Ncfm option trading strategies module pdf

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Derivatives Advanced Module NATIONAL STOCK EXCHANGE OF INDIA LIMITED 2. Name of Module Fees Rs. Test Duration in minutes No. A Beginners' Module 60 50 5 3 Currency Derivatives: Registrars to an Issue and Share Transfer Agents — Corporate Certification Examination 50 3 26 NISM-Series-II-B: Registrars to an Issue and Share Transfer Agents — Mutual Fund Certification Examination 50 3 27 NISM-Series-III-A: Securities Intermediaries Compliance Non-Fund Certification Examination 60 3 28 NISM-Series-IV: Interest Rate Derivatives Certification Examination 60 3 29 NISM-Series-V-A: Mutual Fund Foundation Certification Examination 50 50 50 3 31 NISM-Series-VI: Depository Operations Certification Examination 60 3 32 NISM Series VII: Securities Operations and Risk Management Certification Examination 50 3 33 NISM-Series-VIII: Equity Derivatives Certification Examination 60 3 34 NISM-Series-IX: Merchant Banking Certification Examination 60 3 35 NISM-Series-XI: Equity Sales Certification Examination 50 3 36 NISM-Series-XII: FLIP Module of IMS Proschool The curriculum for each of the modules except Modules of Financial Planning Standards Board India, Finitiatives Learning India Pvt.

This workbook builds on those modules to discuss advanced topics in derivatives. Exponentially Weighted Moving Average EWMA This book has been developed for NSE by Mr. Sundar Sankaran, Director, Advantage India Consulting Pvt. NSE Exchange Plaza, Bandra Kurla Complex, Bandra East , Mumbai INDIA. All content included in this book, such as text, graphics, logos, images, data compilation etc. This book or any part thereof should not be copied, reproduced, duplicated, sold, resold or exploited for any commercial purposes.

Furthermore, the book in its entirety or any part cannot be stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise.

The underlying may be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity.

Depending on how the pay offs are structured, it could be a forward, future, option or swap. However, forwards are not traded in the market. However, futures are tradable in the market. The pay offs in a futures contract are symmetric. The option holder pays the option writer an option premium for entering into the contract. Unlike futures, the pay offs in an option contract are asymmetric.

The downside for the option holder is limited to the premium paid; the option seller has an unlimited downside. American options are exercisable any time until expiry of the contract; European options are exercisable only on expiry of the contract. The payments may cover only interest, or extend to the principal in different currencies or even relate to other asset classes like equity.

The same exposure can be taken, either through the underlying cash market debt, equity etc. A benefit of derivative is the leveraging. For the same outgo, it is possible to have a much higher exposure to the underlying asset in the derivative market, than in the underlying cash market.

This makes it attractive for speculaters and hedgers, besides normal investors. This is calculated by examining the historical returns from the equity share and a diversified equity index over a long period of time say, daily returns over 3 years. As an illustration, the calculation is shown in Table 1. A higher value of R-square indicates that the relationship is indeed strong.

The R-square value of 0. The calculations in Tables 1. Beta and R-square are calculated based on data over a long period of time, say 2 — 3 years. At least 30 observations are required for a normal distribution. Normal discrete compounding with the same parameters would have been calculated as Rs. More frequent compounding increases the terminal value Rs. A call option has intrinsic value if its exercise price K is lower than the prevailing market price S0.

The intrinsic value would be equivalent to S0 — K , but not negative. If the exercise price of a call is higher, it will be allowed to lapse i. Therefore, the intrinsic value of a call is given as Max 0, S0 — K.

A put option has intrinsic value if its exercise price K is higher than the prevailing market price S0. The intrinsic value of a put would be equivalent to K — S0 , but not negative.

If the exercise price of a put is lower, it will be allowed to lapse i. Therefore, the intrinsic value of a put is given as Max 0, K — S0. Time value of an option is the excess that market participants are prepared to pay for an option, over its intrinsic value.

Suppose the premium quoted in the market for a call option with exercise price Rs. The stock is quoting at Rs. Intrinsic value of the option is Max 0, 17 — 15 i. Time value is Rs. The various factors that affect the value of an option i. If it is out of the money i. Therefore, higher the interest rate, more valuable the call option. Higher the interest rate, greater the opportunity cost of money.

Therefore, higher the interest rate, less valuable the put option. This will reduce the intrinsic value of a call option and increase the intrinsic value of a put option.

Binomial and Black Scholes are two approaches to option valuation.

Derivatives advanced module (NATIONAL STOCK EXCHANGE OF INDIA LIMITED)

Black Scholes has its inaccuracies, but is less cumbersome to apply than Binomial. A brief discussion on Black Scholes Option Pricing Model and the option Greeks is featured in Chapters 5 and 6 of this Workbook. Given a distribution, various other interpretations become possible. A normal distribution is defined by its mean and standard deviation. It is depicted in the form of a bell-shaped curve, as shown in Figure 1. In the above case, it is For example, reading from the first row of the table: This means that Because of this asymmetric nature of share prices, normal distribution is not a suitable assumption to capture the behaviour of share prices.

However, the returns from the shares over short periods of time can be said to be normally distributed. If a share has gone up from Rs. Since, log of a stock price in future is assumed to be normally distributed, stock prices are said to be log normally distributed. Several models, including Black-Scholes, assume that during short periods of time, percentage change in stock prices which is the return in a non-dividend paying stock is normally distributed. A variable with log normal distribution can take values between zero and infinity.

A log normal distribution is skewed to one side not symmetric like a normal distribution. It is an important input that affects the valuation of options. There are various facets to volatility. Thus, estimate for annual volatility is 0. ARCH m Model The calculation in Table 1. It can be argued that the more recent data is more important than the earlier data. Autoregressive Conditional Heteroskedasticity ARCH models can handle this.

Broadly, the model can be defined as follows: The weights are given such that the weight for the ith observation is more than that for the i-1th observation; i-1th observation has more weightage than i-2th observation, and so on. The total of all the weightages should be equal to 1 i. With this, volatility can be easily calculated as per the following formula: GARCH Model Generalised Autoregressive Conditional Heteroskedasticity GARCH models represent a further refinement.

The equation is written as follows: GARCH 1,1 is commonly used. Implied Volatility The volatility estimation discussed so far considered historical volatility based on price movement of a market variable, such as price of a stock. Volatility of the stock in turn affects the value of the stock option through a model like Black Scholes.

The Black Scholes model gives the theoretical value of the option, given historical volatility and other parameters that the model is based on. The actual option premia in the market are likely to be different from the theoretical estimation of any market participant, because of differences in the parameters used by various market participants.

Given the market price of an option, and the parameters other than volatility, it is possible to do the Black Scholes calculation backwards, to arrive at the volatility implicit in the price. This is the implied volatility.

Implied volatility of a contract is the same for the whole market. However, historical volatility used by different market participants varies, depending on the periodicity of data, period covered by the data and the model used for the estimation of volatility.

Given the difference in historic volatility, the option value calculated using the same Black Scholes model varies between market participants. Accordingly, the following descripters are prevalent in the FO segment: They expire on the last Thursday of the relevant month.

If the last Thursday is a trading holiday, then they expire on the previous trading day. A new contract is introduced on the trading day following the expiry of the near month contract.

The new contract is introduced for 3-month duration i. Thus, the 3-month trading cycle is maintained, as shown in Table 2. For example, the market lot contract multiplier for Futures on Nifty Index is At the Nifty Index value of 6,, the value of the futures contract on the Nifty Index would be 50 X 6, i. On the NSE, futures are available on: Based on this, NSE has laid down the following criteria: The market wide position limit number of shares shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month.

If an existing security fails to meet the eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that security. However, the existing unexpired A stock which has remained subject to a ban on new position for a significant part of the month consistently for three months, shall be phased out from trading in the FO segment.

Further, once the stock is excluded from the FO list, it shall not be considered for re- inclusion for a period of one year. In such instances, the stock is required to fulfil the eligibility criteria for three consecutive months, to be re-introduced for derivatives trading. The index on which futures and options contracts are permitted shall be required to comply with the eligibility criteria on a continuous basis.

In respect of orders which have come under price freeze, members are required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. For example, the quantity freeze limit for Futures on CNX Nifty is 15, In respect of orders which have come under quantity freeze, members are required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine.

On such confirmation, the Exchange may approve such order. In all other cases, quantity freeze orders shall be cancelled by the Exchange.

NSCCL , a wholly owned subsidiary of NSE. Thus, the exposure of either independent party is to NSCCL. This ensures that even if one of the counter-parties does not meet its obligation, NSCCL will settle the obligation to the other counter-party. These are collected from both parties to the futures contract. NSCCL collects the requisite margins from Clearing Members, who will collect it from Trading Members who in turn will collect from the client.

The margins are monitored on-line on intra-day basis. The following types of margins are prevalent: The standard deviation of daily logarithmic returns of prices in the underlying stock in the cash market in the last six months is computed on a rolling and monthly basis at the end of each month.

In case of calendar spread positions in futures contract, exposure margins are levied on one third of the value of open position of the far month futures contract. The calendar spread position is granted calendar spread treatment till the expiry of the near month contract. The initial and exposure margin is payable upfront by Clearing Members. Margins can be paid by members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts and approved securities. Clearing members who are clearing and settling for other trading members can specify in the NEAT system, the maximum collateral limit towards initial margins, for each trading member and custodial participant clearing and settling through them.

Such limits can be set up by the clearing member, through the facility provided on the trading system upto the time specified in this regard.

The Clearing Members who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily mark-to-market settlement.

The option can be exercised once in a quarter Jan-March, Apr-June, Jul-Sep Oct-Dec. The option once exercised shall remain irrevocable during that quarter. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. Open positions in futures contracts cease to exist after their expiration day. On the same day, Reliance Futures with expiry on March 28, are trading at Rs.

The interest cost would be Rs. The total acquisition cost would thus be Rs. If the futures are available at a price lower than Rs. The calculations are refined in the next section, to arrive a break-even futures price of Rs. An investor holding the underlying share will receive the dividend. But the holder of Reliance Futures will not be entitled to the dividend. The Present Value of Dividend PVD therefore will need to be subtracted from the spot price. However, continuous compounding is normally used instead of discrete compounding.

Cost of carry on continuous basis is 6. The price for March 28 Nifty Futures can be calculated as: If Nifty Futures is trading higher, then arbitragers will see opportunity for arbitrage. They will buy Nifty basket in spot and sell Nifty futures.

This will raise the Nifty spot or pull down Nifty futures, thus restoring equilibrium. Since various companies will pay a dividend at different points of time, the calculation assumes dividend is paid continuously not on discrete basis.

This dividend rate is directly subtracted from the cost of carry, as shown below: The no-arbitrage futures price will be calculated as follows: For example, the market lot for Nifty Futures is Therefore, the contract value would be Rs. The role of arbitrager in restoring equilibrium was also discussed. Let us now examine the role of arbitrager in detail. Arbitragers do not want to take an exposure, but wish to earn riskless profits. Suppose, in the earlier case, Reliance Futures with expiry on March 28, were available in the market at Rs.

The investor would do the following trades: Buy Reliance Shares in the Cash Market Rs. It is an arbitrage transaction. Sell Reliance Shares in the Cash Market say, Rs.

Hughes Optioneering

The profit does not depend on the price of Reliance shares on March If the shares were trading at a price higher than Rs. The net arbitrage profit would remain the same. This is the essence of arbitrage — future change in price of the underlying does not affect the net profit or loss.

A point to note is that in these calculations, the margin payments on Reliance futures have not been considered. Profitability will be lower to the extent of interest cost on the margin payments. Similarly, brokerage and securities transaction tax will reduce the profits.

Sell Reliance Shares in the Cash Market Rs. Buy Reliance Shares in the Cash Market say, Rs. Receive interest income of Rs. Closer to maturity of the contract, the basis will trend towards zero.

On maturity of the futures contract, t is equal to 0. Therefore, the convergence happens in waves, rather than along a straight line. Such a relative price position is called contango. This is the normal position for equity futures that do not involve a dividend. At times, on account of extremely bearish market situations or any technical factors, the futures price may be trading lower than the spot price of the same underlying. In such situations, the stock is said to be in backwardation.

This is more common with commodity futures rather than financial futures, on account of some unique aspects driving valuation of commodity futures, as discussed below. The position yielded a return in the form of dividend besides capital gain. Adjustment for dividend while valuing equity futures has already been discussed.

Investment in commodities like gold and oil entail another element of cost viz. Further, commodities do not yield a dividend. However, the person holding the commodity may earn something out of it.

These elements are part of the calculation of price of commodity futures, as follows- Discrete basis: Futures on Stock X, expiring on April 25 are trading at What trade should he do and how much will he earn in the process, if Stock X goes down to Rs. This direct relationship between spot and futures contracts is depicted in Figure 3. Therefore, the relationship is generally not so straight. Even if not straight, the relationship is clearly direct.

Therefore, investors have a choice of taking their investment position through spot market or futures markets, as discussed in the previous chapter. When the underlying grows in value, the futures contract gains in value too. Thus, the buyer benefits with a rise in the underlying. But, if the underlying were to lose value, then the futures contract will lose value too. The relationship can be seen in payoff matrix shown in Figure 3.

Here, an investor is presumed to have bought Nifty futures when the Nifty was at 5, But since the seller has short-sold the contract, he will lose money when he covers his position at a higher price.

On the other hand, if the underlying were to lose value, then the futures contract will lose value too; the investor who shorted the Nifty future can now buy it back at a lower price and book a profit. The relationship can be seen in the payoff matrix shown in Figure 3. Here, an investor is presumed to have sold Nifty futures when the Nifty was at 5, This is a company he is bullish about. He is however concerned that if the general market goes down, then this stock too will lose value. He can hedge himself against a general decline in the market, by selling Nifty futures.

How many Nifty futures to sell, depends on the relationship between Nifty and the Infosys stock, which is captured by the beta of the stock as discussed in Chapter 1. Suppose the beta of Infosys is 0. The value of Nifty Futures to sell would be Rs.

If the Nifty is at 6,, and the contract multiplier for Nifty Futures is The notional value of each Nifty Futures contract is 6, X 50 i. Thus, the investor will have to sell Rs. Selling Nifty Futures to hedge against purchase of Infosys shares is not a perfect hedge selling Infosys Stock Futures would be more perfect.

How much of the risk is eliminated by selling Nifty futures? The answer lies in the R-square value. The beta value of 0. The revised contract value would be 6, X 50 i. Based on its beta, one would expect Infosys to go up by 0.

This would translate to a share price of Rs. The gain on Infosys shares purchased would have been: Thus, despite the hedge, some risk remains. It arises because Nifty is not a perfect hedge for shares of Infosys. Infosys Futures are a perfect hedge for Infosys shares. To illustrate the point, the data in Figure 3. R-square is 1 i. For example, an automobile manufacturer may choose to hedge itself against fall in demand for its vehicles arising out of rising petrol prices, by buying oil futures.

In the Infosys example, the shares of Infosys had a beta of 0. If the portfolio had only this one share, the beta of the portfolio would have been 0.

By selling the requisite Nifty futures, the portfolio manager has ensured that changes in Nifty do not affect the portfolio i. Suppose he wanted to bring the portfolio beta to 0. Selling 28 Nifty Futures contracts brought down the portfolio beta from 0. In order to bring down the portfolio beta to 0.

In this manner, portfolio managers can target a beta for their portfolio, without changing the securities they have invested in. Suppose, the exposure is for a year, while the longest hedge instrument available in the market is of 3 months. The hedger has no option but to hedge for 3 months. At the end of 3 months, he will roll-over the hedge i. The same process will be repeated at the end of each quarter. Before getting into a position, it is essential for the top management to understand the cash flow impact and profit impact of the hedge, in various price scenarios.

Its beta is 0. How will he hedge his position? Interest rate options are not permitted in India yet. As market yields go up, market value of fixed interest rate debt securities already issued, go down, and vice versa. We know that an investor can protect himself from a decline in equity prices by selling equity futures; he can benefit from an increase in equity prices by buying equity futures. Similarly, an investor can protect himself from an expected decline in debt security prices i.

Offering futures on each individual debt security is not practical, because the contracts would not have any liquidity in the market. In any case, yields in the market are the prime influence of security prices.

Therefore, interest rate futures are offered only on a few real or notional debt securities. Trading hours are 9 am to 5 pm from Monday to Friday. While the short term interest rate futures Contract descripter is FUTIRT are cash settled, the long term interest rate futures Contract descripter is FUTIRD are settled through delivery of securities.

Therefore, NSE specifies a list of securities that are eligible for delivery. This list is prepared based on the following criteria: As an illustration, a list of eligible securities and their conversion factor for two different series of contracts are given in Tables 4. Out of these, the bond which can be bought at the cheapest price from the underlying bond market and delivered against an expiring futures contract is called CTD bond.

For example, suppose a bond has interest payment dates on June 30 and December A party purchasing the bond on July 15 will pay the clean price and accrued interest for the period July 1 to July This is compensation for the seller for having held the bonds for the period since the last interest payment date.

The issuer will pay the interest to the holder of the bonds on the interest payment date. If the buyer holds the bond long enough, it will receive the interest for the entire 6 month period from July 1 to December 31, though it purchased the bonds only on July Thus, the cost of purchasing a bond for delivery is: The concept is illustrated in Table 4. Quantity freeze limit is 1, units i. Thus, in April , contracts are available for expiry in June and September The last trading day for a contract is 2 business days prior to settlement delivery date.

That is also the last day for sellers to intimate their intention regarding delivery of the underlying by 6 pm. The delivery day is the last business day of the contract expiry month. Initial margin is based on SPAN Standard Portfolio Analysis of Risk. The minimum initial margin for Year Notional Coupon bearing GOI security futures contract is 2.

Daily MTM margin is calculated based on daily settlement price. These are levied on both buyer and seller. In cases where the positions are open at end of last trading day and no intention to deliver has been received, the following margins are levied. Final settlement on expiry of contracts is through physical delivery of securities, as per conversion factor already discussed.

uqyhadet.web.fc2.comJ: NCFM

Since each T-Bill has a face value of Rs. Quantity freeze limit is 7, units. They expire at 1 pm on the last Wednesday of the concerned month. In case the last Wednesday of the month is a designated holiday, the expiry day would be the previous working day.

Thus, in April , the permitted contracts are those expiring on April 24, ; May 29, ; June 26, ; September 25, ; December 25, ; and March 26, While the futures contract would expire on a Wednesday, it is for an underlying day T-Bill which will mature 91 days after the expiry of the futures contract. Suppose the settlement date is April 11, The near month futures contract will expire on April 24, But the underlying is a T-Bill that will mature 91 days later, on July 24, This is the quote price.

The T-Bill will be valued in the money market at Rs. This is the valuation price. Money market yield is Rs. It is subject to minimum of 0. For the daily MTM margin, settlement price is calculated every day, as Rs. The weighted average is calculated on the basis of: In the absence of adequate trades, theoretical futures yield is derived using T-Bill benchmark rates as published by Fixed Income Money Market and Derivatives Association of India FIMMDA.

Suppose futures contract was executed at valuation price of Rs. Subsequently, the daily MTM settlement price came to Rs. The buyer of the futures contract has made a MTM profit of Rs. Since each contract represents 2, units, the MTM profit on the contract would be 2, X Rs. Final settlement is done one day after expiry of the contract.

The final settlement price is worked out on the basis of weighted average discount yield obtained from weekly 91 Day T-Bill auction of RBI. Suppose the yield was 4. The final settlement price would be Rs. Since yield has gone up, the final settlement price is lower than the original purchase price for the future. The buyer of the future has made a loss of Rs. On the contract of 2, units, the loss would be 2, X Rs. All T-Bill futures are cash settled in this manner. DIST X,True is used to arrive at the value.

A 3-month option on that stock has exercise price of Rs. What would be its price as per Black Scholes model, if it is an European Call? The total acquisition cost of a share on exercise of call would be Rs. Thus, from the current price of Rs. However, an American Option can be exercised before maturity; an European Option cannot be so exercised before maturity. The benefit of keeping an option position open is the insurance it offers to the portfolio.

This will be lost, if the option is exercised. This is a significant reason why an option may not be exercised. The position regarding exercise varies between call and put options. Exercise of a call option would entail an immediate payment of exercise price. Therefore, it does not make sense for a trader to exercise the call option, so long as no dividend is payable on the stock.

It would be better to sell the call option with a gain if it is in the money. Only if a large dividend is expected on the stock during the life of an option, it may be Therefore, in most cases, Black Scholes can be applied even for American call options. Exercise of a put option leads to immediate receipt of money. Therefore, put options are more likely to be exercised, particularly when they are deep in the money.

In such cases, the trader may choose to value based on the binomial model which is more cumbersome, or live with the inaccuracy of the Black Scholes model. If the Black Scholes value turns out to be lower than the intrinsic value, then they use the intrinsic value.

After a dividend is paid, the stock price corrects itself. This makes the put more valuable. Therefore, unlike with call options, put options may not be exercised if a dividend is expected.

In this situation again, Black Scholes can be applied. A 1-month option on that stock has exercise price of Rs. What would be its price if it is an European Call? What would be its price if it is an European Put? A stock, trading at Rs. Delta varies with the stock price. The relation between delta and stock price for this option is shown in Figure 6. The Y-axis on the left of the graph shows the value of call delta at different values of the stock price. The stock is trading at Rs.

The secondary Y axis on the right of the graph in Figure 6. The put delta has the same shape as the call delta. However, note that the put delta values range from — 1 to 0 instead of 0 to 1 for the call delta values.

It is an indicater of the benefit for the option holder and problem for the option seller on account of fluctuations in the stock price. As seen Figure 6. Therefore, the rate of change, viz. Gamma is the same for both call and put options.

The movement in gamma of the option mentioned in Example 6. Gamma is high when the option is at the money. However, it declines as the option goes deep in the money or out of the money. The graph looks like the normal distribution bell-shaped curve, though it is not symmetrical. The longer extension on the right side implies that for the same difference between stock price and exercise price, in the money calls and out of the money puts have higher gamma than out of the money calls and in the money puts Theta is the sensitivity of the value of the option with respect to change in time to maturity assuming everything else remains the same.

Per day value of Theta which is more meaningful is calculated by dividing by The value is — 0. Thetais usually negative, because shorter the time to maturity, lower the value of the option. Per day value of Theta is — 0. Change in value of Theta of both call and put options as the stock price changes can be seen in Figure 6.

Call on a dividend paying stock can have a positive theta. The call and put options have the same Vega. The change in Vega for different values of the stock price for the option in Example 6. Vega is maximum around the exercise price. The same formulae can be used even in the case of a dividend-paying stock. NCFM - Financial markets a beginners module NSE. NCFM - Fundamental analysis module NSE.

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