Futures and Options in India

BY: YOGIN VORA ON MARCH 25, 2010 NO COMMENT

Options Trading Options Trade Derivatives Trade Trading in shares

The Indian capital market has witness impressive growth and qualitative changes, especially over the last two decades. In the fifties, sixties and most of the seventies, it was in a dormant stage when the investors were generally not familiar with, or inclined towards, the corporate securities. During this time, only few companies accessed the capital market. As a consequence, trading volumes were low during these years. The process of liberalization of the Indian economy since the early nineties has contributed to changes in the capital market scenario. The entry of foreign investors in the market has resulted in a substantial change in the scale of operations. Now, we are on the threshold of introduction of trading in derivatives including futures and options, which is expected to bring a qualitative change in the capital market. In this chapter we will discuss about the introduction of future and options trading on the Indian Bourses. However, we will first consider analytically the Badla System which has been an integral part of the Indian markets for long and how does it compare with the futures and options. Along with it, a review is made of the form in which an option trading has been prevalent in the Indian capital market.

The Badla System

The system of forward trading was prevalent in the Indian capital market for decades. It originated as fortnightly clearings, the clearings being meant as contract for clearance and settlement through clearing house, under the bye-laws and regulations of the stock exchanges. Such contracts for clearing were prohibited in June 1969 by the government of India vide a notification under section 16(1) of the Securities Contract (Regulation) act 1956.This led to a reduction in the stock market activities.

A forward trading system was introduced by the government of India in July, 1983 in the Bombay, Calcutta, Delhi and Ahmedabad stock exchanges. Under the system, the listed shares were divided into two categories: specified and non-specified. The system permitted the carryforward, or badla trading in specified shares. The underlying principle of the system was simply this that although, strictly, forward trading could not be undertaken, transactions were done on a spot basis, but the settlement was carried forward. The system was stuffed with a strict schedule of regulatory measures like daily margins, carry over margins, automatic margins, limits on holdings of individuals, limits on price fluctuations- daily and fortnightly, etc. the system induced liquidity in the stock market, which was largely due to participation of the retail investors who otherwise had no access to fund the purchases. The badla system of trading worked well and led to a stupendous growth of the market in terms of various parameters like the number of investors, number of new issues, market capitalization and turnover. In 1991, the Ministry of Fi9nanace asked the Society for Capital Market Research and Development to undertake an expert study of the trading in shares in stock exchanges, one of the terms of reference to look into the working of Badla system in shares and its effect on trading. In terms of the finding of the study, it was observed that, typically only about onefourth of the outstanding position at the end of settlement got settled by actual delivery, while the remaining bulk got carried forward to next settlement. The committee did not seem to be in agreement with the brokers defence of the system as a provider of liquidity. If felt the carry forward system to be totally unjustifiable and unhealthy practice in economic terms. The system of Badla helps neither speculators, who have neither money to pay nor shares to deliver. In its view, the liquidity provided by speculators, who are not interested in paying and taking delivery on the settlement date, can not be considered as a genuine liquidity. Accordingly, it recommended doing away with the carry forward system. The Badla system was banned in December 1993 by the market regulator, SEBI, presumably because it led to excessive speculation and/or its misuse. Based on the recommendations of the

G S Patel committee that the SEBI had set up, a new carry forward trading system was introduced in January 1996. However, the system did not fond much favour with the broking and investing community. The revised carry forward system entails a number of restrictions which have made it unattractive.

Limits on the Carry Forward Transactions Margins Limited Carry Forward Cumbersome Reporting Requirement

There were voices for relaxations in the stringent conditions laid down in the revised carry forward scheme from time to time and even demands for reviving the old badla system. The re-introduction of Badla trading was suggested in some quarters to be key to the revival of the capital market on account of their deep faith in the ingenuity of the system which simultaneously facilitates hare financing, share lending and carry forward.

Badla: Operation and Rationale

We may look the modus operandi of badla, which has been prevalent I the Indian markets. Under the bye-laws of the stock exchanges, a contract in specified shares can be for

1.

Spot delivery

2. For hand delivery 3. For special delivery 4. For the settlement

Unless otherwise stipulated, when entering into the contract, a contract is deemed to be for the current settlement. At the end of a settlement, all the transactions for each broker are clubbed together and each brokers net position is worked out for that settlement. The brokers then decides in consultation with his clients whether they would accept/give delivery of the shares and pay/receive money in full for the same, would carry forward the sale/purchase. Thus, outstanding positions at the end of a settlement may be categorized as the seller, who want,

and those who do not want, to give deliveries, and the buyers who want, and those who want do not want, to take deliveries. Now the buyer does not want to take the delivery and desires to carry forward the transactions from the current settlement to next settlement period, he usually has to pay contango charge or the badla to the seller. It is a consideration for acquiring by the rights of the rights and the obligation in the shares. If some of the buyers do not want to take delivery in case the quantum of delivery sales exceeds the quantum of delivery purchase, the financiers know as uyaj badla wale emerge, who take the delivery in the current settlement fro the seller giving the delivery and give the delivery I the next settlement to the buyers carrying forward the transactions, receiving the difference between the settlement rate and the sale rates for the next settlement as interest charges. This is termed as seedha badla and the transaction is known as uyaj badla or Mandi badla The badla charges for carrying forward the transaction are determined by the inter-play of the market forces in a half-hour session at the end of the current settlement period and at the beginning of next settlement, know as Badla session. Theses charges, which vary in the halfhour badla session between scrips and also for the same scrip, depend upon various factors like prevailing interest rates, technical position of the market, etc. The rationale for providing the badla facility to carry forward transactions from one settlement period of two weeks to another is that it imparts liquidity and breadth to the market. This allows the absorption of large purchases and sales in relatively narrow fluctuations in prices, leading to stability in the market. The carry forward system provided the investor an opportunity to enhance his position significantly towards liquidity, forecasting of the future market behaviour and reasonable level of speculation, which are essential ingredients for an efficient functioning of the secondary capital market. In the absence of such a facility, all purchases would be required to be taken delivery of with the payments being in respect of the same and, similarly all sales outstanding at the end of the settlement have to result in delivery with respect to the consideration amount. Such a situation

would lead to an ill-liquid and narrow market characterized by sharp oscillation in prices. This is reflected in the fact hat the movement of prices in the specified group is relatively more orderly than in case of the non-specified shares.

Badla versus futures and options

From our discussion about Badla, and the futures and options, it may be observed that;

1. In badla, all net position at the end of the settlement period can be carried forward and
members pay or receive badla charges, while in futures and options, various combinations are available which in futures and options, various combinations are available which enable the operators to close or recluse the open position till the maturity period, and carry forward of open position to the next maturity period is neither necessary nor possible.

2. Badla is basically a financial mechanism. Badla financiers provide finance to the members
with net bought positions. On the other hand, no such financing mechanism exists in futures and options.

3. Badla system encourages short sellers as they generally get badla charges. However, both
bulls and bears have an opportunity to trade in case of options and futures.

Options in India: Teji and Mandi

The operations in the Indian market have been confined to call options (known as teji), put options (know as mandi), their combination in the form of straddles (know as jhota or duranga) and bhav- bhav on stock only. While in options trading markets in the world, options with exercise price less than, equal to, greater than the stock price are available in the markets only out-of-the-money call options i.e. options with an exercise price higher than the current stock price, are traded. Hence the name teji. The seller or the writer of such an option is called teji khaii-wal as he agrees to sell the share in case of teji (the price arising out above the exercise price) for a value, the option premium. The buyer of the option is called teji lagaiiwal.

Similarly, the put options traded are also those which are out-of-the-money options i.e. options with an exercise price lower than the current stock price. The writers of such options agree to buy a share in the event of its price falling below the exercise price, i.e. mandi, in consideration for a premium. The writer of an option of this type is called the mandi khaii-wal while the buyer is a mandi lagaii-wal. Both teji and mandi have an expiry time at the stroke of 15 minutes before the closing time of trading of the next business day. However, sometimes they are event-based, so that while they can originate any day the exercise date is fixed, like the day following the budget day or the day following the annual general meeting of the company whose share underlies the teji/mandi contract. The premium on teji/mandi options is fixed customarily, usually at 25 paise per share, and is not negotiable, although the strike price may be negotiated. On event-based options, the premium payable is double than that on the ordinary options. The greater part of the derivative trading in India is in the form of jhota or fatak, which involves the buyer, known variously as lagaii-wal or lagane-wale or punter, the writer, known by various names like khaii-wal, khane-wala or bookie, and a broker, the mediator. A fatak involves a call option and put option available to the punter at exercise prices higher and lower than a certain value, which is generally the closing price of a share on a given day. The size of fatak, that is to say, the gap between the exercise prices of call and put options is generally higher before and after the market trading hours and it is smaller during these hours. Another derivative traded in the market is known as bhav-bhav or nazrana. In this case, the closing price of the day is taken as the exercise price and the holder of nazrana can exercise a call or put option depending on the price of the stock. For instance, if the closing price of a stock is Rs 66 on a given day, then the holder shall hold both options with him: buy the share from the bookie at a price of Rs 66 or sell to him the share at the same price (Rs 66) at the time of exercise. It will obviously pay the option buyer to buy at Rs 66 if the share price goes beyond this level and sell it to the writer at Rs 66 if the share price decreases below Rs 66.

In nazrana, then, the exercise price is fixed and so is the date of expiry. However, the premium is negotiable. The premium is roughly one-half of the amount of gap in fatak. Thus, with the share price of Rs 66 and a fatak with exercise prices of Rs 63 and Rs 69, the gap is equal to Rs 3. In such case, the premium payable by a buyer shall be around Rs 1.50 per share. The nazrana apparently exposes the writer to greater risk by providing call and put options to the buyer at the same exercise price, in contrast to a fatak where the same options are given but with a gap in the exercise prices. However, a closer look at the two reveals that for a given amount of premium, one has to write option on a larger number of shares in case of a fatak than in case of nazrana. Accordingly, when there are significant fluctuations in the price of the underlying share, a fatak involves a far greater degree of risk than a nazrana.

The chronology of introduction of the futures and options in India is given below:

Although exchanges like Bombay Stock Exchanges and Vadodara Stock Exchange have for long shown their willingness for trading in futures and options, but a concerted effort in this direction was made by the National Stock Exchange (NSE) only in July 1995, when it considered the modalities of introducing deritivative trading, mainly futures and options. Within a few months, NSE developed a system of future and option trading aiming at modifying the carry forward system to include future and options in its scope. By January 1996, the NSE started work on the scheme of such trading in March 1996; it made a presentation to SEBI on its plan to commence trading in futures and options. The exchange proposed to start with index based future and index base of options, which are seen as comparably safer forms of derivatives. By May 1996, the NSE finalized the net worth requirement for the membership of the purposed future and options trading segments, which was set at 5 crore. These constitute NSEs first step towards initialing futures and options trading, which, the NSE visualized, would commence in the month of November, 1996.

The NSE decided for the future and options segment to have two type of membership (restrict to just corporate members): member trading only in futures products, and those who write options. The members were to further earmark cash deposits for the National securities Clearing Corporation Limited (NSCCOL). The deposits collected by the NSCCL were to form part of members contribution to a separate settlement fund for the future and options segment, which was to commence operations along with trading in futures and options. Around this time the Bombay Stock Exchange (BSE) also decided to form a committee to consider the introduction of trading in derivatives, government paper and debt market instruments. It proposed to be working on index- based future and submitted a proposal to SEBI. THE SEBI, in the mean time, set up a special derivatives regulatory department which would coordinate and ensure the sharing the information between stock exchanges. It also set up the L.C. Gupta Committee to go into the question of derivatives trading and to suggest various policy and regulatory measures that need to be undertaken before trading is formally allowed. Recently, the Union Law Ministry has asked SEBI to go ahead with the proposed introduction of futures and options trading without effecting changes in the Securities Contract Regulation Act (SCRA) 1956. In 1995, the Centre had passed an enabling legislation effecting changes in the SCRA which allowed the issuance and trading of options in securities. The L.C.Gupta committee appointed by SEBI is likely to suggest the various policy and regulatory measures that need to be on place before derivatives trading may be formally allowed in India. The trading of futures and options will see light of the day only after the SEBI gives its assent to it.
ayoff & Pricing of Futures and Options - October 1st, 2010 A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the Xaxis and the profits/losses on the Yaxis. In this section we shall take a look at the payoffs for buyers and sellers of futures and options.

Payoff for futures Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.

Options payoffs The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff profile of buyer of asset: Long asset In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be long the asset. Payoff profile for seller of asset: Short asset In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be short the asset. Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option.