Equity Derivatives
Comprehensive Study Guide
A highly detailed, continuous reading guide covering equity markets, index math, futures, options, Greeks, trading strategies, regulations, and clearing mechanisms. Based on the NISM-Series-VIII Certification Examination workbook.
Chapter 1: Basics of Derivatives
1.1 Meaning and Evolution
A derivative is a contract or product whose value is derived from the value of some other underlying asset (like metals, energy, agri-commodities, or financial assets like shares and indices). The history of derivatives dates back to the 12th century when sellers signed contracts for future delivery in European trade fairs. Significant milestones include:
- 1634-1637: Tulip Mania in Holland (speculative boom in tulip futures burst).
- Late 17th Century: Dojima, Japan (futures market in rice to protect against bad weather).
- 1865: The Chicago Board of Trade (CBOT) listed the first "exchange traded" derivative contract (futures).
- 1973: Chicago Board Options Exchange (CBOE) became the first marketplace for listed options.
1.2 Indian Derivatives Market
In India, the L. C. Gupta Committee (1996) laid the regulatory framework. This led to the amendment of the Securities Contract Regulation Act (SCRA) in 1999 to include derivatives as 'securities'. Following recommendations from the J.R. Varma committee (1998) on risk containment, index futures commenced in June 2000, followed by index options (June 2001) and individual stock options/futures.
1.3 Market Participants and Products
Participant Roles:
- Hedgers: Face risk from asset price movements and use derivatives to reduce or eliminate that risk (e.g., a portfolio manager protecting against a crash).
- Speculators/Traders: Predict future price movements and take directional positions to profit, assuming the risk hedgers want to transfer.
- Arbitrageurs: Exploit price differences of the same asset across different markets, ensuring price alignment and market efficiency.
Over-the-Counter (OTC) vs. Exchange-Traded: OTC products (like Forwards and Swaps) are customized, bilateral, private, and carry counterparty risk. Exchange-Traded products (like Futures and Options) are standardized, transparent, anonymous, and guaranteed by a clearing corporation, eliminating counterparty default risk.
Chapter 2: Understanding the Index
An index is a statistical indicator that measures the average share price movement in the market. It serves as a benchmark for portfolio performance and as an underlying asset for index derivatives (like index funds and ETFs).
2.1 Types of Stock Market Indices
- Market Capitalization Weighted: Weights are based on total market cap (Total Outstanding Shares × Price).
- Free-Float Market Capitalization: Weights are based only on shares readily available for trading (excluding promoter and strategic holdings). Most global and Indian indices (Sensex, Nifty 50) use this method today as it better represents market liquidity.
- Price-Weighted Index: Stocks with higher prices have greater influence, regardless of market cap (e.g., Dow Jones Industrial Average, Nikkei 225).
- Equal Weighted Index: All stocks carry the same weight, requiring constant rebalancing by the fund manager to maintain equality as prices fluctuate.
Calculation Example: Price-Weighted vs. Equal-Weighted
Consider an index constructed on January 1, 1995, with a base value of 100.
| Stock | Price on Jan 1, 1995 | Current Price | % Change in Price |
|---|---|---|---|
| AZ | 150 | 650 | 333.33% |
| BY | 300 | 450 | 50.00% |
| CX | 450 | 600 | 33.33% |
| DW | 100 | 350 | 250.00% |
| EU | 250 | 500 | 100.00% |
| Total | 1250 | 2550 |
In a Price-Weighted Index, the value on Jan 1, 1995, is (1250/5) = 250. The current value is (2550/5) = 510. The increase in the index value is ((510 - 250)/250) * 100 = 104%.
In an Equal-Weighted Index, the shares are adjusted so that each stock starts with equal value (e.g., a 25% weight for 4 stocks). When prices change, the fund manager must rebalance the index by selling stocks that increased in price and buying those that fell to maintain equality.
2.2 Impact Cost
Impact cost is the true measure of market liquidity. It represents the percentage degradation in price experienced when executing large transactions compared to the ideal price (the average of the best bid and ask).
Impact Cost % = [(Actual Execution Price - Ideal Price) / Ideal Price] × 100
Impact Cost Example:
Consider an order book. The best buy is Rs. 9.80, and the best sell is Rs. 9.90. The Ideal Price is (9.80 + 9.90)/2 = Rs. 9.85. If you want to buy 1500 shares, and the sell side has 1000 shares at 9.90 and 1500 shares at 10.00:
- Actual buy price = [(1000 * 9.90) + (500 * 10.00)] / 1500 = Rs. 9.9333
- Impact cost for 1500 shares = [(9.9333 - 9.85) / 9.85] * 100 = 0.84%
2.3 Index Management and Prudential Norms
Going beyond 100 stocks offers little additional risk reduction benefit. SEBI enforces prudential norms for derivatives on non-benchmark indices, requiring a minimum of 14 constituents, maximum 20% weight for the top constituent, and maximum 45% combined weight for the top 3 constituents, implemented via phased weight adjustments (e.g., Four-Tranche Weight Adjustment).
Chapter 3: Introduction to Forwards and Futures
3.1 Forwards vs. Futures
A Forward contract is a customized, bilateral OTC agreement carrying liquidity and counterparty risk (default risk). A Futures contract is a standardized, exchange-traded agreement where the Clearing Corporation acts as the counterparty through 'novation', ensuring liquidity and eliminating default risk through daily Mark-to-Market (MTM) margins.
3.2 Futures Terminology & Contract Specifications
- Spot Price: Current cash market price.
- Basis: Difference between Spot Price and Futures Price. Basis becomes zero at expiry (convergence).
- Open Interest (OI): Total number of outstanding contracts (Longs = Shorts, but counted once). Indicates market depth.
Contract Size (Lot Size): SEBI has decided that a derivative contract shall have a value not less than Rs. 15 lakhs at the time of its introduction. The lot size shall be fixed such that the contract value is within Rs. 15 lakhs to Rs. 20 lakhs (effective Nov 2024).
Uniform Expiry Days: Exchanges can only choose either Tuesday or Thursday as the expiry day for all equity derivatives contracts.
3.3 Pricing Models: Cost of Carry
The Cost of Carry Model (Fair Value) assumes no arbitrage opportunities exist in an efficient market:
(F = Fair Futures Price, S = Spot, r = risk-free rate, q = dividend yield, T = time to expiry in years)
Arbitrage Mechanics:
- Cash and Carry Arbitrage: If actual F > Fair F (Futures are overpriced). Borrow funds, Buy Spot, Sell Future.
- Reverse Cash and Carry Arbitrage: If actual F < Fair F (Futures are underpriced). Short Spot, Invest funds, Buy Future.
- Calendar Spread: Arbitrage between futures contracts of different expiration months. Buy the underpriced contract and sell the overpriced one.
Reverse Cash and Carry Example:
Stock B cash market price is Rs. 100. One-month futures price is Rs. 90. (Futures are trading at a discount). Contract multiplier is 200 shares.
- Arbitrageur buys 1 futures contract at Rs. 90 and shorts 200 shares in the cash market at Rs. 100.
- Proceeds of Rs. 20,000 (200 * 100) are invested at 9% p.a. for one month. Interest earned = Rs. 150.56.
- If stock rises to Rs. 110 at expiry: Loss on underlying = Rs. 2000. Profit on futures = Rs. 4000. Net gain = Rs. 2000.
- Total Gain = Rs. 2000 + 150.56 = Rs. 2150.56. (This holds true regardless of whether the stock price rises or falls at expiry).
3.4 Hedging with Futures
Futures are used to manage Systematic Risk (market risk) which cannot be diversified away. The number of index futures contracts needed to hedge a portfolio is determined by the Beta (β).
Chapter 4: Introduction to Options
Options offer asymmetric payoffs. The buyer pays a Premium for the right (but no obligation) to buy (Call) or sell (Put). The seller (Writer) receives the premium and has an obligation.
4.1 Moneyness and Value Components
- In-the-Money (ITM): Positive cash flow on immediate exercise. (Call: Spot > Strike | Put: Spot < Strike). ITM options have intrinsic value.
- Out-of-the-Money (OTM): Negative cash flow on immediate exercise. (Call: Spot < Strike | Put: Spot > Strike). Intrinsic value is zero.
- At-the-Money (ATM): Spot is closest to Strike.
Option Premium = Intrinsic Value + Time Value. Options are "wasting assets" as Time Value decays to zero by the expiration date.
4.2 Payoff Analysis for Option Buyers and Sellers
Long Call: Maximum loss is limited to the premium paid. Maximum profit is unlimited. Breakeven = Strike + Premium.
Short Call: Maximum profit is limited to the premium received. Maximum loss is theoretically unlimited. Breakeven = Strike + Premium.
Long Put: Maximum loss is limited to the premium paid. Maximum profit occurs if the stock falls to zero. Breakeven = Strike - Premium.
Short Put: Maximum profit is limited to the premium received. Maximum loss occurs if the stock falls to zero. Breakeven = Strike - Premium.
4.3 The Option Greeks
- Delta (Δ): Option price change per ₹1 change in underlying. (Calls: 0 to +1, Puts: -1 to 0). Also used as a hedge ratio.
- Gamma (γ): Rate of change of Delta. Measures the acceleration of the option's sensitivity.
- Theta (Θ): Sensitivity to time decay. Always negative for option buyers (value erodes over time).
- Vega (v): Sensitivity to implied volatility. Positive for both long calls and long puts; higher volatility increases premium.
- Rho (ρ): Sensitivity to interest rates. Higher rates increase Call value and decrease Put value.
4.4 Pricing Models & Implied Volatility
The Black & Scholes Model computes the theoretical price using Spot, Strike, Volatility, Time to Expiry, and Interest Rate. Implied Volatility (IV) is reverse-engineered from the current market premium and represents the market's expectation of future volatility. When IV is high, option premiums are high (favorable for selling); when IV is low, premiums are low (favorable for buying).
Chapter 5: Strategies Using Futures and Options
5.1 Option Spread Strategies
Spreads cap both maximum profit and maximum loss, reducing the upfront cost by combining multiple options.
Bull Call Spread
Created by taking a long call position with a lower strike price and selling a call option with a higher strike. Example: Buy 17500 Call at Rs. 185, Sell 17800 Call at Rs. 61.
- Net Premium Paid: 185 - 61 = Rs. 124 (Maximum Loss)
- Maximum Profit: (17800 - 17500) - 124 = Rs. 176
- Breakeven Point: 17500 + 124 = 17624
Bear Put Spread
Created by going long a put option at a higher strike and shorting a put option at a lower strike. Example: Buy 17500 Put at Rs. 125, Sell 17000 Put at Rs. 34.
- Net Premium Paid: 125 - 34 = Rs. 91 (Maximum Loss)
- Maximum Profit: (17500 - 17000) - 91 = Rs. 409
- Breakeven Point: 17500 - 91 = 17409
5.2 Straddles and Strangles
Long Straddle: Buy ATM Call and ATM Put (same strike, same expiry). A bet on high volatility regardless of direction. Requires a massive price swing to overcome the cost of two premiums.
| Option | Long Call (Strike 6000) | Long Put (Strike 6000) | Net Flow |
|---|---|---|---|
| Premium | -257 | -136 | -393 (Max Loss) |
| If Spot = 5300 | -257 (Expires Worthless) | +564 (6000 - 5300 - 136) | +307 |
| If Spot = 6700 | +443 (6700 - 6000 - 257) | -136 (Expires Worthless) | +307 |
Breakeven Points: 6000 - 393 = 5607 AND 6000 + 393 = 6393.
Long Strangle: Buy OTM Call and OTM Put (different strikes, same expiry). Cheaper than a Straddle but requires an even wider price swing to reach the breakeven point.
5.3 Put-Call Parity and Delta Hedging
Put-Call Parity defines the fundamental pricing relationship for European options with the same strike and expiry. Deviations trigger arbitrage:
(Call + Present Value of Strike = Put + Spot)
Delta Hedging: Option traders neutralize their directional risk by taking opposing positions in the underlying futures market. If a trader is short calls (negative delta), they buy futures (positive delta) so the net portfolio delta is zero.
5.4 New Formulation of Open Interest (FutEq OI)
SEBI introduced Future Equivalent Open Interest (FutEq OI) which measures OI at a portfolio level by computing the net Delta adjusted open positions. For example, a Long Position of 500 in a Call with a Delta of 0.5 results in a FutEq OI of 250 (500 * 0.5). This aligns equity options closer with cash markets to strengthen risk management.
Chapter 6: Trading Mechanism
India uses fully automated, screen-based, order-driven systems with Price-Time Priority matching.
6.1 Order Types & Dynamic Price Bands
Orders can be Day, Immediate or Cancel (IOC), Limit, Market, or Stop-Loss. Dynamic Price Bands are flexed only after specific criteria to prevent manipulation.
SEBI's May 2024 Rules for Price Band Flexing:
- Requires 50 trades, 10 unique traders, and 3 brokerage firms on each side before the band adjusts.
- Cooling-off periods: First two increases = 5% rise after 15 mins. Next two = 3% rise after 30 mins. Further increases = 2% rise after 60 mins.
- Sliding bands: If the upper limit moves up, the lower limit also moves up (preventing extreme one-sided movements).
6.2 Algorithmic Trading & IRRA
Algorithmic Trading requires strict SEBI controls: APIs mapped to static IPs, OAuth security, mandatory 2FA, Kill Switches, and mandatory registration for High-Frequency Algos (>10 Orders Per Second).
The Investor Risk Reduction Access (IRRA) platform allows investors to square off open positions or cancel pending orders during a broker's technical glitch. It strictly prohibits initiating new positions.
Chapter 7: Clearing, Settlement and Risk Management
The Clearing Corporation (CC) guarantees settlement via novation. Interoperability allows brokers to clear trades through a single CC of their choice across multiple exchanges, optimizing margin capital.
7.1 Settlement Mechanism
- Index Derivatives: Cash settled on T+1 based on the final settlement price (closing price of the underlying).
- Stock Derivatives: Physically settled. Open futures or ITM options result in the mandatory delivery/receipt of underlying shares. Net settlement is available to offset cash and F&O physical delivery obligations.
- MTM Settlement: Daily Mark-to-Market is cash-settled for futures based on the last 30 minutes volume weighted average price.
7.2 Margining via SPAN
Risk is managed using SPAN (Standard Portfolio Analysis of Risk) based on a 99% Value at Risk (VaR). Additional margins include:
- Initial Margin: Covers worst-case 1-day (options) or 2-day (futures) loss.
- Delivery Margin: Levied on physical settlements starting 4 days prior to expiry in a staggered manner: 20% on Expiry-4, 40% on Expiry-3, 60% on Expiry-2, and 80% on Expiry-1.
- Peak Margin: Monitored intra-day (minimum 4 random snapshots) based on fixed Beginning of Day (BOD) parameters to prevent excessive intra-day leverage by clients.
7.3 Position Limits and Client Collateral
| Entity | Limit Rule |
|---|---|
| Client Level | Higher of 1% of free float market cap OR 5% of open interest. |
| Trading Member (Index) | Higher of Rs. 7500 crores OR 15% of total open interest. |
| Market Wide (MWPL) | 20% of free-float non-promoter holding. Ban period starts at 95% utilization. |
| PAN Level (Index Options) | Net end of day FutEq OI: ₹1,500 Cr. Gross FutEq OI: ₹10,000 Cr. |
Client collateral is accepted only via a direct Margin Pledge in the Depository system, ensuring no transfer of title to the broker, preventing misappropriation.
Chapter 8: Legal and Regulatory Environment
Trading is strictly governed by the Securities Contracts (Regulation) Act, 1956 (SCRA) and the SEBI Act, 1992.
8.1 SC(R)A 1956 & Regulatory Framework
Under Section 2(h) of SCRA, derivatives are formally defined as securities. Section 18A validates derivative contracts only if traded on a recognized exchange and settled through its clearing house.
- Net Worth Criteria: Minimum Rs. 300 Lakhs for Clearing Members, Rs. 100 Lakhs for Self-Clearing Members. They must maintain Rs. 50 Lakhs as Liquid Net Worth continuously.
8.2 SOP for Technical Glitches & Outages
Brokers must report technical glitches within 1 hour and submit a Root Cause Analysis (RCA) via the iSPOT portal within 14 days. If an Exchange suffers a severe outage within the last hour of trading, SEBI's SOP mandates an extension of trading hours (by 1.5 hours) across *all* interoperable exchanges to ensure smooth closure of intraday positions.
Chapter 9: Accounting and Taxation
9.1 Accounting Principles (ICAI Guidelines)
Initial margins are recorded as Current Assets. Daily MTM margins are debited/credited to an MTM Margin Account. Following the "Prudence" principle, anticipated MTM losses must have provisions created against them in the Profit & Loss statement immediately. However, anticipated profits are ignored until final settlement. Option premiums are treated as Current Assets (by the buyer) or Current Liabilities (by the seller).
9.2 Taxation of Derivatives
Section 43(5) Exemption:
Under the Income Tax Act, derivative transactions conducted on recognized stock exchanges are explicitly excluded from being classified as speculative. Gains or losses are treated as normal Business Income (Non-Speculative).
- Set-Off & Carry Forward: Non-speculative F&O losses can be set off against any other business income (except salary) and carried forward for up to 8 assessment years.
- FPIs: For Foreign Portfolio Investors, derivatives income is treated strictly as Capital Gains, not business income.
- Tax Audit: Mandatory if F&O turnover exceeds Rs. 10 Crore. If turnover is below Rs. 2 Crore, traders can declare profits of at least 6% under presumptive taxation (Section 44AD).
Securities Transaction Tax (STT) Rates
| Taxable Securities Transaction | STT Rate | Payable By |
|---|---|---|
| Sale of an option in securities | 0.10 per cent | Seller (on premium) |
| Sale of an option in securities, where option is exercised | 0.125 per cent | Purchaser (on settlement price) |
| Sale of a futures in securities | 0.02 per cent | Seller (on traded price) |
Chapter 10: Sales Practices and Investors Protection
10.1 KYC & Anti-Money Laundering (AML)
The Prevention of Money Laundering Act, 2002 (PMLA) requires strict Customer Due Diligence (CDD). Clients of Special Categories (CSC) (e.g., Politically Exposed Persons, NGOs) require enhanced due diligence. Brokers must securely file Suspicious Transaction Reports (STR) with FIU-IND if they detect irregular patterns.
10.2 Risk Disclosure & SEBI Findings
Based on SEBI studies, brokers must display mandatory pop-up risk facts on login. The client must acknowledge these facts before proceeding:
- 9 out of 10 individual traders in equity Futures and Options Segment, incurred net losses.
- On average, loss makers registered a net trading loss close to ₹ 50,000.
- Over and above the net trading losses incurred, loss makers expended an additional 28% of net trading losses as transaction costs.
- Those making net trading profits incurred between 15% to 50% of such profits as transaction costs.
10.3 Grievance Redressal (SCORES & SMART ODR)
If an investor's dispute is unresolved by the broker, it escalates to SEBI's SCORES portal. The grievance is subsequently routed through the SMART ODR Portal (Online Dispute Resolution platform):
Disputes first undergo a 21-day Conciliation process by an independent conciliator. If this fails, the matter escalates to binding Arbitration. Arbitral awards must be paid by the Market Participant within 15 calendar days unless legally challenged under Section 34 of the Arbitration Act (within 7 days).