when one day passes

with all else remaining the same. We can either measure Theta "per calendar day" or "per

trading day". To obtain the Theta per calendar day, the formula for Theta must be divided by

365; to obtain Theta per trading day, it must be divided by 250.

Vega: The Vega of a portfolio of derivatives is the rate of change in the value of the portfolio

with respect to volatility of the underlying asset. If Vega is high in absolute terms, the

portfolio's value is very sensitive to small changes in volatility. If Vega is low in absolute

terms, volatility changes have relatively little impact on the value of the portfolio.

Rho: The Rho of a portfolio of options is the rate of change of the value of the portfolio with

respect to the interest rate. It measures the sensitivity of the value of a portfolio to interest

rates.


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Historical Volatility HV: The realized volatility of a financial instrument over a given

time period. Generally, this measure is calculated by determining the average deviation from

the average price of a financial instrument in the given time period. Standard deviation is the

most common but not the only way to calculate historical volatility. Also known as"statistical volatility".

Implied Volatility IV: The estimated volatility of a security's price. In general, implied

volatility increases when the market is bearish and decreases when the market is bullish. This

is due to the common belief that bearish markets are more risky than bullish markets. Implied

volatility is sometimes referred to as "vols."

Basis: The variation between the spot price of a deliverable commodity and the relative price

of the futures contract for the same actual that has the shortest duration until maturity. A

security's basis is the purchase price after commissions or other expenses. Also known as

"cost basis" or "tax basis". In the context of IRAs, basis is the after-tax balance in the IRA,

which originates from non-deductible IRA contributions and rollover of after-tax amounts.

Earnings on these amounts are tax-deferred, similar to earnings on deductible contributions

and rollover of pre-tax amounts.

Initial Margin: Initial margin is taken by the stock exchanges from traders in order to cover

the largest potential loss which can happen in one day. Both buyer and seller have to deposit

the initial margins. The initial margin is deposited before the day opens and also before the

traders takes the position in the market. Based on the volatility of underlying the initial

margin can be between 5 to 20 percent.

Mark-to-market margin: All losses of the trader must be met by the trader by depositing

further collateral known as mark to market margin in to the stock exchange, and any profit is

credited to the account of trader at the end of trading day.

Additional margin: In case of sudden higher than expected volatility, additional margin may

be called for by the stock exchange. This is generally imposed by the stock exchanges when

the markets have become too volatile as was the case in year 2008 when Lehman brother

collapse happened.


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Maintenance margin: Some exchanges work on the system of maintenance margin, which is

set at a level slightly less than initial margin. The margin is required to be replenished to the

level of initial margin, only if the margin level drops below the maintenance margin limit.

For example If Initial Margin is fixed at 100 and Maintenance margin is at 85, then the traderis allowed to trade only until the maintenance margin is above 85. If it drops below 85 to 65,

then a margin of 35 is to be paid so that initial margin again becomes 100.

Open Interest: The open interest is the total number of open contracts outstanding in a

particular option series and this figure is tracked by the options exchanges. Every opening

transaction increases the open interest by 1 while every closing transaction decreases the

open interest by 1. This value is useful for determining the liquidity for a particular options

series. A large open interest indicates a more liquid market and making large trades will be

less of a problem.

Put-Call Ratio: The Put-Call Ratio is the number of put options traded divided by the

number of call options traded in a given period. While typically the trading volume is used to

compute the Put-Call Ratio, it is sometimes calculated using open interest volume or total

dollar value instead. Weekly or monthly figures can also be calculated and moving averages

are often used to smooth out the short term daily figures.

Spot price (ST): Spot price of an underlying asset is the price that is quoted for immediate

delivery of the asset. For example, at the NSE, the spot price of Reliance Ltd. at any given

time is the price at which Reliance Ltd. shares are being traded at that time in the Cash

Market Segment of the NSE. Spot price is also referred to as cash price sometimes.

Forward price or futures price (F): Forward price or futures price is the price that is agreed

upon at the date of the contract for the delivery of an asset at a specific future date. These

prices are dependent on the spot price, the prevailing interest rate and the expiry date of the

contract.

Strike price (K): The price at which the buyer of an option can buy the stock (in the case of

a call option) or sell the stock (in the case of a put option) on or before the expiry date of

option contracts is called strike price. It is the price at which the stock will be bought or sold


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when the option is exercised. Strike price is used in the case of options only; it is not used for

futures or forwards.

Expiration date (T): In the case of Futures, Forwards and Index Options, Expiration Date isthe only date on which settlement takes place. In case of stock options, on the other hand,

Expiration date (or simply expiry), is the last date on which the option can be exercised. It is

also called the final settlement date.


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Options

Introduction:

An option is a contract written by a seller that conveys to the buyer the right, but not the

obligation to buy in the case of a call option or to sell in the case of a put option a particular

asset, at a particular price say at Strike price in future. In return for granting the option, the

seller collects the premium from the buyer. Exchange traded options form an important class

of options which have standardized contract features and trade on public exchanges,

facilitating trading among large number of investors. They provide settlement guarantee by

the Clearing Corporation thereby reducing counterparty risk. Options can be used for

hedging, taking a view on the future direction of the market, for arbitrage or for

implementing strategies which can help in generating income for investors under various

market conditions.

Options are fundamentally different from forward and futures contracts. An option gives the

holder of the option the right to do something. The holder does not have to exercise this right.

In contrast, in a forward or futures contract, the two parties have committed themselves to

doing something. Whereas it costs nothing (except margin requirements) to enter into a

futures contract, the purchase of an option requires an upfront payment.

Options Terminologies:

Index options: These options have the index as the underlying. In India, they have aEuropean style settlement. Eg. Nifty options, Mini Nifty options etc.

Stock options: Stock options are options on individual stocks. A stock optioncontract gives the holder the right to buy or sell the underlying shares at the specified

price. They have an American style settlement.

Buyer of an option: The buyer of an option is the one who by paying the optionpremium buys the right but not the obligation to exercise his option on the

seller/writer.


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Writer / seller of an option: The writer / seller of a call/put option is the one whoreceives the option premium and is thereby obliged to sell/buy the asset if the buyer

exercises on him.

Call option: A call option gives the holder the right but not the obligation to buy anasset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell anasset by a certain date for a certain price.

Option price/premium: Option price is the price which the option buyer pays to theoption seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expirationdate, the exercise date, the strike date or the maturity

Strike price: The price specified in the options contract is known as the strike priceor the exercise price.

American options: American options are options that can be exercised at any timeupto the expiration date.

European options: European options are options that can be exercised only on theexpiration date itself.

In-the-money option: An in-the-money (ITM) option is an option that would lead toa positive cash-flow to the holder if it were exercised immediately. A call option on

the index is said to be in-the-money when the current index stands at a level higher

than the strike price (i.e. spot price > strike price). If the index is much higher than the

strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the

index is below the strike price.


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At-the-money option: An at-the-money (ATM) option is an option that would lead tozero cash-flow if it were exercised immediately. An option on the index is at-the-

money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option thatwould lead to a negative cash-flow if it were exercised immediately. A call option on

the index is out-of-the-money when the current index stands at a level which is less

than the strike price (i.e. spot price < strike price). If the index is much lower than the

strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the

index is above the strike price.

Time value of an option: The time value of an option is the difference between itspremium and its intrinsic value. Both calls and puts have time value. An option that is

OTM or ATM has only time value. Usually, the maximum time value exists when the

option is ATM. The longer the time to expiration, the greater is an option's time value,

all else equal. At expiration, an option should have no time value.


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Options Trading Strategies:

Strategy 1:Long Call

For aggressive investors who are very bullish about the prospects for a stock / index, buying

Calls can be an excellent way to capture the upside potential with limited downside risk.

Buying a call is the most basic of all options strategies. It constitutes the first options trade for

someone already familiar with buying / selling stocks and would now want to trade options.

Buying a call is an easy strategy to understand. When you buy it means you are bullish.

Buying a Call means you are very bullish and expect the underlying stock / index to rise in

future.

When to Use: Investor is very bullish on the stock / index.

Risk: Limited to the Premium. (Maximum loss if market expires at or below the option strike

price).

Reward: Unlimited

Breakeven: Strike Price +Premium

Example:

Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191.10. He buys a call option

with a strike price of Rs. 4600 at a premium of Rs. 36.35, expiring on 31st July. If the Nifty

goes above 4636.35, Mr. XYZ will make a net profit (after deducting the premium) on

exercising the option. In case the Nifty stays at or falls below 4600, he can forego the option

(it will expire worthless) with a maximum loss of the premium.


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Strategy: Buy call option

Call Option Strike Price (Rs) 4600

Mr. XYZ Pays Premium (Rs.) 36.65

Break Even Point (Rs.) (Strike Price + Premium) 4636.35

The Payoff schedule:

On expiry Nifty closes at Net Payoff from Call Option (Rs.)

4100.00 -36.35

4300.00 -36.35

4500.00 -36.35

4636.35 0

4700.00 63.65

4900.00 263.65

5100.00 463.65

5300.00 663.65

Analysis:

This strategy limits the downside risk to the extent of premium paid by Mr. XYZ (Rs. 36.35).

But the potential return is unlimited in case of rise in Nifty. A long call Option is the simplest

way to benefit if you believe that the market will make an upward Move and is the most

common choice among first time investors in Options. As the stock Price/index raises the

long Call moves into profit more and more quickly.


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Strategy 2: Short Call

When you buy a Call you are hoping that the underlying stock / index would rise. When you

expect the underlying stock / index to fall you do the opposite. When an investor is verybearish about a stock / index and expects the prices to fall, he can sell Call options. This

position offers limited profit potential and the possibility of large losses on big advances in

underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is

exposed to unlimited risk.

A Call option means an Option to buy. Buying a Call option means an investor expects the

underlying price of a stock / index to rise in future. Selling a Call option is just the opposite

of buying a Call option. Here the seller of the option feels the underlying price of a stock /

index is set to fall in the future.

When to use: Investor is very aggressive and he is verybearish about the stock / index.

Risk: Unlimited

Reward: Limited to the amount of premium

Break-even Point: Strike Price + Premium

Example:

Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price

of Rs. 2600 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at

2600 or below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ

can retain the entire premium of Rs. 154.


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Strategy: Sell Call Option

Current Nifty index 2694

Call Option Strike Price (Rs.) 2600

Mr. XYZ receives Premium (Rs.) 154

Break Even Point (Rs.) (Strike Price

+Premium)*

2754

The payoff schedule:

On expiry

Nifty closes at

Net Payoff from

the Call Options

(Rs.)

2400 154

2500 154

2600 154

2700 54

2754 0

2800 -46

2900 -146

3000 -246


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Analysis:

This strategy is used when an investor is very aggressive and has a strong expectation of a

price fall (and certainly not a price rise). This is a risky strategy since as the stock price /index rises, the short call loses money more and more quickly and losses can be significant if

the stock price / index falls below the strike price. Since the investor does not own the

underlying stock that he is shorting this strategy is also called Short Naked Call.


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Strategy 3: Put Hedge: Buy Stock, Buy Put

In this strategy, we purchase a stock since we feel bullish about it. But what if the price of the

stock went down. You wish you had some insurance against the price fall. So buy a Put on

the stock. This gives you the right to sell the stock at a certain price which is the strike price.

The strike price can be the price at which you bought the stock (ATM strike price) or slightly

below (OTM strike price).

In case the price of the stock rises you get the full benefit of the price rise. In case the price of

the stock falls, exercise the Put Option (remember Put is a right to sell). You have capped

your loss in this manner because the Put option stops your further losses. It is a strategy with

a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price

rise).

But the strategy is not Buy Call Option (Strategy 1). Here you have taken an exposure to an

underlying stock with the aim of holding it and reaping the benefits of price rise, dividends,

bonus rights etc. and at the same time insuring against an adverse price movement.

When to use: When ownership is desired of stock yet investor is concerned about near-term

downside risk. The outlook is conservatively bullish.

Risk: Losses limited to Stock price + Put PremiumPut Strike price

Reward: Profit potential is unlimited.

Break-even Point: Put Strike Price + Put Premium+ Stock PricePut Strike Price

Example:

Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of Rs.

4000 on 4th July. To protect against fall in the price of ABC Ltd. (his risk), he buys an ABC

Ltd. Put option with a strike price Rs.3900 (OTM) at a premium of Rs. 143.80 expiring

on31st July.


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Strategy : Buy Stock + Buy Put Option

Buy Stock (Mr. XYZ pays) Current Market Price of ABC Ltd. (Rs.) 4000

Strike Price (Rs.) 3900

Buy Put

(Mr. XYZ pays)

Premium (Rs.) 143.80

Break Even Point (Rs.)

(Put Strike Price + Put

Premium + Stock Price

Put Strike Price)*

4143.80

Example:

ABC Ltd. is trading at Rs. 4000 on 4th July.

Buy 100 shares of the Stock at Rs. 4000

Buy 100 July Put Options with a Strike Price of Rs. 3900 at a premium of Rs. 143.80 per put.

Net Debit (payout) Stock Bought + Premium Paid

= Rs. 4000 + Rs. 143.80

= Rs. 4,14,380/-

Maximum Loss Stock Price + Put PremiumPut Strike

= Rs. 4000 + Rs. 143.80Rs. 3900

= Rs. 24,380/-

Maximum Gain Unlimited (as the stock rises)

Breakeven Put Strike + Put Premium + Stock PricePut Strike

= Rs. 3900 + Rs. 143.80 + Rs. 4000Rs. 3900= Rs. 4143.80/-


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The payoff schedule

ABC Ltd. closes at

(Rs.) on expiry

Payoff from the

Stock (Rs.)

Net Payoff from the

Put Option (Rs.)

Net Payoff

(Rs.)

3400.00 -600.00 356.20 -243.80

3600.00 -400.00 156.20 -243.80

3800.00 -200.00 -43.80 -243.80

4000.00 0 -143.80 -143.80

4143.80 143.80 -143.80 0

4200.00 200.00 -143.80 56.20

4400.00 400.00 -143.80 256.20

4600.00 600.00 -143.80 456.20

4800.00 800.00 -143.80 656.20

Analysis:

This is a low risk strategy. This is a strategy which limits the loss in case of fall in market but

the potential profit remains unlimited when the stock price rises. A good strategy when you

buy a stock for medium or long term, with the aim of protecting any downside risk.


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Strategy 4: Long Put

Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the

stock / index. When an investor is bearish, he can buy a Put option. A Put Option gives the

buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby

limit his risk.

Example:

Mr. XYZ is bearish on Nifty on 24th June, when the Nifty is at 2694. He buys a Put option

with a strike price Rs. 2600 at a premium of Rs. 52, expiring on 31st July. If the Nifty goes

below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises

above 2600, he can forego the option (it will expire worthless) with a maximum loss of the

premium.

Strategy : Buy Put Option

Current Nifty index 2694

Put Option Strike Price (Rs.) 2600

Mr. XYZ Pays Premium (Rs.) 52


(Strike Price - Premium)

2548


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Analysis:

A bearish investor can profit from declining stock price by buying Puts. He limits his risk to

the amount of premium paid but his profit potential remains unlimited. This is one of the

widely used strategies when an investor is bearish.

The payoff schedule

On expiry Nifty closes at Net Payoff from

Put Option (Rs.)

2300 248

2400 148

2500 48

2548 0

2600 -52

2700 -52

2800 -52

2900 -52


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Strategy 5: Short Put

Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock.

An investor Sells Put when he is Bullishabout the stockexpects the stock price to rise or

stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of

the Put). You have sold someone the right to sell you the stock at the strike price. If the stock

price increases beyond the strike price, the short put position will make a profit for the seller

by the amount of the premium, since the buyer will not exercise the Put option and the Put

seller can retain the Premium (which is his maximum profit). But, if the stock price decreases

below the strike price, by more than the amount of the premium, the Put seller will lose

money. The potential loss being unlimited (until the stock price fall to zero).

When to Use: Investor is very Bullishon the stock / index. The main idea is to make a short

term income.

Risk: Put Strike PricePut Premium.

Reward: Limited to the amount of Premium received.

Breakeven: Put Strike PricePremium

Example:

Mr. XYZ is bullish on Nifty when it is at 4191.10. He sells a Put option with a strike price of

Rs. 4100 at a premium of Rs. 170.50 expiring on 31st July. If the Nifty index stays above4100, he will gain the amount of premium as the Put buyer wont exercise his option. In case

the Nifty falls below 4100, Put buyer will exercise the option and the Mr. XYZ will start

losing money. If the Nifty falls below 3929.50, which is the breakeven point, Mr. XYZ will

lose the premium and more depending on the extent of the fall in Nifty.


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Strategy : Sell Put Option

Current Nifty index 4191.10

Put Option Strike Price (Rs.) 4100

Mr. XYZ receives Premium (Rs.) 170.5


(Strike Price - Premium)*

3929.5

The payoff schedule

On expiry Nifty Closes at Net Payoff from the Put

Option (Rs.)

3400.00 -529.50

3500.00 -429.50

3700.00 -229.50

3900.00 -29.50

3929.50 0

4100.00 170.50

4300.00 170.50

4500.00 170.50

Analysis:

Selling Puts can lead to regular income in a rising or range bound markets. But it should be

done carefully since the potential losses can be significant in case the price of the stock/ index

falls. This strategy can be considered as an income generating strategy.


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Strategy 6: Covered Call

You own shares in a company which you feel may rise but not much in the near term (or at

best stay sideways). You would still like to earn an income from the shares. The covered callis a strategy in which an investor Sells a Call option on a stock he owns (netting him a

premium). The Call Option which is sold in usually an OTM Call. The Call would not get

exercised unless the stock price increases above the strike price. Till then the investor in the

stock (Call seller) can retain the Premium with him. This becomes his income from the stock.

This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about

the stock.

An investor buys a stock or owns a stock which he feels is good for medium to long term but

is neutral or bearish for the near term. At the same time, the investor does not mind exiting

the stock at a certain price (target price). The investor can sell a Call Option at the strike price

at which he would be fine exiting the stock (OTM strike). By selling the Call Option the

investor earns a Premium. Now the position of the investor is that of a Call Seller who owns

the underlying stock. If the stock price stays at or below the strike price, the Call Buyer (refer

to Strategy 1) will not exercise the Call. The Premium is retained by the investor.

In case the stock price goes above the strike price, the Call buyer who has the right to buy the

stock at the strike price will exercise the Call option. The Call seller (the investor) who has to

sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which

the Call seller (the investor) was anyway interested in exiting the stock and now exits at that

price. So besides the strike price which was the target price for selling the stock, the Call

seller (investor) also earns the Premium which becomes an additional gain for him. This

strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned

by the Call Seller (investor). The income increases as the stock rises, but gets capped after the

stock reaches the strike price. Let us see an example to understand the Covered Call strategy.

When to use: This is often employed when an investor has a short-term neutral to moderately

view on the stock he holds. He takes a short position on the call option to generate income

from the option premium. Since the stock is purchased simultaneously with writing (selling)

the call the strategy is commonly referred to as buy-write.

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technical and derivative .. project report

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