Stock Market Operations and Derivative Trading

8/9/2019 Stock Market Operations and Derivative Trading

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STOCK MARKET OPERATIONS:

CASH MARKET &DERIVATIVE

TRADING Dr.B.L.GUPTA


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The selection of any investment proposal

is largely dependent upon the followingfeatures :

1. Safety,

2. Liquidity, and3. Return.

Essential Features of an Investment


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N o one in the world ever became richwithout taking any risk.

The ships are safe in the harbour but theyare not built for this purpose.

Taking no risks may also mean forgoingrewards

In fact, everyone in this World is aspeculator and every thing we do is aspeculation.

INV ESTME N T RISK


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Risk ManagementRisk can be defined as the

combination of the probability of an event and its consequences.

Risk management is a rapidlydeveloping discipline in business


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The focus of good risk

management is the identificationand treatment of risks.Its objective is to add maximum

sustainable value to all theactivities of the organisation.

Risk Management


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SPECULATI V E V/ S I NV ESTME N T OBJECTI V ES

S peculation is related with the trading insecurities for the primary purpose of realisingcapital gains.Investment is related to the putting money intothe asset for certain regular income and gains in

the long run.There is no water-tight compartment betweenspeculation and investment objectives particularlyin the securities market.


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Essential Requirements of Trading

1.Broker Client Agreement2.Opening of a Dematerlised Account.3. S igning of Non-revocable Power of attorney.4.Opening of a Bank Account


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The payoff of a BOUGHT S HARE S is directly proportional to the spotprice of the security. As the spot price increases the profit from the boughtshares also increases or as the spot price decreases the loss from thebought share is also increases.

Profit

Loss

0Spot Price

Payoff profile of a bought share

BUYING IN CASH


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Profit

Loss

0 Spot Price

SELLI NG IN CASH


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Derivatives are financialinstruments that derive their value from an underlying asset.

The underlying assets may beequity, currency or a

commodity.

DERI VATIV ES


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Derivatives are those financial instruments which provides theample scope of trading in the market without holding a large

quantity of stock i.e. without high investment. Derivativeinstruments also protects the portfolio of the investor by paying asmall premium amount. It gives the significant scope of makingprofits with minimum amount of risk involved. The advantage of derivative trading can be summarised as follows :

(1) Advantage of Leverage2) Advantage of Hedging

(3) Advantage of Arbitrage(4) Power to Defer

Benefits of Derivative Trading


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Contract Specifications

1.Trading Cycle Maximum of 3 month

(a) Current Month

(b) Near Month(c) Far month

2.Expiration Day Last Thursday of the expirymonth

3. S ettlement Price Closing value of the underlyingsecurity.

4. S ettlement Mode No physical delivery is allowed.


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Margin RequirementInitial Margin Payable at the time of

execution of the contract.

Mark to Market Margin Payable on dailybasis to cover price fluctuations


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The payoff of a futures contract is directly proportional to the spot price of the underlying. As the spot price increases the profit from the boughtfuture also increases or as the spot price decreases the loss from thebought future also increases.

Profit

Loss

0Spot Price

Payoff profile of a bought future

FUTURE


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P r fit

ss

t P rice

Payoff profile of a sold future


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Call option

Profit

Loss

0Spot PricePremium = Max

Loss

Strike PriceBEP

Payoff profile of a buyer of a call

It is an option to buy an asset at a strike price without any obligati


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Let S = S pot PriceX = S trike priceP = Premium; then

S cenario 1: S > (X + P) = Profit = S (X + P)

S cenario 2: S = (X + P) =BEPS cenario 3: X < S < (X + P) = Loss = (X + P) SS cenario 4: S < X = Max. Loss = P

Pay-off of a call option


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P r fit

ss

t P rice

P remium = MaxP r fit

trike P rice

BEP

Payoff profile for a seller of a call


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Payoff profile for a seller of a call

S cenario 1: S < X = Max. Profit = P

S cenario2: X< S < (X + P) =Profit = X + P S

S cenario 3: S = (X + P)= BEP

S cenario 4: S > (X + P) = Loss = S (X + P)


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P r fit

ss

t P rice P remium = Max ss

trike P riceBEP

Put OptionPut option is an option to sell an underlying asset at the strike pricewithout any obligation.

Payoff profile for a buyer of a put


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Payoff profile for a buyer of a put

S cenario 1: S < (X P) =Profit = X (S + P)

S cenario 2: S = (X P) =BEP

S cenario3:(X P)< S < X= Loss = P (X S )

S cenario 4 : X < S =Max Loss = P


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Profit

Loss

0 SpotPrice

Premium = Max Profit

Strike Price

BEP

Payoff profile for a seller of a put


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Payoff profile for a seller of a put

S cenario 1: X > S = Max. Profit = P

S cenario2: X> S > (X P)= Profit = S (X P)

S cenario 3: S = (X P) =BEP

S cenario 4: S < (X P) = Loss = S (X P)


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Hedging

Hedging is a strategy in which two simultaneouspositions are adopted by the trader in order to protect

any possible lossProfit

Loss

0 Spot Price Premium on Buying put

Strike Price

Payoff of put option

Payoff of BuyFuture

Buy future and buy put


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P r fit

ss

t P riceP remium nBuying Call

trike P rice

P ay ff f ellFuture

P ay ff f BuyCall

S elling future and buy Call


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Straddle

S traddle is a combination strategy of buyingsimultaneously call as well as put with the same

strike price and maturityProfit

Loss

0Spot Price

Premium on Buying Call

Premium on Buying put

Loss Loss

Profit Profit

Strike price minus

premiumStrike

price

Strike price plus premium


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Pro f

oss

0SpotPrice

Premium onSelling a put

Premium onSelling a Call

LossLoss

Pro f it Pro f itStrike price

minus premium

Strike price

Strike price plus premium

Straddle


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S PREAD ST RA T EGIE S


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A spread is the difference between premium received onselling an option and premium paid on buying on option.

It is a simultaneous purchase and sale of option contractsi.e. put or call on the same underlying security.

T he objective of spread strategy is to benefit fromfavourable movement in market price of a security alongwith the restriction of downside.

S pread


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A bull spread is established when an investor expects an increase in prices of the underlying

security.

A bull call can be created by buying a call at lower strike price and selling a call at higher strike price.

The price of the bull spread in the premium paid onbought call and the premium received on sold call.

Bu ll Spread :


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1 . Max. Loss = Difference in premium i.e. premium paid Premium received.

2. Max. Gain = [(Strike price on short position) + (OptionPremium Received)] [(Strike Price on Long position) +(Option Premium Paid)] Or Diff in strike price Max.Loss.

3. 3. EP = Strike Price at bought option + Max. Loss

Payoff Profile of a bull spread


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A bear call is established when an investor

desires a down trend in the price of theunderlying security.

A bear call is created by buying a call at ahigher strike price and selling a call at lower strike price.

Bear Spread :


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1 . Max Profit = Difference in option premiums i.e.Premium received Premium paid.

2. Max. Loss = Difference in exercise price MaxProfit

2. 3. EP = Strike price of the option sold+ Max.Profit.

The payoff of this strategy


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The box spread also requires execution of 4 trades related

to options. The strategy is as follows :

(I) Buy a bull call spread i.e. buying a call at lower strike price and selling a call at higher strike price.

(ii) Buy a put bear spread : Buying a put at higher strike price and selling a put at lower strike price.

Box Spread :


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T he payoff position of the box spread is as follows :

1 . ost of the ox = ost of ull all Spread + ost of bear

put spread2. Profit = Diff in Strike price ost of the ox

3. T he box spread is established to take advantage of

insufficient pricing of bull and bear spread. I f thedifference in strike price is higher then the cost of box, aguaranteed profit opportunity exists provided that all tradesare executed simultaneously at the specified prices.

The Payoff Position


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T he butterfly spread is useful to a trader who expects thatthe price of the underlying will remain range bound.

T he butterfly spread can be created by adopting thefollowing strategies :

(i) T wo call short position on mid strike price.

(ii) One call long position at lower striking price;and

(iii) One call long position at the higher striking

price.

Bu tterfly Spread :


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Trading in derivatives is highly risky unless it isprotected by certain strategy. The minimum contract size

and the market lot of derivative trading are very high for a small investor to deal in. the volatility of the underlyingand the premium/discount on the market price alsoeffects the future price. High open-interest on a

particular expiry date also increases the volatility of themarket. It is therefore required to give close look on thevarious factors of derivative trading.

Risk In Trading


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Trading strategies in derivatives should be framedwith utmost care and caution

Words of Caution

1. Investor's experience in the capital market.2. Investor's willingness to accept risk.3. Age and health of investor.4. Financial strength of the investor.5. Nature of job and family responsibilities.6. Availability of liquid reserves.

7. Investor's devotion towards the market

Following points should be considered carefullybefore making any attempt in the derivativemarket :


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Forward Contracts (Regulation) Act (FCRA), 1952defines goods as every kind of movable property.

All goods and products of agricultural (includingplantation), mineral and fossil origin are allowed for commodity trading .The national commodity exchanges, recognized by the

Central Government, permits commodities which includeprecious (gold and silver) and all metals; cereals andpulses; cotton; oilseeds, oils and raw jute and jutegoods; sugar; coffee and tea; rubber and spices and

many more products..

COMMODITY FUTURE


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Government of India has allowed forward transactions in commoditiesthrough the following Online Commodity Exchanges

National Commodity & DerivativesExchange Limited (N CDEX)

Multi Commodity Exchange of India

Limited (MCX)N ational Multi-Commodity Exchangeof India Limited (N MCEIL)

CURRENCY FUTURE


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Hedgers: :Hedgers are those who protect themselves

from the risk associated with the price of anasset by using derivatives. A person keepsa close watch upon the prices discovered in

trading and when the comfortable price isreflected according to his wants, he sellsfutures contracts. In this way he gets an

assured fixed price of his produce .

Types of Trades in

Commodity Derivatives


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Speculators: :S peculators are some what like a middleman. They are never interested in actualowing the commodity. They will just buyfrom one end and sell it to the other inanticipation of future price movements.They actually bet on the futuremovement in the price of an asset.

COMMODITY FUTURE


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Arbitrators: :

Arbitrators are the person who take theadvantage of a discrepancy between pricesin two different markets trades or products.If he finds future prices of a commodityedging out with the cash price, he will takeoffsetting positions in both the markets tolock in a profit .

COMMODITY FUTURE


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Margin RequirementInitial Margin Payable at the time of

execution of the contract.

Mark to Market Margin Payable on dailybasis to cover price fluctuations


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The payoff of a futures contract is directly proportional to the spot price of the underlying. As the spot price increases the profit from the boughtfuture also increases or as the spot price decreases the loss from the

bought future also increases.Profit

Loss

0 Spot Price

Payoff profile of a bought future

COMMODITY FUTURE


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Payoff profile of asold future

COMMODITY FUTUREProfit

Loss

0 Spot Price


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Details of Contract Specificationof US D /IN R futures

S YMBOL : U S DINR

UNIT OF TRADING : 1000 U S D

TRADING HOUR S : MONDAY- FRIDAY

(9.00am to 5.00 pm)

TRADING CYCLE : 12 MONTH S


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Initial margin:Nearly 3% of the value of the Contract

Mark To Market As per the marketcondition

Calendar spreads:

Minimum Rs. 250/- per

contract for all months of spread

MARGIN


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Daily /Final :

Daily settlement :

on average prices.

F inal settlement :on RBI referencerate.

Mode of settlementCash settled inIndian Rupees

Settlement


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TRADING S PREAD

S PREAD : I t is a simultaneous purchase andsale of futures contracts on the sameunderlying security.

T he objective of spread strategy is to benefit

from favourable movement in market price of a security along with the restriction of downside


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TRADING CALENDER S PREAD

S TRATEGY :

BUYING NEAR MONTH CONTRACT

AND SIMULTANEOUSLY

S ELLING FAR MONTH CONTRACT


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DERIVATIVES ARE THEFINANCIAL WEAPON OF

MASS PROTECTION AND AN

EXCELLENT VEHICLE FOR

ACCUMULATING WEALTH

Dr.B.L.GUPTA


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Stock Market Operations and Derivative Trading

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