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Tools for trading

Cash Market

Trading can be done in Cash Markets as well as Derivative Markets.

Cash market can be traded in the following ways:

Intraday:

• Closing the positions on the same day as initiated.

Advantages: Can go short (sell before buying), with a condition to close (buy) position before the end of the day.
• Can leverage trades. Buy upto10 times of available margin.

BTST:

• Stands for Buy Today Sell Tomorrow.

Positional:

• Buying a stock and waiting for a specific price or a specific period. (2 days to 1 year)

Derivative trading

Why have derivatives?

• 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. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis.

• Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed.
 

Derivatives are of two types: Futures & Options.

What are FUTURES ?

Future contract

• It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into.
But a margin of 10-20 % is taken as a guarantee.

Illustration 1:

• One wants to buy a home worth Rs. 1 Crore
• You buy it by paying a token amount of say (10%) Rs. 10 Lakh.
• Now the price of the home rises to Rs 1.10 Crore. (10 % appreciation).
• You chose to exit the contract.
• You get Rs. 1.1 Crore and pay Rs. 90 lakh to the first owner.
• You had invested Rs. 10 lakh and you get a profit of Rs 10 lakh.
• 100 % profit by just 10 % appreciation.

This is Future Contract.

• One important feature is that you can sell the contract before you buy because you are anticipating a fall in prices of the future contract with a commitment of buying it back before at a future date.
• Example you are anticipating prices of Nifty to fall from 6000 to 5500. You sell Nifty at 6000 (even though you don’t have it) Now when it comes to 5500 you buy it back. You make Rs. 500

Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.

Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day.

Price : 10000
Lot Size : 25
Volume : 250000
Margin Required : 15 % = Rs. 37500

Suppose purchased 1 lot on 1st Jan at 10000.
Starting balance 50000

Derivative trading

Date Closing Level Debit Credit Ledger Balance
1st Jan 10100   2500 52500
2nd Jan 9800 7500   45000
3rd Jan 10000   5000 50000

Options

• Options are in basic similar to insurance.
They were introduced as a risk mitigation for market investments.

• Like one pays insurance for a car and gets a similar compensation if something happens to it similarly we have options which would protect the portfolio if market took an adverse hit. In case nothing adverse happened one had to forget the premium paid.

• Options were introduced for risk transfer, now it is one of the best means for trading the markets. If one expects the underlying to go up one can buy call options and if one expects the underlying to go down one call buy put options.

Strike Price
• Strike price is the various possible prices at which the underlying can trade for that specific contract. These are located at a predefined interval.

• Example in case of Nifty the various strike price are …..5950, 6000, 6050, 6100…,

Out-of-the-money: A call option is out-of-the-money if the market price of the underlying securities is below the exercise price of the option; a put option is out-of-the-money if the market price of the underlying securities is above the exercise price of the options.

In-the-money: An option with intrinsic value and not just time value.
Option price has 2 values:
Time Value and intrinsic Value.

Option Price depends on the probability of the underlying crossing the strike price before expiry which depends on:

a) Price of underlying asset.
b) Time left for expiry.

Understanding the relation of strike price and option price:

Call option is normally bought when one expects the underlying to move up.
But it is not necessary that all call options will move up if the uptrend happens.

Example:
• Nifty is at 6000.
• You anticipate it to go up.
• You buy a 6500 Call contract which expires in 2 days.
• Next day Nifty moves up by 100 points.
• Your call option may move marginally up or mostly decrease in value even though the market has gone up.
• It is because the probability of it crossing 6500 has decreased as there is only 1 day for the contract to expire.
• Chosing the strike price.

At the money: The option with the strike price closest to the underlying asset.

Eg: If Nifty is at 6010, 6000 Strike price Call and put are both At the Money Options.
 

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