CHAPTER 2F (Part 1) : Market Fundamentals - Segments of Market

As we see, market segments can be classified into Equity, Commodity and Currency. We will study each market step by step.

Equity

Points of Difference	Cash Segment	Derivatives Segment
Contract Trading	No contract trading exists, Position can be held life-long	Trading happens in contracts, 3-month contract cycle exists
Lots	Trading happens in unit shares	Trading happens in unit lots (i.e. bundle of shares)
Short Sell	Short Selling is allowed only for Intraday (i.e. NO STBT)	Short Selling is allowed for both Intraday and Delivery
Index Trading	Index trading is not possible	Index trading is possible

I. DERIVATIVES, as the name suggests is an instrument which is derived from some Underlying Asset and its movement depends on the movement of the underlying Asset. The price of underlying asset is known as Spot price.

A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset. Currently the highest turnover in Derivative segment happens on NSE Derivative segment

II. Why have derivatives?

A derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor too can take part in the Derivative instrument to Hedge his risk or speculate on market conditions.

III. FUTURES contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contracts where the underlying is an Index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex. 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract. If last Thursday is a holiday the expiry would fall on the previous trading day.

III A. NIFTY Future - Nifty future is the most traded contract on NSE Derivative segment, with a lot size of 50 shares.

III B. Bank NIFTY - Bank Nifty future contract is derivative from the Bank nifty spot Index which represents the Banking sector stocks, lot size being 25 shares.

III C. Stock Future - Future contracts on Stocks are called Stock futures. Currently there are 200+ Future contracts in NSE Derivative segment.

III D. Some Technical Terms:

• Open Interest: The total number of outstanding contracts which are yet to be squared-off as on date.
• Roll over: A process of squaring off the current open position and taking the same directional position in the next series of the Future contract. Ex: A trader has Long 5 lots of Bank Nifty Future on 27th Nov’14 (Expiry day), he is still bullish on the contract, he sells his November month contract and simultaneously buys 5 lots Bank Nifty in December month. 
• Ban Period: Exchanges have prescribed a MWPL (Market wide position limit) of every future contract in the Exchanges. If the open interest of the contract crosses 95% of the MWPL limit, fresh positions in the underlying are banned and penalized. Traders can square off their existing positions but fresh positions cannot be take until the open interest falls below 80% of the MWPL.

III E. Advantages of Future segment:

• Lower Margin
• No Delivery obligation
• High Liquidity & high profit potential
• Trading in Index allowed

III F. Risks in Future segment:

• Huge loss due to leverage positions
• High Volatility
• Difficult for retail investors to manage trades

IV. The OPTIONS contract - The biggest limitation of Future contract is high margin requirement and unlimited loss potential, which sometimes makes it difficult for a retail trader to hedge/ trade in Futures contracts. Options, as the name suggests gives huge kind of options to choose while the trader wants to trade in derivative contracts.  Similar to the Future contract we have same Index and stock option contracts for the same underlying in the options segment with same expiry cycle. Premium is the price paid by the buyer of an option to own the right of that option.

IVA. Options

• Gives right but not the obligation for the option buyer
• Has the same contract cycle and underlying Asset (Stock & Indices) as in Future Contracts
• Limited loss ,Unlimited profit to the option buyer
• Full premium amount has to be paid upfront for buyer
• Seller has to pay margin
• Different strike prices available in a particular Contract Cycle
• Useful in all kinds of markets Bullish, Bearish, Volatile, Stable

IV B. Types of Options:

• Call option - A Call option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy a lot of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract. When you expect prices to rise, then you take a long position by buying calls. You are bullish. When you expect prices to fall, then you take a short position by selling calls. You are bearish.
• Put Option - A Put Option gives the holder of the right to sell a specific number of    shares of an agreed security at a fixed price for a period of time. When you expect prices to fall, then you take a long position by buying Puts. You are bearish. When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

IV C. Why Trade in options?

• Low Investment required
• Limited Loss
• Can trade for Bullish and Bearish views
• No Delivery obligations

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