Betting on Futures and Options

January 27, 2010: The Indian stock market, for the first time recorded the highest ever turnover of Rs. 1.8 lakh crore. The F&O market turnover was 1.65 lakh crore.

Ever wondered from where does all this money come from? How can million of rupees be traded on a single day in the stock markets?
Look deeply and you will find that the cash market has hardly any contribution to these values. It is the Futures and Options market where the big game is being played.

In this article, I would not delve into the history and objectives of the Futures & Options segment. I would rather stress on the ways “Options” can be used to secure traders of their short term positions in the market and earn big by fulfilling a nominal amount of margin requirement. They are also heavily used for arbitrage purposes. Long term investors usually stay away from such exotic products.
An Option, as the name suggests to a lay man, is a right but not the obligation to do something. It is very similar in case of the securities market. First of all it must be noted that Options are “Derivatives”, i.e., they derive their values from something else which is generally known as its “Underlying”. For example a “Reliance 1000 Call Options” is a Call Option which derives its value from the price at which Reliance is being traded in the cash market.

Everyone earns money in a bullish market, but smart traders are those who can earn even while the markets face heavy selling, which is possible only by making a contract in the Futures & Options segment. Options are of two types: Call Options and Put Options. Call Options are those which are purchased by traders who expect the market to be bullish and Put Options are those which are purchased by traders having a bearish view about the market. The price of an Option depends upon two factors: It’s “Intrinsic Value” which for a Call Option is the amount the stock price is trading above the strike price of the Option and for a Put Option is the amount the stock price is trading below the strike price of the option. The other is the time value of the option also regarded as the amount traders are ready to bet on the market. All options have an expiry date which is the last Thursday of every month. Hence as it can be understood, the time value of an option will be the most during the beginning of the month and will tend to zero at the time of expiry. The premium at which the option can be purchased or sold is the sum of its intrinsic and time value and it is determined in the market itself by the buyers and sellers.

Options may be bought in the market and then sold or it can also be the other way, i.e. one may short sell the option first and then buy it later. In the former case one undertakes limited risk and the profit potential is unlimited but in the latter case one may lose millions in order to gain a few rupees. Strangely, the probability of making profits is more in the latter case. There are also various strategies that traders use to maximize their profit potential. Some of them are Long Call, Protective Call, Bull Call Spread, Short Call Butterfly, Collar and Bear Put Spread.

Now let us take an example to move forward and understand the concept clearly.

Underlying: Nifty
Market Lot: 50 scripts and multiples thereof.
Current Value of Nifty: 5000
Current Date: 1.01.2012
Date of Expiry: 25.01.2012
Trader’s view on the market: Bearish

Let us assume that the trader purchases a Put Option of Strike 4800 at a premium of Rs. 50 per script. Hence, he will gain if the index is below 4750 on the date of expiry. If the index is above 4800 he will have to forego the entire premium and the contact will expire worthless. Here the maximum loss that the trader can suffer is Rs. 50 per script but the more the markets fall, more he will gain which cannot be determined. Let us assume that the index slips to 4700 which means the trader gains Rs. 100 per script; an astonishing 100% return on the premium paid in a month. During the fall of 2008, Investment Banking Company, Goldman Sachs, made profits instead of huge losses that its peers had to face. This was because they had huge amount of accumulated Put Options which helped it overcome the losses it made on the portfolios.
 Buying a Call Option or Put Option is the most basic of all strategies. Risk comes into the game when one begins to short sell or “Blank Sell” as traders term it. If in the above example, instead of buying a Put Option the trader could also have sold Call Options. Let us assume he shorts a Call Option of Strike 5000 at a premium of Rs. 125 per script. Here as long as the index stays below 5125 he does not lose anything but as its value increases the trader loses a rupee for every point increase in the index. At 5125 he is at no profit no loss. Also, the maximum he can earn is Rs. 125 per script.

It is a result of these exotic products that the stock indices all over the world are becoming so aggressive and volatile. The Futures & Options market which is used by most fund managers to hedge their portfolios is also used by individual traders to bet on the market. Several tools such as technical charts analysis and resistance & support identification do help traders but at the end of all it is the smartness of the person which can help him stay away from huge losses.

Futures & Options segment was introduced to protect traders and investors. Today trades in the Futures & Options segment form the expectation of the market and all that happens every day is just the way expectations are being matched with the actions of other people. The stock market is the only market where there is competition between buyers and sellers, not among buyers and sellers.

By Harshwardhan Khandelwal

Debt Ceiling

The US government recently announced the increase in debt ceiling to avoid default on their debts. Debt ceiling is the legal upper cap on the amount of debt the government of the United States of America may borrow. The limit initially required a nod from the Congress for every increase, but with the onset of the world war 1, to provide more flexibility, most types of borrowings were given blanket approval, so long as the raise fell within an established limit.

The established credit limit was $ 14.3 trillion, and the debts of the nation were inching closer to the value. This was a matter of grave concern since once the limit is reached; the government would not be permitted to use borrowed funds, and the borrower would be at default, impairing credit ratings and market trends.

In the past, the debt ceiling has been raised several times from less than a trillion in the 1980s to over $ 6 trillion in the 1990s. But the scenario this time is different, due to the increase in debt compared with the current market size and economy. Due to the fact that the budget is shaping up to cut down funding for some favorite programs and major tax increases, the recent raise has attracted a lot of drama.

Debt ceiling has never been breached till date. Every time it came close to breaching, it has been raised so that more borrowing was permissible. In the event that the debt ceiling is breached somehow, the borrowed funds are locked from usage, thereby instilling a shortage of funds available for productive use and crippling fund movements. This would have caused an acute shortage of funds and crippled development activities. Also, contingencies would have to be put in place, to route in cash to impacted sections from capable ones, thereby reducing the cash flow in those sections and bringing down the entire market as a whole. This would send the entire fiscal sections on a cost cutting mode.

Raising the debt ceiling is a matter of the nation’s discretion. But many would debate that the debt ceiling, in a healthy environment, needs to be worked towards zero, to indicate that the markets are handling their cash flows capably and are not in deficit. By borrowing within the debt limit, the market still looks healthy, since borrowing is within prescribed limits and events are according to plan. But things look very uneasy when the borrowing is over the limit, since it would mean that the system is not functioning as was expected and it puts the entire fiscal system at risk.

Whenever the debt ceiling is raised, it is closely followed by measures to cut down on expenditure and store some money in reserves. This could lead to drastic measures, many of which would not go well with the people working in the systems. Also, morale is lost shortly after, which is redeemed after things work reasonably well. On the other hand, when debt ceiling is lowered, it is a clear indication that the system is functioning above par and therefore, everything is moving profitably.

By Chetan Sabadra and Aakansha Sahai

Eurozone Crisis

            As the threat of a global slowdown hangs like the Sword of Damocles over the world, major European economies like Spain, Italy and recently France are becoming affected by the European debt crisis. It is a cause for concern given that these countries are major economies, with Spain and Italy alone accounting for 29% of Eurozone economic activity. Italy and Spain are Europe’s 3^rd and 4^th largest economies respectively, and are too expensive to rescue through Europe’s bailout fund, having over a third of Europe’s public debt.

       Both Italian and Spanish ten-year bond yields jumped to highs of more than 6% (reflecting plummeting prices), and hence a sharp rise in Italy’s implied borrowing costs. This 6% is too close for comfort to the 7% level beyond which investors become reluctant to fund sovereign borrowers The rising borrowing rates have also sent ripples through both nations political leadership, with Italian Finance Minister Giulio Tremonti calling an emergency meeting to analyze the situation and Spanish Prime Minister Jose Luis Rodriguez Zapatero postponed the start of his near three-week summer vacation to keep abreast of economic developments.

      Three major problems plaguing Italy include a problematic political climate, a forecast of sluggish growth for 2011-2012 and the rising borrowing rates. In particular, investor confidence has been shaken by conflicts of interest, sex scandals and doubts about the credibility of the Italian leadership. Low growth, around 0.1% in the start of 2011, is also a problem. Moody's has an Aa2 rating for Italy and Fitch an AA-, while Standard and Poors has assigned an ‘A+' long-term and 'A-1+' short-term sovereign credit ratings on Italy.

        Spain has issues of its own, with the banking sector remaining in turmoil, skyrocketing unemployment rates and high debt. The unemployment rate has nearly touched 20%, and meager growth has not helped matters. Although Spain found buyers for €661m (£581m) of 18-month bonds, it had to agree to pay a yield, or interest rate, of 3.912%. This is the highest yield on such bonds since 2002 and a significant rise on the 3.26% agreed at the last sale of 18-month bills. Credit rating agencies are taking a negative outlook, with Moody's Aa2 rating for Spain is in line with S&P's AA setting, and Fitch has the country one notch higher at AA+

            The focus of the Eurozone crisis has also recently shifted to France, Europe’s number two economy, with the country’s AAA credit rating under scrutiny. These jitters have translated into panic selling of French bank shares and an abrupt halt to economic growth has merely added to France’s woes. The French government in response has pledged fresh tax rises, spending cuts and other budget measures to help control the situation.

            On August 12^th, 2011, four Eurozone countries – France, Italy, Spain and Belgium have temporarily banned short-selling of financial shares in an attempt to restore order to the markets. Also, the European Central Bank has recently said it would buy bonds from Italy and Spain following emergency talks on the debt crisis. Investors seem to be skeptical as to the efficacy of these moves. The implications of this crisis include a continued volatility in the markets, along with a weak Euro. Only time will tell whether or not these countries will be able to recover from their current tailspin.

By Indraneal Balasubramanian and Lakshya Sharma

Open Outcry 2011

The Finnacle Investments Team kicked off the new season with its traditional market simulation event, ‘Open Outcry’, on the 26^th and 27^th July’2011. The event was organized with much enthusiasm and saw a large participation by the students.

The event was designed in two stages- the eliminator christened as ‘Catch the Culprit’, followed by the main game ‘Open Outcry’.

‘Catch the Culprit’ was designed to extensively challenge the participants’ resource allocation and swift decision making abilities. The main event consisted of a market simulation scenario, wherein the participants were given a virtual portfolio, and had to trade amongst each other based on the news flash provided to them during the game. The game was conducted in two trading rounds. An IPO was introduced towards the end of round 1 to add to the excitement of the game.

The script prices were calculated at the end of each round and to present a more holistic view of the markets, the script price was a composite of the ‘theory’ price and the average traded price.

Eventually, teams were evaluated based on the value of their final portfolios. The team of Finnacle Investments was humbled by the response of the students and the appreciation received from the participants and will continuously strive towards stimulating interest in the financial markets through more interactive events.

Nivesh Mantra 2010

Nivesh Mantra 2010, the flagship event of Finnacle and the investment conclave of IMT Ghaziabad, was inaugurated by Dr. B.D.Singh (Dean MDP & C, IMT) and Mr. Savan Godiawala, Director of Deloitte Touche Tohmatsu India Pvt. Ltd. 

 The first session was a key note speech by Mr. Savan Godiawala in which he enlightened the students on"SEBI Regulations- Public & Private Equity". During the session he touched upon various subjects like IPO requirements and compliances, the listing formalities, preferential allotment, QIPs, private equity, venture capital and IDRs.

The second session of the conclave was on “Wealth Management” and it was conducted by Mr. Siddharth Chaturvedi, Deputy Vice President at Reliance Wealth Management. He touched upon various issues that are prominent in the current scenario and offered valuable insights on the subject.

The third session was conducted by Mr. Gagandeep Singh Banga, Managing Director at Merits Capital. He interacted with students on "Trading Strategies" and spoke in detail regarding investing and trading. He provided valuable insights on intraday trading strategies and programmed trading.

Another highlight of the event was the panel discussion on” Currency Trading and its scope in Indian market”. The discussion was co-ordinated by Prof. Alok Kumar, Faculty of IMT Ghaziabad and Director of MindXpansion. The panel was adorned by great luminaries like Mr. Aloke Nandi, Founder and Managing Director, Ascent Forex Consultants, Mr. Tejas Seth, Associate Vice President at SMC Group and Prof. Gireesh Tripathi, Faculty at IMT Ghaziabad.

The second day of Nivesh Mantra’10 started in the afternoon with the inter B-School "Paper Presentation" competition. Four teams presented their papers in the final round. The judges for this round were Ms Keerti Sharma, Manager Vatika and Ms Prateechi Agarwal, financial controller, IMT –Ghaziabad. At the end of the presentation, Ms Keerti shared some valuable tips on presentation and domain knowledge. The paper presentation competition was followed by the trademark event "Open Outcry”, the trading floor game.

 The journey of the first Investment conclave, Nivesh Mantra’10 came to its end with much fanfare and a larger promise of its next avatar in 2011.