Derivatives Trading in India

Trading in stock index futures contracts started in June 2000. The Bombay Stock Exchange (BSE) was the first exchange to commence derivatives trading on June 9, 2000 followed by the National Stock Exchange (NSE) on June 12, 2000. Exactly after a year trading in index options and trading in individual Stock options commenced in June 2001 and July 2001, respectively. Then in November 2001 futures trading in individual stocks was permitted. There are now four equity derivative products in the Indian market. Worldwide, the most successful equity derivative contracts are index futures, followed by index options and stock options.

Stock Index Options:

Stock index options are where the underlying asset is a Stock Index. For example, S&P, CNX, Nifty or BSE Sensex are the underlying securities. Index options were first introduced by Chicago Board of Options Exchange (CBOE) in 1983 on its index S&P 100. The CBOE is the largest exchange or trading stock options. In index options, one buys or sells the entire stock market’ as a single entity. Index options give an investor the right to buy or sell the value of an index, which consist of a certain number of stocks.

Index options enable investors to gain exposure to a broad market with one trading decision and with one transaction. This reduces the transaction costs. The premium of index option, a percentage of the underlying value, is also low.

Both individual investors and professionals, such as mutual fund managers, use stock index options. Individual investors use stock index options to capitalize on market options (bullish, bearish or neutral) by acting on their views of the broad market or one of its sectors. Professionals use stock index options as tools for enhancing market timing decisions and adjusting asset mixes for asset allocation.

In case of stock index options, an investor can exercise his options only on the last day. These are called European style options. Stock Index options are cash settled.

The index options contract has a minimum size of Rs 2 lakh and a maximum maturity of 12 months with a minimum of three strikes: in the money, near the money, and out of the money. Both NSE and BSE offer five strike prices. The lot size for Nifty and Sensex is 200 units and 100 units, respectively. A portfolio based margining approach is adopted so that an integrated view of the risk involved in the portfolio of each client is possible.

Individual Stock Options: Individual stock options are contracts where the underlying asset is an equity stock. They are mostly American Style Options, that is, they can be exercised on any day during their tenure. Prices are normally quoted in terms of premium per share although each contract is for a larger number of shares.

Suppose an investor bought a June Infosys put (a right to sell) on April 3 at a strike price of Rs 3,800 paying a premium of Rs 650. On that day, spot Infosys was Rs 3,300. The option is in the money as the strike price is greater than the spot price. If it is exercised immediately, the investors profit of Rs 500(3,800 – 3,300) is less than the premium of Rs 650 a shortfall of Rs 150. The investor will make a profit when Infosys falls below Rs 3,150. Stock options are exercised at the closing spot prices of the underlying stock.

Individual stock options provide a wide array of trading strategies to both hedgers and speculators. Investors can insure their portfolio of equity stocks by buying a protective put. Individual stock options enable investors to enjoy more leverage in the form of greater exposure by paying a small amount of premium. Individual stock options are beneficial to ESOP (Employee Stock Options) holders. ESOPs are subject to lock in periods and this lock in period could reduce capital gain in falling markets. Hence, and ESOP holder can buy a put option in the underlying stock and exercise the same if the market price falls below the price of the stock.

At present, 31 stocks are available for derivatives trading. In the case of individual stock options, an investor can exercise his option on any trading day. A holder of a call option receives the difference between the closing price and his strike price. —