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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

1. 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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2. 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.
3. 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.
4. 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.

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.

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.
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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

De nition of Index
Portfolio of securities representing a portion of a market where the percentage change is more
important than the actual numeric value because of di erent calculation methodologies. It can be
used as benchmark for your personal portfolio performance.

Types of Indices based on weight calculation methods

1. Market Cap: (used by India earlier)
A. Market Cap = Share Price×Total Outstanding Shares
B. Index Value = Total Market Capitalisation of all companies/ Number of Companies
C. Weight of X = (Market Cap of Company X / Total Market Cap of All Companies )×100
2. Free-Float Market Cap = Share Price x Free-Float Shares (freely tradable shares; exclude
shares held by promoters/insiders/unvested ESOPs). Examples include Nifty 50, Sensex.
3. Price: Each stock in uences the index in proportion to its price. Small company but higher
share price? Still, more in uence. Examples include Nikkei 225, DJIA.
4. Equal: Every stock has the same weight, regardless. More volatile but helps avoid over-
concentration in large-cap companies.

Impact Cost
Market order means that the buy or sell order is executed immediately at the best price available.
For a buy order, it means the lowest sell quotation available. For a sell order, it means the highest
buy quotation available.
The di erence between the best buy and best sell price is called the spread. The spread is a
function, and indicator, of liquidity in the market. Liquidity in a market, essentially, is the ability of
a buyer to buy the stock at a price closer to expected price, or similarly, the ability of a seller to
sell the stock at a price closer to the expected price. This is a direct consequence of the number
of buy and sell orders (order book depth); higher the number of orders, better are the chances of
your order of nding a good match. A highly traded stock can be said to be highly liquid.

The impact cost shows how much more we pay while buying, or how much less we get while
selling, compared to the ideal price, because of limited liquidity, that is, if the order book is
shallow, and the order you placed is a market order, there can be a huge gap between the price
you expected to sell your stock at and the price you actually get.
Example, the sell-side of the unmatched orders:
Price Quantity

9.7 500

10.2 2000

Buy order of 2500 shares. Ideal Price = 9.95, Actual Price Paid =10.1, Impact cost = 1.51%
Therefore, we paid 1.51% more than the ideal price due to lack of liquidity. Shallow order books
essentially incentivise the traders on the sell-side to quote prices that deviate from the ideal price.
This problem is removed when the order book is deep, because of the competition that arises.
Lets take an example of a liquid stock:

Price Quantity

9.7 500

9.8 600
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9.9 700

10.0 800

10.1 900

Buy Order of 3500 shares. Actual Price Paid = 9.92, Ideal Price = 9.9, Impact Cost = 0.2%
As is apparent, the conclusion is that highly liquid stocks have lower impact cost.

Best Buy Price (Best Bid): This is the Best Sell Price (Best Ask/Offer): This is the
highest price someone is willing to pay for lowest price someone is willing to sell the
a stock at the current moment. "I want to stock for right now. "I want to sell, and
buy, and here's the best offer I’ve made.” If here’s the lowest price I’ll accept.” If you
you place a market sell order, it will hit the place a market buy order, it will hit the
best buy price. best sell price.

Index Management
A. BSE indices: Asia Index Pvt Ltd
B. NSE indices:NSE Indices Ltd
Steps of management:
1. Construction: Selecting index stocks and deciding how the index is calculated.
2. Maintenance: Adjusting the index for corporate actions.
3. Revision: ensure that the index captures the most vibrant lot of securities.
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CHAPTER 3
INTRODUCTION TO FORWARDS AND FUTURES

Forward Contracts
De nition: Bilateral OTC agreement on speci ed terms to buy or sell an asset in the future.

Risks:
1. Liquidity: customised (non-standard) nature of forwards makes it di cult for parties to sell
them in the market; forwards are by nature illiquid.
2. Counterparty: party may default on obligation; credit risk.

Futures Contracts
De nition: agreement to buy or sell an asset (commodity/ nancial) later at agreed price,
facilitated by an exchange and guaranteed (settlement) by an associated clearing corporation.

Limitations:
1. Limited maturities.
2. Standardised (no exibility).
3. High administrative cost due to MTM settlement.

Futures Contract Speci cation (everything decided by exchange, except contract price)
1. Underlying instrument (index/stock) and spot price (cash market traded price).
2. Lot Size/Contract Size/Contract Multiplier: Leverage indicator. Higher contract size means
higher exposure or leverage. Market Exposure = Contract Value = Futures Contract Price
x Contract Size.
3. Contract Cycle: trading period. NSE Contracts follow a 3-month cycle (near, next and far
month). BSE allows monthly and weekly contracts.
4. Tick Size: minimum move allowed in the price quotations. Nifty futures = 0.05
5. Daily Settlement (Mark to Market): All open positions are settled based on the daily settlement
price of the futures contracts which is calculated based on the last 30 minute weighted
(quantity of contracts traded is involved) average price of that futures contracts. Daily
settlement price is di erent for contracts with di erent expiry.
6. Final Settlement Price: On expiry day, open position will be automatically settled based on
the nal settlement price. Final settlement price = closing value of asset in cash market.
(Convergence)

Terminology in Futures Contracts

1. Cost of carry: storage and interest costs minus any income from the asset.
2. Basis: Basis = Spot Price - Futures Price. Positive basis often shows immediate demand
for the asset (rare for nancial assets, can happen for commodities). Negative basis (usual
situation) shows that traders expect spot price to increase. 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.
3. Open Interest: total outstanding contracts for an underlying asset. Long and short positions
are same in number and counted once; 50 long and 50 short positions do not make 100 open
positions, they are 50 open positions. It rises when new long/short positions are opened. It
falls when existing long and short positions are both closed. It stays the same if one trader
closes a position but another opens the same size position.
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4. Price band: range of prices based upon the closing price of the contract on the previous day,
to prevent panic-driven price swings. First day? Range is based on previous day close of
asset in cash market.
5. Position o set: Buying/selling futures 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.
6. Naked Position: long/short position without holding the underlying asset.

Payo Charts for Futures Contracts

Cost of Carry Model

It assumes markets are e cient, so arbitrage cannot 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. Margins are not considered
while computing the fair value/ synthetic futures value. That is why this model is more suitable for
pricing forward contracts rather than futures contracts.

How arbitraging works?

ABC Ltd, Spot Price today: ₹1,000
Cost of Carry for 1 month: ₹10.
So, Fair Futures Price = ₹1,000 + ₹10 = ₹1,010

Cash-and-Carry Arbitrage (When futures are overpriced): Suppose ABC Futures is trading at
₹1,030 (overpriced by ₹20)

• Borrow ₹1,000 at 1% interest (₹10) • Deliver the stock in the futures market
• Buy ABC share in cash market at and receive ₹1,030
₹1,000 • Repay ₹1,010
• Sell futures at ₹1,030 (this locks in • Risk-free pro t = ₹1,030 – ₹1,010 = ₹20
minimum pro t, no loss even if spot
price rises beyond 1030)

As more traders do this, spot price goes up, futures price goes down, and arbitrage vanishes.
How?
1. They buy the stock in the cash market → demand for spot increases → spot price rises.
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2. They sell futures contracts → supply of futures increases → futures price falls.

Reverse Cash-and-Carry Arbitrage (When futures are underpriced): Suppose ABC Futures is
trading at ₹990 (underpriced by ₹20)

• Sell ABC share in cash market at • Receive ABC share via futures contract
₹1,000 (borrow if needed) • Return the borrowed share
• Invest ₹1,000 for 1 month at 1%→ • Keep the ₹1,010 (invested cash)
becomes ₹1,010 • Cost to buy share = ₹990, so Pro t =
• Buy 1-month futures at ₹990 ₹1,010 – ₹990 = ₹20

As more traders do this, spot price falls, futures price rises, and arbitrage vanishes. How?
1. They sell the stock in the cash market → demand for spot decreases → spot price falls.
2. They buy futures contracts → supply of futures decreases → futures price rises.

Pricing Methodology of the Cost and Carry Model

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.

Fair futures price = Spot price + Cost of carry - In ows

F=S×(1+r−q)T

Using continuous compounding: F= Se(r-q)*T

F is fair price of the futures contract, S is the Spot price, q is expected return during holding
period T (in years) and r is cost of carry.

No-Arbitrage Bounds
1. Margins, commissions, taxes, and other costs create no-arbitrage bounds—a range around
fair futures price within which arbitrage isn’t pro table. Wider no-arbitrage bounds mean
price misalignments can exist without being pro table to exploit. This allows ine ciencies
to persist longer.
2. 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.
3. Narrow bounds invite correction; wide bounds allow distortion.
4. 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.

Convenience Yield: psychological value derived from physically holding a commodity,

especially during crisis periods. It’s part of the “in ows” in the futures pricing formula but isn't
always tangible.
Fair Futures Price = Spot Price + Cost of Carry - In ows - Convenience Yield
If it is high, it can pull futures price below spot, overriding the cost of carry (called
"backwardation"), because the market values holding the physical asset more.
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Expectations Model
• 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, 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 above spot, the market expects prices to rise (contango); if futures are
below spot, the market expects prices to fall (backwardation).

Price Risk
Unsystematic (Speci c): Unique to a company or industry. Example: strike, loss of market
share. Can be reduced by diversi cation
Systematic (Market): A ects the whole market. Example: war, policy change. Cannot be
diversi ed away. Can be hedged using index futures.

Hedging

Single Stock Futures: Hedge both speci c Long Hedge: If you plan to invest later but fear
and unsystematic risk for a particular stock (1:1 that the price of that stock may rise, making
hedge ratio). the purchase costly, you can hedge by buying
that stock’s futures now. When price rises, you
will earn pro t on your futures contract which
will help o set the higher purchase cost.
Index Futures: Hedge systematic risk of an
entire portfolio. Cannot use 1:1 ratio since the Short Hedge: If you plan to divest later but
portfolio and index are di erent. The hedge fear that the price of that stock may fall,
ratio is calculated as follows: making the investment less pro table, you can
Number of contracts for hedging portfolio risk hedge by selling the futures contract of that
= Vp * βp / Vi stock now. When price falls, you will earn a
Vp: Value of the portfolio pro t on your futures contract which will help
Vi: Value of index futures contract o set the lower selling cost.
Βp: Beta of the portfolio= Weighted avg of
individual stock betas. W1 β1+W2 β2+…+ Wn Cross Hedge: When no futures exist for the
βn= βp exact asset, hedge using a related asset’s
futures. Using index futures is an example.

Hedge Contract Month: Choose a futures contract that expires just after your planned exit date.

Spread Position: Holding both long and short positions.

A. Inter-commodity spread: Same maturity, di erent products.
B. Calendar spread (or time/horizontal spread): same product, di erent maturities.
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. A
calendar spread becomes a naked position when: Near-month contract expires, or when
one leg is closed.
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CHAPTER 4
INTRODUCTION TO OPTIONS

An option gives its holder the right, but not an obligation, to buy or sell the underlying asset on a
stated day, at a predetermined price. The party taking a long position i.e., buying the option is
called buyer/ holder of the option. (RIGHT) The party taking a short position i.e., selling the option
is called the seller/ writer of the option. (OBLIGATION)
Strike price (K): price per share for which the underlying asset is purchased by the option holder.
Long Position: Loss Capped. Premium paid.
Short Position: Pro ts Capped. Margin requirements.

Call Option
It gives the holder a right to buy the asset at the strike price, and places the option writer under
an obligation to sell. A trader expects:
1. Price to go up when he takes a long position on a call option. Why? This gives him an
opportunity to buy the asset cheap when the price rises. If price movement is unfavourable,
he simply lets the option expire, su ering only the loss of the premium. Conclusion: Unlimited
pro ts, limited losses (max = premium).
2. Price to go down (or stay at) when he takes a short position on a call option. Why?
Since, the trader on the opposite side had expected that the price would go up, he won’t
exercise his right, and call-seller gets to keep the premium. Potential for unlimited losses if
prices rise, as call-seller becomes obligated to sell at the strike price which is lower than the
market price. Conclusion: Limited pro ts (max = premium), unlimited losses.

Put Option
It gives the holder a right to sell the asset at the strike price, and places the option writer under an
obligation to buy. The trader expects:
1. Prices to go down when he takes a long position on a put option. Why? He gets the right
to sell the asset at a price higher than the spot price of the asset. If the price goes up, the
trader won’t exercise his right, and forfeit the premium. Conclusion: Unlimited pro ts, limited
losses (max = premium).
2. Prices to go up when he takes a short position on a put option. Why? Since, the trader on
the opposite side had expected the prices to go down, he won’t exercise his right, and the
put-seller gets to keep the premium. Potential for unlimited losses if prices fall, since he is
obligated to buy the asset at a price higher than market price. Conclusion: Limited pro ts
(max = premium), unlimited losses.

Arijeet buys a call option (long), Arijeet buys a put option (long), Hammad
Hammad sells the option (short). The who sells the option (short). The strike
strike price is 100. price is 100.

Scenario 1: Spot price at expiry is 80. Scenario 1: Spot price at expiry is 80.
Arijeet has the right to buy the asset Arijeet has the right to sell the asset
which is worth 80 now, at 100. He which is now worth 80, at 100. He
chooses not to exercise his right, exercises his right. Hammad is obligated
Hammad gets to keep the premium. to buy a lower valued asset at a higher
price; loss.
Scenario 2: Spot price at expiry is 120.
Arijeet has the right to buy the asset Scenario 2: Spot price at expiry is 120.
which is worth 120 now, at 100. He Arijeet has the right to sell the asset
exercises his right. Hammad is obligated which is now worth 120, at 100. He
to sell the a higher worth asset at a lower chooses not to exercise his right,
price; loss. Hammad gets to keep the premium.
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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): create or increase a long position.
2. Opening sale (Short on option): create or increase a short position.

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 by buying
back the same option (same strike price, same expiry) that you had earlier sold. If the option's
price went down, you are buying it back cheaper → Pro t.
2. Closing sale: seller’s intention is to reduce or eliminate a long position by selling 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.)

Action Purchase Sale

Opening (Increasing) Long Short

Closing (Reducing) Short Long

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

Moneyness of an Option

Type of Option ITM (In-the-Money) ATM (At-the-Money) OTM (Out-of-the-Money)

Spot Price > Strike Spot Price = Strike
Call Option Spot Price < Strike Price
Price Price
Spot Price < Strike Spot Price = Strike
Put Option Spot Price > Strike Price
Price Price

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.

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.
A. Intrinsic value of Call Option: Max(Spot - Strike, 0)
B. Intrinsic value of 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 is the potential for pro t before expiry. Time value re ects volatility (greater
swings = higher chance of pro t = higher time value), and Time left to expiry (more time = more
chance = more time value). ATM and OTM options have only time value, since intrinsic value is
zero.
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Payo Charts for Options (X is strike price; Option Price means Premium)

Option Pricing Fundamentals

1. Spot price of the underlying asset: refer to intrinsic value.
2. Strike price of the option: refer to intrinsic value.
3. Volatility of the underlying asset’s price: Higher volatility increases the premium 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. The call option becomes more
valuable because the opportunity cost of tying up money in the stock is higher. The right to
buy the stock at ₹100 is more attractive when you could earn a higher return elsewhere. The
put option becomes less valuable because the future payo (₹100) is worth less today due to
the higher interest rates.

Option Greeks
1. Delta (Δ): Measures sensitivity of option price to the underlying asset’s price. Call options:
Delta is positive (option price increases as the asset price rises). Put options: Delta is negative
(option price increases as the asset price falls).
2. Gamma (Γ): Measures the rate of change in Delta with respect to a change in the underlying
asset’s price. Gamma indicates how quickly the Delta will change when the underlying asset's
price changes. It is always positive for both call and put options.
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 both call and put options (higher volatility increases the option premium)
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5. Rho (ρ): Measures the change in option price given a one-percentage point change in the risk-
free interest rate. Positive for call options (higher interest rates increase the price of call
options). Negative for put options (higher interest rates decrease the price of put options).

Black-Scholes Model (Fisher Black and Myron Scholes, 1973)

It calculates the theoretical price of European call and put options (not accounting for dividends).
The model uses ve inputs:
1. S = Current stock price
2. X = Strike price
3. t = Time to expiration (in years)
4. r = Risk-free interest rate (continuously compounded)
5. v = Volatility of the stock (standard deviation of returns)

Implied Volatility (IV): 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.
• High IV = expensive options → traders may prefer selling options.
• Low IV = cheap options → traders may prefer buying options.
• Option writers price in possible outcomes by charging higher premiums to protect against
sharp moves.

Binomial Pricing Model (William Sharpe, 1978)

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.
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CHAPTER 5
STRATEGIES USING EQUITY FUTURES AND OPTIONS

Hedging using Long and Short Futures contract

LONG HEDGE SHORT HEDGE

Situation: Plan to buy 10 shares later but face Situation: Plan to sell 10 shares later but face
the risk of stock price rising, making the the risk of price falling making the investment
purchase costly. So, you buy Futures contract less pro table. So, you short Futures contract
to lock in the price now. to lock in the price now.

Futures price today = ₹100. Futures price today = ₹100.

Lot size = 10 shares. Lot size = 10 shares.
So, you buy 1 futures contract since you're So, you short 1 futures contract since you're
buying 10 shares. (1:1 Hedge Ratio) buying 10 shares. (1:1 Hedge Ratio)
1-month later: 1-month later:
Scenario 1: Price Goes Up Scenario 1: Price Goes Down
Spot price = ₹120 Spot price = ₹90
So, your cash market purchase = ₹120 × 10 = So, your cash market sell = ₹90 × 10 = ₹900
₹1200 Futures price now = ₹95
Futures price now = ₹130 Pro t on futures = 100 - 95 = 5
Pro t on futures = 130 - 100 = 20 Total pro t = ₹5 × 10 = ₹50
Total pro t = ₹20 × 10 = ₹200 Total income = ₹900 + ₹50 = ₹950
Net cost of shares = ₹1200 – ₹200 = ₹1000 Cost per share = ₹950/10 =₹95
Cost per share = ₹100/10 =₹100
You sold at ₹5 above the market.
You paid ₹120 in market, but got back ₹200
from futures: e ective cost was near ₹100. Scenario 2: Price Goes Up
Spot price = ₹110
Scenario 2: Price Goes Down So, your cash market sell = ₹110 × 10 =
Spot price = ₹90 ₹1100
So, your cash market purchase = ₹90 × 10 = Futures price now = ₹112
₹900 Loss on futures = (₹112 – ₹100)x10 = ₹120
Futures price now = ₹95 Net cost of shares = ₹1100 - ₹120 = ₹980
Loss on futures = (₹100 – ₹95)x10 = ₹50 Cost per share = ₹98
Net cost of shares = ₹900 + ₹50 = ₹950
Cost per share = ₹95 You sell at ₹12 cheaper than the market,
because of the loss on futures.
You bought cheaper in market, but lost on
futures, e ective cost 95.

Calendar Spread using Futures

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.
1. Calculate the fair price: Fair Price=Spot Price×er×t
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 (long) the underpriced contract.
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. When both futures
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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.

Options Trading Strategies: SPREADS

Spreads are limited pro t and loss techniques that involve combining options of the same type
(calls or puts) on the same underlying asset but with di erent strikes or maturities. Mainly
classi ed into:
Vertical: Same expiry, di erent strike price.
Horizontal (Calendar): Di erent expiry, same strike price.
Diagonal: Di erent expiry and strike price. Only in OTC.

Vertical Spreads

How to read this table? Long CALL PUT

[Bull, Call] = Lower Strike. This means in a bull call spread take a
long position on the call option that lower strike price. This
automatically means that you take a short position on the call BULL LOWER LOWER
STRIKE STRIKE
option that has higher strike price.
BEAR HIGHER HIGHER
STRIKE STRIKE

BULL CALL SPREAD BEAR

CALL SPREAD
Goal: Pro t from upward movement,
while reducing cost compared to buying Goal: Pro t if index stays the same or
a simple call option. falls slightly.
1. Buying a call gives you unlimited 1. Selling a lower strike call (expensive)
upside, but it’s costly. This call and buying a higher strike call (cheap)
provides reward. gives you net premium to begin with.
2. Selling a higher strike call gives you 2. The short call is risky; therefore, it
some premium back, lowering your provides reward.
net cost. This call is the insurance. 3. The long call is cheap; therefore, it is

BULL PUT SPREAD BEAR PUT SPREAD

Goal: expect the price of a stock to go Goal: expect the stock price to fall — but
up slightly or stay above a certain level. not crash massively, just fall moderately.
1. Buying a put at lower strike gives you 1. Buying a put at higher strike provides
insurance. reward.
2. Selling a put at higher strike gives you 2. Selling a lower strike put gives you
high premium back, and you start some premium back, lowering your
with net premium receipt. This option net cost. This option is the insurance.
provides the reward.
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In vertical spreads, loss is related to long positions and pro t is related to short positions.
MAX PROFIT MAX LOSS

BULL (CALL/PUT SPREAD) >= SHORT STRIKE <= LONG STRIKE

BEAR (CALL/PUT SPREAD) <= SHORT STRIKE >= LONG STRIKE

How to read this table?

In a Bull Call Spread, Maximum Loss occurs when spot price at expiry is less than or equal to the
strike price of the long call option. Maximum pro t occurs when the spot price at expiry is more
than the strike price of the short call option.

Options Trading Strategies: STRADDLE

LONG STRADDLE SHORT STRADDLE

Why? Expect large price movement but Why? Expect the underlying price will
unsure about direction. stay close to the strike (low volatility).
1. Take long position on both call (pro t 1. Take short position on both call and
when market rises) and put options put options. (Same strike price)
(pro t when market falls). 2. You receive both premiums upfront,
2. Both options have same strike price so it is a net credit strategy.
and expiry. 3. Maximum pro t = Total premium
3. Since we take long positions on both, received (T); occurs when underlying
we pay premium on both (T). The total expires near the initial spot price (S).
premium paid upfront is the 4. If price moves upwards: short call
maximum loss. creates large losses.
4. If price moves sharply up: Call gain, 5. If price moves downwards: short put
put has limited loss. creates large losses.
5. If price moves sharply down: Put 6. Break Even Range: [S-T,S+T]. Only
gains, call has limited loss. within this range, a trader can make
6. If there is low price movement away pro t.
from the initial spot price of asset (S):
both options lose value.
7. Break Even Range: [S-T, S+T]
Only beyond this range will the trader
start making a pro t.

Options Trading Strategies: STRANGLE

LONG STRANGLE
Why? Expect large price movement but unsure about direction.
1. Buy an OTM Call and an OTM Put on the same asset, same expiry, but di erent strikes.
2. Since we take long positions on both, we pay premium on both (T). The total premium paid
upfront is the maximum loss.
3. If price moves sharply up: Call gain, put has limited loss.
4. If price moves sharply down: Put gains, call has limited loss.
5. If there is low price movement away from the initial spot price of asset (S): both options lose
value, leading to maximum loss.
6. Break Even Range: [S-T, S+T]
Only beyond this range will the trader start making a pro t.
7. Used because of lower upfront cost (OTM options are cheaper)
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SHORT STRANGLE
Why? Expect the underlying to remain within a relatively narrow range until expiry.
1. Sell an OTM Call and an OTM Put on the same asset, same expiry, but di erent strikes.
2. You receive both premiums upfront, so it’s a net credit strategy.
3. Maximum pro t = Total premium received (T); occurs when underlying expires near the initial
spot price (S).
4. If price moves upwards: short call creates large losses.
5. If price moves downwards: short put creates large losses.
6. Break Even Range: [S-T,S+T]. Only within this range, a trader can make pro t.
7. This strategy suits a quiet market outlook but carries very high risk if the underlying moves
sharply in either direction.

Options Trading Strategies: COVERED CALL

A strategy where you own a stock and, at the same time, sell a call option on that stock, to earn
extra income from the premium you get by selling the call, while still holding on to your stock.

Suppose you buy a stock at ₹1590 and sell a call option with a strike price of ₹1600, earning a
₹10 premium (example). If the stock price rises to ₹1640, you make ₹50 pro t on the stock.
However, because you sold the call, it gets exercised, and you e ectively lose ₹30 on the option
side (because ₹1640 is ₹40 above the strike price, but you received ₹10 premium, so net loss is
₹30). Overall, you end up with a ₹20 gain.

If instead the stock falls to ₹1520, you lose ₹70 on the stock, but the call option expires
worthless, letting you keep the ₹10 premium. Your net loss in this case becomes ₹60.

Your maximum pro t happens if the stock price stays above ₹1600 at expiry — your gain is
capped because the call you sold limits how much you can bene t from a rising stock. Your
maximum loss is technically unlimited, because if the stock crashes, you still own it and face
the full downside, though the call premium provides a small cushion.

Choosing which strike price to sell is important. A strike price closer to your stock price gives you
a bigger premium but limits your upside sooner. A farther strike price o ers a smaller premium
but gives your stock more room to rise before your gains get capped.

In short, the covered call is best for people who expect the stock to stay stable or rise a little. It
sacri ces some future gains in exchange for steady income now, making it a popular low-risk
strategy among stock investors.

Options Trading Strategies: COLLAR

Strategy to manage risk by combining two options strategies: the covered call and the protective
put.
It helps limit potential losses while still allowing some pro t from a rising stock price.
In this strategy, you rst own a stock. Then, you sell a call option to generate income from the
premium, and at the same time, you buy a put option to protect yourself if the stock price falls
too much.
For example, if you bought a stock at ₹1590, you could sell a call with a strike price of ₹1600 for
₹10, and buy a put with a strike price of ₹1580 for ₹7.
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If the stock price falls below ₹1580, say to ₹1490, you would lose ₹100 on the stock, but the call
expires worthless. The put option, however, gains ₹90, giving you a smaller net loss of ₹7,
compared to a loss of ₹90 in a simple covered call strategy.
If the stock price rises above ₹1600, say to ₹1690, you would make ₹100 on the stock, but lose
₹80 on the call because it gets exercised. The put expires worthless, but you still end up with a
net gain of ₹13, which is less than the ₹20 you could have made with just the covered call
strategy.
The maximum pro t in a collar is capped because the call you sold limits how much you can
gain from the stock's rise. However, you also have downside protection from the purchased put,
which limits your potential loss. The breakeven point is higher than a covered call because of the
cost of the put, but your risk is much lower since the put helps protect against a large decline in
the stock price.
Overall, the collar strategy is a way for investors to balance risk and reward: it limits potential
pro ts but o ers a oor for losses, making it a good choice for those who want to protect their
investments while still having some chance to pro t.

Options Trading Strategies: BUTTERFLY SPREAD

Strategy where you combine di erent options with the same expiration but di erent strike prices.
It’s designed to make a pro t when the price of the stock stays near the middle strike price at
expiration. The goal is to limit both potential pro t and loss.

You buy one call at a lower strike price, sell two calls at a middle strike price, and buy one
call at a higher strike price.
For example, you might:
• Buy a call at ₹6000 (lower strike) for ₹230.
• Sell two calls at ₹6100 (middle strike) for ₹150 each (total ₹300 received).
• Buy a call at ₹6200 (higher strike) for ₹100.
If the stock price is below ₹6000 at expiration, long calls expire worthless, and you lose the cost
to enter the strategy; ₹30 in this case (300-230-100=-30).
If the stock price is at ₹6100 (the middle strike), the two calls you sold make the most pro t, and
you get the maximum pro t of ₹70; lower strike call gains 100, higher strike call expires
worthless.
If the stock price goes beyond ₹6200, the pro t from the long calls starts to o set the loss from
the short calls, but the total pro t is capped at ₹70. Once the price goes much higher, you start
losing again, but it never exceeds ₹30 loss.
The maximum pro t is at the middle strike price, and the maximum loss is the cost of entering the
trade (₹30).
The strategy works best when you expect the stock to have low volatility and stay near the
middle strike price at expiration.
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.

Options Hedging Strategies: PROTECTIVE PUT

A protective put is a strategy where you own a stock and buy a put option on the same stock. It
acts like insurance: it protects you from signi cant losses if the stock price falls, while still
allowing you to bene t from any gains if the stock price rises.
For example, if you buy a stock at ₹1600 and purchase a put option with a strike price of ₹1600
for ₹20, you're setting up a safety net. If the stock price drops to ₹1530, you lose ₹70 on the
stock. However, the put option lets you sell the stock at ₹1600, so you gain ₹50 from the put
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(because ₹1600 - ₹1530 = ₹70, minus the ₹20 premium you paid). Your net loss is only ₹20,
which is the cost of the put option.
If the stock price rises to ₹1660, you make ₹60 from the stock, but the put expires worthless,
costing you the ₹20 premium you paid. Your net gain is ₹40, and if the stock keeps rising, your
pro t potential is unlimited, minus the cost of the put.
The protective put strategy is good for people who want to protect themselves against a sharp
drop in the stock price while still having the potential to make unlimited gains if the stock goes
up. The maximum loss is limited to the price you paid for the put (₹20), and your pro t potential is
unlimited, just like owning the stock with a bit of extra insurance. The break-even point is at
₹1620 (stock price plus the premium paid for the put).

Arbitrage Using Options: PUT-CALL PARITY

Put-Call Parity is a principle that shows how the prices of call and put options with the same
strike price and expiration date should be related. It helps identify when the market prices are out
of balance, creating opportunities for arbitrage, which means making a pro t with no risk.
The formula for Put-Call Parity is:
Call price + Present value of strike price = Put price + Spot price of the underlying asset
If the prices of the options don’t follow this formula, it indicates an arbitrage opportunity.

For example, if a put option is underpriced compared to a call option, you can make a risk-free
pro t by buying the underpriced put and using the other options in a speci c way.
For instance, if the spot price of a stock is ₹1251, and the call option is priced at ₹47.50, you can
use the formula to gure out the fair price for the put option, which should be ₹28.26. If the put
option is trading at ₹23.15 instead, it's underpriced, and you can exploit this.
To take advantage of this, you could buy the underpriced put, buy the stock, and sell the call.
This way, you'd get a net cash out ow and create a situation where no matter where the stock
price ends up (higher or lower), you can still make a risk-free pro t from the di erences in the
prices of the options.
However, these arbitrage opportunities depend on executing everything at the same time. If
there's a delay, it could lead to losses or missed opportunities. Therefore, while it's theoretically
possible to make a risk-free pro t, it requires careful and timely execution.

DELTA-HEDGING
It works by balancing their option positions with trades in the underlying stock or in futures, so
that small changes in the stock price do not cause gains or losses.

Delta tells us how much the price of an option will move if the stock price moves by one rupee.

For example, if a call option has a delta of 0.50, and the stock price goes up by one rupee, then
the call option price will go up by fty paise.
Suppose a trader has sold (shorted) ten call options, and each option has a delta of 0.50. The lot
size is fty, so one option contract covers fty shares. If the stock price rises by one rupee, the
trader would lose ₹250 because the short calls would become more expensive. To protect
against this loss, the trader needs to take an opposite position: they buy futures contracts on the
stock.
Futures have a delta of 1, meaning they move exactly with the stock price. So, the trader buys
ve futures contracts, each covering fty shares, to completely o set the risk from the short calls.
Now, if the stock price moves a little, the loss on the short calls is balanced by the gain on the
futures, and the trader’s overall position is una ected.
As the stock price changes, the delta of the options also changes. For example, if the stock price
rises, the call options’ delta might increase from 0.50 to 0.60, meaning they become more
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sensitive to stock movements. When this happens, the trader needs to adjust their hedge by
buying or selling more futures to stay balanced.
When the position is set up so that small changes in the stock price do not a ect the trader's
overall pro t or loss, it is called being delta-neutral.
In short, delta-hedging helps traders keep their positions safe from small stock price movements
by continuously adjusting their trades in the stock or futures market as the delta changes.

Put-Call Ratio
The Put-Call Ratio, or PCR, measures how many put options are open compared to call options.
You calculate it by dividing put open interest by call open interest. If PCR is less than 1, there are
more call options than puts, and it shows that traders are bullish. If PCR is greater than 1, there
are more put options than calls, and it shows that traders are bearish.

Interpretation of Open Interest through Futures

1. If futures price and open interest both rise, it usually means the market is bullish, and traders
might want to buy futures.
2. If the futures price rises but open interest falls, it shows that short sellers are exiting, and the
bullish move might not be very strong.
3. If futures price falls and open interest rises, it shows that new short positions are getting
added, which means the market is bearish.
4. If both futures price and open interest fall together, it means traders are closing their long
positions, but the bearish trend may be slowing down, so it is better to wait and watch.

CHAPTER 6
TRADING MECHANISM
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Entities involved in the trading of futures and options

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

• 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 TM. They place
orders, manage accounts, and operate terminals. They are not clients, but
employees, dealers, or operators working for the TM.
2. Trading cum Clearing Member (TCM): (ICICI Securities Ltd.)
• Acts as both a trader and a clearer.
• Can clear their own, clients’, and trades of other Trading Members.
3. 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).
4. Self Clearing Member (SCM): (Zerodha Broking Ltd.)
• A TM who also clears trades, but only for self and clients, not for others.
5. Participant (Client):
• An individual or institution trading through a Trading Member.
• Can have trades via multiple TMs but settles via one Clearing Member.
6. Authorised Person (AP):
• Works under a TM to expand their network.

User Hierarchy in F&O Trading Software

Corporate Manager (Top Branch Manager (Middle Dealer (Lowest Level): Can
Level): Full control over all Level): Manages a speci c only view and manage their
branches and dealers. branch. Can place/view own orders and trades. No
Can place/view all orders, orders and trades of all access to other dealers'
get all reports, and set dealers under their branch. data.
exposure limits.

Order Types & Matching Rules in F&O Trading

Price Conditions Time Conditions

1. Limit Order: Trade at a speci ed Day Order: Valid for the trading day only. Auto-
price or better. E.g., Buy at ₹100 → cancelled if not executed.
executes at ₹100 or lower. IOC (Immediate or Cancel): Executes immediately.
2. Market Order: Executes at the best Partial match is possible. Unmatched portion gets
available market price. No price is auto-cancelled.
speci ed while placing the order.
3. Stop-Loss Order: Trigger-based declining below his buy price. To limit his losses,
order to limit losses. Can be trader may set a trigger price of 95 and a limit
converted into market/limit order, as price of 92. The trigger price must be between last
de ned at the time of placing this traded price and limit price while placing the sell
stop-loss order, once trigger price is limit order. Once the price breaches the trigger
reached. Example: suppose a trader price, the order gets converted to a limit sell order
buys ABC Ltd. shares at Rs 100 in at Rs 92. (Trigger Price is the price at which the
expecting price to rise. Prices start order gets triggered from the stop loss book.)

Order Matching Rules

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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. Partial order matching is possible → multiple trades from one order.
{Orders can be matched in parts with multiple opposite-side orders.}

Eligibility criteria for Equity Derivatives

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.

Product Success Framework (PSF) for Equity Derivatives

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.

PSF Exit Criteria (applied after 6 months of listing)

1. A stock must meet all 4 conditions during the review period (typically 3 months).
2. Trading Member Participation: At least 15% of active F&O trading members (or 200,
whichever is lower) must have traded in that stock.
3. Trading Frequency: Must be traded on at least 75% of trading days in the review period.
4. Average Daily Turnover (Single Side): Must be ≥ ₹75 crores (futures + options premium
combined).
5. Average Daily Notional Open Interest (Single Side): Must be ≥ ₹500 crores (based on
contract value of futures + options).

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 Index Derivatives

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).

PSF for non- agship indices

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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 is 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, strike price, open positions, lot size may get changed. 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
◦ 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)

Dividends
1. Ordinary Dividend: < 2% of market price → No adjustment
2. 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
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).
3. Statutory Charges
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• 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
4. 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

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. Only risk-reducing actions (no new trades) are allowed.
5. Not available for algorithmic traders or institutional clients — only for retail investors.

SEBI framework for addressing technical glitches in stock brokers’ 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)

CHAPTER 7
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INTRODUCTION TO CLEARING AND SETTLEMENT SYSTEM

Functions of Clearing Members:

A. Clearing: Calculate settlement obligations.
B. Settlement: Complete nancial transactions.
C. Risk Management: Set position limits and monitor margins.
Eligibility Norms for Clearing Members:
A. Net-worth: ₹300 lakhs (₹100 lakhs for self-clearing).
B. Security Deposit: ₹50 lakhs to the Clearing Corporation.
C. Extra Deposit: to clearing corporation; ₹10 lakhs per additional Trading Member.

Clearing Mechanism in F&O

1. Calculate Open Positions & Obligations
◦ A CM’s open position = sum of open positions of all 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.
◦ CM A’s open position = 6000 long, 2000 short.

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) {Cash-settled}:

• 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).

B. Final Settlement (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.
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)
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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 –
• 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.
• 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)

Settlement of Options Contracts

1. Daily Premium Settlement: Buyer pays the premium; seller receives it. Net premium is
settled in cash on T+1 (next trading day).
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 ITM options are automatically exercised. Final
amount is settled in cash on T+1.
B. Stock Options (Physically Settled): ITM options are automatically exercised and
settled by delivery. Settlement value = Strike price × Lot size. Delivery and fund
obligations must be met on T+1.

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.

Risk Management in F&O Segment

1. Capital Adequacy: Members must meet stringent capital requirements to ensure nancial
strength.
2. Initial Margin: Clearing corporations charge an upfront initial margin for all open positions,
based on Value-At-Risk (VaR). This margin is collected from TMs and their clients.
3. Mark-to-Market (MTM) Settlement: Open positions are settled daily on an MTM basis.
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4. Real-Time Monitoring: The Clearing Corporation’s system tracks positions in real-time
5. Position Monitoring Tools: Trading terminals help CMs monitor and set limits for TMs under
their supervision. If limits are exceeded, the system halts further trading.

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, to ensure su cient margins are collected to cover potential daily losses. It treats futures
and options uniformly while considering the unique risks of each.

1. Margins in Equity Derivatives Segment

A. Initial Margin: Collected upfront at the client level (gross) and proprietary level (net). Based
on 99% Value at Risk (VaR) over 1-day. 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.
D. Delivery Margins: Applied 4 days before expiry for ITM long options and positions
requiring delivery. Levied gradually: 20,40,60,80.
E. Exposure Margin: Clearing members are subject to these 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.
F. Short Option Minimum Charge: This charge used to apply to deep OTM short options.
G. Net Option Value: computed as the di erence between the long option positions and the
short option positions, valued at the last available closing price of the option contract and
is updated intraday at the current market value of the relevant option contracts at the time
of generation of risk parameters.
H. Client Margins: Clearing corporation intimates all members of the margin liability of each
of their client. Additionally members are also required to report details of margins collected
from clients to clearing corporation, which holds in trust client margin monies to the extent
reported by the member as having been collected from their respective clients.
2. Intra-day Crystallised Losses (ICMTM)
• Applies only to futures.
• These are realised losses from trades that close existing positions during the day.
• Calculated based on weighted average prices.
• 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.

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), and agreements
between clearing members (if separate for each segment).

CHAPTER 8
LEGAL AND REGULATORY ENVIRONMENT
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Securities Contracts (Regulation) Act, 1956, Section 2H: De nition of Securities
1. Shares, scrips, stocks, bonds, debentures, debenture stock, or other marketable
securities in or of any incorporated company or other body corporate.
2. Derivatives
3. Units issued by any collective investment scheme.
4. Government securities
5. Rights or interests in securities.

Section 18A: Legality of Derivative Contracts

Contracts in derivatives shall be legal and valid if they are traded on a recognised stock exchange
and settled on the clearing house of the recognised stock exchange.

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

Liquid Assets and Margin Requirements of Clearing Members:

1. Cash Component: Cash, xed deposits, bank guarantees (BGs), Government securities, T-
Bills, money market mutual funds and gilt funds (10% haircut).
2. Non-Cash Component: Liquid (Group I) equity shares in demat form, and 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.

Trade Guarantee Fund (TGF): Guarantees the settlement of bona de transactions for exchange
members. Protect the interests of investors in securities.

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. Stringent entry norms for derivative broker-members.
4. Investor Protection Fund for the derivatives segment.
5. Separate Governing Boards for Cash and Derivatives segments.
6. Brokers must maintain margins in a separate bank account.
7. 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.
CHAPTER 9
ACCOUNTING AND TAXATION
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Accounting for Forward Contracts as per Accounting Standard - 11
When Forward Contract is for Hedging:
• The premium or discount should be amortised over the life of the contract.
• Exchange di erence is recognised in the Pro t & Loss (P&L) statement for the year.
• Pro t/Loss on cancellation/renewal of the forward contract is recognised in the P&L of
the year.
When Forward Contract is for Trading/Speculation: No premium or discount is recognised.
Everything else same as above.

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 recognised stock exchange.
Impact:
A. P/L on derivative transactions carried out on a recognised stock exchange is not
taxed as speculative income.
B. Loss on derivative transactions can be set o against other income (except salary
income).
C. 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: 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): 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
recognised in the P&L account.
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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
recognised 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.

CHAPTER 10
SALES PRACTICES AND INVESTORS PROTECTION SERVICES

Customer-Oriented Approach in Financial Institutions: Customers have the right to good

advice; nance employees have the duty to provide good advice.

Warnings for Investors: High Return & Risk-Free Investments

1. Spectacular pro ts or guaranteed returns should be approached with caution.
2. No investment is risk-free; returns are always related to the risk taken.
3. 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. Sometimes, investment advisors may misappropriate money from clients. Therefore,
investors should review monthly statements and conduct annual reviews of their investment
plans. Some investment advisers may push clients to purchase unsuitable investment products
that don’t meet the investor’s goals or risk pro le. Investors should carefully review the risk pro le
of each recommendation.

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

Clients of Special Categories (CSC)

1. Non-resident clients (NRIs)
2. High net-worth individuals (HNIs)
3. Trusts, Charities, NGOs, and organisations receiving donations
4. Companies with close family shareholding or bene cial ownership
5. Politically exposed persons (PEPs) of foreign origin
6. Companies o ering foreign exchange o erings
7. Clients in high-risk countries
8. Non face-to-face clients
9. Clients with dubious reputations based on public information
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SEBI Complaints Redress System (SCORES)

• SCORES is a web-based system for managing investor complaints.
• Salient Features of SCORES:
1. Centralised 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.