Understanding Derivatives

Share Market is a Platform To Make Profit by Trading in Shares or Securities. Of course, sometimes, profit may be negative.

THE SMALL

In this article, the phrase The Small stands for people with small fund or small holding capacity.

THE BIG

In this article, the phrase The Big stands for people with large or unlimited fund or large holding capacity. Besides Moneyed Individuals, FIIs, Big Institutions like LIC, UTI, MUTUAL FUNDS etc. can be regarded as THE BIG.

In order to trade, it is necessary to do a transaction.

A transaction is a pair of Buy & Sale.

In order to make transactions in Share Market, we have two segments.

One is CASH SEGMENT & the other is DERIVATIVE SEGMENT.

SEGMENTS

CASH SEGMENT DERIVATIVE SEGMENT

CASH SEGMENT

. This is the most preferred segment. This is safe one. Those who have enough fund, should go for this segment. This segment is good for both THE SMALL & THE BIG.

In this segment you can buy shares within your capacity by making 100 % payment and taking delivery. You have to wait till you get your favorable rates and then sell the shares. You can buy back the same shares when the rates are reasonably low.

Your ownership of position remains with you unless and until you have squared off. Such people are known as Investors. They don’t undergo frequent or day-to-day trading. It is observed that investors earn a good percentage of profit and that also without any tension.

POINTS TO REMEMBER

1. In Cash Segment do not buy all of your required quantity at a time. Buy in certain units. If you desire to buy 500 shares, buy 100 at a time so that you can have fund to buy if the shares are available at lower rates.

2. Similarly while selling do not sell all the shares at a time. If you want to sell 500 shares, sell in the unit of 100 shares so that you may get higher rates for the remaining lots.

3. Do not square off at a very low profit. Try to earn substantial profit. This strategy will help you when you are about to make a substantial loss.

4. Do not do the next transaction in the same item at a very narrow interval of profit. Try to get at least 5 % gain.

5. Try to accumulate a reasonable quantity of a volatile share like RELIANCE at various downward rates. You can do profit churning in Reliance with a quantity of say unit of 50 shares in an open ended way.

DERIVATIVE SEGMENT

This is the segment where one can do higher volume with less fund compared to Cash Segment. There are two parts in this segment. (1) Future Trading & (2) Option Trading

CASH SEGMENT	DERIVATIVES
100 % payment is to be made for buying and similarly 100 % payment is received while selling Ownership – Ownership remains with you unless and until you have squared off the position. Quantity – Any quantity of shares can be bought or sold. There is no compulsion Delivery is to be given or taken.	Prefixed Margin say 20-40 % is to be paid as Deposit (known as margin) to meet with any risk or liability due to the trade done. Ownership of the position remains with you until you have squared off or till the last Thursday of the Contract Month. One cannot buy any odd quantity but has to buy or sell the Lot in prefixed size. There is nothing like delivery.

DERIVATIVES

FUTURE TRADING OPTION TRADING

FUTURE TRADING

Future Trading is jut like Cash Segment Trading. In Future Trading you are not to pay 100 % payment as you have to do in Cash Segment and there is nothing like delivery.

MARGINS

In order to trade in Future, you are required to pay two types of margins.

(1) Initial Margin (2) Daily Margin. Initial Margin is to be paid initially while taking the position. Suppose you buy One Contract of Reliance Future. At that time say the rate is Rs. 400/-. The lot of Reliance is of 600. So the total value of the lot will be Rs. 2,40,000/-. Suppose the Initial Margin fixed for Reliance is say 25 %. So you will have to pay Rs. 60,000/- initially as Initial Margin. The next day the rate becomes Rs. 398/-. So book loss of Rs. 1200/- appears to be there. So you will have to pay this difference to your broker and this amount you pay is known as Daily Margin. Again on the next of the next day, the rate becomes Rs. 395 which means further book loss of Rs. 3 amounting to Rs. 1,800/-. You will have to pay this as Daily Margin. Remember the margin is one kind of Deposit in order to safeguard against any default. Similarly on the third day say the rate becomes Rs. 403 and so your F&O account will be credited with Rs. 4,800/- as there is a book profit of Rs. 8/- per share. In order to avoid daily Give & Take, the client is advised to keep something more than the margin amount that might be required. In case of continuous loss situation when you are not in position to pay margin, your transaction is squared off and the respective loss is debited to your account. In Case of Profit situation you can decide when to square off the transaction.

Future Trading is the most Dangerous One. The people with low funding capacity should not even think of Future Trading.

OPTION TRADING

In option Trading you can take either of the positions viz. BUYER’S POSITION OR SELLER’S POSITION (ALSO KNOWN AS WRITER)

GENERAL EXAMPLE IN A LAYMAN’S LANUGAGE

Let us consider an example. Say Rameshbhai & Sureshbhai are two friends, both dealing in shares. Now Rameshbhai feels that Reliance will be trading at Rs. 500 at the close of the month. At present it is available at Rs. 400 but Rameshbhai does not have fund to buy the lot of 600 shares of Reliance. His friend Sureshbhai is a rich capable person and so Rameshbhai explains Sureshbhai his feelings about Reliance. Rameshbhai says to Sureshbhai that he(Rameshbhai) may buy Reliance from him(Sureshbhai) at the rate of Rs. 410/- later during the month before the expiry date provided that Sureshbhai agrees to make the arrangement. Rameshbhai also gives temptation that he will give him non-refundable commission of Rs. 7 per share immediately in advance. Sureshbhai agrees to take the responsibility of providing Rameshbhai 600 shares of Reliance if he demands the shares and accepts the commission of Rs. 7/- per share from Rameshbhai.

Thus Rameshbhai succeeded in getting the right of buying 600 Shares of Reliance at Rs. 410 and for getting the right he had to pay the not-refundable commission of Rs. 7 per share in advance.

In this example, in derivative language, Rameshbhai is the option buyer and Sureshbhai is option-seller or option-writer. The word commission is known as premium. The pre-decided price of Rs. 410 is known as Strike Price. The right to buy is known as Call. Hence we can say that Rameshbhai bought a Reliance Call with the strike price of Rs. 410 at a premium of Rs. 7/-. Now the Reliance will cost Rs. 410+7=417 to Rameshbhai. When the rates of Reliance is more than Rs. 417, it will be a time for Rameshbhai to exercise his right at a proper time he likes.

BUYER

Buyer of the option has a chance of limited loss in an unfavorable situation and unlimited profit in the favorable situation. Generally those with small fund should be buyer of the option so that he occurs a pre-decided or pre-imagined loss or limited loss in an odd situation but can have unlimited profit in a favorable situation.

SELLER (WRITER)

Seller of the option has a chance of limited profit in a favorable situation and unlimited loss in an unfavorable situation. Generally those, with large stock with them purchased at a very low rate and with good funding arrangement, become Seller of the option. If one does not have fund arrangement, one should not be seller or writer.

OPTION BUYER	OPTION SELLER/WRITER
He has right of buying or selling. He has no obligation. He has to pay premium. Chance of Limited Loss. Chance of Unlimited Profit.	He has no right. He has obligation (responsibility) to provide the buyer with the position. He receives premium. Chance of Unlimited Loss. Chance of Limited Profit.

OPTION

CALL PUT

CALL

Call means a right to buy. If you expect TEJI, you should buy a Call.

PUT

Put means a right to sell. If you expect MANDI, you should buy a Put.

PREMIUM

Premium is the amount payable by an Option-Buyer. The rates of premium are different for different strike price.

STRIKE PRICE

Strike Price is the price at which the option-buyer desires to buy the shares.

TOP 9 TRADING STRATEGIES IN DERIVATIVES

1. BUY CALL

When market is down, buy just out of money Call.

2. BUY PUT

When market is Up and correction is due, buy Put.

3. BUY FUTURE AND SELL CALL

When you are bullish but at the same time you want to cover any downward.

4. BULL SPREAD

When market is in narrow range, buy “IN THE MONEY” CALL and sell “OUT OF MONEY” CALL.

5. CALENDER SPREAD

When you want to take TEJI POSITION for the next month, Sell Current Month CALL and Buy Next month Call.

6. STRANGLE

When you are not sure in which direction the market will go, Buy CALL & PUT of the same strike price.

7. STRADDLE

When results are expected and you do not know in which direction the stock will move, Buy “OUT OF MONEY” Call and “OUT OF MONEY” Put.

8. STOCK INSURANCE

Buy Future and Buy PUT to cover down side.

9. SELL CALL & PUT

In the last days of the Contract Period, Sell naked “OUT OF MONEY” Call & Put.

Examples of Some Complex Transactions – TEST YOURSELF

1. Mukesh expects Teji from now. He buys a Realince Future @ Rs. 439 and sells Reliance 450 Call (with 450 strike price) at the premium of Rs. 9. At the close of contract period, Reliance was Rs. 462. Could Mukesh make profit? If yes, how much ? (Lot Size = 600)

2. Popatlal expects Teji ahead. He buys HLL 180 Call at premium of Rs. 12 and sells 190 Call at the premium of Rs. 8. At the time of settlement end, HLL was trading at 196. Explain Popatlal’s position. (Lot Size = 2000)

3. Manubhai expects Teji ahead. He buys a Realince Future @ Rs. 437 and sells Reliance 450 Call at the premium of Rs. 6. At the close of contract period, Reliance was Rs. 435. Could Manubhai make profit? If yes, how much ? (Lot Size = 600)

4. Lalu expects Teji ahead. He buys HLL 180 Call at premium of Rs. 11 and sells 190 Call at the premium of Rs. 9. At the time of settlement end, HLL was trading at 191. Explain Lalu’s position. (Lot Size = 2000)

5. Dhondiba bought a Reliance 450 Call at Rs. 12 and sold Reliance Future @ Rs. 465. What would be his position when Reliance was quoting at Rs. 445/- ? (Lot Size = 600)

6. Dhakkan sold HLL 180 Call at Rs. 11 and bought HLL 190 call at Rs. 6. What will be his position when HLL is trading at Rs. 189 ? (Lot Size = 2000)

7. Makaiwala sold HLL 180 call at Rs. 6 and HLL 180 PUT at Rs. 7 ? What will he occur when HLL is trading at Rs. 175 ? (Lot Size = 2000)

8. Bhikhamchand sold HLL 190 call at Rs. 5 and HLL 190 PUT at Rs. 6 ? What will be his profit range of rates of HLL? When will he start making loss? (Lot Size = 2000)

9. Deepak sells Infosys 4500 call @ Rs. 75 and buys Infosys future at Rs. 4400. What will be his position when the rate of Infosys suddenly falls to Rs. 3800. (Lot Size = 50)
10. Manoj buys Infosys Future at Rs. 4600 and buys Infosys 4500 PUT at Rs. 50. What will be his position when the rate is Rs. 3850 ? Lot quantity for Infosys is 100. (Lot Size = 50)

11. Pradeep bought HLL 180 CALL at Rs. 12 and sold HLL 190 PUT for Rs. 17, both at a time. What will be his position when HLL is trading at Rs. 185 ? (Lot Size = 2000)

12. Manali sold HLL 180 PUT at Rs. 6/-. She also sold HLL 190 CALL at Rs. 3/-. What will be her position when HLL is about to close at Rs. 184? (Lot Size = 2000)

13. Nitin bought INFOSYS 4400 CALL at Rs. 90/-. He sold INFOSYS 4600 CALL at Rs. 60/-. What will be his position when INFOSYS is about to close at Rs. 4685/- ? (Lot Size = 50)

14. Bhavesh bought Infosys 4400 CALL at Rs. 120/- and Infosys 4400 PUT at Rs. 105. What will be his profit zone ? (Lot Size = 50)

15. Rachana sold HLL 180 CALL at Rs. 12 and HLL 180 PUT at Rs. 10/-. What will be her profit zone? (Lot Size = 2000)

16. Kishor bought Arvind Mills Future at Rs. 44 and sold Arvind Mills 50 Call at Rs. 3/-. How much profit or loss will he occur when the closing rate is Rs. 38 ? (Lot Size = 4300)

17. Bharat bought SATYAM FUTURE @ 286.00. He sold SATYAM 300 CALL at the premium of Rs. 5/-. He also bought SATYAM 280 PUT at the premium of Rs. 4/-. What will be his position when SATYAM closes at Rs. 292? (Lot Size = 1200)

18. Ravindra sold INFOSYS 5000 PUT at premium of Rs. 85/-. He sold INFOSYS FUTURE at Rs. 5300/-. What will be his position if INFOSYS finally closes at Rs. 5050/-? (Lot Size = 50)

19. Ashok bought HLL 130 CALL at premium of Rs. 4.00 and HLL 130 PUT at premium of Rs. 6.00. What will be final effect on him when HLL closes at Rs. 119/-? (Lot Size = 2000)

20. Vijay sold ACC FUTURE at Rs. 238/-. He also sold ACC 230 PUT at the premium of Rs. 8.00. What will be final effect on him when ACC closes at Rs. 219/-? (Lot Size = 1500)

21. What have I done, TEJI or MANDI, in the following situations:

1. When I bought a CALL?

2. When I have sold a CALL?

3. When I have bought a PUT?

4. When I have bought both CALL & PUT?

5. When I have sold both CALL & PUT?

6. When I have sold a PUT & bought a CALL?

7. When I have bought a PUT & sold a CALL?

8. When I have sold a PUT?

Answers of Question-21.

1. TEJI 2. MANDI 3. MANDI 4. TEJI & MANDI

5. MANDI & TEJI 6. TEJI & TEJI

7. MANDI & MANDI 8. TEJI

Note: Lot Sizes of Contracts given at end.

Note: “+” means incoming value and “-” means outgoing value.

ANSWERS OF COMPLEX EXAMPLES
Sr	Details	Value	Qty	Rate
1	Initially
	Buying Reliance Future	-263400.00	600	-439.00
	Selling Reliance 450 Call	5400.00	600	9.00
	Finally	-
	Squaring off Reliance Future	277200.00	600	462.00
	Loss Due 450 Call	-7200.00	600	-12.00
	Profit	12000.00
2	Initially
	Buying HLL 180 Call	-24000.00	2000	-12.00
	Selling HLL 190 Call	16000.00	2000	8.00
	Finally	-
	Due to Buying HLL 180 Call	32000.00	2000	16.00
	Due to Selling HLL 190 Call	-12000.00	2000	-6.00
	Profit	12000.00
3	Initially
	Buying Reliance Future	-262200.00	600	-437.00
	Selling Reliance 450 Call	3600.00	600	6.00
	Finally	-
	Squaring off Reliance Future	261000.00	600	435.00
	Due to Expiry of 450 Call At 435	-	600	0.00
	Profit	2400.00
4	Initially
	Buying HLL 180 Call	-22000.00	2000	-11.00
	Selling HLL 190 Call	18000.00	2000	9.00
	Finally	-
	Due to Buying HLL 180 Call	22000.00	2000	11.00
	Due to Selling HLL 190 Call	-2000.00	2000	-1.00
	Profit	16000.00
5	Initially
	Buying Reliance 450 Call	-7200.00	600	-12.00
	Selling Reliance Future	279000.00	600	465.00
	Finally	-
	Due to Expiry of 450 Call At 445	-	600	0.00
	Squaring off Reliance Future	-267000.00	600	-445.00
	Profit	4800.00
6	Initially
	Selling HLL 180 Call	22000.00	2000	11.00
	Buying HLL 190 Call	-12000.00	2000	-6.00
	Finally	-
	Due to Selling HLL 180 Call	-18000.00	2000	-9.00
	Due to Expiry of 190 Call At 189	-	2000	0.00
	Loss	-8000.00
7	Initially
	Selling HLL 180 Call	12000.00	2000	6.00
	Selling HLL 190 Put	14000.00	2000	7.00
	Finally	-
	Due to Expiry of 180 Call At 175	-	2000	0.00
	Due to Selling HLL 190 Put	-30000.00	2000	-15.00
	Loss	-4000.00
8	Initially
	Selling HLL 190 Call	10000.00	2000	5.00
	Selling HLL 190 Put	12000.00	2000	6.00
	Finally
	Break Even for Call is 195 and for Put is 184. He will make profit when
	HLL remains between 184 and 195. Profit Range : 184 to 195
9	Initially
	Selling INFOSYS 4500 Call	3750.00	50	75.00
	Buying INFOSYS Future @ 4400.00	-220000.00	50	-4400.00
	Finally
	Due to Expiry of 4500 Call At 3850	-	50	0.00
	Squaring Off INFOSYS Future	190000.00	50	3800.00
	Loss	-26250.00
10	Initially
	Buying INFOSYS Future @ 4600.00	-230000.00	50	-4600.00
	Buying INFOSYS 4500 Put @ 50	-2500.00	50	-50.00
	Finally
	Squaring Off INFOSYS Future	192500.00	50	3850.00
	Due to INFOSYS 4500 Put	32500.00	50	650.00
	Loss	-7500.00
11	Initially
	Buying HLL 180 Call	-24000.00	2000	-12.00
	Selling HLL 190 Put	34000.00	2000	17.00
	Finally	-
	Due to Buying HLL 180 Call	10000.00	2000	5.00
	Due to Selling HLL 190 Put	-10000.00	2000	-5.00
	Profit	10000.00
12	Initially
	Selling HLL 180 Put	12000.00	2000	6.00
	Selling HLL 190 Call	6000.00	2000	3.00
	Finally	-
	HLL 180 Put Expired at 184	-	2000	0.00
	HLL 190 Call Expired at 184	-	2000	0.00
	Profit	18000.00
13	Initially
	Buying INFOSYS 4400 Call	-4500.00	50	-90.00
	Selling INFOSYS 4600 Call	3000.00	50	60.00
	Finally
	Due to INFOSYS 4400 Call	14250.00	50	285.00
	Due to INFOSYS 4600 Call	-4250.00	50	-85.00
	Profit	8500.00
14	Initially
	Buying INFOSYS 4400 Call	-6000.00	50	-120.00
	Buying INFOSYS 4400 Put	-5250.00	50	-105.00
	Finally
	Due to INFOSYS 4400 Call	14250.00	50	285.00
	Due to INFOSYS 4400 Put	-4250.00	50	-85.00
	Break Even for Call is 4280 and for Put is 4505. He will make profit when
	INFOSYS remains between 4280 and 4505. Profit Range : 4280 to 4505
15	Initially
	Selling HLL 180 Call	24000.00	2000	12.00
	Selling HLL 180 Put	20000.00	2000	10.00
	Finally
	Break Even for Call is 192 and for Put is 170. She will make profit when
	HLL remains between 170 and 192. Profit Range : 170 to 192
16	Initially
	Buying ARVIND Future @ 44	-189200.00	4300	-44.00
	Selling ARVIND 50 Call	12900.00	4300	3.00
	Finally
	Due to ARVIND Future at 38	163400.00	4300	38.00
	ARVIND 50 Call Expired at 38	-	4300	0.00
	Loss	-12900.00
17	Initially
	Buying SATYAM Future @ 286	-343200.00	1200	-286.00
	Selling SATYAM 300 Call	6000.00	1200	5.00
	Buying SATYAM 280 PUT	-4800.00	1200	-4.00
	Finally
	Due to SATYAM Future at close	350400.00	1200	292.00
	SATYAM 300 CALL expired at 292	-	1200	0.00
	SATYAM 280 PUT expired at 292	-	1200	0.00
	Profit	8400.00
18	Initially
	Selling INFOSYS 5000 PUT	4250.00	50	85.00
	Selling INFOSYS Future	265000.00	50	5300.00
	Finally
	INFOSYS 5000 PUT Expired at 5050	-	50	0.00
	Buying INFOSYS Future	-252500.00	50	-5050.00
	Profit	16750.00
19	Initially
	Buying HLL 130 Call	-8000.00	2000	-4.00
	Buying HLL 130 Put	-12000.00	2000	-6.00
	Finally	-
	HLL 130 Call expired at 119	-	2000	0.00
	Due to Buying HLL 130 Put	22000.00	2000	11.00
	Profit	2000.00
20	Initially
	Selling ACC Future	357000.00	1500	238.00
	Selling ACC 230 PUT	12000.00	1500	8.00
	Finally
	Buying ACC Future	-328500.00	1500	-219.00
	Due to ACC 230 PUT	-16500.00	1500	-11.00
	Profit	24000.00