INVESTING STRATEGIES - THE DERIVATIVE MARKETS - INDIA

The Bombay Stock Exchange (BSE) introduced derivative trading in India
with the launch of the Sensex futures contract in June 2000. Over the
next two years, the BSE and the National Stock Exchange (NSE) launched
the trading of futures and options contracts for various indexes, specific sectors,
and individual stocks. Beginning with virtually no derivatives turnover
in 2001, the NSE has become India’s dominant derivatives marketplace and
has witnessed explosive growth: derivatives turnover was more than double
that of the equity markets turnover by 2004, and at US$1,565.91 billion
in 2006, derivatives turnover was more than three and one half times the
US$425 billion equity markets turnover in 2006. Interestingly, in 2006, 88
percent of the derivatives turnover was in futures, two-thirds of which were
stock futures, with options turnover representing only 11 percent of derivatives
turnover.
Derivatives Definitions and Attributes
Futures Contract
A futures contract is a legally binding agreement to buy
or sell an underlying security at an agreed-upon price on a future date.
Futures contracts are standardized contracts in terms of quantity, quality
(in the case of commodities), delivery time, and place for settlement on
any date in the future. The contracts expire on a prespecified date, which
is called the expiry date of the contract. On expiry, futures can be settled
by delivery of either the underlying asset or cash. Cash settlement entails
paying or receiving the difference between the price at which the contract
was entered and the price of the underlying asset at the time of the expiry
of the contract. The futures traded on the exchanges are financial futures,
representing financial assets, as opposed to commodity futures, representing
hard commodities.
Options Contract
An options contract is a contract that gives the buyer or
holder of the contract the right (but not the obligation) to buy or sell the
underlying asset at a predetermined price within, or at the end of, a specified
period. The buyer or holder of the option purchases the right from the seller
or writer for a consideration, which is called the premium. The seller, or
writer, of an option is obligated to settle the option as per the terms of the
contract when the buyer or holder exercises his right. The underlying asset
could include securities or an index of prices of securities.
Attributes
A particular options contract has four attributes:
1. The underlying security
2. Put or call
3. American- or European-style exercisability
4. Strike price (or exercise price)
The underlying security is the asset that is contracted to be boughtor
sold by the option. There are two types of options:
1. Call option:
An option to buy a fixed number of shares at the specified price.
2. Put option:
An option to sell a fixed number of shares at the specified
price.
Options, both calls and puts, are also classified as either American-style
options or European-style options, distinguished by the eligible time period
during which the option can be exercised:
_ American option: An option that is exercisable on or before the
expiry date.
_ European option: An option that is exercisable only on the expiry
date. The strike price or exercise price is the price at which the option is to
be exercised.
Additional Derivatives Attributes Additional definitions and attributes applicable to derivatives are as follows:
_ Exercising an option:
This is the act by which an option owner uses its
right to either buy (in the case of a call option) or sell (put option) an
underlying asset at the strike price stated on the contract. The request
for an exercise is submitted to the exchange, which randomly assigns
the exercise request to the sellers of the options, who are obligated to
settle the terms of the contract within a specified time frame.
_ Option settlement:
Option contracts can be settled by delivery of the
underlying security or cash. Cash settlement in option contracts entails
paying or receiving the difference between the strike, or exercise, price
and the price of the underlying asset either at the time of expiry of
the contract or at the time of the exercise or assignment of the option
contract.
_ Index futures underlyings:
Index futures contracts are based on an index
such that the underlying asset is the index.
_ Index futures settlement:
Index futures contracts are cash settled on expiry.
_ Index option contracts:
Options contracts are based on an underlying
index as opposed to an underlying single security as in an individual
stock option. Index options contracts are generally European-style options.
These contracts are cash settled on expiry.
_ Minimum contract size:
SEBI specifies that the value of a derivative contract
should not be less than Rs200,000 (∼US$4,500) when introducing
the contract in the market.
_ Lot size of a contract:
For stock-specific derivative contracts, SEBI specifies
that the lot size of the underlying individual security should be in
multiples of 100, and fractions, if any, should be rounded off to the next
higher multiple of 100. This requirement, together with the requirement
for minimum contract sizes, forms the basis of arriving at the lot size of
a contract. For example, if shares of XYZ Ltd. are quoted atRs1,000
each and the minimum contract size is Rs200,000, then the lot size for
that particular scrip is 200,000/1,000 = 200 shares so that one contract
in XYZ Ltd. covers 200 shares.
_ Trading cycle:
The BSE and NSE trade futures and options on a monthly
expiration period with a maximum maturity of three months. At any
one time there are three contracts trading. These contracts are known
as the “near-month,” “next-month,” and “far-month” contracts. The
BSE also trades a limited number of options with a unique, two-week
expiration period.
_ Expiration period:
Standard futures and options contracts expire on the
last Thursday of the expiring month. If the last Thursday is a trading
holiday, the contracts expire on the previous trading day. Anew contract
is introduced on the trading day following the expiry of the near-month
contract. The new contract will be introduced for a duration of three
months. The BSE two-week expiration options expire on the Friday of
the expiring week.
_ Contract exercise type:
BSE options are the European and American styles.
_ Price steps:
The tick size for futures and options contracts is Rs 0.05
(US$0.001).

Futures and Options Eligibility Criteria for the
Selection of Securities and Indexes
SEBI determines the eligibility criteria for introducing futures and options
contracts on stocks and indexes. The following criteria for selecting stocks
and indexes as underlyings for futures and options contracts were adopted
in September 2004:
Eligibility Criteria for Listed Stocks
_ Market capitalization: Stocks are chosen from among the top 500
stocks in terms of average daily market capitalization in the previous
six months on a rolling basis. The average daily market capitalizations
are computed on the 15th of each month, on a rolling basis, to arrive
at the list of the top 500 securities.
_ Liquidity: Stocks are chosen from among the top 500 stocks in terms of average daily traded value in the previous six months on a rolling
basis. The average daily traded values are computed on the 15th of
each month, on a rolling basis, to arrive at the list of top 500 securities.
In addition, quarter-sigma size is evaluated, defined as the order size
(in value terms) required to change the stock price by one-quarter of a
standard deviation.a The stock’s median quarter-sigma order size over
the last six months shall not be less than Rs100,000 (US$2,300).
_ Position limits:
The marketwide position limit in the stock shall not
be less than Rs500 million (US$11 million). The marketwide position
limit (the value of shares) is valued by taking the closing prices of stocks
in the underlying cash market on the date of expiry of contract in
the month.
An existing security must continue to meet the eligibility criteria for
three consecutive months. If it fails to meet the requirements, then no fresh
monthly contract will be issued for that security.

The NSE has taken the position that “a stock that has remained subject
to a ban on new positions for a significant part of the month consistently
for three months shall be phased out from trading in the futures and options
segment.” However, all existing unexpired contracts will be permitted to
continue trading until they expire; new strike prices may also be introduced
for the existing contract months.
The number of securities eligible for futures and options may vary from
month to month depending upon changes in quarter-sigma order sizes, average
daily market capitalization and average daily traded value calculated
every month on a rolling basis for the past six months, and the marketwide
position limit in that security. Contracts may be introduced on new securities
that meet the eligibility criteria, subject to approval by SEBI. Again, the
Web sites of the two exchanges should be consulted for the up-to-date list
of stocks for which futures and options are available.

BSE Trading System
Derivative trading at the BSE takes place through a Derivative Trading and
Settlement System (DTSS), which is a fully automated screen-based trading
platform. The DTSS is designed to allow trading on a real-time basis. In
addition to generating trades by matching opposite orders, the DTSS also
generates various reports for member participants.
_ Order matching rules: Matching orders is prioritized by price and then time. All orders are time-stamped when accepted by the DTSS. A unique
trade-ID is generated for each order, and the complete trade information
is sent to the members involved in the order.
_ Order conditions: The derivatives market is order driven so traders can place only orders in the system. For derivative products, the order types
available have characteristics that are similar to order types in the cash
market, and include:
_ Limit order: An order eligible for execution at or better than the
specified limit price.
_ Market order: There are two types of market orders:
_ Partial fill rest kill (PF): Execute the available quantity and cancel any unexecuted portion (similar to immediate-or-cancel [IOC] in
the United States).
_ Partial fill rest convert (PC): Execute the available quantity and
convert any unexecuted portion into a limit order at the traded
price.
_ Stop loss order: This is an order that is dormant and becomes activated only when the market price of the relevant security reaches or crosses
a threshold, which is a trigger price specified on the order. Until
triggered, the order is a dormant order not eligible for execution.
Stop loss orders are often used to preserve profits or limit losses.
_ A sell order in the stop loss book is entered at a trigger price below the then-current price and triggered when the last traded price in
the normal market reaches or falls below the trigger price of the
order.
_ A buy order in the stop loss book is entered with a trigger price
above the then-current price and becomes triggered when the last
traded price in the normal market reaches or exceeds the trigger
price of the order.
An additional order type is used only in special circumstances.
_ Risk-reducing orders are used when a member’s collateral falls below Rs5,000,000 (US$114,000); he will be allowed to enter only riskreducing
orders and not initiate any new positions. This status for
a member is imposed only when the member violates his collateral
limit. A member who has this status will be allowed to enter only one
risk-reducing order at a time.
All orders entered into the trading system need to have the following
attributes to be accepted for execution:
_ Order type (limit/market PF/market PC/stop loss).
_ Asset code, product type, maturity, call/put and strike price.
_ Buy/sell indicator.
_ Order quantity.
_ Price.
_ Client type (own/institutional/normal).
_ Client code.
_ Order retention/time type:
_ Good till canceled (GTC).
_ Good for day (GFD).
_ Good till date (GTD): Order retention period. For GTD orders, the
number of calendar days for which the order is good must be stated.
_ Protection points. This is a field relevant in market orders and stop
loss orders. The value will be in absolute underlying points and specify
the band from the touchline price or the trigger price within which the
market order or the stop loss order, respectively, can be traded.
More details visit http://www.bseindia.com/deri/deri/landingderivatives.aspx

NSE Trading System
NSE derivatives are traded on the NEAT screen-based trading system. NEAT
has the following characteristics:

Order matching rules: NEAT is an order-driven market and operates
with a price-time priority for matching orders.

Order conditions: NEAT accepts orders with time-related and pricerelated parameters similar to those accepted in the cash market. These
are:

Time-related parameters:

Day order: This order is valid only for the day on which it is entered.
At the end of that trading day, any unmatched (unexecuted) part
of the order is canceled.

Immediate-or-cancel (IOC) order: This order is valid only at the
moment at which it is exposed to the market, to execute at the price
parameters under which it is entered against any orders in the system
meeting those requirements. Any part of the order unexecuted
at the moment after entry is canceled from the market.

Price-related parameters:

Limit order: An order eligible for execution at or better than the
specified limit price.

Market order: An order eligible for execution at the best price then available in the market

Stop loss order: This is an order that is dormant and becomes activated only when the market price of the relevant security reaches
or crosses a threshold, which is a trigger price specified on the order.
Until triggered, the order is a dormant order not eligible for
execution. A sell order in the stop loss book is entered at a trigger
price below the then-current price and triggered when the last
traded price in the normal market reaches or falls below the trigger
price of the order. A buy order in the stop loss book is entered with
a trigger price above the then-current price and becomes triggered
when the last traded price in the normal market reaches or exceeds
the trigger price of the order. Stop loss orders are often used to
preserve profits or limit losses.
Visit http://www.nse-india.com/ for more details on derivatives.