Capital Market


All right everyone, get ready, here we go. This chapter explains the basics; though it covers elementary information every bit is important and will help you to get the entire picture.
We will start up with a very basic question and start building up the pace as we move ahead;
“What is a share?”
A share is a document issued by a company which states that the holder is the owner of the company to the extent of the number or percentage of shares held. A share holder is eligible to receive to the extent of the holding the profits made by the company, bonus shares declared etc. In case the company makes a loss the share holder‟s liability is restricted only to the amount of money paid to acquire the shares and nothing beyond. This is because a share holder has a “limited liability”.
Shares can be bought whenever the company makes a public offering (primary market) or if the shares are listed, from the stock exchange (secondary market).
“What is a Stock Exchange?”
As we have a market place for buying or selling any commodity e.g. vegetable market, cloth market, electronics market etc; the place where trading of Shares, Derivatives, Currencies, Bonds, Debentures, Mutual funds (ETF‟s) or any other security is called as the “Stock Exchange”.
A stock exchange also referred to as the stock market provides the platform for brokers, traders and investors to trade in stocks and other financial securities. The 2 major stock exchanges in India are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). A important point to note is that in India only Public Limited Companies are listed on the stock exchanges and the buy or sell transactions can be carried out only by registered members. Traders and investors have to route their trades through a registered broker only.
A stock exchange plays multiple roles in the economy like It acts as a barometer of the economy It helps raise capital for businesses Creates investment opportunities for retail investors Helps the government to raise capital for development projects Facilitates company growth Corporate governance
“What is an Index?”
An Index measures the markets. It reflects the trend or the mood and shows which way the markets are headed. An index can measure the entire market or also certain sections of it.
The Index for the Bombay Stock Exchange (BSE) is the “Sensex” which comprises of the shares of 30 companies. Though there are close to 3000 companies listed on the BSE, the movement of the “Sensex” is dependent on the price movement of the shares of theses 30 companies.
The Index for the National Stock Exchange (NSE) is the “Nifty” which comprises of the shares of 50 companies. Though there are close to 3000 companies listed on the NSE, the movement of the “Nifty” is dependent on the price movement of the shares of theses 50 companies.
“Regulator”
Every market needs a regulator to ensure that the day to day transactions are carried out in a fair and legitimate manner. The regulator for the stock markets in India is the “Securities and Exchange Board of India” (SEBI).
“Demat”
Demat is an acronym for dematerialized, the shares are held in a Demat account in electronic form. The two main depositories in India are CDSL (Central Depository Services (I) Ltd.) and NSDL (National Securities Depository Ltd.)
“Compulsory Rolling Settlement”
Under rolling settlement, the trades done are to be settled after an x number of days from the trading day. In India the settlement cycle for the cash segment is T + 2 days where T stands for the trading day and 2 stands for the working days; by T+2 it is meant that the final settlement of the transactions (exchange of monies and securities) done on trade day T takes place on the 2nd working day (excluding holidays) from the trade day.

Before we move ahead to the core subjects, let‟s first understand the markets. First of all let us look at the different ways to trade in the markets. There are 2 ways in which one can trade in the markets i.e. the cash segment and Derivatives; again in derivatives there are 2 ways to trade i.e. Futures and Options, refer figure
What makes share prices to move up or down?
To put it across simply it is demand and supply.
If the demand is more than the supply which means that there are more buyers than sellers, this has a positive impact on the share price i.e. the price will rise.
If the supply is more than the demand which means that there are more sellers than buyers, this has a negative impact on the share price i.e. the share price will fall.
Now let us understand what factors impact the demand and supply. There are many factors which influence the demand and supply, to name a few factors for example; If a company bags a major contract or if the government announces a policy which has a positive impact on the sector to which the company belongs, or if the profits of the company have crossed the target or expectation. These factors result in a positive impact because these factors indicate higher earnings, which mean higher profits.
The higher profits will increase the earnings per share; the increase in the earnings increases the valuation of the share hence investors will start buying the shares which increases the demand, whereas investors who had already bought the shares earlier would be un willing to sell the shares as they would prefer to hold on to their positions for higher profits this decreases the supply. In this scenario the demand is more than the supply hence the share price will start rising upwards.
Now let us look at the other side of the coin; If a company loses a major contract or if the government announces a policy which has a negative impact on the sector to which the company belongs, or if the profits of the company do not meet the target or expectation. These factors result in a negative impact because these factors indicate lower earnings, which mean lower profits.
The lower profits will decrease the earnings per share; the decrease in the earnings decreases the valuation of the share, hence investors will not prefer buying the shares which decreases the demand, whereas investors who had already bought the shares earlier would begin to sell the shares as they would prefer to sell their holding to avoid losses this increases the supply. In this scenario the demand is lesser than the supply hence the share price will start falling.
Some other factors which influence the stock markets are political stability in the country, the dollar movement, inflation, GDP growth etc, and since we are now a liberalized economy and connected to the world even the movements in the global markets have a direct impact on our stock markets.
Classification of Companies
In this segment we will understand what is meant by the classification of companies, why classification is required and what role does it play.
You may have read or heard the terms Large cap, Mid cap, Small cap or penny stock umpteen numbers of times. A company classified as a Large cap, Mid cap, Small cap or a penny stock after taking into account its Market Capitalization, why is it important we will discuss it a little later down in this chapter.
“Market Capitalization”
Market capitalization helps us to know how big or small is a company; in short it measures the size of the company. It is computed as Current Market Price x No. of shares outstanding. By shares outstanding we mean the total shares that have been authorized, issued and purchased.
Example: Let us assume that the current market price of share is Rs. 100/- and the total number of shares outstanding is 1000000 then the market capitalization = 100 x 1000000 = 100000000.
“Classification of companies”
Large Cap
Any company whose market capitalization is above Rs. 10000 crores.
Mid Cap
Any company whose market capitalization is above Rs. 1800 crores but below Rs.10000 crores.
Small Cap
Any company whose market capitalization is below Rs. 1800 crores.
Penny Stocks
Penny stock is a slang used for the smallest of Small cap companies.
“Groups”
Every day when we open the newspaper and go to the market section we see an alphabet A in bold and find 200 odd names below it, we see another alphabet B in bold and find another couple of hundred names below it, likewise the same thing is repeated further and we find F, T, Z etc. what do the alphabets indicate, read on to find out.
This is done for the benefit and guidance of the traders and investors.
“A” group
Consists of the most active and tracked class of shares. Generally all the large cap companies are under this group.
“B” group
Consists of all the companies which are not included in the A group. This group excludes the companies which are in the T, TS and Z group.
“F” group
Consists of fixed income securities.
“G” group
Consists of Government securities.
“T” group
Consists of shares which are traded on a trade to trade basis.
“TS” group
Consists of shares which are part of the “BSE – Indonext” segment and are settled on a trade to trade basis as a surveillance measure.
“Z” Group
Consists of those companies who have failed to comply with the listing agreements and/or have not made the necessary arrangements with the depositories for the dematerialization of their shares and/or have failed to resolve investor complaints. Z group scrip‟s are also compulsorily settled on a trade to trade basis.
“Trade to Trade basis”
By trade to trade basis we mean that there is no intraday square up or netting up option or facility is available. All the trades have to result in giving and taking delivery of the shares at the gross level.
“Why is classification of companies and grouping important?”
This is done to inform, and forewarn the traders and investors planning to trade and invest in the markets. As discussed earlier A group scrip‟s would consists of the large cap, B group consists of scrip‟s which are not large caps. T, TS and Z group would consist of the riskiest scrip‟s where trading is done on a trade to trade basis.
As a trader who is opting for margin trading (explained below) or for going in for funding on his/her holding, the amount of shares that can be bought or sold on margin basis is determined on the group the share belongs to; likewise the amount of funding available on the shares held is also determined on the group the share belongs to.
Example: In case a trader wants to trade in “A” group shares, the trader would probably get 10 times margin of the base capital. In case a trader wants to trade in “B” group shares, the trader would probably get 4-5 times margin of the base capital. In case a trader wants to trade in “T, TS or Z” group shares, the trader will not get any margin or funding.
The extent of margin or funding facility for A and B group shares differs from broker to broker and also depend on the credit rating and relation of the trader with the broker.
As a prudent trader it is best to avoid and not trade in T, TS and Z group shares.
“Mark to Market”
Is the process of recording the change in the price of a security, portfolio or account so as to reflect the current fair market value. It is done on a daily basis and used to calculate profits and losses and to confirm that the margin requirements are being met.
Stop Loss
Is a mechanism to get out of a wrong trade with a minimal loss. If the share price movement goes against the expectation a stop loss helps curtail huge losses.
Chapter 3
Stock Market Terminology
This chapter covers the various jargons and terminology used in the market, while many of you would be aware about most of the content given in this chapter it is of utmost importance to people who are new and are about to put their first step in the Stock Markets.
Active Shares
Shares of companies which are traded regularly with high volumes. Active shares can be easily bought or sold.
Auction
Is a mechanism utilized by the exchange to protect the interests of the buying members. Auctions take place when the selling members either give short deliveries or fail to deliver the shares sold; the exchange purchases the required quantity from the open market and gives it to the buying members. The selling members have to bear the cost difference.
Averaging
Buying at different price levels over a period of time so as to have a advantageous average acquisition price.
Bad Delivery
Share certificates where the buyer is unable to get them transferred on his/her name.
Bear
A trader who sells the shares first expecting the prices to come down and then buy at a lower price level.
Bear Market
A period signified by continuous fall in share prices/Indices due to a heavy selling pressure.
Block Trade
Trading large quantity of shares usually done by mutual funds or institutional investors. Usually it is a minimum of 5 lakh equity shares or a value of Rs. 5 crore.
Blue chips
Shares of well managed large established companies which have a proven track record of consistent growth over the years and expected to have sustained growth in the future.
Book closure
A company before declaring a dividend, bonus or rights issue closes its register of share holders for a certain period of time during which no transfer of shares is registered. Only those shares holders whose names appear on the register at the time of book closure are eligible to receive the benefit (i.e. dividend, bonus or rights shares)
Boom
The period in which there is a continuous upward movement of the share prices/indices.
Bottom
The lowest point of a share/index during a stipulated time period (i.e. day, week, month, year etc) is said to be the bottom.
Bottom out
When the share price/ index hit their lowest price level/point and recover from that level they are said to have bottomed out.
Bourse
Refers to the stock exchange
Break out
When the share prices/indices break a resistance level to start an upward movement or when they break a support level and start a downward movement, in other words if the share price/indice breaks its normal trading range it is referred to as a break out.
Bull
A trader who keeps buying shares to sell at a much higher price later to earn profits.
Bull Market
A continuous upward movement of share prices on sustained buying pressure of investors or traders.
Close
The last traded price of a share or index point on a particular trading session in the stock exchange.
Circuit breaker
A system to check excessive speculation in the stock market (very high rise or fall of shares/index) applied by the stock market authorities. Trading is suspended at circuit breaker level for some time to let the market cool down.
Contrarian
A trader who does the exact opposite of what everyone else is doing. I.e. a contrarian will buy shares when everyone is selling and will sell when everyone is buying. The contrarian believes that the markets will perform the opposite of what the majority of traders think.
Contract Note
Is a statement of confirmation of trade/s done on a particular day establishing a legally enforceable relationship between the broker and the client.
Consolidation
A period where the share prices/indices are moving in a narrow range before a break out.
Correction
A short and sharp reversal of the share prices or the index in downward direction after an uptrend or in upward direction after a downtrend.
Crash
A Sharp fall in share prices within a short period of time generally due to panic amongst traders and investors.
Cum Bonus
When the price is quoted as cum bonus it means that the buyer would be entitled to receive the bonus shares announced.
Cum Dividend
When the price is quoted as cum dividend it means that the buyer would be entitled to receive the dividend announced.
Cum Rights
When the price is quoted as cum rights it means that the buyer would be entitled to receive the rights shares announced.
Dead Cat Bounce
A temporary recovery in share prices. Usually happens in a bear market.
Delisting
Taking off the company‟s name from the list of the stock exchange. Once a company is delisted its shares cannot be traded on the stock exchange.
Delta Stocks
The least liquid stocks in a stock exchange.
Discounting
Reaction by traders & investors to news or other factors that may have an impact on the stock market either directly or indirectly.
DII
Domestic institutional investor.
Earnings per Share
Also known as EPS; it is derived by dividing the net profit by the no. of shares.
Ex – Bonus
When the price is quoted as ex-bonus it means that the buyer would not be eligible to receive the bonus shares announced.
Ex – Dividend
When the price is quoted as ex-dividend it means that the buyer would not be eligible to receive the dividend announced.
Ex- Rights
When the price is quoted as ex-rights it means that the buyer would not be eligible to receive the rights shares announced.
Face Value
Refers to the base price of the share.
FII
Foreign institutional investor.
Gap up
When the price of the share/index opens higher than its previous close.
Gap Down
When the price of the share/index opens lower than its previous close.
Green Shoe option
This provision is included in the underwriting agreement. This provision allows the underwriter the right to sell more shares to investors (generally up to 15% of the original issue). This is done when the demand for a security is higher than expected. It is also referred to as the Over-allotment option.
Grey Market
Refers to illegal and unofficial deals of unlisted companies taking place outside the purview of the regulators.
Hammering
Continuous selling of shares by operators to bring down the share prices.
Hedging
Is a method to reduce risk. The purpose of hedging is to insure against a loss. It is done by taking simultaneous positions in different asset classes e.g. Shares – options, future – options etc.
Inactive Shares
Shares of companies which are traded irregularly with low volumes. Inactive shares cannot be easily bought or sold.
In the black
Showing a profit.
In the red
Showing a loss.
Insider trading
Means trading in shares after being in possession of information about the company which is not available to the general public.
IPO
Stands for initial public offering. It means shares offered to the public by the company for the 1st time.
K
Symbol for one thousand
Kerb Trades
Refers to the unofficial trade of shares outside the purview of the stock exchange.
Lambs
Refers to gullible small traders or investors.
Leverage
Borrowing on your existing shares/assets.
Limit Order
A price limit given to the broker. In case of a buy order the broker cannot buy the shares above the price limit and in case of a sell order a broker cannot sell the shares below the price limit.
Listed Company
A company which has a listing agreement with the stock exchange and whose share prices are quoted and listed on the stock exchange.
Lot
The minimum fixed number of a company‟s share which can be bought or sold.
Long Trades
Also referred as long positions or going long; in long trades you buy the shares first, wait for the price to go up and then sell it at the higher price for a profit. In long trades the stop loss is below the purchase price.
Margin
The minimum amount of money to be deposited with a broker for taking a position.
Mark to market
Recording the price or value of a security, portfolio or account on a daily basis to calculate profits or losses or to confirm that margin requirements are being met.
Market forces
The forces of demand and supply which influence the stock prices/indices.
Market Capitalization
Also known as market cap; indicates the size of stock available. It is calculated as current market price of share x no. of shares outstanding
Margin Trading
Is trading with borrowed funds or securities. Generally you can trade up to 2 – 10 times on the amount deposited with the broker (as per the guidelines on the type of shares and facilities offered by your broker).
Melt down
Fast uncontrolled fall in the share prices.
Mixed Trend
If there is a bullish trend for some shares and bearish trend for other shares in other words if there is no clear direction it is called as a mixed trend.
Mahurat Trading
Short trading session on the auspicious day of diwali.
Market Breadth
Also known as advance decline ratio it indicates the difference between the numbers of stocks advancing with that of the number of stocks declining. If the numbers of stocks advancing are more than the number of stocks declining then it indicates positive market breadth and if the number of stocks declining are more than the number of shares advancing then it indicates negative market breadth.
Nifty
It is the index of the National stock exchange which reflects the market movement, comprises of 50 select shares.
Overbought
A stock is considered overbought when the price of a share rises as a result of heavy buying by investors and speculators. Once a share price reaches the overbought zone it will fall as there will be profit booking by the existing holders.
Oversold
A stock is considered oversold when the stock price has fallen due to excessive selling. Once the share price reaches an oversold zone, the price will start going up as the low price would attract buying interest.
Price to earnings ratio
Also known as PE ratio, it is computed by dividing the current price by the EPS.
Position
A trader or investor‟s stake in a particular share. Long position indicates number of shares bought and short position indicates number of shares sold.
Punters
Speculators who hope to make quick profits.
Quoted price
The price at which the share was last bought and sold on the stock exchange.
Rally
Continuous rise in the price of a share or in the overall market.
Range
The high and low price of a stock or the market over a period of time.
Resistance levels
It is price level where traders do not wish to buy but would like to sell and book profit. Resistance is that level where there is a strong selling pressure and the rise in the share price is repeatedly halted as there are more sellers than buyers at that price point. If the price breaks this level it will gain strength and move to higher levels.
Rolling Settlement
Means that all trades have to be settled by end of the day. In India we have T+ 2 settlement cycle. Which means that the transaction entered into day 1 has to be settled in day 1 + 2 working days where the pay in of funds and or securities pay out has to take place.
Scrip
Share certificate.
Short trades
Also referred as short selling, going short or short position; in short trades you sell stocks first and then buy it when the price falls to a lower level and make a profit. In the
stock market you can sell shares without actually possessing them, but you have to buy back the shares before the market closes on that day, failing which the shares will be auctioned and you will have to bear the loss. If the price increases and goes above your selling price you will incur a loss. In short trades the stop loss is above the selling price.
Specified shares
The most widely and actively traded shares also known as A group securities.
Stop loss
Is a mechanism to get out of wrong trades with a minimal loss. It is an exit price level fixed by a trader to minimize his/her loss if the trade goes against the expectation.
Support level
Is the level where there traders do not wish to sell but would like to buy. There is a strong buying pressure which keeps the share price from going down further. It is a level at which the fall in the share price is repeatedly halted as there are more buyers than sellers at the price point. If the price breaks this level it will lose strength and fall to lower levels.
Square up
Closing the position.
Technical correction
A small downward movement of share prices in a rising market usually as a result of profit booking because the prices have either reached their target level or are at a major resistance level.
Technical rally
A temporary rise in stock prices in a falling market, generally as a result of investors buying at the current low levels or the prices may have reached support levels.
Trading range
The range in which a share price has been trading between a high and low point over a specified period of time.
Trend
Shows the direction of the market or a stock at that particular time. A trend can be of short, medium or long term. If the stock prices are going up it is termed as a uptrend, If the stock prices are coming down it is termed as a downtrend. If there is no clear direction in the movement it is termed as a mixed trend.
Undervalued shares
Shares quoting below their book or intrinsic value.
Unrealized loss
Loss not actually sustained. A trader will sustain loss only when he sells the shares whose prices have depreciated until then he will have unrealized loss.
Realized loss
Loss actually sustained.
Unrealized profits
Profits not actually realized. A trader will earn profit only when he sells shares whose prices have appreciated until then he will have unrealized profit.
Realized Profit
Profits actually made.
Chapter 4
Cash Segment
As the word cash tells us all the transactions are done in cash. In India trading in the markets begins at 9.15 am sharp and closes at 3.30 pm sharp. There is compulsory rolling settlement which takes place. The buyer has to pay in full for the shares bought and the seller has to deliver the shares sold. If the seller fails to deliver the shares sold then the shares are auctioned.
Auction
Auction is a mechanism used by the stock exchange to protect the interests of the buying community. If the seller fails to deliver the shares sold.
Ways to trade in the cash segment
There are 2 basic ways to trade in the cash segment Intraday and delivery see figure 4.1 given below.
Figure 4.1
Intraday trading
In India trading in the stock markets starts dot at 9.15 am not a second late or a second early and closes dot at 3.30 pm not a second late or a second early; Intraday trading means taking a position & exiting (squaring up) from the position on the same day before the market close. What it means is that a person could enter into a position anytime from 9.15 am and exit from the position before 3.30 pm. This does not mean that one has to take a position at 9.15 am itself and exit at 3.30pm, one can take a position at let‟s say 10.00 am and exit 10.10 am or one can take a position at 12.45 pm and exit at 3.25pm. Currently in India NRI‟s are not allowed to do intraday trading.
In intraday there are 2 ways to trade. See the figure below. Before we move ahead let us understand the concept of margin trading.
Margin trading
Depending on the type of scrip as to whether it is a “A” group scrip or a “B” group scrip, a trader would be allowed to trade over and above his or her base capital deposited with the broker. It is a temporary credit or overdraft given with the condition that the position is squared off before the markets close.
1) Long: In this type of position we first buy the shares wait for the price to go up and then sell it at the higher price, the difference being our profit. If the price goes below the purchase price we make a loss.
Example : We buy 200 shares of Fast rise co at Rs. 100 and the price rises and goes up to Rs. 106. We sell and square up our position at Rs. 106, hence our profit will be 106(selling price) – 100(buying price) = 6 x 200 = 1200.
2) Short sell: In this type of position we first sell the shares wait for the price to come down and then buy it at the lower price, the difference being our profit. If the price goes above the selling price we make a loss.
In the stock markets one is allowed to sell the shares even if one does not have possession of the shares sold but the selling member has to mandatorily buy the shares sold on the same day before the markets close. If the selling member fails to buy (square up) the number of shares sold before the markets close then the quantity of shares sold are auctioned the next day; the selling member has to bear the costs or penalty. No logic, reason or excuse is accepted.
Example : We sell 200 shares of Fast fall co at Rs. 150 and the price falls and comes down to Rs. 140. We buy and square up our position at Rs. 140, hence our profit will be 150(selling price) – 140(buying price) = 10 x 200 = 2000.
Risk management
Most of the traders entering the markets are not successful and lose a lot of money because of 3 main reasons which are; Fear, greed and an ineffective or a virtually nonexistent risk management technique. To be a successful trader it is of utmost importance to be disciplined, be in control of emotions and have an effective risk management technique in place.
The risk management technique is the main factor which will determine whether a person will survive and make consistent profits or a person will go bankrupt and be thrown out of business.
To support this theory let us consider some examples:
Example 1: Mr. Badluck has a base capital of Rs. 100000 and is into day trading, his broker is giving him a margin trading limit of 10 times his base capital i.e. the broker is allowing Mr. Badluck to have positions up to Rs. 1000000. Mr. Badluck wants to purchase the shares of Unstable co. ltd which is trading at Rs. 1000/ per share.
Mr. Badluck uses the entire limit available and purchases 1000 shares at the price of Rs. 1000 with a stop loss of Rs. 990 and a target of 1020, unfortunately the stop loss gets triggered and Mr. Badluck incurs a loss of Rs. 10 per share. The total loss incurred would be total number of shares x loss per share, so in the above case the total loss would be 1000 x 10 = Rs. 10000.
Now how much is 10000 of the base capital of 100000 of Mr. Badluck; it amounts to a whopping 10%. Mr. Badluck enters into another 5 trades and gets a similar result; in other words Mr. Badluck has done 6 trades and lost 10% on each trade. Hence the total loss of Mr. Badluck is 6 x 10% = 60%. The numbers give a very clear picture Mr. Badluck has lost 60% of his capital.
Do you think Mr. Badluck will be able to recover the lost 60% capital out of his remaining 40% capital? The answer is no. Though it is not impossible but it is very difficult. Honestly let‟s get real that‟s wishful thinking. A couple more of such trades and we will see Mr. Badluck saying good bye to the stock markets.
Ok, then how do we go about it or what is the way to do it?
The answer is simple, we follow the thumb rule. Professional or successful traders as a rule of the thumb ensure that they do not lose more than 2% of their capital in a single trade if the share price movement goes against expectation and the stop loss is triggered.
By following this rule even if you make losses in 10 successive trades (which is highly improbable) you will not lose more than 20% of your capital. Do you think it is possible to recover the lost 20% capital with 80% capital left? The answer is a very definitive yes.
Let‟s consider an example.
Example 2: Like Mr. Badluck, we have a base capital of Rs. 100000 and are into day trading, our broker too is giving us a margin trading limit of 10 times the base capital i.e. the broker is also allowing us to have positions up to Rs. 1000000. Similarly like Mr. Badluck we also want to purchase the shares of Unstable co. ltd which is trading at Rs. 1000/ per share.
Now this is where we start to differ from Mr. Badluck.
Unlike Mr. Badluck the maximum amount of risk we are willing to take per trade is 2% of our base capital, hence amount wise the maximum amount of loss to be taken is 2000 per trade.
So though we have the limit to buy 1000 shares we will buy only 200 shares. Now, why only 200 or why 200? The calculation is simple; the difference between the purchase price (1000) and the stop loss (990) is 10. Hence if we buy 200 shares and the stop loss gets triggered we would stand to lose 200 x 10 = 2000 which is the maximum amount of risk that we are willing to take per trade and we are in sync with our risk management strategy.
Delivery based Trading
In delivery based trading a trader takes delivery of the shares purchased and sell it at a higher price on a later date to make profits. The later date could be after the next couple of days, next week or the next month or the next quarter or any period of time the trader is willing to wait for the target price to be hit. The concept of the stop loss and risk management is also applicable over here.
Example:
We purchase 100 shares of Wait & Watch Co. Ltd. at a price of Rs. 1000/per share with a target price of Rs. 1060. We wait for the price to rise and go up to our target price. We sell the shares once the price reaches the target price i.e. Rs 1060 and book our profit.
Different strategies are followed by traders who are into delivery based trading. Following a strategy depends on the trader‟s mindset, available capital, holding capacity etc. there is no one size fit all strategy, what is right for one may not be right for another. We shall discuss a couple of strategies, but this does mean that these are the only strategies. You as a trader have to decide what the best is for you because nobody knows your mindset and financial capability better than you yourself; this may involve developing an altogether new strategy.
First let‟s look at one of the common method followed by most of the traders;
Example:
We purchase 100 shares of Balancing Co. Ltd. at a price of Rs. 1000/per share. The next day the markets come down and the share price also falls and comes down to Rs. 950.
We purchase additional 100 shares at Rs. 950/per share, hence now our total holding is 200 shares at an average price of Rs. 975/per share. (100 X 1000 = 100000 + 100 X 950 = 95000 = 195000/200 = 975).
During the course of the next few days or weeks the share price falls further down to Rs. 920, we again purchase another additional 100 shares (some traders keep on doubling the quantity, in the current scenario they would purchase 200 shares, but we will stick to 100), hence our total holding now is 300 shares at an average price of Rs. 956.66/per share. (100 X 1000 = 100000 + 100 X 950 = 95000 + 100 X 920 = 92000 = 287000/300 = 956.66).
As you can observe this is a very capital intensive strategy and the trader needs to have a lot of patience and mental strength coupled with a high holding capacity in order to wait for the share price to come up and then sell it at a higher price to earn a profit.
Professional traders have a well chalked out trading strategy and use tools such as technical or fundamental analysis or hire the services of professional analysts to guide them in their trades.
Now let‟s look at some of the methods followed by professional traders;
Example 1:
We purchase 100 shares of Smart move Co. Ltd. at a price of Rs. 1000/per share. The markets start to come down and the share price also starts falling, we exit at Rs 980. We have incurred a loss of Rs. 20/per share. We wait for the markets to stop falling and take support and on signs of recovery we repurchase the shares. We find that the share price is taking support at around Rs. 920; hence we purchase 100 shares at Rs. 920. We will breakeven when the share price touches Rs. 940 (940-920 = 20; the current Rs. 20 profit offsets the Rs. 20 loss we had incurred earlier) the moment the share price starts going above Rs. 940 we start making profits and by the time the share price reaches our original acquisition price of Rs. 1000 we are in substantial profits.
As you can observe this is not a very capital intensive strategy and the trader is spared of the stress and anxiety of watching the price fall everyday and also the trader need not have a high holding capacity in order to wait for the share price to come up and then sell it at a higher price to earn a profit.
Example 2:
We purchase 100 shares of Speed breaker Co. Ltd. at a price of Rs. 1000/per share with a target price of Rs. 1200. The share price starts to rise and goes up to Rs. 1100 at this point of time we find that there is a reversal in the market sentiment and we expect the markets to come down temporarily so we sell the shares and book our profit. We will repurchase the shares again when we find that the markets have stopped falling and are on their way up; the repurchase could be at the original acquisition price i.e. Rs 1000 or a price lower than our original acquisition price or a price which is above our original acquisition price but below our selling price (i.e. Rs. 1100).
Important points to keep in mind while trading
 Understand you mindset and risk taking appetite.
 Have a strategy before entering a trade.
 In intraday trading close all positions before going out to attend any other work.
 Use proper analytical tools or hire the services of professional.
 Verify the credentials of the professional.
 Effective Risk Management.
 Never trade without a Stop loss
 Forget greed and Fear
 Always deal with a registered broker or sub-broker
 Always insist on a contract note
Chapter 5
Futures
A Future is called a derivative because it does not have a value of its own but derives its value from another underlying asset; the asset could be a stock, index, commodity, currency etc. A future is a contract to buy or sell an asset on a future date at a currently agreed price. The purpose of trading in futures is basically to speculate or to hedge a position. Currently in India NRI‟s are not allowed to trade in derivatives.
Futures‟ trading is a high risk and a high return game. A trader gains when another trader losses.
Futures can either be trading at a premium, or at par or at a discount. The explanation is given in the table below.
Premium
If the price in the futures is above the current spot price.
Par
If the price in the futures is the same as the current spot price.
Discount
If the price in the futures is below the current spot price.
Example 1: Future trading at a premium;
The current spot price of ICICI bank is Rs. 1000. The future of ICICI bank is trading at Rs. 1006. This means that the future of ICICI bank is trading at a premium.
Example 2: Future trading at par;
The current spot price of Axis bank is Rs. 1230. The future of Axis bank is trading at Rs. 1230. This means that the future of Axis bank is trading at par.
Example 2: Future trading at a discount;
The current spot price of HDFC bank is Rs. 2060. The future of HDFC bank is trading at Rs. 2050. This means that the future of HDFC bank is trading at par.
Lots
In the cash segment we can buy 1 share or 15 shares or 22 shares or any number of shares that we want, but in futures we deal in „LOTS‟. The lot size consists of a minimum
number of shares that can be transacted, all trades in futures as in options have to be in the multiples of lots, e.g. 1 lot or 2 lots or 3 lots so on and so forth.
Example: The Lot size of Nifty is 50. So if one wants to trade in the nifty futures and wants to either buy or sell 100 shares the trader will have to buy or sell 2 lots.
The lot size would vary for different companies, depending upon the share price and the volumes the regulator decides upon the lot size.
Example: The Lot size of Nifty is 50, the lot size of ICICI bank is 250, the lot size of Larsen and Toubro is 125.
Span Margin
In Futures trading traders are not required to pay the full amount as in the case of the cash segment but are required to maintain sufficient of margin in their accounts as a cover for potential losses. This margin is called as a Span margin; Span stands (standardized portfolio analysis of risk). In India the span margins generally range from 10% to 30%.
Open Interest
Refers to the total number of derivative contracts (Futures and/or options) which are open and are not expired, squared off or fulfilled by delivery, in other words not settled at the end of the day. Larger the open interest means more the activity and liquidity for the particular derivatives contract.
For every buyer there must be a seller. The buyer and the seller combine to create only 1 contract, the contract is considered open from the time a buyer or seller opens it to till the time the counter party closes it.
Example:
1) If there is a new buyer and a new seller and they initiate a position then the open interest increases by one contract
2) If both the buyer and seller are closing an existing position then the open interest decreases by one contract.
3) If the old buyer sells the contract to a new buyer then there is no change in the open interest.
Primarily applicable to the derivatives market, open interest measures the flow of money into the derivatives market and is often used to confirm the trends or the reversal of the trends in the derivatives market.
Expiry
Is the date when the contract expires; in other words it is the cut – off date after which the futures contract ceases to exit. In India the expiry takes place mandatorily on the last Thursday of the month irrespective of the date, the date could be the 31st or the 30th or even the 26th but it has to be the last Thursday of the month. There is a series in expiry which is illustrated in the table given below.
Current
the expiry is on the last Thursday of the current month
Near
the expiry is on the last Thursday of the next month
Far
the expiry is on the last Thursday of the next to next month
The trader has to specify the series at the time of entering the transaction.
Roll over
Refers to the process of shifting the futures contract of an underlying security of the current month or series and taking up a futures contract of the same underlying security for the next month or series.
Cost of Carry
In derivatives it refers to expense or cost incurred for holding a position.
Chapter 6
Options
An option is called a derivative because it does not have a value of its own but derives its value from another underlying asset; the asset could be a stock, index, commodity, currency etc. An option is contract to buy or sell an asset at a specified price on a certain date.
An Option is a “TIME BOUND ASSET” which means that with the passage of time its value keeps on eroding and after a certain time frame it loses its value. The purpose of trading in options is basically to speculate or to hedge a position. One should trade in options only with the amount of money even if lost does not affect the social or financial status, in short money which one is able & willing to risk.
Main Components
Options consists of 2 main components
Call
You buy a call when you expect the price to go up.
Put
You buy a put when you expect the price to come down.
Lots
In the cash segment we can buy 1 share or 15 shares or 22 shares or any number of shares that we want but in options we deal in „LOTS‟. The lot size consists of a minimum number of shares that can be transacted, all trades in options have to be in the multiples of lots, e.g. 1 lot or 2 lots or 3 lots so on and so forth.
Example: The Lot size of Nifty is 50. So if one wants to trade in the nifty option (either call or put) and wants to buy or sell 100 shares the trader will have to buy 2 lots.
The lot size would vary for different companies, depending upon the share price and the volumes the regulator decides upon the lot size.
Example: The Lot size of Nifty is 50, the lot size of ICICI bank is 250, the lot size of Larsen and Toubro is 125.
Strike Price
Strike price is the price at which the specified option can be exercised on expiry (explained below). Strike price is also called as the exercise price. In the case of a call options it means the price at which the shares can be bought on expiry and in the case of the put option the price at which the shares can be sold on expiry. The strike price is one of the key components in calculating the premium.
Premium
Premium is the price paid to acquire the option. Some of the factors considered while computing the premium is the difference between the current price and the strike price, current interest rates, time left to expiry (explained below) etc.
To explain things in a short and simple manner the total value the option premium consists of is the time value and the intrinsic value. As the expiry date comes closer the time value will start diminishing and go closer to 0, whereas the intrinsic value will closely reflect the difference between the current price of the underlying asset and the strike price.
Expiry
Is the date when the contract expires; in other words it is the cut – off date after which the options contract ceases to exit. In India the expiry takes place mandatorily on the last Thursday of the month irrespective of the date, the date could be the 31st or the 30th or even the 26th but it has to be the last Thursday of the month. There is a series in expiry which is illustrated in the table given below.
Current
the expiry is on the last Thursday of the current month
Near
the expiry is on the last Thursday of the next month
Far
the expiry is on the last Thursday of the next to next month
The trader has to specify the series at the time of entering the transaction.
Options Style
There are two styles of options which are explained in the table given below:
American Option
Are those options which can be exercised after the purchase date but on or before the expiry.
European Option
Are those options which can be exercised only on expiry.
Options Types
There are 3 types of options which are explained in the table given below:
In the Money
Has a positive intrinsic value. i.e. the holder will have a positive cash flow if the option is exercised immediately
At the Money
Has no intrinsic value. Current price = Strike price
Out of Money
Has no intrinsic value.
In the case of a Call option
In the Money
In this the current market price is higher than the strike price, in other words the current price is above or greater than the strike price.
At the Money
In this the current market price is equal to the strike price, in other words the current price and the strike price are the same or equal.
Out of Money
In this the current market price is lower than the strike price, in other words the current price is below or lesser than the strike price.
Example 1: In the Money;
If we are holding a call option of ICICI bank with strike price of 980 and the current spot price of ICICI bank is Rs. 1000; then the option is said to be in the money.
Example 2: At the Money;
If we are holding a call option of ICICI bank with strike price of 1000 and the current spot price of ICICI bank is Rs. 1000; then the option is said to be at the money.
Example 3: Out the Money;
If we are holding a call option of ICICI bank with strike price of 1020 and the current spot price of ICICI bank is Rs. 1000; then the option is said to be out of money.
In the case of a Put option
In the Money
In this the current market price is lower than the strike price, in other
words the current price is below or lesser than the strike price.
At the Money
In this the current market price is equal to the strike price, in other words the current price and the strike price are the same or equal.
Out of Money
In this the current market price is higher than the strike price, in other words the current price is above or greater than the strike price.
Example 1: In the Money;
If we are holding a put option of ICICI bank with strike price of 1020 and the current spot price of ICICI bank is Rs. 1000; then the option is said to be in the money.
Example 2: At the Money;
If we are holding a put option of ICICI bank with strike price of 1000 and the current spot price of ICICI bank is Rs. 1000; then the option is said to be at the money.
Example 3: Out the Money;
If we are holding a put option of ICICI bank with strike price of 980 and the current spot price of ICICI bank is Rs. 1000; then the option is said to be out of money.
Trading in options
Options can be either bought or sold. Traders who buy options are called as holders and traders who sell the options are called writers. Traders who buy options have to pay the premium; and traders who sell the options receive the premium.
Traders who have bought options will make a profit when the premium goes up and traders who have written (sold) the options will make a profit when the premium comes down. Let‟s look at the price to premium relation in the figure given below.
A trader need not wait till expiry to from a position in options; a trader can square up and exit at any given point of time after purchasing an option, it could be the next minute, or after a couple of minutes, or hours or days in short any time before expiry. The reason for the exit could either be that the target is achieved and the trader wants to book the profit or the stop loss has been triggered.
Example:
Scenario 1
Let us assume that we had bought a nifty option (either call or put) with a strike price of 5400 by paying a premium of Rs. 100. After a couple of minutes, or hours or days we see that the premium has risen and gone up to Rs. 130. We decide to square up our position and book the profit, so we sell the option and book our profit. Our profit stands at Rs. 30 (130- 100) x the lot size.
Scenario 2
Let us assume that we had bought a nifty option (either call or put) with a strike price of 5400 by paying a premium of Rs. 100. After a couple of minutes, or hours or days we see that the premium has fallen and come down to Rs. 80 which is our stop loss level. We decide to square up our position and book the loss, so we sell the option and book our loss. Our loss stands at Rs. 20 (100- 80) x the lot size.
Price to premium relation
Figure 6.1
As we can see in the figure 6.1 given above; in the case of a call option if the price goes up the premium will go up and in the case of a put option if the price comes down the premium will go up.
The maximum risk of loss faced by a trader who buys an option is the premium paid, In other words the loss is limited and the profit can be unlimited. A trader who buys the option has the right but not an obligation to exercise on expiry.
The maximum profit a trader who has sold an option can earn is the premium received, in other words the profit is limited and the loss can be unlimited. A trader who sells (writes) the option does not have a right but has an obligation to exercise on expiry.
Time Value effect
As mentioned earlier options are time bound assets and with the passage of time the premium value keeps on eroding. Let‟s refer the example given below to understand the effect.
Example: let us assume that the Nifty is currently trading at 5450 and we expect the markets to go up; so we buy a call option with a strike price of 5400 at a premium of Rs. 180.
After a week‟s time we find that the nifty is at the 5450 level (the same level when we entered the position) but the premium of the call option would probably be quoting at Rs. 160. Wondering how the premium has fallen despite the market being at the same level of our entry point; this is because of the time value. The options premium comprises of the intrinsic value and the time value (i.e. time remaining up to expiry) so as the time elapses the time value keeps on eroding.
What happens to the option we are holding on expiry!
On expiry the option holder gets the differential value of the closing market price and the strike price, condition being that it has to be an In the money option.
Example:
In case of a Call option
Scenario 1
Let us assume that we had bought a nifty call option with a strike price of 5400 by paying a premium of Rs. 100. On expiry the closing price of Nifty was 5440. In this scenario the closing price is above the strike price hence it is an in the money option. We will get the difference between the closing price and the strike price which is Rs. 40 (5440 – 5400); but we have incurred a loss of Rs. 60 (100– 40).
Scenario 2
Let us assume that we had bought a nifty call option with a strike price of 5400 by paying a premium of Rs. 100. On expiry the closing price of Nifty was 5570. In this scenario the closing price is above the strike price hence it is an in the money option. We will get the difference between the closing price and the strike price which is Rs. 170 (5570 – 5400); hence we have made a profit of Rs. 70 (170– 100).
Scenario 3
Let us assume that we had bought a nifty call option with a strike price of 5400 by paying a premium of Rs. 100. On expiry the closing price of Nifty was 5399.99; in this case we will get Rs. 0 as the closing market price is below the strike price hence it is an out of money option; hence we have incurred a loss of Rs. 100 (i.e. the premium paid).
Example:
In case of a Put option
Scenario 1
Let us assume that we had bought a nifty put option with a strike price of 5400 by paying a premium of Rs. 100. On expiry the closing price of Nifty was 5350. In this scenario the closing price is below the strike price hence it is an in the money option. We will get the difference between the closing price and the strike price which is Rs. 50 (5400 – 5350); but we have incurred a loss of Rs. 50 (100– 50).
Scenario 2
Let us assume that we had bought a nifty call option with a strike price of 5400 by paying a premium of Rs. 100. On expiry the closing price of Nifty was 5260. In this scenario the closing price is below the strike price hence it is an in the money option. We will get the difference between the closing price and the strike price which is Rs. 140 (5400 – 5260); hence we have made a profit of Rs. 40 (140– 100).
Scenario 3
Let us assume that we had bought a nifty put option with a strike price of 5400 by paying a premium of Rs. 100. On expiry the closing price of Nifty was 5401; in this case we will get Rs. 0 as the closing market price is above the strike price hence it is an out of money option; hence we have incurred a loss of Rs. 100 (i.e. the premium paid).
Important points to keep in mind while trading in Options
 Never play in percentage of profit calculation, always play with amount of profit.
 Never average in options.
 Exit in options (in case you are holding a naked position) as soon as you reached your target, as it‟s a time bond asset its premium decreases as expiry is coming closer.
 Purpose is to make profit not to make low investment, so avoid Out of money Options.
Chapter 7
Cash trading v/s Futures trading

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