Key Regulations in Derivatives

In India we have two premier exchanges The National Stock Exchange of India (NSE) and The Bombay Stock Exchange (BSE) which offer options trading on stock indices as well as individual securities.

Options on stock indices are European in kind and settled only on the last of expiration of the underlying. NSE offers index options trading on the NSE Fifty index called the Nifty. While BSE offers index options on the country’s widely used index Sensex, which consists of 30 stocks.
Options on individual securities are American. The number of stock options contracts to be traded on the exchanges will be based on the list of securities as specified by Securities and Exchange Board of India (SEBI). Additions/deletions in the list of securities eligible on which options contracts shall be made available shall be notified from time to time.
Underlying: Underlying for the options on individual securities contracts shall be the underlying security available for trading in the capital market segment of the exchange.
Security descriptor: The security descriptor for the options on individual securities shall be:

• Market type - N
• Instrument type - OPTSTK
• Underlying - Underlying security
• Expiry date - Date of contract expiry
• Option type - CA/PA
• Exercise style - American Premium Settlement method: Premium Settled; CA - Call American
• PA - Put American.

Trading cycle: The contract cycle and availability of strike prices for options contracts on individual securities shall be as follows:
Options on individual securities contracts will have a maximum of three-month trading cycle. New contracts will be introduced on the trading day following the expiry of the near month contract.
On expiry of the near month contract, new contract shall be introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. (See Index futures learning centre for further reading)
Strike price intervals: The exchange shall provide a minimum of five strike prices for every option type (i.e call & put) during the trading month. There shall be two contracts in-the-money (ITM), two contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike price interval for options on individual securities is given in the accompanying table.
New contracts with new strike prices for existing expiration date will be introduced for trading on the next working day based on the previous day's underlying close values and as and when required. In order to fix on the at-the-money strike price for options on individual securities contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike price interval. The in-the-money strike price and the out-of-the-money strike price shall be based on the at-the-money strike price interval.
Expiry day: Options contracts on individual securities as well as index options shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day.
Order type: Regular lot order, stop loss order, immediate or cancel, good till day, good till cancelled, good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order.
Permitted lot size: The value of the option contracts on individual securities shall not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on individual securities shall be in multiples of 100 and fractions if any, shall be rounded off to the next higher multiple of 100.
Price steps: The price steps in respect of all options contracts admitted to dealings on the exchange shall be Re 0.05.
Quantity freeze: Orders which may come to the exchange as a quantity freeze shall be the lesser of the following: 1 per cent of the marketwide position limit stipulated of options on individual securities as given in (h) below or Notional value of the contract of around Rs 5 crore. In respect of such orders, which have come under quantity freeze, the member shall be required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the exchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc.
Base price: Base price of the options contracts on introduction of new contracts shall be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. However in such of those contracts where orders could not be placed because of application of price ranges, the bases prices may be modified at the discretion of the exchange and intimated to the members.
Price ranges: There will be no day minimum/maximum price ranges applicable for the options contract. The operating ranges and day minimum/maximum ranges for options contract shall be kept at 99 per cent of the base price. In view of this the members will not be able to place orders at prices which are beyond 99 per cent of the base price. The base prices for option contracts may be modified, at the discretion of the exchange, based on the request received from trading members as mentioned above.
Exposure limits: Gross open positions of a member at any point of time shall not exceed the exposure limit as detailed hereunder:

• Index Options: Exposure Limit shall be 33.33 times the liquid networth.

• Option contracts on individual Securities: Exposure Limit shall be 20 times the liquid networth.

Memberwise position limit: When the open position of a Clearing Member, Trading Member or Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore, whichever is higher, in all the option contracts on the same underlying, at any time, including during trading hours.
For option contracts on individual securities, open interest shall be equivalent to the open positions multiplied by the notional value. Notional Value shall be the previous day's closing price of the underlying security or such other price as may be specified from time to time.
Market wide position limits: Market wide position limits for option contracts on individual securities shall be lower of:
*20 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange or, 10 per cent of the number of shares held by non-promoters in the relevant underlying security i.e. 10 per cent of the free float in terms of the number of shares of a company.
The relevant authority shall specify the market wide position limits once every month, on the expiration day of the near month contract, which shall be applicable till the expiry of the subsequent month contract.
Exercise settlement: Exercise type shall be American and final settlement in respect of options on individual securities contracts shall be cash settled for an initial period of 6 months and as per the provisions of National Securities Clearing Corporation Ltd (NSCCL) as may be stipulated from time to time.

Speculation

Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.
Illustration:
Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures.
On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position.
Selling Price : 4000*100            = Rs 4,00,000
Less: Purchase Cost: 3600*100 = Rs 3,60,000
Net gain                                        Rs 40,000
Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a long-term view of the market up to atleast 3 months.

Hedging

We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example.


Illustration:
Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

Cost (Rs)	Selling price	Profit
1000	4000	3000

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.

Shyam defaults	Shyam honours
1000 (Initial Investment)	3000 (Initial profit)
1000 (penalty from Shyam)	(-1000) discount given to Shyam
- (No gain/loss)	2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment.
The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario.
Stocks carry two types of risk – company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta.
Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.
Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.
Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2.      Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to short sell 1.2 * 1 million = 1.2 million worth of Nifty.
Now let us study the impact on the overall gain/loss that accrues:

	Index up 10%	Index down 10%
Gain/(Loss) in Portfolio	Rs 120,000	(Rs 120,000)
Gain/(Loss) in Futures	(Rs 120,000)	Rs 120,000
Net Effect	Nil	Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forgo any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market

Limited Liability Partnership (LLP)

A law to allow "Limited Liability Partnership" (LLP) in India has been enacted by the Parliament of India recently. (Limited Liability Partnership (LLP) Act of 2008).

LLP is an alternative corporate business entity that provides the benefits of limited liability of a company but allows its members the flexibility of organizing their internal management on the basis of a mutually-arrived agreement, as is the case in a partnership firm.

This format would be quite useful for small and medium enterprises in general and for the enterprises in services sector in particular, including professionals and knowledge based enterprises.

As proposed in the Bill, LLP shall be a body corporate and a legal entity separate from its partners. It will have perpetual succession. While the LLP will be a separate legal entity, liable to the full extent of its assets, the liability of the partners would be limited to their agreed contribution in the LLP.

Further, no partner would be liable on account of the independent or unauthorized actions of other partners, thus allowing individual partners to be shielded from joint liability created by another partner’s wrongful business decisions or misconduct.

The salient features of the LLP Act of 2008 are as follows:-

(i) The LLP will be an alternative corporate business vehicle that would give the benefits of limited liability but would allow its members the flexibility of organizing their internal structure as a partnership based on an agreement.

(ii) The proposed Bill does not restrict the benefit of LLP structure to certain classes of professionals only and would be available for use by any enterprise which fulfills the requirements of the Act.

(iii) While the LLP will be a separate legal entity, liable to the full extent of its assets, the liability of the partners would be limited to their agreed contribution in the LLP. Further, no partner would be liable on account of the independent or un-authorized actions of other partners, thus allowing individual partners to be shielded from joint liability created by another partner’s wrongful business decisions or misconduct.

(iv) LLP shall be a body corporate and a legal entity separate from its partners. It will have perpetual succession. Indian Partnership Act, 1932 shall not be applicable to LLPs and there shall not be any upper limit on number of partners in an LLP unlike a ordinary partnership firm where the maximum number of partners can not exceed 20.

(iv) An LLP shall be under obligation to maintain annual accounts reflecting true and fair view of its state of affairs. Since tax matters of all entities in India are addressed in the Income Tax Act, 1961, the taxation of LLPs shall be addressed in that Act.

(v) Provisions have been made in the Bill for corporate actions like mergers, amalgamations etc.

(vii) While enabling provisions in respect of winding up and dissolutions of LLPs have been made in the Bill, detailed provisions in this regard would be provided by way of rules under the Act.