Futures and Options Trading Strategies PDF

Forwards Long Hedge Definition: A long hedge is when you protect yourself from price increases by buying futures contracts. Example:  Situation: You will receive $10,000 in a month and want to invest in stocks. You think stock prices will go up before you get the money.  Actio...

Forwards Long Hedge Definition: A long hedge is when you protect yourself from price increases by buying futures contracts. Example:  Situation: You will receive $10,000 in a month and want to invest in stocks. You think stock prices will go up before you get the money.  Action: You buy index futures now.  Outcome: If stock prices rise, you will pay more for stocks later, but you make a profit on the futures. This profit helps offset the higher price you pay for the stocks. Short Hedge Definition: A short hedge is when you protect yourself from price decreases by selling futures contracts. Example:  Situation: You own a portfolio of stocks worth $10,000 and plan to sell it in a month. You think stock prices will fall.  Action: You sell index futures now.  Outcome: If stock prices drop, your portfolio loses value, but you make a profit on the futures. This profit helps offset the loss in your portfolio. Cross Hedge Definition: A cross hedge is when you use a related asset's futures contract to hedge because a direct futures contract is unavailable. Example:  Situation: You need to hedge the price of jet fuel, but there are no jet fuel futures.  Action: You use crude oil futures because jet fuel and crude oil prices are closely related.  Outcome: If jet fuel prices change, crude oil futures will likely change similarly, helping to protect your position. Hedge Contract Month Definition: The hedge contract month is the month when the futures contract you use for hedging expires. Guideline: Pick a futures contract that expires right after the date you plan to complete your transaction (like selling or buying an asset). Example:  Situation: Today is May 10, and you plan to sell your stock portfolio on June 20.  Action: You want to protect your portfolio's value from market risk until June 20.  What to Do: Choose a futures contract that expires in June, not in May. This way, your hedge will be in place until after you sell your portfolio.  Outcome: If the market goes down before June 20, your June futures contract will help offset any losses in your portfolio. This ensures that your hedge covers the entire period you are concerned about, protecting you until you make your planned transaction OPTION Moneyness of an Option Options are classified based on their current price relative to the strike price into three categories: In- the-money (ITM), At-the-money (ATM), and Out-of-the-money (OTM). 1. In-the-money (ITM) Option: o Definition: An option that would give a positive cash flow if exercised immediately. o Call Option: ITM when the spot price is higher than the strike price.  Example: If the strike price of a call option is Rs.100 and the spot price is Rs.120, the call option is ITM. o Put Option: ITM when the spot price is lower than the strike price.  Example: If the strike price of a put option is Rs.100 and the spot price is Rs.80, the put option is ITM. 2. At-the-money (ATM) Option: o Definition: An option that would lead to zero cash flow if exercised immediately. o Call and Put Option: ATM when the strike price is equal to the spot price.  Example: If the spot price is Rs.100 and there are options with strike prices of Rs.95, Rs.100, and Rs.105, the option with a strike price of Rs.100 is ATM.  3. Out-of-the-money (OTM) Option: o Definition: An option that would give a negative cash flow if exercised immediately. o Call Option: OTM when the spot price is lower than the strike price.  Example: If the strike price of a call option is Rs.100 and the spot price is Rs.80, the call option is OTM. o Put Option: OTM when the spot price is higher than the strike price.  Example: If the strike price of a put option is Rs.100 and the spot price is Rs.120, the put option is OTM. Intrinsic Value and Time Value of an Option The option premium (price) consists of two components: Intrinsic Value and Time Value. 1. Intrinsic Value: o Definition: The amount by which an option is ITM. o Call Option: Intrinsic value is the spot price (S) minus the strike price (X), with a minimum value of zero.  Example: If a call option has a spot price of Rs.120 and a strike price of Rs.100, its intrinsic value is Rs.20 (120 - 100). o Put Option: Intrinsic value is the strike price (X) minus the spot price (S), with a minimum value of zero.  Example: If a put option has a spot price of Rs.80 and a strike price of Rs.100, its intrinsic value is Rs.20 (100 - 80). o Note: ATM and OTM options have zero intrinsic value. 2. Time Value: o Definition: The difference between the option premium and the intrinsic value. o Example:  Suppose a put option has a premium of Rs.177.60 and an intrinsic value of Rs.84.90 (strike price Rs.18400 - spot price Rs.18315.10).  The time value of the put option is Rs.92.70 (177.60 - 84.90). o Note: ATM and OTM options have only time value, as their intrinsic Option Greeks Option premiums change with various factors, such as strike price, volatility, and time to maturity. The sensitivities of an option's price to these factors are known as "Option Greeks": Delta, Gamma, Theta, Vega, and Rho. Delta (Δ)  Definition: Delta measures the sensitivity of the option’s value to a small change in the price of the underlying asset.  Formula: Delta = Change in option premium / Unit change in price of the underlying asset.  Call Option: o For a buyer, Delta is positive. If the spot price rises, the value of the call option increases. o For a seller, Delta is negative.  Put Option: o For a buyer, Delta is negative. If the spot price falls, the value of the put option increases. o For a seller, Delta is positive.  Example: If a call option has a Delta of 0.60, a Rs.1 increase in the underlying asset’s price will increase the option’s price by 60 paise.  Importance: Delta is crucial for option traders for margining and risk management strategies. It is often called the hedge ratio. Gamma (Γ)  Definition: Gamma measures the change in Delta with respect to the change in the price of the underlying asset. It is the second derivative of the option price concerning the price of the underlying asset.  Formula: Gamma = Change in Delta / Unit change in price of the underlying asset.  Example: If a call option has a Delta of 0.50 and a Gamma of 0.08, a Rs.1 increase in the underlying asset's price will change the Delta to 0.58.  Function: Gamma indicates how quickly an option will move in-the-money or out-of-the-money with changes in the underlying asset’s price. Theta (Θ)  Definition: Theta measures the sensitivity of the option’s price to the passage of time. It represents the change in the option premium with a one-day decrease in time to expiration.  Formula: Theta = Change in option premium / Change in time to expiry.  Example: If a call option with 5 days to expiry has a Theta of -1.2, its price will decrease by Rs.1.20 each day until expiration.  Note: Theta is generally negative for long options (both calls and puts) because they lose time value each day. Vega (ν)  Definition: Vega measures the sensitivity of the option price to changes in the underlying asset’s volatility.   Formula: Vega = Change in option premium / Change in volatility.  Example: If a call option has a Vega of 0.80, a 1% increase in the underlying asset's volatility will increase the option’s premium by 0.80%.  Note: Vega is positive for both long calls and long puts. An increase in volatility increases the expected reward from a long option position. Rho (ρ)  Definition: Rho measures the sensitivity of the option’s price to changes in the risk-free interest rate.  Formula: Rho = Change in option premium / Change in cost of funding the underlying.  Function: Rho indicates the change in an option's price for a 1% change in the risk-free interest rate. Calendar Spread A calendar spread is a strategy used in futures trading that involves taking positions in futures contracts with different expiration dates. Here’s a simpler breakdown of the concept: What is a Calendar Spread?  Objective: Arbitrage between futures contracts that expire in different months to exploit price differences.  Action: Buy one futures contract and sell another with a different expiration month.  Goal: Profit from the difference between the two contracts, which should theoretically align with the cost of carrying the underlying asset (e.g., interest rates). Example: 1. Current Situation: o Stock Price: Rs. 120 o Near-Month Futures Price: Rs. 121.30 o Mid-Month Futures Price: Rs. 121.50 o Interest Rate: 8% per annum 2. Calculate Fair Prices: o Near-Month Fair Price: Fair Price=120×e0.08×112=120.80\text{Fair Price} = 120 \times e^{0.08 \times \frac{1}{12}} = 120.80Fair Price=120×e0.08×121=120.80 o Mid-Month Fair Price: Fair Price=120×e0.08×212=121.61\text{Fair Price} = 120 \times e^{0.08 \times \frac{2}{12}} = 121.61Fair Price=120×e0.08×122=121.61 o Ideal Difference: Rs. 121.61 - Rs. 120.80 = Rs. 0.81  o Actual Difference: Rs. 121.50 - Rs. 121.30 = Rs. 0.20 o The near-month contract is overpriced compared to the mid-month contract. 3. Execute the Calendar Spread: o Sell Near-Month Futures at Rs. 121.30 o Buy Mid-Month Futures at Rs. 121.50 Cases: Case 1: Stock Price Increases  Near-Month Futures Expiry Price: Rs. 122  Mid-Month Futures Expiry Price: Rs. 122.82 Calculations: o Loss on Near-Month Futures: Loss=121.30−122=−0.70\text{Loss} = 121.30 - 122 = - 0.70Loss=121.30−122=−0.70 o Gain on Mid-Month Futures: Gain=122.82−121.50=1.32\text{Gain} = 122.82 - 121.50 = 1.32Gain=122.82−121.50=1.32 o Net Gain: Net Gain=1.32−0.70=0.62\text{Net Gain} = 1.32 - 0.70 = 0.62Net Gain=1.32−0.70=0.62 Case 2: Stock Price Decreases  Near-Month Futures Expiry Price: Rs. 120  Mid-Month Futures Expiry Price: Rs. 120.80 Calculations: o Gain on Near-Month Futures: Gain=121.30−120=1.30\text{Gain} = 121.30 - 120 = 1.30Gain=121.30−120=1.30 o Loss on Mid-Month Futures: Loss=121.50−120.80=0.70\text{Loss} = 121.50 - 120.80 = 0.70Loss=121.50−120.80=0.70 o Net Gain: Net Gain=1.30−0.70=0.60\text{Net Gain} = 1.30 - 0.70 = 0.60Net Gain=1.30−0.70=0.60 Key Points:  Low Risk: Since you’re holding opposite positions, the risk is minimized as one position offsets the other.  Low Return: The potential profit is usually small because the strategy exploits small mispricings.  Execution: Both legs of the trade should be executed simultaneously to avoid losses due to price changes in the interval. Practical Considerations:  Liquidity: Calendar spread opportunities are rare because futures prices are closely monitored and adjusted by market participants.  Timing: Any delay in executing the trades can impact profitability. Calendar spreads are typically used to take advantage of pricing inefficiencies and can be a useful tool in managing risk while capturing small profits. Cash-and-Carry Arbitrage Cash-and-carry arbitrage and calendar spread are related but distinct strategies used in futures trading. Here's a comparison to clarify the differences: Cash-and-Carry Arbitrage Objective: Exploit the mispricing between the cash (spot) market and the futures market when futures contracts are overpriced. Process: 1. Buy the underlying asset in the cash market. 2. Sell the futures contract for the same asset. Example:  Stock Price: Rs. 1500  Futures Price: Rs. 1550  Cost of Carry: 9% per annum, i.e., approximately 0.75% per month Fair Futures Price Calculation: Fair Price=1500×e0.09×312=1500×e0.0075×3=1534.13\text{Fair Price} = 1500 \times e^{0.09 \times \frac{3}{12}} = 1500 \times e^{0.0075 \times 3} = 1534.13Fair Price=1500×e0.09×123=1500×e0.0075×3=1534.13 The actual futures price (Rs. 1550) is higher than the fair price (Rs. 1534.13), indicating that the futures are overpriced. Steps: 1. Buy 100 shares of Stock A at Rs. 1500 each. 2. Sell 1 futures contract (100 shares) at Rs. 1550. Arbitrage Profit Calculation:  Profit on Underlying (if stock rises): Profit=(1580−1500)×100=Rs.8000\text{Profit} = (1580 - 1500) \times 100 = Rs. 8000Profit=(1580−1500)×100=Rs.8000   Loss on Futures (if stock rises): Loss=(1580−1550)×100=Rs.3000\text{Loss} = (1580 - 1550) \times 100 = Rs. 3000Loss=(1580−1550)×100=Rs.3000  Net Gain: Net Gain=Rs.8000−Rs.3000=Rs.5000\text{Net Gain} = Rs. 8000 - Rs. 3000 = Rs. 5000Net Gain=Rs.8000−Rs.3000=Rs.5000  Cost of Financing (for holding shares): Cost=34.13×100=Rs.3413\text{Cost} = 34.13 \times 100 = Rs. 3413Cost=34.13×100=Rs.3413  Net Arbitrage Gain: Net Gain=5000−3413=Rs.1587\text{Net Gain} = 5000 - 3413 = Rs. 1587Net Gain=5000−3413=Rs.1587 Scenario if Stock Falls:  Loss on Underlying: Rs. 2000  Profit on Futures: Rs. 7000  Net Arbitrage Gain: Rs. 1587 Chapter 5: Advanced Options Strategies Straddles and Strangles Straddles  Definition: A straddle involves buying a call option and a put option with the same strike price and expiration date.  Usage: This strategy is used when the investor expects a significant price movement but is unsure of the direction.  Example: If a stock is currently priced at Rs. 100, an investor can buy a Rs. 100 call and a Rs. 100 put. If the stock moves significantly in either direction, the profits from one option will offset the losses from the other, leading to a potential profit. Strangles  Definition: A strangle involves buying a call option and a put option with different strike prices but the same expiration date.  Usage: This strategy is also used when the investor expects significant price movement but wants to reduce the initial cost compared to a straddle.  Example: If a stock is currently priced at Rs. 100, an investor might buy a Rs. 110 call and a Rs. 90 put. The strategy profits if the stock price moves significantly above Rs. 110 or below Rs. 90. Collar and Butterfly Spread Collar   Definition: A collar strategy involves buying a protective put and writing a covered call on the same underlying asset.  Usage: This strategy is used to protect gains on a stock while also limiting potential losses.  Example: An investor holding a stock at Rs. 100 might buy a Rs. 90 put and write a Rs. 110 call. This provides downside protection below Rs. 90 and caps upside potential at Rs. 110. Butterfly Spread  Definition: A butterfly spread involves buying one call (or put) at a lower strike price, writing two calls (or puts) at a middle strike price, and buying one call (or put) at a higher strike price.  Usage: This strategy is used when the investor expects the stock price to remain stable.  Example: An investor might buy a Rs. 90 call, write two Rs. 100 calls, and buy a Rs. 110 call. The strategy profits if the stock price stays around Rs. 100. Covered Calls and Protective Puts Covered Calls  Definition: Writing a call option while owning the underlying asset.  Usage: This strategy is used to generate income from premiums while holding the underlying asset.  Example: An investor owns a stock at Rs. 100 and writes a Rs. 110 call. If the stock price stays below Rs. 110, the investor keeps the premium. If the stock price exceeds Rs. 110, the stock is sold at Rs. 110, but the investor still profits from the premium and the price appreciation up to Rs. 110. Protective Puts  Definition: Buying a put option while owning the underlying asset.  Usage: This strategy is used to protect against potential losses in the underlying asset.  Example: An investor owns a stock at Rs. 100 and buys a Rs. 90 put. If the stock price falls below Rs. 90, the investor can sell the stock at Rs. 90, limiting their losses. Arbitrage Using Options Arbitrage  Definition: Arbitrage involves taking advantage of price discrepancies in different markets or forms of the same asset.  Usage: This strategy is used to make a risk-free profit.  Example: If a stock is priced differently in two markets, an investor can buy the stock in the cheaper market and sell it in the more expensive market, profiting from the difference.  Delta-Hedging Using Options Delta-Hedging  Definition: Delta-hedging involves using options to offset the risk of price movements in the underlying asset.  Usage: This strategy is used to create a delta-neutral position, where the overall delta is zero, reducing the risk from small price movements.  Example: If an investor owns shares of a stock and wants to hedge against price movements, they can buy or sell options with a delta that offsets the delta of the stock position. If the stock has a delta of 1.0, and the investor holds 100 shares, they would need options with a combined delta of -100 to hedge the position. Interpreting Open Interest and Put-Call Ratio Open Interest  Definition: Open interest refers to the total number of outstanding derivative contracts, such as options or futures, that have not been settled.  Usage: High open interest indicates high liquidity and interest in the contract, while low open interest may indicate the opposite.  Example: If a particular option has a high open interest, it suggests that there are many buyers and sellers, making it easier to enter and exit positions. Put-Call Ratio  Definition: The put-call ratio is a sentiment indicator that measures the number of put options traded relative to call options.  Usage: A high put-call ratio may indicate bearish sentiment, while a low put-call ratio may indicate bullish sentiment.  Example: If the put-call ratio is 1.5, it means that more put options are being traded than call options, suggesting that investors may be expecting a decline in the underlying asset's price. Chap 6 6.2 Eligibility Criteria for Selection of Stocks for Derivatives Trading The selection of stocks for derivatives trading is crucial to ensure that the underlying assets are suitable for trading in futures and options markets. The criteria are designed to ensure liquidity, market integrity, and the overall stability of the derivatives market. Here are the key eligibility criteria: A. Market Capitalization 1. Top 500 Stocks: o Stocks must be chosen from among the top 500 stocks based on average daily market capitalization over the previous six months. This ensures that only large, stable companies are included, which typically have sufficient liquidity. 2. Average Daily Traded Value: o The stocks should also meet a minimum threshold for average daily traded value over the same period. This criterion helps to ensure that there is enough trading activity to support derivatives trading. B. Liquidity Requirements 1. Median Quarter-Sigma Order Size (MQSOS): o The MQSOS over the last six months must not be less than Rs 25 Lakhs. This measure assesses the typical order size and ensures that the stock can accommodate significant trades without excessive price impact. 2. Average Daily Delivery Value: o The average daily delivery value in the cash market must not be less than Rs 10 crores over the previous six months. This criterion ensures that there is sufficient trading volume and interest in the stock, which is essential for the effective functioning of derivatives. C. Market Wide Position Limit (MWPL) 1. Minimum MWPL: o The market-wide position limit for the stock must not be less than Rs 500 crores on a rolling basis. This limit is crucial for managing risk and preventing excessive speculation in any single stock. D. Continuous Monitoring 1. Ongoing Compliance: o Stocks must continue to meet these eligibility criteria on a continuous basis. If a stock fails to meet the criteria for three consecutive months, it will not be eligible for new derivatives contracts. 2. Existing Contracts: o Even if a stock is excluded from derivatives trading due to non-compliance, existing unexpired contracts may still be allowed to trade until their expiry. New strikes may also be introduced in the existing contract months. E. Re-Eligibility 1. Reintroduction of Stocks: o A stock that has been excluded from derivatives trading can become eligible again. However, it must fulfill the enhanced eligibility criteria for six consecutive months before being reintroduced for derivatives trading. Summary The eligibility criteria for selecting stocks for derivatives trading are designed to ensure that only liquid, stable, and actively traded stocks are included in the derivatives market. This helps maintain market integrity, reduces the risk of manipulation, and ensures that traders can enter and exit positions without significant price disruption.  6.3 Selection Criteria of Index for Trading The eligibility criteria for introducing derivative contracts on an index are as follows: A. Weightage of Constituent Stocks 1. Eligible Stocks: At least 80% of the weightage of the constituent stocks must be individually eligible for derivatives trading. 2. Ineligible Stocks Limit: No single ineligible stock should exceed a weightage of 5% in the index. B. Continuous Compliance  The index must continuously meet the eligibility criteria, with regular checks by exchanges to ensure compliance. C. Market Representation  The index should represent a diverse range of stocks across various sectors to reflect overall market performance. D. Liquidity and Trading Volume  The index must demonstrate sufficient trading activity, including average daily turnover and open interest in the underlying stocks, to support derivatives trading. Summary These criteria ensure that only representative, liquid indices composed of eligible stocks are considered for derivatives trading, maintaining market integrity and providing reliable trading instruments. Product Success Framework for Index Derivatives The product success framework applies to all index derivatives (excluding flagship indices) at the underlying level. The evaluation criteria for index derivatives are as follows: 1. Trading Member Activity: o At least 15% of trading members active in all index derivatives, or a minimum of 20 trading members, must have traded in any derivative contract on the index being reviewed during each month of the review period. 2. Trading Days: o The index must be traded on a minimum of 75% of the trading days during the review period. 3. Average Daily Turnover: o The average daily turnover should be at least INR 10 crore during the review period. 4. Average Daily Open Interest: o The average daily open interest must be at least INR 4 crore during the review period.  Exclusion and Re-inclusion  If an index is excluded from the derivatives list, it cannot be considered for re-inclusion for at least six months. Exchanges may consider re-launching derivative contracts on the same index after making suitable modifications to contract specifications based on market feedback, following a cooling-off period of at least six months, and subject to SEBI approval. 6.4 Adjustments for Corporate Actions Adjustments for corporate actions in stock options are essential to maintain the value of market participants' positions. The adjustments are made to ensure that the relative status of positions remains unchanged before and after the corporate action. A. Adjustment Principles 1. Value Consistency: The adjustments aim to keep the value of positions the same on the cum and ex-date of the corporate action. 2. Relative Status Maintenance: The adjustments help retain the relative status of positions (in-the- money, at-the-money, out-of-money). B. Types of Adjustments Adjustments may involve modifications to:  Strike Price  Position Size  Market Lot/Multiplier C. Adjustment Methodology 1. Timing of Adjustments: Adjustments are carried out on the last trading day when a security is traded on a cum basis, after trading hours. 2. Adjustment Factors: o Bonus Shares:  Adjustment Factor: (A + B) / B, where A is the number of bonus shares and B is the number of existing shares. o Stock Splits and Consolidations:  Adjustment Factor: A / B, where A is the number of shares before the split/consolidation and B is the number of shares after. o Rights Issues: Adjustments are based on the number of existing shares and rights entitlement. D. Corporate Action Types Corporate actions that may necessitate adjustments include:  Bonus Issues  Rights Issues  Mergers and Demergers  Amalgamations  Stock Splits  Consolidations  Hive-offs  Warrants  Secured Premium Notes (SPNs)  Extraordinary Dividends E. Extraordinary Dividends  Dividends below 2% of the market value of the underlying stock are considered ordinary and do not require strike price adjustments.  For extraordinary dividends (above 2%), the strike price will be adjusted, and all positions will carry forward at the daily settlement price less the dividend amount. Summary These adjustments ensure that the trading environment remains fair and that the value of options is preserved during corporate actions, allowing market participants to maintain their positions without forced closures. The adjustments for corporate actions such as bonuses, stock splits, consolidations, and extraordinary dividends are crucial for maintaining the integrity of option contracts. Here’s a summary of how these adjustments are made: 1. Bonus, Stock Splits, and Consolidations: o Strike Price: The new strike price is calculated by dividing the old strike price by the adjustment factor. o Market Lot/Multiplier: The new market lot or multiplier is determined by multiplying the old market lot by the adjustment factor. o Position: The new position is calculated by multiplying the old position by the adjustment factor. o Adjustment Factors:  For bonuses, the adjustment factor is calculated as (A+B)/B where A is the number of existing shares and B is the rights entitlement.  For stock splits and consolidations, the adjustment factor is A/B. 2. Rights Issues: o The total entitlement is calculated as A+B. o The benefits per share and per right entitlement are calculated based on the underlying close price and the issue price of the rights. o An adjustment factor is also calculated to ensure fair treatment of positions. 3. Dividends: o Ordinary dividends (below 2% of the market value) do not lead to adjustments in strike prices. o Extraordinary dividends (above 2%) result in adjustments to the strike prices of option contracts. o The adjustment is based on the total dividend amount being reduced from all strike prices, effective from the ex-dividend date. 4. Merger/Demerger: o The last cum-date for contracts is determined by the exchange, and no new contracts will be introduced for the underlying that ceases to exist post-merger/demerger. o Un-expired contracts will be settled at the last available closing price on the last cum-date. 6.5 Trading Costs Trading costs in the equity derivatives market can significantly impact the overall profitability of trades. These costs can be categorized into three main types: User Charges, Statutory Charges, and Impact Cost. 1. User Charges User charges are fees that traders incur when executing trades through brokers. These include:  Brokerage: o Definition: Brokerage is the commission charged by brokers for executing buy and sell orders on behalf of their clients. o Variability: Brokerage rates can vary widely based on the broker's pricing structure, the type of trade (intra-day vs. delivery), and the additional services offered. For instance, brokers may offer lower rates for intra-day trades compared to delivery trades. o Flat Rate vs. Percentage: Some brokers charge a flat fee per order, while others may charge a percentage of the trade value.  Transaction Charges: o Definition: These are fees collected by stock exchanges from brokers for executing trades. o Pass-Through: Brokers typically pass these transaction charges onto their clients, which can add to the overall cost of trading. 2. Statutory Charges Statutory charges are mandatory fees and taxes imposed by regulatory authorities. They include:  Securities Transaction Tax (STT): o Definition: STT is a tax levied on the purchase and sale of securities in India. o Rates: The applicable STT rates for equity derivatives are as follows:  Sale of an option in securities: 0.0625% (payable by the seller on the option premium).  Sale of an option in securities (when exercised): 0.125% (payable by the purchaser on the settlement price).  Sale of a futures contract in securities: 0.0125% (payable by the seller on the trading price).  Goods and Services Tax (GST): o Definition: GST is a tax applied to the brokerage and transaction charges. o Rate: The GST rate is currently set at 18% on the total of brokerage and transaction charges.  Stamp Duty: o Definition: Stamp duty is a tax on the transfer of securities. o Rates: The stamp duty rates for equity derivatives are:  0.002% (₹200 per crore) for buyers of equity futures.  0.003% (₹300 per crore) for buyers of equity options.   SEBI Turnover Fees: o Definition: This is a fee charged by the Securities and Exchange Board of India (SEBI) based on the turnover of trades. o Rate: The fee is ₹10 per crore of turnover. Bid-Ask Spread and Impact Cost The bid-ask spread and impact cost are two important concepts in trading that reflect the costs associated with executing trades in the market. Here’s a detailed explanation of each: 1. Bid-Ask Spread  Definition: The bid-ask spread is the difference between the highest price that a buyer is willing to pay for a security (the bid price) and the lowest price that a seller is willing to accept (the ask price).  Example: o If the best bid price for a stock is ₹16.60 and the best ask price is ₹16.80, the bid-ask spread is: Bid- Ask Spread=Ask Price−Bid Price=16.80−16.60=₹0.20  Significance: o The bid-ask spread represents a transaction cost for traders. If an investor buys at the ask price and immediately sells at the bid price, they incur a loss equal to the spread. In the example above, if an investor buys at ₹16.80 and sells at ₹16.60, they would lose ₹0.20 per share.  Market Liquidity: o The size of the bid-ask spread is often indicative of market liquidity. A narrower spread typically suggests a more liquid market with higher trading activity, while a wider spread may indicate lower liquidity and higher transaction costs. 2. Impact Cost  Definition: Impact cost is a measure of the cost incurred due to the bid-ask spread and reflects the market impact of executing a trade, especially for larger orders. It quantifies the difference between the ideal price (the average of the best bid and ask prices) and the actual price at which a trade is executed.  Calculation: o The ideal price is calculated as: Ideal Price=2Best Bid Price+Best Ask Price o For example, using the previous bid and ask prices: Ideal Price=216.60+16.80=₹16.70  Execution Impact: o When a trader places a market order, they may not be able to execute the trade at the ideal price due to the bid-ask spread. For instance, if a trader buys a large quantity of shares, they may push the price up, resulting in a higher execution price than the ideal price. This difference is the impact cost.  Example of Impact Cost: o If a trader places a market order to buy a large number of shares, the execution may occur at progressively higher ask prices, leading to a total cost that exceeds the ideal price. If the trader buys at an average price of ₹17.00 instead of the ideal price of ₹16.70, the impact cost would be: Impact Cost=Average Execution Price−Ideal Price=17.00−16.70=₹0.30 per share Summary  Bid-Ask Spread: Represents the immediate transaction cost incurred when buying and selling securities. It is a reflection of market liquidity and trading activity.  Impact Cost: Measures the additional cost incurred due to the market impact of executing trades, particularly for larger orders. It highlights the difference between the ideal price and the actual execution price. 6.6 Algorithmic Trading Definition: Algorithmic trading refers to the process of executing orders using automated and pre- programmed trading instructions. These instructions take into account various factors such as price, timing, and volume to optimize trading strategies. Key Features of Algorithmic Trading: 1. Automation: o Orders are executed automatically by computers based on predefined criteria, reducing the need for manual intervention. This helps in minimizing human errors and emotional biases in trading decisions. 2. Speed: o Computers can place orders at a much faster rate than human traders, allowing for high-frequency trading (HFT) where thousands of trades can be executed in a matter of seconds. 3. Complex Strategies: o Algorithmic trading allows traders to implement complex strategies that may involve multiple variables and conditions, which would be difficult to manage manually. 4. Market Conditions: o Algorithms can adapt to changing market conditions in real-time, adjusting trading strategies based on current data such as security prices and traded volumes. 5. Cost Efficiency: o By automating the trading process, algorithmic trading can help reduce overall trading costs, making it particularly beneficial for institutional investors and large brokers. Applications of Algorithmic Trading:  Institutional Investors: o Large financial institutions use algorithmic trading to execute large orders without significantly impacting the market price.  Retail Traders: o Some brokers offer algorithmic trading services to retail clients, allowing them to utilize automated strategies in the derivatives market.  High-Frequency Trading: o A subset of algorithmic trading that focuses on executing a large number of orders at extremely high speeds to capitalize on small price discrepancies. Regulatory Considerations:  Caution Against Unregulated Platforms: o SEBI (Securities and Exchange Board of India) has warned investors about unregulated platforms that offer algorithmic trading services, emphasizing the importance of dealing with regulated entities to avoid potential risks.  Guidelines for Brokers: o Brokers offering algorithmic trading services are directed not to promote past or expected returns from such strategies, ensuring that investors are not misled by unrealistic promises. 6.7 Tracking Futures and Options Data Prior to the rise of internet trading, daily newspapers served as the primary source of information regarding spot and derivatives prices. However, with advancements in technology, prices in both spot and futures & options (F&O) markets can now be tracked in real-time through the websites of exchanges and various online trading platforms provided by brokers. Key Details Tracked by Market Participants: 1. Date: o Indicates the trade date. 2. Symbol: o Represents the underlying index or stock, such as NIFTY or ACC. 3. Instrument: o Describes the contract type available in the derivatives segment, e.g., FUTSTK (Futures on Stocks), OPTIDX (Options on Index). 4. Expiry Date: o The date on which the contract expires. 5. Option Type: o Specifies the type of option for the contract:  CE: Call European  PE: Put European  CA: Call American  PA: Put American 6. Corporate Action Level: o A flag that changes when there is a corporate action affecting a contract, such as a symbol change or dividend announcement. 7. Strike Price: o The price at which the underlying asset can be bought or sold when exercising an option. 8. Opening Price: o The price at which the contract opened for trading on that day. 9. High Price: o The highest price at which the contract was traded during the day. In real-time, it reflects the highest price traded up to that moment. 10. Low Price: o The lowest price at which the contract was traded during the day. In real-time, it reflects the lowest price traded up to that moment. 11. Closing Price: o The price of the contract at the end of the trading day. 12. Last Traded Price: o The price at which the last contract was traded during the day. In real-time, it reflects the price of the last executed trade. 13. Open Interest: o For futures contracts, open interest is calculated as the total open positions multiplied by the last available closing price. For options contracts, it is the open positions multiplied by the notional value, which is determined by the product of the open position in the option contract and the last available closing price of the underlying asset. 14. Total Traded Quantity: o The total number of contracts that were traded during the day (or up to that moment in real-time). 15. Total Traded Value: o The total monetary value of the contracts traded during the day (or up to that moment in real-time). 16. Number of Trades: o The total number of trades executed for the instrument during the day (or up to that moment in real-time). Information on Trends in F&O Markets:  Positive Trend: o Indicates the top gainers in the futures market.  Negative Trend: o Indicates the top losers in the futures market.  Futures OI Gainers: o Lists futures contracts with the highest percentage increase in open interest for the day.  Futures OI Losers: o Lists futures contracts with the highest percentage decrease in open interest for the day.  Active Calls: o Calls that have high trading volumes on that particular day.  Active Puts: o Puts that have high trading volumes on that particular day.  Put/Call Ratio (PCR): o This ratio provides information about the trading volume of put options relative to call options. It can be calculated based on either the trading volumes or the open interest of the options. Chap7 7.1 Clearing Members Clearing members are essential intermediaries in the clearing and settlement process of trades in the derivatives market. They ensure that trades are settled efficiently and manage the associated risks. Here’s a simplified overview: Types of Clearing Members 1. Self-Clearing Member: o Clears and settles only their own trades, either for themselves or their clients. 2. Trading Member-Cum-Clearing Member: o Clears and settles their own trades as well as those of other trading members and custodial participants. 3. Professional Clearing Member: o Focuses on clearing trades for other trading members but does not trade on their own account.  Responsibilities of Clearing Members  Clearing: o They calculate the net obligations of trading members, determining what needs to be settled.  Settlement: o Responsible for the actual transfer of funds and securities between parties.  Risk Management: o Monitor and manage risks, ensuring that trading members maintain adequate margins to cover potential losses.  Margining: o Collect and manage margins from trading members to mitigate risks. Importance of Clearing Members  Facilitate Trade Execution: o Ensure timely settlement of trades, maintaining market liquidity.  Risk Mitigation: o Reduce counterparty risk by ensuring both parties fulfill their obligations.  Regulatory Compliance: o Adhere to regulations set by authorities like SEBI, ensuring transparency and stability in operations. Clearing Banks Funds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with Clearing Corporation designated clearing bank for F&O segment. Clearing Member Eligibility Norms  Net-worth of at least Rs.300 lakhs. The Net-worth requirement for a Clearing Member who clears and settles only deals executed by him is Rs. 100 lakhs.  Deposit of Rs. 50 lakhs to clearing corporation which forms part of the security deposit of the Clearing Member.  Additional incremental deposits of Rs.10 lakhs to clearing corporation for each additional TM, in case the Clearing Member undertakes to clear and settle deals for other TMs 7.2 Clearing Mechanism The clearing mechanism is a process that ensures trades in the derivatives market are settled efficiently and securely. Here’s a simplified breakdown: Key Steps in the Clearing Mechanism 1. Trade Confirmation: o Both parties confirm the details of the trade (price, quantity) to ensure accuracy. 2. Netting of Positions: o The clearing corporation combines buy and sell positions to determine the net obligations of each trading member, simplifying the settlement process. 3. Margin Requirements: o Trading members must maintain margins (collateral) to cover potential losses, calculated based on their net positions and market conditions. 4. Settlement Process: o The clearing corporation facilitates the transfer of funds and securities between parties, ensuring timely settlement of trades. 5. Risk Management: o The clearing corporation monitors trading members to ensure they maintain adequate margins and comply with regulations, reducing financial risk. 6. Default Management: o If a trading member defaults, the clearing corporation has procedures to manage the situation, such as liquidating positions to cover losses. Importance  Efficiency: Streamlines the settlement process, saving time and resources.  Risk Mitigation: Reduces counterparty risk through netting and margin requirements.  Regulatory Compliance: Ensures trades meet regulatory standards, enhancing market trust. Consider a clearing member ‘A’ who has two trading members (TMs) clearing through him: ‘PQR’ and ‘XYZ’. Here’s how the clearing mechanism works in this scenario: Positions of Trading Members  Trading Member PQR: o Proprietary Position:  Buy: 5000 contracts  Sell: 3000 contracts  Net Position: 5000 - 3000 = 2000 (long) o Client Positions:  Client 1: Buy 3000, Sell 2000 → Net: 1000 (long)  Client 2: Buy 3000, Sell 1000 → Net: 2000 (long)  Trading Member XYZ: o Proprietary Position:  Buy: 1000 contracts  Sell: 2000 contracts  Net Position: 1000 - 2000 = -1000 (short) o Client Positions:  Client 1: Buy 2000, Sell 1000 → Net: 1000 (long)  Client 2: Buy 3000, Sell 4000 → Net: -1000 (short) Calculating Clearing Member A’s Open Position 1. PQR’s Total Position: o Long Position: 2000 (proprietary) + 1000 (Client 1) + 2000 (Client 2) = 5000 (long) o Short Position: 0 2. XYZ’s Total Position: o Long Position: 1000 (Client 1) = 1000 (long) o Short Position: 1000 (proprietary) + 1000 (Client 2) = 2000 (short) 3. Clearing Member A’s Overall Position: o Total Long Position: 5000 (from PQR) + 1000 (from XYZ) = 6000 o Total Short Position: 0 (from PQR) + 2000 (from XYZ) = 2000  Summary of Clearing Member A’s Position  Long Positions: 6000 contracts  Short Positions: 2000 contracts Example For instance, if a trading member has:  Long Positions: 6000 contracts  Short Positions: 2000 contracts The net position would be calculated as:  Net Position = Long Positions - Short Positions = 6000 - 2000 = 4000 contracts (long). This net position is then used to determine the margin requirements and facilitate the settlement process. 7.3 Interoperability of Clearing Corporations Interoperability among clearing corporations allows trades executed on one exchange to be cleared and settled by the clearing corporation of another exchange. This system enhances efficiency and reduces costs for market participants. Here’s a simplified overview: Key Features of Interoperability 1. Single Clearing Corporation: o Brokers can choose one clearing corporation to handle all their trades across different exchanges, eliminating the need to maintain multiple accounts and collateral at various clearing houses. 2. Cost Efficiency: o By consolidating margin and collateral requirements with a single clearing corporation, market participants can better utilize their capital, leading to lower trading costs. 3. Simplified Operations: o Brokers only need to comply with the regulations and requirements of one clearing corporation, streamlining their operational processes. 4. Risk Management: o In case of disruptions at one exchange, trades can still be routed through another clearing corporation, ensuring that clearing and settlement continue without interruption. 5. Increased Competition: o Interoperability fosters competition among clearing corporations, which can lead to improved pricing and services for brokers and clients. Example of Interoperability For instance, if a client has:  A long position in 10 lots of SBI May futures on NSE.  A short position in 6 lots of the same contract on BSE.  The net position would be calculated as:  Net Position = Long 10 lots - Short 6 lots = Long 4 lots. This net position is then used to determine the margin requirements, allowing for more efficient capital allocation. Benefits  Enhanced Market Efficiency: Reduces the complexity and costs associated with trading across multiple exchanges.  Improved Capital Utilization: Allows for better allocation of resources by minimizing the need for excess collateral.  Resilience: Ensures that trading activities can continue smoothly even if one exchange faces operational issues. 7.4 Settlement Mechanism The settlement mechanism is essential for ensuring that all trades in the derivatives market are settled accurately and efficiently. It involves several key processes and types of settlements. Here’s a detailed breakdown: Types of Settlement 1. Cash Settlement: o Used For: Primarily for index futures and options. o Process: At expiry, the difference between the contract price and the settlement price is paid in cash. This avoids the need for physical transfer of securities. 2. Physical Settlement: o Used For: Individual securities futures and options. o Process: On expiry, the actual underlying securities are delivered to the buyer, and the seller receives the agreed price. Key Steps in the Settlement Process 1. Mark-to-Market (MTM) Settlement: o Frequency: Daily. o Purpose: Adjusts margins based on daily price changes. o Calculation: Profits and losses are computed based on:  The difference between the trade price and the day's settlement price for contracts executed during the day.  The previous day's settlement price and the current day's settlement price for carried forward contracts. o Responsibility: Clearing members collect and settle these daily profits and losses for their trading members and clients. 2. Final Settlement: o Timing: On the last trading day of the contract. o Final Settlement Price: Determined based on the last 30 minutes' volume-weighted average price across exchanges. o Cash Settlement: For cash-settled contracts, the difference between the contract price and the final settlement price is settled in cash. o Physical Delivery: For physically settled contracts, the actual securities are delivered. 3. Delivery Instructions: o For Physical Settlement: The delivering clearing member must provide instructions for the transfer of securities to the designated depository pool account by the cut-off time on the settlement day. 4. Funds Settlement: o Pay-in Obligation: Clearing members must ensure they have sufficient funds in their settlement accounts on the settlement day. o Process: The clearing bank debits the paying member's account and credits the receiving member's account based on the settlement instructions. Example of Settlement Process  Scenario: A futures contract is set to expire. o Long Position: 100 contracts at a price of ₹100. o Settlement Price: ₹105 on expiry. Calculations:  MTM Calculation: Daily profit/loss is calculated based on the difference between the trade price and the settlement price.  Final Settlement: The long position holder receives ₹5 per contract (₹105 - ₹100) for a total of ₹500 (100 contracts).  Physical Delivery: If the contract requires physical delivery, the long position holder receives the underlying asset, and the short position holder delivers the asset at the agreed price. Settlement of Options Contracts 1. Exercise and Assignment: o European Style: These options can only be exercised on the expiration date. o American Style: These options can be exercised at any time before the expiration date. o Assignment: When an option is exercised, the clearing corporation assigns the exercise notice to a short position randomly. 2. Cash Settlement: o Index Options: These are settled in cash based on the final settlement price of the underlying index. o Daily MTM: Similar to futures, options also undergo daily MTM settlement. 3. Physical Settlement: o Stock Options: These are settled by the physical delivery of the underlying shares. On the expiration date, the buyer must take delivery of the shares, and the seller must deliver the shares.  Net Settlement of Cash and F&O Segments  Net Settlement Mechanism: This mechanism allows for the netting of obligations arising out of cash segment settlement and physical settlement of F&O positions on expiry. This reduces the price risk and allows netting efficiencies to market participants.  Example: If a client has a long position in a put option and purchases shares of the underlying stock on the expiry day, the net settlement mechanism allows for the netting of these transactions, reducing the need for separate settlements. Key Points to Remember  Settlement Schedule: The settlement schedule is specified by the clearing corporation and must be adhered to by all market participants.  Clearing Corporation: The clearing corporation plays a crucial role in ensuring the smooth settlement of all trades, whether cash or physical.  Risk Management: Effective risk management practices are essential to ensure the stability and integrity of the settlement process. 7.5 Risk Management Risk management in the derivatives market is crucial for maintaining stability and protecting participants from potential losses. Here are the key points: 1. Capital Adequacy: Members must have enough financial resources to cover potential losses. 2. Margins: o Initial Margin: A deposit required to open a position. o Maintenance Margin: The minimum balance needed to keep a position open. 3. Daily Mark-to-Market (MTM): Profits and losses are settled daily, reducing the risk of large losses. 4. Monitoring: Exchanges continuously watch trading activities to prevent manipulation and excessive risk-taking. 5. Default Management: Established procedures are in place to handle member defaults, including risk pools to cover losses. 6. Stress Testing: Regular tests assess how the market would handle extreme conditions. 7. Investor Education: Providing information about risks helps investors make informed decisions. 7.6 Margining and Mark to Market under SPAN Overview of SPAN  SPAN (Standard Portfolio Analysis of Risk): A risk management and margining system developed by the Chicago Mercantile Exchange (CME) to calculate initial margins for various positions in the derivatives market.  Purpose: To assess the overall potential risk in a portfolio and ensure that the margin requirements are sufficient to cover potential losses over a one-day period. Key Objectives of SPAN  Identify Potential Risk: SPAN aims to determine the largest possible loss that a portfolio might reasonably be expected to suffer from one trading day to the next.  Set Initial Margins: It establishes initial margin levels that are adequate to cover this one-day potential loss, thereby protecting the clearing corporation and the market. Risk Array  Definition: The risk array represents the extent to which a specific derivative instrument will gain or lose value from the present time to a specific point in time, under a specific set of market conditions.  Time Frame: The evaluation period for the risk array is set to one trading day. Margining System  Initial Margin: o Calculated by the clearing corporation using SPAN. o Required to be paid upfront by market participants for all open positions. o Initial margins are computed on a gross basis for client positions and on a net basis for proprietary positions.  Premium Margin: o Charged at the client level to cover the premium amount due to the clearing corporation for options. o This margin is applicable until the completion of the pay-in towards premium settlement.  Assignment Margin: o Required for assigned positions of clearing members towards final exercise settlement obligations for options contracts. o This margin is applicable until the obligations are fulfilled.  Delivery Margins: o Levied on the lower of potential deliverable positions or in-the-money long option positions. o Applicable four days prior to the expiry of derivative contracts.  Exposure Margins:  o These margins are applied based on the Value at Risk (VaR) and Extreme Loss percentages calculated in the Capital Market segment. o They are additional to the initial margins and are updated for every change in margin rates. Importance of Mark to Market (MTM)  Definition: Mark to Market (MTM) is a process where the profits and losses of futures contracts are settled on a daily basis.  Daily Settlement: o The MTM settlement adjusts the margins based on daily price changes in the market for the underlying assets. o It ensures that the profits and losses are realized and accounted for on a daily basis, providing a clear picture of the financial position of market participants. Summary  The SPAN system is crucial for managing risk in the derivatives market by ensuring that adequate margins are collected to cover potential losses.  The margining process, including initial, premium, assignment, delivery, and exposure margins, plays a vital role in maintaining market stability and protecting against defaults.  Mark to Market settlements ensure that participants are aware of their financial positions and that profits and losses are accounted for regularly. 7.7 Position Limits Position limits are a crucial component of the risk management framework within derivatives exchanges. They serve to restrict the number of derivatives contracts that a trading member or client can hold, either individually or collectively. The primary purpose of these limits is to prevent market manipulation by ensuring that no single trader can accumulate excessive control over the market or specific stocks through derivatives contracts. Types of Position Limits SEBI (Securities and Exchange Board of India) has established three distinct types of position limits in the equity derivatives segment: 1. Client-Level Position Limits 2. Trading Member-Wise Position Limits 3. Market-Wide Position Limits (MWPL) Client-Level Position Limits  Definition: The gross open position across all derivative contracts for a specific security held by each client must not exceed the higher of: o 1% of the free float market capitalization (in terms of the number of shares). o 5% of the open interest in all derivative contracts for the same underlying stock per Exchange (in terms of the number of shares).  Availability: Client-level position limits for each security are published on the Exchange's website.  Reporting Requirement: Any individual or group acting in concert that collectively owns 15% or more of the open interest on a particular underlying index must report this to the Exchange or Clearing Corporation. Non-compliance is treated as a violation and may lead to penalties as per the relevant rules and regulations. Trading Member-Wise Position Limits  Index Futures: The position limits for trading members in equity index futures contracts are set at the higher of: o Rs. 500 crores or o 15% of the total open interest in the market for equity index futures contracts.  Index Options: Similarly, for equity index options contracts, the trading member position limits are also the higher of: o Rs. 500 crores or o 15% of the total open interest in the market for equity index options contracts.  Individual Securities: The combined position limit for futures and options on individual securities is capped at 20% of the applicable Market Wide Position Limit (MWPL) per Exchange. The Clearing Corporation specifies these limits on the last trading day of each month for the following month. Market-Wide Position Limits (MWPL)  Definition: MWPL for futures and options contracts on individual securities is set at 20% of the number of shares held by non-promoters in the relevant underlying security, essentially representing 20% of the free float.  Specification: The Clearing Corporation announces the MWPL on the last trading day of the month, which is then applicable for the next month.  Monitoring: Trading systems will issue alerts when the open interest in futures and options contracts for a specific security exceeds 60% of the MWPL. If the aggregate open interest across Exchanges surpasses 95% of the MWPL, no new positions will be allowed for that security until the open interest falls to 80% or below. Compliance and Penalties  Exceeding Limits: If client-level position limits are breached, the clearing member or trading member must ensure that the client does not take any new positions and must reduce existing positions to comply with the limits.  Penalties: The exchange imposes penalties on clearing members for violations, which can be recovered from the trading member or client responsible for the breach. Violations of trading member limits are monitored continuously throughout the trading day.  End-of-Day Checks: MWPL violations are assessed at the end of each trading day. If a member or client has increased their positions or created new positions in a stock while a ban on fresh positions is in effect, they may face penalties. 7.9 Settlement of Running Account of Client’s Funds Lying with the Trading Member (TM)  To prevent the misuse of client funds by brokers, SEBI has mandated that brokers must settle the running account of client funds on a regular basis. This is intended to ensure transparency and protect clients' interests in the financial markets. Key Points: 1. Settlement Frequency: Brokers are required to settle the running account of client funds either on a monthly or quarterly basis, depending on the client's preference as per their mandate. 2. Purpose: The primary goal of this regulation is to ensure that clients are aware of their fund status and to prevent any potential misuse of their funds by the trading members. 3. Client Mandate: Clients must provide a clear mandate indicating their preferred frequency for the settlement of their accounts. This ensures that clients have control over how often they wish to review and settle their funds. 4. Transparency: Regular settlements help maintain transparency in the handling of client funds, allowing clients to track their investments and any profits or losses incurred. 5. Compliance: Trading members must comply with these regulations to avoid penalties and ensure the protection of client interests. This regulation is part of a broader framework aimed at enhancing the integrity and reliability of the financial markets, ensuring that clients' funds are managed responsibly and transparently 159. 7.10 Settlement Guarantee Fund and Investor Protection Fund: 7.10 Settlement Guarantee Fund and Investor Protection Fund The establishment of the Settlement Guarantee Fund (SGF) and the Investor Protection Fund (IPF) is crucial for maintaining the integrity and stability of the financial markets. These funds serve distinct but complementary purposes aimed at protecting investors and ensuring smooth settlement processes. Settlement Guarantee Fund (SGF) 6. Purpose: The primary objective of the SGF is to guarantee the settlement of trades executed in various segments of the stock exchange, such as Cash, Futures & Options (F&O), and others. 7. Functionality: In the event that a clearing member fails to honor their settlement commitments, the SGF is utilized to fund the obligations of that member. This ensures that the settlement process continues without disruption, thereby maintaining market confidence. 8. Core SGF: Each segment of the market (e.g., Cash, F&O) has its own Core SGF, which is specifically designed to address the settlement risks associated with that segment. 9. Risk Mitigation: The SGF acts as a safety net, reducing the risk of default by clearing members and ensuring that investors receive their due payments and securities in a timely manner. Investor Protection Fund (IPF) 10. Purpose: The IPF is established to compensate investors in the event that the assets of defaulting members are insufficient to meet the admitted claims of investors. 11. Compensation: If a trading member defaults and is unable to return client funds or securities, the IPF provides compensation to affected investors, thereby protecting their interests. 12. Additional Objectives: Beyond compensation, the IPF also aims to promote investor education, awareness, and research, contributing to a more informed investor base. 13. Administration: The IPF is administered through a registered Trust created specifically for this purpose, ensuring that the funds are managed transparently and effectively. Chapter 9: Accounting and Taxation - Deep and Understandable Breakdown 1. Accounting for Equity Derivatives A. Initial Recognition and Measurement  Initial Recognition: o Fair Value: When you enter into a derivative contract (like futures or options), it’s recorded at fair value on the trade date. This is the amount you would pay or receive if you were to settle the contract immediately. o Example: If you buy a futures contract for ₹100, you recognize it as an asset of ₹100 on the date of purchase.  Subsequent Measurement: o Mark-to-Market (MTM): At the end of each trading day, the contract’s value is reassessed. This process is known as MTM. The change in value is recorded as a gain or loss. o Daily Adjustment: If the value increases, it’s recorded as a gain. If it decreases, it’s a loss. o Example:  Day 1: If the futures contract’s price increases from ₹100 to ₹105, you record a gain of ₹5.  Day 2: If the price drops to ₹95, you record a loss of ₹10. B. Hedge Accounting  Hedging: When derivatives are used to hedge (protect against) risks, like currency fluctuations or interest rate changes, special accounting rules apply. o Documentation: The hedge relationship must be formally documented, including how you’ll measure the effectiveness of the hedge. o Matching Gains/Losses: The timing of recognizing gains or losses from the derivative is matched with the item being hedged, so your financial statements accurately reflect the hedging activity. C. Accounting Entries for Derivatives  Buying a Derivative: o Entry:  Debit: Derivative Asset (for the value of the derivative)  Credit: Cash/Bank (for any upfront payment) o Example: If you buy an option for ₹1,000, the entry would be:  Debit: Derivative Asset ₹1,000  Credit: Cash ₹1,000  Mark-to-Market Adjustments: o Entry:  If the value increases:   Debit: Derivative Asset (for the gain amount)  Credit: MTM Gain  If the value decreases:  Debit: MTM Loss  Credit: Derivative Asset o Example: If your futures contract gains ₹5 in value:  Debit: Derivative Asset ₹5  Credit: MTM Gain ₹5 o If it loses ₹10:  Debit: MTM Loss ₹10  Credit: Derivative Asset ₹10  Settlement of Derivative Contracts: o When the contract is settled or expires:  Entry:  Debit: Cash/Bank (for the settlement value)  Credit: Derivative Asset (to close the position) o Example: If the futures contract settles at ₹110:  Debit: Cash ₹10 (because you made a profit of ₹10)  Credit: Derivative Asset ₹10 D. Disclosure Requirements  Balance Sheet: o Derivatives must be shown as separate line items under financial assets (if you expect to gain) or liabilities (if you expect to lose).  Profit & Loss Statement: o Gains and losses from derivatives are reported under "Other Income" or "Operating Income" depending on whether derivatives are a core part of your business. 2. Taxation of Equity Derivatives A. Income Classification  Business Income: o When: If you frequently trade derivatives, this income is treated as business income. This means it is considered part of your regular business operations. o Taxation: It is taxed under the "Profits and Gains of Business or Profession" head. o Deductions: You can deduct related expenses (like brokerage fees, internet costs, etc.).  Capital Gains: o When: If you hold derivatives as an investment and sell them, the profit is classified as capital gains. o Short-Term Capital Gains (STCG):  If you hold the derivative for less than 12 months.  Tax Rate: Taxed at a flat rate of 15%. o Long-Term Capital Gains (LTCG):   If you hold the derivative for more than 12 months. (This is rare for derivatives as they are usually traded over shorter periods.)  Tax Rate: Taxed at 10% for gains above ₹1 lakh. B. Securities Transaction Tax (STT)  What is STT? o STT is a tax levied on every transaction (buy/sell) of certain securities, including derivatives. It is collected by the stock exchange at the time of the transaction.  STT Rates: o Futures:  0.01% on the sell side (the value of the futures contract). o Options:  0.017% on the sell side (on the premium amount). o Equity Delivery:  0.1% on both the buy and sell sides.  Impact on Tax Calculation: o Business Income: STT paid can be deducted as a business expense. o Capital Gains: STT is not deductible when calculating capital gains. C. Advance Tax  When is Advance Tax Required? o If your total tax liability for the year is ₹10,000 or more, you must pay advance tax. o Installments:  1st Installment: 15% of total tax liability by June 15.  2nd Installment: 45% of total tax liability by September 15.  3rd Installment: 75% of total tax liability by December 15.  4th Installment: 100% of total tax liability by March 15. o This is especially relevant if you have significant income from derivatives trading. D. Filing of Tax Returns  Which Forms to Use: o ITR-3: If your income from derivatives is treated as business income. o ITR-2: If your income from derivatives is treated as capital gains.  Required Documentation: o Keep detailed records of all derivative transactions, including:  Contract notes  Broker statements  Mark-to-Market (MTM) reports o These documents will help accurately report your income and claim deductions. 3. Practical Examples Example 1: Accounting for a Futures Contract  Initial Purchase: o Buy a futures contract for ₹100. o Entry:  Debit: Futures Contract Asset ₹100  Credit: Cash ₹100  Day 1 MTM Gain: o The value of the contract rises to ₹105. o Entry:  Debit: Futures Contract Asset ₹5  Credit: MTM Gain ₹5  Day 2 MTM Loss: o The value drops to ₹95. o Entry:  Debit: MTM Loss ₹10  Credit: Futures Contract Asset ₹10  Settlement: o The contract is settled at ₹110. o Entry:  Debit: Cash ₹10 (the gain from ₹100 to ₹110)  Credit: Futures Contract Asset ₹10 Example 2: Taxation on Derivatives  Scenario: o You earn ₹2,00,000 from derivatives trading, considered business income. o You have related expenses of ₹50,000 (e.g., brokerage, software, etc.). o Net Income:  ₹2,00,000 - ₹50,000 = ₹1,50,000 (this is your taxable income).  Tax Calculation: o If your total income is within the 20% tax bracket, you pay 20% on ₹1,50,000 = ₹30,000 as tax.