NISM SERIES 8 EQUITY DERIVATIVES
Chapter 1: Basics of Derivatives
Derivative is a contract or a product whose value is derived from value of some other asset known as
underlying. Derivatives are based on wide range of underlying assets. These include:
• Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead
• Energy resources such as Oil and Gas, Coal, Electricity
• Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses and
• Financial assets such as Shares, Bonds and Foreign Exchange.
Some of the factors driving the growth of financial derivatives are:
• Increased fluctuations in underlying asset prices in financial markets.
• Integration of financial markets globally.
• Use of latest technology in communications has helped in reduction of transaction costs.
• Enhanced understanding of market participants on sophisticated risk management tools to manage risk.
• Frequent innovations in derivatives market and newer applications of products.
Types of Derivatives
Forwards
It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date
for a particular price that is pre-decided on the date of contract. Both the contracting parties are
committed and are obliged to honour the transaction irrespective of price of the underlying asset at the
time of delivery. Since forwards are negotiated between two parties, the terms and conditions of
contracts are customized. These are OTC contracts.
Futures
A futures contract is similar to a forward, except that the deal is made through an organized and
regulated exchange rather than being negotiated directly between two parties. Indeed, we may say
futures are exchange traded forward contracts.
Options
An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or
before a stated date and at a stated price. While buyer of option pays the premium and buys the right,
writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, if the buyer
exercises his right.
Swaps
A swap is an agreement made between two parties to exchange cash flows in the future according to a
prearranged formula. Swaps are series of forward contracts. Swaps help market participants manage risk
associated with volatile interest rates, currency exchange rates and commodity prices.
Market Participants are of three types in the derivatives market - hedgers, traders (also called
speculators) and arbitrageurs
Types of Derivatives Markets
OTC Derivatives Market
The OTC derivatives markets have following features compared to exchange traded derivatives:
• Contracts are tailor made to fit in the specific requirements of dealing counterparties.
• The management of counter-party (credit) risk is decentralized and located within individual
institutions.
• There are no formal centralized limits on individual positions, leverage, or margining.
• There are no formal rules or mechanisms for risk management to ensure market stability and integrity,
and for safeguarding the collective interest of market participants.
• Transactions are private with little or no disclosure to the entire market.
Exchange Traded Derivatives Market
Exchange‐traded contracts are standardized, traded on organized exchanges with prices determined by
the interaction of buyers and sellers through anonymous auction platform. A clearing house/ clearing
corporation, guarantees contract performance (settlement of transactions).
Significance of Derivatives Market
• Derivatives market helps in improving price discovery based on actual valuations and expectations.
• Derivatives market helps in transfer of various risks from those who are exposed to risk but have low
risk appetite to participants with high risk appetite. For example hedgers want to give away the risk
where as traders are willing to take risk.
• Derivatives market helps shift of speculative trades from unorganized market to organized market.
Risk management mechanism and surveillance of activities of various participants in organized space
provide stability to the financial system
Market participants, who trade in derivatives are advised to carefully read the Model Risk Disclosure
Document, given by the broker to his clients at the time of signing agreement.
Model Risk Disclosure Document is issued by the members of Exchanges and contains important
information on trading in Equities and F&O Segments of exchanges. All prospective participants should
read this document before trading on Capital Market/Cash Segment or F&O segment of the Exchanges.
Chapter 2: Understanding Index
1. Index is a statistical indicator that measures changes in the economy in general or in particular
areas.
2. An index is a portfolio of securities that represent a particular market or a portion of a market.
3. Each Index has its own calculation methodology and usually is expressed in terms of a change
from a base value. the percentage change is more important than the actual numeric value.
4. Financial indices are created to measure price movement of stocks, bonds, T-bills and other type
of financial securities.
5. A stock index is created to provide market participants with the information regarding average
share price movement in the market. Broad indices are expected to capture the overall behaviour
of equity market and need to represent the return obtained by typical portfolios in the country
Significance of Index
• A stock index is an indicator of the performance of overall market or a particular sector.
• It serves as a benchmark for portfolio performance - Managed portfolios, belonging either to
individuals or mutual funds; use the stock index as a measure for evaluation of their performance.
• It is used as an underlying for financial application of derivatives – Various products in OTC and
exchange traded markets are based on indices as underlying asset.
Types of Stock Market Indices
Market capitalization weighted index
In this method of calculation, each stock is given weight according to its market capitalization. So higher
the market capitalization of a constituent, higher is its weight in the index.
Free-Float Market Capitalization Index
if we compute the index based on weights of each security based on free float market cap, it is called
free float market capitalization index. Indeed, both Sensex and Nifty, over a period of time, have moved
to free float basis
Price-Weighted Index
A stock index in which each stock influences the index in proportion to its price. Stocks with a higher
price will be given more weight and therefore, will have a greater influence over the performance of the
index. Dow Jones Industrial Average and Nikkei 225 are popular price‐weighted indices.
Equal Weighted Index
An equally-weighted index makes no distinction between large and small companies, both of which are
given equal weighting. The value of the index is generated by adding the prices of each stock in the
index and dividing that by the total number of stocks
The difference between the best buy and the best sell orders is called bid-ask spread. The “bid-ask
spread” therefore conveys transaction cost for small trade
Percentage degradation ( From an Ideal Price ) that occurs when shares are bought or sold, is called
impact cost. Impact cost varies with transaction size. Also, it would be different for buy side and sell
side.
NSE indices are managed by a separate company called NSE Indices Limited. A good index is a trade-
off between diversification and liquidity. A well diversified index reflects the behaviour of the overall
market/ economy
Index Funds
These types of funds invest in a specific index with an objective to generate returns equivalent to the
return on index. These funds invest in index stocks in the proportions in which these stocks exist in the
index. For instance, Sensex index fund would get the similar returns as that of Sensex index.
Exchange Traded Funds
Exchange Traded Funds (ETFs) is basket of securities that trade like individual stock, on an exchange.
They have number of advantages over other mutual funds as they can be bought and sold on the
exchange. Since, ETFs are traded on exchanges intraday transaction is possible. The first ETF in Indian
Securities Market was the Nifty BeES, introduced by the Benchmark Mutual Fund in December 2001.
Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF on Sensex.
Index Derivatives
• Index Derivatives are derivative contracts which have the index as the underlying asset.
• Index Options and Index Futures are the most popular derivative contracts worldwide.
• Index derivatives are useful as a tool to hedge against the market risk.
Exchange Traded Funds
• Exchange Traded Funds (ETFs) is basket of securities that trade like individual stock, on
an exchange. They have number of advantages over other mutual funds as they can be
bought and sold on the exchange.
• Further, ETFs can be used as basket trading in terms of the smaller denomination and low
transaction cost.
• The first ETF in Indian Securities Market was the Nifty BeES, introduced by the Benchmark
Mutual Fund in December 2001.
• Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF
on Sensex.
Chapter 3: Introduction to Forwards and Futures
Essential features of a forward are:
• It is a contract between two parties (Bilateral contract).
• All terms of the contract like price, quantity and quality of underlying, delivery terms like place,
settlement procedure etc. are fixed on the day of entering into the contract
Forwards are bilateral over the counter (OTC) transactions where the terms of the contract, such as
price, quantity, quality, time and place are negotiated between two parties to the contract. Any alteration
in the terms of the contract is possible if both parties agree to it. Corporations, traders and investing
institutions extensively use OTC transactions to meet their specific requirements.
Major limitations of forwards
Liquidity Risk
Liquidity is nothing but the ability of the market participants to buy or sell the desired quantity of an
underlying asset
Counterparty risk
Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfil its contractual
obligation. In addition to the illiquidity and counterparty risks, there are several issues like lack of
transparency, settlement complications as it is to be done directly between the contracting parties
Future Contract Specifications
Spot Price: The price at which an asset trades in the cash market
Futures Price: The price of the futures contract in the futures market.
Contract Cycle: It is a period over which a contract trades
The maximum number of index futures contracts is of 3 months contract cycle - the near month (Current
Month), the next month and the far month
Expiration Day: The day on which a derivative contract ceases to exist. It is last trading day of the
contract. Generally, it is the last Thursday of the expiry month unless it is a trading holiday on that day.
If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
Tick Size
It is minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts
as part of contract specification. Tick size for Nifty futures is 5 paisa. Bid price is the price buyer is
willing to pay and ask price is the price seller is willing to sell.
Contract Size and contract value
Futures contracts are traded in lots and to arrive at the contract value we have to multiply the price with
contract multiplier or lot size or contract size.
Basis
The difference between the spot price and the futures price is called basis. If the futures price is greater
than spot price, basis for the asset is negative. Similarly, if the spot price is greater than futures price,
basis for the asset is positive. During the life of the contract, the basis may become negative or positive,
as there is a movement in the futures price and spot price. Further, whatever the basis is, positive or
negative, it turns to zero at maturity of the futures contract i.e. there should not be any difference
between futures price and spot price at the time of maturity/ expiry of contract
Cost of Carry
Cost of Carry is the relationship between futures prices and spot prices. It measures the storage cost (in
commodity markets) plus the interest that is paid to finance or ‘carry’ the asset till delivery less the
income earned on the asset during the holding period. For equity derivatives, carrying cost is the interest
paid to finance the purchase less (minus) dividend earned.
Margin Account
As exchange guarantees the settlement of all the trades, to protect itself against default by either
counterparty, it charges various margins from brokers. Brokers in turn charge margins from their
customers
Initial Margin
The amount one needs to deposit in the margin account at the time entering a futures contract is known
as the initial margin
Marking to Market (MTM)
In futures market, while contracts have maturity of several months, profits and losses are settled on day-
to-day basis – called mark to market (MTM) settlement. The exchange collects these margins (MTM
margins) from the loss making participants and pays to the gainers on day-to-day basis.
Open Interest and Volumes Traded
An open interest is the total number of contracts outstanding (yet to be settled) for an underlying asset.
The level of open interest indicates depth in the market.
Long position Outstanding/ unsettled buy position in a contract is called “Long Position”.
Short Position Outstanding/ unsettled sell position in a contract is called “Short Position”.
Open position Outstanding/ unsettled either long (buy) or short (sell) position in various derivative
contracts is called “Open Position”
Naked and calendar spread positions
Naked position in futures market simply means a long or short position in any futures contract without
having any position in the underlying asset.
Calendar spread position is a combination of two positions in futures on the same underlying - long on
one maturity contract and short on a different maturity contract. For instance, a short position in near
month contract coupled with a long position in far month contract is a calendar spread position.
Calendar spread position is computed with respect to the near month series and becomes an open
position once the near month contract expires or either of the offsetting positions is closed. A calendar
spread is always defined with regard to the relevant months i.e. spread between August contract and
September contract, August contract and October contract and September contract and October contract
etc.
Cash and Carry Model for Futures Pricing
Cash and Carry model is also known as non-arbitrage model. This model assumes that in an efficient
market, arbitrage opportunities cannot exist. In other words, the moment there is an opportunity to make
money in the market due to mispricing in the asset price and its replicas, arbitrageurs will start trading to
profit from these mispricing and thereby eliminating these opportunities. This trading continues until the
prices are aligned across the products/ markets for replicating assets.
When an underlying asset is not storable i.e. the asset is not easy to hold/maintain, then one cannot carry
the asset to the future. The cash and carry model is not applicable to these types of underlying assets.
in case of natural disaster like flood in a particular region, people start storing essential commodities like
grains, vegetables and energy products (heating oil) etc. As a human tendency we store more than what
is required for our real consumption during a crisis. If every person behaves in similar way then
suddenly a demand is created for an underlying asset in the cash market. This indirectly increases the
price of underlying assets. In such situations people are deriving convenience, just by holding the asset.
This is termed as convenience return or convenience yield.
if futures price is higher than spot price of an underlying asset, market participants may expect the spot
price to go up in near future. This expectedly rising market is called “Contango market”. Similarly, if
futures price are lower than spot price of an asset, market participants may expect the spot price to come
down in future. This expectedly falling market is called “Backwardation market”.
Price risk is nothing but change in the price movement of asset, held by a market participant, in an
unfavourable direction. This risk broadly divided into two components - specific risk or unsystematic
risk and market risk or systematic risk.
Unsystematic Risk
Specific risk or unsystematic risk is the component of price risk that is unique to particular events of the
company and/or industry. This risk is inseparable from investing in the securities. This risk could be
reduced to a certain extent by diversifying the portfolio.
Systematic Risk
An investor can diversify his portfolio and eliminate major part of price risk i.e. the
diversifiable/unsystematic risk but what is left is the non-diversifiable portion or the market risk-called
systematic risk. Variability in a security’s total returns that are directly associated with overall
movements in the general market or economy is called systematic risk
Beta
A measure of systematic risk of a security that cannot be avoided through diversification. It measures
the sensitivity of a scrip/ portfolio vis-a-vis index movement over a period of time, on the basis of
historical prices. Suppose a stock has a beta equal to 2. This means that historically a security has moved
20% when the index moved 10%, indicating that the stock is more volatile than the index. Scrips/
portfolios having beta more than 1 are called aggressive and having beta less than 1 are called
conservative scrips/ portfolios.
To find the number of contracts for perfect hedge ‘hedge ratio’ is used. Hedge ratio is calculated as:
Number of contracts for perfect hedge = Vp * βp / Vi
Vp – Value of the portfolio βp – Beta of the portfolio Vi – Value of index futures contract Value of
index futures contract or contract size = futures index level * contract multiplier. Readers may note that
for simplification purpose, beta of futures index vis-a-vis cash index is taken as one.
Long hedge is the transaction when we hedge our position in cash market by going long in futures
market.
Short hedge is a transaction when the hedge is accomplished by going short in futures market
Cross hedge
When futures contract on an asset is not available, market participants look forward to an asset that is
closely associated with their underlying and trades in the futures market of that closely associated asset,
for hedging purpose. They may trade in futures in this asset to protect the value of their asset in cash
market. This is called cross hedge.
Hedge contract month
Hedge contract month is the maturity month of the contract through which we hedge our position
Arbitrage opportunities in futures market
Arbitrage is simultaneous purchase and sale of an asset or replicating asset in the market in an attempt to
profit from discrepancies in their prices. Arbitrage involves activity on one or several instruments/assets
in one or different markets, simultaneously. Important point to understand is that in an efficient market,
arbitrage opportunities may exist only for shorter period or none at all. The moment an arbitrager spots
an arbitrage opportunity, he would initiate the arbitrage to eliminate the arbitrage opportunity. Arbitrage
occupies a prominent position in the futures world as a mechanism that keeps the prices of futures
contracts aligned properly with prices of the underlying assets.
The objective of arbitragers is to make profits without taking risk, but the complexity of activity is such
that it may result in losses as well
Arbitrage in the futures market can typically be of three types:
• Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the cash or underlying
market and a short position in futures market.
• Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long position in futures
market and short position in the underlying or cash market.
• Inter-Exchange arbitrage: This arbitrage entails two positions on the same contract in two different
markets/ exchanges.
Inter-market arbitrage This arbitrage opportunity arises because of some price differences existing in
same underlying at two different exchanges. If August futures on stock Z are trading at Rs. 101 at NSE
and Rs. 100 at BSE, the trader can buy a contract at BSE and sell at NSE. The positions could be
reversed over a period of time when difference between futures prices squeeze. This would be profitable
to an arbitrageur.
Chapter 4: Introduction to Options
Options may be categorized into two main types:-
• Call Options
• Put Options
Option, which gives buyer a right to buy the underlying asset, is called Call option and the option which
gives buyer a right to sell the underlying asset, is called Put option
Writer of an option
The writer of an option is one who receives the option premium and is thereby obliged to sell/buy the
asset if the buyer of option exercises his right.
American option
The owner of such option can exercise his right at any time on or before the expiry date/day of the
contract.
European option
The owner of such option can exercise his right only on the expiry date/day of the contract. In India,
Index options are European
Strike price or Exercise price
Strike price is the price per share for which the underlying security may be purchased or sold by the
option holder
In the money (ITM) option
This option would give holder a positive cash flow, if it were exercised immediately. A call option is
said to be ITM, when spot price is higher than strike price. And, a put option is said to be ITM when
spot price is lower than strike price. In our examples, call option is in the money.
At the money (ATM) option
At the money option would lead to zero cash flow if it were exercised immediately. Therefore, for both
call and put ATM options, strike price is equal to spot price.
Out of the money (OTM) option
Out of the money option is one with strike price worse than the spot price for the holder of option. In
other words, this option would give the holder a negative cash flow if it were exercised immediately. A
call option is said to be OTM, when spot price is lower than strike price. And a put option is said to be
OTM when spot price is higher than strike price. In our examples, put option is out of the money.
Time value
It is the difference between premium and intrinsic value, if any, of an option. ATM and OTM options
will have only time value because the intrinsic value of such options is zero.
Open Interest
As discussed in futures section, open interest is the total number of option contracts outstanding for an
underlying asset.
Leverage An option buyer pays a relatively small premium for market exposure in relation to the
contract value. This is known as leverage
Leverage also has downside implications. If the underlying price does not rise/fall as anticipated during
the lifetime of the option, leverage can magnify the investment’s percentage loss. Options offer their
owners a predetermined, set risk
Risk / Loss Return / Profit
Long Premium paid Unlimited
Short Unlimited Premium received
There are five fundamental parameters on which the option price depends:
1) Spot price of the underlying asset
2) Strike price of the option
3) Volatility of the underlying asset’s price
4) Time to expiration
5) Interest rates
Spot price of the underlying asset
If price of the underlying asset goes up the value of the call option increases while the value of the put
option decreases. Similarly if the price of the underlying asset falls, the value of the call option
decreases while the value of the put option increases.
Strike Price
If all the other factors remain constant but the strike price of option increases, intrinsic value of the call
option will decrease and hence its value will also decrease. On the other hand, with all the other factors
remain constant, increase in strike price of option increases the intrinsic value of the put option which in
turn increases its option value.
Volatility
It is the magnitude of movement in the underlying asset’s price, either up or down. It affects both call
and put options in the same way. Higher the volatility of the underlying stock, higher the premium
because there is a greater possibility that the option will move in-the-money during the life of the
contract.
Higher volatility = Higher premium, Lower volatility = Lower premium (for both call and put options).
Time to expiration
The effect of time to expiration on both call and put options is similar to that of volatility on option
premiums. Generally, longer the maturity of the option greater is the uncertainty and hence the higher
premiums. If all other factors affecting an option’s price remain same, the time value portion of an
option’s premium will decrease with the passage of time. This is also known as time decay. Options are
known as ‘wasting assets’, due to this property where the time value gradually falls to zero.
high interest rates will result in an increase in the value of a call option and a decrease in the value of a
put option.
Options Pricing Models
The Binomial Pricing Model
This is a very accurate model as it is iterative, but also very lengthy and time consuming
The Black & Scholes Model
It is one of the most popular, relative simple and fast modes of calculation. Unlike the binomial model, it
does not rely on calculation by iteration.
Option Greeks
Delta (δ or Δ)
The most important of the ‘Greeks’ is the option’s “Delta”. This measures the sensitivity of the option
value to a given small change in the price of the underlying asset. It may also be seen as the speed with
which an option moves with respect to price of the underlying asset. Delta = Change in option premium/
Unit change in price of the underlying asset.
Delta for call option buyer is positive
Delta for put option buyer is negative
Gamma (γ)
It measures change in delta with respect to change in price of the underlying asset. This is called a
second derivative option with regard to price of the underlying asset. It is calculated as the ratio of
change in delta for a unit change in market price of the underlying asset. Gamma = Change in an option
delta/ Unit change in price of underlying asset
Theta (θ)
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. Theta is generally used to gain an idea
of how time decay is affecting your option positions. Theta = Change in an option premium/ Change in
time to expiry
Vega (ν)
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. Vega = Change in an
option premium/ Change in volatility
Rho (ρ)
Rho is 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 in the cost of funding the underlying. Rho =
Change in an option premium/ Change in cost of funding the underlying
Chapter 5: Option Trading Strategies
Option Spreads
Spreads involve combining options on the same underlying and of same type (call/ put) but with
different strikes and maturities. These are limited profit and limited loss positions. They are primarily
categorized into three sections as:
• Vertical Spreads
• Horizontal Spreads
• Diagonal Spreads
Vertical Spreads
Vertical spreads are created by using options having same expiry but different strike prices. Further,
these can be created either using calls as combination or puts as combination. These can be further
classified as:
• Bullish Vertical Spread
o Using Calls
o Using Puts
• Bearish Vertical Spread
o Using Calls
o Using Puts
Horizontal Spread
Horizontal spread involves same strike, same type but different expiry options. This is also known as
time spread or calendar spread.
Diagonal spread
Diagonal spread involves combination of options having same underlying but different expiries as well
as different strikes. Again, as the two legs in a spread are in different maturities, it is not possible to
draw payoffs here as well.
Straddle
This strategy involves two options of same strike prices and same maturity. A long straddle position is
created by buying a call and a put option of same strike and same expiry whereas a short straddle is
created by shorting a call and a put option of same strike and same expiry.
Strangle
This strategy is similar to straddle in outlook but different in implementation, aggression and cost.
Long Strangle
As in case of straddle, the outlook here (for the long strangle position) is that the market will move
substantially in either direction, but while in straddle, both options have same strike price, in case of a
strangle, the strikes are different. Also, both the options (call and put) in this case are out-of-the-money
and hence the premium paid is low.
Short Strangle
This is exactly opposite to the long strangle with two out-of-the-money options (call and put) shorted.
Outlook, like short straddle, is that market will remain stable over the life of options
Covered Call
This strategy is used to generate extra income from existing holdings in the cash market. If an investor
has bought shares and intends to hold them for some time, then he would like to earn some income on
that asset, without selling it, thereby reducing his cost of acquisition.
Protective Put
Any investor, long in the cash market, always runs the risk of a fall in prices and thereby reduction of
portfolio value and MTM losses. A protective put payoff is similar to that of long call. This is called
synthetic long call position. Its like buying insurance to protect your portfolio against market falls.
Collar
A collar strategy is an extension of covered call strategy. in case of covered call, the downside risk
remains for falling prices; i.e. if the stock price moves down, losses keep increasing (covered call is
similar to short put).To put a floor to this downside, we long a put option, which essentially negates the
downside of the short underlying/futures (or the synthetic short put)
Butterfly Spread
As collar is an extension of covered call, butterfly spread is an extension of short straddle.
Downside in short straddle is unlimited if market moves significantly in either direction. To put a limit
to this downside, along with short straddle, trader buys one out of the money call and one out of the
money put. Resultantly, a position is created with pictorial pay-off, which looks like a butterfly and so
this strategy is called “Butterfly Spread”. Butterfly spread can be created with only calls, only puts or
combinations of both calls and puts.
Chapter 6: Introduction to Trading Systems
All the exchanges in India (BSE, NSE and MCX-SX) provide a fully automated screen-based trading
platform for index futures, index options, stock futures and stock options. These trading systems support
an order driven market and simultaneously provide complete transparency of trading operations.
Derivative trading is similar to that of trading of equities in the cash market segment
Entities in the trading system
Broadly there are four entities in the trading system
• Trading Members
• Trading cum Clearing Members
• Self Clearing Member (SCM)
• Professional Clearing Members and
• Participants
Authorised Persons (APs): SEBI had earlier allowed spread of sub-brokership as well as Authorised
Person’s network to expand the brokers’ network. However, SEBI Board in its meeting held on June
21, 2018 decided that sub-brokers as an intermediary shall cease to exist with effect from April 01,
2019. All existing sub-brokers would migrate to become Authorised Persons (APs) or Trading
Members if the sub-brokers meet the eligibility criteria
Corporate Hierarchy
In the Futures and options trading software, trading member will have a provision of defining the
hierarchy amongst users of the system. This hierarchy comprises:
• Corporate Manager
• Branch Manager and
• Dealer
Order Types
Time conditions
Day order: A Day order is an order which is valid for a single day on which it is entered. If the order is
not executed during the day, the trading system cancels the order automatically at the end of the day.
Immediate or cancel (IOC): User is allowed to buy/sell a contract as soon as the order is released into
the trading system. An unmatched order will be immediately cancelled. Partial order match is possible in
this order, and the unmatched portion of the order is cancelled immediately.
Price condition
Limit order: It is an order to buy or sell a contract at a specified price. The user has to specify this limit
price while placing the order and the order gets executed only at this specified limit price or at a better
price than that
Market order: A market order is an order to buy or sell a contract at the bid or offer price currently
available in the market. Price is not specified at the time of placing this order.
Order Matching Rules
In India, F&O platforms offer an order driven market, wherein orders match automatically on price time
priority basis. Orders, as and when they are received, are first time stamped and then immediately
processed for potential match. If a match is not found, then the orders are stored in different 'books'.
Orders are stored in price-time priority in various books in the following sequence:
• Best Price
• Within Price, by time priority.
The best buy order will match with the best sell order. An order may match partially with another order
resulting in multiple trades. For order matching, the best buy order is the one with highest price and the
best sell order is the one with lowest price. This is because the computer views all buy orders available
from the point of view of a seller and all sell orders from the point of view of the buyers in the market.
Price Band
There are no price bands applicable in the derivatives segment. However, in order to prevent erroneous
order entry, operating ranges and day minimum/maximum ranges are kept as below:
• For Index Futures: at 10% of the base price
• For Futures on Individual Securities: at 10% of the base price
• For Index and Stock Options: A contract specific price range based on its delta value is computed and
updated on a daily basis.
Eligibility criteria of stocks
a) The stock shall be chosen from amongst the top 500 stock in terms of average daily market
capitalization and average daily traded value in the previous 6 months on a rolling basis.
b) The stock’s median quarter-sigma order size (MQSOS) over the last six months shall be not less than
Rs.25 Lakhs . For this purpose, a stocks quarter-sigma order size shall mean the order size (in value
terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.
c) The market wide position limit in the stock shall not be less than Rs.500 crores on a rolling basis. The
market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the
underlying cash market on the date of expiry of contract in the month. The market wide position limit of
open position (in terms of the number of underlying stock) on futures and option contracts on a
particular underlying stock shall be 20% of the number of shares held by non-promoters in the relevant
underlying security i.e. free-float holding.
d) The Average daily delivery value in cash market shall not be less than Rs.10 crores in the previous six
months on a rolling basis. The Average Daily Deliverable Value shall be computed taking Deliverable
quantity as per client level as computed by NSE Clearing Limited on a daily basis and close price of the
trade date.
e) All the existing F&O stocks based on the criteria mentioned in SEBI circular number
SEBI/HO/MRD/DOPI/CIR/P/2018/161 dated December 31, 2018 are moved to physical settlement in a
phased manner. The stock wise details are being provided in NSE circular no NSE/FAOP/39873 dated
January 04,2019.
f) If an existing security fails to meet aforesaid continued eligibility criteria for three months
consecutively, then no fresh month contract shall be issued on that security. However, the existing
unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the
existing contract months.
g) Further, the members may also refer to circular no. NSCC/F&O/C&S/365 dated August 26, 2004,
issued by NSE Clearing regarding Market Wide Position Limit, wherein it is clarified that a stock which
has remained subject to a ban on new position for a significant part of the month consistently for three
months, shall be phased out from trading in the F&O segment.
h) The number of eligible securities may vary from month to month depending upon the changes in
average daily market capitalisation, average daily traded value, quarter sigma order sizes and average
daily deliverable value calculated every month on a rolling basis for the past 6 months and also the
market wide position limit in that security.
Re-introduction of excluded stocks
A stock which is excluded from derivatives trading may become eligible once again. In such instances,
the stock is required to fulfill the enhanced eligibility criteria for six consecutive months to be re-
introduced for derivatives trading.
Eligibility criteria of Indices
The Exchange may consider introducing derivative contracts on an index, if weightage of constituent
stocks of the index, which are individually eligible for derivatives trading, is at least 80%. However, no
single ineligible stock in the index shall have a weightage of more than 5% in the index
The corporate actions may be broadly classified under stock benefits and cash benefits
as follows:
Bonus, Rights, Merger/De-merger, Amalgamation, Splits, Consolidations, Hive-off, Warrants, Secured
Premium Notes (SPNs), Extraordinary dividends
Dividends
Dividends which are below 5% of the market value of the underlying stock would be deemed to be
ordinary dividends and no adjustment in the strike price would be made for ordinary dividends. For
extra-ordinary dividends, above 5% of the market value of the underlying stock, the Strike Price would
be adjusted.
Limits in Derivatives Market
Index Options Index Futures Stock
Options
Stock
Futures
Client level /
FPI category
III / MF
Schemes
Higher of --> 1% of the free float market cap OR 5% of the open interest in
the derivative contracts on a particular underlying stock
Trading
Member /
FPI Cat I &
II / Mutual
Fund
Higher of Rs.500
crores OR 15% of the
total open interest in
the market in equity
index option contracts
Higher of Rs.500
crores OR 15% of
the total open
interest in the
market in equity
index futures
contracts
The position limits of Trading
members / FPIs (Category I &
II) / Mutual Funds in individual
stocks is related to the
market‐wide position limit for
the individual stocks. The
combined futures and options
position limit shall be 20% of
the applicable Market Wide
Position Limit (MWPL).
Market wide No MWPL for Index
Options
No MWPL for
Index Futures
At the end of each day the
Exchange disseminates the
aggregate open interest across
all Exchanges in the futures
and options on individual scrips
along with the market wide
position limit for that scrip and
tests whether the aggregate
open interest for any scrip
exceeds 95% of the market
wide position limit for that
scrip. If yes, the Exchange
takes note of open positions of
all client/ TMs as at the end of
that day in that scrip, and from
next day onwards the client/
TMs should trade only to
decrease their positions through
offsetting positions till the
normal trading in the scrip is
resumed.
The normal trading in the scrip
is resumed only after the
aggregate open interest across
Exchanges comes down to 80%
or below of the market wide
position limit.
Clearing Members handle the responsibility of clearing and settlement of all deals
executed by Trading Members, who clear and settle such deals through them. Clearing
Members perform the following important functions:
Clearing: Computing obligations of all his trading members i.e., determining positions to settle.
Settlement: Performing actual settlement.
Risk Management: Setting position limits based on upfront deposits / margins for
each TM and monitoring positions on a continuous basis.
Clearing Member Eligibility Norms
• Net-worth of at least Rs.300 lakhs. The Net-worth requirement for a Clearing Member who clears and
settles only deals executed by him is Rs. 100 lakhs.
• Deposit of Rs. 50 lakhs to clearing corporation which forms part of the security deposit of the Clearing
Member.
• Additional incremental deposits of Rs.10 lakhs to clearing corporation for each additional TM, in case
the Clearing Member undertakes to clear and settle deals for other TMs.
Clearing Mechanism
The first step in clearing process is calculating open positions and obligations of clearing members.
The open position of a CM is arrived at by aggregating the open positions of all the trading members
(TMs) and all custodial participants (CPs) clearing though him, in the contracts which they have traded.
The open position of a TM is arrived at by adding up his proprietary open position and clients’ open
positions, in the contracts which they have traded. While entering orders on the trading system, TMs
identify orders as either proprietary (Pro) or client (Cli).
Proprietary positions are calculated on net basis (buy-sell) for each contract and that of clients are
arrived at by summing together net positions of each individual client.
A TM’s open position is the sum of proprietary open position, client open long position and client open
short position.
Settlement Mechanism
Settlement of Futures Contracts
In Futures contracts, both the parties to the contract have to deposit margin money which is called as
initial margin. Futures contract have two types of settlements, the MTM settlement which happens on a
continuous basis at the end of each day, and the final settlement which happens on the last trading day of
the futures contract. Mark to Market (MTM) Settlement Mark to Market is a process by which margins
are adjusted on the basis of daily price changes in the markets for underlying assets. The profits/ losses
are computed as the difference between:
1. The trade price & the day's settlement price for contracts executed during the day but not squared up.
2. The previous day's settlement price & current day's settlement price for brought forward contracts.
3. The buy price and the sell price for contracts executed during the day and squared up.
Final Settlement
On expiration day of the futures contracts, after the close of trading hours, clearing corporation marks all
positions of a clearing member to the final settlement price.
All long positions are automatically assigned to short positions with the same series, on a random basis,
for either cash settlement or for delivery settlement, whichever is applicable.
Settlement of Options Contracts on Index or Individual Securities
Options contracts have two types of settlements. These are as follows
1) Daily premium settlement,
2) Final settlement
Daily Premium Settlement
In options contract, buyer of an option pays premium while seller receives premium. The amount
payable and receivable as premium are netted to compute the net premium payable or receivable amount
for each client for each option contract. The clearing members who have a premium payable position are
required to pay the premium amount to clearing corporation which in turn passed on to the members
who have a premium receivable position. This is known as daily premium settlement. The premium
payable amount and premium receivable amount are directly credited/ debited to the clearing member’s
clearing bank account.
Final Exercise Settlement
All the in-the-money stock options contracts, except the Close to Money (CTM) options which are
explicitly marked as “Do Not Exercise”, shall get automatically exercised on the expiry day. All these
long positions are automatically assigned to the short positions in option contracts with the same series,
on a random basis.
Settlement of Admitted Deals
Admitted deals executed on a trading day, shall be cleared on a netted basis, by the Clearing
Corporation. The clearing members are responsible for all obligations arising out of such trades
including the payment of margins, penalties, any other levies and settlement of obligations of the trades
entered by them as trading members and also of those trading members and custodial participants for
whom they have undertaken to settle as a clearing member
Settlement Price for derivatives is given in the following table:
Product Settlement Price
Futures Contracts on Index
OR Individual Security
Daily
Settlement
Closing price of the futures contracts on the trading day
(closing price for a futures = last half an hour volume
weighted average price of such contract).
Un-expired illiquid futures
contracts
Daily
Settlement
Theoretical Price computed as per formula F=S *ert
Futures Contracts on Index or
Individual Securities
Final
Settlement
Closing price of the relevant underlying index / security
in the Capital Market segment of exchanges on the last
trading day of the futures contracts.
Options Contracts on Index
and Individual Securities
Final
Exercise
Settlement
Closing price of such underlying security (or in-dex) on
the last trading day of the options contract.
Risk Management
The most critical component of risk containment mechanism for F&O segment is the margining system
and on-line position monitoring. The actual position monitoring and margining is carried out on-line
through Parallel Risk Management System (PRISM) using SPAN® (Standard Portfolio Analysis of
Risk) system for the purpose of computation of on-line margins, based on the parameters defined by
SEBI.
Initial margin
Margins are computed by clearing corporation upto client level with the help of SPAN. Clearing
corporation collects initial margin for all the open positions of a Clearing Member based on the margins
computed. Margins are required to be paid up-front on gross basis at individual client level for client
positions and on net basis for proprietary positions. A Clearing Member collects initial margin from TM
whereas TM collects from his clients.
Initial margin requirements are based on 99% value at risk over a one day time horizon. However, in the
case of futures contracts (on index or individual securities), where it may not be possible to collect mark
to market settlement value, before the commencement of trading on the next day, the initial margin is
computed over a two-day time horizon, applying the appropriate statistical formula
Premium Margin
Along with Initial Margin, Premium Margin is also charged at client level. This margin is required to be
paid by a buyer of an option till the premium settlement is complete.
Assignment Margin for Options on Securities
Along with Initial Margin and Premium Margin, assignment margin is required to be paid on assigned
positions of Clearing Members towards final exercise settlement obligations for option contracts on
individual securities, till such obligations are fulfilled.
Assignment margin is levied on assigned positions of the clearing members towards final exercise
settlement obligations for option contracts on index and individual securities which are settled in cash.
Assignment margin shall be the net exercise settlement value payable by a clearing member towards
final exercise settlement. Assignment margin shall be levied till the completion of pay-in towards the
exercise settlement.
Intra-day crystallised Losses
Clearing Corporation calculates and levy Intraday Crystallised Losses (ICMTM) in the following
manner:
a) ICMTM is computed for all trades which are executed and results into closing out of open positions.
b) ICMTM is calculated based on weighted average prices of trades/positions
c) ICMTM is computed only for futures contracts.
d) ICMTM is part of initial margin and shall be adjusted against the liquid assets of clearing member on
a real time basis.
e) Crystallised losses at a contract level for a client are adjusted against crystallised profits, if any, from
another contract for the same client to arrive at client level profit or loss.
f) All client level losses across all trading members including losses on proprietary positions of trading
members, if any, are grossed up to arrive at clearing member level ICMTM.
g) ICMTM so blocked/ collected is released on completion of daily / final mark to market settlement
pay-in
Delivery Margins
Delivery margins are levied on lower of potential deliverable positions or in-the-money long option
positions, four days prior to expiry of derivative contract, which has to be settled through delivery
Delivery margins are part of the initial margins of the clearing member and are computed at a client
level settlement obligation for all positions to be settled through delivery. Client level potential in-the-
money long option positions are computed on daily basis. In-the-Money options are identified based on
the closing price of the security in the underlying Capital Market segment on the respective day
Exposure Margins
The VAR and Extreme Loss percentage as computed in the Capital Market segment shall be applied on
client level settlement obligations. The margins rate shall be updated for every change in margin rate in
Capital Market segment. Clearing members are subject to exposure margins in addition to initial
margins
Short Option Minimum Charge
Short options positions in extremely deep-out-of-the-money strikes may appear to have little or no risk
across the entire scanning range. However, in the event that underlying market conditions change
sufficiently, these options may move into-the-money, thereby generating large losses for the short
positions in these options. To cover the risks associated with deep-out-of-the-money short options
positions, SPAN assesses a minimum margin for each short option position in the portfolio called the
Short Option Minimum charge, which is set by the Clearing Corporation. The Short Option Minimum
charge serves as a minimum charge towards margin requirements for each short position in an option
contract.
Net Option Value
Net Option Value is computed as the difference between the long option positions and the short option
positions, valued at the last available closing price of the option contract and is updated intraday at the
current market value of the relevant option contracts at the time of generation of risk parameters. The
Net Option Value is added to the Liquid Net Worth of the clearing member.
Client Margins
Clearing corporation intimates all members of the margin liability of each of their client. Additionally
members are also required to report details of margins collected from clients to clearing corporation,
which holds in trust client margin monies to the extent reported by the member as having been collected
from their respective clients.
Salient features of the cross margining available on exchanges are as follows:
1. Cross margining is available across Cash and Derivatives segment.
2. Cross margining is available to all categories of market participants.
3. The positions of clients in both the Capital market and derivatives segments to the extent they offset
each other only are considered for the purpose of cross margining.
4. When a Clearing Member clears for client/ entities in Cash and Derivatives segments, he is then
required to intimate client details through a Collateral Interface for Members (CIM) to benefit from
Cross margining.
5. When different Clearing Members clear for client/entities in Cash and Derivatives segments they are
required to enter into necessary agreements for availing cross margining benefit.
6. Clients who wish to avail cross margining benefit in respect of positions in Index Futures and
Constituent Stock Futures only, their clearing member in the Derivatives segment needs to provide the
details of the clients.
Chapter 8: Legal and Regulatory Environment
Securities Contracts (Regulation) Act, 1956
The Act aims to prevent undesirable transactions in securities. It governs the trading of securities in
India. The term “securities” has been defined in the Section 2(h) of SCRA.
According to the act “Derivatives” is defined as:‐
• A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
• A contract which derives its value from the prices, or index of prices, of underlying securities.
• Commodity derivatives, and Such other instruments as may be declared by the Central
Government to be derivatives.
• Section 18A provides that notwithstanding anything contained in any other law
for the time being in force, contracts in derivative shall be legal and valid if such
contracts are:
o Traded on a recognized stock exchange
o Settled on the clearing house of the recognized stock exchange, in accordance
with the rules and bye–laws of such stock exchanges.
Regulation in Trading
• The derivatives exchange/segment should have a separate governing council and representation
of trading/clearing members shall be limited to maximum of 40% of the total members of the
governing council.
• The Exchange should have a minimum of 50 members
• The minimum contract value shall not be less than Rs. 5 Lakhs
• The minimum networth for clearing members of the derivatives clearing corporation/house shall
be Rs.300 Lakhs
• The minimum contract value shall not be less than Rs 5,00,000
Responsibilities of the Clearing Corporation include:
• Collection of Margins on timely basis
• Smooth operation of the Market
• Daily Clearing and Settlement
• To act as a legal counterparty for every contract
• To monitor positions in derivatives and cash segments
• Deciding Daily Settlement Prices
• Keep consistent record of margins at client level
• Take care not to appropriate client margins against brokers dues
The Clearing Corporation can transfer client positions from one broker member to another broker
member in the event of a default by the first broker member.
Main objectives of Trade Guarantee Fund (TGF):
• To guarantee settlement of bonafide transactions of the members of the exchange.
• To inculcate confidence in the minds of market participants.
• To protect the interest of the investors in securities.
All active members of the Exchange are required to make initial contribution towards Trade Guarantee
Fund of the Exchange.
Chapter 9: Accounting and Taxation
When forward contract is for hedging
• The premium or discount (difference between the value at spot rate and forward rate) should be
amortized over the life of contract.
• Exchange difference (difference between the value of settlement date/ reporting date and value at
previous reporting date/ inception of the contract) is recognized in Profit & Loss statement of the year.
• Profit/ loss on cancellation/ renewal of forward contract are recognized in P&L of the year.
When forward contract is for trading/ speculation
• No premium or discount is recognized.
• A gain or loss i.e. the difference between the forward rate as per contract/ previous year end valuation
rate and the forward rate available at the yearend (reporting date) for remaining maturity period should
be recognized in the P&L of the period.
• Profit/ loss on cancellation / renewal of forward contract are recognized in P&L of the year.
Taxation of Profit/Loss on derivative transaction in securities
Prior to Financial Year 2005–06, transaction in derivatives were considered as speculative transactions
for the purpose of determination of tax liability under the Income -tax Act.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in derivatives carried out in a
“recognized stock exchange” for this purpose. This implies that income or loss on derivative
transactions which are carried out in a “recognized stock exchange” is not taxed as speculative income
or loss. Thus, loss on derivative transactions can be set off against any other income during the year
(except salary income). In case the same cannot be set off, it can be carried forward to subsequent
assessment year and set off against any other non‐speculative business income of the subsequent year.
Such losses can be carried forward for a period of 8 assessment years.
Securities Transaction Tax (STT)
Trading member has to pay securities transaction tax on the transaction executed on the exchange shall
be as under:
STT rates
1. Sale of an option in securities → 0.05 per cent ( from 2016 )
2. Sale of an option in securities, where option is exercised → 0.125 per cent ( Paid by Purchaser)
3. Sale of futures in securities → 0.01 per cent
STT is applicable on all sell transactions for both futures and option contracts.
For the purpose of STT, each futures trade is valued at the actual traded price
and option trade is valued at premium. On this value, the STT rate as prescribed
is applied to determine the STT liability. In case of voluntary or final exercise of
an option contract, STT is levied on settlement price on the day of exercise if the
option contract is in the money.
STT payable by the clearing member is the sum total of STT payable by all trading
members clearing under him. The trading member’s liability is the aggregate STT
liability of clients trading through him
Chapter 10: Sales Practices and Investors Protection Services
Churning
“Churning” refers to when securities professionals making unnecessary and excessive trades in
customer accounts for the sole purpose of generating commissions. Investors should be careful to review
their monthly account statements and investigate any abnormally high trading activity.
Customer Due Diligence
The customer due diligence (“CDD”) measures comprises the following:
• Obtaining sufficient information in order to identify persons who beneficially own or control
securities account
• Verify the customer’s identity using reliable, independent source documents, data or information
• Conduct ongoing due diligence and scrutiny, i.e. perform ongoing scrutiny of the transactions and
account throughout the course of the business relationship to ensure that the transactions being
conducted are consistent with the registered intermediary’s knowledge of the customer, its
business and risk profile, taking into account, where necessary, the customer’s source of funds
Clients of special categories (CSC)
Such clients include the following:
• Non resident clients.
• High networth clients.
• Trust, Charities, NGOs and organizations receiving donations.
• Companies having close family shareholdings or beneficial ownership.
• Politically exposed persons (PEP) of foreign origin.
• Companies offering foreign exchange offerings.
• Clients in high risk countries
• Non face to face clients.
• Clients with dubious reputation as per public information available.etc.
Investors Grievance Mechanism
All exchanges have a dedicated department to handle grievances of investors against the Trading
Members and Issuers. These include the Investor Service Committees (ISC) consisting of Exchange
officials and independent experts whose nomination is approved by Securities and Exchange Board of
India. SEBI also monitors exchange performance related to investor grievance redressal
Arbitration
• Arbitration is a quasi judicial process of settlement of disputes between Trading Members,
Investors, Sub-brokers & Clearing Members and between Investors and Issuers (Listed
Companies).
• The parties to arbitration are required to select the arbitrator from the panel of arbitrators
provided by the Exchange. The arbitrator conducts the arbitration
• proceeding and passes the award normally within a period of 4 months from the date of initial
hearing.
• The arbitration award is binding on both the parties. However, the aggrieved party, within 15
days of the receipt of the award from the arbitrator, can file an appeal to the arbitration tribunal
for re‐hearing the whole case.
• On receipt of the appeal, the Exchange appoints an Appellate Bench consisting of 5 arbitrators
who re‐hear the case and then give the decision. The judgment of the Bench is by a ‘majority’
and is binding on both the parties. The final award of the Bench is enforceable as if it were the
decree of the Court.
• Any party who is dissatisfied with the Appellate Bench Award may challenge the same in
a Court of Law.
SEBI Complaints Redress System (SCORES) [http://scores.gov.in]
SEBI’s web based complaints redressal system is called SCORES (Sebi Complaints REdress System).
SCORES is a centralized grievance management system with tracking mechanism to know the latest
updates and time taken for resolution.
The salient features of SCORES are:
(i) Centralised database of investor complaints
(ii) Online movement of complaints to the concerned listed company or SEBI registered intermediary
(iii) Online upload of Action Taken Reports (ATRs) by the concerned listed company or SEBI
registered intermediary
(iv) Online viewing by investors of actions taken on the complaint and its current status
All complaints are lodged electronically at: https://scores.gov.in
The companies are required to view the pending complaints and take action and provide resolution along
with necessary documents (can be uploaded online). If the company fails to provide resolution within
specific turn-around time, it will be treated as nonredressal or non-compliance in the SCORES system
and the regulator will keep a track of such instances.
