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CHAPTER 1
INTRODUCTION

A derivative is a contract or a product whose value is derived from the value of some other asset
known as the underlying.

1. 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on various
commodities.
2. 1865, the CBOT went a step further and listed the rst “exchange traded” derivative contract
in the US. These contracts were called “futures contracts”.
3. 1919, Chicago Butter and Egg Board, a spin-o of CBOT, was reorganised to allow futures
trading. Later its name was changed to Chicago Mercantile Exchange (CME).
4. 1972, Chicago Mercantile Exchange introduced International Monetary Market (IMM), which
allowed trading in currency futures.
5. 1973, Chicago Board Options Exchange (CBOE) became the rst marketplace for trading
listed options.
6. 1975, CBOT introduced Treasury bill futures contract. It was the rst successful pure interest
rate futures.
7. 1982, Kansas City Board of Trade launched the rst stock index futures.

Factors of derivative market growth: Volatility, Integration, Risk Management, Innovation

1. Volatility in underlying asset prices.

2. Global nancial markets Integration.
3. Enhanced understanding of market participants about risk management.
4. Frequent innovations in derivatives market.

Indian Derivatives Market Timeline

1996: 24–member committee under Dr. L. C. Gupta to develop regulatory framework for
derivatives trading. Recommendations: derivatives should be declared as ‘securities’ so that
regulatory framework applicable to trading of ‘securities’ could also govern trading of
derivatives.
1998: A committee under Prof. J. R. Varma, to recommend measures for risk containment in
derivatives market.
1999: The Securities Contract Regulation Act (SCRA) was amended to include “derivatives”
within the domain of ‘securities’ and a regulatory framework was developed for governing
derivatives trading.
2000: SEBI approved trading in index futures contracts based on Nifty and Sensex, which
commenced trading in June 2000.
2001: Trading in index options commenced in June 2001 and trading in options on individual
stocks commenced in July 2001. Futures contracts on individual stocks started in November
2001.

Products in the Derivatives Market

Forwards: agreement between two parties to buy/sell an underlying asset at a certain future
date for a particular price pre-decided on the date of contract. Both the contracting parties are
committed and are obliged to honour the transaction irrespective of the price of the underlying
asset at the time of delivery. Since forwards are negotiated between two parties, the terms and
conditions of contracts are customised. These are over-the-counter (OTC) contracts.
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Futures: Futures are essentially exchange traded forward contracts, except that the deal is
made through an exchange rather than being negotiated directly between two parties. Futures
are standardised contracts (lot size, maturity date) so that they can be traded on the exchange.
Options: 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 the buyer of an option pays the premium
and buys the right, the writer/seller of an option receives the premium with the 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 ows in the
future according to a prearranged formula. Swaps are a series of forward contracts; just as a
forward contract is an agreement to buy or sell an asset at a speci c future date for a price
agreed upon today, a swap, such as an interest rate swap, involves repeated exchanges of
cash ows at multiple future dates. Example: If a 5-year interest rate swap involves quarterly
payments, it essentially behaves like 20 forward contracts, each set to exchange cash ows at
the end of a quarter. Each of these exchanges is based on: A xed rate determined at the start,
and a oating rate that will be known just before the payment date.
Application of Swaps: help market participants manage risks associated with volatile interest
rates, currency exchange rates and commodity prices.

Market Participants:
1. Hedgers: Goal: Reduce or eliminate nancial risk (like interest rate, currency, or commodity
price risk). Who? Corporations, banks, or investors with existing exposure. How? Use
derivatives to lock in prices or rates to protect against adverse movements. Example: A U.S.
company expecting payment in euros in 6 months uses a currency forward to lock in the
USD/EUR rate, avoiding the risk of currency uctuation.
2. Speculators (Traders): Goal: Pro t from market movements by taking on risk. Who? Hedge
funds, active traders, or individuals betting on price changes. How? Buy or sell derivatives
to gain exposure without owning the underlying asset. Example: A trader believes interest
rates will rise, so they enter into a swap to receive oating and pay xed, aiming to pro t
from the rate increase.
3. Arbitrageurs: Goal: Earn risk-free pro ts by exploiting price di erences in related markets.
Who? Professional trading rms or institutional investors. How? Simultaneously buy low and
sell high in di erent markets or instruments. Example: If a swap is priced di erently in two
markets (say New York and London), an arbitrageur might enter opposite positions in both to
lock in a guaranteed pro t without taking directional risk.

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. A
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.

OTC Derivative Market

The OTC market is not a physical marketplace but a collection of broker-dealers scattered
across the country. The main idea of the market is more a way of doing business than a place.
Features of OTC Derivatives Market:
1. Customised contracts.
2. Credit risk managed by individual parties.
3. No central limits on positions, leverage, or margins.
4. Lacks formal risk management rules for market stability.
5. Private transactions with minimal disclosure.
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Exchange Traded Contracts Market
1. Standardised.
2. Traded on organised exchanges with prices determined by the interaction of buyers and
sellers through anonymous auction platform.
3. A clearing corporation guarantees settlement of transactions.

Signi cance (applications) of Derivatives:

1. Improved Price Discovery: Derivatives re ect the collective expectations of future prices —
whether for stocks, interest rates, commodities, or currencies. Traders’ actions, based on
deep analysis and information, make these prices more re ective of the “true value.” These
prices often lead spot market prices, acting as indicators. Example: If crude oil futures for
next month rise sharply, it may signal that the market expects higher oil prices — giving
producers and consumers early signals.

2. Risk Transfer (From Hedgers to Speculators): Derivatives allow those exposed to risk
(hedgers) to shift it to those willing to bear it (speculators). Example: A farmer (hedger) locks
in a future sale price via futures, o oading price risk. A speculator takes the opposite side,
betting on price movements for pro t. Risk is not destroyed but reallocated to parties who
can better manage or are willing to bear it.

3. Organised Speculation & Systemic Stability: The derivatives market shifts speculative
activities from informal, unregulated settings to regulated exchanges. Derivative exchanges
(like CME, NSE) enforce strict margin rules, clearing systems, and surveillance. Trades are
transparent and settled through central clearing houses.
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CHAPTER 2
UNDERSTANDING THE INDEX

An index is a portfolio of securities that represent a particular market or a portion of a market.

Each index has its own calculation methodology and usually is expressed in terms of a change
from a base value. The base value might be as recent as the previous day or many years in the
past. Thus, the percentage change is more important than the actual numeric value.
A stock index is created to provide market participants with the information regarding the
average share price movement in the market.
Stock Index serves as a benchmark for portfolio performance.

Types of Stock Market Indices

Market capitalisation weighted index: Each stock is given a weight according to its market
capitalisation. Outstanding shares refer to all the shares of a company that are currently held by
shareholders, including: Retail investors, Institutional investors (mutual funds), Insiders
(company executives and employees). Outstanding shares do not mean unsold shares. Unsold
shares, if any, would be held in treasury stock (shares the company has issued but bought
back or held for future use). These do not count towards market capitalisation. Popular indices
in India, Sensex and Nifty, were earlier designed on market capitalisation weighted method.
1. Market Cap=Share Price×Total Outstanding Shares
2. Index Value = Total Market Capitalisation of all companies/ Number of Companies
3. Weight of X =(Market Cap of Company X / Total Market Cap of All Companies )×100

A Free-Float Market Capitalisation Index uses only the freely tradable shares of a company
(called free oat) to calculate its weight in the index — not the total outstanding shares. Free
oat excludes shares held by promoters or company insiders, government holdings, employee
stock options (not yet vested). It gives a more realistic picture of what’s actually available in the
market for trading. If most shares are locked in by insiders or promoters, they don’t a ect daily
trading much — so they shouldn’t dominate the index weight. Let’s say two companies have the
same total market cap, but: Company A: 90% of its shares are freely traded. Company B:
Only 40% are freely traded (rest held by promoters). In a Free-Float Index, Company A would
get a much higher weight than Company B — because more of its shares are actually part of the
active market. Example: Nifty 50, Sensex, S&P 500.
1. Free-Float Market Cap=Share Price×Free-Float Shares
2. Index Value = Total Free Float Capitalisation of all companies/ Number of Companies
3. Weight of X=(Free-Float of X/Total Free-Float All Companies )×100

Price Weighted Index: each stock in uences the index in proportion to its price. So, companies
with higher stock prices have more in uence on the index — even if they’re smaller companies.
Not realistic in modern markets — because price doesn’t re ect company size. Nikkei 225, Dow
Jones Industrial Average (DJIA) is a classic price-weighted index.
1. Index Value = (Sum of Prices of All Stocks) / Divisor
2. Weight of Company X=(Price of Stock X / Sum of Prices of All Stocks )×100

Equal Weighted Index: every stock has the same weight, regardless of its price or market
capitalisation. That means small and large companies in uence the index equally. Equal impact
per stock = more exposure to small/mid-cap stocks; helps avoid over-concentration in large-
cap companies. Can be more volatile than market-cap weighted indices.
The number of shares of each stock is adjusted in such a manner that the value of all stocks in
the index is equal. Thus, each stock has the same weight in the index. Changed prices over a
time period di erently a ects weights (increasing some, decreasing some), this needs to be
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rebalanced by buying stocks which now have lower weight than before, and selling those stocks
which now have higher weight than before.
Index Return = Sum of Return on each stock (+/-)/ Number of Stocks

Impact Cost
Liquidity in the stock market means you can buy or sell large quantities of a stock without
causing much change in its price. Impact cost typically refers to the price movement that
occurs when an investor places a market order that is large enough to move the market price
of the asset. This happens because market orders are executed immediately at the best
available price, which can cause slippage (the di erence between the expected price and the
actual execution price).

Buy Side (Bids): These are people willing to buy, at the following prices:
Price Quantity

4.0 1000

3.9 1000

3.8 2000

3.7 1000

Sell Side (Asks): These are people willing to sell, at the following prices:
Price Quantity

4.5 2000

4.55 1000

4.7 500

4.75 100

Bid-Ask Spread: Best Buy Price (Bid) = ₹4.00, Best Sell Price (Ask) = ₹4.50. So, Bid-Ask Spread
= ₹0.50
Example of a Trade: Case 1: Market Buy Order for 100 shares: You buy from best available seller
→ at ₹4.50
Case 2: Then you Sell those 100 shares: You sell to best available buyer → at ₹4.00
Result: Buy at ₹4.50, Sell at ₹4.00, Loss = ₹0.50 × 100 = ₹50
This ₹50 loss is not due to price movement, but due to the spread — this is like the "fee" you
pay to the market to enter and exit quickly. This is part of what we call "impact cost" — the
hidden cost of trading, especially in less liquid stocks with wider spreads.

Impact cost is the hidden cost of trading large quantities in the market. It shows how much
more you pay while buying, or how much less you get while selling, compared to the ideal price.
It happens due to limited liquidity — when large orders can't be lled at one price. Ideal price is
the average of Best Buy Price and Best Sell Price. Example Best Buy = 9.8, Best Sell = 9.9 then
Ideal Price = 9.85

Actual Price Paid according to sell side:

Price Quantity

9.9 1000

10 500
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If we want 1500 shares; Actual Price Paid = ((1000x9.9)+(500x10))/1500 = 9.9333

Impact Cost (Buy Side): (9.9333-9.85)/9.85 = 0.84%. So, we paid 0.84% more than the ideal
price due to lack of liquidity. Impact cost increases with the size of the order. It is a better
measure of liquidity than just the bid-ask spread. A highly liquid stock will have low impact
cost, even for large trades.
Buy-side Impact cost shows how much we paid extra due to market depth limitations.
Sell-side impact cost shows how much our return was reduced due to market depth limitations.
A stock is highly liquid if you can buy or sell it quickly, in large quantities, without signi cantly
a ecting its price. A stock is liquid when it's easy to enter and exit, even with large orders, at
prices close to the current market rate. Factors that in uence liquidity:
1. Higher daily volume = more buyers & sellers; your order is more likely to get matched quickly.
2. Stocks that attract more investors, traders, institutions tend to have better liquidity.
3. Large-cap stocks are usually more liquid than small/mid-cap stocks, because they're more
widely held and traded.
4. Narrow spread = more liquid; shows that buyers and sellers are close in their expectations.
5. More activity → tighter spreads → more participation → better liquidity: This creates a self-
reinforcing cycle in highly liquid stocks.

Best Buy Price (Best Bid): This is the highest price someone is willing to pay for a stock at the
current moment. "I want to buy, and here's the best o er I’ve made.” If you place a market sell
order, it will hit the best buy price.

Best Sell Price (Best Ask/O er): This is the lowest price someone is willing to sell the stock for
right now. "I want to sell, and here’s the lowest price I’ll accept.” If you place a market buy
order, it will hit the best sell price.

The di erence between best buy and best sell = Bid-Ask Spread, which re ects liquidity and
transaction cost.

In illiquid stocks, large market sell orders can drain the buy side, forcing the seller to accept
lower and lower prices — this causes a price crash and shows how shallow order books
amplify price movement.

Order Book Depth: number of unmatched (pending) and sell orders at various price levels, and
with large quantities.

Feature Deep Order Book Shallow Order Book

Bid-Ask Spread Narrow (e.g., ₹0.50) Wide (e.g., ₹1.50)

Available Volume High Low
Price Stability High (less volatile) Low (more volatile)
Impact of Large Orders Minimal Severe (big price swings)

Market Order: "Just get it done—buy/sell immediately at best available price.” Executes
instantly at current best available price in the market. Priority: Speed > Price.

Limit Order: "Get it done — but only at this price or better.” Example: Placing a limit buy order at
₹99 will only execute if someone is willing to sell at ₹99 or less. You specify the price at which
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you’re willing to buy/sell. Order will execute only if the market hits your price. Priority: Price >
Speed.
Index Management
BSE indices are managed by Asia Index Pvt Ltd and NSE indices are
managed by NSE Indices Limited.
1. Construction: Selecting index stocks and deciding how the index is calculated. A good
index is a trade-o between diversi cation and liquidity. A well-diversi ed index re ects the
behaviour of the overall market/economy.
2. Maintenance: Adjusting the index for corporate actions (bonus, split, merger, etc.).
3. Revision: Replacing stocks in the index based on market trends or investor interest;
continuous exercise to ensure that the index captures the most vibrant lot of securities.

Application of Indices
1. Index Funds: These funds invest in index stocks in the proportions in which these stocks
exist in the index.
2. Index Derivatives: derivative contracts which have the index as the underlying asset. Index
Options and Index Futures are the most popular derivative contracts worldwide.
3. Exchange Traded Funds: investment funds that are traded on stock exchanges, just like
individual stocks. Diversi ed: Hold multiple securities in one fund. Lets say the index upon
which the ETF is based has 50 companies; When you buy a unit of this ETF, you’re indirectly
investing in all 50 companies in the same proportion as the index. You get exposure to the
top 50 companies with just one investment.
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CHAPTER 3
INTRODUCTION TO FORWARDS AND FUTURES

Forward Contracts: agreement made directly between two parties (a bilateral contract) to buy or
sell an asset on a speci c date in the future, at the terms decided today. Any alteration in the
terms of the contract is possible if both parties agree to it. The essential idea of entering into a
forward is to x the price and thereby avoid the price risk.

Limitations of Forwards
1. Liquidity Risk: Liquidity refers to the ability of the market participants to buy or sell the
desired quantity of an underlying asset. Their tailor-made nature and their non-availability on
exchanges creates illiquidity in the contracts. Therefore, it is very di cult for parties to exit
from the forward contract before the contract’s maturity.
2. Counterparty Risk: risk of an economic loss from the failure of the counterparty to ful l its
contractual obligation. A party to the contract may default on his obligation if there is
incentive to default. This risk is also called default risk or credit risk.
3. Lack of transparency, settlement complications as it is to be done directly between the
contracting parties.

Futures Contracts: agreement made through an organised exchange to buy or sell a xed
amount of a commodity or a nancial asset on a future date at an agreed price. The clearing
corporation associated with the exchange guarantees settlement of these trades. A futures
buyer takes a long position, and a futures seller takes a short position.

Limitations of Futures Contract:

1. Limited maturities.
2. Limited underlying set.
3. Lack of exibility in contract design.
4. Increased administrative costs on account of MTM settlement.

Contract Speci cations: The exchange decides all terms and conditions (contract speci cations)
of futures contracts other than the price of the futures contract.
1. Underlying instrument and underlying price: The underlying instrument refer to the index or
stock on which the futures contract is traded. The underlying price is the spot price or the
price at which the underlying asset trades in the cash market.
2. Contract multiplier or Contract Size: Futures contracts are traded in lots. The lot size or
contract size for the index and stock futures is determined by the exchange. Contract sizes
are di erent for each stock and index traded in the derivatives segment. The contract size
can be changed by the exchange from time to time, depending upon the changes in the
index level and stock prices. To arrive at the contract value, we must multiply the futures
price with the contract multiplier (i.e., multiply the futures price with the lot size). The
contract size for the Nifty futures contract is currently 75. As per SEBI’s 2023 circular,
futures and options contracts earlier had to be worth ₹5–10 lakhs. A new contract must be
worth at least ₹15 lakhs when launched. Contract Value tells you how much money you're
e ectively trading. Even though you pay only a margin, your market exposure is equal to
the full contract value.
3. Contract Cycle: It is a period over which a contract trade. Index and stock futures contracts
traded on the NSE follow a three-month trading cycle. Thus, on Oct 03, 2024, index and
stock futures contracts on the NSE are available for trading for the near month (Oct 2024),
the next month (Nov 2024) and the far month (Dec 2024). The BSE o ers trading on monthly
as well as weekly futures contracts.
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4. Expiration Day: This is the day on which a derivative contract ceases to exist. It is the last
trading day of the contract. On expiry date, all the contracts are compulsorily settled. If a
position is to be continued, then it must be rolled over to another futures contract of the
same underlying. For a long position, this means selling the expiring contract and buying the
next contract. Both the sides of a roll over should be executed at the same time.
5. Tick Size: It is the minimum move allowed in the price quotations. Exchanges decide this.
Tick size for Nifty futures is 5 paisa.
6. Daily settlement (mark to market settlement) price: The exchange follows a daily settlement
procedure for open positions in equity index and stock futures contracts. All open positions
are settled daily based on the daily settlement price of the futures contracts, which is
calculated by the exchange on the basis of the last half-an-hour weighted average price of
that futures contract. Thus, the daily settlement price is di erent for each futures contract of
a di erent expiry month.
Example: Imagine you bought 1 lot of Nifty Futures (lot size = 75) at a price of ₹22,000. At
the end of the day, the Exchange calculates the daily settlement price using the last 30
minutes’ weighted average of the Nifty Futures price. Let’s say that price comes out to be
₹22,050. Your buy price = ₹22,000, Daily settlement price = ₹22,050, Gain = ₹50 per unit, Lot
size = 75, Pro t = ₹50 × 75 = ₹3,750. This ₹3,750 is credited to your account by the
clearing corporation at the end of the day. This is done daily, so even if you hold your
position for a week, your account is settled every day at the day’s settlement price.
Even though futures contracts are based on the same stock or index, there are multiple
contracts with di erent expiry months — like: Nifty April Futures (expires end of April),
Nifty May Futures (expires end of May), Nifty June Futures (expires end of June). Each of
these contracts trades at di erent prices because they have di erent time to expiry and they
include di erent expectations about the future.
7. Final settlement price: This is the price at which all open positions in the near-month futures
contracts are nally settled on the expiration day of the near-month futures contract. The
nal settlement price is the closing price of the relevant underlying index or stock in the cash
segment on the last trading day of the futures contract. Let’s say your Nifty futures contract
expires on 27th June, and you haven’t squared o your position. On expiry day, your open
position will be automatically settled based on the nal settlement price. Final settlement
price = closing value of Nifty index in cash market = ₹22,200. Your original buy price =
₹22,000, Pro t = ₹200 per unit, Lot size = 75, Final Pro t = ₹200 × 75 = ₹15,000. This nal
settlement happens only on the expiry day, and it applies to all contracts of that expiry
month.

Terminology
1. Basis: di erence between the spot price and the futures price. If Spot Price > Futures Price
→ Basis is Positive, vice versa. Basis di ers for 1, 2, or 3 futures contracts because Price
expectations are di erent for di erent time periods, Holding the asset for longer involves
more costs (storage, interest), which gets re ected in the futures price. The di erence
between one-month and two-month futures prices should equal the cost of carrying the
asset from the rst to the second month. This links futures prices to the cash market. During
the life of a futures contract spot and futures prices move so, the basis can change,
becoming more or less positive/negative. At the expiry date of a futures contract futures
price = spot price, because the contract settles at the nal closing price of the asset, so
basis = 0.
2. Cost of Carry: links futures and spot prices. It includes storage and interest costs minus any
income from the asset. For equities, it's interest cost minus dividends earned. If ABC Ltd's
share is ₹100, and a person borrows ₹100 at 6% interest to buy it, they'll pay ₹6. If they
receive a ₹2 dividend, the net cost of carry is ₹4. So, their breakeven futures price is ₹104.
Cost of carry varies by participant.
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3. Open Interest: total number of contracts outstanding (to be settled) for an underlying asset.
Day Trades Open interest Trading volume Why OI Changed
at day end for the day

Day 1 A shorts 50 contracts 50 50 Both sides have opened new positions; each
B goes long in 50 contracts new contract adds +1 to OI, so OI = 0 + 50 = 50.
Volume = total contracts traded = 50.

Day 2 C goes long in 100 contracts 150 100 Another 100 brand‑new longs and shorts are
D goes short in 100 contracts created. OI rises by 100 to 150. Volume = 100.

Day 3 A closes short position by 150 50 A’s buy‑to‑close cancels one of the original
buying back 50 contracts shorts, but E’s new short immediately replaces it.
E shorts 50 contracts No net change in total open contracts, so OI
stays 150. Volume = 50.

Day 4 C closes long position by 50 100 Both sides fully exit those 100 positions. Closing
selling 100 contracts and D both long and short reduces OI by 100 down to
closes short position by 50. Volume = 100.
buying back 100 contracts

Open Interest rises when new long & short positions are opened (Day 1, Day 2).
Open Interest falls when existing long & short positions are both closed (Day 4).
Open Interest stays the same if one trader closes a position but another opens the same size
position (Day 3).
Trading Volume simply counts how many contracts changed hands each day, regardless of
whether they opened or closed positions

4. Price Band: the prede ned daily trading range within which a contract can move, based on
the previous day’s closing price of the contract. For example, if a contract closed at ₹100
and has a 10% price band, it can trade between ₹90 and ₹110 the next day. On a contract’s
rst day, the band is based on the previous day's closing price of the underlying asset in the
cash market. It stops irrational or panic-driven price swings. Prevents manipulation or
unexpected shocks that could hurt small traders.
5. Long Position: Outstanding / unsettled buy position in a contract. The term comes from the
idea of being in for the long haul to gain from rising prices.
6. Short Position: Outstanding / unsettled sell position in a contract. The term comes from
being short of the asset.
7. Open Position: Outstanding / unsettled either long or short position in various derivative
contracts. Open position = Net contracts still held. Buying/selling futures reduces or o sets
open positions if it’s the opposite side of an earlier trade with same maturity. Example: if on
day 1 you are short 5 on ABC Futures, and the next day you are long 2 on ABC Futures
(same maturity) then your net position is short 3 on ABC Futures.
8. Naked Position: taking a long or short position without holding any underlying asset.
9. Calendar Spread: involves holding opposite positions (long and short) in futures contracts of
the same asset but with di erent maturities. For example, a short position in a near-month
contract and a long position in a far-month contract forms a calendar spread. The spread is
de ned by the months of the contracts, like between August and September, and becomes
an open-position once the near-month contract expires or a position is closed.

Payo Charts for Futures Contracts

Long as well as short position has unlimited pro t or loss potential. This results into linear
payo s for futures contracts. {K is the entry price; The price per unit (contract value/lot size) at
which the futures contract is bought or sold.}
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Futures Pricing
There is no single way to price futures contracts because di erent assets have di erent demand
and supply patterns, di erent characteristics and cash ow patterns.

Cost of Carry Model (aka no-arbitrage model): It assumes markets are e cient, so no free
money (arbitrage) can exist for long. If there are arbitraging opportunities arbitrageurs will buy in
one market and sell in another to pro t from the gap. This high volume buying and selling
pushes prices back to fair levels.
Example: Stock: ABC Ltd, Spot Price today: ₹1,000, Cost of Carry for 1 month (e.g., interest
for nancing): ₹10. So, Fair Futures Price = ₹1,000 + ₹10 = ₹1,010

Cash-and-Carry Arbitrage (Futures overpriced): Suppose ABC Futures for 1 month is trading
at ₹1,030 (i.e., overpriced by ₹20)

Strategy: Borrow ₹1,000 at 1% monthly interest (₹10), Buy ABC share in cash market at ₹1,000,
Sell 1-month ABC futures at ₹1,030

After 1 Month: Deliver the stock in the futures market and receive ₹1,030, Repay ₹1,010 (₹1,000
principal + ₹10 interest), Risk-free pro t = ₹1,030 – ₹1,010 = ₹20

As more traders do this, spot price goes up, futures price goes down, and arbitrage vanishes.

Reverse Cash-and-Carry Arbitrage (Futures Underpriced): Suppose ABC Futures is trading

at ₹990 (underpriced by ₹20)

Strategy: Sell ABC share in cash market at ₹1,000 (borrow if needed), Invest ₹1,000 for 1 month
at 1% → becomes ₹1,010, Buy 1-month futures at ₹990

After 1 Month: Receive ABC share via futures contract, Return the borrowed share, Keep the
₹1,010 (invested cash), Cost to buy share = ₹990, so Pro t = ₹1,010 – ₹990 = ₹20

As more traders follow, spot price falls, futures price rises, arbitrage disappears.

Cost of transaction and no-arbitrage bounds: Margins, commissions, taxes, and other costs
create no-arbitrage bounds—a range around the fair futures price where arbitrage isn’t
pro table. Only when the futures price moves outside these bounds can arbitrageurs earn a
pro t and take action.
Wider no-arbitrage bounds mean price misalignments can exist without being pro table to
exploit. This allows ine ciencies to persist longer.
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Narrow no-arbitrage bounds mean even small misalignments become pro table to arbitrage.
Arbitrageurs act quickly → prices align faster. Market becomes more e cient as mispricings
vanish rapidly.
Narrow bounds invite correction; wide bounds allow distortion. The tighter the bounds, the
sharper the market.
Arbitrage opportunities do not imply ine ciency — it's unexploited arbitrage that does.
Low costs make arbitrage more feasible — and arbitrage is what keeps markets e cient.
Arbitrage is both a symptom and a cure. It reveals ine ciency, and then removes it.

Adding the in ows during the holding period of underlying assets: underlying assets like
securities (equity or bonds) may have certain in ows, like dividend on equity and interest on
debt instruments, during the holding period. These in ows are adjusted in the computation of
the fair futures price. Fair futures price = Spot price + Cost of carry - In ows. Equation:
F=S×(1+r−q)T
Where F is fair price of the futures contract, S is the Spot price of the underlying asset, q is
expected return during holding period T (in years) and r is cost of carry.
If we use the continuous compounding, we may rewrite the formula as: F= Se(r-q)*T
Note that the cost of transaction, taxes, margins, etc. are not considered while calculating the
fair futures price.

Assumption of Cost carry model:

1. Abundant asset availability: Ensures easy access without price impact.
2. Non-seasonal demand/supply: Keeps carrying cost stable.
3. Easy to hold asset: Simpli es cost calculation.
4. Short selling allowed: Enables reverse arbitrage.
5. No transaction costs: Ensures pure price alignment.
6. No taxes: Avoids distortions in pricing decisions.
7. No margin requirements: Prevents capital lock-up from a ecting arbitrage.

Margins are not considered while computing the fair value/ synthetic futures value. That is why
this model is suitable for pricing forward contracts rather than futures contracts.

Convenience Yield: non-monetary bene t or psychological value that someone gets by

physically holding a commodity, especially during uncertain or crisis periods. It’s part of the
“in ows” in the futures pricing formula but isn't always tangible like dividends or interest.
Fair Futures Price = Spot Price + Cost of Carry - In ows - Convenience Yield
If this convenience yield is high, it can pull futures price below spot, overriding the cost of
carry. This can make futures prices fall below spot prices (called "backwardation"), because
the market values holding the physical asset more. Convenience yield mostly applies to
consumable/physical commodities (not stocks or bonds), and arises when supply is tight or
inventory is low. Opposite of backwardation: Contango (Futures Price > Spot Price); normal
situation due to cost of carry.

Expectations Model of Futures Pricing

The futures price re ects the market’s expectation of the future spot price. It’s especially
useful when the asset can't be stored or shorted. Unlike the cost of carry model, it doesn’t rely
on storage costs—instead, traders price futures based on where they think the spot price will
be. All traders are essentially guessing the spot price at a single point in time—the end of the
contract. That’s why futures prices re ect the expected future spot price, and as expiry
approaches, futures and spot prices converge. On expiry day, they become equal, so
futures are settled at the cash market price of the underlying asset. So, if futures trade
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above spot, the market expects prices to rise (contango); if futures are below spot, the market
expects prices to fall (backwardation).

Price Risk
Price Risk = Risk of asset price moving in an unfavourable direction. It has two parts:
Unsystematic (Speci c) Risk: Unique to a company or industry. Example: strike, loss of market
share. Can be reduced by diversi cation
Systematic (Market) Risk: A ects the whole market. Example: war, policy change. Cannot be
diversi ed away. Can be hedged using index futures

Hedging Tools:
Single Stock Futures: Used to hedge both speci c and market risk for a particular stock (1:1
hedge ratio). A 1:1 hedge ratio means you use one futures contract to hedge one equivalent unit
of the underlying asset. Example: You own 550 shares of HDFC Bank.. One HDFC Bank futures
contract = 550 shares. You use 1 futures contract to hedge your 550 shares.
Index Futures: Used to hedge systematic risk of an entire portfolio.

Hedging with Index Futures: Cannot use 1:1 ratio since the portfolio and index are di erent. To
nd the number of contracts of index futures required for hedging this portfolio’s risk, the hedge
ratio is calculated as follows:
Number of contracts for hedging portfolio risk = Vp * βp / Vi
Vp: Value of the portfolio
Βp: Beta of the portfolio
Vi: Value of index futures contract
For simpli cation purpose, beta of futures index vis-a-vis spot index is taken as one.

Beta (β):
Measures how much a stock/portfolio moves relative to the market.
β > 1: More volatile than market (aggressive)
β < 1: Less volatile (conservative)
Portfolio Beta: Weighted average of individual stock betas. A generalised formula for portfolio
beta can be written as W1 β1+W2 β2+…+ Wn βn= βp

Long Hedge: Used when expecting to invest in the future (time, not derivative) but fear prices
will rise. Hedge by buying index futures now. Later, invest in the cash market and unwind
futures. Helps o set higher purchase cost due to market rise.

Short Hedge: Used when planning to sell in the future but fear prices will fall. Hedge by
shorting index futures now. Later, sell portfolio and close futures, gains on futures o set cash
losses.

Cross Hedge: Used when no futures exist for the exact asset. Hedge using a related asset’s
futures (e.g., use crude oil futures to hedge jet fuel price risk). Using index futures to hedge a
portfolio is also a cross hedge.

Hedge Contract Month: Choose a futures contract that expires just after your planned exit date.
Example: If selling on June 20, use June expiry, not May.

Naked vs Spread Position

Naked position: Holding a single long or short futures contract.
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Spread position: Holding both long and short positions; two types: Inter-commodity spread:
Same maturity, di erent products. Calendar spread (or time/horizontal spread): Same product,
di erent maturities.

Calendar Spread Example

A calendar spread is created when you take opposite positions (one long, one short) in futures
of the same asset, but with di erent expiry months. The spread is always counted with respect
to the near-month contract (i.e., the earliest expiry). Spreads are partially hedged, so
considered less risky than naked positions.
Only calendar spreads are tradable in equity derivatives. Some inter-commodity spreads
exist in commodities (e.g., gold-silver). A calendar spread becomes a naked position when:
Near-month contract expires, or when one leg is closed.

Mr. A’s Positions

• Short 3 contracts in 1-month futures (near-month)
• Long 2 contracts in 2-month futures
• Long 3 contracts in 3-month futures

Mr. A has:
• 3 short (1-month)
• 2 long (2-month) → You can pair these 2 longs with 2 of the 3 shorts in 1-month to create
2 calendar spreads
• 3 long (3-month) → You can pair 1 of the remaining 1-month shorts with 1 of these to
create 1 calendar spread
So total spreads:
• 2 spreads between 1-month (short) & 2-month (long)
• 1 spread between 1-month (short) & 3-month (long)
What’s left?
• You used up all 3 shorts
• You used up 2 of the 2-month longs and 1 of the 3-month longs
• So 2 longs (3-month) are left unmatched

Final Summary:
• Calendar spreads:
◦ 2 between 1-month & 2-month
◦ 1 between 1-month & 3-month
• Leftover 2 longs (3-month) → these are naked positions (unhedged)
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CHAPTER 4
INTRODUCTION TO OPTIONS

Options have emerged as a nancial instrument which allow unlimited pro ts on buying or
selling of the underlying asset with a provision of restricting the losses.

An option is a contract that gives the holder of the option the right, but not an obligation, to buy
or sell the underlying asset on or before a stated date/day, at a predetermined price. This right
can be bought for a price known as the option premium. The party taking a long position i.e.,
buying the option is called buyer/ holder of the option and the party taking a short position i.e.,
selling the option is called the seller/ writer of the option. The option buyer must pay the
premium to the option seller upfront, i.e., at the time of buying the option.

The option buyer or holder has the right but no obligation with regards to buying or selling the
underlying asset, while the option writer has the obligation in the contract. Therefore, the option
buyer will exercise his option only when the situation is favourable to him. On the other hand,
the option writer is legally bound to honour the contract whenever the option buyer decides to
exercise his option.

Two main types of options:

1. Call: gives the buyer/holder a right to buy the underlying asset.
2. Put: gives the buyer/holder a right to sell the underlying asset.

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. He has a sell
obligation in case of a call option (i.e., when the call option holder exercises his right to buy) and
a buy obligation in case of a put option (i.e., when the put option holder exercises his right to
sell).

American option: Can be exercised any time on or before the expiry date.
European option: Can be exercised only on the expiry date. In India, all index and stock options
are European style.

Strike price or Exercise price (X): Strike price is the price per share for which the underlying
security may be purchased by the call option holder.

Exercise of Options: All options are exercised with respect to the settlement value/ closing price
of the stock on the day of expiry. (European/Indian style)

Opening a Position
An opening transaction is one that adds to or creates a new trading position. It can be either a
purchase or a sale.
1. Opening purchase (Long on option): A transaction in which the purchaser’s intention is to
create or increase a long position in a given series of options.
2. Opening sale (Short on option): A transaction in which the seller’s intention is to create or
increase a short position in a given series of options.

Closing a position
A closing transaction is one that reduces or eliminates an existing position by an appropriate
o setting purchase or sale.
1. Closing purchase: purchaser’s intention is to reduce or eliminate a short position. This
transaction is frequently referred to as “covering” a short position. You buy back an option
that you had earlier sold. You initially received a premium for selling that call. This created a
short position in that option. You buy back the same call option (same strike price, same
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expiry). You don’t pay back the premium directly to the buyer. Instead, you pay the market
price of the option at the time you're closing. If the option's price (underlying value/spot
price) went down, you buy it back cheaper → Pro t. If the option's price went up, you buy
it back higher → Loss.
2. Closing sale: seller’s intention is to reduce or eliminate a long position. You sell an option that
you had earlier bought. You do this to book pro ts or cut losses before expiry. (To exit
before expiry, you simply sell the same option (same strike, same expiry) on the exchange.
You’re not exercising the option—you’re trading it in the secondary market.)

Note: A trader does not close out a long call position by purchasing a put.

Contract Size (Lot Size): Number of units of the underlying asset. Varies by stock/index.
Example: Nifty lot = 50 units. Total premium = Premium × Lot Size.

Contract Trading Cycle:

• Stock Options: 3-month cycle – Near, Next, Far month.
• Index Options: Weekly & monthly expiries + 3 quarterly & 8 half-yearly expiries.
• Recent Rule (SEBI, Oct 2024): Only one benchmark index per exchange can have
weekly expiry (from Nov 20, 2024).

Expiry Date:
• Nifty expires on the last Thursday, Bank Nifty on last Wednesday of expiry month.
• If holiday, expiry is on previous trading day.

Tick Size (Minimum Price Movement):

• Index: ₹0.05
• Stocks: ₹0.01 if < ₹250; ₹0.05 if > ₹250 (varies by exchange and stock price).

Final Settlement Price:

• No daily settlement (unlike futures).
• For European-style options, exercised only on expiry.
• Final price = Closing price of underlying on expiry day.

Moneyness of an Option
1. In the Money
2. At the Money: Happens when the Strike Price is equal (or closest) to Spot Price.
3. Out of the Money

Premium paid a ects your nal pro t or loss, but not the moneyness; it is purely about the
spot–strike relationship, not the net outcome.
OTM (Out-of-the-
Type of Option ITM (In-the-Money) ATM (At-the-Money)
Money)
Spot Price > Strike Spot Price = Strike Spot Price < Strike
Call Option
Price Price Price
Spot Price < Strike Spot Price = Strike Spot Price > Strike
Put Option
Price Price Price

Intrinsic value and time value of an option

Option Premium = Intrinsic Value + Time Value
Intrinsic Value: It’s how much an option is in-the-money (ITM). Only ITM options have intrinsic
value. Never negative (you won’t exercise an option at a loss). Intrinsic value is your instant
gain if exercised now.
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Formulas: Call Option: Max(Spot - Strike, 0), Put Option: Max(Strike - Spot, 0)
Time Value: It’s the extra premium paid for the chance that the option may become ITM before
expiry. Time Value = Premium – Intrinsic Value. ATM and OTM options have only time value,
since intrinsic value is zero. Time value is the potential for pro t before expiry. Time value
re ects volatility (greater swings = higher chance of pro t = higher time value), Time left to
expiry (more time = more chance = more time value)

Payo Charts for Options

Long Option: Buyer of the option; has a right but no obligation. Can exercise the option. Max
loss = premium paid. Pro t depends on the underlying's price at expiry.

Short Option: Seller/writer of the option; has an obligation but no right. Can be assigned (for
American options) any time before expiry. Max pro t = premium received. Potential loss =
unlimited.

Long Call
1. You buy a call option with strike price 17,500 at a premium of ₹95 when the index is at
17,562.
2. You’ll exercise the option only if index closes above 17,500 at expiry.
3. If index closes below 17,500 → Don't exercise, loss = premium paid (₹95).
4. If index closes at 17,595 → payo = ₹95, net pro t = ₹0 (Break-even Point = strike +
premium).
5. If index closes at 18,000 → payo = ₹500, net pro t = ₹405.
6. Maximum loss = premium paid (₹4,750 for a 50-lot contract).
7. Maximum pro t = unlimited (as index rises).
8. Long call is cash-settled, no margin required, only premium is paid upfront.

Short Call:
1. Selling a call option means taking the opposite side of a long call.
2. Maximum pro t = premium received (₹95), earned if index stays below strike price (17,500).
3. Maximum loss = unlimited, if index rises above strike + premium (BEP = 17,595).
4. Losses increase as index rises; gains are capped at the premium.
5. Payo is the mirror image of the long call.
6. Seller must pay margin since their losses can be unlimited.
7. Contract value (lot size 50) = ₹8,75,000; max pro t = ₹4,750.

Long Put:
1. You buy the right to sell the index at a strike price (e.g. 17,500) by paying a premium (₹150).
2. You pro t if the index falls below the strike price.
3. If the index stays above 17,500, the option expires worthless; maximum loss = premium
paid (₹150).
4. Cash settlement: Pro t = strike – index closing – premium.
5. Maximum pro t: when index = 0 → 17,500 – 150 = ₹17,350 per unit.
6. Breakeven Point (BEP) = Strike – Premium = 17,350.
7. Lot size = 50 → Max loss = ₹7,500.
8. No margin required as buyer’s risk is limited to premium.
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Short Put:
1. You sell a put option and receive a premium (e.g. ₹150).
2. Pro t if the index stays above the strike price.
3. Max pro t = premium received (₹150); earned if index stays above strike.
4. Max loss occurs if index drops to zero (huge loss).
5. Breakeven Point (BEP) = Strike – Premium = 17,350.
6. Lot size = 50 → Max pro t = ₹7,500.
7. Losses begin below BEP and rise as index falls.
8. Margin required due to high loss potential and obligation to buy if assigned.

Risk and return pro le of option contracts

Risk Return

Long Premium Paid Unlimited

Short Unlimited Premium Received

Comparison of Options and Futures Based on Leverage:

Options: Require only a premium (a small part of the contract value) to gain market exposure.
Provide higher leverage—small investment can lead to large percentage gains. Risk is limited
to the premium paid, but 100% of it can be lost if the option expires worthless.

Futures: Require a margin deposit (usually a percentage of contract value) as collateral. Provide
moderate leverage—gains and losses are proportional to the asset’s movement. Risk is
unlimited—both pro ts and losses can be large, depending on price movement.

The characteristic of options that allows for high leverage is their non-obligatory nature—that is,
option buyers are not required to buy or sell the underlying asset, only to pay a small premium
for the right (not obligation) to do so.

Option pricing fundamentals

5 fundamental parameters on which the option price depends upon:
1. Spot price of the underlying asset: Call options increase in value as the underlying asset's
price rises. Put options decrease in value as the underlying asset's price rises, and vice
versa.
2. Strike price of the option: For call options, a higher strike price decreases the intrinsic value
and premium. For put options, a higher strike price increases the intrinsic value and
premium.
3. Volatility of the underlying asset’s price: Higher volatility increases the premium for both call
and put options due to greater price movement potential.
4. Time to expiration: Longer time to expiration increases the option’s premium due to higher
uncertainty. Time decay causes the premium to decrease as expiration approaches.
5. Interest rates: Higher interest rates increase the value of call options and decrease the value
of put options, especially for individual stocks and indices.

Option Greeks:
1. Delta (Δ): Measures the sensitivity of the option price to a small change in the underlying
asset’s price. Call options: Delta is positive (value increases as the asset price rises). Put
options: Delta is negative (value increases as the asset price falls). Used for hedging and risk
management.
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2. Gamma (Γ): Measures the rate of change in Delta with respect to a change in the underlying
asset’s price. It accelerates the Delta, indicating how quickly an option moves in or out of the
money.

3. Theta (Θ): Measures the time decay of an option, i.e., how much the option price decreases
with a one-day reduction in time to expiration. Generally negative for long options, as
options lose value as expiration approaches.

4. Vega (ν): Measures the sensitivity of an option's price to changes in market volatility.
Positive for long options (both calls and puts), meaning higher volatility increases the option
premium.

5. Rho (ρ): Measures the change in option price given a one-percentage point change in the
risk-free interest rate. A ects the cost of funding the underlying asset.

Binomial Pricing Model

• Introduced by William Sharpe in 1978, the binomial model is a exible and intuitive
approach to option pricing.
• It models the possible future prices of the underlying asset using a binomial tree, where
at each time step, the price can move up or down by xed percentages.
• Each possible price movement is assigned a probability, and the option value is
calculated by working backwards from the nal nodes to the present.
• It is highly accurate and versatile, allowing for factors like early exercise (useful for
American options), but it can be computationally intensive.

Black-Scholes Model
• Developed by Fisher Black and Myron Scholes in 1973, this model is widely used due
to its speed and simplicity.
• It calculates the theoretical price of European call and put options (not accounting for
dividends).
• The model uses ve inputs:
◦ S = Current stock price
◦ X = Strike price
◦ t = Time to expiration (in years)
◦ r = Risk-free interest rate (continuously compounded)
◦ v = Volatility of the stock (standard deviation of returns)

The Black-Scholes model is ideal for quick estimates, while the binomial model o ers more
detailed analysis when accuracy and exibility are needed.

Implied Volatility (IV):

• Implied volatility is the market’s expectation of future volatility, derived from current
option prices using models like Black-Scholes (by inputting known values and solving
for volatility).
• If a stock option is trading at a certain price, IV tells us how volatile the market expects
the stock to be to justify that price.
Use of IV in Trading:
• High IV = expensive options → traders may prefer selling options.
• Low IV = cheap options → traders may prefer buying options.
• Option writers price in possible outcomes (e.g., court verdicts) by charging higher
premiums to protect against sharp moves.
(4.10: Analysis of options from the perspectives of buyer and seller=>not covered here)
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CHAPTER 5
STRATEGIES USING EQUITY FUTURES AND OPTIONS

Futures Contracts for Hedging, Speculation, and Arbitrage

Long Hedge using Stock Futures:

Situation: You want to buy 1500 shares of ABC Ltd, but you don’t have the money now.
You’ll get the money on June 20, so you plan to buy the shares then.

Risk: If you wait till June 20, the share price might increase; You’ll have to buy at a higher
price.

Solution: You go long on a futures contract for ABC Ltd today, on May 10. This locks in a
future price for you.

The Futures Contract: Futures price today (May 10) = ₹457.30. Lot size = 1500 shares. So, you
take 1 futures contract (since you're buying 1500 shares)

On June 20 — Two Scenarios

Scenario 1: Price Goes Up

1. Spot price on June 20 = ₹520
2. So, your cash market purchase = ₹520 × 1500 = ₹7,80,000
3. Futures price now (on June 20) = ₹521.20
4. You close (square o ) your futures position
5. Pro t on futures = ₹521.20 – ₹457.30 = ₹63.90
6. Total pro t = ₹63.90 × 1500 = ₹95,850
7. Net cost of shares = ₹7,80,000 – ₹95,850 = ₹6,84,150
8. Cost per share = ₹6,84,150/1500 =₹456.10

Result: You paid ₹520 in market, but got back ₹95,850 from futures — so your e ective cost
was near ₹457!

Scenario 2: Price Goes Down

1. Spot price on June 20 = ₹390
2. So, your cash market purchase = ₹390 × 1500 = ₹5,85,000
3. Futures price now (on June 20) = ₹391.10
4. You close (square o ) your futures position
5. Loss on futures = ₹457.30 – ₹391.10 = ₹66.20
6. Total loss = ₹66.20 × 1500 = ₹99,300
7. Net cost of shares = ₹5,85,000 + ₹99,300 = ₹6,84,300
8. Cost per share = ₹456.20

Result: You bought cheaper in market, but lost on futures — again, e ective cost ~₹457

Short Hedge using Stock Futures:

Situation: You want to sell 1200 shares of PQR Ltd on July 10 to pay o a personal loan.
But you are worried that the share price might drop before that date.

Risk: If you wait till July 10, the share price might fall, and you’ll get less money from the sale.
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Solution: You sell (short) 2 futures contracts of PQR Ltd today (May 10). 2 contracts because 1
contract = 600 shares, and you have 1200 shares → 600 × 2 = 1200
Today’s spot price = ₹1690
Today’s July futures price = ₹1706
So, you short (sell) 2 futures contracts at ₹1706

On July 10 — Two Scenarios

Scenario 1: Price Falls

1. Spot price on July 10 = ₹1440
2. You sell 1200 shares in the cash market → ₹1440 × 1200 = ₹17,28,000
3. Futures price = ₹1441
4. You close your short futures position (buy back at ₹1441)
5. Pro t on futures = ₹1706 – ₹1441 = ₹265 × 600 × 2 = ₹3,18,000
6. Total amount received = ₹17,28,000 (spot) + ₹3,18,000 (futures) = ₹20,46,000
E ective selling price per share = ₹20,46,000 ÷ 1200 = ₹1705
7. Even though market fell, your hedge gave you a pro t — you still earned close to ₹1706 per
share.

Scenario 2: Price Rises

1. Spot price on July 10 = ₹1800
2. You sell 1200 shares → ₹1800 × 1200 = ₹21,60,000
3. Futures price = ₹1802
4. You close short futures (buy back at ₹1802)
5. Loss on futures = ₹1802 – ₹1706 = ₹96 × 600 × 2 = ₹1,15,200
6. Total amount received = ₹21,60,000 – ₹1,15,200 = ₹20,44,800
E ective selling price per share = ₹20,44,800 ÷ 1200 = ₹1704
7. You earned more in the cash market, but lost on the futures. So again, you e ectively got
around ₹1706 per share.

Hedging a Portfolio Using Index Futures

You have a ₹90 lakh diversi ed stock portfolio with beta = 1.3. You’re worried about a market
crash in the next month. Instead of selling everything, you can hedge market risk using index
futures. To do this, you take a short position in index futures.

How Many Futures to Short?

Use the hedge ratio formula: Hedge Ratio = (β × Portfolio Value)/(Index Futures Price × Lot Size)
Plugging in the values we get Hedge Ratio = 13.22. So, short 13 index futures contracts. If the
market falls, your portfolio loses value, but your short futures position will gain, o setting that
loss. This protects you from systematic market risk without selling your portfolio.

Using Futures for Trading (Speculation)

Bullish View: Long Futures

Example: XYZ Ltd
1. Current stock price = ₹1298
2. Futures price = ₹1300 , Lot size = 850
3. Trader expects price to go up to ₹1350
So, the trader can either:
1. Buy 850 shares in cash market:
Cost = 850 × ₹1298 = ₹11,03,300
If stock rises to ₹1345, pro t = (1345 – 1298) × 850 = ₹39,950
Return = ₹39,950 / ₹11,03,300 = 3.62%
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2. Take a long position in 1 futures contract (lot = 850):
Contract value = 850 × ₹1300 = ₹11,05,000
Margin required = 20% = ₹2,21,000
If futures price rises to ₹1346, pro t = (1346 – 1300) × 850 = ₹39,100
Return = ₹39,100 / ₹2,21,000 = 17.69%

Bearish View: Short Futures

Example: RSB Bank
1. Current stock price = ₹1595
2. Futures price = ₹1602 , Lot size = 550
3. Trader expects price to fall to ₹1520

Trader takes a short position in 1 futures contract: Contract value = ₹1602 × 550 = ₹8,81,100 ,
Margin = 20% = ₹1,76,220
If price drops and futures now trade at ₹1527: Pro t = (1602 – 1527) × 550 = ₹41,250
Return = ₹41,250 / ₹1,76,220 = 23.41%

Arbitrage using Futures

Cash-and-Carry Arbitrage (Futures Overpriced): You Buy in Cash Market and Sell Futures.
Example:
1. Spot price = ₹1500
2. 3-month futures = ₹1550
3. Cost of carry = 9% p.a. = 0.75% per month
4. Contract size = 100 shares

Fair Futures Price: Evaluated using continuous compounding.

Fair price=1500×e0.0075×3=₹1534.13
1. Market price is ₹1550 → Overpriced
2. Di erence = ₹1550 - ₹1534.13 = ₹15.87
3. Arbitrage pro t (expected to be realised) = ₹15.87 × 100 = ₹1587

Strategy: Buy 100 shares in spot at ₹1500 = ₹1,50,000. Sell 1 futures contract at ₹1550.

Outcome on Expiry:
Case I: Spot rises to ₹1580
1. Gain on spot = (1580 – 1500) × 100 = ₹8000
2. Loss on futures = (1580 – 1550) × 100 = ₹3000
3. Net gain before cost (before adjusting for carry cost)= ₹5000
4. Financing cost = ₹34.13 × 100 = ₹3413 {futures price = spot price + carry (or nance) cost;
1534.13 = 1500 + nance cost => nance cost = 34.13 per unit}
5. Net arbitrage gain = ₹5000-₹3413 = ₹1587

Case II: Spot falls to ₹1480

Loss on spot = (1500 – 1480) × 100 = ₹2000
Gain on futures = (1550 – 1480) × 100 = ₹7000
Net gain before cost = ₹5000
Financing cost = ₹3413
Net arbitrage gain = ₹1587

Note: You always earn ₹1587, regardless of price movement, because the pro t comes
from the mis-pricing.
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Reverse Cash-and-Carry Arbitrage
You Sell in Cash Market and Buy Futures.

Example:
1. Spot price = ₹100
2. 1-month futures = ₹90, Contract size = 200 shares
3. Cost of carry = 9% p.a.
4. Arbitrage di erence = ₹10 × 200 = ₹2000

Strategy:
1. Sell 200 shares at ₹100 = ₹20,000
2. Buy 1 futures contract at ₹90
You will buy back the shares at expiry and deliver to settle.

Outcome on Expiry:
Case I: Spot rises to ₹110
1. Loss on spot = ₹2000
2. Gain on futures = ₹4000
3. Net gain = ₹2000
4. Invest ₹20,000 at 9% p.a. for 1 month
Interest=₹150.56
5. Total gain = ₹2150.56

Case II: Spot falls to ₹85

1. Gain on spot = ₹3000
2. Loss on futures = ₹1000
3. Net gain = ₹2000
4. Interest = ₹150.56
5. Total gain = ₹2150.56
Again, the pro t is locked regardless of price move.

Early Exit Example:

Suppose mid-month: Spot = ₹130, Futures = ₹135
Now:
1. Loss on spot = ₹6000
2. Gain on futures = ₹9000
3. Net gain = ₹3000
4. Interest on ₹20,000 for 15 days = ₹74.11
5. Total gain = ₹3074.11

IMPORTANT: Why we don’t use cost of carry in reverse cash-and-carry arbitrage (in the same
way as we do in cash-and-carry):

Cost of carry is already re ected in the fair futures price

When doing cash-and-carry, you buy the spot and sell the future. You’re incurring the carry
cost (holding the stock, borrowing funds), so you need to compare actual futures price to fair
value.
In reverse cash-and-carry, you’re selling the spot and buying the future. You’re not incurring
the cost of carry in the same way — instead, you bene t from the carry, because you’re
getting cash now from spot sale and locking in a cheaper purchase in the future (future is
already undervalued). So you’re earning the implied interest (cost of carry) rather than paying it.
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Calendar Spread Strategy

A calendar spread is a trading strategy where you buy and sell futures contracts of the same
stock or index but with di erent expiry months. The idea is to take advantage of mispricing
between the two futures contracts. You make money when the price di erence (called the
spread) between the two contracts moves back to its fair or expected level.
Step 1: Calculate the fair price: Fair Price=Spot Price×er×t
Step 2: Compare fair prices and market prices: If one contract is overpriced and the other is
underpriced, there’s an arbitrage opportunity. You short (sell) the overpriced contract. You buy
the underpriced contract.
Step 3: Wait for the spread to return to fair value: Once the di erence becomes what it should
be (based on fair prices), you exit both positions and lock in pro t.

Example:
• Spot Price = ₹120
• Interest Rate = 8% per annum
• Near-month Futures Price = ₹121.30
• Mid-month Futures Price = ₹121.50
Fair Price Calculation:
• Near-month: ₹120 × e^(0.08 × 1/12) ≈ ₹120.80
• Mid-month: ₹120 × e^(0.08 × 2/12) ≈ ₹121.61
• Ideal di erence = ₹121.61 - ₹120.80 = ₹0.81
• Actual di erence = ₹121.50 - ₹121.30 = ₹0.20 (narrower)
So, near-month is overpriced, mid-month is underpriced => Sell near-month at ₹121.30, and
Buy mid-month at ₹121.50. Maximum potential pro t = ₹0.81 × Lot Size
When both futures contracts move towards their individual fair values, the spread between them
widens (or narrows) to what it should be — the ideal di erence based on interest rates and time
to expiry. That’s when the arbitrageur unwinds both positions and locks in the pro t from the
mispricing correcting itself. It is Low-Risk because you're betting on price di erence (not price
direction). You hold opposite positions in two related contracts. So, if the stock price rises or
falls, your overall exposure is balanced.

Use of Options for trading and hedging

Options trading strategies include spreads, straddles, and strangles. Among these, spreads
involve combining options of the same type (calls or puts) on the same underlying asset but with
di erent strikes or maturities. Spreads have limited pro t and limited loss and are mainly
classi ed into: Vertical, Horizontal, and Diagonal spreads.

Vertical Spreads – Same expiry, di erent strike prices.

Bull Call Spread: It’s a strategy used when you're moderately bullish on the market. You want
to make a pro t if the market goes up, but you also want to reduce your cost compared to just
buying a call. This is a low-cost, limited-pro t, limited-risk strategy. The cost is lower than just
buying a single call. The pro t is capped, but so is the risk.

You use two call options:

1. Buy a call at a lower strike price (more expensive)
2. Sell a call at a higher strike price (cheaper).

Why do this?
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• Buying a call gives you unlimited upside, but it’s costly
• Selling a higher strike call gives you some premium back, lowering your net cost
• But: This also caps your pro t, since gains beyond the sold call's strike are o set by
losses on it.

Example: You’re bullish and expect the market to rise, but not above 17800. So, you: Buy a
17500 Call for ₹185, Sell a 17800 Call for ₹61. Net cost = ₹185 - ₹61 = ₹124.

Payo Table (At Expiry):

Index at Expiry P&L (Buy 17500 Call) P&L (Sell 17800 Call) Net Gain
-185 (no gain, full +61 (option expires
17100 – 17500 -124
premium lost) worthless)
17600 -85 61 -24
17700 15 61 76
17800 115 61 +176 (Max Pro t)
17900 215 -39 176
18000 315 -139 176

Maximum Pro t = ₹176 (achieved when the index closes at or above 17800)
Maximum Loss = ₹124 (if the index stays at or below 17500)
Break-even Point = 17500 + 124 = 17624

Bull Put Spread: Limited pro t, limited loss and net premium receipt strategy.

1. Sell a put option with a higher strike price → Earn premium {A short put option with a
higher strike price generates more premium than one with a lower strike price; The risk to
the put seller is higher at higher strikes — because there's more room for the price to fall
below the strike.}
2. Buy a put option with a lower strike price → Pay premium (insurance)

Selling a put earns money if the market stays above the strike. But if the market falls a lot, the
losses can be huge. So you buy a lower strike put to limit your losses — like buying
insurance: If the spot price crashes below this strike, the long put starts gaining value rapidly,
which helps o set the big losses from the short higher strike put.

Position Strike Premium Direction

Short Put 17500 ₹125 You receive ₹125
Long Put 17000 ₹34 You pay ₹34
Net Premium Received = ₹125 - ₹34 = ₹91. So you get ₹91 upfront — this is your maximum
pro t.

Payo Table Breakdown:

Spot at Expiry Short Put P&L Long Put P&L Net Gain
16800 -575 166 -409
17000 -375 -34 -409
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17400 25 -34 -9
17500 125 -34 +91 (max pro t)
Max Pro t = ₹91; Happens when market stays at or above 17500
Max Loss = ₹409; Happens when market falls to or below 17000
Break-even = 17500 – 91 = 17409;Above this = pro t; below = loss

Bear Call Spread

The trader is bearish → expects the market not to go up much. He wants to pro t if the index
stays the same or falls slightly.

Short Call at ₹17500 → receives premium ₹185. This is risky alone (unlimited loss if price
shoots up)
Long Call at ₹17800 → pays premium ₹61. Acts as protection, limits the potential loss.

Net premium received = ₹185 - ₹61 = ₹124; Trader starts with a net in ow.

Index @ Expiry Short Call P&L Long Call P&L Net Gain
17100–17500 ₹185 -₹61 ₹124 (Max Pro t)
17600 ₹85 -₹61 ₹24
17700 -₹15 -₹61 -₹76
17800 -₹115 -₹61 -₹176 (Max Loss)
17900 -₹215 ₹39 -₹176
18000 -₹315 ₹139 -₹176

Key Points:
• Max Pro t = ₹124 → happens when price stays at or below 17500
• Max Loss = ₹176 → when price goes above 17800
• Break-even = 17500 + 124 = ₹17624
You earn if the market stays at or falls
You avoid unlimited risk thanks to the long call
Risk and reward are both de ned and limited

Bear Put Spread

1. Buy (Long) Put at ₹17500
◦ Pays premium ₹125
◦ Pro ts if market falls below ₹17500
2. Sell (Short) Put at ₹17000
◦ Receives premium ₹34
◦ Reduces cost
◦ But limits the gain because if the index falls below ₹17000, this leg starts incurring
losses
Net premium paid = ₹125 - ₹34 = ₹91
→ This is the maximum possible loss
Index @ Expiry Short Put P&L Long Put P&L Net Gain
16800 -₹166 ₹575 ₹409 ✅ (Max Pro t)
16900 -₹66 ₹475 ₹409 ✅
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17000 ₹34 ₹375 ₹409 ✅
17100 ₹34 ₹275 ₹309
17200 ₹34 ₹175 ₹209
17300 ₹34 ₹75 ₹109
17400 ₹34 -₹25 ₹9
17500 ₹34 -₹125 -₹91 ❌ (Max Loss)
17600–17800 ₹34 -₹125 -₹91 ❌
•Max Pro t = ₹409
→ Achieved when index is at or below 17000
• Max Loss = ₹91
→ Happens if the index is at or above 17500
• Break-even = 17500 - 91 = ₹17409
→ Below this point, strategy becomes pro table
You’re bearish but don’t expect a huge crash
You want to limit your loss by reducing premium cost
You’re okay with capped pro ts

Horizontal Spread (Time/Calendar Spread)

• Same type of options (calls or puts)
• Same strike price, di erent expiry dates
• Trader bets on change in time value di erence between the two options
• Pro t/loss depends on how this premium gap behaves
• Payo chart not possible, since expiries di er
Diagonal Spread
• Same underlying
• Di erent strike prices and di erent expiry dates
• More complex than other spreads
• Usually used in OTC markets, not ideal for retail or exchange-traded setups
• No standard payo chart due to varying maturities and strikes

Straddle Strategy – Summary & Explanation

✅ What it is:
• Involves buying both a Call and a Put with:
◦ Same strike price
◦ Same expiry date
• Used when a trader expects large movement in price but is uncertain about direction

🔹 Example Setup:
• Underlying price = ₹6,000
• Call Premium = ₹257
• Put Premium = ₹136
• Total Premium Paid = ₹393 (this is the maximum loss)

🔹 Payo Logic:
• If price moves sharply up → Call gains, Put limited loss
• If price moves sharply down → Put gains, Call limited loss
• If price stays near ₹6,000 → Both options lose value, trader su ers max loss ₹393
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🔹 Break-even Points (BEPs):

• Lower BEP = 6000 – 393 = ₹5607
• Upper BEP = 6000 + 393 = ₹6393
Only beyond these levels will the trader start making a pro t.

🔹 Key Points:
• Max Loss: ₹393 (happens when stock stays at ₹6000)
• Pro t Potential: Unlimited in either direction
• Risk Area: Between ₹5607 and ₹6393 → trader incurs losses
• Strategy suits volatile markets or events with uncertainty

Short Straddle – Explanation & Summary

🔹 What it is
• Sell (short) one Call and one Put on the same underlying, with the same strike and same
expiry.
• You receive both premiums upfront, so it’s a net credit strategy.

🔹 When to use
• When you believe the underlying price will stay close to the strike (i.e. low volatility).
• You want to pro t from time decay and lack of large price moves.

🔹 Payo characteristics
• Maximum Pro t = Sum of premiums received (here: ₹257 + ₹136 = ₹393)
– Occurs if the underlying expires exactly at ₹6 000.
• Unlimited Loss Potential
– If price moves far above ₹6 000, the short Call creates unlimited losses.
– If price moves far below ₹6 000, the short Put creates (theoretically) very large losses.

🔹 Break‑even Points (BEPs)

• Lower BEP = Strike – Total Premium = 6 000 – 393 = ₹5 607
• Upper BEP = Strike + Total Premium = 6 000 + 393 = ₹6 393
• Between ₹5 607 and ₹6 393, you still make a small pro t; outside this range, you start
incurring net losses.

🔹 Key Takeaways
• Limited Pro t (₹393) vs. Unlimited Risk ― must be used with extreme caution.
• Best in very quiet markets with little expected movement.
• Monitor closely: any signi cant swing in either direction can quickly erode gains and
produce large losses.

Long Strangle – Explanation & Summary

🔹 What it is
• Outlook: You expect a big move in the underlying, but are unsure of direction.
• Setup: Buy an out‑of‑the‑money (OTM) Call and an OTM Put on the same asset, same
expiry, but di erent strikes.
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🔹 Example
• Spot price: ₹6 100
• Long Call: Strike = ₹6 200, Premium = ₹145
• Long Put: Strike = ₹6 000, Premium = ₹140
• Total Premium Paid (Max Loss): ₹145 + ₹140 = ₹285

🔹 Payo Characteristics
• Maximum Loss (₹285): Occurs if spot at expiry is anywhere between ₹6 000 and ₹6 200
(both options expire worthless).
• Unlimited Pro t:
◦ Upside: If spot rises above ₹6 200 + ₹285 = ₹6 485.
◦ Downside: If spot falls below ₹6 000 – ₹285 = ₹5 715.
• Break‑Even Points:
◦ Lower BEP = 6 000 − 285 = ₹5 715
◦ Upper BEP = 6 200 + 285 = ₹6 485

🔹 Why use it?

• Low upfront cost (OTM options are cheaper).
• Pro t if volatility spikes sharply up or down.
• Loss limited to total premium if market stays in‑range.

🔹 Key Takeaways
Feature Value
Max Loss ₹285
Max Pro t Unlimited
Break Even Below ₹5 715 or above
Range ₹6 485
Best When Expecting major price swings
This strategy is ideal when you anticipate a signi cant move but don’t know its direction—and
you’re willing to cap your loss to the small premium paid.

Short Strangle – Explanation & Summary

🔹 What It Is
• Sell an Out‑of‑the‑Money (OTM) Call and sell an OTM Put on the same underlying,
same expiry, but with di erent strikes.
• You receive both premiums upfront, so it’s a net credit strategy.

🔹 Market View
• You expect the underlying to remain within a relatively narrow range until expiry (low
volatility).

🔹 Example Setup
• Spot Price: ₹6 100
• Short Call: Strike = ₹6 200, Premium = ₹145
• Short Put: Strike = ₹6 000, Premium = ₹140
• Total Premium Received (Max Pro t): ₹145 + ₹140 = ₹285
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🔹 Payo Characteristics
• Maximum Pro t = ₹285
◦ Occurs if spot expires anywhere between ₹6 000 and ₹6 200 (both options expire
worthless).
• Unlimited Loss Potential
◦ If spot rises above ₹6 485 (6 200 + 285), losses on the short Call grow without
bound.
◦ If spot falls below ₹5 715 (6 000 – 285), losses on the short Put grow without
bound.
• Break‑Even Points (BEPs):
◦ Lower BEP = 6 000 – 285 = ₹5 715
◦ Upper BEP = 6 200 + 285 = ₹6 485

🔹 Key Takeaways
Feature Value
Max Pro t ₹285
Max Loss Unlimited
Pro t
Spot stays between strikes
Zone
Spot moves below 5 715 or above
Risk Zone
6 485
Best When Expecting very little movement in price

This strategy suits a quiet market outlook but carries very high risk if the underlying moves
sharply in either direction.

Covered Call – Explanation & Summary

🔹 What It Is
• A covered call strategy involves holding a stock and selling a call option on that stock.
• The goal is to generate additional income from the stockholding through the premium
received from selling the call option, without selling the stock itself.

🔹 Example Setup
• Stock Purchase Price: ₹1590
• Sold Call Strike Price: ₹1600
• Premium Received for the Call: ₹10

🔹 How It Works
1. Stock Price Rises Above ₹1590 (E.g., ₹1640):
◦ Pro t on Stock: ₹1640 – ₹1590 = ₹50
◦ Loss on Call Option: The call option is exercised. The loss is:
₹1640 – ₹1600 + ₹10 = – ₹30
◦ Net Position: ₹50 – ₹30 = ₹20
2. Stock Price Falls Below ₹1590 (E.g., ₹1520):
◦ Loss on Stock: ₹1520 – ₹1590 = – ₹70
◦ Pro t on Call Option: The call expires worthless, so you keep the ₹10 premium.
◦ Net Position: – ₹70 + ₹10 = – ₹60
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🔹 Key Points from the Payo Chart

Stock Price Stock Pro t/ Call Option Pro t/ Net Pro t/
(CMP) Loss Loss Loss
₹1490 – ₹100 ₹10 – ₹90
₹1590 ₹0 ₹10 ₹10
₹1600 ₹10 ₹10 ₹20
₹1640 ₹50 – ₹30 ₹20
₹1690 ₹100 – ₹80 ₹20

🔹 Payo Characteristics
• Maximum Pro t = ₹20
◦ Occurs if stock price is above ₹1600 at expiry. The call is exercised, and your stock
pro t is capped.
• Maximum Loss = Unlimited
◦ If the stock price falls signi cantly below ₹1590, the loss from holding the stock
continues, though the premium from the call provides some cushion.
• Income Generation
◦ The call premium (₹10 in the example) acts as income and lowers the cost basis
of your stock position.

🔹 Strategy Considerations
• Strike Price of Call Option:
◦ A closer strike (e.g., ₹1600 when the stock is at ₹1590) results in a higher
premium but caps potential gains quickly.
◦ A farther strike would o er lower premiums but allow the stock more room to rise
before the call option is exercised.

🔹 Summary
• Covered Call is a low-risk income strategy for stockholders who believe the stock will
not rise far beyond the strike price.
• It limits upside potential (stock gains) but provides downside protection (through the
premium earned from the call option).
• Ideal for stocks that are expected to be stable or slightly bullish.

Collar Strategy – Explanation & Summary

🔹 What It Is
A collar strategy is a combination of the covered call and protective put strategies. It is used
to limit downside risk while still maintaining some pro t potential from the upside.
• In this strategy, an investor:
◦ Holds a stock (long position).
◦ Sells a call option (short position) to generate income from premiums.
◦ Buys a put option (long position) to protect against downside risk.

🔹 Example Setup
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• Stock Purchase Price: ₹1590
• Sold Call Strike Price: ₹1600
• Call Premium: ₹10
• Bought Put Strike Price: ₹1580
• Put Premium: ₹7

🔹 How It Works
1. Stock Price Falls Below ₹1580 (e.g., ₹1490):
◦ Pro t/Loss from Stock: ₹1490 – ₹1590 = – ₹100
◦ Pro t/Loss from Short Call: ₹10 (Call expires worthless)
◦ Pro t/Loss from Long Put: ₹1580 – ₹1490 = ₹90 (gain from put)
◦ Net Position: – ₹100 + ₹10 + ₹90 = – ₹7 (Compared to covered call, which would
have been – ₹90)
2. Stock Price Rises Above ₹1600 (e.g., ₹1690):
◦ Pro t/Loss from Stock: ₹1690 – ₹1590 = ₹100
◦ Pro t/Loss from Short Call: ₹1600 – ₹1690 + ₹10 = – ₹80 (loss from call)
◦ Pro t/Loss from Long Put: ₹– ₹7 (put expires worthless)
◦ Net Position: ₹100 – ₹80 – ₹7 = ₹13 (Compared to covered call, which would have
been ₹20)

🔹 Key Points from the Payo Chart

Stock Price Stock Pro t/ Call Option Pro t/ Put Option Pro t/ Net Pro t/
(CMP) Loss Loss Loss Loss
₹1490 – ₹100 ₹10 ₹83 – ₹7
₹1590 ₹0 ₹10 – ₹7 ₹3
₹1600 ₹10 ₹10 – ₹7 ₹13
₹1690 ₹100 – ₹80 – ₹7 ₹13

🔹 Payo Characteristics
• Maximum Pro t = ₹13
◦ The pro t is capped because the call option limits the upside beyond ₹1600.
However, the pro t is slightly reduced from the covered call strategy due to the
cost of the long put.
• Maximum Loss = – ₹7
◦ The long put option helps to limit downside risk. If the stock price falls signi cantly,
the loss is contained, unlike the unlimited loss potential in the covered call.
• Breakeven Point (BEP):
◦ The BEP moves higher compared to the covered call strategy, re ecting the
premium paid for the long put.
◦ New BEP = ₹1590 (stock price) + ₹7 (put premium) = ₹1597.

🔹 Strategy Considerations
• The collar strategy provides downside protection but caps the upside. The maximum
pro t is limited due to the call being sold, and the maximum loss is limited due to the
purchased put.
• The cost of the put reduces the overall potential pro t compared to the covered call but
provides a safe oor in case the stock price falls signi cantly.

🔹 Summary
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The collar strategy is a risk-management approach that combines a covered call and a
protective put to create a more balanced position. It o ers downside protection while still
allowing for some upside pro t, making it suitable for investors who want to limit potential
losses but are willing to cap potential gains.

Butter y Spread – Explanation & Summary

🔹 What It Is
A butter y spread is an options strategy used to limit both pro t and loss. It involves creating a
position with options of di erent strike prices but with the same expiration. This strategy
typically combines long and short options with the goal of pro ting from low volatility, where
the price of the underlying asset remains near the middle strike price at expiration.
🔹 Structure of the Strategy (using Calls)
• Long Call 1: Buy a call with a lower strike price.
• Short Call 2: Sell two calls with a middle strike price.
• Long Call 3: Buy a call with a higher strike price.

🔹 Example Setup
• Long Call 1 (Strike = 6000): Premium paid = ₹230
• Short Call 2 (Strike = 6100): Premium received = ₹150 (x2, because 2 short calls)
• Long Call 3 (Strike = 6200): Premium paid = ₹100

🔹 Payo Scenarios
1. Price at 6000 or below (Out-of-the-money calls)
• All calls are out-of-the-money and will expire worthless.
• Net Position: Loss of ₹30 (the cost to enter the butter y spread).
2. Price at 6100 (Middle strike)
• Maximum Pro t:
◦ The two short calls at ₹6100 earn the entire premium of ₹150 each.
◦ The long calls at ₹6000 and ₹6200 are either at break-even or slightly in loss.
◦ Net Position: ₹70 (maximum possible pro t).
3. Price at 6200 or higher
• Pro t from Long Calls: The long calls start making pro ts as the price moves past
₹6000.
• Loss from Short Calls: The short calls start losing as the price exceeds ₹6100.
• However, the net position never exceeds ₹70 pro t and starts decreasing after ₹6200.
• Net Position: Always remains at ₹30 loss beyond ₹6200.

🔹 Key Points
• Maximum Pro t = ₹70: This occurs when the stock price at expiration is at the middle
strike price (₹6100).
• Maximum Loss = ₹30: The loss is the cost of entering the strategy and occurs if the
stock price ends up below ₹6000 or above ₹6200.
• Breakeven Points (BEP):
◦ Lower BEP = ₹6030 (6000 + 30)
◦ Upper BEP = ₹6170 (6200 – 30)

🔹 Pro t/Loss at Various Spot Prices

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Stock Price Long Call 1 Short Call 2 Long Call 3 Net Pro t/
(CMP) (6000) (6100) (6200) Loss
5100 –₹230 ₹150 –₹100 –₹30
6000 –₹230 ₹150 –₹100 –₹30
6100 –₹130 ₹150 –₹100 ₹70
6200 –₹30 ₹50 –₹100 –₹30
6300 ₹70 –₹50 ₹0 –₹30
6400 and above Continues at –₹30 Continues at –₹30 Continues at –₹30 –₹30

🔹 Summary
The butter y spread is a limited-risk, limited-reward strategy. The goal is to pro t from the
underlying asset's price staying close to the middle strike price (₹6100 in this case) at
expiration.
• Pro t is maximized when the stock price is exactly at the middle strike.
• Loss is capped and occurs if the stock price is far from the middle strike (either too low
or too high).
This strategy can be created using only calls, only puts, or a combination of both, and it is
used when the trader expects low volatility in the underlying asset's price.

Hedging with Options – Explanation & Summary

🔹 What It Is
Hedging with options is a strategy used to protect an investor from unexpected price
movements in the underlying asset. This is done by using options contracts to insure against
risks of price changes, both upward and downward.

🔹 Call Option for Hedging Against Price Rises

• When an investor plans to buy a stock in the future, they may face the risk of prices
rising unexpectedly, making the stock more expensive than anticipated.
• Buying a call option allows the investor to lock in a strike price today for purchasing the
stock later. This protects the investor from paying a higher price if the stock rises
unexpectedly.
Example:
• Stock price today: ₹463
• Call option strike price: ₹460
• Premium paid: ₹19
• The investor plans to buy the stock at the end of the month, but if the stock price rises to
₹520:
◦ The value of the call option increases, allowing the investor to exercise the option
and buy the stock at ₹460 instead of ₹520.
◦ If the stock price falls to ₹430, the investor will let the call option expire and buy
the stock directly from the market at the lower price (₹430).
This way, the call option insures against an unexpected price increase, ensuring that the
investor can still buy the stock at the predetermined strike price.

🔹 Put Option for Hedging Against Price Drops

• Similarly, if an investor holds a portfolio and is concerned about prices falling
unexpectedly, they can buy a put option to protect against downside risks.
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• A put option gives the investor the right to sell the stock at a speci c price, which acts as
a safety net in case of a price drop.

🔹 Key Takeaways
• Call Options: Protect against upside risk (unexpected price rise).
• Put Options: Protect against downside risk (unexpected price fall).
• Hedging with options helps investors manage risk by locking in prices, whether buying
or selling, and mitigating the impact of unexpected market movements.

Protective Put – Explanation & Summary

🔹 What It Is
A protective put combines a long stock position with a long put option on the same asset
(same strike and expiry). It acts as a form of insurance: you retain unlimited upside but cap your
downside.

🔹 How It Works (Example)

• Buy Stock at ₹1 600
• Buy Put (Strike = ₹1 600) at Premium = ₹20
1. If the price falls to ₹1 530:
• Stock Loss: ₹1 530 – ₹1 600 = – ₹70
• Put Pro t: (₹1 600 – ₹1 530) – ₹20 = + ₹50
• Net Loss: – ₹70 + ₹50 = – ₹20 (limited to the premium)
2. If the price rises to ₹1 660:
• Stock Pro t: ₹1 660 – ₹1 600 = + ₹60
• Put Loss: – ₹20 (premium paid)
• Net Gain: + ₹60 – ₹20 = + ₹40 (rises inde nitely minus premium)

🔹 Payo Characteristics
Spot at Put P/ Net P/
Stock P/L
Expiry L L
₹1 500 – ₹100 ₹80 – ₹20
₹1 600 ₹0 – ₹20 – ₹20
₹1 660 ₹60 – ₹20 ₹40
Rises without limit (minus
Above ₹1 600
₹20)
• Maximum Loss = ₹20 (the premium paid).
• Unlimited Upside (stock gains minus the premium).
• Break‑Even at ₹1 620 (stock price + put premium).

🔹 Why Use It?

• Downside Protection: Caps losses to the put premium if the stock plunges.
• Retain Upside: You still pro t if the stock rallies, much like holding a call.
• Synthetic Long Call: The combined payo of stock + put mimics a long call option.

This makes the protective put ideal for investors who want to stay invested in a rising market
but guard against severe downturns.
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Arbitrage Using Options: Put-Call Parity – Explanation & Summary

Put-Call Parity is a principle that de nes the relationship between the prices of call and put
options with the same strike price and expiry date on the same underlying asset. It helps to
identify arbitrage opportunities when the market prices deviate from their theoretical prices.
The Formula:
c+X⋅e−rt=p+S0
Where:
• c = Call option price
• p = Put option price
• X = Strike price of options
• S₀ = Spot price of the underlying asset
• r = Risk-free interest rate
• t = Time to expiry of options
This formula essentially states that the sum of the call price and the present value of the strike
price should equal the sum of the put price and the spot price.

How It Works:
1. Identifying Arbitrage Opportunity:
◦ If the prices of the call and put options do not align with the formula, an arbitrage
opportunity arises. This means there’s a risk-free pro t opportunity if the put price
is either overpriced or underpriced relative to the call option.
2. Example:
◦ Spot price (S₀) = ₹1251
◦ Call option price (c) = ₹47.50
◦ Strike price (X) = ₹1240
◦ Interest rate (r) = 8% p.a.
◦ Time to expiry (t) = 1 month (or 1/12 year)
3. The formula can be used to calculate the fair price of the put option. Using the put-call
parity, the fair price of the put comes out to ₹28.26. However, if the put is trading at
₹23.15, it is underpriced, creating an arbitrage opportunity.

Arbitrage Strategy:
The arbitrageur can exploit this pricing discrepancy with the following steps:
1. Buy the Underpriced Put Option at ₹23.15.
2. Buy the Stock at ₹1251.
3. Sell the Call Option (short position) for ₹47.50.
This creates a net cash out ow of ₹1226.65 (₹1251 + ₹23.15 – ₹47.50).
Possible Scenarios on Expiry:
• Stock Price Rises to ₹1275:
◦ Sell Stock at ₹1275 (Pro t = ₹1275 – ₹1251 = ₹24).
◦ Short Call incurs a loss of ₹35 (because it’s in-the-money).
◦ Put expires worthless.
◦ Borrowing Repayment: The borrowed amount grows to ₹1234.86 (due to interest).
◦ Net Cash In ow = ₹1275 – ₹35 – ₹1234.86 = ₹5.14 (arbitrage pro t).
• Stock Price Falls to ₹1200:
◦ Sell Stock at ₹1200 (Loss = ₹1251 – ₹1200 = ₹51).
◦ Short Call expires worthless.
◦ Put Option Payo = ₹40 (since the stock price is below strike).
◦ Net Cash In ow = ₹1200 + ₹40 – ₹1234.86 = ₹5.14 (arbitrage pro t again).

Challenges of Arbitrage Execution:

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1. Simultaneous Execution: The strategy requires executing multiple trades at the same
time (buying the stock, buying the put, and shorting the call). Delays in execution can
make it impossible to lock in the arbitrage pro t.
2. Naked Position Risk: If one leg of the trade is executed but the other is delayed, the
trader may end up with a naked position (e.g., holding a short call without the
corresponding hedge), leading to potential losses.

Conclusion:
Put-call parity is a useful principle for identifying arbitrage opportunities in the options market.
By comparing the market price of put and call options to their theoretical values, traders can
potentially earn risk-free pro ts. However, executing such strategies requires precision, as any
delay or missed step could lead to signi cant risks.

Delta-Hedging – Explanation & Summary

Delta-hedging is a strategy used by option traders to manage the risk associated with changes
in the price of the underlying asset. It involves adjusting the position in the underlying asset
(typically through stock or futures contracts) to o set the price movements of options in the
portfolio.

Key Concepts:
1. Delta of an Option:
◦ The delta of an option measures how much the price of the option changes for a
small change in the price of the underlying asset.
◦ For example, if a call option has a delta of 0.50, a 1 rupee increase in the stock
price will cause the call option price to change by 0.50 rupees.
2. Hedging with Delta:
◦ If an option trader holds a position that is sensitive to the price of the underlying
asset (like a short call), they can hedge the position by taking a long position in the
underlying asset (or futures) to o set the risk.

Example of Delta-Hedging:
1. Initial Setup:
◦ Stock Price: ₹100
◦ Position: Short 10 at-the-money (ATM) call options on the stock (lot size of 50).
◦ Call Option Delta: 0.50 (this means a 1 rupee change in the stock price results in a
0.50 rupee change in the option price).
2. Risk Exposure:
◦ Since the trader is short on the call options, if the stock price rises, the option
value increases, causing a loss.
◦ For a 1 rupee increase in stock price, the trader's loss from the short call position
is calculated as:

0.50×50×10=₹250
3. Hedging with Futures:
◦ To hedge this risk, the trader needs to take a long position in the underlying asset
(or futures).
◦ Futures contracts have a delta of 1 (because the price of the futures contract
mirrors the price of the underlying asset).
◦ The trader needs to o set the loss of ₹250 from the short call position by taking a
long futures position:
Lot size=50 so 5 futures contracts=1×5×50=250
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◦ This creates a delta-neutral position, meaning any small movement in the stock
price will not a ect the overall position, as the positive delta of the futures will
o set the negative delta of the short call.
4. Adjusting for Price Changes:
◦ As the stock price changes, the delta of the options will also change. For example,
if the stock rises from ₹100 to ₹110, the delta of the call option might increase from
0.50 to 0.60.
◦ The trader will need to adjust the futures position to maintain delta neutrality. In
this case, the trader might need to buy one more futures contract, making the
total long position 6 futures contracts to keep the portfolio's delta at zero.

What is Delta-Neutral?
• A delta-neutral position is one where the overall exposure to small changes in the
underlying asset’s price is zero. The trader achieves this by balancing the deltas of
di erent positions in their portfolio (e.g., short options and long futures).

Key Takeaways:
• Delta-hedging is used to manage risk in options trading by adjusting positions in the
underlying asset (usually through futures) to o set the price sensitivity of options.
• It aims to maintain a delta-neutral position, meaning the changes in the underlying
asset’s price don’t a ect the portfolio.
• The delta of options changes as the price of the underlying asset changes, so traders
must continually adjust their positions to stay delta-neutral.
In summary, delta-hedging allows traders to manage risk dynamically and keep their option
positions insulated from small price movements in the underlying asset. However, adjustments
need to be made regularly as the delta of options changes over time.

Interpreting Open Interest and Put-Call Ratio for Trading Strategies

Open Interest (OI):

• De nition: Open Interest refers to the total number of outstanding (open) contracts in the
market that have not yet been closed.
• Example: If the May index futures have an open interest of 2,56,000 contracts, it means
2,56,000 contracts have been bought or sold, but they have not been closed yet.

Total Traded Volume:

• De nition: Total Traded Volume is the number of contracts that have been traded during
a speci c time period (typically a day).
• Example: If 2,00,000 contracts of the May index futures are traded today, that is the total
traded volume for the day.

Put-Call Ratio (PCR):

• De nition: The Put-Call Ratio is the ratio of the open interest (OI) or trading volume of put
options to call options. It can help gauge market sentiment.
◦ PCR Calculation:
PCR=Call Open InterestPut Open Interest
• Interpretation:
◦ PCR < 1: More call options than put options, indicating a bearish market
sentiment.
◦ PCR > 1: More put options than call options, indicating a bullish market sentiment.

Using Open Interest and Futures Price for Trading Strategy:

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There are 4 possible scenarios that help traders decide whether to go long or short on futures:
1. Rising Futures Price + Rising Open Interest:
◦ Interpretation: Bullish trend.
◦ Strategy: Go long (buy) futures.
2. Rising Futures Price + Declining Open Interest:
◦ Interpretation: Short-covering, existing short positions are being squared up.
◦ Strategy: This signals that the bullish trend might be weakening. Look for short
positions.
3. Declining Futures Price + Rising Open Interest:
◦ Interpretation: Build-up of short positions and a bearish trend.
◦ Strategy: Go short (sell) futures.
4. Declining Futures Price + Declining Open Interest:
◦ Interpretation: Existing long positions are being squared up, and the bearish trend
is weakening.
◦ Strategy: Avoid new short positions and wait for clearer signals.

Using Put-Call Ratio for Option Trading Strategy:

• PCR < 1: More calls than puts, suggesting a bearish market trend.
• PCR > 1: More puts than calls, suggesting a bullish market trend.
In general, Put-Call Ratio is treated as a contrarian indicator:
• A PCR less than 1 suggests that option traders expect the market to fall (bearish).
• A PCR greater than 1 suggests that option traders expect the market to rise (bullish).

Summary:
• Open Interest helps assess the strength of market trends by showing whether new
positions are being added (signaling strength) or existing positions are being closed
(signaling reversal).
• The Put-Call Ratio helps interpret market sentiment, with a lower ratio indicating a
bearish outlook and a higher ratio suggesting a bullish outlook.
• Both indicators are used to guide trading decisions for futures and options.
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CHAPTER 6
TRADING MECHANISM

Entities involved in the trading of futures and options

Trading Member (TM): (Motilal Oswal Financial Services Ltd.)

• Registered with the stock exchange.
• Can trade for themselves or for clients.
• Has a unique Trading Member ID, shared by all users under them. Users are individuals
authorised to access the trading platform on behalf of a Trading Member (TM). They
place orders, manage accounts, and operate terminals. They are not clients, but
employees, dealers, or operators working for the TM.
• Must control access to their user IDs.
Trading cum Clearing Member (TCM): (ICICI Securities Ltd.)
• Acts as both a trader and a clearer.
• Can clear their own trades (proprietary), clients’ trades, and trades of other Trading
Members.
Professional Clearing Member (PCM): (HDFC Bank Ltd.)
• Clears trades but does not trade.
• Typically large entities like banks/custodians.
• Clears for: Trading Members (TMs), and Institutional clients (Custodial Participants).
Self Clearing Member (SCM): (Zerodha Broking Ltd.)
• A TM who also clears trades, but only for self and clients, not for others.
Participant (Client):
• An individual or institution trading through a Trading Member.
• Can have trades via multiple TMs but settles via one Clearing Member.
Authorised Person (AP):
• Works under a TM to expand their network.
• Sub-brokers are now replaced by APs as per SEBI rules since 2019.

User Hierarchy in F&O Trading Software

Corporate Manager (Top Level): Full control over all branches and dealers. Can place/view all
orders, get all reports, and set exposure limits.

Branch Manager (Middle Level): Manages a speci c branch. Can place/view orders and trades
of all dealers under their branch.

Dealer (Lowest Level): Can only view and manage their own orders and trades. No access to
other dealers' data.

Order Types & Matching Rules in F&O Trading

Order Types by Conditions

Time Conditions:
1. Day Order: Valid for the trading day only. Auto-cancelled if not executed.
2. IOC (Immediate or Cancel): Executes immediately. Partial match is possible. Unmatched
portion gets auto-cancelled.

Price Conditions:
Limit Order: Trade at a speci ed price or better. E.g., Buy at ₹100 → executes at ₹100 or lower.
Market Order: Executes at the best available market price. No price is speci ed while placing
the order.
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Stop-Loss Order: Trigger-based order to limit losses. Can be converted into market/limit order,
as de ned at the time of placing this stop-loss order, once trigger price is reached. Example:
suppose a trader buys ABC Ltd. shares at Rs 100 in expectation that the price will rise.
However, prices start declining below his buy price, trader would like to limit his losses. Trader
may place a limit sell order specifying a trigger price of Rs 95 and a limit price of Rs 92. The
trigger price must be between last traded price and limit price while placing the sell limit order.
Once the market price of ABC breaches the trigger price i.e. Rs 95, the order gets converted to
a limit sell order at Rs 92. (Trigger Price is the price at which the order gets triggered from the
stop loss book.)

Order Matching Rules:

Based on Price-Time Priority: Best price wins. Within same price, earlier order gets preference.
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.
Partial order matching is possible → multiple trades from one order. {Orders can be matched in
parts with multiple opposite-side orders.}

Price Band (to avoid errors, not to limit movement): No price bands like equities. Operating
Ranges apply to avoid erroneous orders: Index Futures: ±10% of base price, Stock Futures:
±10% of base price, Options: Based on delta value, updated daily. If order breaches range → it
gets price freeze warning.

Eligibility Criteria:
1. Top 500 Stocks: Based on average daily market cap and traded value (rolling 6 months).
2. Median Quarter-Sigma Order Size (MQSOS): Must be ≥ ₹75 lakhs. Indicates the stock can
handle large trades without big price impact.
3. Market-Wide Position Limit (MWPL): Must be ≥ ₹1500 crores. Re ects how much total
exposure is allowed in the stock for derivatives.
4. Average Daily Delivery Value (Cash Market): Must be ≥ ₹35 crores. Ensures actual delivery
volume (not just speculation).
5. Cross-Exchange Eligibility: If a stock meets criteria on any one stock exchange, it's
allowed on all exchanges.
If a stock fails any criteria for 3 months in a row, then no new F&O contracts are allowed,
Existing contracts will trade until expiry (new strikes can be added), Re-inclusion not allowed for
1 year after removal.

Exit Norms for Stocks from Derivatives Segment via Product Success Framework (PSF)
To ensure only actively traded and relevant stocks stay in the F&O segment, SEBI introduced
a Product Success Framework (PSF) for single stock derivatives, similar to what exists for
index derivatives.

Key PSF Exit Criteria (applied after 6 months of listing):

A stock must meet all 4 conditions during the review period (typically 3 months). Failing any →
risk of exit.
Trading Member Participation: At least 15% of active F&O trading members (or 200, whichever
is lower) must have traded in that stock.
Trading Frequency: Must be traded on at least 75% of trading days in the review period.
Average Daily Turnover (Single Side): Must be ≥ ₹75 crores (futures + options premium
combined).
Average Daily Notional Open Interest (Single Side): Must be ≥ ₹500 crores (based on contract
value of futures + options).
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If a stock fails the PSF criteria: No fresh contracts will be issued, Existing unexpired contracts
will trade till expiry (new strikes allowed), and Stock is removed only if it fails on all exchanges.

Re-Introduction Rule: A delisted stock can return to derivatives trading only if it meets all
eligibility criteria continuously for 6 months.

Eligibility Criteria for Introducing Index Derivatives

To allow Futures & Options (F&O) on an index:
1. 80% Rule: At least 80% of the index’s weight must come from stocks that are already
eligible for derivatives trading.
2. 5% Cap for Ineligible Stocks: Any single ineligible stock must not exceed 5% weight in the
index.
3. Ongoing Compliance: The exchange reviews monthly. If the index fails for 3 consecutive
months, no new contracts will be introduced. Existing contracts will remain until expiry (new
strikes allowed).

Exit via Product Success Framework (PSF) – for non- agship indices
To stay in the derivatives segment, the index must meet the PSF activity benchmarks:
1. Trader Participation: At least 15% of active index traders, or 20 members (whichever is
lower) must trade it each month during review.
2. Trading Frequency: Index must trade on ≥75% of trading days in the review period.
3. Turnover Threshold: ₹10 crore average daily turnover (single side).
4. Open Interest Threshold: ₹4 crore average daily notional open interest (single side).

Reintroduction Rule: If excluded, the index must stay out for 6 months (cooling-o ). Re-launch
allowed only with changes + SEBI approval.

Adjustments for Corporate Actions

Goal of Adjustment: To ensure that the value of a trader's position remains una ected when
a corporate action (like a bonus or split) occurs. This keeps the position's status (in-the-money,
etc.) intact.

When a corporate action occurs, the following may be changed:

1. Strike Price
2. Open Positions
3. Market Lot / Multiplier
These changes are made on the last day the stock trades on a "cum" basis (i.e. before
corporate action is re ected in the stock price).

Types of Corporate Actions are broadly classi ed as:

1. Stock bene ts: Bonus, splits, rights, mergers, demergers, etc.
2. Cash bene ts: Dividends

Adjustment Methods
1. Bonus Shares
• Adjustment Factor = (A + B)/B where A:B = bonus ratio
• Example: 3:2 → (3+2)/2 = 2.5
• Multiply the old position/lot by 2.5 and divide strike price by 2.5
2. Stock Splits / Consolidation
• Adjustment Factor = A/B (split/consolidation ratio)
3. Rights Issue
• More complex; depends on:
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◦ Number of shares held (A)
◦ Rights o ered (B)
◦ Market price (P)
◦ Issue price (S)
• Adjustment Factor = (P - E)/P where E = (P - S)/(A + B)
Fraction Handling
• Rounding may be required to avoid dealing in fractions.
• Value of position is recalculated pre- and post-adjustment to ensure minimal mismatch.

Dividends
Ordinary Dividend: < 2% of market price → No adjustment
Extraordinary Dividend: ≥ 2% → Strike prices of options are reduced by dividend amount.
Applies from ex-dividend date. For futures, daily settlement price is reduced by dividend
amount
Note: Dividend % is based on stock price just before the dividend is announced.

Merger / Demerger
• No new F&O contracts are introduced after record date is announced
• All existing contracts are closed out (settled) on the last cum date
• Settlement Price = last traded stock price before merger/demerger

Trading Costs

User Charges:
1. Brokerage: Fee charged by brokers; usually lower for intraday.
2. Transaction Charges: Levied by exchanges on both buy/sell sides (for options, on
premium).
Statutory Charges
• STT (Securities Transaction Tax):
◦ Sale of Options: 0.10% (Seller) on premium
◦ Exercised Options: 0.125% (Buyer) on settlement price
◦ Sale of Futures: 0.02% (Seller)
• GST (18%): On brokerage + transaction charges
• Stamp Duty:
◦ Futures: 0.002% (Buyer)
◦ Options: 0.003% (Buyer)
• SEBI Turnover Fees: Rs.10 per crore + GST
IPFT Charges (Investor Protection Fund Trust)
• Futures: ₹10 per crore + 18% GST
• Options: ₹50 per crore of premium + 18% GST

Investor Risk Reduction Access (IRRA) platform:

Purpose: IRRA is a safety mechanism developed by exchanges to help investors manage
trades during technical glitches or outages at their broker's end.

Features
1. Lets investors square o open positions or cancel pending orders when the broker’s
platform fails.
2. Works across multiple exchanges and segments.
3. Activated only when brokers (TMs) report disruptions to the exchange.
4. Investors are noti ed via SMS, email, and public notice.
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5. Brokers must also notify users via their websites.
6. Only risk-reducing actions (no new trades) are allowed.
7. Brokers get an Admin Terminal to monitor and assist investors.
8. Not available for algorithmic traders or institutional clients — only for retail investors.

SEBI framework for addressing technical glitches in stock brokers’ electronic trading systems:

Reporting Requirements
1. Immediate Reporting: Brokers must inform the stock exchange within 1 hour of a technical
glitch.
2. Preliminary Incident Report: To be submitted by T+1 day, detailing the event, impact, and
immediate action taken.
3. Root Cause Analysis (RCA): Must be submitted within 14 days, including: Incident timeline &
duration, and Root cause (including vendor input, if any)

Monitoring Mechanism (LAMA): Exchanges advise implementation of API-based Logging and

Monitoring Mechanism (LAMA); Helps track key system and functional parameters to
maintain smooth trading operations.
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CHAPTER 7
INTRODUCTION TO CLEARING AND SETTLEMENT SYSTEM

The Clearing Corporation handles the clearing, settlement, and risk management of all F&O
segment trades. Under the legal concept of novation, it becomes the central counterparty to all
trades and ensures nancial settlement.
Types of Clearing Members:
• Self-clearing member: Settles only their own trades or their clients'.
• Trading-cum-clearing member: Settles their own trades and those of others.
• Professional clearing member: Settles trades on behalf of trading members.
Members clearing trades for others must provide additional security deposits.
Functions of Clearing Members:
• Clearing: Calculate settlement obligations.
• Settlement: Complete nancial transactions.
• Risk Management: Set position limits and monitor margins.
Clearing Banks:
• Handle fund settlements.
• Clearing Members must maintain a dedicated account with a designated clearing bank.
Eligibility Norms:
• Net-worth: ₹300 lakhs (₹100 lakhs for self-clearing).
• Security Deposit: ₹50 lakhs to the Clearing Corporation.
• Extra Deposit: ₹10 lakhs per additional Trading Member.

Clearing Mechanism in F&O:

1. Step 1: Calculate Open Positions & Obligations
◦ A Clearing Member’s (CM) open position = sum of open positions of all Trading
Members (TMs) and Custodial Participants (CPs) clearing through them.
◦ A TM’s open position = proprietary open position + client open long position +
client open short position.
2. Order Classi cation:
◦ Orders are marked as Proprietary (Pro) or Client (Cli).
◦ Proprietary positions are netted for each contract (Buy – Sell); let’s say a TM has
3000 long positions and 1000 short positions, then his net position is 2000 long.
◦ Client positions are calculated by netting each client’s trades individually and then
aggregating them.
3. Example Summary:
◦ CM A has two TMs: PQR and XYZ.
◦ PQR: Net long position = 5000 (Pro: 2000, Client 1: 1000, Client 2: 2000).
◦ XYZ: Net long = 1000, Net short = 2000.
◦ So, CM A’s open position = 6000 long, 2000 short.
Interoperability of Clearing Corporations
Earlier, each stock exchange had its own clearing corporation, requiring traders to hold separate
memberships, collaterals, and margins across exchanges — leading to higher costs and
ine cient capital use.
In 2019, SEBI implemented interoperability, allowing trades on any exchange to be cleared by
any clearing corporation. Now, brokers can choose a single clearing corporation for all
trades.
Bene ts:
• Lower trading costs and better capital e ciency (e.g., margins calculated on net
position across exchanges).
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• Operational simplicity with compliance to only one clearing corporation.

Settlement Mechanism in Futures Contracts

Since Oct 2019, all stock futures are physically settled on expiry, while index futures remain
cash-settled. There are two types of settlements in futures:

A. Mark-to-Market (MTM) Settlement (Daily):

• Happens daily based on market price changes.
• Pro ts/losses calculated from:
◦ Trade price vs. settlement price for open trades,
◦ Previous vs. current day settlement prices for carried positions,
◦ Buy vs. sell price for intraday squared-o positions.
• Clearing members collect/pay MTM amounts for their TMs/clients.
• Daily settlement price = 30-min volume-weighted average price (VWAP).
• If no trades in last 30 mins, a theoretical price is used:
F = S × e^rt (F = futures price, S = spot price, r = interest rate, t = time to expiry).
• Cash-settled and settled before market opens next day.

B. Final Settlement (on Expiry Day):

• All positions marked to nal settlement price (30-min VWAP).
1. Cash-Settled Futures (Index Futures):
• All positions are marked to market and cash settled.
• For:
◦ Carry-forward positions → Payout = di erence between previous day’s and nal
settlement price.
◦ Same-day trades → Payout = di erence between trade price and nal settlement
price.
• T+1 settlement.
2. Physically Settled Futures (Stock Futures):
• Long and short positions are matched randomly for delivery.
• T+1 delivery:
◦ Seller delivers securities to the depository pool account.
◦ Buyer receives them in their depository account.
◦ Funds are debited/credited between clearing members through clearing banks.

Settlement Obligation in Stock Futures (Physical Delivery)

On expiry, stock futures are physically settled. Settlement obligations depend on the position
type:

1. Long Position (Buyer)

• Receives shares (buy obligation).
• Pays: Final Settlement Price × Lot Size
• Also pays MTM loss/gain = (Final Price – Previous Day's Price) × Lot Size
Example – Mr. P
• Long 1 lot (1500 shares)
• Final Price = ₹475, Previous = ₹482
• Buy obligation: ₹475 × 1500 = ₹7,12,500
• MTM loss: ₹(475 - 482) × 1500 = ₹-10,500 (to be paid in cash)

2. Short Position (Seller)

• Delivers shares (sell obligation).
• Must have shares in demat.
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• Gets MTM pro t/loss = (Final Price – Previous Day's Price) × Lot Size
Example – Mr. Q
• Short 1 lot (1500 shares)
• Final Price = ₹475, Previous = ₹482
• Delivery obligation: 1500 shares
• MTM pro t: ₹(475 - 482) × 1500 = ₹+10,500 (credited in cash)

Note: Both delivery and MTM settlement happen on T+1 day.

Settlement of Options Contracts

Options contracts have two types of settlements:

1. Daily Premium Settlement

• Buyer pays the premium; seller receives it.
• Net premium is settled in cash on T+1 (next trading day).
• Amount is credited/debited to the clearing member’s bank account.

2. Final Exercise Settlement (on expiry day)

Options are European-style (exercised only on expiry). Settlement di ers for index and stock
options:

(A) Index Options (Cash Settled)

• Only in-the-money (ITM) options are automatically exercised.
• Call option value = Closing price − Strike price
• Put option value = Strike price − Closing price
• Final amount is settled in cash on T+1.
Example:
Strike = 17500, Index closes at 17800, Lot = 50
→ (17800 - 17500) × 50 = ₹15,000 (cash settlement)

(B) Stock Options (Physically Settled)

• ITM options are automatically exercised and settled by delivery.
• Call Option:
◦ Long Call → Buy shares at strike price
◦ Short Call → Deliver shares at strike price
• Put Option:
◦ Long Put → Deliver shares at strike price
◦ Short Put → Buy shares at strike price
• Settlement value = Strike price × Lot size
• Delivery and fund obligations must be met on T+1.
Example 1 (Long Call):
Strike = ₹475, Close = ₹510, Lot = 1500
→ Must buy shares worth ₹475 × 1500 = ₹7,12,500
Example 2 (Long Put):
Strike = ₹475, Close = ₹410, Lot = 1500
→ Must deliver 1500 shares; value = ₹7,12,500

Note:
• Short ITM call → Must deliver shares.
• Short ITM put → Must pay for shares received.
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Net Settlement of Cash and F&O Segment on Expiry
• Purpose: Align cash and derivatives markets, reduce risk, and improve settlement
e ciency.
• Mechanism: On expiry, obligations from cash segment and physical settlement of F&O
positions are settled on a net basis.

Example:
• Mr. A holds a long put option (strike ₹110).
• He buys shares at ₹101 on expiry day; settlement price is ₹100.
• Under net settlement:
◦ No need to pay ₹101 or deliver shares separately.
◦ He simply receives ₹9 (₹110 - ₹101) as cash payout.
◦ No actual share delivery or funds pay-in required.

Conditions:
• Available only if trades in cash and F&O are cleared through the same TM-CM (Trading
Member–Clearing Member) setup.
• Not available to investors with di erent clearing arrangements or institutional investors.

Risk Management in F&O Segment

Exchanges, in collaboration with Clearing Corporations, use a comprehensive risk
containment mechanism to manage risks in the derivatives market. Key features include:
• Capital Adequacy: Members must meet stringent capital requirements to ensure
nancial strength.
• Initial Margin: Clearing corporations charge an upfront initial margin for all open
positions, based on Value-At-Risk (VaR). This margin is collected from trading members
(TMs) and their clients.
• Mark-to-Market (MTM) Settlement: Open positions are settled daily on an MTM basis,
re ecting market changes.
• Real-Time Monitoring: The Clearing Corporation’s system tracks positions in real-time,
sets limits, and generates alerts if members exceed prede ned thresholds. Violations
such as margin and position limit breaches are actively monitored.
• Position Monitoring Tools: Trading terminals help Clearing Members (CMs) monitor and
set limits for TMs under their supervision. If limits are exceeded, the system halts further
trading.
The most crucial aspect of risk management is the margining system and online position
monitoring, utilizing tools like the SPAN® system to calculate real-time margins based on
regulatory guidelines.

Margining and Mark-to-Market under SPAN

The SPAN (Standard Portfolio Analysis of Risk) system is used in the Indian derivatives
market to calculate initial margins by estimating the maximum potential one-day loss a
portfolio might incur. It treats futures and options uniformly while considering the unique risks of
each.

1. SPAN’s Purpose
• What it does: Calculates initial margins based on the worst-case one-day loss
scenario for a portfolio.
• Why it's used: To ensure su cient margins are collected to cover potential daily losses.
2. Margins in Equity Derivatives Segment
a. Initial Margin
• Collected upfront using SPAN at the client level (gross) and proprietary level (net).
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• Based on 99% Value at Risk (VaR) over 1-day (or 2-day for certain futures contracts).
• Ensures funds are available to cover potential losses before next-day trading starts.
b. Premium Margin
• Applies to option buyers.
• Covers the option premium that must be paid until the premium settlement is
completed.
c. Assignment Margin
• Applies to assigned options on expiry.
• Covers the nal settlement obligation of assigned ITM options (either cash or delivery).
• Charged till the option is fully settled.

3. Intra-day Crystallised Losses (ICMTM)

• These are realised losses from trades that close existing positions during the day.
• Calculated based on weighted average prices.
• Applies only to futures.
• Losses are adjusted against any pro ts at the client level.
• Final gure is grossed up to the clearing member level.
• Blocked funds are released after daily mark-to-market settlement.

Delivery Margins
• When? Applied 4 days before expiry for ITM long options and positions requiring
delivery.
• How much? Levied gradually:
◦ Day -4: 20%
◦ Day -3: 40%
◦ Day -2: 60%
◦ Day -1: 80%
• Based on client-level delivery obligation.
• Released after settlement.
• If converted to delivery post-expiry, margins like VaR, ELM, MTM (from cash market)
apply.

Exposure Margins
• In addition to initial margins.
• Based on VaR and Extreme Loss Margin (ELM) percentages from the capital market.
• Applied at client level and updated whenever margin rates change.

Short Option Minimum Charge

• This charge used to apply to deep OTM short options.
• Now discontinued as per SEBI circular (Feb 24, 2020).

Net Option Value

• Calculated as: (Long Option Value - Short Option Value).
• Valued using closing or current market price.
• Added to the liquid net worth of clearing members.
• No daily cash settlement for MTM in options.

Client Margin Reporting

• Clearing corporations notify members of client-level margin liabilities.
• Brokers must report how much margin they collected from each client.
• Margins are held in trust; misuse leads to penalties.
• To avoid misuse:
◦ Client securities must be pledged via a ‘margin pledge’ system in depositories.
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◦ A separate Client Securities Margin Pledge Account must be used.
• Clients can view reported margins via web portals.

6. Peak Margin Obligation

• Earlier, brokers collected only end-of-day (EOD) margins, allowing intraday leverage.
• New SEBI rule: Brokers must also consider peak margin during the day (based on 4
snapshots).
• Brokers must ensure:
◦ Margin available ≥ EOD obligation
◦ Margin available ≥ Peak margin observed
• If shortfall in either → penalty.
• Since Aug 1, 2022, penalties only apply if BOD margin is not maintained.
◦ Helps traders plan better, with predictable margin requirements.

7. Cross Margining
• Allows margin o set between cash & derivatives segments.
• Applicable when positions o set each other.
• Requires:
◦ Noti cation through Collateral Interface for Members (CIM).
◦ Agreements between clearing members (if separate for each segment).

8. Early Pay-in (EPI) of Securities/Funds

• If a client makes early delivery of securities/funds:
◦ Their position is exempt from delivery margins.
• Can be done through NSDL or CDSL.
• Clearing members must declare client details to claim EPI bene t.

Pledge/Repledge Mechanism for Client Securities

Why Was It Needed? Earlier, brokers used Power of Attorney (PoA) to move securities from a
client’s demat account to their own for margin purposes.
This led to:
• Misuse of client securities, like using one client's shares to meet another’s margin.
• Brokers diverting assets for proprietary trading or personal business.
• Misappropriation of dividends from inactive client accounts.

What Changed? (Since Sept 2020): SEBI introduced a new pledge/repledge system to protect
clients.
1. No PoA Needed:
Clients no longer give PoA; instead, they pledge securities using Depository’s “Margin
Pledge” facility.
2. Dedicated Demat Accounts:
◦ Broker (TM) opens a Client Securities Margin Pledge Account.
◦ Client pledges shares to this account.
◦ TM can repledge to Clearing Member (CM) only from this account.
◦ CM can repledge to Clearing Corporation (CC).
3. Full Transparency:
◦ Every step of the pledge → repledge trail is visible in the demat system.
◦ No transfer of ownership takes place—securities stay in the client’s name.
4. Client Protection:
◦ Brokers can use repledged securities only for that client’s margin.
◦ Reduces risk of fraud or misuse.
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Segregation & Monitoring of Collateral at Client Level
Why Was It Introduced? SEBI introduced this mechanism to ensure full transparency and clear
tracking of each client’s collateral (both cash and non-cash) at every level — from broker (TM)
to Clearing Corporation (CC).

1. What the Trading Member (TM) Must Report to the Clearing Member (CM):
• (a) Client-wise collateral received
• (b) Collateral retained by TM
• (c) Collateral passed on to CM
2. What the Clearing Member (CM) Must Report to the Clearing Corporation (CC):
• (a) Client collateral received by TM
• (b) Collateral retained by TM
• (c) Collateral placed with CM
• (d) Collateral retained by CM
• (e) Collateral placed with CC

All reporting is done daily.

Purpose / Bene t:
• Ensures collateral is used only for the right client.
• Helps prevent misuse/diversion of funds or securities.
• Provides complete visibility and audit trail for regulators and clearing corporations.

Position Limits in Equity Derivatives

Position limits are caps on the number of derivative contracts (futures/options) that a client or
trading member can hold.
They exist to prevent market manipulation and reduce systemic risk.

Types of Position Limits Set by SEBI:

1. Client-Level Position Limit (for individual clients):
• Applies security-wise.
• Limit is higher of:
◦ 1% of free- oat market capitalisation (in shares), OR
◦ 5% of total open interest in that stock (in shares).
• If a person or group holds 15% or more of total open interest in an index:
➤ Must report to the exchange.
➤ Penalty for non-disclosure.

2. Trading Member-Level Position Limit (for brokers):

• Index Futures & Options: Higher of
◦ ₹7500 crores, OR
◦ 15% of market-wide open interest.
• Individual Securities:
◦ Limit = 20% of Market-Wide Position Limit (MWPL).

3. Market-Wide Position Limit (MWPL):

• 20% of non-promoter holding (free oat) in a stock.
• Monitored by Clearing Corporation, based on last trading day of the month.
• If 60% of MWPL is reached: Alert is triggered.
• If 95% is crossed:
➤ Fresh positions banned from next day.
➤ Normal trading resumes only when open interest drops to 80% or below.
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Violations & Penalties:

• Client Limit Violation:
➤ No new positions allowed, existing must be reduced.
➤ Penalty charged to clearing member.
• TM Limit Violation:
➤ Live monitoring; no increase in open position allowed.
• MWPL Violation:
➤ Checked daily.
➤ Fresh positions banned.
➤ Penalty if positions are added during ban (recovered on T+1 day).

Settlement of Running Account of Client Funds (EISSL)

To prevent misuse of client funds, SEBI requires brokers (TMs) to settle the running account
of clients either monthly or quarterly, based on the client’s choice.
• Settlement must consider the End of Day (EOD) fund obligations across all exchanges.
• Stock Exchanges issue a joint annual calendar at the start of each nancial year to
ensure uniform settlement dates.

SGF, IPF, and SEBI’s Recent Measures

1. Core Settlement Guarantee Fund (Core SGF):

• A mandatory fund for each market segment (Cash, F&O, Currency Derivatives, etc.).
• Used to guarantee trade settlements if a clearing member defaults.
• Ensures settlements continue smoothly without disrupting the market.

2. Investor Protection Fund (IPF):

• Created to compensate investors when a broker defaults and their assets aren't enough
to repay clients.
• Also used for investor education, awareness, and research.
• Managed through a registered trust.

3. SEBI’s Recent Risk-Reduction Measures (to protect investors & ensure market stability):
Effective
Measure Purpose
Date
1 Feb Reduces misuse of leverage by ensuring full premium is
Upfront Option Premium Collection
2025 collected from buyers.
No Calendar Spread Margin Bene t 1 Feb
Prevents risk from contracts offsetting each other on expiry.
on Expiry Day 2025
Intraday Position Monitoring (4 1 Apr
Better oversight of traders' limits to stop manipulation.
snapshots/day) 2025
20 Nov Minimum size raised to ₹15–₹20 lakhs to reduce over-trading/
Revised Index Contract Size
2024 speculation.
20 Nov Each exchange can offer weekly expiry for only one
Weekly Expiry Rationalisation
2024 benchmark index to reduce clutter.
Extra Expiry-Day Margin (2% 20 Nov More protection against high expiry-day volatility from short
ELM) 2024 positions.
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Cyber Security & Cyber Resilience Framework (CSCRF) for Stock Brokers & DPs (EISSL)

Purpose:
• With increasing tech use in securities markets, SEBI introduced a new CSCRF to ensure
data protection, privacy, and market integrity.
• The framework applies to all SEBI Regulated Entities (REs), starting phased
implementation from Jan 1, 2025.

Who it Applies To (Market Infrastructure Institutions – MIIs):

1. Stock Exchanges
2. Depositories
3. Clearing Corporations
4. KYC Registration Agencies (KRAs)
5. Quali ed Registrars & Transfer Agents (QRTAs)

Goals of Cyber Resilience (5 Pillars):

1. Anticipate – Stay prepared and informed against cyber threats.
2. Withstand – Keep essential operations running during attacks.
3. Contain – Isolate and manage cyber incidents to limit spread.
4. Recover – Quickly restore business functions after an attack.
5. Evolve – Adapt systems continuously to prevent future threats.
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Securities Contracts (Regulation) Act, 1956
Objective:
• The primary objective of the Act is to prevent undesirable transactions in securities and
regulate the trading of securities in India.
De nition of Securities:
• Securities as de ned in Section 2(h) of the Act.
The term includes:
◦ Shares, scrips, stocks, bonds, debentures, debenture stock, or other marketable
securities in or of any incorporated company or other body corporate.
◦ Derivatives
◦ Units or any other instrument issued by any collective investment scheme.
◦ Government securities
◦ Any other instruments declared by the Central Government to be securities.
◦ Rights or interests in securities.
De nition of Derivatives:
• A security derived from a debt instrument, share, loan (whether secured or unsecured),
risk instrument, or contract for di erences.
• A contract which derives its value from the prices or index of prices of underlying
securities.
• Commodity derivatives, and any other instruments declared by the Central Government
to be derivatives.

Section 18A: Legality of Derivative Contracts

• Contracts in derivatives shall be legal and valid if:
◦ Traded on a recognized stock exchange.
◦ Settled on the clearing house of the recognized stock exchange, as per the rules
and bye-laws.

Regulation in Trading
• Exchange Requirements:
◦ Derivatives exchange/segment must have a separate governing council.
◦ The representation of trading/clearing members on the governing council is limited
to a maximum of 40%.
◦ A minimum of 50 members should be present on the exchange.
◦ The minimum contract value should be no less than Rs. 5 Lakhs.
• Clearing Member Requirements:
◦ The minimum net worth for clearing members of the derivatives clearing
corporation/house shall be Rs. 3 Crores.
◦ The minimum contract value should be Rs. 5 Lakhs.

Responsibilities of Clearing Corporation

• Key Responsibilities:
◦ Timely collection of margins.
◦ Ensure smooth operation of the market.
◦ Daily clearing and settlement.
◦ Act as the legal counterparty for every contract.
◦ Monitor positions in derivatives and cash segments.
◦ Set daily settlement prices.
◦ Maintain consistent records of margins at the client level.
◦ Ensure that client margins are not appropriated for broker dues.
• Default Action:
◦ In the event of default by a clearing member, client positions can be transferred to
another broker member.
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Trade Guarantee Fund (TGF)
• Objectives:
◦ Guarantee the settlement of bona de transactions for exchange members.
◦ Boost market con dence.
◦ Protect the interests of investors in securities.
• Contributions:
◦ All active members of the exchange must contribute to the Trade Guarantee Fund.

Major Recommendations of Dr. L.C. Gupta Committee:

1. Margins should be based on Value at Risk methodology with 99% con dence.
2. Volatility and exposure should be monitored online.
3. Daily collection of Mark to Market Margins.
4. Stringent entry norms for derivative broker-members.
5. SEBI-approved certi cation exams for dealers, valid for 3 years.
6. Derivative segments should be separate from the cash segment.
7. Investor Protection Fund for the derivatives segment.
8. Derivatives market should be phased, starting with index futures.
9. Separate Governing Boards for Cash and Derivatives segments.
10. Risk Disclosure Document for all clients.
11. Brokers must maintain margins in a separate bank account.
12. Brokers cannot use client margins for any purpose except payment to the clearing
corporation.

Major Recommendations of Prof. J.R. Verma Committee:

1. Calendar spreads on futures should attract lower margins (1% to 3%).
2. Initial margin levels should be dynamic, recalculated based on volatility.
3. Lower margins for calendar spreads.
4. Exchanges need SEBI approval before changing the initial margin calculation
methodology.
5. Di erential margins for conversion of calendar spread positions.
6. Liquid assets must form at least 50% of the total liquid assets.

Liquid Assets and Margin Requirements

1. Cash Component:
◦ Cash, bank xed deposits (FDRs), bank guarantees (BGs).
◦ Government securities and T-Bills.
◦ Money market mutual funds and gilt funds.
2. Non-Cash Component:
◦ Liquid (Group I) equity shares in demat form.
◦ Mutual fund units (except those under the cash component).
3. Liquid Net-worth:
◦ De ned as liquid assets minus initial margin.
◦ Clearing members must maintain a minimum liquid net-worth of Rs. 50 Lakhs.
Regulatory Requirements for Derivative Markets
1. Minimum Net-worth and Deposit:
◦ Clearing members must maintain a minimum deposit in liquid assets of Rs. 50
Lakhs with the exchange or clearing corporation.
2. Mark to Market Settling:
◦ Liquid assets must be marked to market on a weekly basis.
◦ Haircut rates on equity (15%) and debt securities (10%).
3. Client Identi cation:
◦ Brokers must indicate the client on whose behalf the transaction is being entered.
◦ Proprietary trading must be clearly identi ed.
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Clearing Corporation and Brokerage Rules

1. Proprietary Trading:
◦ Must be identi ed separately.
2. Risk Disclosure:
◦ Clients must be provided with a risk disclosure document by brokers.
3. Broker's Responsibilities:
◦ Brokers must maintain a separate bank account for client margins.
◦ They cannot use client margins for any purpose other than settling dues with the
clearing corporation.
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Chapter 9: Accounting and Taxation
Accounting for Forward Contracts as per Accounting Standard - 11
When Forward Contract is for Hedging:
• The premium or discount should be amortized over the life of the contract.
• Exchange di erence is recognized in the Pro t & Loss (P&L) statement for the year.
• Pro t/Loss on cancellation/renewal of the forward contract is recognized in the P&L of
the year.
When Forward Contract is for Trading/Speculation:
• No premium or discount is recognized.
• A gain or loss (di erence between the forward rates for the remaining maturity period)
should be recognized in the P&L of the period.
• Pro t/Loss on cancellation/renewal of the forward contract is recognized in the P&L of
the year.

Accounting of Equity Index and Equity Stock Futures in the Books of the Client
• The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on
accounting for index futures contracts.
• The section focuses on the accounting treatment of equity index futures in the books of
the client.

Taxation of Pro t/Loss on Derivative Transactions in Securities

• Prior to Financial Year 2005–06, transactions in derivatives were considered speculative
for tax purposes under the Income-tax Act.
• Finance Act, 2005 amended section 43(5) to exclude transactions in derivatives carried
out on a recognized stock exchange.
Impact:
◦ Income or loss on derivative transactions carried out on a recognized stock
exchange is not taxed as speculative income.
◦ Loss on derivative transactions can be set o against other income (except salary
income).
◦ If not set o , the loss can be carried forward for up to 8 assessment years to
o set against other non-speculative business income.

Securities Transaction Tax (STT)

• STT Rates:
1. Sale of an option in securities: 0.05% (from 2016).
2. Sale of an option in securities, when exercised: 0.125% (paid by the purchaser).
3. Sale of futures in securities: 0.01%.
• Applicability:
1. STT is applicable on all sell transactions for both futures and options contracts.
2. Option trade is valued at the premium.
3. Futures trade is valued at the actual traded price.
• Voluntary/Final Exercise of an Option Contract:
1. STT is levied on the settlement price on the day of exercise if the option contract is
in the money.
• Clearing Member Responsibility:
1. STT payable by the clearing member is the total STT payable by all trading
members clearing under them.
2. A trading member’s liability is the aggregate STT liability of clients trading through
them.

Accounting for Equity Index/Stock Futures

1. At the Inception of the Contract (Initial Margin):
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◦ Initial margin paid or payable should be debited to “Initial Margin - Equity Index/
Equity Stock Futures Account”.
◦ At the balance sheet date, the balance in the account should be shown under
Currency Assets.
◦ Any excess paid margin should be disclosed as a current asset.
2. At the Time of Daily Settlement (Mark-to-Market Margin):
◦ Payments made or received for Daily Settlement should be debited or credited to
“Mark-to-Market Margin - Equity Index/Equity Stock Futures Account”.
3. Accounting for Open Interests (Balance Sheet Date):
◦ Following the prudence principle, provisions should be created for anticipated
losses, equivalent to the debit balance in the Mark-to-Market Margin Account.
◦ Anticipated pro ts (credit balance) should not be recognized in the P&L account.
4. At Final Settlement or Squaring-Up of the Contract:
◦ At the expiry of the equity index futures, the pro t/loss on nal settlement should
be calculated as the di erence between the nal settlement price and the contract
prices.
◦ The pro t/loss should be recognized in the P&L with corresponding debit/credit to
the Mark-to-Market Margin Account.
◦ The same accounting treatment applies when a contract is squared-up by entering
into a reverse contract.
5. In Case of a Default:
◦ If a client defaults on payment for Daily Settlement, the contract is closed out.
◦ Any unpaid amount is adjusted against the initial margin.
◦ Excess margin, if any, is released. Shortfall, if any, is payable by the client.
Derivatives Income Considered as Normal Business Income
• Derivatives income is now treated as normal business income, not speculative income.
• Losses can be set o against other income (except salary income), reducing taxable
income and thus tax liability.
• If the loss cannot be set o in the current year, it can be carried forward for up to 8
assessment years.
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Chapter 10: Sales Practices and Investors Protection Services
Customer-Oriented Approach in Financial Institutions
• Financial institutions should focus on a customer-oriented approach, ensuring that the
sale of products is customer-led and accompanied by e cient and appropriate advice.
• Summary: “Customers have the right to good advice; nance employees have the duty
to provide good advice.”

Warnings for Investors: High Return & Risk-Free Investments

• Spectacular pro ts or guaranteed returns should be approached with caution.
• No investment is risk-free; returns are always related to the risk taken.
• A product promising high returns in a risk-free manner is unrealistic and should be
avoided.

Investment Advisor Services

• An investment advisor is responsible for making investments on behalf of clients or
providing advice to them.
• The advisor has a duty to act in the best interests of their clients.
• Caution: Sometimes, investment advisors may misappropriate money from clients.
Therefore, investors should review monthly statements and conduct annual reviews of
their investment plans.

Unsuitable Investment Recommendations

• Some unscrupulous investment advisers may push clients to purchase unsuitable
investment products that don’t meet the investor’s goals or risk pro le.
• Example: A broker selling speculative products like options, futures, or penny stocks to
a senior citizen with low risk tolerance.
• Advice: Investors should carefully review the risk pro le of each recommendation.

Investment Seminars
• Investment advisors often invite clients to seminars where sales tactics may be used to
promote unsuitable products.
• Advice: Avoid rushed decisions at sales seminars. Seek objective third-party advice
before committing funds.

Churning
• Churning refers to making unnecessary and excessive trades in customer accounts to
generate commissions.
• Advice: Investors should regularly review monthly statements and investigate any
abnormally high trading activity.

Customer Due Diligence (CDD)

• CDD measures involve:
3. Identifying bene cial owners or controllers of securities accounts.
4. Verifying the customer’s identity using reliable, independent sources.
5. Ongoing due diligence to ensure transactions align with the customer’s pro le and
business knowledge.
• Risk Pro le Considerations:
1. Risk tolerance depends on factors such as age, personal income, family income,
occupation, and education.
2. Objectives should be clari ed to provide proper advice for both short-term and
long-term needs.
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Risk-Based Approach
• Customers can be classi ed into higher or lower risk categories depending on factors
like background, business relationships, and transactions.
• Registered intermediaries should apply customer due diligence measures based on
risk sensitivity.
• Enhanced due diligence is required for higher risk customers.

Clients of Special Categories (CSC)

• Special category clients include:
3. Non-resident clients (NRIs)
4. High net-worth individuals (HNIs)
5. Trusts, Charities, NGOs, and organizations receiving donations
6. Companies with close family shareholding or bene cial ownership
7. Politically exposed persons (PEPs) of foreign origin
8. Companies o ering foreign exchange o erings
9. Clients in high-risk countries
10. Non face-to-face clients
11. Clients with dubious reputations based on public information

Investor Grievance Mechanism

• All exchanges have a dedicated department to handle grievances against Trading
Members and Issuers.
• Investor Service Committees (ISC), consisting of exchange o cials and independent
experts, oversee the grievance process.
• SEBI also monitors exchange performance regarding investor grievance redressal.

SEBI Complaints Redress System (SCORES)

• SCORES is a web-based system for managing investor complaints.
• Salient Features of SCORES:
1. Centralized database of investor complaints.
2. Online movement of complaints to concerned entities.
3. Online upload of Action Taken Reports (ATRs) by concerned parties.
4. Investors can track the status of their complaints and view updates.
• If a company fails to resolve a complaint within the prescribed time, it is recorded as
non-compliance in SCORES, and the regulator monitors these instances.

Proprietary Positions and Margins

• Proprietary positions are calculated on a net basis (buy less sell).
• Margins are required to be paid on a gross basis for client positions and on a net basis
for proprietary positions.
• Clearing members engaged in proprietary trades receive higher exposure as their
positions are calculated on a net basis.

Market Makers or Liquidity Providers

• A market maker or liquidity provider is an entity that quotes both buy and sell prices in
a nancial instrument, aiming to pro t from the bid-o er spread.
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