NISM Series VIII Masterclass: Equity Derivatives Comprehensive Study Notes

NISM Series VIII: Equity Derivatives Comprehensive Study Notes

Chapter 1: Basics of Derivatives

What is a Derivative?

A derivative is a contract or product whose value is derived from the value of another asset, known as the underlying. Underlying assets can include metals, energy resources, agricultural commodities, and financial assets like stocks or indices.

Market Participants

  1. Hedgers: Investors who already face risk from underlying asset prices. They use derivatives to reduce risk and avoid losses.

  2. Speculators/Traders: Participants who try to predict future price movements to profit from taking positions.

  3. Arbitrageurs: Traders who exploit price differences of the same product in two different markets to produce profit.

Significance and Risks

  • Significance: Derivatives improve price discovery, facilitate the transfer of risks, and shift speculative trade from unorganized to organized markets.

  • Risks: Participants face Counterparty risk (default), Price risk (adverse movement), Liquidity risk (inability to exit), Legal risk, and Operational risk (fraud/execution errors).

Chapter 2: Understanding Equity Indices

What is an Index?

An index is a portfolio of securities representing a particular market or sector. It serves as a benchmark for portfolio performance and an underlying asset for derivative contracts.

Calculation Methodologies

  • Market Capitalization Weighted: Stocks are weighted according to their total market cap.

  • Free-Float Market Capitalization: Weights are based only on the equity readily available for trading in the market.

  • Price Weighted: Stocks influence the index in proportion to their per-share price (e.g., higher-priced stocks have more weight).

  • Equal Weighted: Makes no distinction between large and small companies; all are given equal weighting.

Key Concepts

  • Impact Cost: A measure of liquidity; it refers to the cost of executing large orders without significantly moving market prices.

  • Index Derivatives: Popular tools worldwide used to hedge against market risk.

Chapter 3: Introduction to Forwards and Futures

Forwards vs. Futures

  • Forwards: Bilateral, Over-the-Counter (OTC) transactions negotiated directly between two parties. They face high Liquidity risk and Counterparty risk.

  • Futures: Standardized, exchange-traded forward contracts. They offer centralized price discovery and settlement guarantees through a clearing agency.

Futures Terminology

  • Spot Price: The price in the cash market.

  • Futures Price: The price of the contract in the futures market.

  • Basis: The difference between the spot price and the futures price.

  • Cost of Carry: The relationship between futures and spot prices, measuring storage/interest costs minus any income (like dividends) earned during the holding period.

  • Initial Margin: The amount deposited at the time of entering a contract.

  • Mark-to-Market (MTM): The daily settlement of profits and losses.

Chapter 4: Introduction to Options

Option Basics

An option gives the buyer the right, but not the obligation, to buy or sell an asset at a stated price on or before a specific date.

  • Call Option: Right to buy the underlying.

  • Put Option: Right to sell the underlying.

  • Option Premium: The price the buyer pays to the seller (writer).

Moneyness of Options

  • In-the-Money (ITM): Results in a positive cash flow if exercised immediately.

  • At-the-Money (ATM): Strike price is equal to the spot price.

  • Out-of-the-Money (OTM): Strike price is worse than the spot price for the holder.

Option Greeks

  • Delta: Sensitivity of option value to a small change in the underlying price.

  • Gamma: Rate of change in Delta relative to the underlying price.

  • Theta: Sensitivity to time decay; change in price due to the passage of time.

  • Vega: Sensitivity to changes in market volatility.

  • Rho: Sensitivity to a change in the risk-free interest rate.

Chapter 5: Option Trading Strategies

  • Vertical Spread: Using options with the same expiry but different strike prices.

  • Straddle: Buying/Selling a call and a put with the same strike and maturity.

  • Strangle: Buying/Selling a call and a put with different strike prices.

  • Covered Call: Selling a call option against an existing holding in the cash market to generate income.

  • Protective Put: Buying a put to hedge a long position in the cash market against a price fall.

Chapter 6: Trading, Clearing, and Settlement

Trading System Hierarchy

  1. Corporate Manager: Highest level; can define exposure limits for branches.

  2. Branch Manager: Can view activities for all dealers under their branch.

  3. Dealer: Lowest level; can only view their own orders and trades.

Order Types

  • Limit Order: Executed only at a specified price or better.

  • Market Order: Executed at the best currently available bid/offer price.

  • Stop-Loss Order: Executed once a security reaches a certain trigger price.

Clearing and Settlement

  • The Clearing Corporation acts as a legal counterparty to all trades and guarantees financial settlement.

  • Settlement is generally on a T+1 basis.

  • SPAN (Standard Portfolio Analysis of Risk): Software used to calculate initial margins by identifying the largest possible one-day loss in a portfolio.

Chapter 7: Regulatory Environment & Ethics

Key Regulations

  • SCRA (1956): Prevents undesirable transactions in securities and governs stock exchange operations.

  • SEBI Act (1992): Established to protect investors and promote/regulate the securities market.

Sales Practices and Investor Protection

  • Churning: Unethical practice where professionals make excessive trades solely to generate commissions.

  • Anti-Money Laundering (AML): Intermediaries must adopt written procedures for client due diligence and suspicious transaction reporting.

  • SCORES: SEBI's web-based centralized system for lodging and tracking investor complaints against intermediaries.

Dhaval Visariya

AMFI Registered Distributor (ARN-327925) | Software Developer & Finance Enthusiast

Connect with me:
LinkedIn | Telegram | YouTube | GitHub | Medium

Disclaimer: I am an AMFI Registered Mutual Fund Distributor. Views expressed here are for educational purposes. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
📧 Contact: info.apollofinancialservices@gmail.com

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