Varsity

ZERODHA
Introduction to
Stock Markets
ZERODHA.COM/VARSITY
TABLE OF CONTENTS
1 The Need to Invest 1

1.1 Why should one invest 1
1.2 Where to invest 3
1.3 Fixed income instruments 5
1.4 Equity 5
1.5 Real estate 6
1.6 Commodity - Bullion 6
1.7 A note on investments 7
1.8 What are the things to know before investing 7
2 Regulators 9
2.1 What is a stock market? 9
2.2 Stock market participants and the need to regulate them 10
2.3 The Regulator 11
3 Financial Intermediaries 15
3.1 Overview 15
3.2 The Stock broker 16
3.3 Depository and Depository Participants 17
3.4 Banks 18
3.5 NSCCL and ICCL 18
4 The IPO Markets - Part 1 21

4.1 Overview 21
4.2 Origin of a business 21
5 The IPO Markets - Part 2 32

5.1 Overview 32
5.2 Why do companies go public 33
5.3 Merchant bankers 34
5.4 IPO sequence of events 35
5.5 What happens after the IPO 36
5.6 Few IPO Jargons 36
5.7 Recent IPO’s in India 37
6 The Stock Markets 40

6.1 Overview 40
6.2 What really is the stock market ? 41
6.3 What moves the stock ? 42
6.4 How does the stock get traded ? 44
6.5 What happens after you own a stock ? 45
6.6 A note on the holding period 45
6.7 How to calculate returns ? 46
6.8 Where do you fit in ? 47
7 The Stock Markets Index 50

7.1 Overview 50
7.2 The Index 51
7.3 Practical uses of the Index 51
7.4 Index construction methodology 53
7.5 Sector specific indices 57
8 Commonly used Jargons 59
9 The Trading Terminal 65

9.1 Overview 65
9.2 The Login Process 66
9.3 The Market Watch 66
9.4 Buying a stock through the trading terminal 69
9.5 The order book and Trade book 71
9.6 The Bid and Ask price 75
9.7 Conclusion 77
10 Clearing and Settlement process 79

10.1 Overview 79
10.2 What happens when you buy a stock 80
10.3 What happens when you sell a stock 82
11 Five corporate actions and its impact on stock prices 84

11.1 Overview 84
11.2 Dividends 85
11.3 Bonus Issue 86
11.4 Stock split 87
11.5 Rights issue 88
11.6 Buyback of shares 88
12 Key Events and Their Impact on Markets 91

12.1 Overview 91
12.2 Monetary policy 92
12.3 Inflation 93
12.4 Index of Industrial Production 94
12.5 Purchasing Manager index 95
12.6 Budget 95
12.7 Corporate Earnings Announcement 96
13 Getting started 99
13.1 So many modules - how are they interrelated 100
C H A PT E R 1
The Need to Invest
1.1 - Why should one Invest?

Before we address the above question, let us understand what would happen if one choose not
to invest. Let us assume you earn Rs.50,000/- per month and you spend Rs.30,000/- towards your
cost of living which includes housing, food, transport, shopping, medical etc. The balance of
Rs.20,000/- is your monthly surplus. For the sake of simplicity, let us just ignore the effect of per-
sonal income tax in this discussion.
1. To drive the point across, let us make few simple assumptions.

2. The employer is kind enough to give you a 10% salary hike every year
3. The cost of living is likely to go up by 8% year on year
4. You are 30 years old and plan to retire at 50. This leaves you with 20 more years to earn
5. You don’t intend to work after you retire
6. Your expenses are fixed and don’t foresee any other expense
7. The balance cash of Rs.20,000/- per month is retained in the form of hard cash
Going by these assumptions, here is how the cash balance will look like in 20 years as per Table
1.1
1 zerodha.com/varsity
Table 1.1 - Total cash balance in twenty years
If one were to analyze these numbers, you would soon realize this is a scary situation to be in.
Years Yearly income Yearly expense Cash retained
1 600,000 360,000 240,000
2 6,60,000 3,88,800 2,71,200
3 7,26,000 4,19,904 3,06,096
4 7,98,600 4,53,496 3,45,104
5 8,78,460 4,89,776 3,88,684
6 9,66,306 5,28,958 4,37,348
7 10,62,937 5,71,275 4,91,662
8 11,69,230 6,16,977 5,52,254
9 12,86,153 6,66,335 6,19,818
10 14,14,769 7,19,642 6,95,127
11 15,56,245 7,77,213 7,79,032
12 17,11,870 8,39,390 8,72,480
13 18,83,057 9,06,541 9,76,516
14 20,71,363 9,79,065 10,92,298
15 22,78,499 10,57,390 12,21,109
16 25,06,349 11,41,981 13,64,368
17 27,56,984 12,33,339 15,23,644
18 30,32,682 13,32,006 17,00,676
19 33,35,950 14,38,567 18,97,383
20 36,69,545 15,53,652 21,15,893
Total Income 17,890,693
Few things are quite startling from the above calculations:
1. After 20 years of hard work you have accumulated Rs.1.7 Crs.

2. Since your expenses are fixed, your lifestyle has not changed over the years, you probably
even suppressed your lifelong aspirations – better home, better car, vacations etc
3. After you retire, assuming the expenses will continue to grow at 8%, Rs.1.7 Crs is good
enough to sail you through roughly for about 8 years of post retirement life. 8th year onwards
you will be in a very tight spot with literally no savings left to back you up.
What would you do after you run out of all the money in 8 years time? How do you fund your life?
Is there a way to ensure that you collect a larger sum at the end of 20 years?
Let’s consider another scenario as per Table 1.2 in the following page where instead of keeping
the cash idle, you choose to invest the cash in an investment option that grows at let’s say 12%
per annum. For example – in the first year you retained Rs.240,000/- which when invested at 12%
per annum for 20 years yields Rs.2,067,063/- at the end of 20th year.
With the decision to invest the surplus cash, your cash balance has increased significantly. The
cash balance has grown to Rs.4.26 Crs from Rs.1.7 Crs. This is a staggering 2.4x times the regular
amount. This translates to you being in a much better situation to deal with your post retirement
life.
Now, going back to the initial question of why invest? There are few compelling reasons for one to
invest..
1. Fight Inflation – By investing one can deal better with the inevitable – growing cost of living –
generally referred to as Inflation
2. Create Wealth – By investing one can aim to have a better corpus by the end of the defined
time period. In the above example the time period was upto retirement but it can be anything
– children’s education, marriage, house purchase, retirement holidays etc
3. To meet life’s financial aspiration
1.2 - Where to invest?

Having figured out the reasons to invest, the next obvious question would be – Where would one
invest, and what are the returns one could expect by investing.
When it comes to investing one has to choose an asset class that suits the individual’s risk and
return temperament.
Table 1.2 - Cash invested at 12% per annum
Retained Cash
Years Yearly income Yearly expense Cash retained
Invested @12%
1 600,000 360,000 240,000 20,67,063
2 6,60,000 3,88,800 2,71,200 20,85,519
3 7,26,000 4,19,904 3,06,096 21,01,668
4 7,98,600 4,53,496 3,45,104 21,15,621
5 8,78,460 4,89,776 3,88,684 21,27,487
6 9,66,306 5,28,958 4,37,348 21,37,368
7 10,62,937 5,71,275 4,91,662 21,45,363
8 11,69,230 6,16,977 5,52,254 21,51,566
9 12,86,153 6,66,335 6,19,818 21,56,069
10 14,14,769 7,19,642 6,95,127 21,58,959
11 15,56,245 7,77,213 7,79,032 21,60,318
12 17,11,870 8,39,390 8,72,480 21,60,228
13 18,83,057 9,06,541 9,76,516 21,58,765
14 20,71,363 9,79,065 10,92,298 21,56,003
15 22,78,499 10,57,390 12,21,109 21,52,012
16 25,06,349 11,41,981 13,64,368 21,46,859
17 27,56,984 12,33,339 15,23,644 21,40,611
18 30,32,682 13,32,006 17,00,676 21,33,328
19 33,35,950 14,38,567 18,97,383 21,25,069
20 36,69,545 15,53,652 21,15,893 21,15,893
TOTAL CASH AFTER 20 YEARS 4,26,95,771
An asset class is a category of investment with particular risk and return characteristics. The fol-
lowing are some of the popular assets class…
1. Fixed income instruments

2. Equity
3. Real estate
4. Commodities (precious metals)
Fixed Income Instruments

These are investable instruments with very limited risk to the principle and the
return is paid as an interest to the investor based on the particular fixed income
instrument. The interest paid, could be quarterly, semi-annual or annual inter-
vals. At the end of the term of deposit, (also known as maturity period) the capital
is returned to the investor.
Typical fixed income investment includes:
1. Fixed deposits offered by banks

2. Bonds issued by the Government of India
3. Bonds issued by Government related agencies such as HUDCO, NHAI etc
4. Bonds issued by corporates
As of June 2014, the typical return from a fixed income instrument varies between 8% and 11%.
Equity
Investment in Equities involves buying shares of publicly listed companies. The
shares are traded both on the Bombay Stock Exchange (BSE), and the Na-
tional Stock Exchange (NSE).
When an investor invests in equity, unlike a fixed income instrument there is no capital guaran-
tee. However as a trade off, the returns from equity investment can be extremely attractive. In-
dian Equities have generated returns close to 14% – 15% CAGR (compound annual growth rate)
over the past 15 years.
Investing in some of the best and well run Indian companies has yielded over 20% CAGR in the
long term. Identifying such investments opportunities requires skill, hard work and patience.
You may also be interested to know that the returns generated over a long term period (above
365 days, also called long term capital gain) are completely exempted from personal income tax.
This is an added attraction to investing in equities.
Real Estate
Real Estate investment involves transacting (buying and selling) commercial and
non commercial land. Typical examples would include transacting in sites, apart-
ments and commercial buildings. There are two sources of income from real es-
tate investments namely – Rental income, and Capital appreciation of the invest-
ment amount.
The transaction procedure can be quite complex involving legal verification of documents. The
cash outlay in real estate investment is usually quite large. There is no official metric to measure
the returns generated by real estate, hence it would be hard to comment on this.
Commodity – Bullion
Investments in gold and silver are considered one of the most popular invest-
ment avenues. Gold and silver over a long-term period has appreciated in value.
Investments in these metals have yielded a CAGR return of approximately 8%
over the last 20 years. There are several ways to invest in gold and silver. One can
choose to invest in the form of jewelry or Exchange Traded Funds (ETF).
Going back to our initial example of investing the surplus cash it would be interesting to see how
much one would have saved by the end of 20 years considering he has the option of investing in
any one – fixed income, equity or bullion.By investing in fixed income at an average rate of 9% per
annum, the corpus would have grown to Rs.3.3 Crs
1. By investing in fixed income at an average rate of 9% per annum, the corpus would have
grown to Rs.3.3 Crs
2.Investing in equities at an average rate of 15% per annum, the corpus would have
grown to Rs.5.4 Crs
3. Investing in bullion at an average rate of 8% per annum, the corpus would have grown to Rs.
3.09 Crs
Clearly, equities tend to give you the best returns especially when you have a multi – year invest-
ment perspective.
A note on investments
Investments optimally should have a strong mix of all asset classes. It is smart to diversify your
investment among the various asset classes. The technique of allocating money across assets
classes is termed as ‘Asset Allocation’.
For instance, a young professional may be able take a higher amount of risk given his age and
years of investment available to him. Typically investor should allocate around 70% of his investa-
ble amount in Equity, 20% in Precious metals, and the rest in Fixed income investments.
Alongside the same rationale, a retired person could invest 80 percent of his saving in fixed in-
come, 10 percent in equity markets and a 10 percent in precious metals. The ratio in which one
allocates investments across asset classes is dependent on the risk appetite of the investor.
1.3 - What are the things to know before investing

Investing is a great option, but before you venture into investments it is good to be aware of the
following…
1. Risk and Return go hand in hand. Higher the risk, higher the return. Lower the risk, lower is
the return.
2. Investment in fixed income is a good option if you want to protect your principal amount. It is
relatively less risky. However you have the risk of losing money when you adjust the return for
inflation. Example – A fixed deposit which gives you 9% when the inflation is 10% means you
are net net losing 1% per annum. Fixed income investment is best suited for ultra risk averse
investors
3. Investment in Equities is a great option. It is known to beat the inflation over long period of
times. Historically equity investment has generated returns close to 14-15%. However, equity
investments can be risky
4. Real Estate investment requires a large outlay of cash and cannot be done with smaller
amounts. Liquidity is another issue with real estate investment – you cannot buy or sell
whenever you want. You always have to wait for the right time and the right buyer or seller to
transact with you.
5. Gold and silver are known to be a relatively safer but the historical return on such investment
has not been very encouraging.
Key takeaways from this chapter
1. Invest to secure your future

2. The corpus that you intend to build at the end of the defined period is sensitive to the rate of
return the investment generates. A small variation to rate can have a big impact on the corpus
3. Choose an instrument that best suits your risk and return appetite
4. Equity should be a part of your investment if you want to beat the inflation in the long run
C H A PT E R 2
Regulators
2.1 - What is a stock market?

• Investing in equities is an important investment that we make in order to generate inflation
beating returns. This was the conclusion we drew from the previous chapter. Having said that,
how do we go about investing in equities? Clearly before we dwell further into this topic, it is ex-
tremely important to understand the ecosystem in which equities operate.
Just like the way we go to the neighborhood kirana store or a super market to shop for our daily
needs, similarly we go to the stock market to shop (read as transact) for equity investments.
Stock market is where everyone who wants to transact in shares go to. Transact in simple terms
means buying and selling. For all practical purposes, you can’t buy/sell shares of a public com-
pany like Infosys without transacting through the stock markets.
The main purpose of the stock market is to help you facilitate your transactions. So if you are a
buyer of a share, the stock market helps you meet the seller and vice versa.
Now unlike a super market, the stock market does not exist in a brick and mortar form. It exists in
electronic form. You access the market electronically from your computer and go about conduct-
ing your transactions (buying and selling of shares).
Also, it is important to note that you can access the stock market via a registered intermediary
called the stock broker. We will discuss more about the stock brokers at a later point.
There are two main stock exchanges in India that make up the stock markets. They are the Bom-
bay Stock Exchange (BSE) and the National Stock Exchange (NSE). Besides these two exchanges
there are a bunch of other regional stock exchanges like Bangalore Stock Exchange, Madras Stock
Exchange that are more or less getting phased out and don’t really play any meaningful role any-
more.
2.2 - Stock Market Participants and the need to regulate them

The stock market attracts individuals and corporations from diverse backgrounds. Anyone who
transacts in the stock market is called a market participant. The market participant can be classi-
fied into various categories. Some of the categories of market participants are as follows:
1. Domestic Retail Participants – These are people like you and me transacting in markets
2. NRI’s and OCI – These are people of Indian origin but based outside India
3. Domestic Institutions – These are large corporate entities based in India. Classic example
would be the LIC of India.
4. Domestic Asset Management Companies (AMC) – Typical participants in this category
would be the mutual fund companies such as SBI Mutual Fund, DSP Black Rock, Fidelity
Investments, HDFC AMC etc.
5. Foreign Institutional Investors – Non Indian corporate entities. These could be foreign
asset management companies, hedge funds and other investors
Now, irrespective of the category of market participant the agenda for everyone is the same – to
make profitable transactions. More bluntly put – to make money.
When money is involved, human emotions in the form of greed and fear run high. One can easily
fall prey to these emotions and get involved in unfair practices. India has its fair share of such
twisted practices, thanks the operations of Harshad Mehta and the like.
Given this, the stock markets need someone who can set the rules of the game (commonly re-
ferred to as regulation and compliance) and ensure that people adhere to these regulations and
compliance thereby making the markets a level playing field for everyone.
2.3 - The Regulator
In India the stock market regulator is called The Securities and Exchange board of India often
referred to as SEBI. The objective of SEBI is to promote the development of stock exchanges, pro-
tect the interest of retail investors, regulate the activities of market participants and financial in-
termediaries. In general SEBI ensures…
1. The stock exchanges (BSE and NSE) conducts its business fairly
2. Stock brokers and sub brokers conduct their business fairly
3. Participants don’t get involved in unfair practices
4. Corporate’s don’t use the markets to unduly benefit themselves (Example – Satyam
Computers)
5. Small retail investors interest are protected
6. Large investors with huge cash pile should not manipulate the markets
7. Overall development of markets
Given the above objectives it becomes imperative for SEBI to regulate the following entities. All
the entities mentioned below in Table 2.1 are directly involved in the stock markets. A malprac-
tice by anyone of the following entities can disrupt what is otherwise a harmonious market in In-
dia.
SEBI has prescribed a set of rules and regulation to each one of these entities. The entity should
operate within the legal framework as prescribed by SEBI. The specific rules applicable to a spe-
cific entity are made available by SEBI on their website. They are published under the ‘Legal
Framework’ section of their site.
Table 2.1 - Regulators in India
Example of
Entity What do they do? In simpler words
companies
They rate the credit

If a corporate or Govt entity wants to avail
Credit Rating CRISIL, ICRA, worthiness of
loan, CRA checks if the entity is worthy of
Agency (CRA) CARE corporate and
giving a loan
governments
When companies want to raise a loan they

can issue debenture against which they
Debenture Almost all banks Act as a trustee to promise to pay an interest. These
Trustees in India corporate debenture debentures can be subscribed by public. A
Debenture Trustee ensures that the
debenture obligation is honored
Acts like a vault for the shares that you buy.

The depositories hold your shares and
Safekeeping, facilitate exchange of your securities. When
reporting and you buy shares these shares sit in your
Depositories NSDL and CDSL
settlement of clients Depositary account usually referred to as the
securities DEMAT account. This is maintained
electronically by only two companies in
India
Most of the banks You cannot directly interact with NSDL or

Depositary Act as an agent to the
and few stock CDSL. You need to liaison with a DP to open
Participant (DP) two depositories
brokers and maintain you DEMAT account
These are foreign entities with an interest to

Foreign Foreign invest in India. They usually transact in large
Make investments in
Institutional corporate, funds amounts of money, and hence their activity
India
Investors and individuals in the markets have an impact in terms of
market sentiment
Example of
Entity What do they do? In simpler words
companies
If a company plans to raise money by

Help companies raise
Merchant Karvy, Axis Bank, floating an IPO, then merchant bankers are
money in the primary
Bankers Edelweiss Capital the ones who help companies with the IPO
markets
process
An AMC collects money from the public,

Asset HDFC AMC, puts that money in a single account and
Offer Mutual Fund
Management Reliance Capital, then invest that money in markets with an
Schemes
Companies(AMC) SBI Capital objective of making the investments grow
and thereby generate wealth to its investors.
Portfolio
Managers/
They work similar to a mutual fund except in
Religare Wealth Offer PMS schemes
Portfolio a PMS you have to invest a minimum of Rs.
Management,
Management 25,00,000 however there is no such cap in a
Parag Parikh PMS
System mutual fund
(PMS)
Stock Brokers Act as a intermediary Whenever you want to buy or sell shares
Zerodha,
and Sub Brokers between an investor from the stock exchange you have to do so
Sharekhan, ICICI
and the stock through registered stock brokers. A sub
Direct
exchange broker is like an agent to a stock broker
1. Stock market is the place to go to if you want to transact in equities

2. Stock markets exists electronically and can be accessed through a stock broker
3. There are many different kinds of market participants operating in the stock markets
4. Every entity operating in the market has to be regulated and they can operate only within the
framework as prescribed by the regulator
5. SEBI is the regulator of the securities market in India. They set the legal frame work and
regulate all entities interested in operating in the market.
6. Most importantly you need to remember that SEBI is aware of what you are doing and they
can flag you down if you are up to something fishy in the markets!
C H A PT E R 3
Financial Intermediaries
3.1 - Overview
From the time you access the market – let’s just say, to buy a stock till the time the stocks comes
and hits your DEMAT account, a bunch of corporate entities are actively involved in making this
work for you. These entities play their role quietly behind the scene, always complying with the
rules laid out by SEBI and ensure an effortless and smooth experience for your transactions in the
stock market. These entities are generally referred to as the Financial Intermediaries.
Together, these financial intermediaries, interdependent of one another, create an ecosystem in

which the financial markets exists. This chapter will help you get an overview of who these finan-
cial intermediaries are and the services they offer.
3.2 - The Stock Broker
The stock broker is probably one of the most important financial intermediaries that you
need to know. A stock broker is a corporate entity, registered as a trading member with the stock
exchange and holds a stock broking license. They operate under the guidelines prescribed by
SEBI.
A stock broker is your gateway to stock exchanges. To begin with, you need to open something
called as a ‘Trading Account’ with a broker who meets your requirement. Your requirement could
be as simple as the proximity between the broker’s office and your house. At the same time it can
be as complicated as identifying a broker who can provide you a single platform using which you
can transact across multiple exchanges across the world. At a later point we will discuss what
these requirements could be and how to choose the right broker.
A trading account lets you carry financial transactions in the market. A trading account is an ac-
count with the broker which lets the investor to buy/sell securities.
So assuming you have a trading account - whenever you want to transact in the markets you
need to interact with your broker. There are few standard ways through which you can interact
with your broker.
1. You can go to the broker’s office and meet the dealer in the broker’s office and tell him what
you wish to do. A dealer is an executive at the stock broker’s office who carries out these
transactions on your behalf.
2. You can make a telephone call to your broker, identify yourself with your client code (account
code) and place an order for your transaction. The dealer at the other end will execute the
order for you and confirm the status of the same while you are still on the call.
3. Do it yourself – this is perhaps the most popular way of transacting in the markets. The
broker gives you access to the market through software called ‘Trading Terminal’. After you
login in to the trading terminal, you can view live price quotes from the market, and can also
place orders yourself.
The basic services provided by the brokers includes..
1. Give you access to markets and letting you transact

2. Give you margins for trading – We will discuss this point at a later stage
3. Provide support – Dealing support if you have to call and trade. Software support if you have
issues with the trading terminal
4. Issue contract notes for the transactions – A contract note is a written confirmation detailing
the transactions you have carried out during the day
5. Facilitate the fund transfer between your trading and bank account
6. Provide you with a back office login – using which you can see the summary of your account
7. The broker charges a fee for the services that he provides called the ‘brokerage charge’ or
just brokerage. The brokerage rates vary, and its up to you to find a broker who strikes a
balance between the fee he collects versus the services he provides.
3.3 - Depository and Depository Participants

When you buy a property the only way to identify and claim that you actually own the prop-
erty is by producing the property papers. Hence it becomes extremely important to store the
property papers in a safe and secure place.
Likewise when you buy a share (a share represents a part ownership in a company) the only way
to claim your ownership is by producing your share certificate. A share certificate is nothing but a
piece of document entitling you as the owner of the shares in a company.
Before 1996 the share certificate was in paper format however post 1996, the share certificates
were converted to digital form. The process of converting paper format share certificate into digi-
tal format share certificate is called “Dematerialization” often abbreviated as DEMAT.
The share certificate in DEMAT format has to be stored digitally. The storage place for the digital
share certificate is the ‘DEMAT Account’. A Depository is a financial intermediary which offers the
service of Demat account. A DEMAT account in your name will have all the shares in electronic for-
mat you have bought. Think of DEMAT account as a digital vault for your shares.
As you may have guessed, the trading account from your broker and the DEMAT account from the
Depository are interlinked.
So for example if your idea is to buy Infosys shares then all you need to do is open your trading ac-
count, look for the prices of Infosys and buy it. Once the transaction is complete, the role of your
trading account is done. After you buy, the shares of Infosys will automatically come and sit in
your DEMAT account.
Likewise when you wish to sell Infosys shares, all you have to do is open your trading account and
sell the stock. This takes care of the transaction part…however in the backend, the shares which
are sitting in your DEMAT account will get debited, and the shares move out of your DEMAT ac-
count.
At present there are only two depositaries offering you DEMAT account services. They are The Na-
tional Securities Depository Limited (NSDL) and Central Depository Services (India) Limited.
There is virtually no difference between the two and both of them operate under strict SEBI regu-
lations.
Just like the way you cannot walk into National Stock Exchange’s office to open a trading ac-
count, you cannot walk into a Depository to open a DEMAT account. To open a DEMAT account
you need to liaison with a Depository Participant (DP). A DP helps you set up your DEMAT account
with a Depository. A DP acts as an agent to the Depository. Needless to say, even the DP is gov-
erned by the regulations laid out by the SEBI.
3.4 - Banks
Banks play a very straight forward role in the market ecosystem. They help in facilitating
the fund transfer from your bank account to your trading account. You may be interested to note
that for a given trading account only one bank account can be interlinked. You cannot transfer
money from a bank account that is not in your name.
If you have multiple bank accounts, you need to specify which particular bank account that will
be linked to your trading account. Of course you can remove the bank account and link it with an-
other bank account of yours, but that requires some amount of paper work. However, for the
money to come in and go out of your trading account, it has to happen only via the bank account
that has been specified and linked.
Also, at this stage, you must have realized that the three financial intermediaries operate via
three different accounts - trading account, DEMAT account and Bank account. All the three ac-
counts operate electronically and are interlinked giving you a very seamless experience.
3.5 NSCCL and ICCL

NSCCL – National Security Clearing Corporation Ltd and Indian Clearing Corporation are wholly
owned subsidiaries of National Stock Exchange and Bombay Stock Exchange respectively.
The job of the clearing corporation is to ensure guaranteed settlement of your trades/
transactions. For example if you were to buy 1 share of Biocon at Rs.446 per share there must be
someone who has sold that 1 share to you at Rs.446 . For this transaction, you will be debited
Rs.446 from your trading account and someone must be credited that Rs.446 toward the sale of
Biocon. In a typical transaction like this the clearing corporation’s role is to ensure the following:
a) Identify the buyer and seller and match the debit and credit process
b) Ensure no defaults – The clearing corporation also ensures there are no defaults by either
party. For instance the seller after selling the shares should not be in a position to back out
thereby defaulting in his transaction.
For all practical purposes, its ok not to know much about NSCCL or ICCL simply because, you as a
trader or investor would not be interacting with these agencies directly. You just need to be
aware that there are certain professional institutions which are heavily regulated and they work
towards smooth settlement, and efficient clearing activity.
1. The market ecosystem is built by a cluster of financial intermediaries, each offering services
that are unique to the functioning of markets
2. A stock broker is your access to markets, so make sure you choose a broker that matches
your requirements, and services well.
3. A stock broker provides you a trading account which is used for all market related
transactions (buying and selling of financial instruments like shares)
4. A Depository Participant (DP) is a corporate entity that holds the shares in electronic form
against your name in your account. Your account with the DP is called the ‘DEMAT’ account
5. There are only two depositories in India – NSDL and CDSL
6. To open a DEMAT account with one of the depositaries you need to liaison with a Depository
Participant (DP). A DP functions as an agent to the Depository
7. A clearing corporation works towards clearing and settling of trades executed by you.
C H A PT E R 4
The IPO Markets - Part 1

4.1 - Overview
The initial three chapters has set the background on some of the basic market concepts that you
need to know. At this stage it becomes imperative to address a very basic question – Why do com-
panies go public?
A good understanding of this topic lays down a sound foundation for all future topics. We will
learn new financial concepts during the course of this chapter.
4.2 - Origin of a Business

Before we jump ahead to seek an answer as to why companies go public, let us spend some time
figuring out a more basic concept - the origins of a typical business. To understand this concept
better, we will build a tangible story around it. Let us split this story into several scenes just so
that we get a clear understanding of how the business and the funding environment evolves.
SCENE 1 – THE ANGELS
Let us imagine a budding entrepreneur with a brilliant business idea – to manufacture highly fash-
ionable, organic cotton t-shirts. The designs are unique, has attractive price points and the best
quality cotton is used to make these t-shirts. He is confident that the business will be successful,
and is all enthusiastic to launch the idea into a business.
As a typical entrepreneur he is likely to be hit by the typical problem – where would he get the
money to fund the idea? Assuming the entrepreneur has no business background he will not at-
tract any serious investor at the initial stage. Chances are, he would approach his family and
friends to pitch the idea and raise some money. He could approach the bank for a loan as well but
this would not be the best option.
Let us assume that he pools in his own money and also convinces two of his good friends to in-
vest in his business. Because these two friends are investing at the pre revenue stage and taking a
blind bet on the entrepreneur they would be called the Angel investors. Please note, the money
from the angels is not a loan, it is actually an investment made by them.
So let us imagine that the promoter along with the angels raise INR 5 Crore in capital. This initial
money that he gets to kick start his business is called ‘The Seed Fund’. It is important to note
that the seed fund will not sit in the entrepreneur’s (also called the promoter) personal bank ac-
count but instead sits in the company’s bank account. Once the seed capital hits the company’s
bank account, the money will be referred to as the initial share capital of the company.
In return of the initial seed investment, the original three (promoter plus 2 angels) will be issued
share certificates of the company which entitles them an ownership in the company.
The only asset that the company has at this stage is cash of INR 5 Crs, hence the value of the com-
pany is also INR 5 Crs. This is called the company’s valuation.
Issuing shares is quite simple, the company assumes that each share is worth Rs.10 and because
there is Rs.5 crore as share capital, there has to be 50 lakh shares with each share worth Rs.10. In
this context, Rs.10 is called the ‘Face value’ (FV) of the share. The face value could be any number.
If the FV is Rs.5, then the number of shares would be 1 crore, so on and so forth.
The total of 50 lakh shares is called the Authorized shares of the company. These shares have to
be allotted amongst the promoter and two angels plus the company has to retain some amount
of shares with itself to be issued in the future.
So let us assume the promoter retains 40% of the shares and the two angels get 5% each and the
company retains 50% of the shares. Since the promoter and two angels own 50% of the shares,
this allotted portion is called Issued shares.
Table 4.1 - Initial Shareholding Pattern
Name of Share
Sl No No of Shares %Holding
Holder
1 Promoter 2,000,000 40%
2 Angel 1 250,000 5%
3 Angel 2 250,000 5%
Total 2,500,000 50%
The share holding pattern of this company would look something like this..
Please note the balance 50% of the shares totaling 2,500,000 equity shares are retained by the
company. These shares are authorized but not allotted.
Now backed by a good company structure and a healthy seed fund the promoter kick starts his
business operations. He wants to move cautiously, hence he decides to open just one small manu-
facturing unit and one store to retail his product.
S C E N E 2 – T H E V E N T U R E C A P I TA L I S T
His hard work pays off and the business starts to pick up. At the end of the first two years of opera-
tions, the company starts to break even. The promoter is now no longer a rookie business owner,
instead he is more knowledgeable about his own business and of course more confident.
Backed by his confidence, the promoter now wants to expand his business by adding 1 more
manufacturing unit and few additional retail stores in the city. He chalks out the plan and figures
out that the fresh investment needed for his business expansion is INR 7 Crs.
He is now in a better situation when compared to where he was two years ago. The big difference
is the fact that his business is generating revenues. Healthy inflow of revenue validates the busi-
ness and its offerings. He is now in a situation where he can access reasonably savvy investors for
investing in his business. Let us assume he meets one such professional investor who agrees to
give him 7 Crs for a 14% stake in his company.
The investor who typically invests in such early stage of business is called a Venture Capitalist
(VC) and the money that the business gets at this stage is called Series A funding.
After the company agrees to allot 14% to the VC from the authorized capital the shareholding pat-
tern looks like this:
Table 4.2 - Second stage shareholding pattern
Name of Share
Holder
1 Promoter 2,000,000 40%
2 Angel 1 250,000 5%
3 Angel 2 250,000 5%
4 Venture Capitalist 700,000 14%
Total 3,200,000 64%
Note, the balance 36% of shares is still retained within the company and has not been issued.
Now, with the VC’s money coming into the business, a very interesting development has taken
place. The VC is valuing the entire business at INR 50 Crs by valuing his 14% stake in the com-
pany at INR 7Crs. With the initial valuation of 5Crs, there is a 10 fold increase in the company’s
valuation. This is what a good business plan, validated by a healthy revenue stream can do to
businesses. It works as a perfect recipe for wealth creation.
With the valuations going up, the investments made by the initial investors will have an impact.
The following table summarizes the same…
Table 4.3 - Third stage shareholding pattern
Name of Share Initial Initial Shareholding Valuation Wealth

Sl No
Holder Shareholding Valuation after 2 Yrs after 2 Yrs Created
1 Promoter 40% 2 Crs 40% 20 Crs 10 times
2 Angel 1 5% 25 Lakhs 5% 2.5 Crs 10 times
3 Angel 2 5% 25 Lakhs 5% 2.5 Crs 10 times
Venture
4 0% -NA- 14% 07 Crs -NA-
Capitalist
Total 50% 2.5 Crs 64% 32 Crs
Going forward with our story, the promoter now has the additional capital he requires for the
business. The company gets an additional manufacturing unit and few more retail outlets in the
city as planned. Things are going great; popularity of the product grows, translating into higher
revenues, management team gets more professional thereby increasing the operational effi-
ciency and all this translates to better profits.
SCENE 3 – THE BANKER
Three more years pass by and the company is phenomenally successful. The company decides to
have a retail presence in at least 3 more cities. To back the retail presence across three cities, the
company also plans to increase the production capacity and hire more resources. Whenever a
company plans such expenditure to improve the overall business, the expenditure is called ‘Capi-
tal Expenditure’ or simply ‘CAPEX’.
The management estimates 40Crs towards their Capex requirements. How does the company get
this money or in other words, how can the company fund its Capex requirements?
There are few options with the company to raise the required funds for their Capex…
1. The company has made some profits over the last few years; a part of the Capex requirement
can be funded through the profits. This is also called funding through internal accruals
2. The company can approach another VC and raise another round of VC funding by allotting
shares from the authorized capital – this is called Series B funding
3. The company can approach a bank and seek a loan. The bank would be happy to tender this
loan as the company has been doing fairly well. The loan is also called ‘Debt’
The company decides to exercise all the three options at its disposal to raise the funds for Capex.
It ploughs 15Crs from internal accruals, plans a series B - divests 5% equity for a consideration of
10Crs from another VC and raise 15Crs debt from the banker.
Note, with 10Crs coming in for 5%, the valuation of the company now stands at 200 Crs. Of
course, this may seem a bit exaggerated, but then the whole purpose of this story is drive across
the concept!
The shareholding and valuation look something like this
Table 4.4 - Fourth stage shareholding pattern
Name of Share
Sl No No of Shares %Holding Valuation
Holder
1 Promoter 2,000,000 40% 80 Crs
2 Angel 1 250,000 5% 10 Crs
3 Angel 2 250,000 5% 10 Crs
4 VC Series A 700,000 14% 28 Crs
5 VC Series B 250,000 5% 10 Crs
Note, the company still has 31% of shares not allotted to shareholders which are now being val-
ued at 62 Crs. Also, I would encourage you to think about the wealth that has been created over
the years. This is exactly what happens to entrepreneurs with great business ideas, and with a
highly competent management team.
Classic real world examples of such wealth creation stories would be Infosys, Page Industries, Ei-
cher Motors, Titan industries and in the international space one could think of Google, Facebook,
Twitter, Whats app etc.
S C E N E 4 – T H E P R I VAT E E Q U I T Y
Few years pass by and the company’s success continues to shine on. With the growing success of
this 8 year old, 200 Cr Company, the ambitions are also growing. The company decides to raise
the bar and branch out across the country. They also decide to diversify the company by manufac-
turing and retailing fashion accessories, designer cosmetics and perfumes.
The capex requirement for the new ambition is now pegged at 60 Crs. The company does not
want to raise money through debt because of the interest rate burden, also called the finance
charges which would eat away the profits the company generates.
They decide to allot shares from the authorized capital for a Series C funding. They cannot ap-
proach a typical VC because VC funding is usually small and runs into few crores. This is when a
Private Equity (PE) investor comes into the picture.
PE investors are quite savvy. They are highly qualified, and have an excellent professional back-
ground. They invest large amounts of money with the objective of not only providing the capital
for constructive use but also place their own people on the board of the investee company to en-
sure the company steers in the required direction.
Assuming they pick up 15% stake for a consideration of 60Crs, they are now valuing the company
at 400Crs. Let’s have a quick look at the share holding and valuations..
Table 4.5 - Fifth stage shareholding pattern
Name of Share Valuation (in

Holder Crs)
1 Promoter 2,000,000 40% 160
2 Angel 1 250,000 5% 20
3 Angel 2 250,000 5% 20
4 VC Series A 700,000 14% 56
5 VC Series B 250,000 5% 20
6 PE Series C 1,000,000 15% 60
Total 4,450,000 84% 336
Please note, the company has retained back 16% stake which has not been allotted to any share-
holder. This portion is valued at 64 Crs
Usually, when a PE invests, they invest with an objective to fund large capex requirements. Be-
sides they do not invest in the early stage of a business instead they prefer to invest in companies
that already has a revenue stream, and is in operation for a few years. The process of deploying
the PE capital and utilizing the capital for the capex requirements takes up a few years.
SCENE 5 – THE IPO
5 years after the PE investment, the company has progressed really well. They have successfully
diversified their product portfolio plus they have a presence across all the major cities in the
country. Revenues are good, profitability is stable and the investors are happy. The promoter
however does not want settle in for just this.
The promoter now aspires to go international! He wants his brand to be available across all the
major international cities; he wants at least two outlets in each major city across the world.
This means, the company needs to invest in market research to understand what people like in
other countries, they need to invest in people, and also work towards increasing the manufactur-
ing capacities. Besides they also need to invest into real estate space across the world.
This time around the Capex requirement is huge and the management estimates this at 200 Crs.
The company has few options to fund the Capex requirement.
1. Fund Capex from internal accruals

2. Raise Series D from another PE fund
3. Raise debt from bankers
4. Float a bond (this is another form of raising debt)
5. File for an Initial Public Offer (IPO) by allotting shares from authorized capital
6. A combination of all the above
For sake of convenience, let us assume the company decides to fund the capex partly through in-
ternal accruals and also file for an IPO. When a company files for an IPO, they have to offer their
shares to the general public. The general public will subscribe to the shares (i.e if they want to) by
paying a certain price. Now, because the company is offering the shares for the first time to the
public, it is called the “Initial Public Offer’.
We are now at a very crucial juncture, where a few questions needs to be answered..
1. Why did the company decide to file for an IPO? In general why do companies go public?
2. Why did they not file for the IPO when they were in Series A, B and C situation?
3. What would happen to the existing share holders after the IPO?
4. What do the general public look for before they subscribe to the IPO?
5. How does the IPO process evolve?
6. Who are the financial intermediaries involved in the IPO markets?
7. What happens after the company goes public?
In the following chapter we will address each of the above questions plus more, and we will also
give you more insights to the IPO Market. For now, hopefully you should have developed a sense
of how a successful company evolves before they come out to the public to offer their shares.
The purpose of this chapter is to just give you a sense of completeness when one thinks about an
IPO.
1. Before understanding why companies go public, it is important to understand the origin of

business
2. The people who invest in your business in the pre-revenue stage are called Angel Investors
3. Angel investors take maximum risk. They take in as much risk as the promoter
4. The money that angels give to start the business is called the seed fund
5. Angel’s invest relatively a small amount of capital
6. Valuation of a company simply signifies how much the company is valued at. When one
values the company they consider the company’s assets and liabilities
7. A face value is simply a denominator to indicate how much one share is originally worth
8. Authorized shares of the company is the total number of shares that are available with the
company
9. The shares distributed from the authorized shares are called the issued shares. Issued shares
are always a subset of authorized shares.
10.The shareholding pattern of a company tells us who owns how much stake in the company
11.Venture Capitalists invest at an early stage in business; they do not take as much risk as
Angel investors. The quantum of investments by a VC is usually somewhere in between an
angel and private equity investment
12.The money the company spends on business expansion is called capital expenditure or
capex
13.Series A, B, andC etc are all funding that the company seeks as they start evolving. Usually
higher the series, higher is the investment required.
14.Beyond a certain size, VCs cannot invest, and hence the company seeking investments will
have to approach Private Equity firms
15.PE firms invest large sums of money and they usually invest at a slightly more mature stage
of the business
16.In terms of risk, PE’s have a lower risk appetite as compared to VC or angels
17.Typical PE investors would like to deploy their own people on the board of the investee
company to ensure business moves in the right direction
18.The valuation of the company increases as and when the business , revenues and
profitability increases
19.An IPO is a process by means of which a company can raise fund. The funds raised can be for
any valid reason – for CAPEX, restructuring debt, rewarding shareholders etc
C H A PT E R 5
The IPO Markets - Part 2

5.1 - Overview
The previous chapter gave us an understanding on how a company evolved right from the idea
generation stage to all the way till it decides to file for an IPO. The idea behind creating the fic-
tional story in the previous chapter was to give you a sense of how a business matures over time.
The emphasis obviously was on the different stages of business and funding options available at
various stages of business. The previous chapter gives you a perspective of what a company
would have gone through before it comes out to public to offer its shares.
This is extremely important to know because the IPO market, also called the Primary market
sometimes attracts companies offering their shares to public without actually going through a
healthy round of funding in the past. Few rounds of funding by credible VC, and PE firm validate
the quality of the business and its promoters. Of course you need to treat this with a pinch of salt
but nevertheless it acts as an indicator to identify well run companies.
5.2 - Why do companies go public?
We closed the previous chapter with few very critical questions. One of which – Why did the com-
pany decide to file for an IPO, and in general why do companies go public?
When a company decides to file for an IPO, invariably the main reason is to raise funds to fuel
their Capex requirement. The promoter has 3 advantages by taking his company public..
1. He is raising funds to meet Capex requirement
2. He is avoiding the need to raise debt which means he does not have to pay finance charges
which translates to better profitability
3. Whenever you buy a share of a company, you are in essence taking the same amount of risk as
the promoter is taking. Needless to say, the proportion of the risk and its impact will depend on
the quantity of shares you hold. Nonetheless, whether you like it or not, when you buy shares
you also buy risk. So when the company goes public, the promoter is actually spreading his risk
amongst a large group of people.
There are other advantages as well in going for an IPO…
1. Provide an exit for early investors - Once the company goes public, the shares of the
company start trading publicly. Any existing shareholder of the company – could be promoters,
angel investors, venture capitalist, PE funds; can use this opportunity to sell their shares in the
open market. By selling their shares, they get an exit on their initial investment in the company.
They can also choose to sell their shares in smaller chunks if they wish.
2. Reward employees –Employees working for the company would have shares allotted to
them as an incentive. This sort of arrangement between the employee and the company is
called the “Employee Stock Option”. The shares are allotted at a discount to the employees.
Once the company goes public, the employees stand a chance to see capital appreciation in
the shares. Few examples where the employee benefited from ESOP would be Google, Infosys,
Twitter, Facebook etc
3. Improve visibility - Going public definitely increases visibility as the company has a status of
being publicly held and traded. There is a greater chance of people’s interest in the company,
consequently creating a positive impact on its growth.
So let’s just build on our fictional business story from the previous chapter a little further and fig-
ure out the IPO details of this company.
If you recollect, the company requires 200 Crs to fund their capex and the management had de-
cided to fund this partly by internal accrual and partly by filing for an IPO.
Do recollect that company still has 16% of authorized capital translating to 800,000 shares which
are not allotted. The last valuation of these shares when the PE firm invested in Series B was
64Crs. The company has progressed really well ever since the PE firm has invested and naturally
the valuation of these shares would have gone up.
For the sake of simplicity, let us assume the company is now valuing the 16% shares anywhere be-
tween 125 Crs to 150 Crs. This translates to a per share value, anywhere between Rs.1562 to
Rs.1875/-…(125Crs/8lakh).
So if the company puts 16% on the block to the public, they are likely to raise anywhere between
125 to 150 Crs. The remainder has to come from internal accruals. So naturally, the more money
they raise, better it is for the company.
5.3 - Merchant Bankers

Having decided to go public, the company must now do a series of things to ensure a successful
initial public offering. The first and foremost step would be to appoint a merchant banker. Mer-
chant bankers are also called Book Running Lead Managers (BRLM)/Lead Manager (LM). The
job of a merchant banker is to assist the company with various aspects of the IPO process includ-
ing…
• Conduct a due diligence on the company filing for an IPO, ensure their legal compliance and
also issue a due diligence certificate
• Should work closely with the company and prepare their listing documents including Draft Red
Herring Prospectus (DRHP). We will discuss this in a bit more detail at a later stage
• Underwrite shares – By underwriting shares, merchant bankers essentially agree to buy all or
part of the IPO shares and resell the same to public
• Help company arrive at the price band for the IPO. A price band is the lower and upper limit of
the share price within which the company will go public. In case of our example, the price band
will be Rs.1562/- and Rs.1875/-
• Help the company with the road shows – This is like a promotional/marketing activity for the
company’s IPO
• Appointment of other intermediaries namely, registrars, bankers, advertising agencies etc. The
Lead manager also makes various marketing strategies for the issue
Once the company partners with the merchant banker, they will work towards taking the com-
pany public.
5.4 - IPO sequence of events

Needless to say each and every step involved in the IPO sequence has to happen under the SEBI
guidelines. In general, the following are the sequence of steps involved.
• Appoint a merchant banker. In case of a large public issue, the company can appoint more
than 1 merchant banker
• Apply to SEBI with a registration statement – The registration statement contains details on
what the company does, why the company plans to go public and the financial health of the
company
• Getting a nod from SEBI – Once SEBI receives the registration statement, SEBI takes a call on
whether to issue a go ahead or a ‘no go’ to the IPO
• DRHP – If the company gets the initial SEBI nod, then the company needs to prepare the DRHP.
A DRHP is a document that gets circulated to the public. Along with a lot of information, DRHP
should contain the following details..
a.The estimated size of the IPO

b.The estimated number of shares being offered to public
c.Why the company wants to go public and how does the company plan to utilize the funds
along with the timeline projection of fund utilization
d.Business description including the revenue model, expenditure details
e.Complete financial statements
f.Management Discussion and Analysis – how the company perceives the future business op-
erations to emerge
g.Risks involved in the business
h.Management details and their background
• Market the IPO – This would involve TV and print advertisements in order to build awareness
about the company and its IPO offering. This process is also called the IPO road show
• Fix the price band – Decide the price band between which the company would like to go pub-
lic. Of course this can’t be way off the general perception. If it is, then the public will not sub-
scribe for the IPO
• Book Building – Once the road show is done and price band fixed the company now has to offi-
cially open the window during which the public can subscribe for shares. For example, if the
price band is between Rs.100 and Rs.120, then the public can actually choose a price they think
is fair enough for the IPO issue. The process of collecting all these price points along with the re-
spective quantities is called Book Building. Book building is perceived as an effective price dis-
covery method
• Closure – After the book building window is closed (generally open for few days) then the price
point at which the issue gets listed is decided. This price point is usually that price at which
maximum bids have been received.
• Listing Day – This is the day when the company actually gets listed on the stock exchange. The
listing price is the price discovered through the book building process.
5.5 - What happens after the IPO?

During the bidding process (also called the date of issue) investors can bid for shares at a particu-
lar price within the specified price band. This whole system around the date of issue where one
bids for shares is referred to as the Primary Market. The moment the stock gets listed and de-
buts on the stock exchange, the stock starts to trade publicly. This is called the secondary mar-
kets.
Once the stock transitions from primary markets to secondary markets, the stock gets traded
daily on the stock exchange. People start buying and selling the stocks regularly.
Why do people trade? Why does the stock price fluctuate? Well, we will answer all these ques-
tions and more in the subsequent chapters.
5.6 Few key IPO jargons

Before we wrap up the chapter on IPO’s let us review few important IPO jargons.
Under Subscription – Let’s say the company wants to offer 100,000 shares to the public. Dur-
ing the book building process it is discovered that only 90,000 bids were received, then the issue
is said to be under subscribed. This is not a great situation to be in as it indicates negative public
sentiment
Over subscription – If there are 200,000 bids for 100,000 shares on offer then the issue is said
to be oversubscribed 2 times (2x)
Green Shoe Option - Part of the underwriting agreement which allows the issuer to author-
ize additional shares (typically 15 percent) to be distributed in the event of over subscription.
This is also called the over allotment option
Fixed Price IPO –Sometimes the companies fix the price of the IPO and do not opt for a price
band. Such issues are called fixed price IPO
Price Band and Cut off price –Price band is a price range between which the stock gets
listed. For example if the price band is between Rs.100 and Rs.130, then the issue can list within
the range. Let’s says it gets listed at 125, then 125 is called the cut off price.
Recent IPO’s in India*

Here is a look at few recent IPO’s in India. With all the background information you now have,
reading Table 5.1 in the following page should be easy
Table 5.1 - Recent IPO’s in India
Issue Price Issue Size Price Band

Sl No Name of Issue BRLM Date of Issue
(INR) (Lakh Shares) (INR)
Edelweiss 115 to 125

21/04/2014 to
Financial
Wonderla 23/04/2014
1 125 Services and 14,500,000
Holidays Limited
ICICI Securities
Limited
03/12/2013 to
Power Grid
SBI, Citi, ICICI, 06/12/2013
2 Coporation of 90 787,053,309 85 to 90
Kotak, UBS
India Ltd
20/05/2013 to 470 to 543

Citi, Morgan 22/05/2013
3 Just Dial Ltd 530 17,493,458
Stanley
165 to 172
13/03/2013 to
1,57,20,262
Repco Homes SBI, IDFC, JM 15/03/2013
4 172
Finance Limited Financials
01/02/2013 to
195 to 215
V-Mart Retail 05/02/2013
5 210 Anand Rathi 4,496,000
Ltd
*Source : NSE India, as of June 2014
1. Companies go public to raise funds, provide an exit for early investors, reward employees
and gain visibility
2. Merchant banker acts as a key partner with the company during the IPO process
3. SEBI regulates the IPO market and has the final word on whether a company can go public
or not
4. As an investor in the IPO you should read through the DRHP to know everything about the
company
5. Most of the IPOs in India follow a book building process
C H A PT E R 6
The Stock Markets

6.1 - Overview
Having understood the IPO process and what really goes behind the company’s transition from
primary to secondary market we are now set to explore the stock markets a step further.
By virtue of being a public company, the company is now liable to disclose all information related
to the company to the public. The shares of a public limited company are traded on the stock ex-
changes on a daily basis.
There are few reasons why market participants trade stocks. We will explore these reasons in this
chapter.
6.2 - What really is the stock market?
Like we discussed in chapter 2, the stock market is an electronic market place. Buyers and sellers
meet and trade their point of view.
For example, consider the current situation of Infosys. At the time of writing this, Infosys is facing
a succession issue, and most of its senior level management personnel are quitting the company
for internal reasons. It seems like the leadership vacuum is weighing down the company’s reputa-
tion heavily. As a result, the stock price dropped to Rs.3,000 all the way from Rs.3,500. Whenever
there are new reports regarding Infosys management change, the stock prices react to it.
Assume there are two traders – T1 and T2.
T1’s point of view on Infosys - The stock price is likely to go down further because the company
will find it challenging to find a new CEO.
If T1 trades as per his point of view, he should be a seller of the Infosys stock.
T2, however views the same situation in a different light and therefore has a different point of
view – According to him, the stock price of Infosys has over reacted to the succession issue and
soon the company will find a great leader, after whose appointment the stock price will move up-
wards.
If T2 trades as per his point of view, he should be a buyer of the Infosys stock.
So at, Rs.3, 000 T1 will be a seller, and T2 will be a buyer in Infosys.
Now both T1 and T2 will place orders to sell and buy the stocks respectively through their respec-
tive stock brokers. The stock broker, obviously routes it to the stock exchange.
The stock exchange has to ensure that these two orders are matched, and the trade gets exe-
cuted. This is the primary job of the stock market – to create a market place for the buyer and
seller.
The stock market is a place where market participants can access any publicly listed company
and trade from their point of view, as long as there are other participants who have an opposing
point of view. After all, different opinions are what make a market.
6.3 - What moves the stock?
Let us continue with the Infosys example to understand how stocks really move. Imagine you are
a market participant tracking Infosys.
It is 10:00 AM on 11th June 2014 ,and the price of Infosys is 3000. The management makes a state-
ment to the press that they have managed to find a new CEO who is expected to steer the com-
pany to greater heights. They are confident on his capabilities and they are sure that the new CEO
will deliver much more than what is expected out of him.
Two questions –
a.How will the stock price of Infosys react to this news?

b.If you were to place a trade on Infosys, what would it be? Would be a buy or a sell?
The answer to the first question is quite simple, the stock price will move up.
Infosys had a leadership issue, and the company has fixed it. When positive announcements are
made market participants tend to buy the stock at any given price and this cascades into a stock
price rally.
Let me illustrate this further in Table 6.1
Table 6.1 - Trade Flow
What price What does

Last Traded New Last
Sl No Time the seller the buyer
Price Trade Price
wants do?
1 10:00 3000 3002 He buys 3002
2 10:01 3002 3006 He buys 3006
3 10:03 3006 3011 He buys 3011
4 10:05 3011 3016 He buys 3016
Notice, whatever prices the seller wants the buyer is willing to pay for it. This buyer-seller reac-
tion tends to push the share price higher.
So as you can see, the stock price jumped 16 Rupees in a matter of 5 minutes. Though this is a fic-
tional situation, it is a very realistic, and typical behavior of stocks. The stocks price tends to go
up when the news is good or expected to be good.
In this particular case, the stock moves up because of two reasons. One, the leadership issue has
been fixed, and two, there is also an expectation that the new CEO will steer the company to
greater heights.
The answer to the second question is now quite simple; you buy Infosys stocks considering the
fact that there is good news surrounding the stock.
Now, moving forward in the same day, at 12:30 PM ‘The National Association of Software & Serv-
ices company’, popularly abbreviated as NASSCOM makes a statement. For those who are not
aware, NASSCOM is a trade association of Indian IT companies. NASSCOM is considered to be a
very powerful organization and whatever they say has an impact on the IT industry.
The NASSCOM makes a statement stating that the customer’s IT budget seems to have come
down by 15%, and this could have an impact on the industry going forward.
By 12:30 PM let us assume Infosys is trading at 3030. Few questions for you..
a.How does this new information impact Infosys?

b.If you were to initiate a new trade with this information what would it be?
c.What would happen to the other IT stocks in the market?
The answers to the above questions are quite simple. Before we start answering these questions,
let us analyze NASSCOM’s statement in a bit more detail.
NASSCOM says that the customer’s IT budget is likely to shrink by 15%. This means the revenues
and the profits of IT companies are most likely to go down soon. This is not great news for the IT
industry.
Let us now try and answer the above questions..
a.Infosys being a leading IT major in the country will react to this news. The reaction could
be mixed one because earlier during the day there was good news specific to Infosys. How-
ever a 15% decline in revenue is a serious matter and hence Infosys stocks are likely to trade
lower
b.At 3030, if one were to initiate a new trade based on the new information, it would be a
sell on Infosys
c.The information released by NASSCOM is applicable to the entire IT stocks and not just
Infosys. Hence all IT companies are likely to witness a selling pressure.
So as you notice, market participants react to news and events and their reaction translates to
price movements! This is what makes the stocks move.
At this stage you may have a very practical and valid question brewing in your mind. You may be
thinking what if there is no news today about a particular company? Will the stock price stay flat
and not move at all?
Well, the answer is both yes and no, and it really depends on the company in focus.
For example let us assume there is absolutely no news concerning two different companies..
1. Reliance Industries Limited

2. Shree Lakshmi Sugar Mills
As we all know, Reliance is one the largest companies in the country and regardless of whether
there is news or not, market participants would like to buy or sell the company’s shares and there-
fore the price moves constantly.
The second company is a relatively unknown and therefore may not attract market participant’s
attention as there is no news or event surrounding this company. Under such circumstances, the
stock price may not move or even if it does it may be very marginal.
To summarize, the price moves because of expectation of news and events. The news or events
can be directly related to the company, industry or the economy as a whole. For instance the ap-
pointment of Narendra Modi as the Indian Prime Minister was perceived as positive news and
therefore the whole stock market moved.
In some cases there would be no news but still the price could move due to the demand and sup-
ply situation.
6.4 - How does the stock get traded?

You have decided to buy 200 shares of Infosys at 3030, and hold on to it for 1 year. How does it ac-
tually work? What is the exact process to buy it? What happens after you buy it?
Luckily there are systems in place which are fairly well integrated.
With your decision to buy Infosys, you need to login to your trading account (provided by your
stock broker) and place an order to buy Infosys. Once you place an order, an order ticket gets gen-
erated containing the following details:
a. Details of your trading account through which you intend to buy Infosys shares – there-
fore your identity is reveled.
b. The price at which you intend to buy Infosys
c.The number of shares you intend to buy
Before your broker transmits this order to the exchange he needs to ensure you have sufficient
money to buy these shares. If yes, then this order ticket hits the stock exchange. Once the order
hits the market the stock exchange (through their order matching algorithm) tries to find a seller
who is willing to sell you 200 shares of Infosys at 3030.
Now the seller could be 1 person willing to sell the entire 200 shares at 3030 or it could be 10 peo-
ple selling 20 shares each or it could be 2 people selling 1 and 199 shares respectively. The permu-
tation and combination does not really matter. From your perspective, all you need is 200 shares
of Infosys at 3030 and you have placed an order for the same. The stock exchange ensures the
shares are available to you as long as there are sellers in the market.
Once the trade is executed, the shares will be electronically credited to your DEMAT account. Like-
wise the shares will be electronically debited from the sellers DEMAT account.
6.5 - What happens after you own a stock?

After you buy the shares, the shares will now reside in your DEMAT account. You are now a part
owner of the company, to the extent of your share holding. To give you a perspective, if you own
200 shares of Infosys then you own 0.000035% of Infosys.
By virtue of owning the shares you are entitled to few corporate benefits like dividends, stock
split, bonus, rights issue, voting rights etc. We will explore all these shareholder privileges at a
later stage.
6.6 - A note on holding period

Holding period is defined as the period during which you intend to hold the stock. You may be sur-
prised to know that the holding period could be as short as few minutes to as long as ‘forever’.
When the legendary investor Warren Buffet was asked what his favorite holding period was, he in
fact replied ‘forever’.
In the earlier example quoted in this chapter, we illustrated how Infosys stocks moved from 3000
to 3016 in a matter of 5 minutes. Well, this is not a bad return after all for a 5 Minute holding pe-
riod! If you are satisfied with it you can very well close the trade and move on to find another op-
portunity. Just to remind you, this is very much possible in real markets. When things are hot,
such moves are quite common.
6.7 - How to calculate returns?

Now, everything in markets boils down to one thing. Generating a reasonable rate of return!
If your trade generates a good return all your past stock market sins are forgiven. This is what
really matters.
Returns are usually expressed in terms of annual yield. There are different kinds of returns that
you need to be aware of. The following will give you a sense of what they are and how to calcu-
late the same…
Absolute Return – This is return that your trade or investment has generated in absolute terms. It
helps you answer this question – I bought Infosys at 3030 and sold it 3550. How much percentage
return did I generate?
The formula to calculate the same is [Ending Period Value / Starting Period Value – 1]*100
i.e [3550/3030 -1] *100
= 0.1716 * 100
= 17.16%
A 17.6% is not a bad return at all!
Compounded Annual Growth Rate (CAGR) – An absolute return can be misleading if you want to
compare two investments. CAGR helps you answer this question - I bought Infosys at 3030 and
held the stock for 2 years and sold it 3550. At what rate did my investment grow over the last two
years?
CAGR factors in the time component which we had ignored when we computed the absolute re-
turn.
The formula to calculate CAGR is ..
Applying this to answer the question..
{[3550/3030]^(1/2) – 1} = 8.2%
This means the investment grew at a rate of 8.2% for 2 years. Considering the fact that Indian
fixed deposit market offers a return of close to 8.5% return with capital protection an 8.2% return
suddenly looks a bit unattractive.
So, always use CAGR when you want to check returns over multiple years. Use absolute return
when your time frame is for a year or lesser.
What if you have bought Infosys at 3030 and sold it at 3550 within 6 months? In that case you
have generated 17.16% in 6 months which translates to 34.32% (17.16% * 2) for the year.
So the point is, if you have to compare returns, its best done when the return is expressed on an
annualized basis.
6.8 - Where do you fit in?

Each market participant has his or her own unique style to participate in the market. Their style
evolves as and when they progress and witness market cycles. Their style is also defined by the
kind of risk they are willing to take in the market. Irrespective of what they do, they can be catego-
rized as either a trader or an investor.
A trader is a person who spots an opportunity and initiates the trade with an expectation of prof-
itably exiting the trade at the earliest given opportunity. A trader usually has a short term view on
markets. A trader is alert and on his toes during market hours constantly evaluating opportuni-
ties based on risk and reward. He is unbiased toward going long or going short. We will discuss
what going long or short means at a later stage.
There are different types of traders :
a.Day Trader – A day trader initiates and closes the position during the day. He does not carry for-
ward his positions. He is risk averse and does not like taking overnight risk. For example – He
would buy 100 shares of TCS at 2212 at 9:15AM and sell it at 2220 at 3:20 PM making a profit of
Rs.800/- in this trade. A day trader usually trades 5 to 6 stocks per day.
b.Scalper – A type of a day trader. He usually trades very large quantities of shares and holds the
stock for very less time with an intention to make a small but quick profit. For example – He
would buy 10,000 shares of TCS as 2212 at 9:15 and sell it 2212.1 at 9.16. He ends up making
1000/- profit in this trade. In a typical day, he would have placed many such trades. As you may
have noticed a scalp trader is highly risk averse.
c.Swing Trader – A swing trader holds on to his trade for slightly longer time duration, the dura-
tion can run into anywhere between few days to weeks. He is typically more open to taking
risks. For example – He would buy 100 shares of TCS at 2212 on 12th June 2014 and sell it 2214
on 19th June 2014.
Some of the really successful traders the world has seen are – George Soros, Ed Seykota, Paul Tu-
dor, Micheal Steinhardt, Van K Tharp, Stanley Druckenmiller etc
An investor is a person who buys a stock expecting a significant appreciation in the stock. He is
willing to wait for his investment to evolve. The typical holding period of investors usually runs
into a few years. There are two popular types of investors..
a.Growth Investors – The objective here is to identify companies which are expected to grow sig-
nificantly because of emerging industry and macro trends. A classic example in the Indian con-
text would be buying Hindustan Unilever, Infosys, Gillette India back in 1990s. These companies
witnessed huge growth because of the change in the industry landscape thereby creating mas-
sive wealth for its shareholders.
b.Value Investors – The objective here is to identify good companies irrespective of whether they
are in growth phase or mature phase but beaten down significantly due to the short term mar-
ket sentiment thereby making a great value buy. An example of this in recent times is L&T. Due
to short term negative sentiment; L&T was beaten down significantly around August/
September of 2013. The stock price collapsed to 690 all the way from 1200. At 690 (given its fun-
damentals around Aug 2013), a company like L&T is perceived as cheap, and therefore a great
value pick. Eventually it did pay off, as the stock price scaled back to 1440 around May 2014.
Some of the really famous investors the world has seen – Charlie Munger, Peter Lynch, Benjamin
Graham, Thomas Rowe, Warren Buffett, John C Bogle, John Templeton etc.
So what kind of market participant would you like to be?
1. A stock market is a place where a trader or an investor can transact (buy, sell) in shares
2. A stock market is a place where the buyer and seller meet electronically
3. Different opinions makes a market
4. The stock exchange electronically facilitate the meeting of buyers, and sellers
5. News and events moves the stock prices on a daily basis
6. Demand supply mismatch also makes the stock prices move
7. When you own a stock you get corporate privileges like bonus, dividends, rights etc
8. Holding period is defined as the period during which you hold your shares
9. Use absolute returns when the holding period is 1 year or less. Use CAGR to identify the
growth rate over multiple years
10.Traders, and investors differ on two counts – risk taking ability and the holding period.
C H A PT E R 7
The Stock Markets Index
7.1 - Overview
If I were to ask you to give me a real time summary on the traffic situation, how would you possi-
bly do it?
Your city may have 1000’s of roads and junctions; it is unlikely you would check each and every
road in the city to find the answer. The wiser thing for you to do would be to quickly check, a few
important roads and junctions across the four directions of the city and observe how the traffic is
moving. If you observe chaotic conditions across these roads then you would simply summarize
the traffic situation as chaotic, else traffic can be considered normal.
The few important roads and junctions that you tracked to summarize the traffic situation served
as a barometer for the traffic situation for the entire city!
Drawing parallels, if I were to ask you how the stock market is moving today, how would you an-
swer my question? There are approximately 5,000 listed companies in the Bombay Stock Ex-
change and about 2,000 listed companies in the National Stock Exchange. It would be clumsy to
check each and every company, figure out if they are up or down for the day and then give a de-
tailed answer.
Instead you would just check few important companies across key industrial sectors. If majority
of these companies are moving up you would say markets are up, if the majority is down, you
would say markets are down, and if there is a mixed trend, you would say markets are sideways!
So essentially identify a few companies to represent the broader markets. So every time some-
one asks you how the markets are doing, you would just check the general trend of these se-
lected stocks and then give an answer. These companies that you have identified collectively
make up the stock market index!
7.2 - The Index

Luckily you need not actually track these selected companies individually to get a sense of how
the markets are doing. The important companies are pre packaged, and continuously monitored
to give you this information. This pre packaged market information tool is called the ‘Market In-
dex’.
There are two main market indices in India. The S&P BSE Sensex representing the Bombay stock
exchange and CNX Nifty representing the National Stock exchange.
S&P stands for Standard and Poor’s, a global credit rating agency. S&P has the technical expertise
in constructing the index which they have licensed to the BSE. Hence the index also carries the
S&P tag.
CNX Nifty consists of the largest and most frequently traded stocks within the National Stock Ex-
change. It is maintained by India Index Services & Products Limited (IISL) which is a joint venture
of National Stock Exchange and CRISIL. In fact the term ‘CNX’ stands for CRISIL and NSE.
An ideal index gives us minute by minute reading about how the market participants perceive the
future. The movements in the Index reflect the changing expectations of the market participants.
When the index goes up, it is because the market participants think the future will be better. The
index drops if the market participants perceive the future pessimistically.
7.3 - Practical uses of the Index

Some of the practical uses of Index are discussed below.
Information – The index reflects the general market trend for a period of time. The
index is a broad representation of the country’s state of economy. A stock market
index that is up indicates people are optimistic about the future. Likewise when the
stock market index is down it indicates that people are pessimistic about the fu-
ture.
For example the Nifty value on 1st of January 2014 was 6301 and the value as of 24th June 2014
was 7580. This represents a change of 1279 points in the index of 20.3% increase. This simply
means that during the time period under consideration, the markets have gone up quite signifi-
cantly indicating a strong optimistic economic future.
The time frame for calculating the index can be for any length of time.. For example, the Index at
9:30 AM on 25th June 2014 was at 7,583 but an hour later it moves to 7,565. A drop of 18 points
during this period indicates that the market participants are not too enthusiastic.
Benchmarking – For all the trading or investing activity that one does, a yardstick
to measure the performance is required. Assume over the last 1 year you invested
Rs.100,000/- and generated Rs.20,000 return to make your total corpus Rs.120,000/-
. How do you think you performed? Well on the face of it, a 20% return looks great.
However what if during the same year Nifty moved to 7,800 points from 6,000 points generating a
return on 30%?
Well suddenly it may seem to you, that you have underperformed the market! If not for the Index
you can’t really figure out how you performed in the stock market. You need the index to bench-
mark the performance of a trader or investor. Usually the objective of market participants is to
outperform the Index.
Trading - Trading on the index is probably one of most popular uses of the index. Ma-
jority of the traders in the market trade the index. They take a broader call on the
economy or general state of affairs, and translate that into a trade.
For example imagine this situation. At 10:30 AM the Finance Minister is expected to
deliver his budget speech. An hour before the announcement Nifty index is at 6,600 points. You
expect the budget to be favorable to the nation’s economy. What do you think will happen to the
index? Naturally the index will move up. So in order to trade your point of view, you may want to
buy the index at 6,600. After all, the index is the representation of the broader economy.
So as per your expectation the budget is good and the index moves to 6,900. You can now book
your profits, and exit the trade at a 300 points profit! Trades such as these are possible through
what is known as ‘Derivative’ segment of the markets. We are probably a bit early to explore de-
rivatives, but for now do remember that index trading is possible through the derivative markets.
Portfolio Hedging – Investors usually build a portfolio of securities. A typical portfo-
lio contains 10 – 12 stocks which they would have bought from a long term perspec-
tive. While the stocks are held from a long term perspective they could foresee a pro-
longed adverse movement in the market (2008) which could potentially erode the
capital in the portfolio. In such a situation, investors can use the index to hedge the portfolio. We
will explore this topic in the risk management module.
7.4 - Index construction methodology

It is important to know how the index is constructed /calculated especially if one wants to ad-
vance as an index trader. As we discussed, the Index is a composition of many stocks from differ-
ent sectors which collectively represents the state of the economy. To include a stock in the index
it should qualify certain criteria. Once qualified as an index stock, it should continue to qualify on
the stated criteria. If it fails to maintain the criteria, the stock gets replaced by another stock
which qualifies the prerequisites.
Based on the selection procedure the list of stocks is populated. Each stock in the index should
be assigned a certain weightage. Weightage in simpler terms define how much importance a cer-
tain stock in the index gets compared to the others. For example if ITC Limited has 7.6% weight-
age on Nifty 50 index, then it is as good as saying the that the 7.6% of Nifty’s movement can be at-
tributed to ITC.
The obvious question is - How do we assign weights to the stock that make up the Index?
There are many ways to assign weights but the Indian stock exchange follows a method called
free float market capitalization. The weights are assigned based on the free float market capi-
talization of the company, larger the market capitalization, higher the weight.
Free float market capitalization is the product of total number of shares outstanding in the mar-
ket, and the price of the stock.
For example company ABC has a total of 100 shares outstanding in the market, and the stock
price is at 50 then the free float market cap of ABC is 100*50 = Rs.5,000.
At the time of writing this chapter, the following as per Table 7.1 are the 50 stocks in Nifty as per
their weightage…
Table 7.1 - Nifty stocks as per their weightage
Sl No Name of the company Industry Weightage (%)
1 ITC Limited Cigarettes 7.60
2 ICICI Bank Ltd Banks 6.55
3 HDFC Ltd Housing Finance 6.45
4 Reliance Industry Ltd Refineries 6.37
5 Infosys Ltd Computer Software 6.26
6 HDFC Bank Ltd Banks 5.98
7 TCS Ltd Computer Software 5.08
8 L&T Ltd Engineering 4.72
9 Tata Motors Ltd Automobile 3.09
10 SBI Ltd Banks 2.90
11 ONGC Ltd Oil Exploration 2.73
12 Axis Bank Ltd Banks 2.50
13 Sun Pharma Ltd Pharmaceuticals 2.29
14 M&M Ltd Automobiles 2.13
15 HUL Ltd FMCG 1.87
16 Bharti Airtel Ltd Telecom Services 1.70
17 HCL Technologies Ltd Computer software 1.61
18 Tata Steel Ltd Metal -Steel 1.42
19 Kotak Mahindra Bank Ltd Banks 1.40
20 Sesa Sterlite Ltd Mining 1.38
21 Dr.Reddy’s Lab Ltd Pharmaceuticals 1.37
22 Wipro Ltd Computer Software 1.37
23 Maruti Suzuki India Ltd Automobile 1.29
24 Tech Mahindra Ltd Computer Software 1.24
25 Hero Motocorp Ltd Automobile 1.20
26 NTPC Ltd Power 1.15
27 Power Grid Corp Ltd Power 1.13
28 Asian Paints Ltd Paints 1.10
29 Lupin Ltd Pharmaceuticals 1.09
30 Bajaj Auto Ltd Automobile 1.07
31 Hindalco Industries Ltd Metal – Aluminum 0.95
32 Ultratech Cements Ltd Cements 0.95
33 Indusind Bank Ltd Banks 0.94
34 Coal India Ltd Mining 0.93
35 Cipla Ltd Pharmaceuticals 0.89
Electrical
36 BHEL Ltd 0.79
Equipment
37 Grasim Industries Ltd Cements 0.79
38 Gail (India) Ltd Gas 0.78
39 IDFC Ltd Financial Services 0.74
40 Cairn India Ltd Oil Exploration 0.72
41 United Sprits Ltd Distillery 0.70
42 Tata Power Co.Ltd Power 0.68
43 Bank of Baroda Banks 0.63
44 Ambuja Cements Ltd Cements 0.61
45 BPCL Refineries 0.58
46 Punjab National Bank Banks 0.55
47 NMDC Ltd Mining 0.52
48 ACC Ltd Cements 0.50
49 Jindal Steel & Power Steel 0.38
50 DLF Ltd Construction 0.34
As you can see, ITC Ltd has the highest weightage. This means the Nifty index is most sensitive to
price changes in ITC Ltd, and least sensitive to price changes in DLF Ltd.
7.5 - Sector specific indices

While the Sensex and Nifty represent the broader markets there are certain indices that repre-
sents specific sectors. These are called the sectoral indices. For example the Bank Nifty on NSE
represents the mood specific to the banking industry. The CNX IT on NSE represents the behavior
of all the IT stocks in the stock markets. Both BSE and NSE have sector specific indexes. The con-
struction and maintenance of these indices is similar to the other major indices.
1. An index acts as a barometer of the whole economy

2. An index going up indicates that the market participants are optimistic
3. An index going down indicates that the market participants are pessimistic
4. There are two main indices in India – The BSE Sensex and NSE’s Nifty
5. Index can be used for a variety of purposes – information, bench marking, trading and
hedging.
6. Index trading is probably the most popular use of the index
7. India follows the free float market capitalization method to construct the index
8. There are sector specific indices which convey the sentiment of specific sectors
C H A PT E R 8
Commonly Used Jargons
The objective of this chapter is to help you learn some of the common market terminologies, and
concepts associated with it.
Bull Market (Bullish) – If you believe that the stock prices are likely to go up then you are
said to be bullish on the stock price. From a broader perspective, if the stock market index is go-
ing up during a particular time period, then it is referred to as the bull market.
Bear Market (Bearish) – If you believe that the stock prices are likely to go down then you
are said to be bearish on the stock price. From a broader perspective, if the stock market index is
going down during a particular time period, then it is referred to as the bear market.
Trend - A term ‘trend’ usually refers to the general market direction, and its associated
strength. For example, if the market is declining fast, the trend is said to be bearish. If the market
is trading flat with no movement then the trend is said to be sideways.
Face value of a stock – Face value (FV) or par value of a stock indicates the fixed denomina-
tion of a share. The face value is important with regard to corporate action. Usually when divi-
dends and stock split are announced they are issued keeping the face value in perspective. For ex-
ample the FV of Infosys is 5, and if they announce an annual dividend of Rs.63 that means the divi-
dend yield is 1260%s (63 divided by 5).
52 week high/low – 52 week high is the highest point at which a stock has traded during the
last 52 weeks (which also marks a year) and likewise 52 week low marks the lowest point at
which the stock has traded during the last 52 weeks. The 52 week high and low gives a sense of
the range within which the stock has traded during the year. Many people believe that if a stock
reaches 52 week high, then it indicates a bullish trend for the foreseeable future. Similarly if a
stock has hits 52 week low, some traders believe that it indicates a bearish trend for a foreseeable
future.
All time high/low – This is similar to the 52 week high and low, with the only difference be-
ing the all time high price is the highest price the stock has ever traded from the time it has been
listed. Similarly, the all time low price is the lowest price at which the stock has ever traded from
the time it has been listed.
Long Position – Long position or going long is simply a reference to the direction of your
trade. For example if you have bought or intend to buy Biocon shares then you are said to be long
on Biocon or planning to go long on Biocon respectively. If you have bought the Nifty Index with
an expectation that the index will trade higher then essentially you have a long position on Nifty.
If you are long on a stock or an index, you are said to be bullish.
Short Position – Going short or simply ‘shorting’ is a term used to describe a transaction car-
ried out in a particular order. This is a slightly tricky concept. To help you understand the concept
shorting, I’d like to narrate a recent incident that happened to me at work.
If you are a gadget enthusiast like me, you would probably know that Xiaomi (Chinese manufac-
tures of Smartphone) recently entered into an exclusive partnership with Flipkart to sell their flag-
ship smart phone model called Mi3 in India. The price of Mi3 was speculated to be around
Rs.14,000/-. If one wished to buy Mi3, he had to be a registered Flipkart user, the phone was not
available for a non registered user, and the registration was open only for a short time. I had
promptly registered to buy the phone, but my colleague Rajesh had not. Though he wanted to
buy the phone, he could not because he had not registered on time.
Out of sheer desperation, Rajesh walked up to me, and made an offer. He said, he is willing to buy
the phone from me at Rs. 16,500/-. Being a trader at heart, I readily agreed to sell him the phone!
In fact I even demanded him to pay me the money right away.
After I pocketed the money, I thought to myself, what have I done?? Look at the situation I’ve put
myself into? I’ve sold a phone to Rajesh, which I don’t own yet!!
But then, it was not a bad deal after all. I agree, I had sold a phone that I dint own. However I
could always buy the phone on Flipkart, and pass on the new unopened box to Rajesh. My only
fear in this transaction was, what if the price of the phone is above Rs.16,500?? In that case I’d
make a loss, and I’d regret entering into this transaction with Rajesh. For example if the phone
was priced at Rs.18,000 my loss would be Rs.1,500 (18,000 – 16,500).
However to my luck, the phone was priced at Rs.14,000/-, I promptly bought it on Flipkart, upon
delivery, I handed over the phone to Rajesh, and in the whole process I made a clean profit of
Rs.2,500/- (16500 – 14000)!
If you look at the sequence of transactions, first I sold the phone (that I dint own) to Rajesh, and
then I bought it later on Flipkart, and delivered the same to Rajesh. Simply put I had sold first,
and bought it later!
This type of transaction is called a ‘Short Trade’.
The concept of shorting is very counter intuitive simply because we are not used to ‘shorting’ in
our day to day activity, unless you have a trader mentality :)
Going back to stock markets, think about this very simple transaction – on day 1 you buy shares
of Wipro at Rs.405, two days later (day 3) the stock moves and you sell your shares at Rs.425. You
made a profit of Rs.20/- on this transaction.
In this transaction your first leg of the trade was to buy Wipro at Rs.405, and the second leg was
to sell Wipro at Rs.425, and you were bullish on the stock.
Going forward, on day 4, the stock is still trading at Rs.425, and you are now bearish on the stock.
You are convinced that the stock will trade lower at Rs.405 in few days time. Now, is there a way
you can profit out of your bearish expectation? Well, you could, and it can be done so by shorting
the stock.
You sell the stock at Rs.425, and 2 days later assuming the stock trades at Rs.405, you buy it back.
If you realize the first leg of the trade was to sell at Rs.425, and the second leg was to buy the
stock at Rs.405. This is always the case with shorting – you first sell at a price you perceive as high
with an intention of buying it back at a lower price at a later point in time.
You have actually executed the same trade as buying at Rs.405 and selling at Rs.425 but in re-
verse order.
An obvious question you may have – How can one sell Wipro shares without owning it. Well you
can do so, just like the way I sold a phone that I did not own.
When you first sell, you are essentially borrowing it from someone else in the market, and when
you buy it back, you actually return the shares back. All this happens in the backend, and the
stock exchange facilitates the process of borrowing, and returning it back.
In fact when you short a stock, it works so seamlessly that you will not even realize that you are
borrowing it from someone else. From your perspective, all you need to know is that when you
are bearish on the stock, you can short the stock, and the exchange takes care of borrowing the
stock on your behalf. When you buy the stocks back, the exchange will ensure the stocks are re-
turned back.
To sum it all up...
a.When you short, you have a bearish view on the stock. You profit if the stock price goes down.
After you short, if the stock price goes up, you will end up making a loss
b.When you short you essentially borrow from another market participant, and you will have to
deliver these shares back. You need not worry about the mechanics of this. The system will en-
sure all this happens in the background
c.Shorting a stock is easy – either you call your broker and ask him to short the stock or you do it
yourself by selecting the stock you wish to short, and click on sell
d.For all practical purposes, if you want to short a stock, and hold the position for few days, it is
best done on the derivatives markets
e.When you are short, you make money when the stock price goes down. You will make a loss if
the stock price goes up after you have shorted the stock.
To summarize long and short positions as per table 8.1 in the following page........
Table 8.1- Long and short positions
Make
You will lose
Position 1st Leg 2nd Leg Expectation money
money if
when
Stock price
Long Buy Sell Bullish Stock goes up
drops
Stock goes Stock price
Short Sell Buy Bearish
down goes up
Square off – Square off is a term used to indicate that you intend to close an existing posi-
tion. If you are long on a stock squaring off the position means to sell the stock. Please remem-
ber, when you are selling the stock to close an existing long position you are not shorting the
stock!
When you are short on the stock, squaring off position means to buy the stock back. Remember
when you buy it back, you are just closing an existing position and you are not going long!
Table 8.2 - Square off positions
When you are Square off position is

Long Sell the stock
Short Buy the stock
Intraday position – Is a trading position you initiate with an expectation to square off the po-
sition within the same day.
OHLC – OHLC stands for open, high, low and close. We will understand more about this in
the technical analysis module. For now, open is the price at which the stock opens for the day,
high is the highest price at which the stock trade during the day, low is the lowest price at which
the stock trades during the day, and the close is the closing price of the stock. For example, the
OHLC of ACC on 17th June 2014 was 1486, 1511, 1467 and 1499.
Volume – Volumes and its impact on the stock prices is an important concept that we will
explore in greater detail in the technical analysis module. Volumes represent the total transac-
tions (both buy and sell put together) for a particular stock on a particular day. For example, on
17th June 2014, the volume on ACC was 5, 33,819 shares.
Market Segment – A market segment is a division within which a certain type of financial in-
strument is traded. Each financial instrument is characterized by its risk and reward parameters.
The exchange operates in three main segments.
a.Capital Market – Capital market segments offers a wide range of tradable securities such as eq-
uity, preference shares, warrants and exchange traded funds. Capital Market segment has sub seg-
ments under which instruments are further classified. For example, common shares of compa-
nies are traded under the equity segment abbreviated as EQ. So if you were to buy or sell shares
of a company you are essentially operating in the capital market segment
b.Futures and Options – Futures and Option, generally referred to as equity derivative segment is
where one would trade leveraged products. We will explore the derivative markets in greater
depth in the derivatives module
c.Whole sale Debt Market – The whole sale debt market deals with fixed income securities. Debt
instruments include government securities, treasury bills, bonds issued by a public sector under-
taking, corporate bonds, corporate debentures etc.
CHAPTER 9
The Trading Terminal
9.1 – Overview
When a market participant wants to transact in the market, he can do so by opting one
of the options:
1. Call the stock broker, and trade usually called “Call & Trade”
2. Use a web browser to access the markets
3. Use the trading software called the Trading Terminal
Each of the above method is a gateway to the exchanges. The gateway allows you to do
multiple things such as transacting in shares, tracking your Profit & Loss, tracking
market movements, following news, managing your funds, viewing stock charts,
accessing trading tools etc. The purpose of this chapter is to familiarize you with the
trading terminal (TT), and its interface.
A trading terminal is software which can be downloaded from your broker’s website
and is installed on your computer. The trading terminal is quite a user friendly
interface, as most of its functionalities are menu driven. To access the trading terminal,
you need to have a trading account with your broker.
A good TT offers you numerous useful features. We will start by understanding a few
basic features. To keep this chapter as practical as possible let us set two basic tasks to
using the TT.
1. Buy 1 share of ITC, and

2. Track the price of Infosys
While we achieve the above two tasks, we will also learn about all the relevant
concepts. For the purpose of this chapter, we will be using Zerodha’s web platform
‘Kite’
9.2 – The login process
The trading terminal is quite sensitive as it contains all your trading account
information. In order to ensure adequate security, brokers usually follow a stringent
login process. The process involves entering your password and answering two secret
questions, the answers to which only you know. The snapshot below shows this
process.
9.3 – The Market watch
Once your login to the platform you will have to populate the ‘market watch’ with the
stocks you are interested. Think about the market watch as a blank slate. Once the
stock is loaded on the market watch you can easily transact and query information
about it. A blank market watch looks like this (this is also the screen that you see once
you log in)
Keeping the first task in mind we will load ITC Ltd onto the market watch. To do this we
simply have to type in the stock symbol ITC in the search bar and the drop down will
show the stock in different exchanges(NSE/BSE)
Click on the Add symbol to add the stock to the marketwatch
The marketwatch will display last traded price, percentage change of the stock
 The last traded price of the stock (LTP) – This gives us a sense of how much the stock
is trading at the very moment
 Percentage change – This indicates the percentage points the LTP is varying with
respect to the previous day close
 Some basic information that will be needed at this point would be:
 Previous day close – At what price did the stock close the previous day
 OHLC – Open, High, Low and Close gives us a sense of the range within which the
stock is trading during the day
 Volumes – Gives a sense on how many shares are being traded at a particular point
of time
You can find this information under Market Depth. If you hover over the stock name,
you will find Buy, Sell, Market Depth and Stock Information. If you click on Marketdepth,
you will find the above information along with the best bid and ask price ladder. We will
be covering Bid and Ask price in the later part of the Chapter.
As you can see, the last traded price of ITC is Rs.262.25, it is trading -0.40% lower than
the previous day close which is Rs.263.30. The open for the day was at Rs.265.90, the
highest price and the lowest price at which the stock traded for the day was Rs.265.90
and Rs.262.15 respectively. The volume for the day is close to 27 lakh shares.
9.4 – Buying a stock through the trading terminal
Our goal is to buy 1 share of ITC. We now have ITC in our trading terminal, and we are
convinced that buying ITC at Rs.261, which is roughly Rs.1.25 lesser than the last traded
price is a great idea.
The first step for this process would be to invoke what is called a buy order form.
o Hover over the stock you want to Buy and click on the Buy Icon(B)
o This will invoke the Buy. When the buy order form is invoked, the following order form
will appear on your screen.
The order form is pre populated with some information like the price and quantity. We
need to modify this as per our requirement. Let us begin by the first drop down option
on the top. By default, the exchange specified would be NSE.
The next entry is the ‘order type’. By clicking on the drop down menu you will see the
following four options:
 Limit
 Market
 SL
 SL-Market
Let us understand what these options actually mean.
You can opt for a ‘Limit’ order when you are very particular about the price you want
pay for a stock. In our case, the last traded price of ITC is Rs.262.25 but say we want to
limit our buy price to Rs.261. In such a situation where we are particular about the price
we want to transact in, we can opt for a limit order price. If the price does not fall to
Rs.261, then you will not get the shares. This is one of the drawbacks of a limit order.
You can also opt for a market order when you intend to buy at market available prices
instead of a very specific price that you have in mind. So if you were to place a market
order, as long as there are sellers available, your order will go through and ITC will be
bought in the vicinity of Rs.262.25. Suppose the price goes up to Rs.265 coinciding with
your market order placement, then you will get ITC at Rs.265. This means when you
place a market order, you will never be sure of the price at which you would transact,
and this could be quite a dangerous situation if you are an active trader.
A stop loss order protects you from an adverse movement in the market after initiating
a position. Suppose you buy ITC at Rs.262.25 with an expectation that ITC will hit Rs.275
in the near future. But instead, what if the price of ITC starts going down? We can
protect ourselves firstly by defining what would be the worst possible loss you are
willing to take. For instance, in the example let us assume you don’t want to take a loss
beyond Rs.255
This means you have gone long on ITC at Rs.262.25 and the maximum loss you are
willing to take on this trade is Rs.6 (255). If the stock price drops down to Rs.255, the
stop loss order gets active and hits the exchange and you will be out of the loss making
position. As long as the price is above 255 the stop loss order will be dormant.
A stop loss order is a passive order. In order to activate it, we need to enter a trigger
price. A trigger price, usually above the stop loss price acts as a price threshold and
only after crossing this price the stop loss order transitions from a passive order to an
active order.
Going with the above example:
We are long at Rs.261. In case the trade goes bad we would want to get rid of the
position at Rs.255, therefore 255 is the stop loss price. The trigger price is specified so
that the stoploss order would transition from passive to active order. The trigger price
has to be higher than the stop loss price. We can set this to Rs.256. If the price drops to
Rs.256 from 255 the stop loss order gets active.
Going back to the main buy order entry form, once the order type is selected we now
move directly to the quantity. Remember the task is to buy 1 share of ITC; hence we
enter 1 in the quantity box. We ignore the trigger price and disclosed quantity for now.
The next thing to select would be the product type.
Select CNC for delivery trades. Meaning if your intention is to buy and hold the shares
for multiple days/months/years then you need to ensure the shares reside in your
demat account. Selecting CNC is your way of communicating this to your broker.
Select NRML or MIS if you want to trade intraday. MIS is a margin product; we will
understand more on this when we take up the module on derivatives.
Once these details are filled in your order form, the order is good to hit the markets.
The order gets transmitted to the exchange as soon as you press the submit button on
the order form. A unique order ticket number is generated against your order.
Once the order is sent to the exchange it will not get executed unless the price hits
Rs.261. As soon as the price drops to Rs.26 (and assuming there are sellers willing to
sell 1 shares) you order gets through, and is eventually executed. As soon as your order
is executed, you will own 1 shares of ITC.
9.5 – The order book and Trade book
The order book and trade book are two online registers within trading terminal. The
order book keeps track of all the orders that you have sent to the exchange and the
trade book tracks all the trades that you have transacted during the day.
The order book has all the details regarding your order. You can navigate to the
orderbook by clicking the Orders tab
The order book provides the details of the orders you have placed. You should access
the order book to:
 Double check the order details – quantity, price, order type, product type
 Modify the orders – For example if you want to modify the buy order from 332 to 333
you can do so from the order book
 Check Status – After you have placed the order you can check the status of the same.
The status would state open if the order is completed partially, it would state
completed if the order has been completed, and it would state rejected if your order
has been rejected. You can also see the details of the rejection in the order book.
If you notice, there is an open order to buy 1 share of ITC at Rs.261.
If you hover over the pending orders, you can find the option to modify or cancel the
order
By clicking ‘modify’ the order form will be invoked and you can make the desired
changes to the order.
Once the order has been processed and the trade has been executed, the trade details
will be available in the trade book. You can find the trade book just below the
orderbook
Here is a snapshot of the trade book
The trade book confirms that the user executed an order to buy 1 share of ITC at Rs
262.2. Also notice a unique exchange order number is generated for the trade.
So with this our first task is complete!
You now officially own 1 share of ITC. This share will reside in our DEMAT account till
you decide to sell it.
The next task is to track the price of Infosys. The first step would be to add Infosys to
the market watch. We can do this by searching for Infosys in the search box.
The trading symbol for Infosys is Infy. Once we select Infy, we press Add to add it to the
market watch.
We can now track some live information about Infosys. The last trade price is
Rs.1014.75; the stock is down -0.11% from its previous days close of Rs.1015.85. Infosys
opened the day at Rs.1014.80 made a low of Rs.998.40 and a high of Rs.1028.95. The
volumes were 3.6 million shares.
Please note, while the open price will be fixed at Rs. 1014.80 the high and low prices
change as and when the price of Infosys changes. For example, if Infosys moves from
Rs.1014.2 to Rs.1050, then the high price will reflect Rs. 1050 as the new high.
Notice that the LTP of Infosys is highlighted in green and ITC in red. If the current LTP
is more than the previous LTP, the cell is highlighted in green else in red.
Have a look at the snapshot below:
The price of Infosys dropped from 1014.20 to 1020.80, and hence the colour changed to
red from blue.
Besides the basic information about the LTP, OHLC, and volume we can also dig a bit
deeper to understand the real time market participation. To see this, we need to invoke
what is called a ‘Market Depth’ window also referred to as the snap quote window. As
you can see, there is a lot of information in the snap quote window. I specifically want
to draw your attention to the numbers in blue and red called the Bid and Ask prices.
You can use Kite by Zerodha more effectively by going through its user manual
9.6 – The Bid and Ask Price

If you want to buy a share, you obviously need to buy it from a seller. The seller will sell
the shares at a price that he thinks is fair enough. The price that the sellers ask you is
called the ‘Ask Price’. The ask price is highlighted in red. Let us analyse this in a bit
more detail.
By default, the snap quote window displays the top 5 bid and asks prices. In the table
above we have the top 5 ask prices.
The first ask price is Rs.3294.80. At this particular moment, this is the best price to buy
Infosys and there are only 2 shares available at this price being offered by 2 different
sellers (both of them are selling 1 share each). The next best price is Rs. 3294.85. At this
price there are 4 shares available being offered by 2 different sellers. The third best
price is Rs.3295 at which 8 shares are available, and this price is offered by two sellers.
So on and so forth.
As you notice, the higher the ask price the lower is the priority. For example, at
5th position is an ask price of Rs.3296.25 for 5 shares. This is because the stock
exchanges give priority to sellers willing to sell their shares at the least possible price.
Notice even if you want to buy 10 shares at Rs.3294.8 you can only buy 2 shares because
there are only 2 sellers at Rs.3294.8. However, if you are not particular about the price
(aka limit price) you can place a market order. When you place a market order a t this
stage, this is what happens:
 2 shares are bought @ Rs.3294.8

The 10 shares will be bought at three different prices. Also in the process the LTP of
Infosys will jump to Rs.3295 from Rs.3294.8
If you want to sell a share, you obviously need to sell it to a buyer willing to buy it from
you. The buyer will buy the shares at a price that he thinks is fair enough. The price that
the buyer demands is called the ‘bid price’. The bid price is highlighted in blue. Let us
analyse this part in a bit more detail:
Again by default the snap quote window displays the top five bid prices. Notice the best
price at which you can sell shares is at Rs.3294.75, and at this price you can only sell 10
shares as there are only 5 buyers willing to buy from you.
If you were to sell 20 Infosys shares at market price the following would be the
execution pattern:
 10 shares sold @ Rs.3294.75

 1 share sold @ Rs.3294.15
So in essence, the bid and ask prices gives you information about the top 5 prices at
which the buyers and sellers are stacked up. It is extremely important for you to
understand how the buyers and sellers are placing their trades especially if you are an
intraday trader.
9.7 – Conclusion
The trading terminal is your gateway to markets. Trading terminal has many features
that are useful to traders. We will explore these features as we progress through the
various learning modules. For now, you should be in a position to understand how to
set up a market watch, transact (buy and sell) in stocks, view the order and trade book,
and understand the market depth window.
1. A trading terminal is your gateway to markets. You must know the operations of a
trading terminal if you aspire to become an active trader
2. You can load the stock you are interested in on the market watch to track all the
relevant information
3. Some of the basic information on market watch is – LTP, % change, OHLC and
volumes
4. To buy a stock you need to invoke a buy order form by pressing ‘B’ key. Likewise, to
sell a stock you need to invoke a sell order form by pressing ‘S’ key
5. You choose a limit order type when you are keen on transacting at a particular price,
else you can opt for a market order
6. You choose CNC as product type if you want to buy and hold the stock across
multiple days. If you want to trade intraday, you choose NRML or MIS
7. An order book lets you track orders that are both open and completed. You can
modify the open orders by clicking on the modify button at the bottom of the order
book
8. Once the order is completed you can view the trade details in the trade book. In
case of a market order then you can view the exact trade price by accessing the
trade book
9. You can press the F6 key to invoke the market depth or snap quote window. The
market watch enables you to see bid and ask prices
10. The bid & ask prices refers to the price at which you can transact. By default, the top
5 bid and ask prices are displayed in the market depth window at all times.
C H A PT E R 10
Clearing and Settlement

10.1 - Overview
While the topic on clearing and settlement is quite theoretical it is important to understand the
mechanics behind it. As a trader or an investor you need not actually worry about how the trades
are cleared and settled as there are professional intermediaries to carry out this function seam-
lessly for you.
However the lack of understanding of the clearing and settlement process could leave a void, and
would not give a sense of completeness to the learning process. Hence for this reason we will ex-
plore what happens behind the scene from the time you buy a stock to the time it hits your DE-
MAT account.
We will keep this very practical with a clear emphasis on what you as a market participant should
really know.
10.2 - What happens when you buy a stock?
Day 1 – The trade (T Day), Monday
Assume on 23rd June 2014 (Monday) you buy 100 shares of Reliance Industries at Rs.1,000/- per
share. The total buy value is Rs.100,000/- (100 * 1000). The day you make the transaction is re-
ferred to as the trade date, represented as ‘T Day’.
By the end of trade day your broker will debit Rs.100,000/- and the applicable charges towards
your purchase. Assuming the trade is executed through Zerodha, the applicable charges would
be as follows as per Table 10.1:
TABLE 10.1 - Charge List
Sl No Chargeable Item Applicable Charges Amount
0.1% or Rs.20/-
1 Brokerage 20/-
whichever is lower
Security Transaction
2 0.1% of the turnover 100/-
Charges
0.00325% of the
3 Transaction Charges 3.25/-
turnover
12% of Brokerage +
4 Service Tax 2.79/-
Transaction charges
5 Education Cess 2% of service tax 0.0558/-
6 Higher education Cess 1% of service tax 0.0279/-
Rs.20 per crore of

7 SEBI Charges 0.2/
transaction
Total 126.32/-
So an amount of Rs.100,000/- plus Rs.126.32/- (which includes all the applicable charges) totaling
Rs.100,126.32/- will be debited from your trading account the day you make the transaction. Do
remember, the money goes out of your account but the stock has not come into your DEMAT ac-
count yet.
Also, on the same day the broker generates a ‘contract note’ and sends you a copy of the same. A
contract note is like a bill generated detailing every transaction your made. This is an important
document which is worth saving for future reference. A contract note typically shows a break up
of all transactions done during the day along with the trade reference number. It also shows the
breakup of charges charged by the broker.
Day 2 – Trade Day + 1 (T+ day, Tuesday)
The day after you made the transaction is called the T+1 day. On T+1 day you can sell the stock
that you purchased the previous day. If you do so, you are basically doing a quick trade called
“Buy Today, Sell Tomorrow” (BTST) or “Acquire Today, Sell Tomorrow” (ATST). Remember the
stock is not in your DEMAT account yet. Hence, there is a risk involved, and you could be in trou-
ble for selling a stock that you don’t really own. This doesn’t mean, every time you do a BTST
trade you end up in trouble, but it does once in a way especially when you trade B group and illiq-
uid stocks. The reason why this happens is a little convoluted, and we deliberately will not touch
this topic now.
If you are starting fresh in the markets, I would suggest you do not do BTST trades unless you un-
derstand the risk involved.
From your perspective nothing happens on T+1 day. However in the background the money re-
quired to purchase the shares is collected by the exchange along with the exchange transaction
charges and Security transaction tax.
Day 3 – Trade Day + 2 (T+2 day, Wednesday)
On day 3 or the T+2 day, around 11 AM shares are debited from the person who sold you the
shares and credited to the brokerage with whom you are trading, who will in turn credit it to your
DEMAT account by end of day. Similarly money which was debited from you is credited to the per-
son who sold the shares.
The shares will now start reflecting in the DEMAT account indicating that you own 100 shares of
Reliance.
So for all practical purposes if you buy a share on day T Day, you can expect to receive the shares
in your DEMAT account only by end of T+2 day. The shares are available for transaction on
T+3day.
10.3 - What happens when you sell a stock?

The day you sell the stocks is again called the trade day, represented as ‘T Day’. The moment you
sell the stock from your DEMAT account, the stock gets blocked .Before the T+2 day the blocked
shares are given to the exchange. On T+2 day you would receive the funds from the sale which
will be credited to your trading account after deduction of all applicable charges.
1. The day you make a transaction, it is called the trade date, represented as ‘T Day’
2. The broker is required to issue you a contract note for all the transactions carried out by end
of T day
3. When you buy a share, the same will be reflected in your DEMAT account by end of T+2 day
4. All equity/stock settlements in India happen on a T+2 basis
5. When you sell shares, the shares are blocked immediately and the sale proceeds credited
again on T +2 day
C H A PT E R 11
Five Corporate Actions and its

Impact on Stock Prices
11.1 - Overview
Corporate actions are initiatives taken up by a corporate entity that bring in a change to its stock.
There are many types of corporate actions that an entity can choose to initiate. A good under-
standing of these corporate actions gives a clear picture of the company’s financial health, and
also to determine whether to buy or sell a particular stock.
In this chapter, we will be looking into the four most important corporate actions and their im-
pact on stock prices.
A corporate action is initiated by the board of directors, and approved by the company’s share-
holders.
11.2 - Dividends
Dividends are paid by the company to its shareholders. Dividends are paid to
distribute the profits made by the company during the year. Dividends are
paid on a per share basis. For example, during the financial year 2012-13 Info-
sys had declared a dividend of Rs.42 per share. The dividend paid is also ex-
pressed as a percentage of the face value. In the above case, the face value of
Infosys was Rs.5/- and the dividend paid was Rs.42/- hence the dividend payout is said to be
840% (42/5).
It is not mandatory to pay out the dividends every year. If the company feels that instead of pay-
ing dividends to shareholders they are better off utilizing the same cash to fund new project for a
better future, then can do so.
Besides, the dividends need not be paid from the profits alone. If the company has made a loss
during the year but it does hold a healthy cash reserve, then the company can still pay dividends
from its cash reserves.
Sometimes distributing the dividends may be the best way forward for the company. When the
growth opportunities for the company have exhausted and the company holds excess cash, it
would make sense for the company to reward its shareholders thereby repaying the trust the
shareholders hold in the company.
The decision to pay dividend is taken in the Annual General Meeting (AGM) during which the direc-
tors of the company meet. The dividends are not paid right after the announcement. This is be-
cause the shares are traded throughout the year and it would be difficult to identify who gets the
dividend and who doesn’t. The following timeline would help you understand the dividend cycle.
Dividend Declaration Date: This is the date on which the AGM takes place and the company’s
board approves the dividend issue
Record Date: This is the date on which the company decides to review the shareholders register to
list down all the eligible shareholders for the dividend. Usually the time difference between the
dividend declaration date and record date is at least 30 days
Ex Date/Ex Dividend date: The ex dividend date is normally set two business days before the re-
cord date. Only shareholders who own the shares before the ex dividend date are entitled to the
dividend. This is because in India the normal settlement is on T+2 basis. So for all practical pur-
poses if you want to be entitled for dividend you need to ensure you buy the shares before the ex
dividend date.
Dividend Payout Date: This is the day on which the dividends are paid out to shareholders listed in
the register of the company.
Cum Dividend: The shares are said to be cum dividend till the ex dividend date.
When the stock goes ex dividend, usually the stock drops to the extent of dividends paid. For ex-
ample if ITC (trading at Rs. 335) has declared a dividend of Rs.5. On ex date the stock price will
drop to the extent of dividend paid, and as in this case the price of ITC will drop down to Rs.330.
The reason for this price drop is because the amount paid out no longer belongs to the company.
Dividends can be paid anytime during the financial year. If it’s paid during the financial year it is
called the interim dividend. If the dividend is paid at the end of the financial year it is called the
final dividend.
11.3 - Bonus Issue

A bonus issue is a stock dividend, allotted by the company to reward the
shareholders. The bonus shares are issued out of the reserves of the com-
pany. These are free shares that the shareholders receive against shares that
they currently hold. These allotments typically come in a fixed ratio such as,
1:1, 2:1, 3:1 etc.
If the ratio is 2:1 ratio, the existing shareholders get 2 additional shares for every 1 share they
hold at no additional cost. So if a shareholder owns 100 shares then he will be issued an addi-
tional 200 shares, so his total holding will become 300 shares. When the bonus shares are issued,
the number of shares the shareholder holds will increase but the overall value of investment will
remain the same.
To illustrate this kindly refer to Table 11.1 in the following page, let us assume a bonus issue on
different ratios – 1:1, 3:1 and 5:1
Table 11.1 - Bonus Issue
Share price Value of Number of

Bonus No of shares held Share price after Value of Investment
before Bonus Investment shares held
Issue before bonus Bonus issue
issue after Bonus
1:1 100 75 7,500 200 37.5 7500

3:1 30 550 16,500 120 137.5 16,500
5:1 2000 15 30,000 12,000 2.5 30,000
Similar to the dividend issue there is a bonus announcement date, ex bonus date, and record date.
Companies issue bonus shares to encourage retail participation, especially when the price per
share of a company is very high and it becomes tough for new investors to buy shares. By issuing
bonus shares, the number of outstanding shares increases, but the value of each share reduces as
shown in the example above.
11.4 - Stock Split

The word stock split- for the first time sounds weird but this happens on a regular
basis in the markets. What this means is quite obvious – the stocks that you hold
actually are split!
When a stock split is declared by the company the number of shares held increases but the invest-
ment value/market capitalization remains the same similar to bonus issue. The stock is split with
reference to the face value. Suppose the stock’s face value is Rs.10, and there is a 1:1 stock split
then the face value will change to Rs.5. If you owned 1 share before split you would now own 2
shares after the split.
We will illustrate this with an example, refer to Table 11.2 in the following page:
Table 11.2 - Stock Split
No of
Share
shares you Investment
Price No of shares Share Price after Investment value
Split own Value New FV
Old FV before you own after the split after split
Ratio before before split
split split
split
1:1 10 100 900 90,000 5 200 450 90,000
1:5 10 100 900 90,000 2 500 180 90,000
Similar to bonus issue, stock split is usually to encourage more retail participation by reducing
the value per share.
11.5 - Rights Issue

The idea behind a rights issue is to raise fresh capital. However instead of go-
ing public, the company approaches their existing shareholders Think about
the rights issue as a second IPO but for a select group of people (existing
shareholders). The rights issue could be an indication of a promising new de-
velopment in the company. The shareholders can subscribe to the rights issue in the proportion
of their share holding. For example 1:4 rights issue means for every 4 shares a shareholder owns,
he can subscribe to 1 additional share. Needless to say the new shares under the rights issue will
be issued at a lower price than what prevails in the markets.
However, a word of caution – The investor should not be swayed by the discount offered by the
company but they should look beyond that. Rights issue is different from bonus issue as one is
paying money to acquire shares. Hence the shareholder should subscribe only if he or she is com-
pletely convinced about the future of the company. Also, if the market price is below the subscrip-
tion price/right issue price it is obviously cheaper to buy it from the open market.
11.6 Buyback of shares

A buyback can be seen as a method for company to invest in itself by buying
shares from other investors in the market. Buybacks reduce the number of
shares outstanding in the market, however buyback of shares is an important
method of corporate restructuring.
There could be many reasons why corporates choose to buy back shares..
1. Improve the profitability on a per share basis

2. To consolidate their stake in the company
3. To prevent other companies from taking over
4. To show the confidence of the promoters about their company
5. To support the share price from declining in the markets
When a company announces a buy back, it signals the company’s confidence about itself. Hence
this is usually a positive for the share price.
1. Corporate actions has an impact on stock prices

2. Dividends are means of rewarding the shareholders. Dividend is announced as a percentage
of face value
3. If you aspire to get the dividend you need to own the stock before the ex dividend date
4. A bonus issue is a form of stock dividend. This is the company’s way of rewarding the
shareholders with additional shares
5. A stock spilt is done based on the face value. The face value and the stock price changes in
proportion to the change in face value
6. Rights issue is way through which the company raises fresh capital from the existing
shareholders. Subscribe to it only if you think it makes sense
7. Buy back signals a positive outlook of the promoters. This also conveys to the shareholders
that the promoters are optimistic of the company’s prospects.
C H A PT E R 12
Key Events and Their Impact

on Markets
12.1 - Overview
For a market participant transacting just based on company specific information may not be suffi-
cient. It is also important to understand the events that influence the markets. Various outside
factors, economic and/or non-economic events have a key impact on the performance of stocks
and markets in general.
In this chapter we will try to understand some of these events, and also how the stock market re-
acts to them.
12.2 - Monetary Policy
The monetary policy is a tool with which the Reserve Bank of India (RBI) controls the money sup-
ply by controlling the interest rates. They do this by tweaking the interest rates. RBI is India’s cen-
tral bank. World over every country’s central bank is responsible for setting the interest rates.
While setting the interest rates the RBI has to strike a balance between growth and inflation. In a
nutshell – if the interest rates are high that means the borrowing rates are high (particularly for
corporations). If corporate can’t borrow easily they cannot grow. If corporations don’t grow, the
economy slows down.
On the other hand when the interest rates are low, borrowing becomes easier. This translates to
more money in the hands of the corporations and consumers. With more money there is in-
creased spending which means the sellers tend to increase prices leading to inflation.
In order to strike a balance, the RBI has to consider all the factors and should carefully set a few
key rates. Any imbalance in these rates can lead to an economic chaos. The key RBI rates that you
need to track are as follows:
Repo Rate – Whenever banks want to borrow money they can borrow from the RBI. The rate at
which RBI lends money to other banks is called the repo rate. If repo rate is high that means the
cost of borrowing is high, leading to a slow growth in the economy. Currently, the repo rate in In-
dia is 8%. Markets don’t like the RBI increasing the repo rates.
Reverse repo rate – Reverse Repo rate is the rate at which RBI borrows money from banks. When
banks lend money to RBI they are certain that RBI will not default, and hence they are happier to
lend their money to RBI as opposed to a corporate. However when banks choose to lend money
to the RBI instead of the corporate entity, the supply of money in the banking system reduces. An
increase in reverse repo rate is not great for the economy as it tightens the supply of money. The
reverse repo rate is currently at 7%.
Cash reserve ratio (CRR) – Every bank is mandatorily required to maintain funds with RBI. The
amount that they maintain is dependent on the CRR. If CRR increases then more money is re-
moved from the system, which is again not good for the economy.
The RBI meets every quarter to review the rates. This is a key event that the market watches out
for. The first to react to rate decisions would be interest rate sensitive stocks across various sec-
tors such as – banks, automobile, housing finance, real estate, metals etc.
12.3 - Inflation
Inflation is a sustained increase in the general prices of goods and services. Increasing inflation
erodes the purchasing power of money. All things being equal, if the cost of 1 KG of onion has in-
creased from Rs.15 to Rs.20 then this price increase is attributed to inflation. Inflation is inevita-
ble but a high inflation rate is not desirable as it could lead to economic uneasiness. A high level
of inflation tends to send a bad signal to markets. Governments work towards cutting down the
inflation to a manageable level. Inflation is generally measured using an index. If the index is go-
ing up by certain percentage points then it indicates rising inflation, likewise index falling indi-
cates inflation cooling off.
There are two types of inflation indices – Wholesale Price Index (WPI) and Consumer Price Index
(CPI).
Wholesale Price Index (WPI) – The WPI indicates the movement in prices at the wholesale level. It
captures the price increase or decrease when they are sold between organizations as opposed to
actual consumers. WPI is an easy and convenient method to calculate inflation. However the infla-
tion measured here is at an institutional level and does not necessarily capture the inflation expe-
rienced by the consumer.
As I write this, the WPI inflation for the month of May 2014 stands at 6.01%.
Consumer Price Index (CPI)- The CPI on the other hand captures the effect of the change in prices
at a retail level. As a consumer, CPI inflation is what really matters. The calculation of CPI is quite
detailed as it involves classifying consumption into various categories and sub categories across
urban and rural regions. Each of these categories is made into an index. This means the final CPI
index is a composition of several internal indices.
The computation of CPI is quite rigorous and detailed. It is one of the most critical metrics for
studying the economy. A national statistical agency called the Ministry of Statistics and Pro-
gramme implementation (MOSPI) publishes the CPI numbers around the 2nd week of every
month.
The CPI stands at 8.28% for the month of May 2014. Here is a chart for the inflation for the last
one year in India.
As you can notice, the CPI inflation has kind of cooled off from the peak of 11.16% in November
2013. The RBI’s challenge is to strike a balance between inflation and interest rates. Usually a low
interest rate tends to increase the inflation and a high interest rate tends to arrest the inflation.
12.4 - Index of Industrial Production (IIP)

The Index of Industrial Production (IIP) is a short term indicator of how the industrial sector in
the country is progressing. The data is released every month (along with inflation data) by Minis-
try of Statistics and Programme implementation (MOSPI). As the name suggests, the IIP meas-
ures the production in the Indian industrial sectors keeping a fixed reference point. As of today,
India uses the reference point of 2004-05. The reference point is also called the base year.
Roughly about 15 different industries submit their production data to the ministry, which collates
the data and releases it as an index number. If the IIP is increasing it indicates a vibrant industrial
environment (as the production is going up) and hence a positive sign for the economy and mar-
kets. A decreasing IIP indicates a sluggish production environment, hence a negative sign for the
economy and markets.
To sum up, an upswing in the industrial production is good for the economy and a downswing
rings an alarm. As India is getting more industrialized, the relative importance of the Index of In-
dustrial Production is increasing.
A lower IIP number puts pressure on the RBI to lower the interest rates. The following graph
shows the change in IIP in percentage terms for the last 1 year.
12.5 - Purchasing Managers Index (PMI)
The Purchasing managers index (PMI) is an economic indicator which tries to capture the busi-
ness activity across the manufacturing and service sectors in the country. This is a survey based
indicator where the respondents – usually the purchasing managers indicate their change in busi-
ness perception with respect to the previous month. A separate survey is conducted for the serv-
ice and the manufacturing sectors. The data from the survey is consolidated on to a single index.
Typical areas covered in the survey include factors such as new orders, output, business expecta-
tions and employment amongst others.
The PMI number usually oscillates around 50. A reading above 50 indicates expansion and below
50 indicates a contraction in the economy. And a reading at 50 indicates no change in the econ-
omy.
12.6 - Budget
The Budget is an event during which the Ministry of Finance discusses the country’s finance in de-
tail. The Finance Minister on behalf of the ministry makes a budget presentation to the entire
country. During the budget, major policy announcements and economic reforms are announced
which has an impact on various industries across the markets. Therefore the budget plays a very
important role in the economy
To illustrate this further, one of the expectations for the budget (July 2014) was to increase the du-
ties on cigarette. As expected, during the budget, the Finance Minister raised the duties on ciga-
rette, and hence the prices of cigarettes were also increased. An increased cigarette price has a
few implications:
1. Increased cigarette prices discourage smokers from buying cigarettes (needless to say this is
a debatable) and hence the profitability of the cigarette manufacturing companies such as ITC
decreases. If the profitability decreases then investors may want to sell shares of ITC.
2. If market participants start selling ITC, then the markets will come down because ITC is an
index heavy weight.
In fact as a reaction to the budget announcement ITC traded 3.5% lower for this precise reason.
Budget is an annual event and it is announced during the last week of February. However under
certain special circumstances such as a new government formation the budget announcement
could be delayed.
12.7 - Corporate Earnings Announcement
This is perhaps one of the important events to which the stocks react. The listed companies (trad-
ing on stock exchange) are required to declare their earning numbers once in every quarter, also
called the quarterly earning numbers. During an earnings announcement the corporate gives out
details on various operational activities including..
1. How much revenue the company has generated?

2. How has the company managed its expense?
3. How much money the company paid in terms of taxes and interest charges?
4. What is the profitability during the quarter?
Besides some companies give an overview of what they expect from the upcoming quarters. This
forecast is called the ‘corporate guidance’.
Invariably every quarter the first blue chip company to make the quarterly announcement is Info-
sys Limited. They also give out guidance regularly. Market participants keenly follow what Infosys
has to say in terms of guidance as it has an overall impact on the markets.
The table below gives you an overview of the earning season in India:
Table 12.1 - Quarterly Earnings
Result Announcement
Sl No Months Quarter
1 April to June Quarter 1 (Q1) 1st week of July
2 July to September Quarter 2 (Q2) 1st week of Oct
3 October to December Quarter 3 (Q3) 1st Week of Jan
4 January to March Quarter 4 (Q4) 1st Week of April
Every quarter when the company declares their earnings, the market participants match the earn-
ings with their own expectation of how much the company should have earned. The market par-
ticipant’s expectation is called the ‘street expectation’.
The stock price will react positively if the company’s earnings are better than the street expecta-
tion. On a similar logic, the stock price will react negatively if the actual numbers are below the
street expectation.
If the street expectation and actual numbers match, more often than not the stock price tends to
trade flat with a negative bias. This is mainly owing to fact that the company could not give any
positive surprises.
1. Markets and individual stocks react to events. Market participants should equip themselves
to understand and decipher these events
2. Monetary policy is one of the most important economic event. During the monetary policy,
review actions on repo, reverse repo, CRR etc are initiated
3. Interest rates and inflation are related. Increasing interest rates curbs inflation and vice versa
4. Inflation data is released every month by MOSPI. As a consumer, CPI inflation data is what
you need to track
5. IIP measures the industrial production activity. Increase in IIP cheers the markets and lower
IIP disappoints the market
6. PMI is a survey based business sentiment indicator. The PMI number oscillates around the 50
mark. Above 50 is good news to markets and PMI below 50 is not.
7. The Budget is an important market event where policy announcements and reform initiatives
are taken. Markets and stocks react strongly to budget announcements
8. Corporate earnings are reported every quarter. Stocks react mainly due to the variance in
actual number versus the street’s expectation.
C H A PT E R 13
Getting started!
Assuming you are done reading and understanding the entire 12 chapters in our very first module
– Introduction to stock markets, you are now warmed up to dig deeper!
The objective of the first module is to give you quick hands on introduction to the stock markets.
In our endeavor to introduce the stock markets to you, we have carefully selected concepts that
you need to know, especially if you are absolutely new to markets. If you have many unanswered
questions at this stage, it is a good sign. You will find your answers as we proceed to other mod-
ules.
At this stage, it is extremely important for you to understand why we have so many different learn-
ing modules, and how these modules are interrelated. To give you a head up, here are some of
the modules that we will cover in Varsity.
1. Introduction to Stock Markets

2. Technical analysis
3. Fundamental Analysis
4. Futures Trading
5. Option Theory
6. Option Strategies
7. Quantitative Concepts
8. Commodity Markets
9. Risk Management & Trading Philosophy
10.Trading Strategies & Systems
11.Financial Modeling for Investment practice
13.1 - So many modules – how are they interrelated?

The idea of ‘Varsity at Zerodha’ is to put up a repository of high quality market related educa-
tional content. The content, will cover various aspects of fundamental analysis, technical analy-
sis, derivatives, trading strategies, risk management, financial modeling etc. Each main topic is
categorized as a module. If you are new to the markets, you could be wondering how each of
these topics fit within the grand scheme of things.
To help you get a perspective, allow me to post a simple question to you.
In order to be successful in the markets, what according to you is the single most important fac-
tor? Success in markets is easily defined – if you make money consistently you are successful, and
if you don’t you are not!
So if you were to answer this question for me, chances are you will think about factors such as
risk management, discipline, market timing, access to information etc as the key to be successful
in markets.
While one cannot deny the importance of these factors what is even more compelling and pri-
mary is developing a point of view (POV).
A point of view is an art of developing a sense of direction on a stock or the markets in general. If
you think the stock is going up, your POV is bullish hence you would be a buyer of the stock. Like-
wise if you think a stock is going down your POV is bearish therefore you would be a seller of the
stock.
Having said that, how do you actually develop a point of view? How do you figure out if the stock
is going up or down?
To develop a point of view, one needs to develop a systematic approach to analyze the markets.
There are a few methods using which you can figure out/ analyze what to buy or sell. They are:
1. Fundamental Analysis (FA)

2. Technical Analysis (TA)
3. Quantitative Analysis (QA)
4. Outside views
Just to give you a preview, here is a typical illustration of a trader’s thought process while devel-
oping a POV (whether to buy or sell stocks) based on a particular method of analysis -
FA based POV – The quarterly numbers looks impressive. The company has reported a 25% top
line and 15% bottom-line growth. The company’s guidance also looks positive. With all the funda-
mentals factors aligned, the stock looks bullish hence the stock is a buy.
TA based POV – The MACD indicator has turned bullish along with a bullish engulfing candlestick
pattern, with that study the stock’s short term sentiment looks positive therefore the stocks is a
buy.
QA based POV – With the recent up move, the stock’s price to earnings (PE) touched the 3rd stan-
dard deviation. There is only 1% chance for the PE to breach the 3rd standard deviation. Hence it
is prudent to expect a reversion to mean; therefore the stock is a sell.
Outside view – The analyst on TV is recommending a buy on the stock therefore the stock is a
buy.
The POV you take should always be based on your own analysis rather than an outsider’s view, as
more often than not one ends up regretting taking an action based on anoutside view.
So after developing a POV what does one generally do? Does he straight away go and trade the
point of view? Here is where the complexity of markets starts to kick in.
If the POV is bullish, you can choose to do one of the following:
1. Buy the stock in the spot market
2. Buy the stock in the derivatives markets.
a.Within derivatives you can choose to buy the futures
b.Or choose to trade via the option market
i) Within the option market there are call options and put options.
ii) You can also do a combination of call and put options to create a synthetic bullish
trade
So what you choose to do after developing a POV is a totally a different ball game. Choosing the
right instrument to trade which complements your POV is highly critical to profitable trading.
For example, if I’m extremely bullish on a stock from 1 year perspective then I’m better off doing
a delivery trade. However if I’m out rightly bullish on the stock from a short tem perspective (say
1 week) then I’d rather choose a futures instrument to trade.
If I’m bullish with constraints attached (example - I’m expecting the markets to bounce because
of a great budget announcement, but I don’t want to risk much) then it would be prudent to
choose an options instrument.
So the message here is – the market participant should develop a point of view and complement
the POV with the right trading instrument. A well researched POV combined with the right instru-
ment to trade is a perfect recipe for market success.
Also by now, hopefully you have got a sense of how all the different modules in “Varsity” play an
important role in assimilating the market.
So keeping this in background, go ahead and explore the content on Varsity at Zerodha.
The next two modules will explore concepts that will help us develop POV based on Technical
and Fundamental Analysis.
After reading through these two modules you will get a sense of developing a point of view on
markets. The later modules we will discuss the different trading instruments that you can choose
to complement your point of view. As we progress along, we will ramp up the flow to help you
start calibrating your trades with effective risk management techniques.
CHAPTER 14
Supplementary Note
IPO, OFS, and FPO – How are they different?
IPO
Initial Public Offering is when a company is introduced in to the publicly traded stock
markets for the very first time. In the IPO, the promoters of the company choose to offer
a certain percentage of shares to the public. The reason for going public and the
process of an IPO is explained in detail in Chapter 4 and 5.
The primary reason for going public is to raise capital which would be to fund expansion
projects or cash out early investors. After the IPO is listed on the exchange and is traded
in the secondary market, promoters of the company might still want additional capital
for which there are three options available: Rights Issue, Offer for Sale and Follow -on
Public Offer
Rights Issue
The promoters can choose to raise additional capital from its existing shareholders by
offering them new shares at a discounted price (generally lower than Market Price). The
company offers new shares in proportion of shares already held by the shareholders.
For example, a 1:4 Rights Issue would mean that for every 4 shares held 1 additional
share is offered. Although this option looks good, it limits the company to raise the
capital from a small number of investors who are already holding shares of the
company and might not want to invest more. A rights issue leads to creation of new
shares that are offered to the shareholders, which in turn, dilutes the value of the
previous held shares.
An example of a Rights issue is of South Indian Bank which announced a 1:3(One share
for every 3 held) issue at a price of Rs 14 which is 30% lower than the Market Price the
stock was trading (Rs 20 as on Record date 17 Feb 2017). The bank offered 45.07 lakh
shares to the existing shareholders.
Rights issue is covered in detail in Chapter 11 covering key Corporate Actions
OFS
The promoters can choose to offer the secondary issue of shares to the whole market
unlike a rights issue which is restricted to existing shareholders. The Exchange provides
a separate window through the stock brokers for the Offer for Sale. The exchange
allows company to route funds through OFS only if the Promoters want to sell out their
holdings and/or to maintain minimum public shareholding requirement (For example,
Govt. PSU have a public shareholding requirement of 25%).
There is a floor price set by the company, at or above which bids can be made by both
Retail and Non-Retail investors. The shares are allotted, if bids are at cut-off price or
above will be settled by the exchange into the investor Demat account in T+1 Days.
An example of an Offer for Sale is NTPC limited which offered a maximum of 46.35
million shares at a floor price of Rs 168 and was fully subscribed in the 2 day period.
The OFS was held on 29th August 2017 for Non-Retail Investors and 30th August 2017.
FPO
A FPO also has the same intent of raising additional capital after it has been listed but
follows a different mechanism for the application and allotment of shares. Shares can
be diluted and fresh shares can be created and offered in an FPO. Just like an IPO, a
FPO requires that Merchant Bankers be appointed to create a Draft Red Herring
Prospectus which has to be approved by SEBI after which bidding is allowed in a 3 -5
day period. Investors can place their bids through ASBA and shares are allotted based
on the Cut-off Price decided after the book building process. Since the introduction of
OFS in 2012, FPOs are seldom used due to the lengthy process of approvals.
The company decides on a Price Band and the FPO is publicly advertised. Prospective
investors can bid for the issue using ASBA portal through Internet Banking or apply
offline through a Bank Branch. After the bidding process is complete, the cut -off price
is declared based on the demand and the additional shares allotted are listed on the
exchange for trading in the secondary markets.
An example of an FPO is of Engineers India Ltd which underwent an issue in February

2014 with a price band of Rs 145-Rs 150. The issue was oversubscribed by 3 times. The
shares on the day of starting date of the issue was trading at Rs 151.1. The lower price
band was at a 4.2% discount from the market price.
Difference between OFS and FPO
o An OFS is used to offload the shares of Promoters while a FPO is used to fund new
projects
o Dilution of shares is allowed in a FPO leading to change in Shareholding structure while

OFS does not affect the number of authorized shares.
o Only the top 200 companies by Market Capitalisation are allowed to use the OFS route
to raise funds while FPO option can be used by all listed companies
o Ever since OFS has been introduced by SEBI, FPO issues have come down and
companies prefer to choose the OFS route to raise funds
Module 2
Technical Analysis
1.1 – Overview
The previous module set us on a good plane with the basic understanding about the
stock markets. Taking cues from the previous module, we now know that
developing a well researched point of view is critical for stock market success. A
good point of view should have a directional view and should also include
information such as:
1. Price at which one should buy and sell stocks

2. Risk involved
3. Expected reward
4. Expected holding period
Technical Analysis (also abbreviated as TA) is a popular technique that allows you to
do just that. It not only helps you develop a point of view on a particular stock or
index but also helps you define the trade keeping in mind the entry, exit and risk
perspective.
Like all research techniques, Technical Analysis also comes with its own attributes,
some of which can be highly complex. However technology makes it easy to
understand. We will discover these attributes as we proceed along this module.
1.2 – Technical Analysis, what is it?

Consider this analogy.
Imagine you are vacationing in a foreign country where everything including the
language, culture, climate, and food is new to you. On day 1, you do the regular
touristy activities, and by evening you are very hungry. You want to end your day by
having a great dinner. You ask around for a good restaurant and you are told about
a nice food street which is close by. You decide to give it a try.
To your surprise, there are many vendors selling different varieties of food.
Everything looks different and interesting. You are absolutely clueless as to what to
eat for dinner. To add to your dilemma you cannot ask around as you do not know
the local language. So given all this, how will you make a decision on what to eat?
1
Well, you have two options to figure out what to eat.
Option 1: You visit a vendor, figure out what they are cooking / selling. Check on the
ingredients used, cooking style, probably taste a bit and figure out if you actually like
the food. You repeat this exercise across a few vendors, after which you would most
likely end up eating at a place that satisfies you the most.
The advantage with this technique is that you know exactly what you are eating
since you have researched about it on your own. However on the flip side, the
methodology you adopted is not really scalable as there could be about 100 odd
vendors, and with limited time at your disposal, you can probably cover about 4 or 5
vendors. Hence there is a high probability that you could have missed the best
tasting food on the street!
Option 2: You just stand in a corner and observe all the vendors. You try and find a
vendor who is attracting the maximum crowd. Once you find such a vendor you
make a simple assumption -‘The vendor is attracting so many customers which
means he must be making the best food!’ Based on your assumption and the
crowd’s preference you decide to go to that particular vendor for your dinner.
Chances are that you could be eating the best tasting food available on the street.
The advantage of this method is the scalability. You just need to spot the vendor
with the maximum number of customers and bet on the fact that the food is good
based on the crowd’s preference. However, on the flipside the crowd need not
always be right.
If you could recognize, option 1 is very similar to Fundamental Analysis where you
research about a few companies thoroughly. We will explore about Fundamental
Analysis in greater detail in the next module.
2
Option 2 is very similar to Technical Analysis where one scans for opportunities
based on the current trend aka the preference of the market.
Technical Analysis is a research technique to identify trading opportunities in

market based on the actions of market participants. The actions of markets
participants can be visualized by means of a stock chart. Over time, patterns are
formed within these charts and each pattern conveys a certain message. The job of
a technical analyst is to identify these patterns and develop a point of view.
Like any research technique, technical analysis stands on a bunch of assumptions.

As a practitioner of technical analysis, you need to trade the markets keeping these
assumptions in perspective. Of course we will understand these assumptions in
details as we proceed along.
Also, at this point it makes sense to throw some light on a matter concerning FA and
TA. Often people get into the argument contending a particular research technique
is a better approach to market. However in reality there is no such thing as the best
research approach. Every research method has its own merits and demerits. It
would be futile to spend time comparing TA and FA in order to figure out which is a
better approach.
Both the techniques are different and not comparable. In fact a prudent trader
would spend time educating himself on both the techniques so that he can identify
great trading or investing opportunities.
1.3 – Setting expectations

Often market participants approach technical analysis as a quick and easy way to
make a windfall gain in the markets. On the contrary, technical analysis is anything
but quick and easy. Yes, if done right, a windfall gain is possible but in order get to
that stage one has to put in the required effort to learn the technique.
If you approach TA as a quick and easy way to make money in markets, trading
catastrophe is bound to happen. When a trading debacle happens, more often than
not the blame is on technical analysis and not on the trader’s inability to efficiently
apply Technical Analysis to markets. Hence before you start delving deeper into
technical analysis it is important to set expectations on what can and cannot be
achieved with technical analysis.
1. Trades – TA is best used to identify short term trades. Do not use TA to identify long
term investment opportunities. Long term investment opportunities are best
identified using fundamental analysis. Also, If you are a fundamental analyst, use TA
to calibrate the entry and exit points
2. Return per trade – TA based trades are usually short term in nature. Do not expect
huge returns within a short duration of time. The trick with being successful with TA
3
is to identify frequent short term trading opportunities which can give you small but
consistent profits.
3. Holding Period – Trades based on technical analysis can last anywhere between
few minutes and few weeks, and usually not beyond that. We will explore this
aspect when we discuss the topic on timeframes.
4. Risk – Often traders initiate a trade for a certain reason, however in case of an
adverse movement in the stock, the trade starts making a loss. Usually in such
situations, traders hold on to their loss making trade with a hope they can recover
the loss. Remember, TA based trades are short term, in case the trade goes sour, do
remember to cut the losses and move on to identify another opportunity.
1. Technical Analysis is a popular method to develop a point of view on markets.

Besides, TA also helps in identifying entry and exit points
2. Technical Analysis visualizes the actions of market participants in the form of stock
charts
3. Patterns are formed within the charts and these patterns help a trader identify
trading opportunities
4. TA works best when we keep a few core assumptions in perspective
5. TA is used best to identify short terms trades
4
Chapter 3
Introducing Technical Analysis

69
2.1– Overview
In the previous chapter we briefly understood what Technical Analysis was all about.
In this chapter we will focus on the versatility and the assumptions of Technical
Analysis.
2.2 – Application on asset types

Probably one of the greatest versatile features of technical analysis is the fact you
can apply TA on any asset class as long as the asset type has historical time series
data. Time series data in technical analysis context is information pertaining to the
price variables namely – open high, low, close, volume etc.
Here is an analogy that may help. Think about learning how to drive a car. Once you
learn how to drive a car, you can literally drive any type of car. Likewise you only
need to learn technical analysis once. Once you do so, you can apply the concept of
TA on any asset class – equities, commodities, foreign exchange, fixed income etc.
This is also probably one of the biggest advantages of TA when compared to the
other fields of study. For example when it comes to fundamental analysis of equity,
one has to study the profit and loss, balance sheet, and cash flow statements.
However fundamental analysis for commodities is completely different.
5
If you are dealing with agricultural commodity like Coffee or Pepper then the
fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory
etc. However the fundamentals of metal commodities are different, so is for energy
commodities. So every time you choose a commodity, the fundamentals change.
However the concept of technical analysis will remain the same irrespective of the
asset you are studying. For example, an indicator such as ‘Moving average
convergence divergence’ (MACD) or ‘Relative strength index’ (RSI) is used exactly the
same way on equity, commodity or currency.
2.3 – Assumption in Technical Analysis

Unlike fundamental analysts, technical analysts don’t care whether a stock is
undervalued or overvalued. In fact the only thing that matters is the stocks past
trading data (price and volume) and what information this data can provide about
the future movement in the security.
Technical Analysis is based on few key assumptions. One needs to be aware of

these assumptions to ensure the best results.
1) Markets discount everything – This assumption tells us that, all known and
unknown information in the public domain is reflected in the latest stock price. For
example there could be an insider in the company buying the company’s stock in
large quantity in anticipation of a good quarterly earnings announcement. While he
does this secretively, the price reacts to his actions thus revealing to the technical
analyst that this could be a good buy.
2) The ‘how’ is more important than ‘why’ – This is an extension to the first
assumption. Going with the same example as discussed above – the technical
analyst would not be interested in questioning why the insider bought the stock as
long he knows how the price reacted to the insider’s action.
3) Price moves in trend – All major moves in the market is an outcome of a trend.
The concept of trend is the foundation of technical analysis. For example the recent
upward movement in the NIFTY Index to 7700 from 6400 did not happen overnight.
This move happened in a phased manner, in over 11 months. Another way to look
at it is, once the trend is established, the price moves in the direction of the trend.
4) History tends to repeat itself – In the technical analysis context, the price trend
tends to repeat itself. This happens because the market participants consistently
react to price movements in a remarkably similar way, each and every time the price
moves in a certain direction. For example in up trending markets, market
participants get greedy and want to buy irrespective of the high price. Likewise in a
down trend, market participants want to sell irrespective of the low and unattractive
prices. This human reaction ensures that the price history repeats itself.
6
2.4 – The Trade Summary
The Indian stock market is open from 9:15 AM to 15:30 PM. During the 6 hour 15
minute market session, there are millions of trades that take place. Think about an
individual stock – every minute there is a trade that gets executed on the exchange.
The question is, as a market participant, do we need to keep track of all the different
price points at which a trade is executed?
To illustrate this further, let us consider this imaginary stock in which there are
many trades. Look at the picture below. Each point refers to a trade being executed
at a particular time. If one manages to plot a graph which includes every second
from 9:15 AM to 15:30 PM, the graph will be cluttered with many points. Hence in
the chart below, for ease of understating I’ve plotted a limited time scale period:
Market opened at 9:15 AM and closed at 15:30 PM during which there were many
trades. It will be practically impossible to track all these different price points. In fact
what one needs is a summary of the trading action and not really the details on all
the different price points.
By tracking the Open, high, low and close we can draw a summary of the price
action.
The open – When the markets open for trading, the first price at which a trade
executes is called the opening Price.
The high – This represents the highest price at which the market participants were
willing to transact for the given day.
The Low – This represents the lowest level at which the market participants were
willing to transact for the given day.
The close – The Close price is the most important price because it is the final price
at which the market closed for a particular period of time. The close serves as an
indicator for the intraday strength. If the close is higher than the open, then it is
7
considered a positive day else negative. Of course we will deal with this in a greater
detail as we progress through the module.
The closing price also shows the market sentiment and serves as a reference point
for the next day’s trading. For these reasons, closing price is more important than
the Open, High or Low prices.
The open, high, low, close prices are the main data points from the technical
analysis perspective. Each of these prices have to be plotted on the chart and
analyzed.
1. Technical Analysis is not bound by its scope. The concepts of TA can be applied
across any asset class as long as it has a time series data
2. TA is based on few core assumptions.
1. Markets discount everything
2. The how is more important than why
3. Price moves in trends
4. History tends to repeat itself
3. A good way to summarize the daily trading action is by marking the open, high, low
and close prices usually abbreviated as OHLC
8
Module 2 — Technical Analysis
Chapter 3
The Chart Types

136
3.1– Overview
Having recognized that the Open (O), high (H), low (L), and close (C) serves as the
best way to summarize the trading action for the given time period, we need a
charting technique that displays this information in the most comprehensible way. If
not for a good charting technique, charts can get quite complex. Each trading day
has four data points’ i.e the OHLC. If we are looking at a 10 day chart, we need to
visualize 40 data points (1 day x 4 data points per day). So you can imagine how
complex it would be to visualize 6 months or a year’s data.
As you may have guessed, the regular charts that we are generally used to – like the
column chart, pie chart, area chart etc does not work for technical analysis. The only
exception to this is the line chart.
The regular charts don’t work mainly because they display one data point at a given
point in time. However Technical Analysis requires four data points to be displayed
at the same time.
Below are some of the chart types:
1. Line chart
2. Bar Chart
9
3. Japanese Candlestick
The focus of this module will be on the Japanese Candlesticks however before we
get to candlesticks, we will understand why we don’t use the line and bar chart.
3.2 – The Line and Bar chart

The line chart is the most basic chart type and it uses only one data point to form
the chart. When it comes to technical analysis, a line chart is formed by plotting the
closing prices of a stock or an index. A dot is placed for each closing price and the
various dots are then connected by a line.
If we are looking 60 day data then the line chart is formed by connecting the dots of
the closing prices for 60 days.
The line charts can be plotted for various time frames namely monthly, weekly,
hourly etc. So ,if you wish to draw a weekly line chart, you can use weekly closing
prices of securities and likewise for the other time frames as well.
The advantage of the line chart is its simplicity. With one glance, the trader can
identify the generic trend of the security. However the disadvantage of the line chart
is also its simplicity. Besides giving the analysts a view on the trend, the line chart
does not provide any additional detail. Plus the line chart takes into consideration
only the closing prices ignoring the open, high and low. For this reason traders
prefer not to use the line charts.
The bar chart on the other hand is a bit more versatile. A bar chart displays all the
four price variables namely open, high, low, and close. A bar has three components.
1. The central line – The top of the bar indicates the highest price the security has
reached. The bottom end of the bar indicates the lowest price for the same period.
2. The left mark/tick – indicates the open
3. The right mark/tick – indicates the close
10
For example assume the OHLC data for a stock as follows:
Open – 65
High – 70
Low – 60
Close – 68
For the above data, the bar chart would look like this:
As you can see, in a single bar, we can plot four different price points. If you wish to
view 5 days chart, as you would imagine we will have 5 vertical bars. So on and so
forth.
Note the position of the left and right mark on the bar chart varies based on how
the market has moved for the given day.
If the left mark, which represents the opening price is placed lower than the right
mark, it indicates that the close is higher than the open (close > open), hence a
positive day for the markets. For example consider this: O = 46, H = 51, L = 45, C =
49. To indicate it is a bullish day, the bar is represented in blue color.
11
Likewise if the left mark is placed higher than the right mark it indicates that the
close is lower than the open (close <open), hence a negative day for markets. For
example consider this: O = 74, H=76, L=70, C=71. To indicate it is a bearish day, the
bar is represented in red color.
The length of the central line indicates the range for the day. A range can be defined
as the difference between the high and low. Longer the line, bigger the range,
shorter the line, smaller is the range.
While the bar chart displays all the four data points it still lacks a visual appeal. This
is probably the biggest disadvantage of a bar chart. It becomes really hard to spot
potential patterns brewing when one is looking at a bar chart. The complexity
increases when a trader has to analyze multiple charts during the day.
Hence for this reason the traders do not use bar charts. However it is worth
mentioning that there are traders who prefer to use bar charts. But if you are
starting fresh, I would strongly recommend the use of Japanese Candlesticks.
Candlesticks are the default option for the majority in the trading community.
3.3 – History of the Japanese Candlestick

Before we jump in, it is worth spending time to understand in brief the history of
the Japanese Candlesticks. As the name suggests, the candlesticks originated from
Japan. The earliest use of candlesticks dates back to the 18th century by a Japanese
rice merchant named Homma Munehisa.
12
Though the candlesticks have been in existence for a long time in Japan, and are
probably the oldest form of price analysis, the western world traders were clueless
about it. It is believed that sometime around 1980’s a trader named Steve Nison
accidentally discovered candlesticks, and he actually introduced the methodology to
the rest of the world. He authored the first ever book on candlesticks titled
“Japanese Candlestick Charting Techniques” which is still a favorite amongst many
traders.
Most of the pattern in candlesticks still retains the Japanese names; thus giving an
oriental feel to technical analysis.
3.4 – Candlestick Anatomy

While in a bar chart the open and the close prices are shown by a tick on the left
and the right sides of the bar respectively, however in a candlestick the open and
close prices are displayed by a rectangular body.
In a candle stick chart, candles can be classified as a bullish or bearish candle

usually represented by blue/green/white and red/black candles respectively.
Needless to say, the colors can be customized to any color of your choice; the
technical analysis software allows you to do this. In this module we have opted for
the blue and red combination to represent bullish and bearish candles respectively.
Let us look at the bullish candle. The candlestick, like a bar chart is made of 3
components.
1. The Central real body – The real body, rectangular in shape connects the opening
and closing price
2. Upper shadow – Connects the high point to the close
3. Lower Shadow – Connects the low point to the open
Have a look at the image below to understand how a bullish candlestick is formed:
This is best understood with an example. Let us assume the prices as follows..
13
Open = 62
High = 70
Low = 58
Close = 67
Likewise, the bearish candle also has 3 components:
1. The Central real body – The real body, rectangular in shape which connects the
opening and closing price. However the opening is at the top end and the closing is
at the bottom end of the rectangle
2. Upper shadow – Connects the high point to the open
3. Lower Shadow – Connects the Low point to the close
This is how a bearish candle would look like:
This is best understood with an example. Let us assume the prices as follows..
Open = 456
High = 470
Low = 420
Close = 435
14
Here is a little exercise to help you understand the candlestick pattern better. Try
and plot the candlesticks for the given data.
Day Open High Low Close
Day 1 430 444 425 438
Day 2 445 455 438 450
Day 3 445 455 430 437
If you find any difficulty in doing this exercise, feel free to ask your query in the
comments at the end of this chapter.
Once you internalize the way candlesticks are plotted, reading the candlesticks to
identify patterns becomes a lot easier.
This is how the candlestick chart looks like if you were to plot them on a time series.
The blue candle indicates bullishness and red indicates bearishness.
15
Also note, a long bodied candle depicts strong buying or selling activity. A short
bodied candle depicts less trading activity and hence less price movement.
To sum up, candlesticks are easier to interpret in comparison to the bar chart.
Candlesticks help you to quickly visualize the relationship between the open and
close as well as the high and low price points.
3.5 – A note on time frames

A time frame is defined as the time duration during which one chooses to study a
particular chart. Some of the popular time frames that technical analysts use are:
o Monthly Charts
o Weekly charts
o Daily or End of day charts
o Intraday charts – 30 Mins, 15 mins and 5 minutes
One can customize the time frame as per their requirement. For example a high
frequency trader may want to use a 1 minute chart as opposed to any other time
frame.
Here is a quick note on different types of time frames.
Time
Open High Low Close No of Candles
Frame
The opening Highest price at Lowest price at The closing

price on the which the stock which the stock price on the 12 candles for the
Monthly
first day of the traded during the traded during the last day of entire year
month entire month entire month the month
Highest price at Lowest price at

The closing
Monday’s which the stock which the stock 52 candles for the
Weekly price on
Opening Price traded during the traded during the entire year
Friday
entire week entire week

The closing One candle per day,
Daily or Opening price which the stock which the stock
price of the 252 candles for the
EOD of the day traded during the traded during the
day entire year
day entire day
16
The opening The closing
Intraday which the stock which the stock
price at the price as on Approximately 12
30 traded during the traded during the
beginning of the 30th candles per day
minutes 30 minute 30 minute
the 1st minute minute
duration duration

Intraday which the stock which the stock
price at the price as on
15 traded during the traded during the 25 candles per day
beginning of the 15th
minutes 15 minute 15 minute
duration duration

which the stock which the stock
Intraday 5 price at the price as on
traded during the traded during the 75 candles per day
minutes beginning of the 5th
5 minute 5 minute
duration duration
As you can see from the table above as and when the time frame reduces, the
number of candles (data points) increase. Based on the type of trader you are, you
need to take a stand on the time frame you need.
The data can either be information or noise. As a trader, you need to filter
information from noise. For instance a long term investor is better off looking at
weekly or monthly charts as this would provide information. While on the other
hand an intraday trader executing 1 or 2 trades per day is better off looking at end
of day (EOD) or at best 15 mins charts. Likewise for a high frequency trader, a 1
minute charts can convey a lot of information.
So based on your stance as a trader you need to choose a time frame. This is
extremely crucial for your trading success, because a successful trader looks for
information and discards the noise.
1. Conventional chart type cannot be used for technical analysis as we need to plot 4
data points simultaneously
2. Line chart can be used to interpret trends but besides that no other information
can be derived
17
3. Bar charts lacks visual appeal and one cannot identify patterns easily. For this
reason bar charts are not very popular
4. There are two types of candlesticks – Bullish candle and Bearish candle. The
structure of the candlestick however remains the same
5. When close > open = It is a Bullish candle. When close < open = It is a Bearish
candle
6. Time frames play a very crucial role in defining the trading success. One has to
choose this carefully
7. The number of candle increases as and when the frequency increases
8. A traders should be in a position to discard noise from relevant information
18
Chapter 4
Getting Started with Candlesticks

112
4.1 – History tends to repeat itself – The big assumption

As mentioned earlier one of the key assumptions in technical analysis is that, we
rely on the fact that the history tends to repeats itself. This probably is one of the
most important assumptions in Technical Analysis.
It would make sense to explore this assumption in greater detail at this juncture as
candlestick patterns are heavily dependent on it.
Assume today, the 7th of July 2014 there are few things happening in a particular
stock. Let us call this factor:
1. Factor 1 – The stock has been falling for the last 4 consecutive trading sessions
2. Factor 2 –Today (7th July 2014) is the 5th session and the stock is falling on relatively
lower volumes
3. Factor 3 – The range in which the stock trades today is quite small compared to the
last four days.
With these factors are playing in the background, let us assume that on the next day
(8th July 2014) the fall in stock gets arrested and in fact the stock rallies towards a
positive close. So, as an outcome of the 3 factors the stock went up on the 6 th day.
19
Time passes and let’s says after a few months, the same set of factors is observed
for 5 consecutive trading sessions. What would you expect for the 6th day?
According to the assumption – History tends to repeat itself. However we need to

make an addendum to this assumption. When a set of factors that has panned out
in the past tends to repeat itself in the future, we expect the same outcome to
occur, as was observed in the past, provided the factors are the same.
Therefore, based on this assumption even this time round we can expect the stock
price to go up on the 6thtrading session.
4.2 – Candlestick patterns and what to expect

The candlesticks are used to identify trading patterns. Patterns in turn help the
technical analyst to set up a trade. The patterns are formed by grouping two or
more candles in a certain sequence. However, sometimes powerful trading signals
can be identified by just single candlestick pattern.
Hence, candlesticks can be broken down into single candlestick pattern and multiple
candlestick patterns.
Under the single candlestick pattern we will be learning the following…
1. Marubozu
1. Bullish Marubozu
2. Bearish Marubozu
2. Doji
3. Spinning Tops
4. Paper umbrella
1. Hammer
2. Hanging man
5. Shooting star
Multiple candlestick patterns are a combination of multiple candles. Under the
multiple candlestick patterns we will learn the following:
1. Engulfing pattern
1. Bullish Engulfing
2. Bearish Engulfing
2. Harami
1. Bullish Harami
2. Bearish Harami
3. Piercing Pattern
4. Dark cloud cover
20
5. Morning Star
6. Evening Star
Of course you must be wondering what these names mean. As I had mentioned in
the previous chapter, some of the patterns retain the original Japanese name.
Candlestick patterns help the trader develop a complete point of view. Each pattern
comes with an in built risk mechanism. Candlesticks gives an insight into both entry
and stop loss price.
4.3 – Few assumptions specific to candlesticks

Before we jump in and start learning about the patterns, there are few more
assumptions that we need to keep in mind. These assumptions are specific to
candlesticks. Do pay a lot of attention to these assumptions as we will keep
referring back to these assumptions quite often later.
At this stage, these assumptions may not be very clear to you. I will explain them in
greater detail as and when we proceed. However, do keep these assumptions in the
back of your mind:
o Buy strength and sell weakness – Strength is represented by a bullish (blue)

candle and weakness by a bearish (red) candle. Hence whenever you are buying
ensure it is a blue candle day and whenever you are selling, ensure it’s a red candle
day.
o Be flexible with patterns (quantify and verify) – While the text book definition of
a pattern could state a certain criteria, there could be minor variations to the
pattern owing to market conditions. So one needs to be a bit flexible. However one
needs to be flexible within limits, and hence it is required to always quantify the
flexibility.
o Look for a prior trend – If you are looking at a bullish pattern, the prior trend
should be bearish and likewise if you are looking for a bearish pattern, the prior
trend should be bullish.
In the next chapter, we will begin with learning about single candlestick patterns.
1. History tends to repeat itself – we modified this assumption by adding the factor
angle
2. Candlestick patterns can be broken down into single and multiple candlestick
patterns
3. There are three important assumptions specific to candlestick patterns
21
1. Buy strength and sell weakness
2. Be flexible – quantify and verify
3. Look for a prior trend.
22
Chapter 5
Single Candlestick patterns (Part 1)

355
5.1 – Overview
As the name suggests, a single candlestick pattern is formed by just one candle. So
as you can imagine, the trading signal is generated based on 1 day’s trading action.
The trades based on a single candlestick pattern can be extremely profitable
provided the pattern has been identified and executed correctly.
One needs to pay some attention to the length of the candle while trading based on
candlestick patterns. The length signifies the range for the day. In general, the
longer the candle, the more intense is the buying or selling activity. If the candles
are short, it can be concluded that the trading action was subdued.
The following picture gives a perspective on the long/short – bullish, and bearish
candle.
23
The trades have to be qualified based on the length of the candle as well. One
should avoid trading based on subdued short candles. We will understand this
perspective as and when we learn about specific patterns.
5.2 – The Marubozu

The Marubozu is the first single candlestick pattern that we will understand. The
word Marubozu means “Bald” in Japanese. We will understand the context of the
terminology soon. There are two types of marubozu – the bullish marubozu and the
bearish marubozu.
Before we proceed, let us lay down the three important rules pertaining to
candlesticks. We looked at it in the previous chapter; I’ve reproduced the same for
quick reference:
1. Buy strength and sell weakness

2. Be flexible with patterns (verify and quantify)
3. Look for prior trend
Marubozu is probably the only candlestick pattern which violates rule number 3 i.e
look for prior trend. A Marubuzo can appear anywhere in the chart irrespective of
the prior trend, the trading implication remains the same.
The text book defines Marubozu as a candlestick with no upper and lower shadow
(therefore appearing bald). A Marubuzo has just the real body as shown below.
However there are exceptions to this. We will look into these exceptions shortly.
24
The red candle represents the bearish marubuzo and the blue represents the
bullish marubuzo.
5.3 – Bullish Marubuzo

The absence of the upper and lower shadow in a bullish marubuzo implies that the
low is equal to the open and the high is equal to the close. Hence whenever
the, Open = Low and High = close, a bullish marubuzo is formed.
A bullish marubuzo indicates that there is so much buying interest in the stock that
the market participants were willing to buy the stock at every price point during the
day, so much so that the stock closed near its high point for the day. It does not
matter what the prior trend has been, the action on the marubuzo day suggests that
the sentiment has changed and the stock in now bullish.
The expectation is that with this sudden change in sentiment there is a surge of
bullishness and this bullish sentiment will continue over the next few trading
sessions. Hence a trader should look at buying opportunities with the occurrence of
a bullish marubuzo. The buy price should be around the closing price of the
marubuzo.
25
In the chart above (ACC Limited), the encircled candle is a bullish marubuzo. Notice
the bullish marubuzo candle does not have a visible upper and a lower shadow. The
OHLC data for the candle is: Open = 971.8, High = 1030.2, Low = 970.1, Close =
1028.4
Please notice, as per the text book definition of a marubozu Open = Low, and High
= Close. However in reality there is a minor variation to this definition. The variation
in price is not much when measured in percentage terms, for example the variation
between high and close is 1.8 which as a percentage of high is just 0.17%. This is
where the 2nd rule applies – Be flexible, Quantify and Verify.
With this occurrence of a marubuzo the expectation has turned bullish and hence
one would be a buyer of the stock. The trade setup for this would be as follows:
Buy Price = Around 1028.4 and Stoploss = 970.0
As it is evident, candlestick patterns do not give us a target. However we will address

the issue of setting targets at a later stage in this module.
Having decided to buy the stock, when do we actually buy the stock? The answer to
this depends on your risk appetite. Let us assume there are two types of trader with
different risk profiles – the risk taker and the risk averse.
The risk taker would buy the stock on the same day as the marubozu is being
formed. However the trader needs to validate the occurrence of a marubozu.
Validating is quite simple. Indian markets close at 3:30 PM. So, around 3:20 PM one
needs to check if the current market price (CMP) is approximately equal to the
high price for the day, and the opening price of the day is approximately equal
to the low price the day. If this condition is satisfied, then you know the day is
forming a marubozu and therefore you can buy the stock around the closing price.
It is also very important to note that the risk taker is buying on a bullish/blue candle
day, thereby following rule 1 i.e buy on strength and sell on weakness.
26
The risk averse trader would buy the stock on the next day i.e the day after the
pattern has been formed. However before buying the trader needs to ensure that
the day is a bullish day to comply with the rule number 1. This means the risk averse
buyer can buy the stock only around the close of the day. The disadvantage of
buying the next day is that the buy price is way above the suggested buy price, and
therefore the stoploss is quite deep. However as a trade off the risk averse trader is
buying only after doubly confirming that the bullishness is indeed established.
As per the ACC’s chart above, both the risk taker and the risk averse would have
been profitable in their trades.
Here is another example (Asian Paints Ltd) where both the risk taker, and the risk
averse trader would have been profitable.
Here is an example where the risk averse trader would have benefited :
Notice in the chart above, a bullish marubuzo has been encircled. The risk taker
would have initiated a trade to buy the stock on the same day around the close, only
to book a loss on the next day. However the risk averse would have avoided buying
the stock entirely because the next day happened to be a red candle day. Going by
the rule, we should buy only on a blue candle day and sell on a red candle day.
27
5.4 – The Stoploss on Bullish Marubuzo
What if after buying, the market reverses its direction and the trade goes wrong?
Like I had mentioned earlier, candlestick patterns comes with a inbuilt risk
management mechanism. In case of a bullish marubuzo, the low of the stock acts as
a stoploss. So after you initiate a buy trade , in case the markets moves in the
opposite direction, you should exit the stock if price breaches the low of the
marubuzo.
Here is an example where the bullish marubuzo qualified as a buy for both the risk
averse and the risk taker. The OHLC is : O = 960.2, H = 988.6, L = 959.85, C = 988.5.
But the pattern eventually failed and one would have booked a loss. The stoploss
for this trade would be the low of marubuzo, i.e 959.85.
Booking a loss is a part of the game. Even a seasoned trader goes through this.
However the best part of following the candlestick is that the losses are not allowed
to run indefinitely. There is a clear agenda as to what price one has to get out of a
trade provided the trade starts to move in the opposite direction. In this particular
case booking a loss would have been the most prudent thing to do as the stock
continued to go down.
Of course there could be instances where the stoploss gets triggered and you pull
out of the trade. But the stock could reverse direction and start going up after you
pulled out of the trade. But unfortunately this is also a part of the game and one
cannot really help it. No matter what happens, the trader should stick to the rules
and not find excuses to deviate from it.
28
5.3 – Bearish Marubuzo
Bearish Marubuzo indicates extreme bearishness. Here the open is equal to the
high and close the is equal to low. Open = High, and Close = Low.
A bearish marubuzo indicates that there is so much selling pressure in the stock
that the market participants actually sold at every price point during the day, so
much so that the stock closed near its low point of the day. It does not matter what
the prior trend has been, the action on the marubuzo day suggests that the
sentiment has changed and the stock is now bearish.
The expectation is that this sudden change in sentiment will be carried forward over
the next few trading sessions and hence one should look at shorting opportunities.
The sell price should be around the closing price of the marubuzo.
In the chart above (BPCL Limited), the encircled candle indicates the presence of a
bearish marubuzo. Notice the candle does not have an upper and a lower shadow.
The OHLC data for the candle is as follows:
Open = 355.4, High = 356.0, Low = 341, Close = 341.7
As we had discussed earlier a minor variation between the OHLC figures leading to
small upper and lower shadows is ok as long as it is within a reasonable limit.
The trade on the bearish marubuzo would be to short BPCL approximately at 341.7
with a stoploss at the high point of the candle. In this case the stoploss price is
356.0. Of course at this stage we still haven’t dealt with setting targets, and we will
figure that out much later in this module.
29
Do remember this, once a trade is initiated you should hold on to it until either the
target is hit or the stoploss is breached. If you attempt to do something else before
any one of these event triggers, then most likely your trade could go bust. So staying
on course of the plan is extremely crucial.
Trade can be initiated based on the risk appetite of the person. The risk taker can
initiate a short trade on the same day around the closing. Of course, he has to make
sure that the candle is forming a bearish marubuzo. To do this at 3:20PM the trader
has to confirm if the open is approximately equal to the high and the current
market price is equal to the low price. If the condition is validated, then it is a
bearish marubuzo and hence a short position can be initiated.
If the trader is risk averse, he can wait till the next day’s closing. The short trade will
go through only by 3:20PM next day after ensuring that the day is a red candle day.
This is also to ensure that we comply with 1st rule – Buy strength, and Sell weakness.
In the BPCL chart above, both risk taker and risk averse would have been profitable.
Here is another chart, Cipla Limited, where the bearish marubuzo has been
profitable for both risk taker, and a risk averse trader. Remember these are short
term trades and one needs to be quick in booking profits.
Here is a chart which show bearish marubuzo pattern which would have not worked
out for the risk taker but a risk averse trader would have entirely avoided initiating
the trade, thanks to rule 1.
30
5.4 – The trade trap
Earlier in this chapter we did discuss about the length of the candle. One should
avoid trading during an extremely small (below 1% range) or long candle (above
10% range).
A small candle indicates subdued trading activity and hence it would be difficult to
identify the direction of the trade. On the other hand a long candle indicates
extreme activity. The problem with lengthy candles would be the placement of
stoploss. The stoploss would be deep and in case the trade goes wrong the penalty
to pay would be painful. For this reason, one should avoid trading on candles that
are either too short or too long.
1. Remember the rules based on which candlesticks work

2. Marubuzo is the only pattern which violates rule number 3 i.e Look for prior trend
3. A bullish marubuzo indicates bullishness
1. Buy around the closing price of a bullish marubozu
2. Keep the low of the marubuzo as the stoploss
4. A bearish marubuzo indicates bearishness
1. Sell around the closing price of a bearish marubozu
2. Keep the high of the marubuzo as the stoploss
5. An aggressive trader can place the trade on the same day as the pattern forms
6. Risk averse traders can place the trade on the next day after ensuring that it obeys
rule number 1 i.e Buy strength, and Sell weakness
7. An abnormal candle lengths should not be traded
1. Short candle indicates subdued activity
2. Long candle indicates extreme activity, however placing stoploss becomes an issue.
31
Chapter 6

136
6.1 – The Spinning Top

The spinning top is a very interesting candlestick. Unlike the Marubuzo, it does not
give the trader a trading signal with specific entry or an exit point. However the
spinning top gives out useful information with regard to the current situation in the
market. The trader can use this information to position himself in the market.
A spinning top looks like the candle shown below. Take a good look at the candle.
What observations do you make with regard to the structure of the candle?
Two things are quite prominent…
32
o The candles have a small real body
o The upper and lower shadow are almost equal
What do you think would have transpired during the day that leads to the creation
of a spinning top? On the face of it, the spinning top looks like a humble candle with
a small real body, but in reality there were a few dramatic events which took place
during the day.
Let us follow these events:
1. Small real body – This indicates that the open price and close price are quite close
to each other. For instance the open could be 210 and the close could be 213. Or
the open could be 210 and close at 207. Both these situations lead to the creation of
a small real body because a 3 point move on a 200 Rupee stock is not much.
Because the open and close price points are nearby to one another, the color of the
candle does not really matter. It could be a blue or a red candle, what really matters
is the fact that the open prices and close prices are near to one another.
2. The upper shadow – The upper shadow connects the real body to the high point of
the day. If it is a red candle, the high and open are connected. If it is blue candle, the
high and close are connected. If you think about the real body in conjunction with
the upper shadow ignoring the lower shadow what do you think had happened?
The presence of the upper shadow tells us that the bulls did attempt to take the
market higher. However they were not really successful in their endeavor. If the
bulls were truly successful, then the real body would have been a long blue candle
and not really a short candle. Hence this can be treated as an attempt by the bulls
to take the markets higher but they were not really successful at it.
3. The lower shadow – The lower shadow connects the real body to the low point of
the day. If it is a red candle, the low and close are connected. If it is a blue candle,
the low and open are connected. If you think about the real body in conjunction
with the lower shadow ignoring the upper shadow what do you think had
happened? This is pretty much the same thing that happened with the bulls. The
presence of the lower shadow tells us that the bears did attempt to take the market
lower. However they were not really successful in their endeavor. If the bears were
truly successful, then the real body would have been long red candle and not really
a short candle. Hence this can be treated as an attempt by the bears to take the
markets lower but they were not really successful.
Now think about the spinning top as a whole along with all its components i.e real
body, upper shadow, and lower shadow. The bulls made a futile attempt to take the
market higher. The bears tried to take the markets lower and it did not work either.
Neither the bulls nor the bears were able to establish any influence on the market
as this is evident with the small real body. Thus Spinning tops are indicative of a
market where indecision and uncertainty prevails.
If you look at a spinning top in isolation it does not mean much. It just conveys
indecision as both bulls and bears were not able to influence the
33
markets. However when you see the spinning top with respect to the trend in the
chart it gives out a really powerful message based on which you can position your
stance in the markets.
6.2 – Spinning tops in a downtrend

What if the spinning tops were to occur when the stock is in a down trend?
In a down trend, the bears are in absolute control as they manage to grind the
prices lower. With the spinning top in the down trend the bears could be
consolidating their position before resuming another bout of selling. Also, the bulls
have attempted to arrest the price fall and have tried to hold on to their position,
though not successfully. After all, if they were successful the day would have
resulted in a good blue candle and not really a spinning top.
So what stance would you take considering that there are spinning tops in a down
trend. The stance depends on what we expect going forward. Clearly there are two
foreseeable situations with an equal probability:
1. Either there will be another round of selling

2. Or the markets could reverse its directions and the prices could increase
Clearly, with no clarity on what is likely to happen, the trader needs to be prepared
for both the situations i.e reversal and continuation.
If the trader has been waiting for an opportunity to go long on the stock, probably
this could be his opportunity to do so. However to play safe he could test the waters
with only half the quantity. If the trader wants to buy 500 shares, he could probably
enter the trade with 250 shares and could wait and watch the market. If the market
reverses its direction, and the prices indeed start going up then the trader can
average up by buying again. If the prices reverse; most likely the trader would have
bought the stocks at the lowest prices.
If the stock starts to fall, the trader can exit the trade and book a loss. At least the
loss is just on half the quantity and not really on the entire quantity.
Here is a chart, which shows the downtrend followed by a set of spinning tops. The
stock rallied post the occurrence of the spinning top.
34
Here is another chart which shows the continuation of a down trend after the
occurrence of spinning tops.
So, think about the spinning top as “The calm before the storm”. The storm could be
in the form of a continuation or a reversal of the trend. In which way the price will
eventually move is not certain, however what is certain is the movement itself. One
needs to be prepared for both the situations.
6.2 – Spinning tops in an uptrend

A spinning top in an uptrend has similar implications as the spinning top in a down
trend, except that we look at it slightly differently. Look at the chart below, what can
you see and what would be the inference?
35
An obvious observation is the fact that there is an uptrend in the market, which
implies the bulls have been in absolute control over the last few trading sessions.
However with the occurrence of the recent spinning tops the situation is a bit tricky:
1. The bulls are no longer in control, if they were, spinning tops would not be form on
the charts
2. With the formation of spinning tops, the bears have made an entry to the markets.
Though not successful, but the emphasis is on the fact that the bulls gave a leeway
to bears
Having observed the above, what does it actually mean and how do you position
yourself in the market?
1. The spinning top basically conveys indecision in the market i.e neither the bulls nor
the bears are able to influence the markets.
2. Placing the above fact in the context of an uptrend we can conclude two things..
1. The bulls could be consolidating their position before initiating another leg of up move
2. Or the bulls are fatigued and may give way to bears. Hence a correction could be around the
corner.
3. The chances of both these events taking place is equal i.e 50%
Having said that, what should you do? The chances of both events playing out are
equal, how are you going to take a stance? Well, in such a situation you should
prepare for both the outcomes!
Assume you had bought the stock before the rally started; this could be your chance
to book some profits. However, you do not book profits on the entire quantity.
Assume you own 500 shares; you can use this opportunity to book profits on 50% of
your holding i.e 250 shares. Two things can happen after you do this:
1. The bears make an entry – When this happens the market starts to slide down, and
as you have booked 50% profits at a higher price, and can now choose to book
36
profits on the balance 50% as well. Your net selling price will anyway be higher than
the current market price.
2. The bulls make an entry – It turns out that the bulls were indeed taking a pause and
the rally continues, at least you are not completely out of the market as you still
have the balance 50% of your holdings invested in the markets
The stance you take helps you tackle both the outcomes.
Here is a chart which shows an uptrend and after the occurrence of spinning tops,
the stock rallied. By being invested 50%, you can continue to ride the rally.
To sum up, the spinning top candle shows confusion and indecision in the market
with an equal probability of reversal or continuation. Until the situation becomes
clear the traders should be cautious and they should minimize their position size.
6.3 – The Dojis

The Doji’s are very similar to the spinning tops, except that it does not have a real
body at all. This means the open and close prices are equal. Doji’s provide crucial
information about the market sentiments and is an important candlestick pattern.
37
The classic definition of a doji suggests that the open price should be equal to the
close price with virtually a non existant real body. The upper and lower wicks can be
of any length.
However keeping in mind the 2nd rule i.e ‘be flexible, verify and quantify’ even if there
is a wafer thin body, the candle can be considered as a doji.
Obviously the color of the candle does not matter in case of a wafer thin real body.
What matters is the fact that the open and close prices were very close to each
other.
The Dojis have similar implications as the spinning top. Whatever we learnt for
spinning tops applies to Dojis as well. In fact more often than not, the dojis and
spinning tops appear in a cluster indicating indecision in the market.
Have a look at the chart below, where the dojis appear in a downtrend indicating
indecision in the market before the next big move.
Here is another chart where the doji appears after a healthy up trend after which
the market reverses its direction and corrects.
38
So the next time you see either a Spinning top or a Doji individually or in a cluster,
remember there is indecision is the market. The market could swing either ways
and you need to build a stance that adapts to the expected movement in the
market.
1. A spinning top has a small real body. The upper and lower shadows are almost
equal in length
2. The colour of the spinning top does not matter. What matters is the fact that the
open and close prices are very close to each other
3. Spinning tops conveys indecision in the market with both bulls and bears being in
equal control
4. Spinning top at the top end of the rally indicates that either the bulls are taking a
pause before they can resume the uptrend further or the bears are preparing to
break the trend. In either case, the trader’s stance has to be cautious. If the trader’s
intent is to buy, he is better off buying only half the quantity and he should wait for
the markets to move in his direction
5. Spinning top at the bottom end of the rally indicates that either the bears are taking
a pause before they can resume the down trend further or the bulls are preparing
to break the trend and take the markets higher. Either case, the trader’s stance has
to be cautious. If the traders intent is to buy, he is better off buying only half the
quantity and he should wait for the markets to make the move
6. Doji’s are very similar to spinning tops. Doji also convey indecision in the market. By
definition dojis do not have a real body. However in reality, even if a wafer thin body
appears it is acceptable
7. A trader’s stance based on dojis is similar to stance taken when a spinning top
occurs.
39
Chapter 7

292
7.1 – Paper Umbrella

The paper umbrella is a single candlestick pattern which helps traders in setting up
directional trades. The interpretation of the paper umbrella changes based on
where it appears on the chart.
A paper umbrella consists of two trend reversal patterns namely the hanging man
and the hammer. The hanging man pattern is bearish and the hammer pattern is
relatively bullish. A paper umbrella is characterized by a long lower shadow with a
small upper body.
40
If the paper umbrella appears at the bottom end of a downward rally, it is called
the ‘Hammer’.
If the paper umbrella appears at the top end of an uptrend rally, it is called
the ‘Hanging man’.
To qualify a candle as a paper umbrella, the length of the lower shadow should be
at least twice the length of the real body. This is called the ‘shadow to real body
ratio’.
Let us look at this example: Open = 100, High = 103, Low = 94, Close = 102 (bullish
candle).
Here, the length of the real body is Close – Open i.e 102-100 = 2 and the length of
the lower shadow is Open – Low i.e 100 – 94 = 6. As the length of the lower shadow
is more than twice of the length of the real body; hence we can conclude that a
paper umbrella has formed.
7.2 – The Hammer formation

The bullish hammer is a significant candlestick pattern that occurs at the bottom of
the trend. A hammer consists of a small real body at the upper end of the trading
range with a long lower shadow. The longer the lower shadow the more bullish the
pattern.
The chart below shows the presence of two hammers formed at the bottom of a
down trend.
Notice the blue hammer has a very tiny upper shadow, which is acceptable
considering the “Be flexible – quantify and verify” rule.
A hammer can be of any color as it does not really matter as long as it qualifies ‘the
shadow to real body’ ratio. However, it is slightly more comforting to see a blue
colored real body.
The prior trend for the hammer should be a down trend. The prior trend is
highlighted with the curved line. The thought process behind a hammer is as
follows:
41
1. The market is in a down trend, where the bears are in absolute control of the
markets
2. During a downtrend, every day the market would open lower compared to the
previous day’s close and again closes lower to form a new low
3. On the day the hammer pattern forms, the market as expected trades lower, and
makes a new low
4. However at the low point, there is some amount of buying interest that emerges,
which pushes the prices higher to the extent that the stock closes near the high
point of the day
5. The price action on the hammer formation day indicates that the bulls attempted to
break the prices from falling further, and were reasonably successful
6. This action by the bulls has the potential to change the sentiment in the stock,
hence one should look at buying opportunities
The trade setup for the hammer is as follows:
1. A hammer formation suggests a long trade

2. The trader’s entry time depends on the risk appetite of the trader. If the trader is a
risk taker, he can buy the stock the same day. Remember, the color of the real body
in hammer does not matter; hence there is no violation to the Rule 1. If the trader is
risk averse, he can buy the stock the day after the pattern has formed only after
ensuring that the day is a blue candle day
1. Risk takers can qualify the day as a hammer by checking the following condition at
3:20PM on the hammer day..
1. Open and close should be almost the same (within 1-2% range)
2. Lower shadow length should be at least twice the length of real body
3. If both these conditions are met, then the pattern is a hammer and the risk taker
can go long
2. The risk averse trader should evaluate the OHLC data on the 2 nd If it’s a blue candle,
the trade is valid and hence he can go long
3. The low of the hammer acts as the stoploss for the trade
The chart below shows the formation of a hammer where both the risk taker and
the risk averse would have set up a profitable trade. This is a 15 minutes intraday
chart of Cipla Ltd.
42
The trade set up would be as follows:
Buy Price for a risk taker – He takes the trade on the Hammer candle itself at –
Rs.444/-
Buy price for a risk averse – He takes the trade on the next candle after evaluating
that the candle is blue at – Rs. 445.4/-
Stoploss for both the traders is at Rs.441.5/-, which is the low of the hammer
formation.
Do notice how the trade has evolved, yielding a desirable intraday profit.
Here is another chart where the risk averse trader would have benefited by virtue of
the ‘Buy strength and Sell weakness’ rule.
Here is another interesting chart with two hammer formation.
43
Both the hammers qualified on the pre conditions of a hammer i.e :
1. Prior trend to be a down trend

2. Shadow to real body ratio
On the first hammer, the risk averse trader would have saved himself from a loss
making trade, thanks to Rule 1 of candlesticks. However, the second hammer would
have enticed both the risk averse and risk taker to enter a trade. After initiating the
trade, the stock did not move up, it stayed nearly flat and cracked down eventually.
Please note once you initiate the trade you stay in it until either the stop loss or the
target is reached. You should not tweak the trade until one of these events occurs.
The loss in this particular trade (first hammer) is inevitable. But remember this is a
calculated risk and not a mere speculative risk.
Here is another chart where a perfect hammer appears, however it does not satisfy
the prior trend condition and hence it is not defined pattern.
7.3 – The Hanging man

If a paper umbrella appears at the top end of a trend, it is called a Hanging man. The
bearish hanging man is a single candlestick, and a top reversal pattern. A hanging
man signals a market high. The hanging man is classified as a hanging man only if
is preceded by an uptrend. Since the hanging man is seen after a high, the
bearish hanging man pattern signals selling pressure.
44
A hanging man can be of any color and it does not really matter as long as it
qualifies ‘the shadow to real body’ ratio. The prior trend for the hanging man should
be an uptrend, as highlighted by the curved line in the chart above. The thought
process behind a hanging man is as follows:
1. The market is in an uptrend, hence the bulls are in absolute control

2. The market is characterized by new highs and higher lows
3. The day the hanging man pattern appears, the bears have managed to make an
entry
4. This is emphasized by a long lower shadow of the hanging man
5. The entry of bears signifies that they are trying to break the strong hold of the bulls
Thus, the hanging man makes a case for shorting the stock. The trade set up would
be as follows:
1. For the risk taker, a short trade can be initiated the same day around the closing
price
2. For the risk averse, a short trade can be initiated at the close of the next day after
ensuring that a red candle would appear
1. The method to validate the candle for the risk averse, and risk taker is exactly the
same as explained in the case of a hammer pattern
Once the short has been initiated, the high of the candle works as a stoploss for the
trade.
45
In the chart above, BPCL Limited has formed a hanging man at 593. The OHLC
details are –
Open = 592, High = 593.75, Low = 587, Close = 593. Based on this, the trade set up
would be as follows:
o The risk taker, initiates the short trade on the day the pattern appears (at 593)
o The risk averse, initiates the short trade on the next day at closing prices after
ensuring it is a red candle day
o Both the risk taker and the risk averse would have initiated their respective trades
o The stoploss price for this trade would be the high price i.e above 593.75
The trade would have been profitable for both the risk types.
7.4 –My experience with a paper umbrella

While both the hammer and the hanging man are valid candlestick patterns, my
dependence on a hammer is a little more as opposed to a hanging man. All else
equal, if there were two trading opportunities in the market, one based on hammer
and the other based on hanging man I would prefer to place my money on hammer.
The reason to do so is simply based on my experience in trading with both the
patterns.
My only concern with a hanging man is the fact that if the bears were indeed
influential during the day, why did the price go up after making a low? This
according to me re establishes the bull’s supremacy in the market.
I would encourage you to develop your own thesis based on observations that you
make in the markets. This will not only help you calibrate your trade more
accurately but also help you develop structured market thinking.
46
7.5 – The shooting star
The shooting star is the last single candlestick pattern that we will learn about
before we move to multiple candlestick patterns. The price action on the shooting
star is quite powerful, thus making the shooting star a very popular candlestick
pattern to trade.
The shooting star looks just like an inverted paper umbrella.
Unlike a paper umbrella, the shooting star does not have a long lower shadow.
Instead it has a long upper shadow where the length of the shadow is at least twice
the length of the real body. The colour of the body does not matter, but the pattern
is slightly more reliable if the real body is red. The longer the upper wick, the more
bearish is the pattern. The small real body is a common feature between the
shooting star and the paper umbrella. Going by the text book definition, the
shooting star should not have a lower shadow, however a small lower shadow, as
seen in the chart above is considered alright. The shooting star is a bearish
pattern; hence the prior trend should be bullish.
The thought process behind the shooting star is as follows:
o The stock is in an uptrend implying that the bulls are in absolute control. When bulls
are in control, the stock or the market tends to make a new high and higher low
o On the day the shooting star pattern forms, the market as expected trades higher,
and in the process makes a new high
47
o However at the high point of the day, there is a selling pressure to an extent where
the stock price recedes to close near the low point of the day, thus forming a
shooting star
o The selling indicates that the bears have made an entry, and they were actually
quite successful in pushing the prices down. This is evident by the long upper
shadow
o The expectation is that the bears will continue selling over the next few trading
sessions, hence the traders should look for shorting opportunities
Take a look at this chart where a shooting star has been formed right at the top of
an uptrend.
The OHLC data on the shooting star is; open = 1426, high = 1453, low = 1410, close =
1417. The short trade set up on this would be:
1. The risk taker will initiate the trade at 1417, basically on the same day the shooting
star forms
1. The risk taker initiates the trade the same day after ensuring that the day has
formed a shooting star. To confirm this the trader has to validate:
1. If the current market price is more or less equal to the low price
2. The length of the upper shadow is at least twice the length of the real body
2. The risk averse will initiate the trade on the next day, only after ensuring that the
2nd day a red candle has formed
2. Once the trade has been initiated, the stoploss is to be placed at the high of the
pattern. In the case the stop loss is at 1453
As we have discussed this before, once a trade has been set up, we should wait for
either the stoploss or the target to be triggered. It is advisable not to do anything
else, except for maybe trailing your stoploss. Of course, we still haven’t discussed
about trailing stoploss yet. We will discuss it at later stage.
48
Here is a chart where both the risk taker and the risk averse would have made a
remarkable profit on a trade based on shooting star.
Here is an example, where both the risk averse and the risk taker would have
initiated the trade based on a shooting star. However the stoploss has been
breached. Do remember, when the stop loss triggers, the trader will have to exit the
trade, as the trade no longer stands valid. More often than not exiting the trade is
the best thing to do when the stoploss triggers.
1. A paper umbrella has a long lower shadow and a small real body. The lower shadow
and the real body should maintain the ‘shadow to real body’ ratio. In case of the
paper umbrella the lower shadow should be at least twice the length of the real
body
49
2. Since the open and close prices are close to each other, the color of the paper
umbrella should not matter
3. If a paper umbrella appears at the bottom of a down trend, it is called the ‘hammer’
4. If the paper umbrella appears at the top end of an uptrend, it is called the hanging
man
5. The hammer is a bullish pattern and one should look at buying opportunities when
it appears
6. The low of the hammer acts as the stop loss price trade
7. The hanging man is a bearish pattern which appears at the top end of the trend,
one should look at selling opportunities when it appears
8. The high of the hanging man acts as the stop loss price for the trade
9. The shooting star is a bearish pattern which appears at the top end of the trend.
One should look at shorting opportunities when a shooting star appears
10. The high of the shooting star will be the stop loss price for the trade.
50
Chapter 8
Multiple candlestick patterns (Part 1)

360
8.1 – The Engulfing Pattern

In a single candlestick pattern, the trader needed just one candlestick to identify a
trading opportunity. However when analyzing multiple candlestick patterns, the
trader needs 2 or sometimes 3 candlesticks to identify a trading opportunity. This
means the trading opportunity evolves over a minimum of 2 trading sessions.
The engulfing pattern is the first multiple candlestick pattern that we need to look
into. The engulfing pattern needs 2 trading sessions to evolve. In a typical engulfing
pattern, you will find a small candle on day 1 and a relatively long candle on day 2
which appears as if it engulfs the candle on day 1. If the engulfing pattern appears
at the bottom of the trend, it is called the “Bullish Engulfing” pattern. If the engulfing
pattern appears at the top end of the trend, it is called the “Bearish Engulfing”
pattern.
8.2 – The Bullish Engulfing Pattern

The bullish engulfing pattern is a two candlestick pattern which appears at the
bottom of the down trend. As the name suggests, this is a bullish pattern which
prompts the trader to go long. The two day bullish engulfing pattern is encircled in
the chart below. The prerequisites for the pattern are as follows:
51
1. The prior trend should be a downtrend
2. The first day of the pattern (P1) should be a red candle reconfirming the
bearishness in the market
3. The candle on the 2nd day of pattern (P2) should be a blue candle, long enough to
engulf the red candle
The thought process behind the bullish engulfing pattern is as follows:
1. The market is in down trend with prices steadily moving down

2. On the first day of the pattern (P1), the market opens low and makes a new low.
This forms a red candle in the process
3. On the second day of the pattern (P2), the stock opens near the closing prices of P1,
and attempts to make a new low. However, at this low point of the day there is a
sudden buying interest, which drives the prices to close higher than the previous
day’s open. This price action forms a blue candle
4. The price action on P2 also suggests that bulls made a very sudden and strong
attempt to break the bearish trend and they did so quite successfully. This is evident
by the long blue candle on P2
5. The bears would not have expected the bull’s sudden action on P2 and hence the
bull’s action kind of rattles the bears causing them some amount of nervousness
6. The bullishness is expected to continue over the next few successive trading
sessions, driving the prices higher and hence the trader should look for buying
opportunities
The trade set up for the bullish engulfing pattern is as follows:
1. The bullish engulfing pattern evolves over two days

2. The suggested buy price is around the close price of blue candle i.e on P2
o Risk taker initiates the trade on P2 itself after ensuring P2 is engulfing P1
o The risk averse initiates the trade on the next day i.e the day after P2 around the
closing price, after confirming the day is forming a blue candle
52
o If the day after P2 is a red candle day, the risk averse trader will ignore the trade,
owing to rule 1 of candlesticks (Buy strength and Sell weakness)
o On a personal note, in multiple candlestick patterns where the trade evolves over 2
or more days it is worth to be a risk taker as opposed to a risk averse trader
3. The stop loss for the trade would be at the lowest low between P1, and P2
Needless to say, once the trade has been initiated you will have to wait until the
target has been hit or the stoploss has been breached. Of course, one can always
trail the stop loss to lock in profits.
Have a look at DLF’s chart below; the bullish engulfing pattern is encircled.
The OHLC on P1 – Open = 163, High = 168, Low = 158.5, Close = 160. On P2 the
OHLC details are – Open = 159.5, High = 170.2, Low = 159, Close = 169.
The trade set up for the bullish engulfing pattern is as follows:
1. The risk taker would go long on P2 at 169. He can do this by validating P2 as an

engulfing pattern. To validate P2 as an engulfing patterns there are 2 conditions:
o One, the current market price at 3:20PM on P2 should be higher than P1’s open.
o Second, the open on P2 should be equal to or lower than P1’s close
2. The risk averse will initiate the trade, the day after P2 only after ensuring that the
day is a blue candle day. So if the P1 falls on a Monday, the risk averse would be
initiating the trade on Wednesday, around 3:20 PM. However, as I had mentioned
earlier, while trading based on multiple candlestick pattern, it may be worth
initiating the trade on pattern completion day itself i.e P2
3. The stop loss on this trade will be the lowest low between P1 and P2. In this
example, lowest low falls on P1 at 158.5
In this example, both the risk averse and the risk taker would have been profitable.
Here is an example of a perfect bullish engulfing pattern formed on Cipla Ltd, the
risk averse trader would have completely missed out a great trading opportunity.
53
There is often a lot of confusion on whether the candle should engulf just the real
body or the whole candle, including the lower and upper shadows. In my personal
experience, as long as the real bodies are engulfed, I would be happy to classify the
candle as a bullish engulfing pattern. Of course, candlestick sticklers would object to
this but what really matters is how well you hone your skills in trading with a
particular candlestick pattern.
So going by that thought, I’d be happy to classify the following pattern as a bullish
engulfing pattern, even though the shadows are not engulfed.
8.3 – The bearish engulfing pattern

The bearish engulfing pattern is a two candlestick pattern which appears at the top
end of the trend, thus making it a bearish pattern. The thought process remains
very similar to the bullish engulfing pattern, except one has to think about it from a
shorting perspective.
54
Take a look at the chart below, the two candles that make up the bearish engulfing
pattern is encircled. You will notice:
1. To begin with the bulls are in absolute control pushing the prices higher
2. On P1, as expected the market moves up and makes a new high, reconfirming a
bullish trend in the market
3. On P2, as expected the market opens higher and attempts to make a new high.
However at this high point selling pressure starts. This selling comes unexpected
and hence tends to displace the bulls
4. The sellers push the prices lower, so much so that the stock closes below the
previous day’s (P1) open. This creates nervousness amongst the bulls
5. The strong sell on P2 indicates that the bears may have successfully broken down
the bull’s stronghold and the market may continue to witness selling pressure over
the next few days
6. The idea is to short the index or the stock in order to capitalize on the expected
downward slide in prices
The trade set up would be as follows:
1. The bearish engulfing pattern suggests a short trade

2. The risk taker initiates the trade on the same day after validating two conditions
o The open on P2 is higher than P1’s close
o The current market price at 3:20 PM on P2 is lower than P1’s open price. If the two
conditions are satisfied, then it would be logical to conclude that it is a bearish
engulfing pattern
3. The risk averse will initiate the trade on the day after P2 only after ensuring that the
day is a red candle day
4. Since the bearish engulfing pattern is a 2 day pattern, it makes sense to be a risk
taker. However this purely depends on the individual’s risk appetite
55
Take a look at the chart below of Ambuja Cements. There are two bearish engulfing
patterns formed. The first pattern on the chart (encircled, starting from left) did not
work in favor of a risk taker. However the risk averse would have completely
avoided taking the trade. The second bearish engulfing pattern would have been
profitable for both the risk taker and the risk averse.
The OHLC data for the bearing engulfing pattern (encircled at the top end of the
chart) is as below:
P1: Open – 214, High – 220, Low – 213.3, Close – 218.75
P2: Open – 220, High – 221, Low – 207.3, Close – 209.4
The trade setup for the short trade, based on the bearish engulfing pattern is as
follows:
1. On P2 by 3:20 PM the risk taker would initiate the short trade at 209 after ensuring
P1, and P2 together form a bearish engulfing pattern
2. The risk averse will initiate the trade, the day after P2 only after ensuring that the
day is a red candle day
3. The stoploss in both the cases will the highest high of P1 and P2, which in this case
is at 221.
Both the risk averse and the risk taker would have been profitable in this particular
case.
8.4 – The presence of a doji

Now here is a very interesting chart. From my own personal experience I can tell
you, charts like the one shown below are highly profitable. One should not miss
such trading opportunities
Take a look at the chart, what are the things that catch your attention?
1. An obvious uptrend as highlighted
56
2. A bearish engulfing pattern right at the top end of the upward rally
3. A doji formation on the day following P2
What implication would a doji have in this chart?
Let us inspect this chart event by event:
1. A prolonged uptrend in the chart confirms the bulls are in absolute control
2. On P1 a blue candle is formed, reconfirming the bull’s dominance in the markets
3. On P2 markets open higher and make a new high comforting the bulls. However at
the high point a strong surge to sell builds up, to an extent that the prices closes
below P1’s opening prices
4. This trading action on P2 sets in a bit of panic to bulls, but they are not shaken yet
5. On day 3, let us call it as P3, though the opening is weak it is not much lower
compared to P2’s close. This is not too comforting for the bulls, as they expect the
markets to be stronger.
6. During P3 the market attempts to move higher (Doji’s upper shadow) however the
high is not sustained. Even the low is not sustained and eventually the day closes
flat forming a Doji. As you may recall, Dojis indicate indecision in the market
7. On P2 bulls panicked and on P3 bulls were uncertain
8. Panic with uncertainty is the perfect recipe for a catastrophe. Which explains the
long red candle following the Doji
From my own personal trading experience I can tell you that whenever a doji follows
a recognizable candlestick pattern, the opportunity created is bigger. Besides
illustrating this point, I also want to draw your attention to chart analysis
methodology. Notice in this particular chart, we did not just look at what was
happening on P1 or P2 but we went beyond that and actually combined two
different patterns to develop a comprehensive view on the market.
57
8.5 – The Piercing Pattern
The piercing pattern is very similar to the bullish engulfing pattern with a very minor
variation. In a bullish engulfing pattern the P2’s blue candle engulfs P1’s red candle
completely. However in a piercing pattern P2’s blue candle partially engulfs P1’s red
candle, however the engulfing should be between 50% and less than 100%. You can
validate this visually or calculate the same. For example if P1’s range (Open – Close)
is 12 , P2’s range should be at least 6 or higher but below 12.
As long as this condition is satisfied, everything else is similar to the bullish

engulfing including the trade set up. Here a risk taker would initiate the trade on P2
around the close. The risk averse would initiate the trade, the day after P2 only after
ensuring a blue candle is formed. The stoploss would be the low of the pattern.
Have a look at the following chart:
Here P2’s blue candle engulfs just under 50% of P1’s red candle. For this reason we
do not consider this as a piercing pattern.
58
8.6 – The Dark Cloud Cover
The dark cloud cover is very similar to the bearish engulfing pattern with a minor
variation. In a bearish engulfing pattern the red candle on P2 engulfs P1’s blue
candle completely. However in a dark cloud cover, the red candle on P2 engulfs
about 50 to 100% of P1’s blue candle. The trade set up is exactly the same as the
bearish engulfing pattern. Think about the dark cloud cover as the inverse of a
piercing pattern.
8.7 – A perspective on selecting a trade

Typically stocks in the same sector have similar price movement. For example, think
about TCS and Infosys or ICICI Bank and HDFC bank. Their price movement is similar
because these companies are more or less of the same size, have similar business,
and the same external factors that affect their business. However this does not
mean their stock price movement would match point to point. For example if there
is negative news in the banking sector, banking stocks are bound to fall. In such a
scenario if the stock price of ICICI Bank falls by 2%, it is not really necessary that
59
HDFC Bank’s stock price should also fall exactly 2%. Probably HDFC Bank stock price
may fall by 1.5% or 2.5%. Hence the two stocks may form 2 different (but somewhat
similar) candlestick patterns such as a bearish engulfing and dark cloud cover at the
same time.
Both these are recognisable candlestick patterns but if I were to choose between
the two patterns to set up a trade. I would put my money on the bearish engulfing
pattern as opposed to a dark cloud cover. This is because the bearishness in a
bearish engulfing pattern is more pronounced (due to the fact that it engulfs the
previous day’s entire candle). On the same lines I would choose a bullish engulfing
pattern over a piercing pattern.
However there is an exception to this selection criterion. Later in this module I will
introduce a 6 point trading checklist. A trade should satisfy at least 3 to 4 points on
this checklist for it to be considered as a qualified trade. Keeping this point in
perspective, assume there is a situation where the ICICI Bank stock forms a piercing
pattern and the HDFC Bank stock forms a bullish engulfing pattern. Naturally one
would be tempted to trade the bullish engulfing pattern, however if the HDFC Bank
stock satisfies 3 checklist points, and ICICI Bank stock satisfies 4 checklist points, I
would go ahead with the ICICI Bank stock even though it forms a less convincing
candlestick pattern.
On the other hand, if both the stocks satisfy 4 checklist points I will go ahead with
the HDFC Bank trade.
1. Multiple candlestick patterns evolve over two or more trading days

2. The bullish engulfing pattern evolves over two trading days. It appears at the
bottom end of downtrend. Day one is called P1 and day 2 is called P2
3. In a bullish engulfing pattern, P1 is a red candle, and P2 is a blue candle. P2’s blue
candle completely engulfs P1;s red candle
4. A risk taker initiates a long trade at the close of P2 after ensuring P1 and P2 together
form a bullish engulfing pattern. A risk averse trader will initiate the trade the day
after P2, near the close of the day
5. The stoploss for the bullish engulfing pattern is the lowest low between P1 and P2
6. The bearish engulfing pattern appears at the top end of an uptrend. P1’s blue
candle is completely engulfed by P2’s red candle
7. A risk taker initiates a short trade at the close of P2 after ensuring P1 and P2
together form a bearish engulfing pattern. The risk averse trader will initiate the
trade the day after P2, after confirming the day forms a red candle
60
8. The highest high of P1 and P2 forms the stoploss for a bearish engulfing pattern
9. The presence of a doji after an engulfing pattern tends to catalyze the pattern’s
evolution.
10. The piercing pattern works very similar to bullish engulfing pattern, except that P2’s
blue candle engulfs at least 50% and below 100% of P1’s red candle
11. The dark cloud cover works similar to the bearish engulfing pattern, except that P2’s
red candle engulfs at least 50% and below 100% of P1’s blue candle.
61
Chapter 9
Multiple Candlestick Patterns (Part 2)

139
9.1 – The Harami Pattern

Before you get thinking, the word ‘Harami’ does not stand for the word harami used
in Hindi . Apparently it is old Japanese word for ‘pregnant’. You’d appreciate the
intuitiveness of this word, when you see the candlestick formation.
Harami is a two candle pattern. The first candle is usually long and the second
candle has a small body. The second candle is generally opposite in colour to the
first candle. On the appearance of the harami pattern a trend reversal is possible.
There are two types of harami patterns – the bullish harami and the bearish harami.
9.2 – The Bullish Harami

As the name suggests, the bullish harami is a bullish pattern appearing at the
bottom end of the chart. The bullish harami pattern evolves over a two day period,
similar to the engulfing pattern.
In the chart below, the bullish harami pattern is encircled.
62
The thought process behind a bullish harami pattern is as follows:
1. The market is in a downtrend pushing the prices lower, therefore giving the bears
absolute control over the markets
2. On day 1 of the pattern (P1) a red candle with a new low is formed, reinforcing the
bear’s position in the market
3. On day 2 of the pattern (P2) the market opens at a price higher than the previous
day’s close. On seeing a high opening price the bears panic ,as they would have
otherwise expected a lower opening price
4. The market gains strength on P2 and manages to close on a positive note, thus
forming a blue candle. However P2’s closing price is just below the previous days
(P1) open price
5. The price action on P2 creates a small blue candle which appears contained
(pregnant) within P1’s long red candle
6. The small blue candle on a standalone basis looks harmless, but what really causes
the panic is the fact that the bullish candle appears all of a sudden, when it is least
expected
7. The blue candle not only encourages the bulls to build long positions, but also
unnerves the bears
8. The expectation is that panic amongst the bears will spread in an accelerated
manner, giving a greater push to bulls. This tends to push the prices higher. Hence
one should look at going long on the stock.
The trade setup for the bullish harami is as follows:
1. The idea is to go long on the bullish harami formation

2. Risk takers can initiate a long trade around the close of the P2 candle
3. Risk takers can validate the following conditions to confirm if P1, and P2 together
form a bullish harami pattern:
1. The opening on P2 should be higher than the close of P1
2. The current market price at 3:20 PM on P2 should be less than P1’s opening price
63
3. If both these conditions are satisfied then one can conclude that both P1 and P2
together form a bullish harami pattern
4. The risk averse can initiate a long trade at the close of the day after P2, only after
confirming that the day is forming a blue candle
5. The lowest low of the pattern will be the stoploss for the trade
Here is a chart of Axis Bank; the bullish harami is encircled below:
The OHLC details for the pattern are as follows:
P1 – Open = 868, High = 874, Low = 810, Close = 815

The risk taker would initiate the long position at the close of P2 which is around 835.
The stop loss for the trade would be lowest low price between P1 and P2; which in
this case it is 810.
The risk averse will initiate the trade the day near the close of the day after P2,
provided it is a blue candle day, which in this case is.
Once the trade has been initiated, the trader will have to wait for either the target to
be hit or the stop loss to be triggered.
Here is a chart below where the encircled candles depict a bullish harami pattern,
but it is not. The prior trend should be bearish, but in this case the prior trend is
almost flat which prevents us from classifying this candlestick pattern as a bullish
harami.
64
And here is another example where a bullish harami occurred but the stoploss on
the trade triggered leading to a loss.
9.3 – The bearish harami

The bearish harami pattern appears at the top end of an uptrend which gives the
trader a opportunity to initiate a short trade.
The thought process behind shorting a bearish harami is as follows:
65
1. The market is in an uptrend, placing the bulls in absolute control
2. On P1, the market trades higher, and makes a new high and closes positively
forming a blue candle day. The trading action reconfirms the bulls dominance in the
market
3. On P2 the market unexpectedly opens lower which displaces the bulls ,and sets in a
bit of panic to bulls
4. The market continues to trade lower to an extent where it manages to close
negatively forming a red candle day
5. The unexpected negative drift in the market causes panic making the bulls to
unwind their positions
6. The expectation is that this negative drift is likely to continue and therefore one
should look at setting up a short trade.
The trade setup for the short trade based on bearish harami is as follows:
1. The risk taker will short the market near the close of P2 after ensuring P1 and P2
together forms a bearish harami. To validate this, two conditions must be satisfied:
1. The open price on P2 should be lower than the close price of P1
2. The close price on P2 should be greater than the open price of P1
2. The risk averse will short the market the day after P2 after ensuring it forms a red
candle day
3. The highest high between P1 and P2 acts as the stoploss for the trade.
Here is a chart of IDFC Limited where the bearish engulfing pattern is identified. The
OHLC details are as follows:

P2 – Open = 126.9, High = 129.70, Low, = 125, Close = 124.80
The risk taker will initiate the trade on day 2, near the closing price of 125. The risk
averse will initiate the trade on the day after P2, only after ensuring it forms a red
66
candle day. In the above example, the risk averse would have avoided the trade
completely.
The stop loss for the trade would be the highest high between P1 and P2. In this
case it would be 129.70.
1. The harami pattern evolves over 2 trading sessions – P1 and P2.

2. Day 1 (P1) of the pattern forms a long candle and day 2(P2) of the pattern forms a
small candle which appears as if it has been tucked inside the P1’s long candle
3. A bullish harami candle pattern is formed at the lower end of a down trend. P1 is a
long red candle, and P2 is a small blue candle. The idea is to initiate a long trade
near the close of P2 (risk taker). A risk averse trader will initiate the long trade near
the close of the day after P2 only after ensuring it forms a blue candle day
4. The stop loss on a bullish harami pattern is the lowest low price between P1 and P2
5. The bearish harami pattern is formed at the top end of an uptrend. P1 is a long blue
candle, and P2 is a small red candle. The idea is to initiate a short trade near the
close of P2 (risk taker). The risk averse will initiate the short near the close of the day
only after ensuring it is a red candle day
6. The stop loss on a bearish harami pattern is the highest high price between P1 and
P2.
67
Chapter 10
Multiple Candlestick Patterns (Part 3)

292
The morning star and the evening star are the last two candlestick patterns we will
be studying.
Before we understand the morning star pattern, we need to understand two

common price behaviors –gap up opening and gap down opening. Gaps (a general
term used to indicate both gap up and gap down) are a common price behavior. A
gap on a daily chart happens when the stock closes at one price but opens on the
following day at a different price.
10.1 – The Gaps

Gap up opening – A gap up opening indicates buyer’s enthusiasm. Buyers are
willing to buy stocks at a price higher than the previous day’s close. Hence, because
of enthusiastic buyer’s outlook, the stock (or the index) opens directly above the
previous day’s close. For example consider the closing price of ABC Ltd was Rs.100
on Monday. After the market closes on Monday assume ABC Ltd announces their
quarterly results. The numbers are so good that on Tuesday morning the buyers are
willing to buy the stock at any price. This enthusiasm would lead to stock price
jumping to Rs.104 directly. This means though there was no trading activity between
Rs.100 and Rs.104, yet the stock jumped to Rs.104. This is called a gap up
opening. Gap up opening portrays bullish sentiment.
In the following image the green arrows points to a gap up openings.
68
Gap down opening – Similar to gap up opening, a gap down opening shows the
enthusiasm of the bears. The bears are so eager to sell, that they are willing to sell
at a price lower than the previous day’s close. In the example stated above, if the
quarterly results were bad, the sellers would want to get rid of the stock and hence
the market on Tuesday could open directly at Rs.95 instead of Rs.100. In this case,
though there was no trading activity between Rs.100 and Rs.95 yet the stock
plummeted to Rs.95. Gap down opening portrays bearish sentiment. In the
following image the green arrows points to a gap down opening.
10.2 – The Morning Star

The morning star is a bullish candlestick pattern which evolves over a three day
period. It is a downtrend reversal pattern. The pattern is formed by combining 3
consecutive candlesticks. The morning star appears at the bottom end of a down
trend. In the chart below the morning star is encircled.
69
The morning star pattern involves 3 candlesticks sequenced in a particular order.
The pattern is encircled in the chart above. The thought process behind the morning
star is as follow:
1. Market is in a downtrend placing the bears in absolute control. Market makes

successive new lows during this period
2. On day 1 of the pattern (P1), as expected the market makes a new low and forms a
long red candle. The large red candle shows selling acceleration
3. On day 2 of the pattern (P2) the bears show dominance with a gap down opening.
This reaffirms the position of the bears
4. After the gap down opening, nothing much happens during the day (P2) resulting in
either a doji or a spinning top. Note the presence of doji/spinning top represents
indecision in the market
5. The occurrence of a doji/spinning sets in a bit of restlessness within the bears, as
they would have otherwise expected another down day especially in the backdrop
of a promising gap down opening
6. On the third day of the pattern (P3) the market/stock opens with a gap up followed
by a blue candle which manages to close above P1’s red candle opening
7. In the absence of P2’s doji/spinning top it would have appeared as though P1 and
P3 formed a bullish engulfing pattern
8. P3 is where all the action unfolds. On the gap up opening itself the bears would
have been a bit jittery. Encouraged by the gap up opening buying persists through
the day, so much so that it manages to recover all the losses of P1
9. The expectation is that the bullishness on P3 is likely to continue over the next few
trading sessions and hence one should look at buying opportunities in the market
Unlike the single and two candlestick patterns, both the risk taker and the risk
averse trader can initiate the trade on P3 itself. Waiting for a confirmation on the
4th day may not be necessary while trading based on a morning star pattern.
The long trade setup for a morning star would be as follows:
1. Initiate a long trade at the close of P3 (around 3:20PM) after ensuring that P1, P2,
and P3 together form a morning star
70
2. To validate the formation of a morning star on P3 the following conditions should
satisfy:
1. P1 should be a red candle
2. With a gap down opening, P2 should be either a doji or a spinning top
3. P3 opening should be a gap up, plus the current market price at 3:20 PM should be
higher than the opening of P1
3. The lowest low in the pattern would act as a stop loss for the trade
10.3 – The evening star

The evening star is the last candlestick pattern that we would learn in this module.
The evening star is a bearish equivalent of the morning star. The evening star
appears at the top end of an uptrend. Like the morning star, the evening star is a
three candle formation and evolves over three trading sessions.
The reasons to go short on an evening star are as follows:
1. The market is in an uptrend placing the bulls in absolute control

2. During an uptrend the market/stock makes new highs
3. On the first day of the pattern (P1), as expected the market opens high, makes a
new high and closes near the high point of the day. The long blue candle formed on
day 1 (P1) shows buying acceleration
4. On the 2nd day of the pattern (P2) the market opens with a gap reconfirming the
bull’s stance in the market. However after the encouraging open the market/stock
does not move and closes by forming a doji/spinning top. The closing on P2 sets in a
bit of panic for bulls
71
5. On the 3rd day of the pattern (P3), the market opens gap down and progresses into a
red candle. The long red candle indicates that the sellers are taking control. The
price action on P3 sets the bulls in panic
6. The expectation is that the bulls will continue to panic and hence the bearishness
will continue over the next few trading session. Therefore one should look at
shorting opportunities
The trade setup for an evening star is as follows:
1. Short the stock on P3, around the close of 3:20 PM after validating that P1 to P3
form an evening star
2. To validate the evening star formation on day 3, one has to evaluate the following:
1. P1 should be a blue candle
2. P2 should be a doji or a spinning top with a gap up opening
3. P3 should be a red candle with a gap down opening. The current market price at
3:20PM on P3 should be lower than the opening price of P1
3. Both risk taker and risk averse can initiate the trade on P3
4. The stop loss for the trade will be the highest high of P1, P2, and P3.
10.4 – Summarizing the entry and exit for candlestick patterns

Before we conclude this chapter let us summarize the entry and stop loss for both
long and short trades. Remember during the study of candlesticks we have not dealt
with the trade exit (aka targets). We will do so in the next chapter.
Risk taker – The risk taker enters the trade on the last day of the pattern formation
around the closing price (3:20 PM). The trader should validate the pattern rules and
if the rules are validated; then the opportunity qualifies as a trade.
Risk averse – The risk averse trader will initiate the trade after he identifies a
confirmation on the following day. For a long trade the colour of candle should be
blue and for a short trade the color of the candle should be red.
As a rule of thumb, higher the number of days involved in a pattern the better it is
to initiate the trade on the same day.
The stoploss for a long trade is the lowest low of the pattern. The stoploss for a
short trade is the highest high of the pattern.
10.5 – What next?

We have looked at 16 candlestick patterns, and is that all you may wonder?.
No, not really. There are many candlestick patterns and I could go on explaining
these patterns but that would defeat the ultimate goal.
72
The ultimate goal is to understand and recognize the fact that candlesticks are a
way of thinking about the markets. You need not know all the patterns.
Think about car driving, once you learn how to drive a car, it does not matter which
car you drive. Driving a Honda is pretty much the same as driving a Hyundai or Ford.
Driving comes naturally irrespective of which car you are driving. Likewise once you
train your mind to read the thought process behind a candlestick it does not matter
which pattern you see. You will exactly know how to react and how to set up a trade
based on the chart that you are seeing. Of course in order to reach this stage, you
will have to go through the rigor of learning and trading the standard patterns.
So my advice to you would be to know the patterns that we have discussed here.
They are some of the most frequent and profitable patterns to trade on the Indian
markets. As you progress, start developing trades based on the thought process
behind the actions of the bulls and the bears. This, over time is probably the best
approach to study candlesticks.
1. Star formation occurs over three trading sessions. The candle of P2 is usually a doji
or a spinning top
2. If there is a doji on P2 in a star pattern, it is called a doji star (morning doji star,
evening doji star) else it is just called the star pattern (morning star, evening star)
3. Morning star is a bullish pattern which occurs at the bottom end of the trend. The
idea is to go long on P3 with the lowest low of the pattern being the stop loss for the
trade
4. Evening star is a bearish pattern, which occurs at the top end of an up trend. The
idea is to go short on P3, with the highest high of the pattern acting as a stop loss
5. The star formation evolves over a 3 days period, hence both the risk averse and risk
taker are advised to initiate the trade on P3
6. Candlesticks portray the traders thought process. One should nurture this thought
process as he dwells deeper into the candlestick study
73
Chapter 11
The Support and Resistance

301
While discussing candlestick patterns, we had learnt about the entry and the
stoploss points, however the target price was not discussed. We will discuss the
same in this chapter.
The best way to identify the target price is to identify the support and the resistance
points. The support and resistance (S&R) are specific price points on a chart which
are expected to attract maximum amount of either buying or selling. The support
price is a price at which one can expect more buyers than sellers. Likewise the
resistance price is a price at which one can expect more sellers than buyers.
On a standalone basis traders can use S&R to identify trade entry points as well.
11.1 – The Resistance

As the name suggests, resistance is something which stops the price from rising
further. The resistance level is a price point on the chart where traders expect
maximum supply (in terms of selling) for the stock/index. The resistance level is
always above the current market price.
The likely hood of the price rising up to the resistance level, consolidating, absorbing
all the supply, and then declining is high. The resistance is one of the critical
technical analysis tool which market participants look at in a rising market. The
resistance often acts as a trigger to sell.
Here is the chart of Ambuja Cements Limited. The horizontal line coinciding at
Rs.215 on chart, marks the resistance level for Ambuja Cements.
74
I have deliberately compressed the chart to include more data points, the reasons
for which I will shortly explain. But before that there are two things that you need to
pay attention to while looking at the above chart:
1. The resistance level, indicated by a horizontal line, is higher than the current market
price.
2. While the resistance level is at 215, the current candle is at 206.75. The current
candle and its corresponding price level are encircled for your reference
For a moment let us imagine Ambuja cements at Rs.206 forming a bullish marubuzo
with a low of 202. We know this is a signal to initiate a long trade, and we also know
that the stoploss for this trade is at 202. With the new found knowledge on
resistance, we now know that we can set 215 as a possible target for this trade!
Why 215 you may wonder? The reasons are simple:-
1. Resistance of 215 implies there is a likelihood of excess supply

2. Excess supply builds selling pressure
3. Selling pressure tends to drag the prices lower
Hence for reasons stated above, when a trader is long he can look at resistance
points to set targets and to set exit points for the trade.
Also, with the identification of the resistance the long trade can now be completely
designed as follows:
Entry – 206, Stoploss – 202, and Target – 215.
The next obvious question is how do we identify the resistance level? Identifying
price points as either a support or resistance is extremely simple. The identification
process is the same for both support and resistance. If the current market price is
below the identified point, it is called a resistance point; else it is called a support
point.
75
Since the process is the same, let us proceed to understand ‘support’, and we will
follow it up with the procedure to identify S&R.
11.2 – The Support

Having learnt about resistance, understanding the support level should be quite
simple and intuitive. As the name suggests, the support is something that prevents
the price from falling further. The support level is a price point on the chart where
the trader expects maximum demand (in terms of buying) coming into the
stock/index. Whenever the price falls to the support line, it is likely to bounce back.
The support level is always below the current market price.
There is a maximum likely hood that the price could fall till the support, consolidate,
absorb all the demand, and then start to move upwards. The support is one of the
critical technical level market participants look for in a falling market. The support
often acts as a trigger to buy.
Here is the chart of Cipla Limited. The horizontal line coinciding at 435 on chart
marks the support level for Cipla.
Few things that you need to notice on the chart above:
76
1. The support level, indicated by the horizontal line is below the current market price
2. While the support level is at 435, the current candle is at 442.5. The current candle
and its corresponding price level are encircled for your reference
Like we did while understanding resistance, let us imagine a bearish pattern
formation – perhaps a shooting star at 442 with a high of 446. Clearly with a
shooting star, the call is to short Cipla at 442, with 446 as the stoploss. Since we
know 435 the immediate support, we can set the target at 435.
So what makes Rs.435 target worthy? The following reasons back the decision:
1. Support at 435 implies there is a maximum likely hood of excess demand to emerge
2. Excess demand builds buying pressure
3. Buying pressure tends to drag the price higher
Hence for the reasons stated above, when a trader is short, he can look at support
points to set targets and to set exit points for the trade.
Also, with the identification of the support, the short trade is now completely
designed.
Entry – 442, stoploss – 446, and target – 435.
11.3 – Construction/Drawing of the Support and Resistance level

Here is a 4 step guide to help you understand how to identify and construct the
support and the resistance line.
Step 1) Load data points – If the objective is to identify short term S&R load at least
3-6 months of data points. If you want to identify long term S&R, load at least 12 –
18 months of data points. When you load many data points, the chart looks
compressed. This also explains why the above two charts looks squeezed.
1. Long term S&R – is useful for swing trading

2. Short term S&R – is useful intraday and BTST trades
Here is a chart where I have loaded 12 months of data points
77
Step 2) Identify at least 3 price action zones – A price action zone can be
described as ‘sticky points’ on chart where the price has displayed at least one of the
behaviors:
1. Hesitated to move up further after a brief up move

2. Hesitated to move down further after a brief down move
3. Sharp reversals at particular price point
Here are a series of charts that identifies the above 3 points in the same order:
In the chart below, the encircled points indicate the price hesitating to move up
further after a brief up move:
In the chart below, the encircled points indicate the price hesitating to move down
further after a brief down move:
78
In the chart below, the encircled points indicate sharp price reversals:
Step 3) Align the price action zones – When you look at a 12 month chart, it is
common to spot many price action zones. But the trick is to identify at least 3 price
action zones that are at the same price level.
For example here is a chart where two price action zones are identified but they are
not at the same price point.
79
Look at the following chart, I have encircled 3 price action zones that are around the
same price points:
A very important point to note while identifying these price action zones is to make
sure these price zone are well spaced in time. Meaning, if the 1st price action zone is
identified on 2nd week on May, then it will be meaningful to identify the 2nd price
action zone at any point after 4th week of May (well spaced in time). The more
distance between two price action zones, the more powerful is the S&R
identification.
Step 4) Fit a horizontal line – Connect the three price action zones with a
horizontal line. Based on where this line fits in with respect to the current market
price, it either becomes a support or resistance.
Have a look at this chart
Starting from left:
1. The 1st circle highlights a price action zone where there is a sharp reversal of price
2. The 2nd circle highlights a price action zone where price is sticky
80
3. The 3rd circle highlights a price action zone where there is a sharp reversal of price
4. The 4th circle highlights a price action zone where price is sticky
5. The 5th circle highlights the current market price of Cipla – 442.5
In the above chart all the 4 price action zones are around the same price points i.e
at 429. Clearly, the horizontal line is below the current market price of 442.5, thus
making 429 as an immediate support price for Cipla.
Please note, whenever you run a visual exercise in Technical Analysis such as
identifying S&R, you run the risk of approximation. Hence always give room for
error. The price level is usually depicted in a range and not at a single price point. It
is actually a zone or an area that acts as support or resistance.
So going by the above logic, I would be happy to consider a price range around 426
to 432 as a support region for Cipla. There is no specific rule for this range, I just
subtracted and added 3 points to 429 to get my price range for support!
Here is another chart, where both S&R have been identified for Ambuja Cements
Limited.
The current price of Ambuja is 204.1, the support is identified at 201 (below current
market price), and the resistance at 214 (above current market price). So if one were
to short Ambuja at 204, the target, based on support can be at 201. Probably this
would be a good intraday trade. For a trader going long at 204, 214 can be a
reasonable target expectation based on resistance.
Notice in both the support and the resistance level, there at least 3 price action zone
identified at the price level, all of which are well spaced in time.
81
11.4 – Reliability of S&R
The support and resistance lines are only indicative of a possible reversal of prices.
They by no means should be taken for as certain. Like anything else in technical
analysis, one should weigh the possibility of an event occurring (based on patterns)
in terms of probability.
For example, based on the chart of Ambuja Cements –
Current Market Price = 204

Resistance = 214
The expectation here is that if at all Ambuja cements starts to move up it is likely to
face a resistance at 214. Meaning, at 214 sellers could emerge who can potentially
drag the prices lower. What is the guarantee that the sellers would come in at 214?
In other words, what is dependence of the resistance line? Honestly, your guess is
as good as mine.
However, historically it can be seen that whenever Ambuja reached 214, it reacted in
a peculiar way leading to the formation of a price action zone. The comforting factor
here is that the price action zone is well spaced in time. This mean 214 stands as a
time tested price action zone. Therefore keeping the very first rule of technical
analysis in perspective i.e “History tends to repeat itself” we go with the belief
that support and resistance levels will be reasonably honored.
Purely from my personal trading experience well constructed S&R points are usually
well respected.
11.4 – Optimization and checklist

Perhaps, we are now at the most important juncture in this module. We will start
discovering few optimization techniques which will help us identify high quality
trades. Remember, when you seek quality, quantity is always compromised, but this
is a compromise that is worth making. The idea is to identify quality trading signals
as opposed to identifying plenty, but worthless trades.
Optimization in general is a technique wherein you fine tune a process for best
possible results. The process in this context is about identifying trades.
Let us go back to candlesticks patterns, maybe to the very first we learnt – bullish
marubuzo. A bullish marubuzo suggests a long trade near the close of the
marubuzo, with the low of the marubuzo acting as the stoploss.
Assume the following credentials for the bullish marubuzo:
Open = 432, High = 449, Low = 430, Close = 448
Hence the entry for the long trade is approximately at 448, with 430 as the stoploss.
82
Now what if the low of the marubuzo also coincides with a good time tested
support? Do you see a remarkable confluence of two technical theories here?
We have a double confirmation to go long. Think about it on following terms:
1. A recognized candlestick pattern (bullish marubuzo) suggests the trader to initiate a

long trade
2. A support near the stoploss price suggests the trader the presence of significant
buying interest around the low
While dealing with a fairly random environment such as the markets, what a trader
really needs is a well crafted trade setup. The occurrence of the above two
conditions (marubuzo + support near the low) suggests the same action i.e to
initiate a long trade in this case.
This leads us to an important idea. What if we had a checklist (call it a framework if

you like) for every trade that we consider? The checklist would act as a guiding
principle before initiating a trade. The trade should comply to the conditions
specified in the checklist. If it does, we take the trade; else we just drop it and look
for another trade opportunity that complies with the checklist.
Discipline, they say makes up for the 80% of the trader’s success. The checklist in my
opinion forces you to be disciplined; it helps you avoid taking abrupt and reckless
trading decision.
In fact to begin with we have the first two very important factors of the checklist:
1. The stock should form a recognizable candlestick pattern

1. Note: We have learnt some of the popular patterns in this module. To begin with
you can use just these patterns to comply with checklist
2. S&R should confirm to the trade. The stoploss price should be around S&R
1. For a long trade, the low of the pattern should be around the support
2. For a short trade, the high of the pattern should be around the resistance
Going forward in this module, as and when we learn new TA concepts, we will build
this checklist. But just to quench your curiosity, the final checklist will have 6
checklist points. In fact when we have the grand 6 checklist points, we will weigh
down each one of them. For example, checklist point number 4 may not be as
important as point number 1, but nevertheless it is more important than 100 other
factors that distract the trader.
1. S&R are price points on the chart
83
2. Support is a price point below the current market price that indicate buying interest
3. Resistance is a price point above the current market price that indicate selling
interest
4. To identify S&R, place a horizontal line in such a way that it connects at least 3 price
action zones, well spaced in time. The more number of price action zones (well
spaced in time) the horizontal line connects, the stronger is S&R
5. S&R can be used to identify targets for the trade. For a long trade, look for the
immediate resistance level as target. For a short trade, look for the immediate
support level as target.
6. Lastly, comply with the checklist for optimal trading results
84
Chapter 12
Volumes
307
Volume plays a very integral role in technical analysis as it helps us to confirm

trends and patterns. Consider volumes as means to gain insights into how other
participants perceive the market.
Volumes indicate how many shares are bought and sold over a given period of time.
The more active the share, higher would be its volume. For example, you decide to
buy 100 shares of Amara Raja Batteries at 485, and I decide to sell 100 shares of
Amara Raja Batteries at 485. There is a price and quantity match, which results in a
trade. You and I together have created a volume of 100 shares. Many people tend to
assume volume count as 200 (100 buy + 100 sell) which is not the right way to look
at volumes.
The following fictional example should help you understand how volumes add up
on a typical trading day:
Sl No Time Buy Quantity Sell Quantity Price Volume Cumulative Volume
01 9:30 AM 400 400 62.20 400 400
85
02 10.30 AM 500 500 62.75 500 900
03 11:30 AM 350 350 63.10 350 1,250
04 12:30 PM 150 150 63.50 150 1,400
05 1:30 PM 625 625 63.75 625 2,025
06 2:30 PM 475 475 64.20 475 2,500
07 3:30 PM 800 800 64.50 800 3,300
At 9:30 AM there were 400 shares exchanged at the price of 62.20. An hour later,
500 shares were traded at 62.75. So at 10:30 AM if you were to check the total
volume for the day, it would be 900 (400 + 500). Likewise 350 shares at 63.10 were
traded at 11:30 AM, and upto 11:30 AM, the volume was 1,250 (400+500+350). So
on, and so forth.
Here is a screen shot from the live market highlighting the volumes for some of the
shares. The screen shot was taken around 2:55 PM on 5th of August 2014.
If you notice, the volume on Cummins India Limited is 12,72,737 shares, likewise the
volume on Naukri (Info Edge India Limited) is 85,427 shares.
The volume information that you see here is the cumulative volume. Meaning, at
2:55 PM, a total of 12,72,737 shares of Cummins were traded at various price points
ranging from 634.90 (low) and 689.85 (high).
86
With 35 minutes left for the markets to close, it is only logical to expect the volumes
to increase (of course assuming traders continue to trade the stock for the rest of
the day). In fact here is another screen shot taken at 3:30 PM for the same set of
stocks with volume highlighted.
As you can see, the volume for Cummins India Limited has increased from 12,72,737
to 13,49,736. Therefore, for Cummins India the volume for the day is 13,49,736
shares. The volume for Naukri has increased from 85,427 to 86,712, making 86,712
shares as the volume for the day. It is important for you to note that the volumes
shown here are cumulative.
12.1 – The volume trend table

Volume information on its own is quite useless. For example, we know that the
volumes on Cummins India is 13,49,736 shares. So how useful is this information
when read in isolation? If you think about it, it has no merit and hence would
actually mean nothing. However when you associate today’s volume information
with the preceding price and volume trend, then volume information becomes lot
more meaningful.
In the table below you will find a summary of how to use volume information:
Sl No Price Volume What is the expectation?
01 Increases Increases Bullish
02 Increases Decreases Caution – weak hands buying
87
03 Decreases Increases Bearish
04 Decreases Decreases Caution – weak hands selling
The first line in the table above says, when the price increases along with an
increase in volume, the expectation is bullish.
Before we understand the table above in detail, think about this – we are talking
about an ‘increase in volume’. What does this actually mean? What is the reference
point? Should it be an increase over the previous day’s volume number or the
previous week’s aggregate volume?
As a practice, traders usually compare today’s volume over the average of the last
10 days volume. Generally the rule of thumb is as follows:
High Volume = Today’s volume > last 10 days average volume

Low Volume = Today’s volume < last 10 days average volume
Average Volume = Today’s volume = last 10 days average volume
To get the last 10 day average, all you need to do is draw a moving average line on
the volume bars and the job is done. Of course, we will discuss moving averages in
the next chapter.
In the chart above, you can see that volumes are represented by blue bars (at the
bottom of the chart). The red line overlaid on the volume bars indicates the 10 day
average. As you notice, all the volume bars that are over and above the 10 day
average can be considered as increased volume where some institutional activity (or
large participation) has taken place.
Keeping this in perspective, I would suggest you now look at the volume – price
table.
88
12.2 – Thought process behind the volume trend table
When institutional investors buy or sell they obviously do not transact in small
chunks. For example, think about LIC of India, they are one of the biggest domestic
institutional investors in India. If they would buy shares of Cummins India, would
you think they would buy 500 shares? Obviously not, they would probably buy
500,000 shares or even more. Now, if they were to buy 500,000 shares from the
open market, it will start reflecting in volumes. Besides, because they are buying a
large chunk of shares, the share price also tends to go up. Usually institutional
money is referred to as the “smart money”. It is perceived that ‘smart money’ always
makes wiser moves in the market compared to retail traders. Hence following the
smart money seems like a wise idea.
If both the price and the volume are increasing this only means one thing – a big
player is showing interest in the stock. Going by the assumption that smart money
always makes smart choices the expectation turns bullish and hence one should
look at buying opportunity in the stock.
Or as a corollary, whenever you decide to buy, ensure that the volumes are
substantial. This means that you are buying along with the smart money.
This is exactly what the 1st row in the volume trend table indicates – expectation
turns bullish when both the price and volume increases.
What do you think happens when the price increases but the volume decreases as
indicated in the 2ndrow?
Think about it on the following terms:
1. Why is the price increasing?

1. Because market participants are buying
2. Are there any institutional buyers associated with the price increase?
1. Not likely
3. How would you know that there are no meaningful purchase by institutional
investors
1. Simple, if they were buying then the volumes would have increased and not
decrease
4. So what does an increase in price, associated by decreasing volumes indicate?
1. It means the price is increasing because of a small retail participation and not really
influential buying. Hence you need to be cautious as this could be a possible bull
trap
Going forward, the 3rd row says, a decrease in price along with an increase in
volume sets a bearish expectation. Why do you think so?
89
A decrease in price indicates that market participants are selling the stock. Increase
in volumes indicates the presence of smart money. Both events occurring together
(decrease in price + increase in volumes) should imply that smart money is selling
stocks. Going by the assumption that the smart money always makes smart choices,
the expectation is bearish and hence one should look at selling opportunity in the
stock.
Or as a corollary, whenever you decide to sell, ensure that the volumes are good.
This means that you too are selling, along with the smart money.
Moving forward, what do you think happens when both volume and price decrease
as indicated in the 4throw?
Think about it in on following terms:
1. Why is the price decreasing?

1. Because market participants are selling.
2. Are there any institutional sellers associated with the price decrease?
1. Not likely
3. How would you know that there are no meaningful sell orders by institutional
investors
1. Simple, if they were selling then the volume would increase and not decrease
4. So how would you infer a decline in price and a decline in volume?
1. It means the price is decreasing because of small retail participation, and not really
influential (read as smart money) selling. Hence you need to be cautions as this
could be a possible bear trap.
12.3 – Revisiting the checklist

Let us revisit the checklist and revaluate from the volumes perspective. Imagine this
hypothetical technical situation in a stock:
1. Occurrence of a bullish engulfing pattern – this suggests a long trade for reasons
discussed previously
2. A support level around the low of bullish engulfing – support indicates demand.
Therefore the occurrence of a bullish engulfing pattern near the support area
suggests there is indeed a strong demand for the stock and hence the trader can
look at buying the stock.
1. With a recognizable candlestick pattern and support near the stoploss, the trader
gets a double confirmation to go long
Now along with support near the low, imagine high volumes on the 2nd day of the
bullish engulfing pattern i.e on P2 (blue candle). What can you infer from this?
90
The inference is quite clear – high volumes plus increase in price confirms to us that
large influential market participants are positioning themselves to buy the stock.
With all three independent variables i.e candlesticks, S&R, and volumes suggest to
take the same action i.e to go long. If you realize this is a triple confirmation!
The point that I want to drive across is the fact that volumes are very powerful as it
helps the trader in confirming a trade. For this reason it is an important factor and
therefore must be included in the checklist.
Here is how the updated checklist now stands:

2. S&R should confirm the trade. The stoploss price should be around S&R
3. Volumes should confirm to the trade
1. Presence of above average volumes on both buy and sell day
2. Low volumes are not encouraging and hence do feel free to hesitate taking a trade
where the volumes are low
Key takeaways from the chapter
1. Volumes are used to confirm a trend

2. 100 share buy and 100 shares sell makes the total volume 100, not 200
3. The end of day volumes indicates the cumulative volume across trades executed
throughout the day
4. High volumes indicates the presence of smart money
5. Low volumes indicate retail participation
6. When you initiate a trade to either go long or short always make sure if volumes
confirm
7. Avoid trading on low volume days
91
Chapter 13
Moving Averages
345
We have all learnt about averages in school, moving average is just an extension of
that. Moving averages are trend indicators and are frequently used due to their
simplicity and effectiveness. Before we learn moving averages, let us have a quick
recap on how averages are calculated.
Assume 5 people are sitting on a nice sunny beach enjoying a nice chilled bottled
beverage. The sun is so bright and nice that each one of them end up drinking
several bottles of the beverage. Assume the final count to be something like this:
Sl No Person No of Bottles
01 A 07
02 B 05
03 C 06
04 D 03
92
05 E 08
Total # of bottles consumed 29
Assume a 6th person walks in to find out 29 bottles of beverages lying around them.
He can quickly get a sense of ‘roughly’ how many bottles each of them consumed by
dividing [the total number of bottles] by [total number of people].
In this case it would be:
=29/5
=5.8 bottles per head.
So, the average in this case tells us roughly how many bottles each person had
consumed. Obviously there would be few of them who had consumed above and
below the average. For example, Person E drank 8 bottles of beverage, which is way
above the average of 5.8 bottles. Likewise, person D drank just 3 bottles of
beverage, which is way below the average of 5.8 bottles. Therefore average is just
an estimate and one cannot expect it to be accurate.
Extending the concept to stocks, here are the closing prices of ITC Limited for the
last 5 trading sessions. The last 5 day average close would be calculated as follows:
Date Closing Price
14/07/14 344.95
15/07/14 342.35
16/07/14 344.20
17/07/14 344.25
18/07/14 344.0
93
Total 1179.75
= 1179.75 / 5
= 343.95
Hence the average closing price of ITC over the last 5 trading sessions is 343.95.
13.1 – The ‘moving’ average (also called the simple moving average)
Consider a situation where you want to calculate the average closing price of Marico
Limited for the latest5 days. The data is as follows:
Date Closing Price
21/07/14 239.2
22/07/14 240.6
23/07/14 241.8
24/07/14 242.8
25/07/14 247.9
Total 1212.3
= 1212.3/ 5
= 242.5
Hence the average closing price of Marico over the last 5 trading sessions is 242.5
Moving forward, the next day i.e 28th July (26th and 27th were Saturday and Sunday
respectively) we have a new data point. This implies now the ‘new’ latest 5 days
would be 22nd, 23rd, 24th, 25th and 28th. We will drop the data point belonging to the
21st as our objective is to calculate the latest 5 day average.
94
Date Closing Price
22/07/14 240.6
23/07/14 241.8
24/07/14 242.8
25/07/14 247.9
28/07/14 250.2
Total 1223.3
= 1223.3/ 5
= 244.66
Hence the average closing price of Marico over the last 5 trading sessions is 244.66
As you can see, we have included the latest data (28th July), and discarded the oldest
data (21st July) to calculate the 5 day average. On 29th, we would include 29th data
and exclude 22nd data, on 30th we would include 30th data point but eliminate
23rd data, so on and so forth.
So essentially, we are moving to the latest data point and discarding the oldest to
calculate the latest 5 day average. Hence the name “moving” average!
In the above example, the calculation of moving average is based on the closing
prices. Sometimes, moving averages are also calculated using other parameters
such as high, low, and open. However the closing prices are used mostly by the
traders and investors as it reflects the price at which the market finally settles down.
Moving averages can be calculated for any time frame, from minutes, hours to
years. Any time frame can be selected from the charting software based of your
requirements.
95
For those of you familiar with excel, here is a screenshot of how moving averages
are calculated on MS Excel. Notice how the cell reference moves in the average
formula, eliminating the oldest to include the latest data points.
Cell Ref Date Close Price 5 Day Average Average Formula
D3 1-Jan-14 1287.7
D4 2-Jan-14 1279.25
D5 3-Jan-14 1258.95
D6 6-Jan-14 1249.7
D7 7-Jan-14 1242.4
D8 8-Jan-14 1268.75 1263.6 =AVERAGE(D3:D7)
D9 9-Jan-14 1231.2 1259.81 =AVERAGE(D4:D8)
D10 10-Jan-14 1201.75 1250.2 =AVERAGE(D5:D9)
D11 13-Jan-14 1159.2 1238.76 =AVERAGE(D6:D10)
D12 14-Jan-14 1157.25 1220.66 =AVERAGE(D7:D11)
D13 15-Jan-14 1141.35 1203.63 =AVERAGE(D8:D12)
D14 16-Jan-14 1152.5 1178.15 =AVERAGE(D9:D13)
96
D15 17-Jan-14 1139.6 1162.41 =AVERAGE(D10:D14)
D16 20-Jan-14 1140.6 1149.98 =AVERAGE(D11:D15)
D17 21-Jan-14 1166.35 1146.26 =AVERAGE(D12:D16)
D18 22-Jan-14 1165.4 1148.08 =AVERAGE(D13:D17)
D19 23-Jan-14 1168.25 1152.89 =AVERAGE(D14:D18)
As it is evident, the moving average changes as and when the closing price changes.
A moving average as calculated above is called a ‘Simple Moving Average’ (SMA).
Since we are calculating it as per the latest 5 days of data it is called referred to as 5
Day SMA.
The averages for the 5 day (or it could be anything like 5, 10, 50, 100, 200 days) are
then joined to form a smooth curving line known as the moving average line, and it
continues to move as the time progresses.
In the chart shown below, I have overlaid a 5 day SMA over ACC’s candlestick graph.
97
So what does a moving average indicate and how does one use it? Well, there are
many applications of moving average and shortly I will introduce a simple trading
system based on moving averages. But before that, let us learn about the
Exponential Moving Average.
13.2 – The exponential moving average

Consider the data points used in the this example,
Date Closing Price
22/07/14 240.6
23/07/14 241.8
24/07/14 242.8
25/07/14 247.9
28/07/14 250.2
Total 1214.5
When one calculates the average across these numbers there is an unstated
assumption. We are essentially giving each data point equal importance. Meaning,
we are assuming that the data point on 22ndJuly is as important as the data point on
28th July. However, when it comes to markets, this may not always be true
Remember the basic assumption of technical analysis – markets discount

everything. This means the latest price that you see (on 28th July) discounts all the
known and unknown information. This also implies the price on 28th is more sacred
than the price on 25th.
Going by this, one would like to assign weightage to data points based on the
‘newness’ of the data. Therefore the data point on 28th July gets the highest
weightage, 25th July gets the next highest weightage, 24th July gets the 3rd highest, and
so on.
98
By doing so, I have essentially scaled the data points according to its newness – the
latest data point gets the maximum attention and the oldest data point gets the
least attention.
The average calculated on this scaled set of numbers gives us the Exponential
Moving Average (EMA). I deliberately skipped the EMA calculation part, simply
because most of the technical analysis software lets us drag and drop the EMA on
prices. Hence we will focus on EMA’s application as opposed to its calculation.
Here is a chart of Cipla Ltd. I have plotted a 50 day SMA (black) and a 50 day EMA
(red) on Cipla’s closing prices. Though both SMA and EMA are for a 50 day period,
you can notice that the EMA is more reactive to the prices and hence it sticks closer
to the price.
The reason why EMA is quicker to react to the current market price is because EMA
gives more importance to the most recent data points. This helps the trader to take
quicker trading decisions. Hence for this reason, traders prefer the use of the EMA
over the SMA.
13.3 – A simple application of moving average

The moving average can be used to identify buying and selling opportunities with its
own merit. When the stock price trades above its average price, it means the traders
are willing to buy the stock at a price higher than its average price. This means the
traders are optimistic about the stock price going higher. Therefore one should look
at buying opportunities.
Likewise, when the stock price trades below its average price, it means the traders
are willing to sell the stock at a price lesser than its average price. This means the
traders are pessimistic about the stock price movement. Therefore one should look
at selling opportunities.
99
We can develop a simple trading system based on these conclusions. A trading
system can be defined as a set of rules that help you identify entry and exit points.
We will now try and define one such trading system based on a 50 day exponential
moving average. Remember a good trading system gives you a signal to enter a
trade and a signal to close out the trade. We can define the moving average trading
system with the following rules:
Rule 1) Buy (go long) when the current market price turns greater than the 50 day
EMA. Once you go long, you should stay invested till the necessary sell condition is
satisfied
Rule 2) Exit the long position (square off) when the current market price turns lesser
than the 50 day EMA
Here is a chart that shows the application of the trading system on Ambuja
cements. The black line on the price chart is the 50 day exponential moving average.
Starting from left, the first opportunity to buy originated at 165, highlighted on the
charts as B1@165. Notice, at point B1, the stock price moved to a point higher than
its 50 day EMA. Hence as per the trading system rule, we initiate a fresh long
position.
Going by the trading system, we stay invested till we get an exit signal, which we
eventually got at 187, marked as S1@187. This trade generated a profit of Rs.22 per
share.
100
The next signal to go long came at B2@178, followed by a signal to square off
at S2@182. This trade was not impressive as it resulted in a profit of just Rs.4.
However the last trade, B3@165, and S3@215 was quite impressive resulting in a
profit of Rs.50.
Here is a quick summary of these trades based on the trading system fared:
Sl No Buy Price Sell Price Gain/Loss % Return
01 165 187 22 13%
02 178 182 04 2.2%
03 165 215 50 30%
From the above table, it is very clear that the first and last trades were profitable,
but the 2nd trade was not so profitable. If you inspect why this happened, it is
evident that during the 1st and the 3rd trade, the stock was trending but during the
2nd trade the stock moved sideways.
This leads us to a very important conclusion about the moving averages. Moving
averages works brilliantly when there is a trend and fails to perform when the stock
moves sideways. This basically means the ‘Moving average’ in its simplest form is a
trend following system.
From my own personal experience of trading based on moving averages, I have

noticed a few important characteristics:
1. Moving averages gives you many trading signals (buy and sell) during a sideways
market. Most of these signals result in marginal profits, if not for losses
2. However usually one of those many trades results in a massive rally (like
the B3@165 trade) leading to impressive gains
3. It would be very difficult to segregate the big winner from the many small trades
4. Hence the trader should not be selective in terms of selecting signals that moving
average system suggest. In fact the trader should trade all the trades that the
system suggests
5. Remember the losses are minimum in a moving average system, but that 1 big
trade is good enough to compensate all the losses and can give you sufficient
profits
101
6. The profit making trade ensures you are in the trend as long as the trend lasts.
Sometime even upto several months. For this reason, MA can be used as a proxy for
identifying long term investment ideas
7. The key to MA trading system is to take all the trades and not be judgmental about
the signals being generated by the system.
Here is another example of BPLC, where the MA system suggested multiple trades
during the sideways market, however none of them were really profitable. However,
the last trade resulted in a 67% profit in about 5 months.
13.4 – Moving average crossover system

As its evident now the problem with the plain vanilla moving average system is that
it generates far too many trading signals in a sideway market. A moving average
crossover system is an improvisation over the plain vanilla moving average system.
It helps the trader to take fewer trades in a sideways market.
In a MA crossover system, instead of the usual single moving average, the trader
combines two moving averages. This is usually referred to as ‘smoothing’.
A typical example of this would be to combine a 50 day EMA, with a 100 day EMA.
The shorter moving average (50 days in this case) is also referred to as the faster
moving average. The longer moving average (100 days moving average) is referred
to as the slower moving average.
The shorter moving average takes lesser number of data points to calculate the
average and hence it tends to stick closer to the current market price, and therefore
reacts more quickly. A longer moving average takes more number of data points to
calculate the average and hence it tends to stay away from the current market price.
Hence the reactions are slower.
Here is the chart of Bank of Baroda, showing you how the two moving averages
stack up when loaded on a chart.
102
As you can see, the black 50 day EMA line is closer to the current market price (as it
reacts faster) when compared to the pink 100 day EMA (as its reacts slower).
Traders have modified the plain vanilla MA system with the crossover system to
smoothen out the entry and exit points. In the process, the trader gets far fewer
signals, but the chances of the trade being profitable are quite high.
The entry and exit rules for the crossover system is as stated below:
Rule 1) – Buy (fresh long) when the short term moving averages turns greater than
the long term moving average. Stay in the trade as long as this condition is satisfied
Rule 2) – Exit the long position (square off) when the short term moving average
turns lesser than the longer term moving average
Let us apply the MA crossover system to the same BPCL example that we looked at.
For ease of comparison, I have reproduced the BPCL’s chart with a single 50 day MA.
Notice, when the markets were moving sideways, MA suggested at least 3 trading
signals. However the 4thtrade was the winner which resulted in 67% profit.
The chart shown below shows the application of a MA crossover system with 50 and
100 day EMA.
103
The black line plots the 50 day moving average and the pink line plots the 100 day
moving average. As per the cross over rule, the signal to go long originates when the
50 day moving average (short term MA) crosses over the 100 day moving average
(long term MA). The crossover point has been highlighted with an arrow. Please do
notice how the crossover system keeps the trader away from the 3 unprofitable
trades. This is the biggest advantage of a cross over system.
A trader can use any combination to create a MA cross over system. Some of the
popular combinations for a swing trader would be:
1. 9 day EMA with 21 day EMA – use this for short term trades ( upto few trading
session)
2. 25 day EMA with 50 day EMA – use this to identify medium term trade (upto few
weeks)
3. 50 day EMA with 100 Day EMA – use this to identify trades that lasts upto few
months
4. 100 day EMA with 200 day EMA – use this to identify long term trades (investment
opportunities), some of them can even last for over a year or more.
Remember, longer the time frame the lesser the number of trading signals.
Here is an example of a 25 x 50 EMA crossover. There are three trading signals that
qualify under the crossover rule.
104
Needless to say, the MA crossover system can also be applied for intraday trading.
For instance one could use the 15 x 30 minutes crossover to identify intraday
opportunities. A more aggressive trader could use 5 x 10 minute crossover.
You may have heard this popular saying in the markets – “The trend is you friend”.
Well, the moving averages help you identify this friend.
Remember, MA is a trend following system – as long as there is a trend, the moving

averages works brilliantly. It does not matter which time frame you use or which
cross over combination you use.
1. A standard average calculation is a quick approximation of a series of numbers

2. In a average calculation where the latest data is included, and the oldest is excluded
is called a Moving Average
3. The simple moving average (SMA) gives equal weightage to all data points in the
series
4. An exponential moving average (EMA) scales the data according to its newness.
Recent data gets the maximum weightage and the oldest gets the least weightage
5. For all practical purposes, use an EMA as opposed to SMA. This is because the EMA
gives more weightage to the most recent data points
6. The outlook is bullish when the current market price is greater than the EMA. The
outlook turns bearish when the current market price turns lesser than the EMA
7. In a non trending market, moving averages may result in whipsaws thereby causing
frequent losses. To overcome this a EMA crossover system is adopted
8. In a typical crossover system, the price chart is over laid with two EMAs. The shorter
EMA is faster to react, while the longer EMA is slower to react
105
9. The outlook turns bullish when the faster EMA crosses and is above the slower EMA.
Hence one should look at buying the stock. The trade lasts upto a point where the
faster EMA starts going below the slower EMA
10. The longer the time frame one chooses for a crossover system, the lesser the
trading signals.
106
Chapter 14
Indicators (Part 1)
138
If you look at a stock chart displayed on a trader’s trading terminal, you are most
likely to see lines running all over the chart. These lines are called the ‘Technical
Indicators’. A technical indicator helps a trader analyze the price movement of a
security.
Indicators are independent trading systems introduced to the world by successful

traders. Indicators are built on preset logic using which traders can supplement
their technical study (candlesticks, volumes, S&R) to arrive at a trading decision.
Indicators help in buying, selling, confirming trends, and sometimes predicting
trends.
Indicators are of two types namely leading and lagging. A leading indicator leads
the price, meaning it usually signals the occurrence of a reversal or a new trend in
advance. While this sounds interesting, you should note, not all leading indicators
are accurate. Leading indicators are notorious for giving false signals. Therefore, the
trader should be highly alert while using leading indicators. In fact the efficiency of
using leading indicators increases with trading experience.
A majority of leading indicators are called oscillators as they oscillate within a

bounded range. Typically an oscillator oscillates between two extreme values – for
example 0 to 100. Based on the oscillator’s reading (for example 55, 70 etc) the
trading interpretation varies.
A lagging indicator on the other hand lags the price; meaning it usually signals the
occurrence of a reversal or a new trend after it has occurred. You may think, what
107
would be the use of getting a signal after the event has occurred? Well, it is better
late than never. One of the most popular lagging indicators is the moving averages.
You might be wondering if the moving average is an indicator in itself, why we

discussed it even before we discussed the indicators formally. The reason is that
moving averages is a core concept on its own. It finds its application within several
indicators such as RSI, MACD, Stochastic etc. Hence, for this reason we discussed
moving average as a standalone topic.
Before we proceed further into understanding individual indicators, I think it is a

good idea to understand what momentum means. Momentum is the rate at which
the price changes. For example if stock price is Rs.100 today and it moves to Rs.105
the next day, and Rs.115, the day after, we say the momentum is high as the stock
price has changed by 15% in just 3 days. However if the same 15% change
happened over let us say 3 months, we can conclude the momentum is low. So the
more rapidly the price changes, the higher the momentum.
14.1 – Relative Strength Index

Relative strength Index or just RSI, is a very popular indicator developed by J.Welles
Wilder. RSI is a leading momentum indicator which helps in identifying a trend
reversal. RSI indicator oscillates between 0 and 100, and based on the latest
indicator reading, the expectations on the markets are set.
The term “Relative Strength Index” can be a bit misleading as it does not compare
the relative strength of two securities, but instead shows the internal strength of the
security. RSI is the most popular leading indicator, which gives out strongest signals
during the periods of sideways and non trending ranges.
The formula to calculate the RSI is as follows:
Let us understand this indicator with the help of the following example:
Assume the stock is trading at 99 on day 0, with this in perspective; consider the
following data points:
Sl No Closing Price Points Gain Points Lost
108
01 100 1 0
02 102 2 0
03 105 3 0
04 107 2 0
05 103 0 4
06 100 0 3
07 99 0 1
08 97 0 2
09 100 3 0
10 105 5 0
11 107 2 0
12 110 3 0
13 114 4 0
14 118 4 0
109
Total 29 10
In the above table, points gained/lost denote the number of points gained/lost with
respect to the previous day close. For example if today’s close is 104 and yesterday’s
close was 100, points gained would be 4 and points lost would be 0. Similarly, if
today’s close was 104 and previous day’s close was 107, the points gained would be
0 and points lost would be 3. Please note that, the loses are computed as positive
values.
We have used 14 data points for the calculation, which is the default period setting
in the charting software. This is also called the ‘look-back period’. If you are
analyzing hourly charts the default period is 14 hours, and if you are analyzing daily
charts, the default period is 14 days.
The first step is to calculate ‘RS’ also called the RSI factor. RS as you can see in the
formula, is the ratio of average points gained by the average points lost.
Average Points Gained = 29/14
= 2.07
Average Points Lost = 10/14
= 0.714
RS = 2.07/0.714
= 2.8991
Plugging in the value of RS in RSI formula,
= 100 – [100/ (1+2.8991)]
= 100 – [100/3.8991]
= 100 – 25.6469
RSI = 74.3531
As you can see RSI calculation is fairly simple. The objective of using RSI is to help
the trader identify over sold and overbought price areas. Overbought implies that
the positive momentum in the stock is so high that it may not be sustainable for
long and hence there could be a correction. Likewise, an oversold position indicates
that the negative momentum is high leading to a possible reversal.
Take a look at the chart of Cipla Ltd, you will find a lot of interesting developments:
110
To begin with, the red line below the price chart indicates the 14 period RSI. If you
notice the RSI’s scale you will realize its upper bound to 100, and lower bound to 0.
However 100 and 0 are not visible in the chart.
When the RSI reading is between 30 and 0, the security is supposed to be oversold
and ready for an upward correction. When the security reading is between 70 and
100, the security is supposed to be heavily bought and is ready for a downward
correction.
The first vertical line marked from left shows a level where RSI is below 30, in fact
RSI is 26.8. Hence RSI suggests that the stock is oversold. In this particular example,
the RSI value of 26.8, also coincides with a bullish engulfing pattern. This gives the
trader a double confirmation to go long! Needless to say, both volumes and S&R
should also confirm to this.
The second vertical line, points to a level where the RSI turns 81, a value which is
considered overbought. Hence, if not for looking at shorting opportunities, the
trader should be careful in his decision to buy the stock. Again, if you notice the
candles, they form a bearish engulfing pattern. So a bearish engulfing pattern,
backed by an RSI of 81 is a sign to short the stock. What follows this is a quick and a
short correction in the stock.
The example that I have shown here is quite nice, meaning both the candlestick
pattern and RSI perfectly align to confirm the occurrence of the same event. This
may not always be true. This leads us to another interesting way to interpret RSI.
Imagine the following two scenarios:
Scenario 1) A stock which is in a continuous uptrend (remember the uptrend can

last from few days to few years) the RSI will remain stuck in the overbought region
for a long time, and this is because the RSI is upper bound to 100. It cannot go
beyond 100. Invariably the trader would be looking at shorting opportunities but the
stock on the other hand will be in a different orbit. Example – Eicher motors Limited,
the stock has generate a return of close to 100% year on year.
111
Scenario 2) A stock which is in a continuous downtrend the RSI will be stuck in the
oversold region since the RSI is lower bound to 0. It cannot go beyond 0. In this case
as well the trader will be looking at buying opportunities but the stock will be going
down lower. Example – Suzlon Energy, the stock has generated a return of negative
34% year on year.
This leads us to interpret RSI in many different ways besides the classical
interpretation (which we discussed earlier)
1. If the RSI is fixed in an overbought region for a prolonged period, look for buying
opportunities instead of shorting. The RSI stays in the overbought region for a
prolonged period because of an excess positive momentum
2. If the RSI is fixed in an oversold region for a prolonged period, look for selling
opportunities rather than buying. RSI stays in the oversold region for a prolonged
period because of an excess negative momentum
3. If the RSI value starts moving away from the oversold value after a prolonged
period, look for buying opportunities. For example, the RSI moves above 30 after a
long time may mean that the stock may have bottomed out, hence a case of going
long.
4. If the RSI value starts moving away from the overbought value after a prolonged
period, look for selling opportunities. For example, RSI moving below 70 after a long
time. This means the stock may have topped out, hence a case for shorting
14.2 – One last note

None of the parameters used while analyzing RSI should be treated with rigidity. For
example, J.Welles Wilder opted to use a look back period of 14 days simply because
that was the value which gave the best results considering the market conditions in
1978 (which is when RSI was introduced to the world). You may choose to use
5,10,20, or even 100 days look back period if you wish too. In fact this is how you
develop your edge as a trader. You need to analyze what works for you and adopt
the same. Please note, fewer the days you use to calculate the RSI, the more volatile
the indicator would be.
Also, J.Welles Wilder decided to use 0-30 level to indicate oversold regions and 70-
100 level to indicate overbought region. Again this is not set in stone, you can arrive
at you own combination.
I personally prefer to use 0-20 level and 80-100 level to identify oversold and
overbought regions respectively. I use this along with the classical 14 day look back
period.
Of course, I urge you to explore parameters that work for you. In fact this is how
you would eventually develop as a successful trader.
112
Finally, do remember RSI is not used often as a standalone indicator by traders, it is
used along with other candlestick patterns and indicators to study the market.
1. Indicators are independent trading systems developed, and introduced by

successful traders
2. Indicators are leading or lagging. Leading indicators signals the possible occurrence
of an event. Lagging indicators on the other hand confirms an ongoing trend
3. RSI is a momentum oscillator which oscillates between 0 and 100 level
4. A value between 0 and 30 is considered oversold, hence the trader should look at
buying opportunities
5. A value between 70 and 100 is considered overbought, hence the trader should look
at selling opportunities
6. If the RSI value is fixed in a region for a prolonged period, it indicates excess
momentum and hence instead of taking a reversed position, the trader can consider
initiating a trade in the same direction.
113
Chapter 15
Indicators (Part 2)
193
15.1 Moving Average Convergence and Divergence (MACD)

The Moving Average Convergence and Divergence (MACD) indicator was developed
by Gerald Appel in the late seventies. Traders consider MACD as the grand old
daddy of indicators. Though invented in the seventies, MACD is still considered as
one of the most reliable indicators by momentum traders.
As the name suggests, MACD is all about the convergence and divergence of the two
moving averages. Convergence occurs when the two moving averages move
towards each other, and a divergence occurs when the moving averages move away
from each other.
A standard MACD is calculated using a 12 day EMA and a 26 day EMA. Please note,
both the EMA’s are based on the closing prices.We subtract the 26 EMA from the 12
day EMA, to estimate the convergence and divergence (CD) value. A simple line
graph of this is often referred to as the ‘MACD Line’. Let us go through the math
first and then figure out the applications of MACD.
Date Close 12 Day EMA 26 Day EMA MACD Line
114
1-Jan-14 6302
2-Jan-14 6221
3-Jan-14 6211
6-Jan-14 6191
7-Jan-14 6162
8-Jan-14 6175
9-Jan-14 6168
10-Jan-14 6171
13-Jan-14 6273
14-Jan-14 6242
15-Jan-14 6321
16-Jan-14 6319
17-Jan-14 6262 6230
20-Jan-14 6304 6226
115
21-Jan-14 6314 6233
22-Jan-14 6339 6242
23-Jan-14 6346 6254
24-Jan-14 6267 6269
27-Jan-14 6136 6277
28-Jan-14 6126 6274
29-Jan-14 6120 6271
30-Jan-14 6074 6258
31-Jan-14 6090 6244
3-Feb-14 6002 6225
4-Feb-14 6001 6198
5-Feb-14 6022 6176
6-Feb-14 6036 6153 6198 -45
7-Feb-14 6063 6130 6188 -58
116
10-Feb-14 6053 6107 6182 -75
11-Feb-14 6063 6083 6176 -94
12-Feb-14 6084 6066 6171 -106
13-Feb-14 6001 6061 6168 -107
Let us go through the table starting from left:
1. We have the dates, starting from 1st Jan 2014

2. Next to the dates we have the closing price of Nifty
3. We leave the first 12 data points (closing price of Nifty) to calculate the 12 day EMA
4. We then leave the first 26 data points to calculate the 26 day EMA
5. Once we have both 12 and 26 day EMA running parallel to each other (6th Feb 2014)
we calculate the MACD value
6. MACD value = [12 day EMA – 26 day EMA]. For example on 6th Feb 2014, 12 day EMA
was 6153, and 26 day EMA was 6198, hence the MACD would be 6153-6198 = – 45
When we calculate the MACD value over a series of 12 and 26 day EMAs and plot it
as a line graph, we get the MACD line, which oscillates above and below the central
line.
Date Close 12 Day EMA 26 Day EMA MACD Line
1-Jan-14 6302
2-Jan-14 6221
3-Jan-14 6211
6-Jan-14 6191
117
7-Jan-14 6162
8-Jan-14 6175
9-Jan-14 6168
10-Jan-14 6171
13-Jan-14 6273
14-Jan-14 6242
15-Jan-14 6321
16-Jan-14 6319
17-Jan-14 6262 6230
20-Jan-14 6304 6226
21-Jan-14 6314 6233
22-Jan-14 6339 6242
23-Jan-14 6346 6254
24-Jan-14 6267 6269
118
27-Jan-14 6136 6277
28-Jan-14 6126 6274
29-Jan-14 6120 6271
30-Jan-14 6074 6258
31-Jan-14 6090 6244
3-Feb-14 6002 6225
4-Feb-14 6001 6198
5-Feb-14 6022 6176
6-Feb-14 6036 6153 6198 -45
7-Feb-14 6063 6130 6188 -58
10-Feb-14 6053 6107 6182 -75
11-Feb-14 6063 6083 6176 -94
12-Feb-14 6084 6066 6171 -106
13-Feb-14 6001 6061 6168 -107
119
14-Feb-14 6048 6051 6161 -111
17-Feb-14 6073 6045 6157 -112
18-Feb-14 6127 6045 6153 -108
19-Feb-14 6153 6048 6147 -100
20-Feb-14 6091 6060 6144 -84
21-Feb-14 6155 6068 6135 -67
24-Feb-14 6186 6079 6129 -50
25-Feb-14 6200 6092 6126 -34
26-Feb-14 6239 6103 6122 -19
28-Feb-14 6277 6118 6119 -1
3-Mar-14 6221 6136 6117 20
4-Mar-14 6298 6148 6112 36
5-Mar-14 6329 6172 6113 59
6-Mar-14 6401 6196 6121 75
120
7-Mar-14 6527 6223 6131 92
10-Mar-14 6537 6256 6147 110
11-Mar-14 6512 6288 6165 124
12-Mar-14 6517 6324 6181 143
13-Mar-14 6493 6354 6201 153
14-Mar-14 6504 6380 6220 160
Given the MACD value, lets try and find the answer for few obvious questions:
1. What does a negative MACD value indicate?

2. What does a positive MACD value indicate?
3. What does the magnitude of the MACD value actually mean? As in, what information
does a -90 MACD convey versus a – 30 MACD ?
The sign associated with the MACD just indicates the direction of the stock’s move.
For example if the 12 Day EMA is 6380, and 26 Day EMA is 6220 then the MACD
value is +160. Now, under what circumstance do you think the 12 day EMA will be
greater than the 26 day EMA? Well, we had looked into this in the moving average
chapter. The shorter term average will generally be higher than the longer term only
when the stock price is trending upwards. Also, do remember, the shorter term
average will always be more reactive to the current market price than the longer
term average. Hence a positive sign tells us that there is positive momentum in the
stock, and the stock is drifting upwards. The higher the momentum, the higher is
the magnitude. For example, +160 indicate a positive trend which is stronger than
+120.
However, while dealing with the magnitude, always remember the price of the stock
influences the magnitude. For example, higher the underlying price such as Bank
Nifty, naturally, the higher will be the magnitude of the MACD.
When the MACD is negative, it means the 12 day EMA is lower than the 26 day EMA.
Therefore the momentum is negative. Higher the magnitude of the MACD, the more
strength in the downward trend.
121
The difference between the two moving averages is called the MACD spread. The
spread decreases when the momentum mellows down and increases when the
momentum increases. To visualize convergence and the divergence traders usually
plot the chart of the MACD value, often referred to as the MACD line.
The following is the MACD line chart of Nifty for data points starting from 1st Jan
2014 to 18th Aug 2014.
As you can see the MACD line oscillates over a central zero line. This is also called
the ‘Center line’. The basic interpretation of the MACD indicator is that:
1. When the MACD Line crosses the center line from the negative territory to positive
territory, it means there is divergence between the two averages. This is a sign of
increasing bullish momentum; therefore one should look at buying opportunities.
From the chart above, we can see this panning out around 27thFeb
2. When the MACD line crosses the center line from positive territory to the negative
territory it means there is convergence between the two averages. This is a sign of
increasing bearish momentum; therefore one should look at selling opportunities.
As you can see, there were two instance during which the MACD almost turned
negative (8th May, and 24th July) but the MACD just stopped at the zero line and
reversed directions
Traders generally argue that while waiting for the MACD line to crossover the center
line a bulk of the move would already be done and perhaps it would be late to enter
a trade. To overcome this, there is an improvisation over this basic MACD line. The
improvisation comes in the form of an additional MACD component which is the 9
day signal line. A 9 day signal line is a exponential moving average (EMA) of the
MACD line. If you think about this, we now have two lines:
1. A MACD line
2. A 9 day EMA of the MACD line, also called the signal line
122
With these two lines, a trader can follow a simple 2 line crossover strategy as
discussed in the moving averages chapter, and no longer wait for the center line
cross over.
1. The sentiment is bullish when the MACD line crosses the 9 day EMA wherein MACD
line is greater than the 9 day EMA. When this happens, the trader should look at
buying opportunities
2. The sentiment is bearish when the MACD line crosses below the 9 day EMA wherein
the MACD line is lesser than the 9 day EMA. When this happens, the trader should
look at selling opportunities
The chart below plots the MACD indicator on Asian Paints Limited. You can see the
MACD indicator below the price chart.
The indicator uses standard parameters of MACD:
1. 12 day EMA of closing prices

2. 26 day EMA of closing prices
3. MACD line (12D EMA – 26D EMA) represented by the black line
4. 9 day EMA of the MACD line represented by the red line
The vertical lines on the chart highlight the crossover points on the chart where a
signal to either buy or sell has originated.
For example, the first vertical line starting from left points to a crossover where the
MACD line lies below the signal line (9 day EMA) lies and suggests a short trade.
The 2nd vertical line from left, points to a crossover where the MACD line lies above
the signal line, hence one should look at buying opportunity. So on and so forth.
Please note, at the core of the MACD system, are moving averages. Hence the MACD
indicator has similar properties like that of a moving average system. They work
123
quite well when there is a strong trend and are not too useful when the markets are
moving sideways. You can notice this between the 1st two line starting from left.
Needless to say, the MACD parameters are not set in stone. One is free to change
the 12 day, and 26 day EMA to whatever time frame one prefers. I personally like to
use the MACD in its original form, as introduced by Gerald Appel.
15.2 – The Bollinger Bands

Introduced by John Bollinger in the 1980s, Bollinger bands (BB) is perhaps one of
the most useful indicators used in technical analysis. BB are used to determine
overbought and oversold levels, where a trader will try to sell when the price
reaches the top of the band and will execute a buy when the price reaches the
bottom of the band.
The BB has 3 components:
1. Middle line which is The 20 day simple moving average of the closing prices
2. An upper band – this is the +2 standard deviation of the middle line
3. A lower band – this is the -2 standard deviation of the middle line
The standard deviation (SD) is a statistical concept; which measures the variance of
a particular variable from its average. In finance, the standard deviation of the stock
price represents the volatility of a stock. For example, if the standard deviation of a
stock is 12%, it is as good as saying that the volatility of the stock is 12%.
In BB, the standard deviation is applied on the 20 day SMA. The upper band
indicates the +2 SD. By using a +2 SD, we simply multiply the SD by 2, and add it to
the average.
For example if the 20 day SMA is 7800, and the SD is 75 (or 0.96%), then the +2 SD
would be 7800 + (75*2) = 7950. Likewise, a -2 SD indicates we multiply the SD by 2,
and subtract it from the average. 7800 – (2*75) = 7650.
We now have the components of the BB:
1. 20 day SMA = 7800

2. Upper band = 7950
3. Lower band = 7650
Statistically speaking, the current market price should hover around the average
price of 7800. However, if the current market price is around 7950, then it is
considered expensive with respect to the average, hence one should look at
shorting opportunities with an expectation that the price will scale back to its
average price.
Therefore the trade would be to sell at 7950, with a target of 7800.
124
Likewise if the current market price is around 7650, it is considered cheap with
respect to the average prices, and hence one should look at buying opportunities
with and expectation that the prices will scale back to its average price.
Therefore the trade would be to buy at 7650, with a target of 7800.
The upper and lower bands act as a trigger to initiate a trade.
The following is the chart of BPCL Limited,
The central black line is the 20 day SMA. The two red lines placed above and below
the black like are the +2 SD, and -2SD. The idea is to short the stock when the price
touches the upper band with an expectation that it will revert to average. Likewise
one can go long when the price touches the lower band with an expectation it will
revert to the average.
I have highlighted using a down arrow all the sell signals BB generated, while most
of the signals worked quite well, there was a phase when the price stuck to the
upper band. In fact the price continued to drift higher, and therefore even the upper
band expanded. This is called an envelope expansion.
The BB’s upper and lower band together forms an envelope. The envelope expands,
whenever the price drifts in a particular direction indicating a strong momentum.
The BB signal fails when there is an envelope expansion. This leads us to an
important conclusion; BB works well in sideways markets, and fails in a trending
market.
Personally whenever, I use BB I expect the trade to start working in my favor almost
immediately. If it does not, I start validating the possibility of an envelope
expansion.
15.3 – Other Indicators

There are numerous other technical indicators, and the list is endless. The question
is, should you know all these indicators to be a successful trader? The answer is a
125
simple no. Technical indicators are good to know, but they by no means should be
your main tool of analysis.
I have personally met many aspiring traders who spend a lot of time, and energy
learning different indicators, but this in the long run is futile. The working
knowledge of few basic indicators, such as the ones discussed in this module are
sufficient.
15.4 – The Checklist

In the previous chapters, we started building a checklist that acts as a guiding force
behind the trader’s decision to buy or sell. It is time to revisit that checklist.
The indicators act as tool which the traders can use to confirm their trading
decisions, it is worthwhile to check what the indicators are conveying before placing
a buy or a sell order. While the dependence on indicators is not as much S&R,
volumes or candlestick patterns, it is always good to know what the basic indicators
are suggesting. For this reason, I would recommend adding indicators in the
checklist, but with a twist to it. I will explain the twist in a bit, but before that let us
reproduce the updated checklist.

3. Volumes should confirm
1. Ensure above average volumes on both buy and sell day
2. Low volumes are not encouraging, hence do feel free to hesitate while taking trade
where the volumes are low
4. Indicators should confirm
1. Scale the size higher if the confirm
2. If they don’t confirm, go ahead with the original plan
The sub bullet points under indicators are where the twist lies.
Now, hypothetically imagine a situation where you are looking at opportunity to buy
shares of Karnataka Bank Limited. On a particular day, Karnataka Bank has formed
a bullish hammer, assume everything ticks on the checklist:
1. Bullish hammer is a recognizable candlestick pattern

2. The low of the bullish hammer also coincides with the support
3. The volumes are above average
4. There is also an MACD crossover (signal line turns greater than the MACD line)
126
With all four checklist points being ticked off I would be very glad to buy Karnataka
Bank. Hence I place an order to buy, let us say for 500 shares.
However, imagine a situation where the first 3 checklist conditions are met but the
4th condition (indicators should confirm) is not satisfied. What do you think I should
do?
I would still go ahead and buy, but instead of 500 shares, I’d probably buy 300
shares.
This should hopefully convey to you how I tend to (and advocate) the use of
indicators.
When Indicators confirm, I increase my bet size, but when Indicators don’t confirm I
still go ahead with my decision to buy, but I scale down my bet size.
However I would not do this with the first three checklist points. For example, if the
low of the bullish hammer does not coincide in and around the support, then I’ll
really reconsider my plan to buy the stock; in fact I may skip the opportunity, and
look for another opportunity.
But I do not treat the indicators with the same conviction. It is always good to know
what indicators convey, but I don’t base my decisions on that. If the indicators
confirm, I increase the bet size, if they don’t, I still go ahead with my original game
plan.
1. A MACD is a trend following system

2. MACD consists of a 12 Day, 26 day EMA
3. MACD line is 12d EMA – 26d EMA
4. Signal line is the 9 day SMA of the MACD line
5. A crossover strategy can be applied between MACD Line, and the signal line
6. The Bollinger band captures the volatility. It has a 20 day average, a +2 SD, and a -2
SD
7. One can short when the current price is at +2SD with an expectation that the price
reverts to the average
8. One can go long when the current price is at -2SD with an expectation that the price
reverts to the average
9. BB works well in a sideways market. In a trending market the BB’s envelope
expands, and generates many false signals
127
10. Indicators are good to know, but it should not be treated as the single source for
decision making.
128
Chapter 16
The Fibonacci Retracements

161
The topic on Fibonacci retracements is quite intriguing. To fully understand and

appreciate the concept of Fibonacci retracements, one must understand the
Fibonacci series. The origins of the Fibonacci series can be traced back to the
ancient Indian mathematic scripts, with some claims dating back to 200 BC.
However, in the 12th century, Leonardo Pisano Bogollo an Italian mathematician
from Pisa, known to his friends as Fibonacci discovered Fibonacci numbers.
The Fibonacci series is a sequence of numbers starting from zero arranged in such a
way that the value of any number in the series is the sum of the previous two
numbers.
The Fibonacci sequence is as follows:
0 , 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…
Notice the following:

233 = 144 + 89
144 = 89 + 55
89 = 55 +34
Needless to say the series extends to infinity. There are few interesting properties of
the Fibonacci series.
129
Divide any number in the series by the previous number; the ratio is always
approximately 1.618.
For example:
610/377 = 1.618
377/233 = 1.618
233/144 = 1.618
The ratio of 1.618 is considered as the Golden Ratio, also referred to as the Phi.
Fibonacci numbers have their connection to nature. The ratio can be found in
human face, flower petals, animal bodies, fruits, vegetables, rock formation, galaxial
formations etc. Of course let us not get into this discussion as we would be
digressing from the main topic. For those interested, I would suggest you search on
the internet for golden ratio examples and you will be pleasantly surprised. Further
into the ratio properties, one can find remarkable consistency when a number is in
the Fibonacci series is divided by its immediate succeeding number.
For example:
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618
At this stage, do bear in mind that 0.618, when expressed in percentage is 61.8%.
Similar consistency can be found when any number in the Fibonacci series is divided
by a number two places higher.
For example:
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382
0.382 when expressed in percentage terms is 38.2%
Also, there is consistency when a number in the Fibonacci series is divided by a

number 3 place higher.
For example:
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
55/233 = 0.236
0.236 when expressed in percentage terms is 23.6%.
130
16.1 – Relevance to stocks markets
It is believed that the Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% finds its
application in stock charts. Fibonacci analysis can be applied when there is a
noticeable up-move or down-move in prices. Whenever the stock moves either
upwards or downwards sharply, it usually tends to retrace back before its next
move. For example if the stock has run up from Rs.50 to Rs.100, then it is likely to
retrace back to probably Rs.70, before it can move Rs.120.
‘The retracement level forecast’ is a technique using which one can identify upto
which level retracement can happen. These retracement levels provide a good
opportunity for the traders to enter new positions in the direction of the trend. The
Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% helps the trader to identify the possible
extent of the retracement. The trader can use these levels to position himself for
trade.
Have a look at the chart below:
I’ve encircled two points on the chart, at Rs.380 where the stock started its rally and
at Rs.489, where the stock prices peaked.
I would now define the move of 109 (380 – 489) as the Fibonacci upmove. As per
the Fibonacci retracement theory, after the upmove one can anticipate a correction
in the stock to last up to the Fibonacci ratios. For example, the first level up to which
the stock can correct could be 23.6%. If this stock continues to correct further, the
trader can watch out for the 38.2% and 61.8% levels.
Notice in the example shown below, the stock has retraced up to 61.8%, which
coincides with 421.9, before it resumed the rally.
131
We can arrive at 421 by using simple math as well –
Total Fibonacci up move = 109
61.8% of Fibonacci up move = 61.8% * 109 = 67.36
Retracement @ 61.8% = 489- 67.36 = 421.6
Likewise, we can calculate for 38.2% and the other ratios. However one need not
manually do this as the software will do this for us.
Here is another example where the chart has rallied from Rs.288 to Rs.338.
Therefore 50 points move makes up for the Fibonacci upmove. The stock retraced
back 38.2% to Rs.319 before resuming its up move.
The Fibonacci retracements can also be applied to stocks that are falling, in order to
identify levels upto which the stock can bounce back. In the chart below (DLF
132
Limited), the stock started to decline from Rs.187 to Rs. 120.6 thus making 67 points
as the Fibonacci down move.
After the down move, the stock attempted to bounce back retracing back to Rs.162,
which is the 61.8% Fibonacci retracement level.
16.2 – Fibonacci Retracement construction

As we now know Fibonacci retracements are movements in the chart that go against
the trend. To use the Fibonacci retracements we should first identify the 100%
Fibonacci move. The 100% move can be an upward rally or a downward rally. To
mark the 100% move, we need to pick the most recent peak and trough on the
chart. Once this is identified, we connect them using a Fibonacci retracement tool.
This is available in most of the technical analysis software packages including
Zerodha’s Pi
Here is a step by step guide:
Step 1) Identify the immediate peak and trough. In this case the trough is at 150 and
peak is at 240. The 90 point moves make it 100%.
Step 2) Select the Fibonacci retracement tool from the chart tools
133
Step 3) Use the Fibonacci retracement tool to connect the trough and the peak.
After selecting the Fibonacci retracement tool from the charts tool, the trader has to
click on trough first, and without un-clicking he has to drag the line till the peak.
While doing this, simultaneously the Fibonacci retracements levels starts getting
plotted on the chart. However, the software completes the retracement
identification process only after you finish selecting both the trough and the peak.
This is how the chart looks after selecting both the points.
134
You can now see the fibonacci retracement levels are calculated and loaded on the
chart. Use this information to position yourself in the market.
16.3 – How should you use the Fibonacci retracement levels?

Think of a situation where you wanted to buy a particular stock but you have not
been able to do so because of a sharp run up in the stock. In such a situation the
most prudent action to take would be to wait for a retracement in the stock.
Fibonacci retracement levels such as 61.8%, 38.2%, and 23.6% act as a potential
level upto which a stock can correct.
By plotting the Fibonacci retracement levels the trader can identify these
retracement levels, and therefore position himself for an opportunity to enter the
trade. However please note like any indicator, use the Fibonacci retracement as a
confirmation tool.
I would buy a stock only after it has passed the other checklist items. In other words
my conviction to buy would be higher if the stock has:
1. Formed a recognizable candlestick pattern

2. The stoploss coincides with the S&R level
3. Volumes are above average
Along with the above points, if the stoploss also coincides with the Fibonacci level
then I know the trade setup is well aligned to all the variables and hence I would go
in for a strong buy. The usage of the word ‘strong’ just indicates the level of
conviction in the trade set up. The more confirming factors we use to study the
trend and reversal, more robust is the signal. The same logic can also be applied for
the short trade.
1. The Fibonacci series forms the basis for Fibonacci retracement

2. A Fibonacci series has many mathematical properties. These mathematical
properties are prevalent in many aspects of nature
3. Traders believe the Fibonacci series has its application in stock charts as it identified
potential retracement levels
4. Fibonacci retracements are levels (61.8%, 38.2%, and 23.6% ) upto which a stock can
possibly retrace before it resumes the original directional move
5. At the Fibonacci retracement level the trader can look at initiating a new trade.
However, before initiating the trade other points in the checklist should also
confirm.
135
Chapter 17
The Dow Theory (Part 1)

82
The Dow Theory has always been a very integral part of technical analysis. The Dow
Theory was used extensively even before the western world discovered
candlesticks. In fact even today Dow Theory concepts are being used. In fact traders
blend the best practices from Candlesticks and Dow Theory.
The Dow Theory was introduced to the world by Charles H. Dow, who also founded
the Dow-Jones financial news service (Wall Street Journal). During his time, he wrote
a series of articles starting from 1900s which in the later years was referred to as
‘The Dow Theory’. Much credit goes to William P Hamilton, who compiled these
articles with relevant examples over a period of 27 years. Much has changed since
the time of Charles Dow, and hence there are supporters and critics of the Dow
Theory.
17.1 – The Dow Theory Principles

The Dow Theory is built on a few beliefs. These are called the Dow Theory tenets.
These tenets were developed by Charles H Dow over the years of his observation on
the markets. There are 9 tenets that are considered as the guiding force behind the
Dow Theory. They are as follows:
Sl
Tenet What does it mean?
No
136
The stock market indices discount everything which is known &
unknown in the public domain. If a sudden and unexpected event
01 Indices discounts everything
occurs, the stock market indices quickly recalibrates itself to reflect
the accurate value
Overall there are 3 broad

02 Primary Trend, Secondary Trend, and Minor Trends
market trends
This is the major trend of the market that lasts from a year to
several years. It indicates the broader multiyear direction of the
03 The Primary Trend market. While the long term investor is interested in the primary
trend, an active trader is interested in all trends. The primary trend
could be a primary uptrend or a primary down trend
These are corrections to the primary trend. Think of this as a minor

counter reaction to the larger movement in the market. Example –
04 The Secondary Trend corrections in the bull market, rallies & recoveries in the bear
market. The counter trend can last anywhere between a few
weeks to several months
Minor Trends/Daily These are daily fluctuations in the market, some traders prefer to
05
fluctuations call them market noise
We cannot confirm a trend based on just one index. For example

the market is said to be bullish only if CNX Nifty, CNX Nifty Midcap,
All Indices must confirm with
06 CNX Nifty Smallcap etc all move in the same upward direction. It
each other
would not be possible to classify markets as bullish, just by the
action of CNX Nifty alone
The volumes must confirm along with price. The trend should be
supported by volume. In an uptrend the volume must increase as
07 Volumes must confirm the price rises and should reduce as the price falls. In a downtrend,
volume must increase when the price falls and decrease when the
price rises. You could refer chapter 12 for more details on volume
137
Markets may remain sideways (trading between a range) for an
Sideway markets can
extended period. Example:- Reliance Industries between 2010 and
08 substitute secondary
2013 was trading between 860 and 990. The sideways markets can
markets
be a substitute for a secondary trend
Between the open, high, low and close prices, the close is the most
The closing price is the most
09 important price level as it represents the final evaluation of the
sacred
stock during the day
17.2 – The different phases of Market
Dow Theory suggests the markets are made up of three distinct phases, which are
self repeating. These are called the Accumulation phase, the Mark up phase, and the
Distribution phase.
The Accumulation phase usually occurs right after a steep sell off in the market. The
steep sell off in the markets would have frustrated many market participants, losing
hope of any sort of uptrend in prices. The stock prices would have plummeted to
rock bottom valuations, but the buyers would still be hesitant of buying fearing
there could be another sell off. Hence the stock price languishes at low levels. This is
when the ‘Smart Money’ enters the market.
Smart money is usually the institutional investors who invest from a long term
perspective. They invariably seek value investments which is available after a steep
sell off. Institutional investors start to acquire shares regularly, in large quantities
over an extended period of time. This is what makes up an accumulation phase.
This also means that the sellers who are trying to sell during the accumulation
phase will easily find buyers, and therefore the prices do not decline further. Hence
invariably the accumulation phase marks the bottom of the markets. More often
138
than not, this is how the support levels are created. Accumulation phase can last up
to several months.
Once the institutional investors (smart money) absorb all the available stocks, short
term traders sense the occurrence of a support. This usually coincides with
improved business sentiment. These factors tend to take the stock price higher. This
is called the mark up phase. During the Mark up phase, the stock price rallies
quickly and sharply. The most important feature of the mark up phase is the speed.
Because the rally is quick, the public at large is left out of the rally. New investors are
mesmerized by the return and everyone from the analysts to the public see higher
levels ahead.
Finally when the stock price reaches new highs (52 week high, all time high)
everyone around would be talking about the stock market. The news reports turn
optimistic, business environment suddenly appears vibrant, and everyone one
(public) wants to invest in the markets. The public by and large, wants to get
involved in the markets as there is a positive sentiment. This is when the
distribution phase occurs.
The judicious investors (smart investors) who got in early (during the accumulation
phase) will start offloading their shares slowly. The public will absorb all the volumes
off loaded by the institutional investors (smart money) there by giving them the well
needed price support. The distribution phase has similar price properties as that of
the accumulation phase. In the distribution phase, whenever the prices attempt to
go higher, the smart money off loads their holdings. Over a period of time this
action repeats several times and thus the resistance level is created.
Finally when the institutional investors (smart money) completely sell off their
holdings, there would no further support for prices, and hence what follows after
the distribution phase is a complete sell off in the markets, also known as the mark
down of prices. The selloff in the market leaves the public in an utter state of
frustration.
Completing the circle, what follows the selloff phase is a fresh round of
accumulation phase, and the whole cycle repeats again. It is believed that that entire
cycle from accumulation phase to the selloff spans over a few years.
It is important to note that no two market cycles are the same. For example in the
Indian context the bull market of 2006 – 07 is way different from the bull market of
2013-14. Sometimes the market moves from the accumulation to the distribution
phase over a prolonged multi-year period. On the other hand, the same move from
the accumulation to the distribution can happen over a few months. The market
participant needs to tune himself to the idea of evaluating markets in the context of
different phases, as this sets a stage for developing a view on the market.
139
17.3 – The Dow Patterns
Like in candlesticks, there are few important patterns in Dow Theory as well. The
trader can use these patterns to identify trading opportunities. Some of the patterns
that we will study are:
1. The Double bottom & Double top formation

2. The Triple Bottom & Triple Top
3. Range formation, and
4. Flag formation
The support and resistance is also a core concept for the Dow Theory, but because
of its importance (in terms of placing targets and stop loss) we have discussed it
much earlier a chapter dedicated to it.
17.4 – The Double bottom and top formation

A double top & double bottom is considered a reversal pattern. A double bottom
occurs when the price of a stock hits a particular low price level and rebounds back
with a quick recovery. Following the price recovery the stock trades at a higher level
(relative to the low price) for at least 2 weeks (well spaced in time). After which the
stock attempts to hit back to the low price previously made. If the stock holds up
once again and rebounds, then a double bottom is formed.
A double bottom formation is considered bullish, and hence one should look at
buying opportunities. Here is a chart that shows a double bottom formation in Cipla
Limited:
Notice the time interval between the two bottom formations. It is evident that the
price level was well spaced in time.
Likewise in a double top formation, the stock attempts to hit the same high price
twice but eventually sells off. Of course the time gap between the two attempts of
crossing the high should at least be 2 weeks. In the chart below (Cairn India Ltd), we
can notice the double top at 336 levels. On close observation you will notice the first
140
top was around Rs.336, and the second top was around Rs.332. With some amount
of flexibility a small difference such as this should be considered alright.
From my own trading experience, I find both double tops and double bottoms very
useful while trading. I always look for opportunities where the double formation
coincides with a recognizable candlesticks formation.
For instance, imagine a situation where in the double top formation, the 2nd top
forms a bearish pattern such as shooting star. This means, both from the Dow
Theory and candlestick perspective there is consensus to sell; hence the conviction
to take the trade is higher.
17.5 – The triple top and bottom

As you may have guessed, a triple formation is similar to a double formation, except
that the price level is tested thrice as opposed twice in a double bottom. The
interpretation of the triple formation is similar to the double formation.
As a rule of thumb the more number of times the price tests, and reacts to a certain
price level, the more sacred the price level is considered. Therefore by virtue of this,
the triple formation is considered more powerful than the double formation.
The following chart shows a triple top formation for DLF Limited. Notice the sharp
sell off after testing the price level for the 3rd time, thus completing the triple top.
141
1. Dow Theory was used in the western world even before candlesticks were formally
introduced
2. Dow Theory works on 9 basic tenets
3. Market can be viewed in 3 basic phases – accumulation, mark up, and distribution
phase
4. The accumulation phase is when the institutional investor (smart money) enters the
market, mark up phase is when traders make an entry, and the final distribution
phase is when the larger public enter the market
5. What follows the distribution phase is the mark down phase, following which the
accumulation phase will complete the circle
6. The Dow theory has a few basic patterns, which are best used in conjunction with
candlesticks
7. The double and triple formations are reversal patterns, which are quite effective
8. The interpretation of double and triple formations are the same
142
Chapter 18
The Dow Theory (Part 2)

91
18.1 – Trading Range

The concept of range is a natural extension to the double and triple formation. In a
range, the stock attempts to hit the same upper and lower price level multiple times
for an extended period of time. This is also referred to as the sideways market. As
the price oscillates in a narrow range without forming a particular trend, it is called a
sideways market or sideways drift. So, when both the buyers and sellers are not
confident about the market direction, the price would typically move in a range, and
hence typical long term investors would find the markets a bit frustrating during this
period.
However the range provides multiple opportunities to trade both ways (long and
short) with reasonable accuracy for a short term trader. The upside is capped by
resistance and the downside by the support. Thus it is known as a range bound
market or a trading market as there are enough opportunities for both the buyers
and the sellers.
In the chart below you can see the stock’s behaviour in a typical range:
As you can see the stock hit the same upper (Rs.165) and the same lower (Rs.128)
level multiple times, and continued to trade within the range. The area between the
upper and lower level is called the width of the range. One of the easy trades to
initiate in such a scenario would be to buy near the lower level, and sell near the
higher level. In fact the trade can be both ways with the trader opting to short at the
higher level and buying it back at the lower level.
143
In fact the chart above is a classic example of blending Dow Theory with candlestick
patterns. Starting from left, notice the encircled candles:
1. The bullish engulfing pattern is suggesting a long

2. Morning doji star suggesting a long
3. Bearish engulfing pattern is suggesting a short
4. Bearish harami pattern is suggesting a short
The short term trader should not miss out such trades, as these are easy to identify
trading opportunities with high probability of being profitable. The duration of the
range can be anywhere between a few weeks to a couple of years. The longer the
duration of the range the longer is the width of the range.
18.2 – The range breakout

Stocks do breakout of the range after being in the range for a long time. Before we
explore this, it is interesting to understand why stocks trade in the range in the first
place.
Stocks can trade in the range for two reasons:
1. When there are no meaningful fundamental triggers that can move the stock –
These triggers are usually quarterly/ annual result announcement, new products
launches, new geographic expansions, change in management, joint ventures,
mergers, acquisitions etc. When there is nothing exciting or nothing bad about the
company the stock tends to trade in a trading range. The range under these
circumstances could be quite long lasting until a meaningful trigger occurs
2. In anticipation of a big announcement – When market anticipates a big corporate
announcement the stock can swing in either directions based on the outcome of the
announcement. Till the announcement is made both buyers and sellers would be
hesitant to take action and hence the stock gets into the range. The range under
144
such circumstances can be short-lived lasting until the announcement (event) is
made.
The stock after being in the range can break out of the range. The range breakout
more often than not indicates the start of a new trend. The direction in which the
stock will breakout depends on the nature of the trigger or the outcome of the
event. What is more important is the breakout itself, and the trading opportunity it
provides.
A trader will take a long position when the stock price breaks the resistance levels
and will go short after the stock price breaks the support level.
Think of the range as an enclosed compression chamber where the pressure builds
up on each passing day. With a small vent, the pressure eases out with a great force.
This is how the breakout happens. However, the trader needs to be aware of the
concept of a ‘false breakout’.
A false breakout happens when the trigger is not strong enough to pull the stock in
a particular direction. Loosely put, a false breakout happens when a ‘not so trigger
friendly event’ occurs and impatient retail market participants react to it. Usually the
volumes are low on false range breakouts indicating, there is no smart money
involved in the move. After a false breakout, the stock usually falls back within the
range.
A true breakout has two distinct characteristics:
1. Volumes are high and

2. After the breakout, the momentum (rate of change of price) is high
Have a look at the chart below:
The stock attempted to breakout of the range three times, however the first two
attempts were false breakouts. The first 1st breakout (starting from left) was
145
characterized by low volumes, and low momentum. The 2nd breakout was
characterized by impressive volumes but lacked momentum.
However the 3rd breakout had the classic breakout attributes i.e high volumes and
high momentum.
18.3 – Trading the range breakout

Traders buy the stock as soon as the stock breaks out of the range on good
volumes. Good volumes confirm just one of the prerequisite of the range breakout.
However, there is no way for the trader to figure out if the momentum (second
prerequisite) will continue to build. Hence, the trader should always have a stoploss
for range breakout trades.
For example – Assume the stock is trading in a range between Rs.128 and Rs.165.
The stock breaks out of the range and surges above Rs.165 and now trades at
Rs.170. Then trader would be advised to go long 170 and place a stoploss at Rs.165.
Alternatively assume the stock breaks out at Rs.128 (also called the breakdown) and
trades at Rs.123. The trader can initiate a short trade at Rs.123 and treat the level of
Rs.128 as the stoploss level.
After initiating the trade, if the breakout is genuine then the trader can expect a
move in the stock which is at least equivalent to the width of the range. For example
with the breakout at Rs.168, the minimum target expectation would be 43 points
since the width is 168 – 125 = 43. This translates to a price target of Rs.168+43 = 211.
18.4 – The Flag formation

The flag formation usually takes place when the stock posts a sustained rally with
almost a vertical or a steep increase in stock prices. Flag patterns are marked by a
big move which is followed by a short correction. In the correction phase, the price
would generally move within two parallel lines. Flag pattern takes the shape of a
parallelogram or a rectangle and they have the appearance of a flag on the pole.
The price decline can last anywhere between 5 and 15 trading session.
146
With these two events (i.e price rally, and price decline) occurring consecutively a
flag formation is formed. When a flag forms, the stock invariably spurts back all of a
sudden and continues to rally upwards.
For a trader who has missed the opportunity to buy the stock, the flag formation
offers a second chance to buy. However the trader has to be quick in taking the
position as the stock tends to move up all of a sudden. In the chart above the
sudden upward moved is quite evident.
The logic behind the flag formation is fairly simple. The steep rally in the stock offers
an opportunity for market participants to book profits. Invariably, the retail
participants who are happy with the recent gains in the stock start booking profits
by selling the stock. This leads to a decline in the stock price. As only the retail
participants are selling, the volumes are on the lower side. The smart money is still
invested in the stock, and hence the sentiment is positive for the stock. Many
traders see this as an opportunity to buy the stock and hence the price rallies all of
a sudden.
18.5 – The Reward to Risk Ratio (RRR)

The concept of reward to risk ratio (RRR) is generic and not really specific to Dow
Theory. It would have been apt to discuss this under ‘trading systems and Risk
management’. However RRR finds its application across every type of trading, be it
trades based on technical analysis or investments through fundamentals. For this
reason we will discuss the concept of RRR here.
The calculation of the reward to risk ratio is very simple. Look at the details of this
short term long trade:
Entry: 55.75
Stop loss: 53.55
Expected target: 57.20
On the face of it, considering it is a short term trade, the trade looks alright.
However, let us inspect this further:
147
What is the risk the trader is taking? – [Entry – Stoploss] i.e 55.75 – 53.55 = 2.2
What is the reward the trader is expecting? – [Exit – Entry] i.e 57.2 – 55.75 = 1.45
This means for a reward of 1.45 points the trader is risking 2.2 points or in other
words the Reward to Risk ratio is 1.45/2.2 = 0.65. Clearly this is not a great trade.
A good trade should be characterised by a rich RRR. In other words, for every Rs.1/-
you risk on a trade your expected return should be at least Rs.1.3/- or higher,
otherwise it is simply not a worth the risk.
For example consider this long trade:

Entry: 107
Stop loss: 102
Expected target: 114
In this trade the trader is risking Rs.5/- (107 – 102) for an expected reward of Rs.7/-
(114 – 107). RRR in this case is 7/5 = 1.4. This means for every Rs.1/- of risk the
trader is assuming, he is expecting Rs.1.4 as reward. Not a bad deal.
The minimum RRR threshold should be set by each trader based on his/her risk
appetite. For instance, I personally don’t like to take up trades with a RRR of less
than 1.5. Some aggressive traders don’t mind a RRR of 1, meaning for every Rs.1
they risk they expect a reward of Rs.1. Some would prefer the RRR to be at least
1.25. Ultra cautious traders would prefer their RRR to be upwards of 2, meaning for
every Rs.1/- of risk they would expect at least Rs.2 as reward.
A trade must qualify the trader’s RRR requirement. Remember a low RRR is just not
worth the trade. Ultimately if RRR is not satisfied then even a trade that looks
attractive must be dropped as it is just not worth the risk.
To give you a perspective think about this hypothetical situation:
A bearish engulfing pattern has been formed, right at the top end of a trade. The
point at which the bearish engulfing pattern has formed also marks a double top
formation. The volumes are very attractive as they are at least 30% more than the
10 day average volumes. Near the bearish engulfing patterns high the chart is
showing a medium term support.
In the above situation, everything seems perfectly aligned to short trade. Assume
the trade details are as below:
Entry: 765.67
Stop loss: 772.85
Target: 758.5
Risk: 7.18 (772.85 – 765.67) i.e [Stoploss – Entry]
Reward: 7.17 (765.67 – 758.5) i.e [Entry – Exit]
RRR: 7.17/7.18 = ~ 1.0
148
As I mentioned earlier, I do have a stringent RRR requirement of at least 1.5. For this
reason even though the trade above looks great, I would be happy to drop it and
move on to scout the next opportunity.
As you may have guessed by now, RRR finds a spot in the checklist.
18.6 – The Grand Checklist

Having covered all the important aspects of Technical Analysis, we now need to
look at the checklist again and finalize it. As you may have guessed Dow Theory
obviously finds a place in the checklist as it provides another round of confirmation
to initiate the trade.
1. The stock should form a recognisable candlestick pattern

3. Volumes should confirm
1. Ensure above average volumes on both buy and sell day
2. Low volumes are not encouraging, and hence do feel free to hesitate while taking
trade where the volumes are low
4. Look at the trade from the Dow Theory perspective.
1. Primary, secondary trends
2. Double, triple, range formations
3. Recognisable Dow formation
5. Indicators should confirm
1. Scale the trade size higher if indicators confirm to your plan of action
2. If the indicators do not confirm go ahead with the original plan
6. RRR should be satisfactory
1. Think about your risk appetite and identify your RRR threshold
2. For a complete beginner, I would suggest the RRR to be as high as possible as this
provides a margin of safety
3. For an active trader, I would suggest a RRR of at least 1.5
When you identify a trading opportunity, always look how the trade is positioned
from the Dow Theory perspective. For example if you are considering a long trade
based on candlesticks, then look at what the primary and secondary trend is
suggesting. If the primary trend is bullish, then it would be a good sign, however if
we are in the secondary trend (which is counter to the primary) then you may want
to think twice as the immediate trend is counter to the long trade.
149
If you follow the checklist mentioned above and completely understand its
importance, I can assure you that your trading will improve multiple folds. So the
next time you take a trade, ensure you comply with above checklist. If not for
anything, at least you will have no reason to initiate a trade based on loose and
unscientific logic.
18.7 – What next?

We have covered many aspects of technical analysis in this module. I can assure you
the topics covered here are good enough to put you on a strong platform. You may
believe there is a need to explore other patterns and indicators that we have not
discussed here. If we have not discussed a pattern or an indicator here on Varsity,
do remember it is for a specific purpose. So be assured that you have all that you
need to begin your journey with Technical analysis.
If you can devote time to understanding each one of these topics thoroughly, then
you can be certain about developing a strong TA based thinking framework. The
next logical progression from here would be to explore ideas behind back testing
trading strategies, risk management, and trading psychology. All of which we will
cover in the subsequent modules.
In the next concluding chapter, we will discuss few practical aspects that will help
you get started with Technical Analysis.
1. A range is formed when the stock oscillates between the two price points
2. A trader can buy at the lower price point, and sell at the higher price point
3. The stock gets into a range for a specific reason such as the lack of fundamental
triggers, or event expectation
4. The stock can break out of the range. A good breakout is characterized by above
average volumes and sharp surge in prices
5. If the trader has missed an opportunity to buy a stock, the flag formation offers
another window to buy
6. RRR is a critical parameter for trade evaluation. Develop a minimum RRR threshold
based on your risk appetite
7. Before initiating a trade the trader should look at the opportunity from the Dow
Theory perspective
150
Chapter 19
The Finale – Helping you get started

458
19.1 – The Charting Software

Over the last 18 chapters we have learnt many aspects of Technical Analysis. If you
have read through all the chapters and understood what is being discussed, you are
certainly at a stage where you can start trading based on Technical Analysis. The
objective of this chapter is to help you get started with identifying technical trading
opportunities.
Kindly note, the suggestions I have put forth in this chapter are based on my trading
experience.
To begin with, you need a chart visualization software, simply called the ‘Charting
Software’. The charting software helps you look at the various stock charts and
analyze the same. Needless to say, the charting software is a very important tool for
a technical analyst.
There are many charting software’s available. The two most popular ones are
‘Metastock’ and ‘Amibroker’. Majority of the technical analysts use one of the two
charting software’s. Needless to say, these are paid software’s and you need to
purchase the software license before using it.
There are a few online free charting tools that are available which you can use –
these are available on Yahoo Finance, Google Finance and pretty much all the
business media websites. However, my advice to you is – if you aspire to become a
technical analyst, get access to a good charting software.
Think of the charting software as a DVD player, once you have a DVD player
installed, you will still need to rent DVDs to watch movies. Similarly, once you have a
151
charting software installed, you will still need to feed it with data to actually view the
charts. The data feed required is provided by the data vendors.
There are many data vendors in India giving you access to data feeds. I would
suggest you look up on the internet for reliable vendors. You just need to inform
the data vendor which charting software you have, and he will provide you the data
feeds in a format that is compatible with your charting software. Of course, the data
feeds come at a cost. Once you sign up with a data vendor, he will first give you all
the historical data, after which you will have to update the data from his server on a
daily basis to stay current.
From my experience buying the latest version of a good charting software

(Metastock or Amibroker) can cost you a onetime fee of anywhere between
Rs.25,000/- and Rs.30,000/-. Add to this another Rs.15,000/- to Rs.25,000 towards
the data feeds. Of course, while the software cost is one time, the cost of data feeds
recurs annually. Do note, the older versions of the charting software may cost you
much lesser.
Now, if you are in no mood to spend so much for the charting software & data feed
combination there is another alternative. And that would be Zerodha’s Pi.
As you may know, Zerodha has a proprietary trading terminal called ‘Pi’. Pi helps you
in many ways; I would like to draw your attention to some of its features in the
context of Technical Analysis:
1. It is bundled – Pi is a charting software and a data feed package bundled into a

single software
2. Great Visualizations – Pi helps you visualize charts across multiple time frames
including intraday charts
3. Advanced Features – Pi has advanced charting features and includes 80 built-in
technical indicators and over 30 drawing tools
4. Scripting you strategy – Pi has a scripting language employing which you can code
technical strategies and back test the same on historical data. Do note, on Varsity
we will soon include a module on building trading strategies and scripting
5. Easy Opportunity Recognition – Pi has pattern recognition feature that lets you
draw a pattern on the screen. Once you draw, just command Pi to scout for that
pattern across the market and it will do just that for you
6. Trade from Pi – Pi also lets you execute trades directly from the chart (a huge plus
point for a technical trader)
7. Data Dump – Pi has a massive historical data dump (over 50,000 candles) which
means back testing your strategy will be more efficient
8. Your personal trading assistant – Pi’s ‘Expert Advisor’, keeps you informed about
the patterns being developed in the live markets
152
9. Super Advanced features – Pi has Artificial Intelligence and Genetic Algorithms.
These are optimisation tools which helps you optimize your trading algorithms
10. It is free – Zerodha is giving it free of cost to all its active traders
The list is quite exhaustive ranging from the basic to advanced features. I would
strongly suggest you try out Pi before you decide to venture out for charting
package and data feed bundle.
19.2 – Which timeframe to choose?

We discussed ‘Timeframes in chapter 3. I would request you to read through it again
to refresh your memory.
Selecting the timeframe while scanning for trading opportunities is perhaps one of
the biggest confusion a newbie technical analyst has. There are many timeframes
you can choose from – 1 minute, 5 minutes, 10 minutes, 15 minutes, EOD, Weekly,
Monthly, and Yearly. It is quite easy to get confused with this.
As a thumb rule, the higher the timeframe, the more reliable the trading signal is.
For example a ‘Bullish Engulfing’ pattern on the 15 minute timeframe is far more
reliable than a ‘Bullish Engulfing’ pattern on a 5 minute timeframe. So keeping this
in perspective, one has to choose a timeframe based on the intended length of the
trade.
So how do you decide your intended length of your trade?
If you are starting out fresh or if you are not a seasoned trader I would suggest you
avoid day trading. Start with trades with an intention to hold the trade for a few
days. This is called ‘Positional Trading’ or ‘Swing Trading’. An active swing trader
usually keeps his trading position open for a few days. The best look back period for
a swing trader is 6 months to 1 year.
On the other hand, a scalper is a seasoned day trader; typically he uses 1minute or
5 minutes timeframe.
Once you are comfortable with holding trades over multiple days, graduate yourself
to ‘Day Trading’. My guess is, your transition from a positional trader to a day trader
153
will take some time. Needless to say for a dedicated and disciplined trader, the
transition period is remarkably lesser.
19.3 – Look back period

Look back period is simply the number of candles you wish to view before taking a
trading decision. For instance, a look back period of 3 months means you are
looking at today’s candle in the backdrop of at least the recent 3 months data. By
doing this you will develop a perspective on today’s price action with reference to
last 3 months price action.
For swing trading opportunities, what is the ideal look back period? From my
experience, I would suggest that a swing trader should look for at least 6 months to
1 year data. Likewise a scalper is better off looking at last 5 days data.
However, while plotting the S&R levels you should increase the look back period to
at least 2 years.
19.4 – The opportunity universe

There are roughly about 6000 listed stocks in the Bombay Stock Exchange (BSE) and
close to about 2000 listed stocks in the National Stock Exchange (NSE). Does it make
sense for you to scan for opportunities across these thousands of stocks, on a daily
basis? Obviously not. Over a period of time you need to identify a set of stocks that
you are comfortable trading. These set of stocks would constitute your “Opportunity
154
Universe’. On a daily basis you scan your opportunity universe to identify trading
opportunities.
Here are some pointers to select stocks to build your opportunity universe:
1. Ensure the stock has adequate liquidity. One way to ensure adequate liquidity is to
look at the bid ask spread. The lesser the spread, the more liquid the stock
1. Alternatively you can have ‘minimum volume criteria’. For example you can consider
only those stocks where the volume per day is at least 500000
2. Make sure the stock is in the ‘EQ’ segment. This is basically because stocks in the ‘EQ’
segment can be day traded. I agree, I discouraged day trading for a newbie,
however in a situation where you initiated a positional trade and the target is
achieved the same day, there is no harm in closing the position intraday
3. This is a bit tricky, but make sure the stock is not operator driven. Unfortunately
there is no quantifiable method to identify operator driven stocks. This comes to
you by sheer experience
If you find it difficult to find stocks that comply with the above points, I would advise
you to simply stick to the Nifty 50 or the Sensex 30 stocks. These are called the
index stocks. Index stocks are carefully selected by the exchanges, this selection
process ensures they comply with many points including the ones mentioned
above.
Keeping Nifty 50 as your opportunity universe is probably a good idea for both
swing trader and scalper.
19.5 – The Scout

Let us now proceed to understand how one should go about selecting stocks for
trading. In other words, we will try and indentify a process, employing which we can
scan for trading opportunities. The process is mainly suited for a swing trader.
We have now set the 4 important aspects –
1. The charting software – Suggest you use Zerodha’s Pi

2. Timeframe – End of Day data
155
3. Opportunity Universe – Nifty 50 stocks
4. Trade type – Positional trades with an option to square off intraday, provided the
target hits the same day
5. Look back period – Between 6 months to 1 year. Increase to 2 years while plotting
the S&R level
Having fixed these important practical aspects, I will now proceed to share my
methodology of scanning trading opportunities. I have divided the process into 2
parts:
Part 1 – The Short listing process
1. I look at the chart of all the stocks within my opportunity universe

2. While looking at the chart, my attention is only on the recent 3 or maximum 4
candles
3. While looking at the recent 3 candles, I check if there is any recognisable candlestick
pattern being developed
4. If I find an interesting pattern, I short list this stock for further investigation and I
continue the scouting process. I always ensure I check all the 50 charts
Part 2 – The Evaluation process
At this stage, I am usually left with 4-5 shortlisted stocks (out of the 50 stocks in my
opportunity universe) which exhibit a recognisable candlestick pattern. I then
proceed to evaluate these 4-5 charts in detail. Typically I spend at least 15 – 20
minutes on each chart. Here is what I do when looking at the shortlisted chart:
1. I generally look at how strong the pattern is – I am specifically interested in checking

if there is any need for me to be more flexible
1. For example, if a Bullish Marubuzo has a shadow, I evaluate the length of the
shadow with reference to the range
2. After this I look at the ‘prior trend’. For all bullish patterns, the prior trend should be
a downtrend, and for all bearish patterns the prior trend should be an uptrend. I do
pay a lot of attention to prior trends
3. At this stage if everything looks good (i.e. I have identified a recognizable pattern
with a well defined prior trend), I proceed to inspect the chart further
4. After this I look at the volumes. The volume should be at least equal to or more than
the 10 day average volume
5. Provided both the candlestick pattern and volumes confirm, I then proceed to check
the existence of the support (in case of a long trade) and resistance (in case of a
short trade) level
1. The S&R level should coincide (as much as possible) with the stoploss of the trade
(as defined by the candlestick pattern)
156
2. If the S&R level is more than 4% away from the stoploss, I stop evaluating the chart
further and proceed to the next chart
6. I then look for Dow patterns – particularly for double and triple top & bottom
formations, flags formations and the possibility of a range breakout
1. Needless to say, I also establish the Primary and secondary market trend
7. If the steps 1 to 5 are satisfactory, I proceed to calculate the risk to reward ratio
(RRR)
1. To calculate RRR, I first establish the target by plotting either the support or
resistance level
2. The minimum RRR should be at least 1.5
8. At last I look at the MACD and RSI indicators to get a perspective, if they confirm and
if I have spare cash I increase my trade size
Usually out of the 4-5 shortlisted stocks, at the most 1 or 2 may qualify for a trade.
There are days when there are no trading opportunities. Deciding not to trade in
itself is a big trading decision. Do remember this is a fairly stringent checklist, if a
stock is confirming to the checklist, my conviction to trade is very high.
I have mentioned this many times in this module, I will mention this for one last
time – once you place a trade, do nothing till either your target is achieved or
stoploss is triggered. Of course you can trail your stoploss, which is a healthy
practice. But otherwise do nothing, if your trade complies with the checklist and do
remember the trade is highly curetted; hence the chance of being successful is high.
So it makes sense to stay put with conviction.
19.5 – The Scalper

For a seasoned swing trader, scalping is another option. Scalping is a technique
where the trader initiates a fairly large trade with an intention of holding the trade
for a few minutes. Here is a typical example of the trade done by a scalper –
1st Leg of the trade 2nd leg of the trade
157
Time – 10:15 AM Time – 10:25 AM
Stock – Infosys Stock – Infosys
Price – 3980 Price – 3976
Action – Sell Action – Buy
Quantity – 1000 shares Quantity – 1000 shares
Overall profit after applicable charges = Rs.2653/-
Do note, the overall profit is calculated considering that you are trading with
Zerodha, the overall profitability would shrink remarkably if you are scalping with an
expensive brokerage rates. Containing transaction charges is one of the keys to
successful scalping.
A scalper is a highly focused trader with a sharp sense for price. He utilizes highly
precise charts such with 1 minute and 5 minute timeframe to make his trading
decisions. A successful scalper executes many such trades within the day. His
objective is simple – large quantity trade with an intention to hold for a few minutes.
He intends to profit from the small moves in the stock.
If you aspire to be a scalper, here are few guidelines –
1. Do remember the checklist we have mentioned but do not expect all the checklist
items to comply as the trade duration is very low
2. If I were to handpick just 1 or 2 items in the checklist for scalping, it would be
candlestick pattern and volume
3. A risk reward ratio of even 0.5 to 0.75 is acceptable while scalping
4. Scalping should be done only on liquid stocks
5. Have an effective risk management system – be really quick to book a loss if need
be
6. Keep a tab on the bid ask spread to see how the volumes are building
7. Keep a tab on global markets – for example if there is a sudden drop in the Hang
Seng (Hong Kong stock exchange) it invariably leads to a sudden drop in local
markets
8. Choose a low cost broker to ensure your costs are controlled
158
9. Use margins effectively, do not over leverage
10. Have a reliable intraday charting software
11. If you sense the day is going wrong, stop trading and move away from your terminal
Scalping as a day trading technique requires a great presence of mind and a
machine like approach. A successful scalper embraces volatility and is indifferent to
market swings.
1. If you aspire to become a technical trader ensure you equip yourself with good
charting software. Zerodha’s Pi is my preference
2. Choose EOD chart for both day trading and swing trading
3. Look at intraday charts if you like scalping the markets
4. The look back period should be at least 6 months to 1 year for swing trading
5. Nifty 50 is a great opportunity universe to begin with
6. The opportunity scanning can be done in 2 parts
7. Part 1 involves skimming through the charts of all the stocks in opportunity universe
and short listing those charts that display a recognizable candlestick pattern
8. Part 2 involves investigating the shortlisted charts to figure out if they comply with
the checklist
9. Scalping is advisable for seasoned swing traders
159
Chapter 20
Supplementary Notes 1
354
Average Directional Index (ADX)

About:
The Average Directional Index (ADX), Minus Directional Indicator (-DI) and Plus
Directional Indicator (+DI) represent a group of directional movement indicators
that form a trading system developed by Welles Wilder. The Average Directional
Index (ADX) measures trend strength without regard to trend direction. The other
two indicators, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI),
complement ADX by defining trend direction. Used together, chartists can
determine both the direction and strength of the trend. Source: stockcharts.com
What should you know?
1. ADX system has three components – ADX, +DI, and -DI

2. ADX is used to measure the strength/weakness of the trend and not the actual
direction
3. ADX above 25 indicates that the present trend is strong, ADX below 20 suggest that
the trend lacks strength. ADX between 20 and 25 is a grey area
4. A buy signal is generated when ADX is 25 and the +DI crosses over –DI
5. A sell signal is generated when ADX is 25 and the –DI crosses over +DI
160
6. Once the buy or sell signal is generated, take the trade by defining the stop loss
7. The stop loss is usually the low of the signal candle (for buy signals) and the high of
the signal candles ( for short signals)
8. The trade stays valid till the stoploss is breached (even if the +DI and –DI reverses
the crossover)
9. The default look back period for ADX is 14 days
On Kite:
Load the ADX indicator from studies. Kite gives you an option to change the look
back period, by default the look back period is set
You can customize the color of all the three components of the ADX system. Click on
‘create’ to load the indicator –
161
By default the ADX indicator is loaded below the instrument. The black line
represents ADX, ensure it is above 25 while looking for the crossovers.
Alligator Indicator
About:
An indicator designed to signal a trend absence, formation and direction. Bill
Williams saw the alligator’s behavior as an allegory of the market’s one: the resting
phase is turning into the price-hunting as the alligator awakes so that to come back
to sleep after the feeding is over. The longer the alligator is sleeping the hungrier it
gets and the stronger the market move will be. Source: infimarkets.com
1. The Alligator indicator is overlaid on the price chart

2. The indicator is made up of three simple moving averages – 13, 8, and 5 period
averages are used
3. The 13 period MA refers to the Alligator’s jaw, 8 period MA refers to the Alligator’s
teeth, and the 5 period MA refers to the Alligator’s lips
4. By default 13 MA is colored blue, 8 MA is colored red, and 5 MA is colored green
5. A buy signal is generated when the following condition is satisfied –
1. All three MA’s are separated
2. The price is above the 5MA, 5MA is above 8MA, and 8MA is above 13 MA
3. Once the above condition is satisfied, it means that the asset is trending up
162
4. When the uptrend is established, it is upto the trader to identify a good entry point
within this trend
6. A sell signal is generated when the following condition is satisfied –
1. All three MA’s are separated
2. The price is below the 5MA, 5MA is below 8MA, and 8MA is below 13 MA
3. Once the above condition is satisfied, it means that the asset is trending down
4. When the downtrend is established, it is upto the trader to identify a good entry
point within this trend
7. Periods when the 13, 8, and 5 MA are intervened (or moving flat) is considered a ‘no
trader’ zone and therefore the trader is advised to stay out of markets
On Kite:
Load the Alligator indicator from the studies. As you can see the default values of
the moving averages are loaded i.e 13, 8, and 5.
As you can see, the indicator input also loads the ‘offset’ values for each MA. These
offset values are also loaded by default values. Offsetting or displacing the moving
average reduces the number of whipsaws in the average. Needless to say that you
can change the default values for moving average and offset to any value that you
deem appropriate. Further you can even customize the color of each indicator to
your preference.
Here is the snapshot of how the indicator looks when the indicator is overlaid on the
chart. Do notice there are 2 instances when the sell condition is satisfied
(highlighted in red) and 1 instance when the buy condition is satisfied (highlighted in
blue).
163
Aroon
About:
Developed by Tushar Chande in 1995, Aroon is an indicator system that determines
whether a stock is trending or not and how strong the trend is. “Aroon” means
“Dawn’s Early Light” in Sanskrit. Chande chose this name because the indicators are
designed to reveal the beginning of a new trend. The Aroon indicators measure the
number of periods since price recorded an x-day high or low. There are two
separate indicators: Aroon-Up and Aroon-Down.
A 25-day Aroon-Up measures the number of days since a 25-day high. A 25-day
Aroon-Down measures the number of days since a 25-day low. In this sense, the
Aroon indicators are quite different from typical momentum oscillators, which focus
on price relative to time. Aroon is unique because it focuses on time relative to
price. Chartists can use the Aroon indicators to spot emerging trends, identify
consolidations, define correction periods and anticipate reversals. Source:
stockcharts.com
1. The indicator measures the number of days since last high or low is made, hence
the indicator is a measure of time relative to the price
2. Aroon consists of two component – Aroon up and Aroon Down
3. The default value for Aroon is 25 days. Aroon up measures the number of days
since the last 25 day high occurred and Aroon down measures the number of days
since the last 25 days low has occurred
4. Both Aroon up and Aroon down are plotted side by side
5. Aroon Up/Down is lower bound to zero and upper bound to 100
6. A buy is generated when Aroon up is above 50 and Aroon low is below 30
164
7. A sell is generated when Aroon down is above 50 and Aroon up is below 30
On Kite:
Here is the snapshot of the indicator when loaded from studies –
As you can see the default period is 14, feel free to change this to any number you
wish. 14 here represent the ‘number of days’. Do remember if the period is 14, the
Aroon measures the number of days since the stock made 14 days high/low.
165
As you can see both Aroon up and Aroon Down are plotted.
Aroon Oscillator
Aroon Oscillator is an extension of the Aroon indicator. The Aroon Oscillator
measures the difference between the Aroon up and Aroon down and plots the
difference in the form of an oscillator. The oscillator swings between -100 to +100,
with the ‘0’ level as the center point.
The snapshot below shows the Aroon Oscillator loaded on to the chart –
A reading above zero means that Aroon-Up is greater than Aroon-Down, which
implies that prices are making new highs more recently than new lows. Conversely,
readings below zero indicate that Aroon-Down is greater than Aroon-Up. This
implies that prices are recording new lows more recently than new highs.
As you can see, the Aroon Oscillator is either going to be positive or negative the
vast majority of the time. This makes interpretation straight-forward. Time and price
favor an uptrend when the indicator is positive and a downtrend when the indicator
is negative. A positive or negative threshold can be used to define the strength of
the trend. For example, a surge above +50 would reflect a strong upside move,
while a plunge below -50 would indicate a strong downside move. Source:
stockcharts.com
Average True Range

About:
Developed by J. Welles Wilder, the Average True Range (ATR) is an indicator that
166
measures volatility. As with most of his indicators, Wilder designed ATR with
commodities and daily prices in mind. Commodities are frequently more volatile
than stocks. They were are often subject to gaps and limit moves, which occur when
a commodity opens up or down its maximum allowed move for the session. A
volatility formula based only on the high-low range would fail to capture volatility
from gap or limit moves. Wilder created Average True Range to capture this
“missing” volatility. It is important to remember that ATR does not provide an
indication of price direction, just volatility. Source: stockcharts.com
1. Average True Range (ATR) is an extension of True Range concept

2. ATR is not upper or lower bound, hence can take any value
3. ATR is stock price specific, hence for Stock 1 ATR can be in the range of 1.2 and
Stock 2 ATR could be in the range of 150
4. ATR attempts to measure the volatility situation and not really the direction of the
prices
5. ATR is used to identify stop loss as well
6. If the ATR of a stock is 48, then it means that on average the stock is likely to move
48 points either ways up or down. You can add this to the current day’s range to
estimate the day’s range. For example the stock price is 1320, then the stock is likely
to trade between 1320 – 48 = 1272 and 1320 + 48 = 1368
7. If the ATR for the next day decreases to say 40, then it means that the volatility is
decreasing, and so is the expected range for the day
8. It is best to use ATR to identify the volatility based SL while trading. Assume you
have initiated a long trade on the stock at 1325, then your SL should be at least 1272
or below since the ATR is 48
9. Likewise if you have initiated a short at 1320, then your stoploss should be at least
1368 or above
10. If these SL levels are outside your risk to reward appetite, the its best to avoid such
trade.
On Kite:
As you can see, the default value of ATR is 14, which means to say that the system
calculates the ATR for the last 14 days. Of course you can change this to any value to
wish. Here is the snapshot –
167
168
Once you load the chart, ATR is plotted below the price chart as seen below –
So the next time you place a stoploss make sure you check the ATR value to see if
stoploss level is relevant. You may also want to read more about volatility and its
application (including volatility based SL) – Click Here
Average True Range Band

The ATR bands are an extension of the ATR concept. The idea is to plot an envelope
around the stock price to evaluate if the stock prices are behaving “normally” or
trending in a particular direction. In order to do this, the ATR band calculates the
upper and lower band.
1. The ATR band calculates and plots the upper and lower envelope around the stock
price
2. To begin with a moving average of stock price is calculated
3. The ATR value is added to the moving average value, and this forms the upper
envelop
4. The ATR value is subtracted to the moving average value, and this forms the lower
envelop
5. If the stock price penetrates either the upper or lower envelop, then the expectation
is that the stock price will continue to move in the same direction. For example if the
stock price has penetrated above the upper envelop, the expectation is that the
stock will continue to move higher
6. You can even use the ATR bands as an alternate to the Bollinger Band trading
system. You can read more about the Bollinger Band (section 15.2)
On Kite:
When you load the ATR band from studies, you will be prompted for few inputs –
169
Period refers to the MA time frame; the default value is 5 days. You can change this
to whichever time frame that you deem suitable. We would suggest you ignore ‘shift’
parameter. For the ‘field’ option select ‘close’, this means to say that you are plotting
the MA values on the closing prices. The rest of the options are mainly aesthetic
features, feel free to explore them. Once you click create, you will see the ATR bands
plotted on the chart.
170
Super trend
Before understanding the supertrend indicator, understanding the ATR is necessary
as super trend employs ATR values to calculate the indicator values. The supertrend
indicator is plotted over the price chart of the stock or the index. The indicator line
changes its color between green and red based on the price moment in the
underlying. Super trend does not predict the direction, rather once the direction is
established it will guide you to initiate a position and suggests you to stay in the
position till the trend sustains.
1. When plotted, the supertrend indicator appears like a alternating green and red
continuous line
2. A buy signal is generated when the stock/index price turns greater than the
indicator value. At this stage, the indicator color turn green and you can also see a
crossover of the price versus the indicator (price greater than indicator value)
3. Once the long position has been established, the trader is advised to hold the
position till the price closes below the green line. So in a sense the green line helps
as a trailing stoploss for the long position
4. A sell signal is generated when the stock/index price turns lesser than the indicator
value. At this stage, the indicator color turn red and you can also see a crossover of
the price versus the indicator (price lesser than indicator value)
5. The sell signal can be used to initiate a fresh short or exit long. Although waiting for
the sell signal to exit the existing long position can sometime lead to taking a loss.
So the trader should use his discretion here
171
6. Once the short position has been established, the trader is advised to hold the
position till the price closes below the green line. So in a sense the red line helps as
a trailing stoploss for the short position
7. Supertrend is basically used to identify a trend therefore it works best in a trending
market
8. The supertrend indicator when compared to a regular Moving Average trading
system generates fewer false signals, for this reason the super trend indicator is
preferred over a Moving Average trading system
On Kite:
When you select Supertrend indicator from the list of studies you will be prompted
for two inputs – Period and Multiplier.
Period refers to the ATR number of days. The default value on Kite is 7, which
means to say that the system will calculate the ATR value for the last 7 days. You can
input any value you deem suitable.
The multiplier refers to a value by which the ATR will get multiplied. The default
value on Kite is 3, so whatever is the value of ATR, it will get multiplied by 3.
Multiplier is a crucial input for Super trend. If the multiplier value is too high, then
lesser number of signals are generated. Likewise if the multiplier value is too small,
then the frequency of signals increase, hence chances of generating false trading
signals are quite high. I would suggest you keep this value between 3 and 4.
172
Once the indicator is plotted, this is how it appears on the chart –
Notice how the indicator changes the color as the price moves. Also, whenever the
buy/sell signal is generated green and red arrows are generated (respectively)
prompting the trader to go long or short on the stock.
Volume weighted average price (VWAP)

VWAP is one of the one of the simplest indicators to use. It works on the principle of
averaging the traded price in terms of volume traded. Let me give you an example
of to help you understand this better.
Here is how Infy traded between 14:30 and 14:35 on 2nd Nov 2016 –
The data is quite simple to understand, for example, at 14:32, 2475 shares were
traded, it made a high of 983.95, low of 983, and closed the minute at 983.1.
173
Now, we use this data and compute the VWAP price. In order to do this, we calculate
the following –
1. Typical price = which is the average price of High, Low, and close
2. Volume Price (VP) = we get this by multiplying the typical price with its volume
3. Total VP = This is a cumulative number, which is got by adding the current VP to the
previous VP
4. Total volume = This is again a cumulative number, which is got by adding the
current volume to the previous volume
5. VWAP = We get this VWAP number by dividing the Total VP by Total Volume. The
resulting number indicates the average traded price, weighted by volume.
Let’s do the math on Infy data –
As you see, the VWAP is a dynamic number, changing based on how the trades flow
in.
How to use the VWAP?
1. VWAP is an intraday indicator, use it on minute charts. Often when you plot this, you
will notice a jump at 9:15 AM, when compared to previous day’s data. Ignore this
jump as it means nothing
2. VWAP is an average and like any indicators employing averages, this too lags the
current market price
3. VWAP is used for 2 main reasons – to get a sense of intraday direction and to get a
sense of the efficiency of order execution
4. If the current price is below VWAP, then the general opinion is that the intraday
trend is down
5. If the current price is above VWAP, then the general opinion is that the stock is
trending higher
6. If the VWAP lies in between the high and low, then the expectation is that the stock
will remain volatile
7. If you intend to short a stock, then it is considered an efficient fill if you short the
stock at a price higher than VWAP
174
8. Likewise, if you intend to go long on a stock, then it is considered an efficient fill if
you go long at a price lower than VWAP
On Kite:
Open the chart of your preference and select VWAP from the studies drop down –
Note, VWAP can be applied only on intraday time frame and cannot be applied on
EOD data.
Once you select the time frame (1 min, 5 mins, 10 mins etc), the engine calculates
the VWAP and plots it on the chart as an overlay.
175
You can now visualize the VWAP and the current market price and plan your trades
accordingly.
176
Module 3
Fundamental Analysis
Module 3 — Fundamental Analysis
Chapter 1
Introduction to Fundamental Analysis

83
1.1 – Overview
Fundamental Analysis (FA) is a holistic approach to study a business. When an
investor wishes to invest in a business for the long term (say 3 – 5 years) it becomes
extremely essential to understand the business from various perspectives. It is
critical for an investor to separate the daily short term noise in the stock prices and
concentrate on the underlying business performance. Over the long term, the stock
prices of a fundamentally strong company tend to appreciate, thereby creating
wealth for its investors.
We have many such examples in the Indian market. To name a few, one can think of
companies such as Infosys Limited, TCS Limited, Page Industries, Eicher Motors,
Bosch India, Nestle India, TTK Prestige etc. Each of these companies have delivered
on an average over 20% compounded annual growth return (CAGR) year on year for
over 10 years. To give you a perspective, at a 20% CAGR the investor would double
his money in roughly about 3.5 years. Higher the CAGR faster is the wealth creation
process. Some companies such as Bosch India Limited have delivered close to 30%
CAGR. Therefore, you can imagine the magnitude, and the speed at which wealth is
created if one would invest in fundamentally strong companies.
1
Here are long term charts of Bosch India, Eicher Motors, and TCS Limited that can
set you thinking about long term wealth creation. Do remember these are just 3
examples amongst the many that you may find in Indian markets.
At this point you may be of the opinion that I am biased as I am selectively posting
charts that look impressive. You may wonder how the long term charts of
companies such as Suzlon Energy, Reliance Power, and Sterling Biotech may look?
Well here are the long term charts of these companies:
2
These are just 3 examples of the wealth destructors amongst the many you may
find in the Indian Markets.
The trick has always been to separate the investment grade companies which create
wealth from the companies that destroy wealth. All investment grade companies
3
have a few common attributes that sets them apart. Likewise all wealth destructors
have a few common traits which is clearly visible to an astute investor.
Fundamental Analysis is the technique that gives you the conviction to invest for a
long term by helping you identify these attributes of wealth creating companies.
1.2 – Can I be a fundamental analyst?

Of course you can be. It is a common misconception that only chartered
accountants and professionals from a commerce background can be good
fundamental analysts. This is not true at all. A fundamental analyst just adds 2 and 2
to ensure it sums up to 4. To become a fundamental analyst you will need few basic
skills:
1. Understanding the basic financial statements

2. Understand businesses with respect to the industry in which it operates
3. Basic arithmetic operations such as addition, subtraction, division, and
multiplication
The objective of this module on Fundamental Analysis is to ensure that you gain the
first two skill sets.
1.3 – I’m happy with Technical Analysis, so why bother about Fundamental
Analysis?
Technical Analysis (TA) helps you garner quick short term returns. It helps you time
the market for a better entry and exit. However TA is not an effective approach to
create wealth. Wealth is created only by making intelligent long term investments.
However, both TA & FA must coexist in your market strategy. To give you a
perspective, let me reproduce the chart of Eicher Motors:
4
Let us say a market participant identifies Eicher motors as a fundamentally strong
stock to invest, and therefore invests his money in the stock in the year 2006. As you
can see the stock made a relatively negligible move between 2006 and 2010. The
real move in Eicher Motors started only from 2010. This also means FA based
investment in Eicher Motors did not give the investor any meaningful return
between 2006 and 2010. The market participant would have been better off taking
short term trades during this time. Technical Analysis helps the investor in taking
short term trading bets. Hence both TA & FA should coexist as a part of your market
strategy. In fact, this leads us to an important capital allocation strategy called “The
Core Satellite Strategy”.
Let us say, a market participant has a corpus of Rs.500,000/-. This corpus can be
split into two unequal portions, for example the split can be 60 – 40. The 60% of
capital which is Rs.300,000/- can be invested for a long term period in fundamentally
strong companies. This 60% of the investment makes up the core of the portfolio.
One can expect the core portfolio to grow at a rate of at least 12% to 15% CAGR year
on year basis.
The balance 40% of the amount, which is Rs.200,000/- can be utilized for active short
term trading using Technical Analysis technique on equity, futures, and options. The
Satellite portfolio can be expected to yield at least 10% to 12% absolute return on a
yearly basis.
1.4 – Tools of FA
The tools required for fundamental analysis are extremely basic, most of which are
available for free. Specifically you would need the following:
1. Annual report of the company – All the information that you need for FA is available
in the annual report. You can download the annual report from the company’s
website for free
5
2. Industry related data – You will need industry data to see how the company under
consideration is performing with respect to the industry. Basic data is available for
free, and is usually published in the industry’s association website
3. Access to news – Daily News helps you stay updated on latest developments
happening both in the industry and the company you are interested in. A good
business news paper or services such as Google Alert can help you stay abreast of
the latest news
4. MS Excel – Although not free, MS Excel can be extremely helpful in fundamental
calculations
With just these four tools, one can develop fundamental analysis that can rival
institutional research. You can believe me when I say that you don’t need any other
tool to do good fundamental research. In fact even at the institutional level the
objective is to keep the research simple and logical.
1. Fundamental Analysis is used to make long term investments

2. Investment in a company with good fundamentals creates wealth
3. Using Fundamental Analysis one can separate out an investment grade company
from a junk company
4. All investment grade companies exhibit few common traits. Likewise all junk
companies exhibit common traits
5. Fundamental analysis helps the analysts identify these traits
6. Both Technical analysis and fundamental analysis should coexist as a part of your
market strategy
7. To become a fundamental analyst, one does not require any special skill. Common
sense, basic mathematics, and a bit of business sense is all that is required
8. A core satellite approach to the capital allocation is a prudent market strategy
9. The tools required for FA are generally very basic, most of these tools are available
for free.
6
Chapter 2
Mindset of an Investor
45
2.1– Speculator Vs Trader Vs Investor

Depending on how you would like to participate in the market, you can choose to
speculate, trade or invest. All the three types of participation are different from one
another. One has to take a stance on the type of market participant he would like to
be. Having clarity on this can have a huge impact on his Profit & Loss account.
To help you get this clarity, let us consider a market scenario and identify how each
one of the market participants (speculator, trader, and investor) would react to it.
SCENARIO
RBI in the next two days is expected to convene to announce their latest stance on
the monetary policy. Owing to the high and sticky inflation, RBI has hiked the
interest rates during the previous 4 monetary policy reviews. Increase in interest
rates, as we know means tougher growth prospects for Corporate India – hence
corporate earnings would take a hit.
Assume there are three market participants – Sunil, Tarun, and Girish. Each of them
view the above scenario differently, and hence would take different actions in the
market. Let us go through their thought process.
(Please note: I will briefly speak about option contracts here, this is only for
illustration purpose. We will understand more about derivatives in the subsequent
modules)
7
Sunil: He thinks through the situation and his thought process is as follows:
o He feels the interest rate are at an unsustainably high level

o High interest rates hampers the growth of corporate India
o He also believes that RBI has hiked the interest rates to a record high level and it
would be really tough for RBI to hike the rate again
o He looks at what the popular analysts on TV are opinionating about the situation,
and he is happy to note that his thoughts and the analyst thoughts are similar
o He concludes that RBI is likely to cut the rates if not for keeping the interest rates
flat
o As an outcome, he expects the market to go up
To put his thoughts into action, he buys call options of State Bank of India.
Tarun: He has a slightly different opinion about the situation. His thought process is
as below:
o He feels expecting RBI to cut the rates is wishful thinking. In fact he is of the opinion
that nobody can clearly predict what RBI is likely to do
o He also identifies that the volatility in the markets is high, hence he believes that
option contracts are trading at very high premiums
o He knows from his previous experience (via back testing) that the volatility is likely
to drop drastically just after RBI makes its announcement
To put his thoughts into action, he sells 5 lots of Nifty Call options and expects
to square off the position just around the announcement time.
Girish: He has a portfolio of 12 stocks which he has been holding for over 2 years.
Though he is a keen observer of the economy, he has no view on what RBI is likely
to do. He is also not worried about the outcome of the policy as he anyway plans to
hold on to his shares for a long period of time. Hence with this perspective he feels
the monetary policy is yet another short term passing tide in the market and will not
have a major impact on his portfolio. Even if it does, he has both the time and
patience to hold on to his shares.
However, Girish plans to buy more of his portfolio shares if the market overreacts to
the RBI news and his portfolio stocks falls steeply after the announcement is made.
8
Now, what RBI will eventually decide and who makes money is not our concern. The
point is to identify who is a speculator, a trader, and an investor based on their
thought process. All the three men seem to have logic based on which they have
taken a market action. Please note, Girish’s decision to do nothing itself is a market
action.
Sunil seems to be highly certain on what RBI is likely to do and therefore his market
actions are oriented towards a rate cut. In reality it is quite impossible to call a shot
on what RBI (or for that matter any regulator) will do. These are complex matters
and not straightforward to analyze. Betting on blind faith, without a rational
reasoning backing ones decision is speculation. Sunil seems to have done just that.
Tarun has arrived at what needs to be done based on a plan. If you are familiar with
options, he is simply setting up a trade to take advantage of the high options
premium. He is clearly not speculating on what RBI is likely to do as it does not
matter to him. His view is simple – volatility is high; hence the premiums are
attractive for an options seller. He is expecting the volatility to drop just prior to RBI
decision.
Is he speculating on the fact that the volatility will drop? Not really, because he
seems to have back tested his strategy for similar scenarios in the past. A trader
designs all his trades and not just speculates on an outcome.
Girish, the investor on the other hand seems to be least bit worked up on what RBI
is expected to do. He sees this as a short term market noise which may not have
any major impact on his portfolio. Even if it did have an impact, he is of the opinion
that his portfolio will eventually recover from it. Time is the only luxury markets
offer, and Girish is keen on leveraging this luxury to the maximum. In fact he is even
prepared to buy more of his portfolio stocks in case the market overreacts. His idea
is to hold on to his positions for a long period of time and not get swayed by short
term market movements.
All the three of them have different mindsets which leads them to react differently
to the same situation. The focus of this chapter is to understand why Girish, the
investor has a long term perspective and not really bothered about short term
movements in the market.
2.2 – The compounding effect

To appreciate why Girish decided to stay invested and not really react to short term
market movement, one has to understand how money compounds. Compounding
in simple terms is the ability of money to grow when the gains of year 1 is
reinvested for year 2.
9
For example consider you invest Rs.100 which is expected to grow at 20% year on
year (recall this is also called the CAGR). At the end of the first year the money is
expected to grow to Rs.120. At the end of year 1 you have two options:
1. Let Rs.20 in profits remain invested along with the original principal of Rs.100 or
2. Withdraw the profits of Rs.20.
You decide not withdraw Rs.20 profit; instead you decide to reinvest the money for
the 2nd year. At the end of 2nd year, Rs.120 grows to Rs.144. At the end of 3rd year
Rs.144 grows to Rs.173. So on and so forth.
Compare this with withdrawing Rs.20 profits every year. Had you opted to withdraw
Rs.20 every year then at the end of 3rd year the profits would have been just Rs. 60.
However since you decided to stay invested, the profits at the end of 3 years is
Rs.173. A good Rs.13 or 21.7% over Rs.60 is generated just because you opted to do
nothing and decided to stay invested. This is called the compounding effect. Let us
take this analysis a little further, have a look at the chart below:
The chart above shows how Rs.100 invested at 20% grows over a 10 year period. If
you notice, it took almost 6 years for the money to grow from Rs.100 to Rs.300.
However the next Rs.300 was generated in only 4 years i.e from the 6th to 10th
year.
This is in fact the most interesting property of the compounding effect. The longer
you stay invested, the harder (and faster) the money works for you. This is exactly
why Girish decided to stay invested – to exploit the luxury of time that the market
offers.
All investments made based on fundamental analysis require the investors to stay
committed for the long term. The investor has to develop this mindset while he
chooses to invest.
10
2.3 – Does investing work?
Think about a sapling – if you give it the right amount of water, manure, and care
would it not grow? Of course it will. Likewise, think about a good business with
healthy sales, great margins, innovative products, and an ethical management. Is it
not obvious that the share price of such companies would appreciate? In some
situations the price appreciation may delay (recall the Eicher Motors chart from
previous chapter), but it certainly will always appreciate. This has happened over
and over again across markets in the world, including India.
An investment in a good company defined by investable grade attributes will

always yield results. However, one has to develop the appetite to digest short term
market volatility.
2.4 – Investible grade attributes? What does that mean?

Like we discussed briefly in the previous chapter, an investible grade company has a
few distinguishable characteristics. These characteristics can be classified under two
heads namely the ‘Qualitative aspect’ and the ‘Quantitative aspects’. The process of
evaluating a fundamentally strong company includes a study of both these aspects.
In fact in my personal investment practice, I give the qualitative aspects a little more
importance over the quantitative aspects.
The Qualitative aspect mainly involves understanding the non numeric aspects of
the business. This includes many factors such as:
1. Management’s background – Who are they, their background, experience,

education, do they have the merit to run the business, any criminal cases against
the promoters etc
2. Business ethics – is the management involved in scams, bribery, unfair business
practices
3. Corporate governance – Appointment of directors, organization structure,
transparency etc
4. Minority shareholders – How does the management treat minority shareholders,
do they consider their interest while taking corporate actions
5. Share transactions – Is the management buying/selling shares of the company
through clandestine promoter groups
6. Related party transactions – Is the company tendering financial favors to known
entities such as promoter’s relatives, friends, vendors etc at the cost of the
shareholders funds?
7. Salaries paid to promoters – Is the management paying themselves a hefty salary,
usually a percentage of profits
8. Operator activity in stocks – Does the stock price display unusual price behavior
especially at a time when the promoter is transacting in the shares
11
9. Shareholders – Who are the significant shareholders in the firm, who are the
people with above 1% of the outstanding shares of the company
10. Political affiliation – Is the company or its promoters too close to a political party?
Does the business require constant political support?
11. Promoter lifestyle – Are the promoters too flamboyant and loud about their
lifestyle? Do they like to display their wealth?
A red flag is raised when any of the factors mentioned above do not fall in the right
place. For example, if a company undertakes too many related party transactions
then it would send a signal of favoritism and malpractice by the company. This is
not good in the long run. So even if the company has great profit margins,
malpractice is not acceptable. It would only be a matter of time before the market
discovers matters pertaining to ‘related party transactions’ and punishes the
company by bringing the stock price lower. Hence an investor would be better off
not investing in companies with great margins if such a company scores low on
corporate governance.
Qualitative aspects are not easy to uncover because these are very subtle matters.
However a diligent investor can easily figure this out by paying attention to annual
report, management interviews, news reports etc. As we proceed through this
module we will highlight various qualitative aspects.
The quantitative aspects are matters related to financial numbers. Some of the
quantitative aspects are straightforward while some of them are not. For example
cash held in inventory is straight forward however ‘inventory number of days’ is not.
This is a metric that needs to be calculated. The stock markets pay a lot of attention
to quantitative aspects. Quantitative aspects include many things, to name few:
1. Profitability and its growth

2. Margins and its growth
3. Earnings and its growth
4. Matters related to expenses
5. Operating efficiency
6. Pricing power
7. Matters related to taxes
8. Dividends payout
9. Cash flow from various activities
10. Debt – both short term and long term
11. Working capital management
12. Asset growth
13. Investments
14. Financial Ratios
12
The list is virtually endless. In fact, each sector has different metrics. For example:
For a retail Industry: For an Oil and Gas Industry:
1. Total number of stores 1. Oil to Natural Gas revenue ratio

2. Average sales per store 2. Exploration costs
3. Total sales per square foot 3. Opening oil balance (inventory)
4. Merchandise margins 4. Developed reserves
5. Owned store to franchisee ratio 5. Total production growth
Over the next few chapters we will understand how to read the basic financial
statements, as published in the annual report. As you may know, the financial
statement is the source for all the number crunching as required in the analysis of
quantitative aspects.
Key takeaways from this chapter:
1. The mindset of a trader and an investor is different

2. The investor has to develop an investment mindset if he is serious about investing
3. The investor should stay invested for a long period of time for the returns to
compound
4. The speed at which the money doubles increases drastically the more time you stay
invested. This is one of the properties of compounding
5. Every investment has to be evaluated on two aspects – qualitative & quantitative
6. Qualitative aspects revolve around the non numeric information related to the
company
7. The quantitative aspects involve analyzing numeric data. The financial statements
are the important source of finding the quantitative data.
13
Chapter 3
How to Read the Annual Report of a

Company
71
3.1 – What is an Annual Report?

The annual report (AR) is a yearly publication by the company and is sent to the
shareholders and other interested parties. The annual report is published by the
end of the Financial Year, and all the data made available in the annual report is
dated to 31st March. The AR is usually available on the company’s website (in the
investors section) as a PDF document or one can contact the company to get a hard
copy of the same.
Since the annual report is published by the company, whatever is mentioned in the
AR is assumed to be official. Hence, any misrepresentation of facts in the annual
report can be held against the company. To give you a perspective, AR contains the
auditor’s certificates (signed, dated, and sealed) certifying the sanctity of the
financial data included in the annual report.
Potential investors and the present shareholders are the primary audience for the
annual report. Annual reports should provide the most pertinent information to an
investor and should also communicate the company’s primary message. For an
investor, the annual report must be the default option to seek information about a
company. Of course there are many media websites claiming to give the financial
14
information about the company; however the investors should avoid seeking
information from such sources. Remember the information is more reliable if we
get it get it directly from the annual report.
Why would the media website misrepresent the company information you may ask?
Well, they may not do it deliberately but they may be forced to do it due to other
factors. For example the company may like to include ‘depreciation’ in the expense
side of P&L, but the media website may like to include it under a separate header.
While this would not impact the overall numbers, it does interrupt the overall
sequencing of data.
3.2 – What to look for in an Annual Report?

The annual report has many sections that contain useful information about the
company. One has to be careful while going through the annual report as there is a
very thin line between the facts presented by the company and the marketing
content that the company wants you to read.
Let us briefly go through the various sections of an annual report and understand
what the company is trying to communicate in the AR. For the sake of illustration, I
have taken the Annual Report of Amara Raja Batteries Limited, belonging to
Financial Year 2013-2014. As you may know Amara Raja Batteries Limited
manufactures automobile and industrial batteries. You can download ARBL’s FY2014
AR from here (http://www.amararaja.co.in/annual_reports.asp)
Please remember, the objective of this chapter is to give you a brief orientation on
how to read an annual report. Running through each and every page of an AR is not
practical; however, I would like to share some insights into how I would personally
read through an AR, and also help you understand what kind of information is
required and what information we can ignore.
For a better understanding, I would urge you to download the Annual Report of
ARBL and go through it simultaneously as we progress through this chapter.
ARBL’s annual report contains the following 9 sections:
o Financial Highlights
o The Management Statement
o Management Discussion & Analysis
o 10 year Financial highlights
o Corporate Information
o Director’s Report
o Report on Corporate governance
o Financial Section, and
15
o Notice
Note, no two annual reports are the same; they are all made to suite the company’s
requirement keeping in perspective the industry they operate in. However, some of
the sections in the annual report are common across annual reports.
The first section in ARBL’s AR is the Financial Highlights. Financial Highlights

contains the bird’s eye view on how the financials of the company looks for the year
gone by. . The information in this section can be in the form of a table or a graphical
display of data. This section of the annual report generally does a multi-year
comparison of the operating and business metrics.
Here is the snapshot of the same:
The details that you see in the Financial Highlights section are basically an extract
from the company’s financial statement. Along with the extracts, the company can
also include a few financial ratios, which are calculated by the company itself. I
briefly look through this section to get an overall idea, but I do not like to spend too
much time on it. The reason for looking at this section briefly is that, I would anyway
calculate these and many other ratios myself and while I do so, I would gain greater
clarity on the company and its numbers. Needless to say, over the next few chapters
we will understand how to read and understand the financial statements of the
company and also how to calculate the financial ratios.
The next two sections i.e the ‘Management Statement’ and ‘Management
Discussion & Analysis’ are quite important. I spend time going through these
sections. Both these sections gives you a sense on what the management of the
company has to say about their business and the industry in general. As an investor
or as a potential investor in the company, every word mentioned in these sections is
16
important. In fact some of the details related to the ‘Qualitative aspects’ (as
discussed in chapter 2), can be found in these two sections of the AR.
In the ‘Management Statement’ (sometimes called the Chairman’s Message), the

investor gets a perspective of how the man sitting right on top is thinking about his
business. The content here is usually broad based and gives a sense on how the
business is positioned. When I read through this section, I look at how realistic the
management is. I am very keen to see if the company’s management has its feet on
the ground. I also observe if they are transparent on discussing details on what
went right and what went wrong for the business.
One example that I explicitly remember was reading through the chairman’s
message of a well established tea manufacturing company. In his message, the
chairman was talking about a revenue growth of nearly 10%, however the historical
revenue numbers suggested that the company’s revenue was growing at a rate of 4-
5%. Clearly in this context, the growth rate of 10% seemed like a celestial move. This
also indicated to me that the man on top may not really be in sync with ground
reality and hence I decided not to invest in the company. Retrospectively when I
look back at my decision not to invest, it was probably the right decision.
Here is the snapshot of Amara Raja Batteries Limited; I have highlighted a small part
that I think is interesting. I would encourage you to read through the entire message
in the Annual Report.
17
Moving ahead, the next section is the ‘Management Discussion & Analysis’ or
‘MD&A’. This according to me is perhaps one of the most important sections in the
whole of AR. The most standard way for any company to start this section is by
talking about the macro trends in the economy. They discuss the overall economic
activity of the country and the business sentiment across the corporate world. If the
company has high exposure to exports, they even talk about global economic and
business sentiment.
ARBL has both exports and domestic business interest; hence they discuss both
these angles in their AR. See the snapshot below:
18
ARBL’s view on the Indian economy:
19
Following this the companies usually talk about the trends in the industry and what
they expect for the year ahead. This is an important section as we can understand
what the company perceives as threats and opportunities in the industry. Most
importantly I read through this, and also compare it with its peers to understand if
the company has any advantage over its peers.
For example, if Amara Raja Batteries limited is a company of interest to me, I would
read through this part of the AR and also would read through what Exide Batteries
Limited has to say in their AR.
Remember until this point the discussion in the Management Discussion & Analysis
is broad based and generic (global economy, domestic economy, and industry
trends). However going forward, the company would discuss various aspects related
to its business. It talks about how the business had performed across various
divisions, how did it fare in comparison to the previous year etc. The company in
fact gives out specific numbers in this section.
Here is a snapshot of the same:
20
Some companies even discuss their guidelines and strategies for the year ahead
across the various verticals they operate in. Do have a look at the snapshot below:
After discussing these in ‘Management Discussion & Analysis’ the annual report
includes a series of other reports such as – Human Resources report, R&D report,
Technology report etc. Each of these reports are important in the context of the
21
industry the company operates in. For example, if I am reading through a
manufacturing company annual report, I would be particularly interested in the
human resources report to understand if the company has any labor issues. If there
are serious signs of labor issues then it could potentially lead to the factory being
shut down, which is not good for the company’s shareholders.
3.3 – The Financial Statements

Finally, the last section of the AR contains the financial statements of the company.
As you would agree, the financial statements are perhaps one of the most
important aspects of an Annual Report. There are three financial statements that
the company will present namely:
1. The Profit and Loss statement

2. The Balance Sheet and
3. The Cash flow statement
We will understand each of these statements in detail over the next few chapters.
However at this stage it is important to understand that the financial statements
come in two forms.
1. Standalone financial statement or simply standalone numbers and

2. Consolidated financial statement or simply consolidated numbers
To understand the difference between standalone and consolidated numbers, we
need to understand the structure of a company.
Typically, a well established company has many subsidiaries. These companies also
act as a holding company for several other well established companies. To help you
understand this better, I have taken the example of CRISIL Limited’s shareholding
structure. You can find the same in CRISIL’s annual report. As you may know, CRISIL
is an Indian company with a major focus on corporate credit rating services.
22
As you can see in the above share holding structure:
1. Standard & Poor’s (S&P), a US based rating agency holds a 51% stake in CRISIL.
Hence S&P is the ‘Holding company’ or the ‘Promoter’ of CRISIL
2. The balance 49% of shares of CRISIL is held by Public and other Financial institutions
3. However, S&P itself is 100% subsidiary of another company called ‘The McGraw-Hill
Companies’
1. This means McGraw Hill fully owns S&P, and S&P owns 51% of CRISIL
4. Further, CRISIL itself fully owns (100% shareholding) another company called
‘Irevna’.
Keeping the above in perspective, think about this hypothetical situation. Assume,
for the financial year 2014, CRISIL makes a loss of Rs.1000 Crs and Irevna, its 100%
subsidiary makes a profit of Rs.700 Crs. What do you would be the overall
profitability of CRISIL?
Well, this is quite simple – CRISIL on its own made a loss of Rs.1000 Crs, but its
subsidiary Irevna made a profit of Rs.700 Crs, hence the overall P&L of CRISIL is
(Rs.1000 Crs) + Rs.700 Crs = (Rs.300 Crs).
Thanks to its subsidiary, CRISIL’s loss is reduced to Rs.300 Crs as opposed to a

massive loss of Rs.1000 Crs. Another way to look at it is, CRISIL on
a standalone basis made a loss of Rs.1000 Crs, but on a consolidated basis made a
loss of Rs.300 Crs.
23
Hence, Standalone Financial statements represent the standalone numbers/
financials of the company itself and do not include the financials of its subsidiaries.
However the consolidated numbers includes the companies (i.e.standalone
financials) and its subsidiaries financial statements.
I personally prefer to look through the consolidated financial statements as it gives

a better representation of the company’s financial position.
3.4 – Schedules of Financial Statements

When the company reports its financial statements, they usually report the full
statement in the beginning and then follow it up with a detailed explanation.
Have a look at the snapshot of one of ARBL’s financial statement (balance sheet):
Each particular in the financial statement is referred to as the line item. For example
the first line item in the Balance Sheet (under Equity and Liability) is the share
capital (as pointed out by the green arrow). If you notice, there is a note number
associated with share capital. These are called the ‘Schedules’ related to the
financial statement. Looking into the above statement, ARBL states that the share
capital stands at Rs.17.081 Crs (or Rs.170.81 Million). As an investor I obviously
would be interested to know how ARBL arrived at Rs.17.081 Crs as their share
capital. To figure this out, one needs to look into the associated schedule (note
number 2). Please look at the snapshot below:
24
Of course, considering you may be new to financial statements, jargon’s like share
capital make not make much sense. However the financial statements are extremely
simple to understand, and over the next few chapters you will understand how to
read the financial statements and make sense of it. But for now do remember that
the main financial statement gives you the summary and the associated schedules
give the details pertaining to each line item.
1. The Annual Report (AR) of a company is an official communication from the

company to its investors and other stakeholders
2. The AR is the best source to get information about the company; hence AR should
be the default choice for the investor to source company related information
3. The AR contains many sections, with each section highlighting certain aspect of the
business
4. The AR is also the best source to get information related to the qualitative aspects of
the company
5. The management discussion and analysis is one of the most important sections in
the AR. It has the management’s perspective on the overall economy of the country,
their outlook on the industry they operate in for the year gone by (what went right
and what went wrong), and what they foresee for the year ahead
6. The AR contains three financial statements – Profit & Loss statement, Balance Sheet,
and Cash Flow statement
7. The standalone statement contains the financial numbers of only the company in
consideration. However the consolidated numbers contains the company and its
subsidiaries financial numbers.
25
Chapter 4
Understanding the P&L Statement (Part

1)
53
4.1 – Overview of the financial statements

You can think about the financial statements from two different angles:
1. From the maker’s perspective

2. From the user’s perspective
A maker prepares the financial statements. He is typically a person with an
accounting background. His job involves preparing ledger entries, matching bills and
receipts, tallying the inflows versus the outflows, auditing etc. The final objective of
the is to prepare transparent financial statements which best represents the true
financial position of the company. To prepare such a financial statement certain
skills are required, usually these skills are developed through the rigor of a
Chartered Accountant’s training program.
The user on the other hand just needs to be in a position to understand what the
maker has prepared. He is just the user of the financial statements. He need not
really know the details of the journal entries or the audit procedure. His main
concern is to read what is being stated and use it to make his decisions.
To put this in context, think about Google. Most of us do not understand Google’s
complex search engine algorithm that runs in the backend, however we all know
how to use Google effectively. Such is the distinction between the maker and the
user of financial statements.
A common misconception amongst the market participants is that, they believe the
fundamental analyst needs to be thorough with concepts of financial statement
preparation. While knowing this certainly helps, it is not really required. To be a
fundamental analyst, one just needs to be the user and not the maker of the
financial statements.
There are three main financial statements that a company showcases to represent
its performance.
1. The Profit and Loss statement

2. The Balance Sheet
3. The Cash flow statement
26
Over the next few chapters we will understand each of these statements from the
user’s perspective.
4.2 – The Profit and Loss statement

The Profit and Loss statement is also popularly referred to as the P&L statement,
Income Statement, Statement of Operations, and Statement of Earnings. The Profit
and Loss statement shows what has transpired during a time period. The P&L
statement reports information on:
1. The revenue of the company for the given period (yearly or quarterly)
2. The expenses incurred to generate the revenues
3. Tax and depreciation
4. The earnings per share number
From my experience, the financial statements are best understood by looking at the
actual statement and figuring out the information. Hence, here is the P&L statement
of Amara Raja Batteries Limited (ARBL). Let us understand each and every line item.
27
4.3 – The Top Line of the company (Revenue)
You may have heard analysts talk about the top line of a company. When they do
so, they are referring to the revenue side of the P&L statement. The revenue side is
the first set of numbers the company presents in the P&L.
Before we start understanding the revenue side, let us notice a few things
mentioned on the header of the P&L statement:
The header clearly states:
1. The statement of P&L for the year ending March 31, 2014, hence this is an annual
statement and not a quarterly statement. Also, since it is as of March 31st 2014 it is
evident that the statement is for the Financial Year 2013 – 2014 or simply it can be
referred to as the FY14 numbers
2. All currency is denominated in Rupee Million. Note – 1 Million Rupees is equal to
Ten Lakh Rupees. It is upto the company’s discretion to decide which unit they
would prefer to express their numbers in
3. The particulars show all the main headings of the statement. Any associated note to
the particulars is present in the note section (also called the schedule). An
associated number is assigned to the note (Note Number)
4. By default when companies report the numbers in the financial statement they
present the current year number on the left most column and the previous year
number to the right. In this case the numbers are for FY14 (latest) and FY13
(previous)
The first line item on the revenue side is called the Sale of Products.
28
Since we know we are dealing with a batteries company, clearly sale of products
means the Rupee value of all the battery sales the company has sold during FY14.
The sales stand at Rs.38,041,270,000/- or about Rs.3,804 Crore. The company sold
batteries worth Rs.3,294 Cr in the previous financial year i.e FY13.
Please note, I will restate all the numbers in Rupee Crore as I believe this is more
intuitive to understand.
The next line item is the excise duty. This is the amount (Rs.400 Crs) the company
would pay to the government; hence the revenue has to be adjusted.
The revenue adjusted after the excise duty is the net sales of the company. The
net sales of ARBL is Rs.3403 Crs for FY14. The same was Rs.2943 Crs for FY13.
Apart from the sale of products, the company also draws revenue from services.
This could probably be in the form of annual battery maintenance. The revenue
from sale of services stands at Rs.30.9Crs for FY14.
The company also includes “other operating revenues” at Rs.2.1crs.This could be

revenues through the sale of products or services that is incidental to the core
operations of the company.
Finally the revenue from Sale of products + Sale of services + Other operating
revenues sums up to give the total operating revenue of the company. This is
reported at Rs.3436 Crs for FY14 and Rs.2959Crs for FY13. Interesting, there is a
note; numbered 17 associated with “Net Revenue from Operations” which will help
us inspect this aspect further.
Do recall, in the previous chapter we had discussed about notes and schedules of
the financial statement.
The following snapshot gives the details of note 17.
29
Clearly, the notes give a more detailed analysis of the split up of revenues from
operations (does not include other income details). As you can see under the
particulars, section ‘a’ talks about the split up under sales of products.
1. Sale of storage batteries in the form of finished goods for the year FY14 is Rs.3523
Crs versus Rs.3036 Crs in FY13
2. Sale of Storage batteries (stock in trade) is Rs.208 Crs in FY14 versus 149 Crs. Stock
in trade refers to finished goods of previous financial year being sold in this financial
year
3. Sale of home UPS (stock in goods) is at Rs.71 Crs in FY14 versus Rs.109 Crs FY13
4. Net sales from sales of products adjusted for excise duty amounts to Rs.3403 Crs,
which matches with the number reported in the P&L statement
5. Likewise you can notice the split up for revenue from services. The revenue number
of Rs.30.9 tallies with number reported in the P&L statement
6. In the note, the company says the “Sale of Process Scrap” generated revenue of
Rs.2.1 Cr. Note that the sale of process scrap is incidental to the operations of the
company, hence reported as ‘Other operating revenue”.
7. Adding up all the revenue streams of the company i.e Rs.3403 Crs+ Rs.30.9 Crs
+Rs.2.1 Crs gets us the Net revenue from operations = Rs.3436 Crs.
8. You can also find similar split up for FY13
If you notice the P&L statement, apart from net revenue from operations ARBL also
reports ‘Other Income’ of Rs.45.5 Crs. Note number 18 reproduced below explains
what the other income is all about.
30
As we can see the other income includes income that is not related to the main
business of the company. It includes interest on bank deposits, dividends, insurance
claims, royalty income etc. Usually the other income forms (and it should) a small
portion of the total income. A large ‘other income’ usually draws a red flag and it
would demand a further investigation.
So adding up revenue from operations (Rs.3436 Crs) and other income (Rs.45 Crs),
we have the total revenue of for FY14 at Rs.3482Crs.
1. The financial statement provides information and conveys the financial position of
the company
2. A complete set of financial statements include the Profit & Loss Account, Balance
Sheet and Cash Flow Statement
3. A fundamental Analyst is a user of financial statement, and he just needs to know
what the maker of the financial statements states
4. The profit and loss statement gives the profitability of the company for the year
under consideration
5. The P&L statement is an estimate, as the company can revise the numbers at a later
point. Also by default companies publish data for the current year and the previous
year, side by side
6. The revenue side of the P&L is also called the top line of the company
7. Revenue from operations is the main source of revenue for the company
8. Other operating income includes revenue incidental to the business
31
9. The other income includes revenue from non operating sources
10. The sum of revenue from operations (net of duty), other operating income, and
other incomes gives the ‘Net Revenue from Operations’
32
Chapter 5
Understanding P&L Statement (Part 2)

121
5.1 – The Expense details

In the previous chapter we had learnt about the revenues a company generates.
Moving further on the P&L statement, in this chapter we will look at the expense
side of the Profit and Loss Statement along with the associated notes. Expenses are
generally classified according to their function, which is also called the cost of sales
method or based on the nature of expense. An analysis of the expenses must be
shown in the Profit and Loss statement or in the notes. As you can see in the extract
below almost all the line items have a note associated to it.
The first line item on the expense side is ‘Cost of materials consumed’; this is
invariably the cost of raw material that the company requires to manufacture
33
finished goods. As you can see the cost of raw material consumed/raw material is
the largest expense incurred by the company. This expense stands at Rs.2101 Crs
for the FY14 and Rs.1760 Crs for the FY13. Note number 19 gives the associated
details for this expense, let us inspect the same.
As you can see note 19 gives us the details of the material consumed. The company
uses lead, lead alloys, separators and other items all of which adds up to Rs.2101
Crs.
The next two line items talks about ‘Purchases of Stock in Trade’ and ‘Change in
Inventories of finished goods , work–in-process & stock–in-trade’. Both these line
items are associated with the same note (Note 20).
Purchases of stock in trade, refers to all the purchases of finished goods that the
company buys towards conducting its business. This stands at Rs.211 Crs. I will give
you more clarity on this line item shortly.
Change in inventory of finished goods refers to the costs of manufacturing incurred

by the company in the past , but the goods manufactured in the past were sold in
the present/current financial year. This stands at (Rs.29.2) Crs for the FY14.
A negative number indicates that the company produced more batteries in the FY14
than it managed to sell. To give a sense of proportion (in terms of sales and costs of
sales) the company deducts the cost incurred in manufacturing the extra goods
from the current year costs. The company will add this cost when they manage to
sell these extra products sometime in future. This cost, which the company adds
back later, will be included in the “Purchases of Stock in Trade” line item.
Here is an extract of Note 20 which details the above two line items:
34
The details mentioned on the above extract are quite straightforward and is easy to
understand. At this stage it may not be necessary to dig deeper into this note. It is
good to know where the grand total lies. However, when we take up ‘Financial
Modeling’ as a separate module we will delve deeper into this aspect.
The next line item on the expense side is “Employee Benefit Expense”. This is quite
intuitive as it includes expense incurred in terms of the salaries paid, contribution
towards provident funds, and other employee welfare expenses. This stands at
Rs.158 Crs for the FY14. Have a look at the extract of note 21 which details the
‘Employee Benefit Expense’.
Here is something for you to think about – A company generating Rs.3482 Crs is
spending only Rs.158 Crs or just 4.5% of its sales on its employees. In fact this is the
pattern across most of companies (at least non IT). Perhaps it is time for you to
rethink about that entrepreneurial dream you may have nurtured.
The next line item is the “Finance Cost / Finance Charges/ Borrowing Costs”. Finance
cost is interest costs and other costs that an entity pays when it borrows funds. The
35
interest is paid to the lenders of the company. The lenders could be banks or private
lenders. The company’s finance cost stands at Rs.0.7 Crs for the FY14. We will
discuss more about the debt and related matters when we take up the chapter on
the balance sheet later.
Following the finance cost the next line item is “Depreciation and Amortization”
costs which stand at Rs.64.5 Crs. To understand depreciation and amortization we
need to understand the concept of tangible and intangible assets.
A tangible asset is one which has a physical form and provides an economic value to
the company. For example a laptop, a printer, a car, plants, machinery, buildings etc.
An intangible asset is something that does not have a physical form but still
provides an economic value to the company such as brand value, trademarks,
copyrights, patents, franchises, customer lists etc.
An asset (tangible or intangible) has to be depreciated over its useful life. Useful life
is defined as the period during which the asset can provide economic benefit to the
company. For example the useful life of a laptop could be 4 years. Let us
understand depreciation better with the help of the following example.
Zerodha, a stock broking firm generates Rs.100,000/- from the stock broking
business. However Zerodha incurred an expense of Rs.65,000/- towards the
purchase of a high performance computer server. The economic life (useful life) of
the server is expected to be 5 years. Now if you were to look into the earning
capability of Zerodha it appears that on one hand Zerodha earned Rs.100,000/- and
on the other hand spent Rs.65,000/- and therefore retained just Rs.35,000/-. This
skews the earnings data for the current year and does not really reflect the true
earning capability of the company.
Remember the asset even though purchased this year, would continue to provide
economic benefits over its useful life. Hence it makes sense to spread the cost of
acquiring the asset over its useful life. This is called depreciation. This means
instead of showing an upfront lump sum expense (towards purchase of an asset),
the company can show a smaller amount spread across the useful life of an asset.
Thus Rs.65,000/- will be spread across the useful life of the server, which is 5. Hence
65,000/ 5 = Rs.13,000/- would be depreciated every year over the next five years. By
depreciating the asset, we are spreading the upfront cost. Hence after the
depreciation computation, Zerodha would now show its earrings as Rs.100,000 –
Rs.13,000 = Rs.87,000/-.
We can do a similar exercise for non tangible assets. The depreciation equivalent for
non tangible assets is called amortization.
Now here is an important idea – Zerodha depreciates the cost of acquiring an asset
over its useful life. However, in reality there is an actual outflow of Rs.65,000/- paid
36
towards the asset purchase. But now, it seems like the P&L is not capturing this
outflow. As an analyst, how do we get a sense of the cash movement? Well, the cash
movement is captured in the cash flow statement, which we will understand in the
later chapters.
Here is the snapshot of Note 23, detailing the depreciation cost.
The last line item on the expense side is “other expenses” at Rs.434.6 Crs. This is a
huge amount classified under ‘other expenses’, hence it deserves a detailed
inspection.
37
From the note it is quite clear that other expenses include manufacturing, selling,
administrative and other expenses. The details are mentioned in the note. For
example, Amara Raja Batteries Limited (ARBL) spent Rs.27.5 Crs on advertisement
and promotional activities.
Adding up all the expenses mentioned in the expense side of P&L, it seems that
Amara Raja Batteries has spent Rs.2941.6 Crs.
5.2 – The Profit before tax

It refers to the net operating income after deducting operating expenses but before
deducting taxes and interest. Proceeding further on the P&L statement we can see
that ARBL has mentioned their profit before tax and exceptional item numbers.
Simply put the profit before tax (PBT) is:
Profit before Tax = Total Revenues – Total Operating Expenses
= Rs.3482 – Rs.2941.6
=Rs.540.5
However there seems to be an exceptional item/ extraordinary item of Rs.3.8 Crs,

which needs to be deducted. Exceptional items/ extraordinary items are expenses
38
occurring at one odd time for the company and the company does not foresee this
as a recurring expense. Hence they treat it separately on the P&L statement.
Hence profit before tax and extraordinary items will be:
= 540.5 – 3.88
= Rs.536.6 Crs
The snapshot below (extract from P&L) shows the PBT(Profit Before Tax) of ARBL:
5.3 – Net Profit after tax

The net operating profit after tax is defined as the company’s operating profit after
deducting its tax liability. We are now looking into the last part of the P&L
statement, which is the profit after tax. This is also called the bottom line of the P&L
statement.
As you can see from the snapshot above, to arrive at the profit after tax (PAT) we
need to deduct all the applicable tax expenses from the PBT. Current tax is the
corporate tax applicable for the given year. This stands at Rs.158 Crs. Besides this,
there are other taxes that the company has paid. All taxes together total upto
Rs.169.21 Crs. Deducting the tax amount from the PBT of Rs.536.6 gives us the
profit after tax (PAT) at Rs.367.4 Crs.
Hence Net PAT = PBT – Applicable taxes.
The last line in the P&L statement talks about basic and diluted earnings per share.
The EPS is one of the most frequently used statistics in financial analysis. EPS also
serves as a means to assess the stewardship and management role performed by
the company directors and managers. The earnings per share (EPS) is a very sacred
number which indicates how much the company is earning per face value of the
ordinary share. It appears that ARBL is earning Rs.21.51 per share. The detailed
calculation is as shown below:
39
The company indicates that there are 17,08,12,500 shares outstanding in the
market. Dividing the total profit after tax number by the outstanding number of
shares, we can arrive at the earnings per share number. In this case:
Rs.367.4 Crs divided by 17,08,12,500 yields Rs.21.5 per share.
5.4 – Conclusion
Now that we have gone through all the line items in the P&L statement let us relook
at it in its entirety.
40
Hopefully, the statement above should look more meaningful to you by now.
Remember almost all line items in the P&L statement will have an associated note.
You can always look into the notes to seek greater clarity. Also at this stage we have
just understood how to read the P&L statement, but we still need to analyze what
the numbers mean. We will do this when we take up the financial ratios. Also, the
P&L statement is very closely connected with the other two financial statements i.e
the balance sheet and the cash flow statement. We will explore these connections at
a later stage.
1. The expense part of the P&L statement contains information on all the expenses
incurred by the company during the financial year
2. Each expense can be studied with reference to a note which you can explore for
further information
41
3. Depreciation and amortization is way of spreading the cost of an asset over its
useful life
4. Finance cost is the cost of interest and other charges paid when the company
borrows money for its capital expenditure.
5. PBT = Total Revenue – Total Expense – Exceptional items (if any)
6. Net PAT = PBT – applicable taxes
7. EPS reflects the earning capacity of a company on a per share basis. Earnings are
profit after tax and preferred dividends.
8. EPS = PAT / Total number of outstanding ordinary shares
42
Chapter 6
Understanding Balance Sheet Statement

(Part 1)
132
6.1 – The balance sheet equation

While the P&L statement gives us information pertaining to the profitability of the
company, the balance sheet gives us information pertaining to the assets, liabilities,
and the shareholders equity. The P&L statement as you understood, discusses
about the profitability for the financial year under consideration, hence it is good to
say that the P&L statement is a standalone statement. The balance sheet however is
prepared on a flow basis, meaning, it has financial information pertaining to the
company right from the time it was incorporated. Thus while the P&L talks about
how the company performed in a particular financial year; the balance sheet on the
other hand discusses how the company has evolved financially over the years.
Have a look at the balance sheet of Amara Raja Batteries Limited (ARBL):
43
As you can see the balance sheet contains details about the assets, liabilities, and
equity.
We had discussed about assets in the previous chapter. Assets, both tangible and
intangible are owned by the company. An asset is a resource controlled by the
company, and is expected to have an economic value in the future. Typical
examples of assets include plants, machinery, cash, brands, patents etc. Assets are
of two types, current and non-current, we will discuss these later in the chapter.
Liability on the other hand represents the company’s obligation. The obligation is
taken up by the company because the company believes these obligations will
provide economic value in the long run. Liability in simple words is the loan that the
company has taken and it is therefore obligated to repay back. Typical examples of
obligation include short term borrowing, long term borrowing, payments due etc.
Liabilities are of two types namely current and non-current. We will discuss about
the kinds of liabilities later on in the chapter.
In any typical balance sheet, the total assets of company should be equal to the
total liabilities of the company. Hence,
44
Assets = Liabilities
The equation above is called the balance sheet equation or the accounting
equation. In fact this equation depicts the key property of the balance sheet i.e the
balance sheet should always be balanced. In other word the Assets of the company
should be equal to the Liabilities of the company. This is because everything that a
company owns (Assets) has to be purchased either from either the owner’s capital
or liabilities.
Owners Capital is the difference between the Assets and Liabilities. It is also called
the ‘Shareholders Equity’ or the ‘Net worth’. Representing this in the form of an
equation :
Share holders equity = Assets – Liabilities
6.2 –A quick note on shareholders’ funds

As we know the balance sheet has two main sections i.e. the assets and the
liabilities. The liabilities as you know represent the obligation of the company. The
shareholders’ fund, which is integral to the liabilities side of the balance sheet, is
highlighted in the snapshot below. Many people find this term a little confusing.
If you think about it, on one hand we are discussing about liabilities which represent
the obligation of the company, and on the other hand we are discussing the
shareholders’ fund which represents the shareholders’ wealth. This is quite counter
intuitive isn’t it? How can liabilities and shareholders’ funds appear on the ‘Liabilities’
side of balance sheet? After all the shareholders funds represents the funds
belonging to its shareholders’ which in the true sense is an asset and not really a
liability.
45
To make sense of this, you should change the perceptive in which you look at a
company’s financial statement. Think about the entire company as an individual,
whose sole job is run its core operation and to create wealth to its shareholders’. By
thinking this way, you are in fact separating out the shareholders’ (which also
includes its promoters) and the company. With this new perspective, now think
about the financial statement. You will appreciate that, the financial statements is a
statement published by the company (which is an entity on its own) to communicate
to the world about its financial well being.
This also means the shareholders’ funds do not belong to the company as it
rightfully belongs to the company’s shareholders’. Hence from the company’s
perspective the shareholders’ funds are an obligation payable to shareholders’.
Hence this is shown on the liabilities side of the balance sheet.
6.3 –The liability side of balance sheet

The liabilities side of the balance sheet details out all the liabilities of the company.
Within liabilities there are three sub sections – shareholders’ fund, non-current
liabilities, and current liabilities. The first section is the shareholders’ funds.
To understand share capital, think about a fictional company issuing shares for the
first time. Imagine, Company ABC issues 1000 shares, with each share having a face
value of Rs.10 each. The share capital in this case would be Rs.10 x 1000 =
Rs.10,000/- (Face value X number of shares).
In the case of ARBL, the share capital is Rs.17.081 Crs (as published in the Balance
Sheet) and the Face Value is Rs.1/-. I got the FV value from the NSE’s website:
46
I can use the FV and share capital value to calculate the number of shares
outstanding. We know:
Share Capital = FV * Number of shares
Therefore,
Number of shares = Share Capital / FV
Hence in case of ARBL,
Number of shares = 17,08,10,000 / 1
= 17,08,10,000 shares
The next line item on the liability side of the Balance Sheet is the ‘Reserves and
Surplus’. Reserves are usually money earmarked by the company for specific
purposes. Surplus is where all the profits of the company reside. The reserves and
surplus for ARBL stands at Rs.1,345.6 Crs. The reserves and surplus have an
associated note, numbered 3. Let us look into the same.
47
As you can notice from the note, the company has earmarked funds across three
kinds of reserves:
1. Capital reserves – Usually earmarked for long term projects. Clearly ARBL does not
have much amount here. This amount belongs to the shareholders, but cannot be
distributed to them.
2. Securities premium reserve / account – This is where the premium over and
above the face/par value of the shares sits. ARBL has a Rs.31.18 Crs under this
reserve
3. General reserve – This is where all the accumulated profits of the company which is
not yet distributed to the shareholder reside. The company can use the money here
as a buffer. As you can see ARBL has Rs.218.4 Crs in general reserves.
The next section deals with the surplus. As mentioned earlier, surplus holds the
profits made during the year. Couple of interesting things to note:
1. As per the last year (FY13) balance sheet the surplus was Rs.829.8Crs. This is what is stated as
the opening line under surplus. See the image below:
48
1. The current year (FY14) profit of Rs.367.4 Crs is added to previous years closing
balance of surplus. Few things to take note here:
1. Notice how the bottom line of P&L is interacting with the balance sheet. This highlights a very
important fact – all the three financial statements are closely related
2. Notice how the previous year balance sheet number is added up to this year’s number. This
highlights the fact that the balance sheet is prepared on a flow basis, adding the carrying
forward numbers year on year
2. Previous year’s balance plus this year’s profit adds up to Rs.1197.2 Crs. The
company can choose to apportion this money for various purposes.
1. The first thing a company does is it transfers some money from the surplus to general reserves
so that it will come handy for future use. They have transferred close to Rs.36.7 Crs for this
purpose
2. After transferring to general reserves they have distributed Rs.55.1 Crs as dividends over which
they have to pay Rs.9.3 Crs as dividend distribution taxes.
3. After making the necessary apportions the company has Rs.1095.9 Crs as surplus as
closing balance. This as you may have guessed will be the opening balance for next
year’s (FY15) surplus account.
4. Total Reserves and Surplus = Capital reserve + securities premium reserve + general
reserves + surplus for the year. This stands at Rs.1345.6 Crs for the FY 14 against
Rs.1042.7 Crs for the FY13
The total shareholders’ fund is a sum of share capital and reserves & surplus. Since
this amount on the liability side of the balance sheet represents the money
belonging to shareholders’, this is called the ‘shareholders funds’.
6.4 – Non Current Liabilities

Non-current liabilities represent the long term obligations, which the company
intends to settle/ pay off not within 365 days/ 12 months of the balance sheet date.
These obligations stay on the books for few years. Non-current liabilities are
generally settled after 12 months after the reporting period.
Here is the snapshot of the non-current liabilities of Amara Raja batteries Ltd.
The company has three types of non-current liabilities; let us inspect each one of
them.
The long term borrowing (associated with note 4) is the first line item within the
non-current liabilities. Long term borrowing is one of the most important line item
in the entire balance sheet as it represents the amount of money that the company
has borrowed through various sources. Long term borrowing is also one of the key
49
inputs while calculating some of the financial ratios. Subsequently in this module we
will look into the financial ratios.
Let us look into the note associated with ‘Long term borrowings’:
From the note it is quite clear that the ‘Long term borrowings’ is in the form of
‘interest free sales tax deferment’. To understand what interest free sales tax
deferment really means, the company has explained just below the note (I have
highlighted the same in a red box). It appears to be some sort of tax incentive from
the state government. The company plans to settle this amount over a period of 14
years.
You will find that there are many companies which do not have long term
borrowings (debt). While it is a good to know that the company has no debt, you
must also question as to why there is no debt? Is it because the banks are refusing
to lend to the company? or is it because the company is not taking initiatives to
expand their business operations. Of course, we will deal with the analysis part of
the balance sheet later in the module.
Do recollect, we looked at ‘Finance Cost’ as a line item when we looked at the P&L
statement. If the debt of the company is high, then the finance cost will also be high.
The next line item within the non-current liability is ‘Deferred Tax Liability’. The
deferred tax liability is basically a provision for future tax payments. The company
foresees a situation where it may have to pay additional taxes in the future; hence
they set aside some funds for this purpose. Why do you think the company would
put itself in a situation where it has to pay more taxes for the current year at some
point in the future?
Well this happens because of the difference in the way depreciation is treated as
per Company’s act and Income tax. We will not get into this aspect as we will digress
from our objective of becoming users of financial statements. But do remember,
deferred tax liability arises due to the treatment of depreciation.
50
The last line item within the non-current liability is the ‘Long term provisions’. Long
term provisions are usually money set aside for employee benefits such as gratuity;
leave encashment, provident funds etc.
6.5 – Current liabilities

Current liabilities are a company’s obligations which are expected to be settled
within 365 days (less than 1 year). The term ‘Current’ is used to indicate that the
obligation is going to be settled soon, within a year. Going by that ‘non-current’
clearly means obligations that extend beyond 365 days.
Think about this way – if you buy a mobile phone on EMI (via a credit card) you
obviously plan to repay your credit card company within a few months. This
becomes your ‘current liability’. However if you buy an apartment by seeking a 15
year home loan from a housing finance company, it becomes your ‘non-current
liability’.
Here is the snapshot of ARBL’s current liabilities:
As you can see there are 4 line items within the current liabilities. The first one is the
short term borrowings. As the name suggests, these are short term obligations of
the company usually undertaken by the company to meet day to day cash
requirements (also called working capital requirements). Here is the extract of note
7, which details what short term borrowings mean:
Clearly as you can see, these are short term loans availed from the State bank of
India and Andhra Bank towards meeting the working capital requirements. It is
interesting to note that the short term borrowing is also kept at low level, at just
Rs.8.3Crs.
51
The next line item is Trade Payable (also called account payable) which is at Rs.127.7
Crs. These are obligations payable to vendors who supply to the company. The
vendors could be raw material suppliers, utility companies providing services,
stationary companies etc. Have a look at note 8 which gives the details:
The next line item just says ‘Other current liabilities’ which stands at Rs.215.6 Crs.
Usually ‘Other current Liabilities’ are obligations associated with the statutory
requirements and obligations that are not directly related to the operations of the
company. Here is note 9 associated with ‘Other current liabilities’:
The last line item in current liabilities is the ‘Short term provisions’ which stands at
Rs.281.8 Crs. Short term provisions is quite similar to long term provisions, both of
which deals with setting aside funds for employee benefits such as gratuity, leave
encashment, provident funds etc. Interestingly the note associated with ‘Short term
Provisions’ and the ‘Long term provisions’ is the same. Have a look at the following:
52
Since note 6 is detailing both long and short term provisions it runs into several
pages, hence for this reason I will not represent an extract of it. For those who are
curious to look into the same can refer to pages 80, 81, 82 and 83 in the FY14
Annual report for Amara Raja Batteries Limited.
However, from the user of a financial statement perspective all you need to know is
that these line items (short and long term provisions) deal with the employee and
related benefits. Please note, one should always look at the associated note to run
through the details.
We have now looked through half of the balance sheet which is broadly classified as
the Liabilities side of the Balance sheet. Let us relook at the balance sheet once
again to get a perspective:
53
Clearly,
Total Liability = Shareholders’ Funds + Non Current Liabilities + Current

Liabilities
= 1362.7 + 143.03 + 633.7
Total Liability = Rs.2139.4 Crs
54
1. A Balance sheet also called the Statement of Financial Position is prepared on a flow
basis which depicts the financial position of the company at any given point in time.
It is a statement which shows what the company owns ( assets) and what the
company owes (liabilities)
2. A business will generally need a balance sheet when it seeks investors, applies for
loans, submits taxes etc.
3. Balance sheet equation is Assets = Liabilities + Shareholders’ Equity
4. Liabilities are obligations or debts of a business from past transactions and Share
capital is number of shares * face value
5. Reserves are the funds earmarked for a specific purpose, which the company
intends to use in future
6. Surplus is where the profits of the company reside. This is one of the points where
the balance sheet and the P&L interact. Dividends are paid out of the surplus
7. Shareholders’ equity = Share capital + Reserves + Surplus. Equity is the claim of the
owners on the assets of the company. It represents the assets that remain after
deducting the liabilities. If you rearrange the Balance Sheet equation, Equity =
Assets – Liabilities.
8. Non-current liabilities or the long term liabilities are obligations which are expected
to be settled in not less than 365 days or 12 months of the balance sheet date
9. Deferred tax liabilities arise due to the discrepancy in the way the depreciation is
treated. Deferred tax liabilities are amounts of income taxes payable in the future
with respect to taxable differences as per accounting books and tax books.
10. Current liabilities are the obligations the company plans to settle within 365 days
/12 months of the balance sheet date.
11. In most cases both long and short term provisions are liabilities dealing with
employee related matters
12. Total Liability = Shareholders’ Funds + Non Current Liabilities + Current Liabilities. .
Thus, total liabilities represent the total amount of money the company owes to
others
55
Chapter 7
Understanding the Balance Sheet

Statement (Part 2)
36
7.1 – The Assets side of Balance Sheet

In the previous chapter we looked at the liability side of the balance sheet in detail.
We will now proceed to understand the 2nd half of the balance sheet i.e the Asset
side of the balance sheet. The Asset side shows us all the assets the company owns
(in different forms) right from its inception. Assets in simple terms are the resources
held by a company, which help in generating the revenues. Here is the snapshot of
the Assets side of the balance sheet:
As you can see the Asset side has two main sections i.e Non-current assets and
Current assets. Both these sections have several line items (with associated notes)
included within. We will look into each one of these line items.
56
7.2 – Non-current assets (Fixed Assets)
Similar to what we learnt in the previous chapter, non-current assets talks about the
assets that the company owns, the economic benefit of which is enjoyed over a long
period (beyond 365 days). Remember an asset owned by a company is expected to
give the company an economic benefit over its useful life.
If you notice within the non-current assets there is a subsection called “Fixed Assets”
with many line items under it. Fixed assets are assets (both tangible and intangible)
that the company owns which cannot be converted to cash easily or which cannot
be liquidated easily. Typical examples of fixed assets are land, plant and machinery,
vehicles, building etc. Intangible assets are also considered fixed assets because
they benefit companies over a long period of time. If you see, all the line items
within fixed assets have a common note, numbered 10, which we will explore in
great detail shortly.
Here is the snapshot of fixed assets of Amara Raja Batteries Limited:
The first line item ‘Tangible Assets’ is valued at Rs.619.8Crs. Tangible assets consists
of assets which has a physical form. In other words these assets can be seen or
touched. This usually includes plant and machinery, vehicles, buildings, fixtures etc.
Likewise the next line item reports the value of Intangible assets valued at Rs.3.2
Crs. Intangible assets are assets which have an economic value, but do not have a
physical nature. This usually includes patents, copyrights, trademarks, designs etc.
57
Remember when we discussed the P&L statement we discussed depreciation.
Depreciation is a way of spreading the cost of acquiring the asset over its useful life.
The value of the assets deplete over time, as the assets lose their productive
capacity due to obsolescence and physical wear and tear. This value is called the
Depreciation expense, which is shown in the Profit and Loss account and the
Balance Sheet.
All the assets should be depreciated over its useful life. Keeping this in perspective,
when the company acquires an asset it is called the ‘Gross Block’. Depreciation
should be deducted from the Gross block, after which we can arrive at the ‘Net
Block’.
Net Block = Gross Block –Accumulated Depreciation
Note, the term ‘Accumulated’ is used to indicate all the depreciation value since the
incorporation of the company.
When we read tangible assets at Rs.619.8 Crs and Intangible assets at Rs.3.2 Crs, do
remember the company is reporting its Net block, which is Net of Accumulated
depreciation. Have a look at the Note 10, which is associated with fixed assets.
At the top of the note you can see the Gross Block, Depreciation/amortization, and
Net block being highlighted. I have also highlighted two net block numbers which
tallies with what was mentioned in the balance sheet.
Let us look at a few more interesting aspects on this note. Notice under Tangible
assets you can see the list of all the assets the company owns.
58
For example, the company has listed ‘Buildings’ as one of its tangible asset. I have
highlighted this part:-
As of 31st March 2013 (FY13) ARBL reported the value of the building at Rs.93.4 Crs.
During the FY14 the company added Rs.85.8Crs worth of building, this amount is
classified as ‘additions during the year’. Further they also wound up 0.668 Crs worth
of building; this amount is classified as ‘deductions during the year’. Hence the
current year value of the building would be:
Previous year’s value of building + addition during this year – deduction during the
year
93.4 + 85.8 – 0.668
= 178.5Crs
59
You can notice this number being highlighted in blue in the above image. Do
remember this is the gross block of the building. From the gross block one needs to
deduct the accumulated depreciation to arrive at the ‘Net Block’. In the snapshot
below, I have highlighted the depreciation section belonging to the ‘Building’.
As of 31st March 2013 (FY13) ARBL has depreciated Rs.17.2 Crs, to which they need
to add Rs.2.8 Crs belonging to the year FY14, adjust 0.376 Crs as the deduction for
the year. Thus, the Total Depreciation for the year is:-
Previous year’s depreciation value + Current year’s depreciation – Deduction for the
year
= 17.2 + 2.8 – 0.376
Total Depreciation= Rs.19.736 Crs. This is highlighted in red in the image above.
So, we have building gross block at Rs.178.6 Crs and depreciation at Rs.19.73 Crs
which gives us a net block of Rs.158.8 Crs ( 178.6– 19.73). The same has been
highlighted in the image below:
60
The same exercise is carried out for all the other tangible and intangible assets to
arrive at the Total Net block number.
The next two line items under the fixed assets are Capital work in progress (CWIP)
and Intangible assets under development.
CWIP includes building under construction, machinery under assembly etc at the
time of preparing the balance sheet. Hence it is aptly called the “Capital Work in
Progress”. This amount is usually mentioned in the Net block section. CWIP is the
work that is not yet complete but where a capital expenditure has already been
incurred. As we can see, ARBL has Rs.144.3 Crs under CWIP. Once the construction
process is done and the asset is put to use, the asset is moved to tangible assets
(under fixed assets) from CWIP.
The last line item is ‘Intangible assets under development’. This is similar to CWIP
but for intangible assets. The work in process could be patent filing, copyright filing,
brand development etc. This is at a miniscule cost of 0.3 Crs for ARBL. All these costs
are added to arrive at the total fixed cost of the company.
7.3 – Non-current assets (Other line items)

Besides the fixed assets under the non-current assets, there are other line items as
well. Here is a snapshot for the same:
Non-current investments are investments made by ARBL with a long term

perspective. This stands at Rs.16.07 Crs. The investment could be anything – buying
61
listed equity shares, minority stake in other companies, debentures, mutual funds
etc. Here is the partial (as I could not fit the entire image) snapshot of Note 11. This
should give you a perspective.
The next line item is long term loans and advances which stand at Rs.56.7Crs. These
are loans and advances given out by the company to other group companies,
employees, suppliers, vendors etc.
The last line item under the Non-current assets is ‘Other Non-current assets’ which
is at Rs. 0.122 Crs. This includes other miscellaneous long term assets.
62
7.4 – Current assets
Current assets are assets that can be easily converted to cash and the company
foresees a situation of consuming these assets within 365 days. Current assets are
the assets that a company uses to fund its day to day operations and ongoing
expenses.
The most common current assets are cash and cash equivalents, inventories,
receivables, short term loans and advances and sundry debtors.
Here is the snapshot of the current assets of ARBL:
The first line item on the Current assets is Inventory which stands at Rs.335.0 Crs.
Inventory includes all the finished goods manufactured by the company, raw
materials in stock, goods that are manufactured incompletely etc. Inventories are
goods at various stages of production and hence have not been sold. When any
product is manufactured in a company it goes through various processes from raw
material, to work in progress to a finished good. Snapshot of Note 14 associated
with inventory of the company is as shown below:
As you can see, a bulk of the inventory value comes from ‘Raw material’ and ‘Work-
in- progress’.
The next line item is ‘Trade Receivables’ also referred to as ‘Accounts Receivables’.
This represents the amount of money that the company is expected to receive from
its distributors, customers and other related parties. The trade receivable for ARBL
stands at Rs.452.7 Crs.
The next line item is the Cash and Cash equivalents, which are considered the most
liquid assets found in the Balance sheet of any company. Cash comprises of cash on
63
hand and cash on demand. Cash equivalents are short term, highly liquid
investments which has a maturity date of less than three months from its
acquisition date. This stands at Rs.294.5 Crs. Note 16 associated with Cash and bank
balances is as shown below. As you can see the company has cash parked in various
types of accounts.
The next line item is short-term loans and advances, that the company has tendered
and which is expected to be repaid back to the company within 365 days. It includes
various items such as advances to suppliers, loans to customers, loans to
employees, advance tax payments (income tax, wealth tax) etc. This stands at
Rs.211.9 Crs. Following this, is the last line item on the Assets side and infact on the
Balance sheet itself. This is the ‘Other current assets’ which are not considered
important, hence termed ‘Other’. This stands at Rs.4.3 Crs.
To sum up, the Total Assets of the company would now be:-
Fixed Assets + Current Assets
= Rs.840.831 Crs + Rs.1298.61 Crs
= Rs. 2139.441 Crs, which is exactly equal to the liabilities of the company.
With this we have now run through the entire Assets side of the Balance sheet, and
infact the whole of Balance sheet itself. Let us relook at the balance sheet in its
entirety:
64
As you can see in the above, the balance sheet equation holds true for ARBL’s
balance sheet,
Asset = Shareholders’ Funds + Liabilities
Do remember, over the last few chapters we have only inspected the balance sheet
and the P&L statements. However, we have not analyzed the data to infer if the
numbers are good or bad. We will do the same when we look into the financial ratio
analysis chapter.
In the next chapter, we will look into the last financial statement which is the cash
flow statement. However, before we conclude this chapter we must look into the
many ways the Balance sheet and the P&L statement are interconnected.
7.5 – Connecting the P&L and Balance Sheet

Let us now focus on the Balance Sheet and the P&L statement and the multiple
ways they are connected (or affect) to each other.
Have a look at the following image:
65
In the image above, on the left hand side we have the line items on a typical
standard P&L statement. Corresponding to that on the right hand side we have
some of the standard Balance Sheet items. From the previous chapters, you already
know what each of these line items mean. However, we will now understand how
the line items in the P&L and the Balance Sheet are connected to each other.
To begin with, consider the Revenue from Sales. When a company makes a sale it
incurs expenses. For example if the company undertakes an advertisement
campaign to spread awareness about its products, then naturally the company has
to spend cash on the campaign. The money spent tends to decrease the cash
balance. Also, if the company makes a sale on credit, the Receivables (Accounts
Receivables) go higher.
Operating expenses includes purchase of raw material, finished goods and other
similar expenses. When a company incurs these expenses, to manufacture goods
two things happen. One, if the purchase is on credit (which invariably is) then
the Trade payables (accounts payable) go higher. Two, the Inventory level also
gets affected. Whether the inventory value is high or low, depends on how much
time the company needs to sell its products.
When companies purchase Tangible assets or invest in Brand building exercises

(Intangible assets) the company spreads the purchase value of the asset over the
economic useful life of the asset. This tends to increase
the depreciation mentioned in the Balance sheet. Do remember the Balance sheet
is prepared on a flow basis, hence the Depreciation in balance sheet is accumulated
year on year. Please note, Depreciation in Balance sheet is referred to as
the Accumulated depreciation.
Other income includes monies received in the form of interest income, sale of
subsidiary companies, rental income etc. Hence, when companies
undertake investment activities, the other incomes tend to get affected.
As and when the company undertakes Debt (it could be short term or long term),
the company obviously spends money towards financing the debt. The money that
goes towards financing the debt is called the Finance Cost/Borrowing Cost. Hence,
when debt increases the finance cost also increases and vice versa.
66
Finally, as you may recall the Profit after tax (PAT) adds to the surplus of the
company which is a part of the Shareholders equity.
1. The Assets side of the Balance sheet displays all the assets the company owns
2. Assets are expected to give an economic benefit during its useful life
3. Assets are classified as Non-current and Current asset
4. The useful life of Non-current assets is expected to last beyond 365 days or 12
months
5. Current assets are expected to payoff within 365 days or 12 months
6. Assets inclusive of depreciation are called the ‘Gross Block’
7. Net Block = Gross Block – Accumulated Depreciation
8. The sum of all assets should equal the sum of all liabilities. Only then the Balance
sheet is said to have balanced.
9. The Balance sheet and P&L statement are inseparable. They are connected to each
other in many ways.
67
Chapter 8
The Cash Flow statement

73
8.1 – Overview
The Cash flow statement is a very important financial statement, as it reveals how
much cash the company is actually generating. Is this information not revealed in
the P&L statement you may think? Well, the answer is both a yes and a no.
Consider the following scenario.
Assume a simple coffee shop selling coffee and short eats. All the sales the shop
does is mostly on cash basis, meaning if a customer wants to have a cup of coffee
and a snack, he needs to have enough money to buy what he wants. Going by that
on a particular day, assume the shop manages to sell Rs.2,500/- worth of coffee and
Rs.3,000/- worth of snacks. It is evident that the shop’s income is Rs.5,500/- for that
day. Rs.5,500/- is reported as revenues in P&L, and there is no ambiguity with this.
Now think about another business that sells laptops. For sake of simplicity, let us
assume that the shop sells only 1 type of laptop at a standard fixed rate of
Rs.25,000/- per laptop. Assume on a certain day, the shop manages to sells 20 such
laptops. Clearly the revenue for the shop would be Rs.25,000 x 20 = Rs.500,000/-.
But what if 5 of the 20 laptops were sold on credit? A credit sale is when the
customer takes the product today but pays the cash at a later point in time. In this
situation here is how the numbers would look:
Cash sale: 15 * 25000 = Rs.375,000/-
Credit sale: 5 * 25000 = Rs.125,000/-
Total sales: Rs.500,000/-
If this shop was to show its total revenue in its P&L statement, you would just see a
revenue of Rs.500,000/- which may seem good on the face of it. However, how
much of this Rs.500,000/- is actually present in the company’s bank account is not
clear. What if this company had a loan of Rs.400,000/- that had to be repaid back
urgently? Even though the company has a sale of Rs.500,000 it has only Rs.375,000/-
in its account. This means the company has a cash crunch, as it cannot meet its debt
obligations.
The cash flow statement captures this information. A statement of cash flows
should be presented as an integral part of an entity’s financial statements. Hence in
68
this context evaluation of the cash flow statement is highly critical as it reveals
amongst other things, the true cash position of the company.
To sum up, every company’s financial performance is not so much dependent on

the profits earned during a period, but more realistically on liquidity or cash flows.
8.2 – Activities of a company

Before we go ahead to understand the cash flow statement, it is important to
understand ‘the activities’ of a company. If you think about a company and the
various business activities it undertakes, you will realize that the company’s activities
can be classified under one of the three standard baskets. We will understand this
in terms of an example.
Imagine a business, maybe a very well established fitness center (Talwalkars, Gold’s
Gym etc) with a sound corporate structure. What are the typical business activities
you think a fitness center would have? Let me go ahead and list a few business
activities:
1. Display advertisements to attract new customers

2. Hire fitness instructors to help clients in their fitness workout
3. Buy new fitness equipments to replace worn out equipments
4. Seek short term loan from bankers
5. Issue a certificate of deposit for raising funds
6. Issue new shares to a few known friends to raise fresh capital for expansion (also
called preferential allotment)
7. Invest in a startup company working towards innovative fitness regimes
8. Park excess money (if any) in fixed deposits
9. Invest in a building coming up in the neighborhood, for opening a new fitness
center sometime in the future
10. Upgrade the sound system for a better workout experience
69
As you can see the above listed business activities are quite diverse however they
are all related to the business. We can classify these activities as:
1. Operational activities (OA): Activities that are directly related to the daily core
business operations are called operational activities. Typical operating activities
include sales, marketing, manufacturing, technology upgrade, resource hiring etc.
2. Investing activities (IA): Activities pertaining to investments that the company
makes with an intention of reaping benefits at a later stage. Examples include
parking money in interest bearing instruments, investing in equity shares, investing
in land, property, plant and equipment, intangibles and other non current assets etc
3. Financing activities (FA): Activities pertaining to all financial transactions of the
company such as distributing dividends, paying interest to service debt, raising fresh
debt, issuing corporate bonds etc
All activities a legitimate company performs can be classified under one of the
above three mentioned categories.
Keeping the above three activities in perspective, we will now classify each of the
above mentioned activities into one of the three categories /baskets.
1. Display advertisements to attract new customers – OA

2. Hire fitness instructors to help customers with their fitness workout – OA
3. Buy new fitness equipment to replace worn out equipments – OA
4. Seek a short term loan from bankers – FA
5. Issue a certificate of deposit (CD) for raising funds – FA
6. Issue new shares to few known friends to raise fresh capital for expansion (also
called preferential allotment) – FA
7. Invest in a startup company working towards innovative fitness regimes – IA
8. Park excess money (if any) in fixed deposit – IA
9. Invest in a building coming up in the neighborhood for opening a new fitness center
sometime in the future – IA
10. Upgrade the sound system for better workout experience- OA
Now think about the cash moving in and out of the company and its impact on the
cash balance. Each activity that the company undertakes has an impact on cash. For
example “Upgrade the sound system for a better workout experience” means the
company has to pay money towards the purchase of a new sound system, hence
the cash balance decreases. Also, it is interesting to note that the new sound system
itself will be treated as a company asset.
Keeping this in perspective, we will now understand for the example given above
how the various activities listed would impact the cash balance and how would it
impact the balance sheet.
70
Activity Activity Cash
Rational On Balance Sheet
No Type Balance
Expenditure towards Treated as an asset as it increases

01 OA Decreases
advertisement the brand value
Expenditure towards new Treated as an asset as it increases

02 OA Decreases
recruits the company’s intellectual capital
Expenditure towards new

03 OA Decreases Treated as asset
equipment
Loan means cash inflow to

04 FA Increases Loan is a liability
business
Deposits via CD means cash

05 FA Increases CD is a liability
inflow
Issue of fresh capital means cash Treated as a liability as share capital

06 FA Increases
inflow increases
Investment in startup means

07 IA Decreases Investment is an asset
cash outflow
Money parked in FD means cash Equivalent to cash, hence

08 IA Decreases
going out of business considered an asset
Investment in building means

09 IA Decreases Gross block considered an asset
cash going out of business
Expenditure towards the sound

10 OA Decreases Treated as an asset
system
The table above is colour coded:
71
1. Increase in cash is colour coded in blue
2. Decrease in cash is colour coded in red
3. Assets are colour coded in green and
4. Liabilities are colour coded in purple.
If you look through the table and start correlating the ‘Cash Balance’ and
‘Asset/Liability’ you will observe that:
1. Whenever the liabilities of the company increases the cash balance also increases
1. This means if the liabilities decreases, the cash balance also decreases
2. Whenever the asset of the company increases, the cash balance decreases
1. This means if the assets decreases, the cash balance increases
The above conclusion is the key concept while constructing a cash flow statement.
Also, extending this further you will realize that each activity of the company be it
operating activity, financing activity, or investing activity either produces cash (net
increase in cash) or reduces (net decrease in cash)the cash for the company.
Hence the total cash flow for the company will be:-
Cash Flow of the company = Net cash flow from operating activities + Net Cash flow from investing
activities + Net cash flow from financing activities
8.3 – The Cash Flow Statement

Having some insight into the cash flow statement, you would now appreciate the
fact that you need to look into the cash flow statement to review the company from
a cash perspective.
Typically when companies present their cash flow statement they split the
statement into three segments to explicitly show how much cash the company has
generated across the three business activities. Continuing with our example from
the earlier chapters, here is the cash flow statement of Amara Raja Batteries Limited
(ARBL):
72
I will skip going through each line item as most of them are self explanatory,
however I want you to notice that ARBL has generated Rs.278.7 Crs from operating
activities. Note, a company which has a positive cash flow from operating activities
is always a sign of financial well being.
Here is the snapshot of ARBL’s cash flow from investing activities:
As you can see, ARBL has consumed Rs.344.8 Crs in its investing activities. This is
quite intuitive as investing activities tend to consume cash. Also remember healthy
73
investing activities foretells the investor that the company is serious about its
business expansion. Of course how much is considered healthy and how much is
not, is something we will understand as we proceed through this module.
Finally, here is the snapshot of ARBL’s cash balance from financing activities:
ARBL consumed Rs.53.1Crs through its financing activities. If you notice the bulk of
the money went in paying dividends. Also, if ARBL takes on new debt in future it
would lead to an increase in the cash balance (remember increase in liabilities,
increases cash balance). We know from the balance sheet that ARBL did not
undertake any new debt.
Let us summarize the cash flow from all the activities:
Cash Flow from Rupees Crores (2013-14) Rupees Crores (2012-13)
Operating Activities 278.7 335.4
Investing Activities (344.8) (120.05)
Financing Activities (53.1) (34.96)
Total (119.19) 179.986
This means the company consumed a total cash of Rs.119.19 Crs for the financial
year 2013 -2014. Fair enough, but what about the cash from the previous year? As
we can see, the company generated Rs.179.986 Crs through all its activities from the
previous year. Here is an extract from ARBL’s cash flow statement:
74
Look at the section highlighted in green (for the year 2013-14). It says the opening
balance for the year is Rs.409.46Crs. How did they get this? Well, this happens to be
the closing balance for the previous year (refer to the arrow marks). Add to this the
current year’s cash equivalents which is (Rs.119.19) Crs along with a minor forex
exchange difference of Rs.2.58 Crs we get the total cash position of the company
which is Rs.292.86 Crs. This means, while the company guzzled cash on a yearly
basis, they still have adequate cash, thanks to the carry forward from the previous
year.
Note, the closing balance of 2013-14 will now be the opening balance for the FY
2014 – 15. You can watch out for this when ARBL provides its cash flow numbers for
the year ended 31st March 2015.
At this point, let us run through a few interesting questions and answers:
1. What does Rs.292.86 Crs actually state?

1. This literally shows how much cash ARBL has in its various bank accounts
2. What is cash?
1. Cash comprises cash on hand and demand deposits. Obviously, this is a liquid asset of the
company
3. What are liquid assets?
1. Liquid assets are assets that can be easily converted to cash or cash equivalents
4. Are liquid assets similar to ‘current items’ that we looked at in the Balance sheet?
1. Yes, you can think of it that way
5. If cash is current and cash is an asset, shouldn’t it reflect under the current asset on
the Balance sheet?
1. Exactly and here it is. Look at the balance sheet extract below.
75
Clearly, we can now infer that the cash flow statement and the balance sheet
interact with each other. This is in line with what we had discussed earlier i.e all the
three financial statements are interconnected with each other.
8.4 – A brief on the financial statements

Over the last few chapters we have discussed the three important financial
statements of the company i.e the P&L statement, the Balance Sheet and the Cash
Flow statement of the company. While the Cash flow and P&L statement are
prepared on a standalone basis (representing the financial position for the given
year), the Balance Sheet is prepared on a flow basis.
The P&L statement discusses how much the company earned as revenues versus
how much the company expended in terms of expenses. The retained earnings of
the company also called the surplus of the company are carried forward to the
balance sheet. The P&L also incorporates the depreciation number. The
depreciation mentioned in the P&L statement is carried forward to the balance
sheet.
The Balance Sheet details the company’s assets and liabilities. On the liabilities side
of the Balance sheet the company represents the shareholders’ funds. The assets
should always be equal to the liabilities, only then do we say the balance sheet has
balanced. One of the key details on the balance sheet is the cash and cash
equivalents of the firm. This number tells us, how much money the company has in
its bank account. This number comes from the cash flow statement.
The cash flow statement provides information to the users of the financial
statements about the entity’s ability to generate cash and cash equivalents as well
as indicates the cash needs of a company. The statement of cash flows are prepared
on a historical basis providing information about the cash and cash equivalents,
classifying cash flows in to operating, financing and investing activities. The final
number of the cash flow tells us how much money the company has in its bank
account.
We have so far looked into how to read the financial statements and what to expect
out of each one of them. We have not yet ventured into how to analyze these
numbers. One of the ways to analyze the financial numbers is by calculating a few
important financial ratios. In fact we will focus on the financial ratios in the next few
chapters.
76
1. The Cash flow statement gives us a picture of the true cash position of the company
2. A legitimate company has three main activities – operating activities, investing
activities and the financing activities
3. Each activity either generates or drains money for the company
4. The net cash flow for the company is the sum of operating activities, investing
activities and the financing activities
5. Investors should specifically look at the cash flow from operating activities of the
company
6. When the liabilities increase, cash level increases and vice versa
7. When the assets increase, cash level decreases and vice versa
8. The net cash flow number for the year is also reflected in the balance sheet
9. The Statement of Cash flow is a useful addition to the financial statements of a
company because it indicates the company’s performance.
77
Chapter 9
The Financial Ratio Analysis (Part 1)

133
9.1 – A note on Financial Ratios

Over the last few chapters we have understood how to read the financial
statements. We will now focus our attention on analyzing these financial
statements. The best way to analyze the financial statements is by studying the
‘Financial Ratios’. The theory of financial ratios was made popular by Benjamin
Graham, who is popularly known as the father of fundamental analysis. Financial
ratios help in interpreting the results, and allows comparison with previous years
and other companies in the same industry.
A typical financial ratio utilizes data from the financial statement to compute its
value. Before we start understanding the financial ratios, we need to be aware of
certain attributes of the financial ratios.
On its own merit, the financial ratio of a company conveys very little information.
For instance, assume Ultratech Cements Limited has a profit margin of 15%, how
useful do you think this information is? Well, not much really. 15% profit margin is
good, but how would I know if it is the best?
However, assume you figure out ACC Cement’s profit margin is 12%. Now, as we
comparing two similar companies, comparing the profitability makes sense. Clearly,
Ultratech Cements Limited seems to be a more profitable company between the
two. The point that I am trying to drive across is that more often than not, Financial
Ratios on its own is quite mute. The ratio makes sense only when you compare the
ratio with another company of a similar size or when you look into the trend of the
financial ratio. This means that once the ratio is computed the ratio has to be
analyzed (either by comparison or tracking the ratio’s historical trend) to get the
best possible inference.
Also, here is something that you need to be aware off while computing ratios.
Accounting policies may vary across companies and across different financial years.
A fundamental analyst should be cognizant of this fact and should adjust the data
accordingly, before computing the financial ratio.
78
9.2 – The Financial Ratios
Financial ratios can be ‘somewhat loosely’ classified into different categories, namely
–
1. Profitability Ratios
2. Leverage Ratios
3. Valuation Ratios
4. Operating Ratios
The Profitability ratios help the analyst measure the profitability of the company.
The ratios convey how well the company is able to perform in terms of generating
profits. Profitability of a company also signals the competitiveness of the
management. As the profits are needed for business expansion and to pay
dividends to its shareholders a company’s profitability is an important consideration
for the shareholders.
The Leverage ratios also referred to as solvency ratios/ gearing ratios measures
the company’s ability (in the long term) to sustain its day to day operations.
Leverage ratios measure the extent to which the company uses the debt to finance
growth. Remember for the company to sustain its operations, it has to pay its bills
and obligations. Solvency ratios help us understand the company’s long term
sustainability, keeping its obligation in perspective.
79
The Valuation ratios compare the stock price of the company with either the
profitability of the company or the overall value of company to get a sense of how
cheap or expensive the stock is trading. Thus this ratio helps us in analysing
whether the current share price of the company is perceived as high or low. In
simpler words, the valuation ratio compares the cost of a security with the perks of
owning the stock.
The Operating Ratios, also called the ‘Activity Ratios’ measures the efficiency at
which a business can convert its assets (both current and noncurrent) into
revenues. This ratio helps us understand how efficient the management of the
company is. For this reason, Operating Ratios are sometimes called the
‘Management Ratios’.
Strictly speaking, ratios (irrespective of the category it belongs to) convey a certain
message, usually related to the financial position of the company. For example,
‘Profitability Ratio’ can convey the efficiency of the company, which is usually
measured by computing the ‘Operating Ratio’. Because of such overlaps, it is difficult
to classify these ratios. Hence the ratios are ‘somewhat loosely’ classified.
9.3 – The Profitability Ratios

We will look into the following ratios under ‘The Profitability Ratio’:
1. EBITDA Margin (Operating Profit Margin)

o EBITDA Growth (CAGR)
2. PAT Margin
o PAT Growth (CAGR)
80
3. Return on Equity (ROE)
4. Return on Asset (ROA)
5. Return on Capital Employed (ROCE)
EBITDA Margin:
The Earnings before Interest Tax Depreciation & Amortization (EBITDA)

Margin indicates the efficiency of the management. It tells us how efficient the
company’s operating model is. EBITDA Margin tells us how profitable (in percentage
terms) the company is at an operating level. It always makes sense to compare the
EBITDA margin of the company versus its competitor to get a sense of the
management’s efficiency in terms of managing their expense.
In order to calculate the EBITDA Margin, we first need to calculate the EBITDA itself.
EBITDA = [Operating Revenues – Operating Expense]
Operating Revenues = [Total Revenue – Other Income]
Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]
EBIDTA Margin = EBITDA / [Total Revenue – Other Income]
Continuing the example of Amara Raja Batteries Limited, the EBITDA Margin
calculation for the FY14 is as follows:
We first calculate EBITDA , which is computed as follows:
[Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation &
Amortization]
Note: Other income is income by virtue of investments and other non operational
activity. Including other income in EBITDA calculation would clearly skew the data.
For this reason, we have to exclude Other Income from Total Revenues.
[3482 – 46] – [2942 – 0.7 – 65]
= [3436] – [2876]
= 560 Crores
Hence the EBITDA Margin is:
560 / 3436
= 16.3%
I have two questions for you at this stage:
81
1. What does an EBITDA of Rs.560 Crs and an EBITDA margin of 16.3% indicate?
2. How good or bad an EBITDA margin of 16.3% is?
The first question is a fairly simple. An EBITDA of Rs.560 Crs means that the
company has retained Rs.560 Crs from its operating revenue of Rs.3436 Crs. This
also means out of Rs.3436 Crs the company spent Rs.2876 Crs towards its expenses.
In percentage terms, the company spent 83.7% of its revenue towards its expenses
and retained 16.3% of the revenue at the operating level, for its operations.
Now for the 2nd question, hopefully you should not have an answer.
Remember we did discuss this point earlier in this chapter. A financial ratio on its
own conveys very little information. To make sense of it, we should either see the
trend or compare it with its peers. Going with this, a 16.3% EBITDA margin conveys
very little information.
To makes some sense of the EBITDA margin, let us look at Amara Raja’s EBITDA
margin trend for the last 4 years, (all numbers in Rs Crs, except EBITDA margin):
Year Operating Revenues Operating Expense EBITDA EBITDA Margin
2011 1761 1504 257 14.6%
2012 2364 2025 340 14.4%
2013 2959 2508 451 15.2%
2014 3437 2876 560 16.3%
It appears that ARBL has maintained its EBITDA at an average of 15%, and in fact on
a closer look it is clear the EBITDA margin is increasing. This is a good sign as it
shows consistency and efficiency in the management’s operational capabilities.
In 2011 the EBITDA was Rs.257 Crs and in 2014 the EBITDA is Rs.560Crs. This
translates to a 4 year EBITDA CAGR growth of 21%.
Please note, we have discussed the formula for CAGR in module 1.
Clearly, it appears that both EBITDA margin and EBITDA growth are quite
impressive. However we still do not know if it is the best. In order to find out if it is
the best one needs to compare these numbers with its competitors. In case of ARBL
82
it would be Exide batteries Limited. I would encourage you to do the same for Exide
and compare the results.
PAT Margin:
While the EBITDA margin is calculated at the operating level, the Profit After Tax
(PAT) margin is calculated at the final profitability level. At the operating level we
consider only the operating expenses however there are other expenses such as
depreciation and finance costs which are not considered. Along with these expenses
there are tax expenses as well. When we calculate the PAT margin, all expenses are
deducted from the Total Revenues of the company to identify the overall
profitability of the company.
PAT Margin = [PAT/Total Revenues]
PAT is explicitly stated in the Annual Report. ARBL’s PAT for the FY14 is Rs.367 Crs on
the overall revenue of Rs.3482 Crs (including other income). This translates to a PAT
margin of:
= 367 / 3482
=10.5 %
Here is the PAT and PAT margin trend for ARBL:
Year PAT (in INR Crs) PAT Margin
2011 148 8.4%
2012 215 8.9%
2013 287 9.6%
2014 367 10.5%
The PAT and PAT margin trend seems impressive as we can clearly see a margin
expansion. The 4 year CAGR growth stands at 25.48%, which is again good. Needless
to say, it always makes sense to compare ratios with its competitors.
Return on Equity (RoE):
83
The Return on Equity (RoE) is a very important ratio, as it helps the investor assess
the return the shareholder earns for every unit of capital invested. RoE measures
the entity’s ability to generate profits from the shareholders investments. In other
words, RoE shows the efficiency of the company in terms of generating profits to its
shareholders. Obviously, higher the RoE, the better it is for the shareholders. In fact
this is one of the key ratios that helps the investor identify investable attributes of
the company. To give you a perspective, the average RoE of top Indian companies
vary between 14 – 16%. I personally prefer to invest in companies that have a RoE of
18% upwards.
This ratio is compared with the other companies in the same industry and is also
observed over time.
Also note, if the RoE is high, it means a good amount of cash is being generated by
the company, hence the need for external funds is less. Thus a higher ROE indicates
a higher level of management performance.
RoE can be calculated as: [Net Profit / Shareholders Equity* 100]
There is no doubt that RoE is an important ratio to calculate, but like any other
financial ratios it also has a few drawbacks. To help you understand its drawbacks,
consider this hypothetical example.
Assume Vishal runs a Pizza store. To bake pizza’s Vishal needs an oven which costs
him Rs.10,000/-. Oven is an asset to Vishal’s business. He procures the oven from his
own funds and seeks no external debt. At this stage you would agree on his balance
sheet he has a shareholder equity of Rs.10,000 and an asset equivalent to Rs.10,000.
Now, assume in his first year of operation, Vishal generates a profit of Rs.2500/-.
What is his RoE? This is quite simple to compute:
RoE = 2500/10000*100
=25.0%.
Now let us twist the story a bit. Vishal has only Rs.8000/- he borrows Rs.2000 from
his father to purchase an oven worth Rs.10000/-. How do you think his balance
sheet would look?
On the liability side he would have:
Shareholder Equity = Rs.8000
Debt = Rs.2000
This makes Vishal’s total liability Rs. 10,000. Balancing this on the asset side, he has
an asset worth Rs.10,000. Let us see how his RoE looks now:
84
RoE = 2500 / 8000*100
= 31.25%
With an additional debt, the RoE shot up quite significantly. Now, what if Vishal had
only Rs.5000 and borrowed the additional Rs.5000 from his father to buy the oven.
His balance sheet would look like this:
Debt = Rs.5000
Vishal’s total liability is Rs. 10,000. Balancing this on the asset side, he has an asset
worth Rs.10,000. Let us see how his RoE looks now:
RoE = 2500 / 5000 *100
=50.0%
Clearly, higher the debt Vishal seeks to finance his asset, (which in turn is required
to generate profits) higher is the RoE. A high RoE is great, but certainly not at the
cost of high debt. The problem is with a high amount of debt, running the business
gets very risky as the finance cost increases drastically. For this reason inspecting
the RoE closely becomes extremely important. One way to do this is by
implementing a technique called the ‘DuPont Model’ also called DuPont Identity.
This model was developed in 1920’s by the DuPont Corporation. DuPont Model
breaks up the RoE formula into three components with each part representing a
certain aspect of business. The DuPont analysis uses both the P&L statement and
the Balance sheet for the computation.
The RoE as per DuPont model can be calculated as:
If you notice the above formula, the denominator and the numerator cancels out
with one another eventually leaving us with the original RoE formula which is:
RoE = Net Profit / Shareholder Equity *100
However in the process of decomposing the RoE formula, we gained insights into
three distinct aspects of the business. Let us look into the three components of the
DuPont model that makes up the RoE formula :
85
o Net Profit Margin = Net Profits/ Net Sales*100
This is the first part of the DuPont Model and it expresses the company’s ability to
generate profits. This is nothing but the PAT margin we looked at earlier in this
chapter. A low Net profit margin would indicate higher costs and increased
competition.
o Asset Turnover = Net Sales / Average Total asset
Asset turnover ratio is an efficiency ratio that indicates how efficiently the company
is using its assets to generate revenue. Higher the ratio, it means the company is
using its assets more efficiently. Lower the ratio, it could indicate management or
production problems. The resulting figure is expressed as number of times per year.
o Financial Leverage = Average Total Assets / Shareholders Equity
Financial leverage helps us answer this question – ‘For every unit of shareholders
equity, how many units of assets does the company have’. For example if the
financial leverage is 4, this means for every Rs.1 of equity, the company supports
Rs.4 worth of assets. Higher the financial leverage along with increased amounts of
debt, will indicate the company is highly leveraged and hence the investor should
exercise caution. The resulting figure is expressed as number of times per year.
As you can see, the DuPont model breaks up the RoE formula into three distinct
components, with each component giving an insight into the company’s operating
and financial capabilities.
Let us now proceed to implement the DuPont Model to calculate Amara Raja’s RoE
for the FY 14. For this we need to calculate the values of the individual components.
Net Profit Margin: As I mentioned earlier, this is same as the PAT margin. From our
calculation earlier, we know the Net Profit Margin for ARBL is 9.2%
Asset Turnover = Net Sales / Average Total assets
We know from the FY14 Annual Report, Net sales of ARBL stands at Rs.3437 Crs.
The denominator has Average Total Assets which we know can be sourced from the
Balance Sheet. But what does the word ‘Average’ indicate?
From ARBL’s balance sheet, the total asset for FY14 is Rs.2139Crs. But think about
this, the reported number is for the Financial Year 2014, which starts from 1st of
April 2013 and close on 31st March 2014. This implies that at the start of the financial
year 2014 (1st April 2013), the company must have commenced its operation with
assets that it carried forward from the previous financial year (FY 2013). During the
financial year (FY 2014) the company has acquired some more assets which when
added to the previous year’s (FY2013) assets totaled to Rs.2139 Crs. Clearly the
company started the financial year with a certain rupee value of assets but closed
the year with a totally different rupee value of assets.
86
Keeping this in perspective, if I were to calculate the asset turnover ratio, which
asset value should I consider for the denominator? Should I consider the asset value
at the beginning of the year or at the asset value at the end of the year? To avoid
confusion, the practice is to take average of the asset values for the two financial
years.
Do remember this technique of averaging line items, as we will be using this across
other ratios as well.
From ARBL’s annual report we know:
Net Sales in FY14 is Rs.3437Crs
Total Assets in FY13 is Rs.1770 Crs
Average Assets = (1770 + 2139) / 2
= 1955
Asset Turnover = 3437 / 1955
= 1.75 times
This means for every Rs.1 of asset deployed, the company is generating Rs.1.75 in
revenues.
We will now calculate the last component that is the Financial Leverage.
Financial Leverage = Average Total Assets / Average Shareholders Equity
We know the average total assets is Rs.1955. We just need to look into the
shareholders equity. For reasons similar to taking the “Average Assets” as opposed
to just the current year assets, we will consider “Average Shareholder equity” as
opposed to just the current year’s shareholder equity.
Shareholders Equity for FY13 = Rs.1059 Crs
Average shareholder equity = Rs.1211 Crs
Financial Leverage = 1955 / 1211
= 1.61 times
87
Considering ARBL has little debt, Financial Leverage of 1.61 is indeed an
encouraging number. The number above indicates that for every Rs.1 of Equity,
ARBL supports Rs.1.61 of assets.
We now have all the inputs to calculate RoE for ARBL, we will now proceed to do the
same:
RoE = Net Profit Margin X Asset Turnover X Financial Leverage
= 9.2% * 1.75 * 1.61
~ 25.9%. Quite impressive I must say!
I understand this is a lengthy way to calculate RoE, but this is perhaps the best way
as in the process of calculating RoE, we can develop valuable insights into the
business. DuPont model not only answers what the return is but also the quality of
the return.
However if you wish do a quick RoE calculation you can do so the following way:
RoE = Net Profits / Avg shareholders Equity
From the annual report we know for the FY14 the PAT is Rs.367 Crs
RoE = 367 / 1211
= 30.31%
Return on Asset (RoA):
Having understood the DuPont Model, understanding the next two ratios should be
simple. Return on Assets (RoA) evaluates the effectiveness of the entity’s ability to
use the assets to create profits. A well managed entity limits investments in non
productive assets. Hence RoA indicates the management’s efficiency at deploying its
assets. Needless to say, higher the RoA, the better it is.
RoA = [Net income + interest*(1-tax rate)] / Total Average Assets
From the Annual Report, we know:
Net income for FY 14 = Rs.367.4 Crs
And we know from the Dupont Model the Total average assets (for FY13 and FY14) =
Rs.1955 Crs
So what does interest *(1- tax rate) mean? Well, think about it, the loan taken by
the company is also used to finance the assets which in turn is used to
generate profits. So in a sense, the debtholders (entities who have given loan to the
company) are also a part of the company. From this perspective the interest paid
88
out also belongs to a stakeholder of the company. Also, the company benefits in
terms of paying lesser taxes when interest is paid out, this is called a ‘tax shield’. For
these reasons, we need to add interest (by accounting for the tax shield) while
calculating the ROA.
The Interest amount (finance cost) is Rs.7 Crs, accounting for the tax shield it would
be
= 7* (1 – 32%)
= 4.76 Crs . Please note, 32% is the average tax rate.
Hence ROA would be –
RoA = [367.4 + 4.76] / 1955
~ 372.16 / 1955
~19.03%
Return on Capital Employed (ROCE):
The Return on Capital employed indicates the profitability of the company taking
into consideration the overall capital it employs.
Overall capital includes both equity and debt (both long term and short term).
ROCE = [Profit before Interest & Taxes / Overall Capital Employed]
Overall Capital Employed = Short term Debt + Long term Debt + Equity
From ARBL’s Annual Report we know:
Profit before Interest & Taxes = Rs.537.7 Crs
Overall Capital Employed:
Short term debt: Rs.8.3 Crs
Long term borrowing: Rs.75.9 Crs
Shareholders equity = Rs.1362 Crs
Overall capital employed: 8.3 + 75.9 + 1362 = 1446.2 Crs
ROCE = 537.7 / 1446.2
= 37.18%
89
1. A Financial ratio is a useful financial metric of a company. On its own merit the ratio
conveys very little information
2. It is best to study the ratio’s recent trend or compare it with the company’s peers to
develop an opinion
3. Financial ratios can be categorized into ‘Profitability’, ‘Leverage’, ‘Valuation’, and
‘Operating’ ratios. Each of these categories give the analyst a certain view on the
company’s business
4. EBITDA is the amount of money the company makes after subtracting the
operational expenses of the company from its operating revenue
5. EBITDA margin indicates the percentage profitability of the company at the
operating level
6. PAT margin gives the overall profitability of the firm
7. Return on Equity (ROE) is a very valuable ratio. It indicates how much return the
shareholders are making over their initial investment in the company
8. A high ROE and a high debt is not a great sign
9. DuPont Model helps in decomposing the ROE into different parts, with each part
throwing light on different aspects of the business
10. DuPont method is probably the best way to calculate the ROE of a firm
11. Return on Assets in an indicator of how efficiently the company is utilizing its assets
12. Return on Capital employed indicates the overall return the company generates
considering both the equity and debt.
13. For the ratios to be useful, it should be analyzed in comparison with other
companies in the same industry.
14. Also, ratios should be analyzed both at a single point in time and as an indicator of
broader trends over time
90
Chapter 9

133
9.1 – A note on Financial Ratios

Over the last few chapters we have understood how to read the financial
statements. We will now focus our attention on analyzing these financial
statements. The best way to analyze the financial statements is by studying the
‘Financial Ratios’. The theory of financial ratios was made popular by Benjamin
Graham, who is popularly known as the father of fundamental analysis. Financial
ratios help in interpreting the results, and allows comparison with previous years
and other companies in the same industry.
A typical financial ratio utilizes data from the financial statement to compute its
value. Before we start understanding the financial ratios, we need to be aware of
certain attributes of the financial ratios.
On its own merit, the financial ratio of a company conveys very little information.
For instance, assume Ultratech Cements Limited has a profit margin of 15%, how
useful do you think this information is? Well, not much really. 15% profit margin is
good, but how would I know if it is the best?
However, assume you figure out ACC Cement’s profit margin is 12%. Now, as we
comparing two similar companies, comparing the profitability makes sense. Clearly,
Ultratech Cements Limited seems to be a more profitable company between the
two. The point that I am trying to drive across is that more often than not, Financial
Ratios on its own is quite mute. The ratio makes sense only when you compare the
ratio with another company of a similar size or when you look into the trend of the
financial ratio. This means that once the ratio is computed the ratio has to be
91
analyzed (either by comparison or tracking the ratio’s historical trend) to get the
best possible inference.
Also, here is something that you need to be aware off while computing ratios.
Accounting policies may vary across companies and across different financial years.
A fundamental analyst should be cognizant of this fact and should adjust the data
accordingly, before computing the financial ratio.
9.2 – The Financial Ratios

Financial ratios can be ‘somewhat loosely’ classified into different categories, namely
–
1. Profitability Ratios
2. Leverage Ratios
3. Valuation Ratios
4. Operating Ratios
The Profitability ratios help the analyst measure the profitability of the company.
The ratios convey how well the company is able to perform in terms of generating
profits. Profitability of a company also signals the competitiveness of the
management. As the profits are needed for business expansion and to pay
dividends to its shareholders a company’s profitability is an important consideration
for the shareholders.
The Leverage ratios also referred to as solvency ratios/ gearing ratios measures
the company’s ability (in the long term) to sustain its day to day operations.
92
Leverage ratios measure the extent to which the company uses the debt to finance
growth. Remember for the company to sustain its operations, it has to pay its bills
and obligations. Solvency ratios help us understand the company’s long term
sustainability, keeping its obligation in perspective.
The Valuation ratios compare the stock price of the company with either the
profitability of the company or the overall value of company to get a sense of how
cheap or expensive the stock is trading. Thus this ratio helps us in analysing
whether the current share price of the company is perceived as high or low. In
simpler words, the valuation ratio compares the cost of a security with the perks of
owning the stock.
The Operating Ratios, also called the ‘Activity Ratios’ measures the efficiency at
which a business can convert its assets (both current and noncurrent) into
revenues. This ratio helps us understand how efficient the management of the
company is. For this reason, Operating Ratios are sometimes called the
‘Management Ratios’.
Strictly speaking, ratios (irrespective of the category it belongs to) convey a certain
message, usually related to the financial position of the company. For example,
‘Profitability Ratio’ can convey the efficiency of the company, which is usually
measured by computing the ‘Operating Ratio’. Because of such overlaps, it is difficult
to classify these ratios. Hence the ratios are ‘somewhat loosely’ classified.
9.3 – The Profitability Ratios

We will look into the following ratios under ‘The Profitability Ratio’:
93
1. EBITDA Margin (Operating Profit Margin)
o EBITDA Growth (CAGR)
2. PAT Margin
o PAT Growth (CAGR)
3. Return on Equity (ROE)
4. Return on Asset (ROA)
5. Return on Capital Employed (ROCE)
EBITDA Margin:
The Earnings before Interest Tax Depreciation & Amortization (EBITDA)

Margin indicates the efficiency of the management. It tells us how efficient the
company’s operating model is. EBITDA Margin tells us how profitable (in percentage
terms) the company is at an operating level. It always makes sense to compare the
EBITDA margin of the company versus its competitor to get a sense of the
management’s efficiency in terms of managing their expense.
In order to calculate the EBITDA Margin, we first need to calculate the EBITDA itself.
EBITDA = [Operating Revenues – Operating Expense]
Operating Revenues = [Total Revenue – Other Income]
Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]
EBIDTA Margin = EBITDA / [Total Revenue – Other Income]
Continuing the example of Amara Raja Batteries Limited, the EBITDA Margin
calculation for the FY14 is as follows:
We first calculate EBITDA , which is computed as follows:
[Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation &
Amortization]
Note: Other income is income by virtue of investments and other non operational
activity. Including other income in EBITDA calculation would clearly skew the data.
For this reason, we have to exclude Other Income from Total Revenues.
[3482 – 46] – [2942 – 0.7 – 65]
= [3436] – [2876]
= 560 Crores
Hence the EBITDA Margin is:
560 / 3436
94
= 16.3%
I have two questions for you at this stage:
1. What does an EBITDA of Rs.560 Crs and an EBITDA margin of 16.3% indicate?
2. How good or bad an EBITDA margin of 16.3% is?
The first question is a fairly simple. An EBITDA of Rs.560 Crs means that the
company has retained Rs.560 Crs from its operating revenue of Rs.3436 Crs. This
also means out of Rs.3436 Crs the company spent Rs.2876 Crs towards its expenses.
In percentage terms, the company spent 83.7% of its revenue towards its expenses
and retained 16.3% of the revenue at the operating level, for its operations.
Now for the 2nd question, hopefully you should not have an answer.
Remember we did discuss this point earlier in this chapter. A financial ratio on its
own conveys very little information. To make sense of it, we should either see the
trend or compare it with its peers. Going with this, a 16.3% EBITDA margin conveys
very little information.
To makes some sense of the EBITDA margin, let us look at Amara Raja’s EBITDA
margin trend for the last 4 years, (all numbers in Rs Crs, except EBITDA margin):
Year Operating Revenues Operating Expense EBITDA EBITDA Margin
2011 1761 1504 257 14.6%
2012 2364 2025 340 14.4%
2013 2959 2508 451 15.2%
2014 3437 2876 560 16.3%
It appears that ARBL has maintained its EBITDA at an average of 15%, and in fact on
a closer look it is clear the EBITDA margin is increasing. This is a good sign as it
shows consistency and efficiency in the management’s operational capabilities.
In 2011 the EBITDA was Rs.257 Crs and in 2014 the EBITDA is Rs.560Crs. This
translates to a 4 year EBITDA CAGR growth of 21%.
Please note, we have discussed the formula for CAGR in module 1.
95
Clearly, it appears that both EBITDA margin and EBITDA growth are quite
impressive. However we still do not know if it is the best. In order to find out if it is
the best one needs to compare these numbers with its competitors. In case of ARBL
it would be Exide batteries Limited. I would encourage you to do the same for Exide
and compare the results.
PAT Margin:
While the EBITDA margin is calculated at the operating level, the Profit After Tax
(PAT) margin is calculated at the final profitability level. At the operating level we
consider only the operating expenses however there are other expenses such as
depreciation and finance costs which are not considered. Along with these expenses
there are tax expenses as well. When we calculate the PAT margin, all expenses are
deducted from the Total Revenues of the company to identify the overall
profitability of the company.
PAT Margin = [PAT/Total Revenues]
PAT is explicitly stated in the Annual Report. ARBL’s PAT for the FY14 is Rs.367 Crs on
the overall revenue of Rs.3482 Crs (including other income). This translates to a PAT
margin of:
= 367 / 3482
=10.5 %
Here is the PAT and PAT margin trend for ARBL:
Year PAT (in INR Crs) PAT Margin
2011 148 8.4%
2012 215 8.9%
2013 287 9.6%
2014 367 10.5%
The PAT and PAT margin trend seems impressive as we can clearly see a margin
expansion. The 4 year CAGR growth stands at 25.48%, which is again good. Needless
to say, it always makes sense to compare ratios with its competitors.
96
Return on Equity (RoE):
The Return on Equity (RoE) is a very important ratio, as it helps the investor assess
the return the shareholder earns for every unit of capital invested. RoE measures
the entity’s ability to generate profits from the shareholders investments. In other
words, RoE shows the efficiency of the company in terms of generating profits to its
shareholders. Obviously, higher the RoE, the better it is for the shareholders. In fact
this is one of the key ratios that helps the investor identify investable attributes of
the company. To give you a perspective, the average RoE of top Indian companies
vary between 14 – 16%. I personally prefer to invest in companies that have a RoE of
18% upwards.
This ratio is compared with the other companies in the same industry and is also
observed over time.
Also note, if the RoE is high, it means a good amount of cash is being generated by
the company, hence the need for external funds is less. Thus a higher ROE indicates
a higher level of management performance.
RoE can be calculated as: [Net Profit / Shareholders Equity* 100]
There is no doubt that RoE is an important ratio to calculate, but like any other
financial ratios it also has a few drawbacks. To help you understand its drawbacks,
consider this hypothetical example.
Assume Vishal runs a Pizza store. To bake pizza’s Vishal needs an oven which costs
him Rs.10,000/-. Oven is an asset to Vishal’s business. He procures the oven from his
own funds and seeks no external debt. At this stage you would agree on his balance
sheet he has a shareholder equity of Rs.10,000 and an asset equivalent to Rs.10,000.
Now, assume in his first year of operation, Vishal generates a profit of Rs.2500/-.
What is his RoE? This is quite simple to compute:
RoE = 2500/10000*100
=25.0%.
Now let us twist the story a bit. Vishal has only Rs.8000/- he borrows Rs.2000 from
his father to purchase an oven worth Rs.10000/-. How do you think his balance
sheet would look?
Debt = Rs.2000
97
This makes Vishal’s total liability Rs. 10,000. Balancing this on the asset side, he has
an asset worth Rs.10,000. Let us see how his RoE looks now:
RoE = 2500 / 8000*100
= 31.25%
With an additional debt, the RoE shot up quite significantly. Now, what if Vishal had
only Rs.5000 and borrowed the additional Rs.5000 from his father to buy the oven.
His balance sheet would look like this:
Debt = Rs.5000
Vishal’s total liability is Rs. 10,000. Balancing this on the asset side, he has an asset
worth Rs.10,000. Let us see how his RoE looks now:
RoE = 2500 / 5000 *100
=50.0%
Clearly, higher the debt Vishal seeks to finance his asset, (which in turn is required
to generate profits) higher is the RoE. A high RoE is great, but certainly not at the
cost of high debt. The problem is with a high amount of debt, running the business
gets very risky as the finance cost increases drastically. For this reason inspecting
the RoE closely becomes extremely important. One way to do this is by
implementing a technique called the ‘DuPont Model’ also called DuPont Identity.
This model was developed in 1920’s by the DuPont Corporation. DuPont Model
breaks up the RoE formula into three components with each part representing a
certain aspect of business. The DuPont analysis uses both the P&L statement and
the Balance sheet for the computation.
The RoE as per DuPont model can be calculated as:
If you notice the above formula, the denominator and the numerator cancels out
with one another eventually leaving us with the original RoE formula which is:
RoE = Net Profit / Shareholder Equity *100
However in the process of decomposing the RoE formula, we gained insights into
three distinct aspects of the business. Let us look into the three components of the
DuPont model that makes up the RoE formula :
98
o Net Profit Margin = Net Profits/ Net Sales*100
This is the first part of the DuPont Model and it expresses the company’s ability to
generate profits. This is nothing but the PAT margin we looked at earlier in this
chapter. A low Net profit margin would indicate higher costs and increased
competition.
o Asset Turnover = Net Sales / Average Total asset
Asset turnover ratio is an efficiency ratio that indicates how efficiently the company
is using its assets to generate revenue. Higher the ratio, it means the company is
using its assets more efficiently. Lower the ratio, it could indicate management or
production problems. The resulting figure is expressed as number of times per year.
o Financial Leverage = Average Total Assets / Shareholders Equity
Financial leverage helps us answer this question – ‘For every unit of shareholders
equity, how many units of assets does the company have’. For example if the
financial leverage is 4, this means for every Rs.1 of equity, the company supports
Rs.4 worth of assets. Higher the financial leverage along with increased amounts of
debt, will indicate the company is highly leveraged and hence the investor should
exercise caution. The resulting figure is expressed as number of times per year.
As you can see, the DuPont model breaks up the RoE formula into three distinct
components, with each component giving an insight into the company’s operating
and financial capabilities.
Let us now proceed to implement the DuPont Model to calculate Amara Raja’s RoE
for the FY 14. For this we need to calculate the values of the individual components.
Net Profit Margin: As I mentioned earlier, this is same as the PAT margin. From our
calculation earlier, we know the Net Profit Margin for ARBL is 9.2%
Asset Turnover = Net Sales / Average Total assets
We know from the FY14 Annual Report, Net sales of ARBL stands at Rs.3437 Crs.
The denominator has Average Total Assets which we know can be sourced from the
Balance Sheet. But what does the word ‘Average’ indicate?
From ARBL’s balance sheet, the total asset for FY14 is Rs.2139Crs. But think about
this, the reported number is for the Financial Year 2014, which starts from 1st of
April 2013 and close on 31st March 2014. This implies that at the start of the financial
year 2014 (1st April 2013), the company must have commenced its operation with
assets that it carried forward from the previous financial year (FY 2013). During the
financial year (FY 2014) the company has acquired some more assets which when
added to the previous year’s (FY2013) assets totaled to Rs.2139 Crs. Clearly the
company started the financial year with a certain rupee value of assets but closed
the year with a totally different rupee value of assets.
99
Keeping this in perspective, if I were to calculate the asset turnover ratio, which
asset value should I consider for the denominator? Should I consider the asset value
at the beginning of the year or at the asset value at the end of the year? To avoid
confusion, the practice is to take average of the asset values for the two financial
years.
Do remember this technique of averaging line items, as we will be using this across
other ratios as well.
From ARBL’s annual report we know:
Net Sales in FY14 is Rs.3437Crs
Average Assets = (1770 + 2139) / 2
= 1955
Asset Turnover = 3437 / 1955
= 1.75 times
This means for every Rs.1 of asset deployed, the company is generating Rs.1.75 in
revenues.
We will now calculate the last component that is the Financial Leverage.
Financial Leverage = Average Total Assets / Average Shareholders Equity
We know the average total assets is Rs.1955. We just need to look into the
shareholders equity. For reasons similar to taking the “Average Assets” as opposed
to just the current year assets, we will consider “Average Shareholder equity” as
opposed to just the current year’s shareholder equity.
Average shareholder equity = Rs.1211 Crs
Financial Leverage = 1955 / 1211
= 1.61 times
100
Considering ARBL has little debt, Financial Leverage of 1.61 is indeed an
encouraging number. The number above indicates that for every Rs.1 of Equity,
ARBL supports Rs.1.61 of assets.
We now have all the inputs to calculate RoE for ARBL, we will now proceed to do the
same:
RoE = Net Profit Margin X Asset Turnover X Financial Leverage
= 9.2% * 1.75 * 1.61
~ 25.9%. Quite impressive I must say!
I understand this is a lengthy way to calculate RoE, but this is perhaps the best way
as in the process of calculating RoE, we can develop valuable insights into the
business. DuPont model not only answers what the return is but also the quality of
the return.
However if you wish do a quick RoE calculation you can do so the following way:
RoE = Net Profits / Avg shareholders Equity
From the annual report we know for the FY14 the PAT is Rs.367 Crs
RoE = 367 / 1211
= 30.31%
Return on Asset (RoA):
Having understood the DuPont Model, understanding the next two ratios should be
simple. Return on Assets (RoA) evaluates the effectiveness of the entity’s ability to
use the assets to create profits. A well managed entity limits investments in non
productive assets. Hence RoA indicates the management’s efficiency at deploying its
assets. Needless to say, higher the RoA, the better it is.
RoA = [Net income + interest*(1-tax rate)] / Total Average Assets
From the Annual Report, we know:
Net income for FY 14 = Rs.367.4 Crs
And we know from the Dupont Model the Total average assets (for FY13 and FY14) =
Rs.1955 Crs
So what does interest *(1- tax rate) mean? Well, think about it, the loan taken by
the company is also used to finance the assets which in turn is used to
generate profits. So in a sense, the debtholders (entities who have given loan to the
company) are also a part of the company. From this perspective the interest paid
101
out also belongs to a stakeholder of the company. Also, the company benefits in
terms of paying lesser taxes when interest is paid out, this is called a ‘tax shield’. For
these reasons, we need to add interest (by accounting for the tax shield) while
calculating the ROA.
The Interest amount (finance cost) is Rs.7 Crs, accounting for the tax shield it would
be
= 7* (1 – 32%)
= 4.76 Crs . Please note, 32% is the average tax rate.
Hence ROA would be –
RoA = [367.4 + 4.76] / 1955
~ 372.16 / 1955
~19.03%
Return on Capital Employed (ROCE):
The Return on Capital employed indicates the profitability of the company taking
into consideration the overall capital it employs.
Overall capital includes both equity and debt (both long term and short term).
ROCE = [Profit before Interest & Taxes / Overall Capital Employed]
Overall Capital Employed = Short term Debt + Long term Debt + Equity
From ARBL’s Annual Report we know:
Profit before Interest & Taxes = Rs.537.7 Crs
Overall Capital Employed:
Short term debt: Rs.8.3 Crs
Long term borrowing: Rs.75.9 Crs
Shareholders equity = Rs.1362 Crs
Overall capital employed: 8.3 + 75.9 + 1362 = 1446.2 Crs
ROCE = 537.7 / 1446.2
= 37.18%
102
1. A Financial ratio is a useful financial metric of a company. On its own merit the ratio
conveys very little information
2. It is best to study the ratio’s recent trend or compare it with the company’s peers to
develop an opinion
3. Financial ratios can be categorized into ‘Profitability’, ‘Leverage’, ‘Valuation’, and
‘Operating’ ratios. Each of these categories give the analyst a certain view on the
company’s business
4. EBITDA is the amount of money the company makes after subtracting the
operational expenses of the company from its operating revenue
5. EBITDA margin indicates the percentage profitability of the company at the
operating level
6. PAT margin gives the overall profitability of the firm
7. Return on Equity (ROE) is a very valuable ratio. It indicates how much return the
shareholders are making over their initial investment in the company
8. A high ROE and a high debt is not a great sign
9. DuPont Model helps in decomposing the ROE into different parts, with each part
throwing light on different aspects of the business
10. DuPont method is probably the best way to calculate the ROE of a firm
11. Return on Assets in an indicator of how efficiently the company is utilizing its assets
12. Return on Capital employed indicates the overall return the company generates
considering both the equity and debt.
13. For the ratios to be useful, it should be analyzed in comparison with other
companies in the same industry.
14. Also, ratios should be analyzed both at a single point in time and as an indicator of
broader trends over time
103
Chapter 10

99
10.1 – The Leverage Ratios

We touched upon the topic of financial leverage while discussing Return on Equity
and the DuPont analysis. The use of leverage (debt) is like a double edged sword.
Well managed companies seek debt if they foresee a situation where, they can
deploy the debt funds in an environment which generates a higher return in
contrast to the interest payments the company has to makes to service its debt. Do
recollect a judicious use of debt to finance assets also increases the return on
equity.
However if a company takes on too much debt, then the interest paid to service the
debt eats into the profit share of the shareholders. Hence there is a very thin line
that separates the good and the bad debt. Leverage ratios mainly deal with the
overall extent of the company’s debt, and help us understand the company’s
financial leverage better.
We will be looking into the following leverage ratios:
1. Interest Coverage Ratio

2. Debt to Equity Ratio
104
3. Debt to Asset Ratio
4. Financial Leverage Ratio
So far we have been using Amara Raja Batteries Limited (ARBL) as an example,
however to understand leverage ratios, we will look into a company that has a
sizable debt on its balance sheet. I have chosen Jain Irrigation Systems Limited (JISL),
I would encourage you calculate the ratios for a company of your choice.
Interest Coverage Ratio:

The interest coverage ratio is also referred to as debt service ratio or the debt
service coverage ratio. The interest coverage ratio helps us understand how much
the company is earning relative to the interest burden of the company. This ratio
helps us interpret how easily a company can pay its interest payments. For example,
if the company has an interest burden of Rs.100 versus an income of Rs.400, then
we clearly know that the company has sufficient funds to service its debt. However a
low interest coverage ratio could mean a higher debt burden and a greater
possibility of bankruptcy or default.
The formula to calculate the interest coverage ratio:

[Earnings before Interest and Tax / Interest Payment]
The ‘Earnings before Interest and Tax’ (EBIT) is:

EBITDA – Depreciation & Amortization
Let us apply this ratio on Jain Irrigation Limited. Here is the snapshot of Jain
Irrigation’s P&L statement for the FY 14, I have highlighted the Finance costs in red:
105
We know EBITDA = [Revenue – Expenses]
To calculate the expenses, we exclude the Finance cost (Rs.467.64Crs) and

Depreciation & Amortization cost (Rs.204.54) from the total expenses of Rs.5730.34
Crs.
Therefore EBITDA = Rs.5828.13 – 5058.15 Crs

EBITDA = Rs. 769.98 Crs
We know EBIT = EBITDA – [Depreciation & Amortization]
= Rs.769.98 – 204.54
= Rs. 565.44
We know Finance Cost = Rs.467.64,
Hence Interest coverage is:
= 565.44/ 467.64
= 1.209x
The ‘x’ in the above number represents a multiple. Hence 1.209x should be read as
1.209 ‘times’.
106
Interest coverage ratio of 1.209x suggests that for every Rupee of interest payment
due, Jain Irrigation Limited is generating an EBIT of 1.209 times.
Debt to Equity Ratio:

This is a fairly straightforward ratio. Both the variables required for this
computation can be found in the Balance Sheet. It measures the amount of the total
debt capital with respect to the total equity capital. A value of 1 on this ratio
indicates an equal amount of debt and equity capital. Higher debt to equity (more
than 1) indicates higher leverage and hence one needs to be careful. Lower than 1
indicates a relatively bigger equity base with respect to the debt.
The formula to calculate Debt to Equity ratio is:

[Total Debt/Total Equity]
Please note, the total debt here includes both the short term debt and the long term
debt.
Here is JSIL’s Balance Sheet, I have highlighted total equity, long term, and short
term debt:
Total debt = Long term borrowings + Short term borrowings

= 1497.663 + 2188.915
= Rs.3686.578Crs
Total Equity is Rs.2175.549 Crs
Thus, Debt to Equity ratio will be computed as follows:

= 3686.578 / 2175.549
= 1.69
107
Debt to Asset Ratio:
This ratio helps us understand the asset financing pattern of the company. It
conveys to us how much of the total assets are financed through debt capital.
The formula to calculate the same is:

Total Debt / Total Assets
For JSIL, we know the total debt is Rs.3686.578Crs.

From the Balance Sheet, we know the total assets as Rs.8204.447 Crs:
Hence the Debt to Asset ratio is:

=3686.578 / 8204.44
= 0.449 or ~45%.
This means roughly about 45% of the assets held by JSIL is financed through debt
capital or creditors (and therefore 55% is financed by the owners). Needless to say,
higher the percentage the more concerned the investor would be as it indicates
higher leverage and risk.
Financial Leverage Ratio

We briefly looked at the financial leverage ratio in the previous chapter, when we
discussed about Return on Equity. The financial leverage ratio gives us an indication,
to what extent the assets are supported by equity.
The formula to calculate the Financial Leverage Ratio is:

Average Total Asset / Average Total Equity
From JSIL’s FY14 balance sheet, I know the average total assets is Rs.8012.615.The
average total equity is Rs.2171.755. Hence the financial leverage ratio or simply the
leverage ratio is:
8012.615 / 2171.755
= 3.68
108
This means JSIL supports Rs.3.68 units of assets for every unit of equity. Do
remember higher the number, higher is the company’s leverage and the more
careful the investor needs to be.
10.2 – Operating Ratios

Operating Ratios also called ‘Activity ratios’ or the ‘Management ratios’ indicate the
efficiency of the company’s operational activity. To some degree, the operating
ratios reveal the management’s efficiency as well. These ratios are called the Asset
Management Ratios, as these ratios indicate the efficiency with which the assets of
the company are utilized.
Some of the popular Operating Ratios are:
1. Fixed Assets Turnover Ratio

2. Working Capital Turnover Ratio
3. Total Assets Turnover Ratio
4. Inventory Turnover Ratio
5. Inventory Number of Days
6. Receivable Turnover Ratio
7. Days Sales Outstanding (DSO)
The above ratios combine data from both the P&L statement and Balance sheet. We
will understand these ratios by calculating them for Amara Raja Batteries Limited.
To get a true sense of how good or bad the operating ratios of a company are, one
must compare the ratios with the company’s peers /competitors or these ratios
should be compared over the years for the same company.
109
Fixed Assets Turnover
The ratio measures the extent of the revenue generated in comparison to its
investment in fixed assets. It tells us how effectively the company uses its plant and
equipment. Fixed assets include the property, plant and equipment. Higher the
ratio, it means the company is effectively and efficiently managing its fixed assets.
Fixed Assets Turnover = Operating Revenues / Total Average Asset
The assets considered while calculating the fixed assets turnover should be net of
accumulated depreciation, which is nothing but the net block of the company. It
should also include the capital work in progress. Also, we take the average assets for
reasons discussed in the previous chapter.
From ARBL’s FY14 Balance Sheet:
= (767.864 + 461.847)/2
= Rs.614.855 Crs
We know the operating revenue for FY14 is Rs.3436.7 Crs, hence the Fixed Asset
Turnover ratio is:
= 3436.7 / 614.85
=5.59
While evaluating this ratio, do keep in mind the stage the company is in. For a very
well established company, the company may not be utilizing its cash to invest in
fixed assets. However for a growing company, the company may invest in fixed
assets and hence the fixed assets value may increase year on year. You can notice
this in case of ARBL as well, for the FY13 the Fixed assets value is at Rs.461.8 Crs and
for the FY14 the fixed asset value is at Rs.767.8 Crs.
This ratio is mostly used by capital intensive industries to analyze how effectively the
fixed assets of the company are used.
Working Capital Turnover

Working capital refers to the capital required by the firm to run its day to day
operations. To run the day to day operations, the company needs certain type of
assets. Typically such assets are – inventories, receivables, cash etc. If you realize
these are current assets. A well managed company finances the current assets by
current liabilities. The difference between the current assets and current liabilities
gives us the working capital of the company.
110
Working Capital = Current Assets – Current Liabilities
If the working capital is a positive number, it implies that the company has working
capital surplus and can easily manage its day to day operations. However if the
working capital is negative, it means the company has a working capital deficit.
Usually if the company has a working capital deficit, they seek a working capital loan
from their bankers.
The concept of ‘Working Capital Management’ in itself is a huge topic in Corporate

Finance. It includes inventory management, cash management, debtor’s
management etc. The company’s CFO (Chief Financial Officer) strives to manage the
company’s working capital efficiently. Of course, we will not get into this topic as we
will digress from our main topic.
The working capital turnover ratio is also referred to as Net sales to working capital.
The working capital turnover indicates how much revenue the company generates
for every unit of working capital. Suppose the ratio is 4, then it indicates that the
company generates Rs.4 in revenue for every Rs.1 of working capital. Needless to
say, higher the number, better it is. Also, do remember all ratios should be
compared with its peers/competitors in the same industry and with the company’s
past and planned ratio to get a deeper insight of its performance.
The formula to calculate the Working Capital Turnover:

Working Capital Turnover = [Revenue / Average Working Capital]
Let us implement the same for Amara Raja Batteries Limited. To begin with, we
need to calculate the working capital for the FY13 and the FY14 and then find out
the average. Here is the snapshot of ARBL’s Balance sheet, I have highlighted the
current assets (red) and current liabilities (green) for both the years:
111
The average working capital for the two financial years can be calculated as follows:
Current Assets for the FY13 Rs.1256.85
Current Liabilities for the FY13 Rs.576.19
Working Capital for the FY13 Rs.680.66
Current Asset for the FY14 Rs.1298.61
Current Liability for the FY14 Rs.633.70
Working Capital for the FY14 Rs.664.91
Average Working Capital Rs.672.78
We know the revenue from operations for ARBL is Rs.3437 Crs. Hence the working
capital turnover ratio is:
= 3437 / 672.78
= 5.11 times
The number indicates that for every Rs.1 of working capital, the company is
generating Rs.5.11 in terms of revenue. Higher the working capital turnover ratio
the better it is, as it indicates the company is generating better sales in comparison
with the money it uses to fund the sales.
Total Assets Turnover

This is a very straight forward ratio. It indicates the company’s capability to generate
revenues with the given amount of assets. Here the assets include both the fixed
assets as well as current assets. A higher total asset turnover ratio compared to its
historical data and competitor data means the company is using its assets well to
generate more sales.
Total Asset Turnover = Operating Revenue / Average Total Assets
The average total assets for ARBL is as follws –
112
Total Assets for FY 13 – Rs.1770.5 Crs and Total Assets for FY 14 – 2139.4 Crs. Hence
the average assets would be Rs. 1954.95 Crs.
Operating revenue (FY 14) is Rs. 3437 Crs. Hence Total Asset Turnover is:
= 3437 / 1954.95
= 1.75 times
Inventory Turnover Ratio

Inventory refers to the finished goods that a company maintains in its store or
showroom with an expectation of selling the finished goods to prospective clients.
Typically, the company besides keeping the goods in the store would also keep
some additional units of finished goods in its warehouse.
If a company is selling popular products, then the goods in the inventory gets
cleared rapidly, and the company has to replenish the inventory time and again.
This is called the ‘Inventory turnover’.
For example think about a bakery selling hot bread. If the bakery is popular, the
baker probably knows how many pounds of bread he is likely to sell on any given
day. For example, he could sell 200 pounds of bread daily. This means he has to
maintain an inventory of 200 pounds of bread every day. So, in this case the rate of
replenishing the inventory and the inventory turnover is quite high.
This may not be true for every business. For instance, think of a car manufacturer.
Obviously selling cars is not as easy as selling bread. If the manufacturer produces
50 cars, he may have to wait for sometime before he sells these cars. Assume, to
sell 50 cars (his inventory capacity) he will need 3 months. This means, every 3
months he turns over his inventory. Hence in a year he turns over his inventory 4
times.
Finally, if the product is really popular the inventory turnover would be high. This is
exactly what the ‘Inventory Turnover Ratio’ indicates.
The formula to calculate the ratio is:

Inventory Turnover = [Cost of Goods Sold / Average Inventory]
Cost of goods sold is the cost involved in making the finished good. We can find this
in the P&L Statement of the company. Let us implement this for ARBL.
To evaluate the cost of goods sold, I need to look into the expense of the company,
here is the extract of the same:
113
Cost of materials consumed is Rs.2101.19 Crs and purchases of stock-in-trade is
Rs.211.36 Crs. These line items are directly related to the cost of goods sold. Along
with this I would also like to inspect ‘Other Expenses’ to identify any costs that are
related to the cost of goods sold. Here is the extract of Note 24, which details ‘Other
Expenses’.
There are two expenses that are directly related to manufacturing i.e. Stores &
spares consumed which is at Rs.44.94 Crs and the Power & Fuel cost which is at
Rs.92.25Crs.
Hence the Cost of Goods Sold = Cost of materials consumed + Purchase of stock in
trade + Stores & spares consumed + Power & Fuel
= 2101.19 + 211.36 + 44.94 + 92.25
COGS= Rs.2449.74 Crs
This takes care of the numerator. For the denominator, we just take the average
inventory for the FY13 and FY14. From the balance sheet – Inventory for the FY13 is
Rs.292.85 Crs and for the FY14 is Rs.335.00 Crs. The average works out to Rs.313.92
Crs
The Inventory turnover ratio is:

= 2449.74 / 313.92
114
= 7.8 times
~ 8.0 times a year
This means Amara Raja Batteries Limited turns over its inventory 8 times in a year
or once in every 1.5 months. Needless to say, to get a true sense of how good or
bad this number is, one should compare it with its competitor’s numbers.
Inventory Number of days

While the Inventory turnover ratio gives a sense of how many times the
company ‘replenishes’ their inventory, the ‘Inventory number of Days’ gives a sense
of how much time the company takes to convert its inventory into cash. Lesser the
number of days, the better it is. A short inventory number of day’s number implies,
the company’s products are fast moving. The formula to calculate the inventory
number of days is:
Inventory Number of Days = 365 / Inventory Turnover
The inventory number of days is usually calculated on a yearly basis. Hence in the
formula above, 365 indicates the number of days in a year.
Calculating this for ARBL:

= 365 / 7.8
= 46.79 days
~ 47.0 days
This means ARBL roughly takes about 47 days to convert its inventory into cash.
Needless to say, the inventory number of days of a company should be compared
with its competitors, to get a sense of how the company’s products are moving.
Now here is something for you to think about – What would you think about the
following situation?
1. A certain company under consideration has a high inventory turnover ratio

2. Because of a high inventory turnover ratio, the inventory number of days is very low
On the face of it, the inventory management of this company looks good. A high
inventory turnover ratio signifies that the company is replenishing its inventory
quickly, which is excellent. Along with the high inventory turnover, a low inventory
number of days indicate that the company is quickly able to convert its goods into
cash. Again, this is a sign of great inventory management.
However, what if the company has a great product (hence they are able to sell
quickly) but a low production capacity? Even in this case the inventory turnover will
be high and inventory days will be low. But a low production capacity can be a bit
worrisome as it raises many questions about the company’s production:
1. Why is the company not able to increase their production?
115
2. Are they not able to increase production because they are short of funds?
3. If they are short of funds, why can’t they seek a bank loan?
4. Have they approached a bank and are not been able to raise a loan successfully?
5. If they are not able to raise a loan, why?
6. What if the management does not have a great track record, hence the banks
hesitation to give a loan?
7. If funds are not a problem, why can’t the company increase production?
8. Is sourcing raw materials difficult? Is the raw material required regulated by
government (like Coal, power, Oil etc).
9. Difficult access to raw material – does that mean the business is not scalable?
As you can see, if any of the points above is true, then a red flag is raised, hence
investing in the company may not be advisable. To fully understand the production
issues (if any), the fundamental analyst should read through the annual report
(especially the management discussion & analysis report) from the beginning to the
end.
This means whenever you see impressive inventory numbers, always ensure to
double check the production details as well.
Accounts Receivable Turnover Ratio

Having understood the inventory turnover ratio, understanding the receivable
turnover ratio should be quite easy. The receivable turnover ratio indicates how
many times in a given period the company receives money/cash from its debtors
and customers. Naturally a high number indicates that the company collects cash
more frequently.
The formula to calculate the same is:

Accounts Receivable Turnover Ratio = Revenue / Average Receivables
From the balance sheet we know,

Trade Receivable for the FY13 : Rs.380.67 Crs
Trade Receivable for the FY14 : Rs. 452.78 Crs
Average Receivable for the FY13 : Rs.416.72
Operating Revenue for the FY14 : Rs.3437 Crs
Hence the Receivable Turnover Ratio is:

= 3437 / 416.72
= 8.24 times a year
~ 8.0 times
This means ARBL receives cash from its customers roughly about 8.24 times a year
or once every month and a half.
116
Days Sales Outstanding (DSO) )/ Average Collection Period/ Day Sales in
Receivables
The days sales outstanding ratio illustrates the average cash collection period i.e the
time lag between billing and collection. This calculation shows the efficiency of the
company’s collection department. Quicker/faster the cash is collected from the
creditors, faster the cash can be used for other activities. The formula to calculate
the same is:
Days Sales outstanding = 365 / Receivable Turnover Ratio
Solving this for ARBL,

= 365 / 8.24
= 44.29 days
This means ARBL takes about 45 days from the time it raises an invoice to the time it
can collect its money against the invoice.
Both Receivables Turnover and the DSO indicate the credit policy of the firm. A
efficiently run company, should strike the right balance between the credit policy
and the credit it extends to its customers.
1. Leverage ratios include Interest Coverage, Debt to Equity, Debt to Assets and the
Financial Leverage ratios
2. The Leverage ratios mainly study the company’s debt with respect to the company’s
ability to service the long term debt
3. Interest coverage ratio inspects the company’s earnings ability (at the EBIT level) as
a multiple of its finance costs
4. Debt to equity ratio measures the amount of equity capital with respect to the debt
capital. Debt to equity of 1 implies equal amount of debt and equity
5. Debt to Asset ratio helps us understand the asset financing structure of the
company (especially with respect to the debt)
6. The Financial Leverage ratio helps us understand the extent to which the assets are
financed by the owner’s equity
7. The Operating Ratios also referred to as the Activity ratios include – Fixed Assets
Turnover, Working Capital turnover, Total Assets turnover, Inventory turnover,
Inventory number of days, Receivable turnover and Day Sales Outstanding ratios
8. The Fixed asset turnover ratio measures the extent of the revenue generated in
comparison to its investment in fixed assets
117
9. Working capital turnover ratio indicates how much revenue the company generates
for every unit of working capital
10. Total assets turnover indicates the company’s ability to generate revenues with the
given amount of assets
11. Inventory turnover ratio indicates how many times the company replenishes its
inventory during the year
12. Inventory number of days represents the number of days the company takes to
convert its inventory to cash
1. A high inventory turnover and therefore a low inventory number of days is a great combination
2. However make sure this does not come at the cost of low production capacity
13. The Receivable turnover ratio indicates how many times in a given period the
company receives money from its debtors and customers
14. The Days sales outstanding (DSO) ratio indicates the Average cash collection period
i.e the time lag between the Billing and Collection
118
Chapter 11

69
11.1 – The Valuation Ratio

Valuation in general, is the estimate of the ‘worth’ of something. In the context of
investments, ‘something’ refers to the price of a stock. When making an investment
decision, irrespective of how attractive the business appears, what matters finally is
the valuation of the business. Valuations dictate the price you pay to acquire a
business. Sometimes, a mediocre business at a ridiculously cheap valuation may be
a great investment option as opposed to an exciting business with an extremely
high valuation.
The valuation ratios help us develop a sense on how the stock price is valued by the
market participants. These ratios help us understand the attractiveness of the stock
price from an investment perspective. The point of valuation ratios is to compare
the price of a stock viz a viz the benefits of owning it. Like all the other ratios we had
looked at, the valuation ratios of a company should be evaluated alongside the
company’s competitors.
Valuation ratios are usually computed as a ratio of the company’s share price to an
aspect of its financial performance. We will be looking at the following three
important valuation ratios:
1. Price to Sales (P/S) Ratio

2. Price to Book Value (P/BV) Ratio and
119
3. Price to Earnings (P/E) Ratio
Continuing with the Amara Raja Batteries Limited (ARBL) example, let us implement
these ratios to see how ARBL fares. The stock price of ARBL is a vital input used to
calculate the valuation ratios. As I write this chapter on 28th of Oct 2014, ARBL is
trading at Rs.661 per share.
We also need the total number of shares outstanding in ARBL to calculate the above
ratios. If you recollect, we have calculated the same in chapter 6. The total number
of shares outstanding is 17,08,12,500 or 17.081Crs
Price to Sales (P/S) Ratio
In many cases, investors may use sales instead of earnings to value their
investments. The earnings figure may not be true as some companies might be
experiencing a cyclical low in their earning cycle. Additionally due to some
accounting rules, a profitable company may seem to have no earnings at all, due to
the huge write offs applicable to that industry. So, investors would prefer to use this
ratio. This ratio compares the stock price of the company with the company’s sales
per share. The formula to calculate the P/S ratio is:
Price to sales ratio = Current Share Price / Sales per Share
Let us calculate the same for ARBL. We will take up the denominator first:
Sales per share = Total Revenues / Total number of shares
We know from ARBL’s P&L statement the:
Total Revenue = Rs.3482 Crs
Number of Shares = 17.081 Crs
Sales per share = 3482 / 17.081
Therefore the Sales per share = Rs. 203.86
This means for every share outstanding, ARBL does Rs.203.86 worth of sales.
Price to Sales Ratio = 661 / 203.86
= 3.24x or 3.24 times
A P/S ratio of 3.24 times indicates that, for every Rs.1 of sales, the stock is valued
Rs.3.24 times higher. Obviously, higher the P/S ratio, higher is the valuation of the
firm. One has to compare the P/S ratio with its competitors in the industry to get a
fair sense of how expensive or cheap the stock is.
120
Here is something that you need to remember while calculating the P/S ratio.
Assume there are two companies (Company A and Company B) selling the same
product. Both the companies generate a revenue of Rs.1000/-each. However,
Company A retains Rs.250 as PAT and Company B retains Rs.150 as PAT. In this
case, Company A has a profit margin of 25% versus Company B’s which has a 15%
profit margin. Hence the sales of Company A is more valuable than the sales of
Company B. Hence if Company A is trading at a higher P/S, then the valuation
maybe justified, simply because every rupee of sales Company A generates, a higher
profit is retained.
Hence whenever you feel a particular company is trading at a higher valuation from
the P/S ratio perspective, do remember to check the profit margin for cues.
Price to Book Value (P/BV) Ratio
Before we understand the Price to Book Value ratio, we need to understand what
the term ‘Book Value’ means.
Consider a situation where the company has to close down its business and
liquidate all its assets. What is the minimum value the company receives upon
liquidation? The answer to this lies in the “Book Value” of the firm.
The “Book Value” of a firm is simply the amount of money left on table after the
company pays off its obligations. Consider the book value as the salvage value of
the company. Suppose the book value of a company is Rs.200Crs, then this is the
amount of money the company can expect to receive after it sells everything and
settles its debts. Usually the book value is expressed on a per share basis. For
example, if the book value per share is Rs.60, then Rs.60 per share is what the
shareholder can expect in case the company decides to liquidate. The ‘Book Value’
(BV) can be calculated as follows:
BV = [Share Capital + Reserves (excluding revaluation reserves) / Total Number

of shares]
Let us calculate the same for ARBL:
From ARBL’s balance sheet we know:
Share Capital = Rs.17.1 Crs
Reserves = Rs.1345.6 Crs
Revaluation Reserves = 0
Number of shares: 17.081
Hence the Book Value per share = [17.1+1345.6 – 0] / 17.081
121
= Rs.79.8 per share
This means if ARBL were to liquidate all its assets and pay off its debt, Rs.79.8 per
shares is what the shareholders can expect.
Moving ahead, if we divide the current market price of the stock by the book value
per share, we will get the price to the book value of the firm. The P/BV indicates how
many times the stock is trading over and above the book value of the firm. Clearly
the higher the ratio, the more expensive the stock is.
Let us calculate this for ARBL. We know:
Stock price of ARBL = Rs.661 per share
BV of ARBL = 79.8 per share
P/BV = 661/79.8
= 8.3x or 8.3 times
This means ARBL is trading over 8.3 times its book value.
A high ratio could indicate the firm is overvalued relative to the equity/ book value
of the company. A low ratio could indicate the company is undervalued relative to
the equity/ book value of the company.
Price to Earning (P/E) Ratio
The Price to Earnings ratio is perhaps the most popular financial ratio. Everybody
likes to check the P/E of a stock. Because of the popularity the P/E ratio enjoys, it is
often considered the ‘financial ratio superstar’.
The P/E of a stock is calculated by dividing the current stock price by the Earning
Per share (EPS). Before we proceed further to understand the PE ratio, let us
understand what “Earnings per Share” (EPS) stands for.
EPS measures the profitability of a company on a per share basis. For example
assume a certain company with 1000 shares outstanding generates a profit of
Rs.200000/-. Then the earnings on a per share basis would be:
=200000 / 1000
= Rs.200 per share.
Hence the EPS gives us a sense of the profits generated on a per share basis.
Clearly, higher the EPS, better it is for its shareholders.
If you divide the current market price with EPS we get the Price to Earnings ratio of a
firm. The P/E ratio measures the willingness of the market participants to pay for
122
the stock, for every rupee of profit that the company generates. For example if the
P/E of a certain firm is 15, then it simply means that for every unit of profit the
company earns, the market participants are willing to pay 15 times. Higher the P/E,
more expensive is the stock.
Let us calculate the P/E for ARBL. We know from its annual report –
PAT = Rs.367Crs
Total Number of Shares = 17.081 Crs
EPS = PAT / Total Number of shares
= 367 / 17.081
= Rs.21.49
Current Market Price of ARBL = 661
Hence P/E = 661 / 21.49
= 30.76 times
This means for every unit of profit generated by ARBL, the market participants are
willing to pay Rs.30.76 to acquire the share.
Now assume, ARBL’s price jumps to Rs.750 while the EPS remains at Rs.21.49, the
new P/E would be:
= 750/21.49
= 34.9 times
While the EPS stayed flat at Rs.21.49 per share, the stock’s P/E jumped. Why do you
think this happened?
Clearly, the P/E Ratio jumped because of the increase in the stock price. As we know
the stock price of a company increases when the expectations from the company
increases.
Remember, P/E Ratio is calculated with ‘earnings’ in its denominator. While looking
at the P/E ratio, do remember the following key points:
1. P/E indicates how expensive or cheap the stock is trading at. Never buy stocks that
are trading at high valuations. I personally do not like to buy stocks that are trading
beyond 25 or at the most 30 times its earnings, irrespective of the company and the
sector it belongs to
2. The denominator in P/E ratio is the ‘Earnings’, and the earnings can be manipulated
123
3. Make sure the company is not changing its accounting policy too often – this is one
of the ways the company tries to manipulate its earnings.
4. Pay attention to the way depreciation is treated. Provision for lesser depreciation
can boost earnings
5. If the company’s earnings are increasing but not its cash flows and sales, then
clearly something is not right
11.2 – The Index Valuation

Just like a stock, the stock market indices such as the BSE Sensex and the CNX Nifty
50 have their valuations which can be measured by the P/E ,P/B and Dividend Yield
ratios. The Index valuation is usually published by the stock exchanges on a daily
basis. The index valuations give us a sense of how cheap or expensive the market is
trading at. To calculate the CNX Nifty 50 P/E ratio, the National Stock Exchange
combines the market capitalization for all the 50 stocks and divides that amount by
the combined earnings for all the 50 stocks. Tracking the Index P/E ratio, gives a
sense of the current state of market as perceived by the market participants. Here is
the historical chart of Nifty 50 P/E ratio* –
* Source – Creytheon
From the P/E chart above, we can make a few important observations –
1. The peak Index valuation was 28x (early 2008), what followed this was a major crash
in the Indian markets
2. The corrections drove the valuation down to almost 11x (late 2008, early 2009). This
was the lowest valuation the Indian market had witnessed in the recent past
3. Usually the Indian Indices P/E ratio ranges between 16x to 20x, with an average of
18x
4. As of today (2014) we are trading around 22x, which is above the average P/E ratio
Based on these observations, the following conclusions can be made –
124
1. One has to be cautious while investing in stocks when the market’s P/E valuations is
above 22x
2. Historically the best time to invest in the markets is when the valuations are around
16x or below.
One can easily find out Index P/E valuation on a daily basis by visiting the National
Stock Exchange (NSE) website.
On NSE’s home page click on Products > Indices > Historical Data > P/E, P/B & Div
> Search
In the search field enter today’s date and you will get the latest P/E valuation of the
market. Do note, the NSE updates this information around 6:00 PM every day.
Here is a snapshot of the search result –
Clearly as of today (13th Nov 2014) the Indian market is trading close to the higher
end of the P/E range; history suggests that we need to be cautious while taking
investment decisions at this level.
1. Valuation in general, is the estimate of the ‘worth’ of something

2. Valuation ratios involves inputs from both the P&L statement and the Balance Sheet
3. The Price to Sales ratio compares the stock price of the company with the
company’s sales per share
o Sales per share is simply the Sales divided by the Number of shares
125
4. Sales of a company with a higher profit margin is more valuable in comparison to
the sales of a company with lower profit margins
5. If a company is going bankrupt, the ‘Book Value’ of a firm is simply the amount of
money left on table after the company pays off its obligations
6. Book value is usually expressed on a per share basis
7. The Price/BV indicates how many times the stock price is trading over and above the
book value of the firm
8. EPS measures the profitability of a company on a per share basis
9. The P/E ratio indicates the willingness of market participants to pay for a stock,
keeping the company’s earnings in perspective
10. One has to be cautious about the earning manipulation while evaluating the P/E
ratio
11. The Indices have a valuation which can be measured by the P/E, P/B or Dividend
Yield ratio
12. It is advisable to exercise caution when the Index is trading at a valuation of 22x or
above
13. A valuation gets attractive when the index is trading at 16x or below
14. The index valuations are published by NSE on their website on a daily basis
126
Chapter 12
The Investment Due Diligence

48
12.1 – Taking stock

Over the last few chapters we understood how to read the financial statements and
calculate a few important financial ratios. These chapters have laid the foundation
to the final objective of this module which is – To use fundamental analysis to
identify the stocks to invest. If you recollect in the earlier chapters, we had discussed
about investable grade attributes. Investable grade attributes simply define the
prerequisites of a company that needs to be validated before making an investment
decision. Think of the investable grade attributes as a checklist based on the
fundamentals of the company. A company that satisfies most of the items in the
checklist, is considered investment worthy.
Now this is where few differences come up. For instance, what I consider as an
investable grade attribute may not be so important to you. For example – I may pay
a lot of attention to corporate governance but another investor may choose not pay
so much attention to corporate governance. He could simply brush it off saying “all
companies have shades of grey, as long as the numbers add up I am fine investing
in the company”.
So the point is, there is no prescribed checklist. Each investor has to build his own
checklist based on his investment experience. However, one has to ensure that each
item on the checklist is qualified based on sound logic. Later in this chapter, I will
share a checklist that I think is reasonably well curated. You could take pointers
from this checklist, if you are starting out fresh. We will keep this checklist as a
guideline and proceed further in this module.
127
12.2 – Generating a stock idea
Now before we proceed further and generate a checklist, we must address a more
basic issue. The process of investing requires us to first select a stock that looks
interesting. After selecting the stock we must subject it to the checklist to figure out
if the stock matches all the checklist criteria, if it does we invest, else we look for
other opportunities.
So in the first place, how do we even select a stock that looks interesting? In other
words, how do we generate a list of stocks that seems interesting enough to
investigate further? Well, there are a few methods to do this –
1. General Observation – This may sound rudimentary, but believe me this is one of
the best ways to develop a stock idea. All you need to do is keep your eyes and ears
open and observe the economic activity around you. Observe what people are
buying and selling, see what products are being consumed, keep an eye on the
neighborhood to see what people are talking about. In fact Peter Lynch, one of the
most illustrious Wall Street investor advocates this method in his book “One up on
Wall Street”. Personally I have used this method to pick some of my investments –
PVR Cinemas Ltd (because I noticed PVR multiplexes mushrooming in the City),
Cummins India Limited (because I noticed most of the buildings had a Cummins
diesel generator in their premises), and Info Edge Limited (Info Edge owns
naukri.com, which is probably the most preferred job portal).
2. Stock screener – A stock screener helps to screen for stocks based on the
parameters you define and therefore helps investors perform quality stock analysis
.For example you can use a stock screener to identify stocks that have a ROE of 25%
along with PAT margins of 20%. A stock screener is very helpful tool when you want
to shortlist a handful of investment ideas from a big basket of stocks. There are
128
many stock screeners available; I personally like the Google finance’s stock screener
and screener.in.
3. Macro Trends – Keeping a general tab on the macroeconomic trend is a great way
of identifying good stocks. Here is an illustration of the same – As of today there is a
great push for infrastructure projects in India. An obvious beneficiary of this push
would be the cement companies operating in India. Hence, I would look through all
the cement companies and apply the checklist to identify which amongst all the
cement companies are well positioned to leverage this macro trend.
4. Sectoral Trends – This is sector specific. One needs to track sectors to identify
emerging trends and companies within the sector that can benefit from it. For
example the non alcoholic beverages market is a very traditional sector. Mainly,
three kinds of products are sold and they are coffee, tea, and packaged water.
Hence, most of the companies manufacture and sell just these three products.
However there is a slight shift in the consumer taste these days – the market for
energy drink is opening up and it seems to be promising. Hence the investor may
want to check for companies within the sector that is best positioned to leverage
this change and adapt to it.
5. Special Situation – This is a slightly complicated way of generating a stock idea.
One has to follow companies, company related news, company events etc to
generate an idea based on special situation. One example that I distinctly remember
was that of Cox & Kings. You may know that Cox & Kings is one of the largest and
the oldest tour operator in India. In late 2013, the company announced inclusion of
Mr.Keki Mistry (from HDFC Bank) to its advisory board. Corporate India has an
immense respect for him as he is known to be a very transparent and efficient
business professional. A colleague of mine was convinced that Cox & Kings would
benefit significantly with Mr. Keki Mistry on its board. This alone acted as a primary
trigger for my colleague to investigate the stock further. Upon further research my
colleague happily invested in Cox & Kings Limited. Good for my him, as I write this
today I know he is sitting on a 200% gain
6. Circle of Competence – This is where you leverage your professional skills to
identify stock ideas. This is a highly recommended technique for a newbie investor.
This method requires you to identify stocks within your professional domain. For
example, if you are a medical professional your circle of competence would be the
healthcare industry. You will probably be a better person to understand that
industry than a stock broker or an equity research analyst. All you need to do is
identify which are the listed companies in this space and pick the best based on
your assessment. Likewise if you are banker, you will probably know more about
banks than the others do. So, leverage your circle of competence to pick your
investments.
The point is that the trigger for investigating stocks may come from any source. In
fact, as and when you feel a particular stock looks interesting, just add it to your list.
This list over time will be your ‘watch list’. A very important thing to note here is that
a stock may not satisfy the checklist items at a particular time, however as the time
129
progresses, as business dynamics change at some point it may match up to the
checklist. Hence, it is important to evaluate the stocks in your watch list from time to
time.
12.3 – The Moat

After selecting a stock, one has to run the checklist to investigate the stock further.
This is called the “Investment due diligence”. The due diligence process is very
critical and one has to ensure maximum attention is paid to each and every aspect
of this exercise. I will shortly present a checklist that I think is reasonable. But before
that, we need to talk about ‘The Moat’.
Moat (or economic moat) is a term that was popularized by Warren Buffet. The term
simply refers to the company’s competitive advantage (over its competitors). A
company with a strong moat, ensures the company’s long term profits are
safeguarded. Of course the company should not only have a moat, but it should
also be sustainable over a long period of time. A company which possesses wider
moat characteristics (such as better brand name, pricing power, and better market
share) would be more sustainable, and it would be difficult for the company’s rivals
to eat away its market share.
To understand moats, think of “Eicher Motors Limited”. Eicher Motors is a major

Indian automobile manufacturer. It manufactures commercial vehicles along with
the iconic Royal Enfield bikes. The Royal Enfield bikes enjoy a huge fan following
both in India and outside India. It has a massive brand recall. Royal Enfield caters to
a niche segment which is growing fast. Their bikes are not as expensive as the
Harley Davidson nor are they as inexpensive as probably the TVS bikes. It would be
very hard for any company to enter this space and shake up or rattle the brand
loyalty that Royal Enfield enjoys. In other words, displacing Eicher Motors from this
sweet spot will require massive efforts from its competitors. This is one of Eicher
Motors’ moat.
There are many companies that exhibit such interesting moats. In fact true wealth
creating companies have a sustainable moat as an underlying factor. Think about
130
Infosys – the moat was labor arbitrage between US and India, Page Industries – the
moat was manufacturing and distribution license of Jockey innerwear, Prestige
Industries – the moat was manufacturing and selling pressure cookers, Gruh
Finance Limited – the moat was small ticket size credits disbursed to a certain
market segment…so on an so forth. Hence always invest in companies which have
wider economic moats.
12.4 – The Due Diligence

The equity research due diligence process involves the following stages –
1. Understanding the business – requires reading the annual reports

2. Application of the checklist and
3. Valuation – to estimate the intrinsic value of the business
In stage 1 i.e Understanding the business we dwell deep into the business with a
perspective of knowing the company inside out. We need to make a list of questions
for which we need to find answers to. A good way to start would be by posting a
very basic question about the company – What business is the company involved
in?
To find the answer, we do not go to Google and search, instead look for it in the
company’s latest Annual Report or their website. This helps us understand what the
company has to say about themselves.
When it comes to my own investing practice, I usually like to invest in companies

where the competition is less and there is very little government intervention. For
example, when I decided to invest in PVR Cinemas, there were only 3 listed players
in that space. PVR, INOX, and Cinemax. PVR and Cinemax merged leaving just 2
listed companies in that space. However, there are a few new players who have
entered this space now, hence it is time for me to re evaluate my investment thesis
in PVR.
Once we are comfortable knowing the business, we move to stage 2 i.e application
of the checklist. At this stage we get some performance related answers. Without
much ado, here is the 10 point checklist that I think is good enough for a start –
Sl
Variable Comment What does it signify
No
Gross Profit Higher the margin, higher is the evidence of a

1 > 20%
Margin (GPM) sustainable moat
131
Revenue In line with the gross Revenue growth should be in line with the profit
2
Growth profit growth growth
EPS should be
If a company is diluting its equity then it is not good
3 EPS consistent with the Net
for its shareholders
Profits
Company should not be High debt means the company is operating on a high
4 Debt Level
highly leveraged leverage. Plus the finance cost eats away the earnings
Applicable for A growing inventory along with a growing PAT margin

5 Inventory manufacturing is a good sign. Always check the inventory number of
companies days
Sales backed by
Sales vs This signifies that the company is just pushing its
6 receivables is not a
Receivables products to show revenue growth
great sign
Cash flow from If the company is not generating cash from operations
7 Has to be positive
operations then it indicates operating stress
Return on Higher the ROE, better it is for the investor, however

8 >25%
Equity make sure you check the debt levels along with this
Avoid companies that have multiple business

Business 1 or 2 simple business
9 interests. Stick to companies that operate in 1 or 2
Diversity lines
segments
If there are too many subsidiaries then it could be a

10 Subsidiary Not many sign of the company siphoning off money. Be cautious
while investing in such companies.
Lastly, a company could satisfy each and every point mentioned in the checklist
above, but if the stock is not trading at the right price in the market, then there is no
point buying the stock. So how do we know if the stock is trading at the right price
or not? Well, this is what we do in stage 3. We need to run a valuation exercise on
132
the stock. The most popular valuation method is called the “Discounted Cash Flow
(DCF) Analysis”.
Over the next few chapters, we will discuss the framework to go about formally
researching the company. This is called “Equity Research”. The focus of our
discussion on equity research will largely be on Stage 2 and 3, as I believe stage 1
involves reading up the annual report in a fairly detailed manner.
1. A stock idea can come from any source

o Circle of competence and General observation is a great way to start
2. It is advisable to have a watch list which includes stocks that look interesting
3. Once a stock is identified we should look for sustainable moats
4. The due diligence process involves understanding the business, running the
checklist to understand its financial performance, and the valuation exercise
5. When it comes to understanding the business, one should be completely thorough
with the business operations of the company
6. The checklist should be improvised as and when the investor gains investment
experience
7. The DCF method is one of the best techniques to identify the intrinsic value of the
business
133
Chapter 13
Equity Research (Part 1)

110
13.1 – What to expect?

Having set the context in the previous chapter, we will now proceed to develop a
methodology for conducting a ‘limited resource’ equity research. The reason why I
call it ‘limited resource’ is because you and I as a retail investor have access to just
few resources to conduct equity research. These resources are – internet, company
annual report, and MS Excel. Whilst an Institution has access to human resource
(analyst), access to company management, financial data base (such as Bloomberg,
Reuters, Factset etc), industry reports etc. So my objective here is to demonstrate
how one can understand a company and its business better with the limited
resources at hand. Of course we will do this exercise keeping the end objective in
perspective i.e to make a decision on whether to buy or not to buy a stock.
As mentioned in the previous chapter, we will structure the equity research process
in 3 stages-
1. Understanding the Business

2. Application of the checklist
3. Intrinsic Value estimation (Valuation) to understand the fair price of the stock
Each stage mentioned above has several steps within it. One must understand that
there is no shortcut to this and one must not compromise any of these steps.
13.2 – Stock Price vs Business Fundamentals

When we take up a company for research, the first step is to understand the
business as much as possible. People often miss this crucial step and go directly
into the stock price analysis. Well, just analyzing the stock price is great if you have a
short term perspective. However for long term investments, understanding the
business is essential.
Why is it important you may wonder? Well, the reason is simple, the more you know
the company the higher is your conviction to stay put with the investment especially
during bad times (aka bear markets). Remember during bear markets, the prices
react and not the business fundamentals. Understanding the company and its
business well gives you the required conviction to reason out why it makes sense to
stay invested in the stock even though the market may think otherwise. They say
bear markets creates value, so if you have a high conviction on the company you
should consider buying into the stock during bear markets and not really selling the
134
stock. Needless to say, this is highly counter intuitive and it takes years of
investment practice to internalize this fact.
Anyway, moving ahead the best source to get information related to the business is
the company’s website and its annual report. We need to study at least the last 5
year annual report to understand how the company is evolving across business
cycles.
13.3 – Understanding the Business

As a first step towards understanding the business, we need to make a list of
questions for which we need to find answers to. Do note, the answers to all these
questions can be found out by reading through the company’s annual report and
website.
Here are a bunch of questions that I think helps us in our quest to understand the
business. I have discussed the rationale behind each question.
Sl
Question Rational behind the question
No
1 What does the company do? To get a basic understanding of the business
Who are its promoters? What To know the people behind the business. A sanity check to
2
are their backgrounds? eliminate criminal background, intense political affiliation etc
135
What do they manufacture (in
To know their products better, helps us get a sense of the
3 case it is a manufacturing
product’s demand supply dynamics
company)?
To get a sense of their geographic presence. Also at times their

How many plants do they have plants could be located in a prime location, and the value of
4
and where are they located? such location could go off balance sheet, making the company
highly undervalued
Are they running the plant in full Gives us an idea on their operational abilities, demand for their
5
capacity? products, and their positioning for future demand
Helps us understand the dependency of the company. For

What kind of raw material is example the raw material could be regulated by Govt (like Coal)
6
required? or the raw material needs to be imported either of which needs
further investigation
Who are the company’s clients By knowing the client base we can get a sense of the sales cycle
7
or end users? and efforts required to sell the company’s products
Helps in knowing the competitors. Too many competing

companies means margin pressure. In such a case the company
8 Who are their competitors? has to do something innovative. Margins are higher if the
company operates in – monopoly, duopoly, or oligopoly market
structure
Besides the promoter and promoter group, it helps to know who

Who are the major shareholders else owns the shares of the company. If a highly successful
9
of the company? investor holds the shares in the company then it could be a good
sign
Gives a sense on how ambitious and innovative the company is.

Do they plan to launch any new While at the same time a company launching products outside
10
products? their domain raises some red flags – is the company losing
focus?
136
Do they plan to expand to
11 Same rational as above
different countries?
Helps us understand which segment (and therefore the product)

What is the revenue mix? Which
12 is contributing the most to revenue. This in turns helps us
product sells the most?
understand the drivers for future revenue growth
This is both good and bad – Good because it acts a natural

Do they operate under a heavy barrier from new competition to enter the market, bad because
13
regulatory environment? they are limited with choices when it comes to being innovative
in the industry
Who are their bankers, Good to know, and to rule out the possibility of the companies
14
auditors? association with scandalous agencies
How many employees do they Gives us a sense of how labor intensive the company’s
15 have? Does the company have operations are. Also, if the company requires a lot of people with
labor issues? niche skill set then this could be another red flag
What are the entry barriers for

Helps us understand how easy or difficult it is for new companies
16 new participants to enter the
to enter the market and eat away the margins
industry?
Is the company manufacturing

If yes, the company maybe sitting on a time bomb – think about
products that can be easily
17 companies manufacturing computer hardware, mobile handsets,
replicated in a country with
garments etc
cheap labor?
Does the company have too If yes, you need to question why? Is it a way for the company to
18
many subsidiaries? siphon off funds?
These questions are thought starters for understanding any company. In the
process of finding answers you will automatically start posting new questions for
which you will have to find answers to. It does not matter which company you are
looking at, if you follow this Q&A framework I’m very confident your understanding
of the company would drastically increase. This is because the Q&A process
137
requires you to read and dig out so much information about the company that you
will start getting a sense of greater understanding of the company.
Remember, this is the first step in the equity research process. If you find red flags
(or something not right about the company) while discovering the answers, I would
advise you to drop researching the company further irrespective of how attractive
the business looks. In case of a red flag, there is no point proceeding to stage 2 of
equity research.
From my experience I can tell you that stage 1 of equity research i.e ‘Understanding
the Company’ takes about 15 hours. After going through this process, I usually try to
summarize my thoughts on a single sheet of paper which would encapsulate all the
important things that I have discovered about the company. This information sheet
has to be crisp and to the point. If I’m unable to achieve this, then it is a clear
indication that I do not know enough about the company. Only after going through
stage 1, I proceed to stage 2 of equity research, which is “Application of Checklist”.
Please do bear in mind the equity research stages are sequential and should follow
the same order.
We will now proceed to stage 2 of equity research. The best way to understand
stage 2 is by actually implementing the checklist on a company.
We have worked with Amara Raja Batteries Limited (ARBL) throughout this module,
hence I guess it makes sense to go ahead and evaluate the checklist on the same
company. Do remember, the company may differ but the equity research
framework remains the same.
As we proceed, a word of caution at this point – the discussion going forward will
mainly revolve around ARBL as we will understand this company better. The idea
here is not to showcase how good or bad ARBL is but instead to illustrate a
framework of what I perceive as a ‘fairly adequate’ equity research process.
13.4 – Application of checklist

The stage 1 of equity research process helps us understand the how, what, who,
and why of the business. It helps us develop a holistic view on the company.
However, like they say – the proof of the pudding is in the eating; so no matter how
attractive the business looks the numbers of the company should also look
attractive.
The objective of the 2nd stage of equity research is to help us comprehend the
numbers and actually evaluate if both the nature of the business and the financial
performance of the business complement each other. If they do not complement
each other then clearly the company will not qualify as investible grade.
138
We looked at the checklist in the previous chapter; I’ll reproduce the same here for
quick reference.
Sl
Variable Comment What does it signify
No
Net Profit In line with the gross Revenue growth should be in line with the profit
1
Growth profit growth growth
EPS should be consistent If a company is diluting its equity then it is not

2 EPS
with the Net Profits good for its shareholders
Gross Profit Higher the margin, higher is the evidence of a

3 > 20%
Margin (GPM) sustainable moat
High debt means the company is operating on a

Company should not be
4 Debt Level high leverage. Plus the finance cost eats away the
highly leveraged
earnings
A growing inventory along with a growing PAT

Applicable for
5 Inventory margin is a good sign. Always check the inventory
manufacturing companies
number of days
Sales backed by
Sales vs This signifies that the company is just pushing its
6 receivables is not a great
Receivables products to show revenue growth
sign
Cash flow from If the company is not generating cash from

7 Has to be positive
operations operations then it indicates operating stress
Higher the ROE, better it is for the investor,

8 Return on Equity >25% however make sure you check the debt levels
along with this
139
Let us go ahead and evaluate each of the checklist items on Amara Raja Batteries
and see what the numbers are suggesting. To begin with we will look into the P&L
items – Gross Profit, Net Profit, and EPS of the company.
Revenue & Pat Growth
The first sign of a company that may qualify as investable grade is the rate at which
it is growing. To evaluate the growth the company, we need to check the revenue
and PAT growth. We will evaluate growth from two perspectives –
1. Year on Year growth – this will gives us a sense of progress the company makes on a
yearly basis. Do note, industries do go through cyclical shifts. From that perspective
if a company has a flat growth, it is ok. However just make sure you check the
competition as well to ensure the growth is flat industry wide.
2. Compounded Annual Growth Rate (CAGR) – The CAGR gives us a sense of how the
company is evolving and growing across business cycles. A good, investable grade
company is usually the first company to overcome the shifts in business cycles. This
will eventually reflect in a healthy CAGR.
Personally I prefer to invest in companies that are growing (Revenue and PAT) over
and above 15% on a CAGR basis.
Let us see how ARBL fares here…
FY 09 -10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Revenue (INR Crs) 1481 1769 2392 3005 3482
Revenue Growth 19.4% 35.3% 25.6% 15.9%
PAT (INR Crs) 167 148 215 287 367
PAT Growth (11.3%) 45.2% 33.3% 27.8%
The 5 year CAGR revenue growth is 18.6% and the 5 year CAGR PAT growth is
17.01%. These are an interesting set of numbers; they qualify as a healthy set of
numbers. However, we still need to evaluate the other numbers on the checklist.
Earnings per Share (EPS)
140
The earnings per share represent the profitability on a per share basis. The EPS and
PAT growing at a similar rate indicates that the company is not diluting the earnings
by issuing new shares, which is good for the existing shareholders. One can think of
this as a reflection of the company’s management’s capabilities.
FV Rs.1 FY 09 -10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
EPS (In INR) 19.56 17.34 12.59 16.78 21.51
Share Cap(INR Crs) 17.08 17.08 17.08 17.08 17.08
EPS Growth – -11.35% – 27.39% 33.28% 28.18%
The 5 year EPS CAGR stands at 1.90% for the FY14.
Gross Profit margins
Gross profit margins, expressed as a percentage is calculated as a –
Gross Profits / Net Sales
Where,
Gross Profits = [Net Sales – Cost of Goods Sold]
Cost of goods sold is the cost involved in making the finished good, we had
discussed this calculation while understanding the inventory turnover ratio. Let us
proceed to check how ARBL’s Gross Profit margins has evolved over the years.
In INR Crs, unless indicated FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Net Sales 1464 1757 2359 2944 3404
COGS 1014 1266 1682 2159 2450
Gross Profits 450 491 677 785 954
141
Gross Profit Margins 30.7% 27.9% 28.7% 26.7% 28.0%
Clearly the Gross Profit Margins (GPM) looks very impressive. The checklist
mandates a minimum GPM of 20%. ARBL has a much more than the minimum GPM
requirement. This implies a couple of things –
1. ARBL enjoys a premium spot in the market structure. This maybe because of the
absence of competition in the sector, which enables a few companies to enjoy
higher margins
2. Good operational efficiency, which in turn is a reflection of management’s
capabilities
Debt level – Balance Sheet check
The first three points in the checklist were mainly related to the Profit & Loss
statement of the company. We will now look through a few Balance sheet items.
One of the most important line item that we need to look at on the Balance Sheet is
the Debt. An increasingly high level of debt indicates a high degree of financial
leverage. Growth at the cost of financial leverage is quite dangerous. Also do
remember, a large debt on balance sheets means a large finance cost charge. This
eats into the retained earnings of the firm.
Here is how the debt stands for ARBL –
Debt( INR Crs) Evaluation –
FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Debt 91.19 95.04 84.07 87.17 84.28
EBIT 261 223 321 431 541
Debt/EBIT (%) 35% 42.61% 26.19% 20.22% 15.57%
The debt seems to have stabilized around 85Crs. In fact it is encouraging to see that
the debt has come down in comparison to the FY 09-10. Besides checking for the
interest coverage ratio (which we have discussed previously) I also like to check the
debt as a percent of ‘Earnings before interest and taxes’ (EBIT). This just gives a
quick perspective on how the company is managing its finance. We can see that the
Debt/EBIT ratio has consistently reduced.
142
I personally think ARBL has done a good job here by managing its debt level
efficiently.
Inventory Check
Checking for the inventory data makes sense only if the company under
consideration is a manufacturing company. Scrutinizing the inventory data helps us
in multiple ways –
1. Raising inventory with raising PAT indicates are signs of a growing company
2. A stable inventory number of days indicates management’s operational efficiency to
some extent
Let us see how ARBL fares on the inventory data –
FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Inventory (INR Crs) 217.6 284.7 266.6 292.9 335.0
Inventory Days 68 72 60 47 47
PAT (INR Crs) 167 148 215 287 367
The inventory number of days is more or less stable. In fact it does show some sign
of a slight decline. Do note, we have discussed the calculation of the inventory
number of days in the previous chapter. Both the inventory and PAT are showing a
similar growth signs which is again a good sign.
Sales vs Receivables
We now look at the sales number in conjunction to the receivables of the company.
A sale backed by receivables is not an encouraging sign. It signifies credit sales and
therefore many questions arise out of it. For instance – are the company sales
personal force selling products on credit? Is the company offering attractive (but not
sustainable) credit to suppliers to push sales?
FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Net Sales(INR Crs) 1464 1758 2360 2944 3403
143
Receivables (INR Crs) 242.3 305.7 319.7 380.7 452.6
Receivables as as a% of Net Sales 16.5% 17.4% 13.5% 12.9% 13.3%
The company has shown stability here. From the table above we can conclude a
large part of their sales is not really backed back receivables, which is quite
encouraging. In fact, just liked the inventory number of days, the receivables as % of
net sales has also showed signs of a decline, which is quite impressive.
Cash flow from Operations
This is in fact one of the most important checks one needs to run before deciding to
invest in a company. The company should generate cash flows from operations; this
is in fact where the proof of the pudding lies. A company which is draining cash
from operations raises some sort of red flag.
In INR Crs FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Cash flow from Operations 214.2 86.1 298.4 335.4 278.7
The cash flow from operations though a bit volatile has remained positive
throughout the last 5 years. This only means ARBL’s core business operations are
generating cash and therefore can be considered successful.
Return on Equity
We have discussed at length about Return on Equity in chapter 9 of this module. I

would encourage you to go through it again if you wish to refresh. Return on Equity
(ROE) measures in percentage the return generated by the company keeping the
shareholders equity in perspective. In a sense ROE measures how successful the
promoters of the company are for having invested their own funds in the company.
Here is how ARBL’s ROE has fared for the last 5 years –
In INR Crs FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
PAT 167 148 215 287 367
144
Shareholders’ Equity 543.6 645.7 823.5 1059.8 1362.7
ROE 30.7% 22.9% 26.1% 27.1% 27.0%
These numbers are very impressive. I personally like to invest in companies that
have a ROE of over 20%. Do remember, in case of ARBL the debt is quite low, hence
the good set of return on equity numbers is not backed by excessive financial
leverage, which is again highly desirable.
Conclusion
Remember we are in stage 2 of equity research. I see ARBL qualifying quite well on
almost all the required parameters in stage 2. Now, you as an equity research
analyst have to view the output of stage 2 in conjunction with your finding from
stage 1 (which deals with understanding the business). If you are able to develop a
comfortable opinion (based on facts) after these 2 stages, then the business surely
appears to have investable grade attributes and therefore worth investing.
However before you go out and buy the stock, you need to ensure the price is right.
This is exactly what we do in stage 3 of equity research.
Key takeways from this chapter
1. ‘Limited Resource’ Equity Research can be performed in 3 stages

1. Understanding the Business
2. Application of the checklist
3. Valuations
2. The objective of the stage 1 i.e understanding the business requires us to gather all
information related to the business. The best way to go about this is the Q&A way
3. In the Q&A way, we begin with posting some simple and straightforward questions
for which we find answers
4. By the time we finish stage 1, we should be through with all the information related
to the business
5. Most of the answers required in stage 1 is present in the company’s annual report
and website
6. Do remember while researching the company in stage 1, if there is something not
very convincing about the company, it is often a good idea to stop researching
further
145
7. It is very important for you get convinced (based on true facts) about the company
in stage 1. This is how you will develop a strong conviction to stay put during bear
markets
8. Stage 2 of Equity Research requires you to evaluate the performance of the
company on various counts.
9. You will proceed to stage 3 only after the company clears in stage 1 & 2.
146
Chapter 14
DCF Primer
47
14.1 – The Stock Price

In the previous chapter we understood stage 1 and stage 2 of equity research. Stage
1 dealt with understanding the business and stage 2 dealt with understanding the
financial performance of the company. One can proceed to stage 3, only if he is
convinced with the findings of both the earlier stages. Stage 3 deals with the stock
price valuation.
An investment is considered a great investment only if a great business is bought at

a great price. In fact, I would even stretch to say that it is perfectly fine to buy a
mediocre business, as long as you are buying it at a great price. This only shows the
significance of ‘the price’ when it comes to investing.
The objective of the next two chapters is to help you understand “the price”. The
price of a stock can be estimated by a valuation technique. Valuation per say helps
you determine the ‘intrinsic value’ of the company. We use a valuation technique
called the “Discounted Cash Flow (DCF)” method to calculate the intrinsic value of
the company. The intrinsic value as per the DCF method is the evaluation of the
‘perceived stock price’ of a company, keeping all the future cash flows in
perspective.
The DCF model is made up of several concepts which are interwoven with one
another. Naturally we need to understand each of these concepts individually and
then place it in the context of DCF. In this chapter we will understand the core
concept of DCF called “The Net Present Value (NPV)” and then we will proceed to
understand the other concepts involved in DCF, before understanding the DCF as a
whole.
147
14.2 – The future cash flow
The concept of future cash flow is the crux of the DCF model. We will understand
this with the help of a simple example.
Assume Vishal is a pizza vendor who serves the best pizza’s in town. His passion for
baking pizzas leads him to an innovation. He invents an automatic pizza maker
which automatically bakes pizzas. All he has to do is, pour the ingredients required
for making a pizza in the slots provided and within 5 minutes a fresh pizza pops out.
He figures out that with this machine, he can earn an annual revenue of
Rs.500,000/- and the machine has a life span of 10 years.
His friend George is very impressed with Vishal’s pizza machine. So much so that,
George offers to buy this machine from Vishal.
Now here is a question for you – What do you think is the minimum price that
George should pay Vishal to buy this machine? Well, obviously to answer this
question we need to see how economically useful this machine is going to be for
George. Assuming he buys this machine today (2014), over the next 10 years, the
machine will earn him Rs.500,000/- each year.
Here is how George’s cash flow in the future looks like –
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000
148
Do note, for the sake of convenience, I have assumed the machine will start
generating cash starting from 2015.
Clearly, George is going to earn Rs.50,00,000/- (10 x 500,000) over the next 10 years,
after which the machine is worthless. One thing is clear at this stage, whatever is the
cost of this machine, it cannot cost more than Rs.50,00,000/-. Think about it – Does
it make sense to pay an entity a price which is more than the economic benefit it
offers?
To go ahead with our calculation, assume Vishal asks George to pay “Rs.X” towards
the machine. At this stage, assume George has two options – either pay Rs.X and
buy the machine or invest the same Rs.X in a fixed deposit scheme which not only
guarantees his capital but also pays him an interest of 8.5%. Let us assume that
George decides to buy the machine instead of the fixed deposit alternative. This
implies, George has foregone an opportunity to earn 8.5% risk free interest. This is
the ‘opportunity cost’ for having decided to buy the machine.
So far, in our quest to price the automatic pizza maker we have deduced three
crucial bits of information –
1. The total cash flow from the pizza maker over the next 10 years – Rs.50,00,000/-
2. Since the total cash flow is known, it also implies that the cost of the machine
should be less than the total cash flow from the machine
3. The opportunity cost for buying the pizza machine is, an investment option that
earns 8.5% interest
Keeping the above three points in perspective, let us move ahead. We will now focus
on the cash flows. We know that George will earn Rs.500,000/- every year from the
machine for the next 10 years. So think about this – George in 2014, is looking at the
future –
1. How much is the Rs.500,000/- that he receives in 2016 worth in today’s terms?
4. To generalize, how much is the cash flow of the future worth in today’s terms?
The answer to these questions lies in the realms of the “Time value of money”. In
simpler words, if I can calculate the value of all the future cash flows from that
machine in terms of today’s value, then I would be in a better situation to price that
machine.
Please note – in the next section we will digress/move away from the pizza problem,
but we will eventually get back to it.
149
14.3 – Time Value of Money (TMV)
Time value of money plays an extremely crucial role in finance. The TMV finds its
application in almost all the financial concepts. Be it discounted cash flow analysis,
financial derivatives pricing, project finance, calculation of annuities etc, the time
value of money is applicable. Think of the ‘Time value of money’ as the engine of a
car, with the car itself being the “Financial World”.
The concept of time value of money revolves around the fact that, the value of
money does not remain the same across time. Meaning, the value of Rs.100 today is
not really Rs.100, 2 years from now. Inversely, the value of Rs.100, 2 years from now
is not really Rs.100 as of today. Whenever there is passage of time, there is an
element of opportunity. Money has to be accounted (adjusted) for that opportunity.
If we have to evaluate, what would be the value of money that we have today
sometime in the future, then we need to move the ‘money today’ through the
future. This is called the “Future Value (FV)” of the money. Likewise, if we have to
evaluate the value of money that we are expected to receive in the future in today’s
terms, then we have to move the future money back to today’s terms. This is called
the “Present Value (PV)” of money.
In both the cases, as there is a passage of time, the money has to be adjusted for
the opportunity cost. This adjustment is called “Compounding” when we have to
calculate the future value of money. It is called “Discounting” when we have to
calculate the present value of money.
Without getting into the mathematics involved (which by the way is really simple) I
will give you the formula required to calculate the FV and PV.
Example 1 – How much is Rs.5000/- in today’s terms (2014) worth five years later
assuming an opportunity cost of 8.5%?
This is a case of Future Value (FV) computation, as we are trying to evaluate the
future value of the money that we have today –
Future Value = Amount * (1+ opportunity cost rate) ^ Number of years.
= 5000 *(1 + 8.5%) ^ 5
= 7518.3
This means Rs.5000 today is comparable with Rs.7518.3 after 5 years, assuming an
opportunity cost of 8.5%.
Example 2 – How much is Rs.10,000/- receivable after 6 years, worth in today’s

terms assuming an opportunity cost of 8.5%?
150
This is clearly the case of Present Value (PV) computation as we are trying to
evaluate the present value of cash receivable in future in terms of today’s value.
Present Value = Amount / (1+Discount Rate) ^ Number of years
= 10,000 / (1+ 8.5% ) ^ 6
= 6129.5
This means Rs.10,000/- receivable after 6 years in future is comparable

to Rs.6,129.5 in today’s terms assuming a discount rate of 8.5%.
Example 3 – If I reframe the question in the first example – How much is Rs.7518.3
receivable in 5 years worth in today’s terms given an opportunity cost @ 8.5%?
We know this requires us to calculate the present value. Also, since we have done
the reverse of this in example 1, we know the answer should be Rs.5000/- . Let us
calculate the present value to check this –
= 7518.3 / (1 + 8.5%) ^ 5
= 5000.0
Assuming you are clear with the concept of time value of money, I guess we are now
equipped to go back to the pizza problem.
14.4 – The Net Present Value of cash flows

We are still in the process of evaluating the price of the pizza machine. We know
George is entitled to receive a stream of cash flows (by virtue of owning the pizza
machine) in the future. The cash flow structure is as follows
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000
We posted this question earlier, let me repost it again – How much is the cash flow
of the future worth in today’s terms?
As we can see, the cash flow is uniformly spread across time. We need to calculate
the present value of each cash flow (receivable in the future) by discounting it with
the opportunity cost.
Here is a table that calculates the PV of each cash flow keeping the discount rate of
8.5% –
151
Year Cash Flow (INR) Receivable in (years) Present Value (INR)
2015 500,000 1 460,829
2016 500,000 2 424808
2017 500,000 3 391481
2018 500,000 4 360802
2019 500,000 5 332535
2020 500,000 6 306485
2021 500,000 7 282470
2022 500,000 8 260,335
2023 500,000 9 239,946
2024 500,000 10 221151
Total 50,00,000 32,80,842
The sum of all the present values of the future cash flow is called “The Net Present
Value (NPV)”. The NPV in this case is Rs. 32,80,842 This also means, the value of all
the future cash flows from the pizza machine in today’s terms is Rs. 32,80,842. So if
George has to buy the pizza machine from Vishal, he has to ensure the price is
Rs. 32,80,842 or lesser, but definitely not more than that and this is roughly how
much the pizza machine should cost George.
152
Now, think about this – What if we replace the pizza machine with a company? Can
we discount all future cash flows that the company earns with an intention to
evaluate the company’s stock price? Yes, we can and in fact this is exactly what will
we do in the “Discounted Cash Flow” model.
1. A valuation model such as the DCF model helps us estimate the price of a stock
2. The DCF model is made up of several inter woven financial concepts
3. The ‘Time Value of Money’ is one of the most crucial concept in finance, as it finds its
application in several financial concepts including the DCF method
4. The value of money cannot be treated the same across the time scale – which
means the value of money in today’s terms is not really the same at some point in
the future
5. To compare money across time we have to ‘time travel the money’ after accounting
for the opportunity cost
6. Future Value of money is the estimation of the value of money we have today at
some point in the future
7. Present value of money is the estimation of the value of money receivable in the
future in terms of today’s value
8. The Net Present Value (NPV) of money is the sum of all the present values of the
future cash flows
153
Chapter 15
Equity Research (Part 2)

185
15.1 – Getting started with the DCF Analysis

We discussed about “The Net Present Value (NPV)” in the previous chapter. NPV
plays a very important role in the DCF valuation model. Having understood this
concept, we now need to understand a few other topics that are related to DCF
valuation model. In fact, we will learn more about these concepts by implementing
the DCF model on Amara Raja Batteries Limited (ARBL). With this, we will conclude
the 3rdstage of Equity Research i.e ‘The Valuation’.
In the previous chapter in order to evaluate the price of the pizza machine, we
looked at the future cash flows from the pizza machine and discounted them back
to get the present value. We added all the present value of future cash flows to get
the NPV. Towards the end of the previous chapter we also toyed around with the
idea –What will happen if the pizza machine is replaced by the company’s stock?
Well, in that case we just need an estimate of the future cash flows from the
company and we will be in a position to price the company’s stock.
But what cash flow are we talking about? And how do we forecast the future cash
flow for a company?
154
15.1 – The Free Cash Flow (FCF)
The cash flow that we need to consider for the DCF Analysis is called the “Free Cash
flow (FCF)” of the company. The free cash flow is basically the excess operating cash
that the company generates after accounting for capital expenditures such as
buying land, building and equipment. This is the cash that shareholders enjoy after
accounting for the capital expenditures. The mark of a healthy business eventually
depends on how much free cash it can generate.
Thus, the free cash is the amount of cash the company is left with after it has paid
all its expenses including investments.
When the company has free cash flows, it indicates the company is a healthy
company. Hence investors often look out of such companies whose share prices
are undervalued but who have high or rising free cash flow, as they believe over
time the disparity will disappear as the share price will soon increase.
Thus the Free cash flow helps us know if the company has generated earnings in a
year or not. Hence as an investor to assess the company’s true financial health, look
at the free cash flow besides the earnings.
FCF for any company can be calculated easily by looking at the cash flow statement.
The formula is –
FCF = Cash from Operating Activities – Capital Expenditures
Let us calculate the FCF for the last 3 financial years for ARBL –
Particular 2011 -12 2012 -13 2013 -14
Cash from Operating Activities (after income tax) Rs.296.28 Crs Rs.335.46 Rs.278.7
Capital Expenditures Rs.86.58 Rs.72.47 Rs.330.3
Free Cash Flow (FCF) Rs.209.7 Rs.262.99 (Rs.51.6)
Here is the snapshot of ARBL’s FY14 annual report from where you can calculate the
free cash flow –
155
Please note, the Net cash from operating activities is computed after adjusting for
income tax. The net cash from operating activities is highlighted in green, and the
capital expenditure is highlighted in red.
You may now have a fair point in your mind – When the idea is to calculate the
future free cash flow, why are we calculating the historical free cash flow? Well, the
reason is simple, while working on the DCF model, we need to predict the future
free cash flow. The best way to predict the future free cash flow is by estimating the
historical average free cash flow and then sequentially growing the free cash flow by
a certain rate.. This is a standard practice in the industry.
Now, by how much do we grow the free cash flow is the next big question? Well, the
growth rate you would assume should be as conservative as possible. I personally
like to estimate the FCF for at least 10 years. I do this by growing the cash flow at a
certain rate for the first 5 years, and then I factor in a lower rate for the next five
years. If you are getting a little confused here, I would encourage you to go through
the following step by step calculation for a better clarity.
Step 1 – Estimate the average free cash flow
As the first step, I estimate the average cash flow for the last 3 years for ARBL –
= 209.7 + 262.99 + (51.6) / 3
=Rs.140.36 Crs
156
The reason for taking the average cash flow for the last 3 years is to ensure, we are
averaging out extreme cash flows, and also accounting for the cyclical nature of the
business. For example in case of ARBL, the latest year cash flow is negative at
Rs.51.6 Crs. Clearly this is not a true representation of ARBL’s cash flow, hence for
this reason it is always advisable to take the average free cash flow figures.
Step 2 – Identify the growth rate
Select a rate which you think is reasonable. This is the rate at which, the average
cash flow will grow going forward. I usually prefer to grow the FCF in 2 stages. The
first stage deals with the first 5 years and the 2ndstage deals with the last 5 years.
Specifically with reference to ARBL, I prefer to use 18% for the first 5 years and
around 10% for the next five years. If the company under consideration is a mature
company, that has grown to a certain size (as in a large cap company), I would
prefer to use a growth rate of 15% and 10% respectively. The idea here is to be as
conservative as possible.
Step 3 – Estimate the future cash flows
We know the average cash flow for 2013 -14 is Rs.140.26 Crs. At 18% growth, the
cash flow for the year 2014 – 2015 is estimated to be –
= 140.36 * (1+18%)
= Rs. 165.62 Crs.
The free cash flow for the year 2015 – 2016 is estimated to be –
165.62 * (1 + 18%)
= Rs. 195.43 Crs.
So on and so forth. Here is a table that gives the detailed calculation…
Estimate of future cash flow –
Sl No Year Growth rate assumed Future Cash flow (INR Crs)
01 2014 – 15 18% 165.62
02 2015 – 16 18% 195.43
157
03 2016 – 17 18% 230.61
04 2017 – 18 18% 272.12
05 2018 – 19 18% 321.10
06 2019 – 20 10% 353.21
07 2020 – 21 10% 388.53
08 2021 – 22 10% 427.38
09 2022 – 23 10% 470.11
10 2023 – 24 10% 517.12
With this, we now have a fair estimate of the future free cash flow. How reliable are
these numbers you may ask. After all, predicting the free cash flow implies we are
predicting the sales, expenses, business cycles, and literally every aspect of the
business. Well, the estimate of the future cash flow is just that, it is an estimate. The
trick here is to be as conservative as possible while assuming the free cash flow
growth rate. We have assumed 18% and 10% growth rate for the future, these are
fairly conservative growth rate numbers for a well managed and growing company.
15.2 – The Terminal Value

We have tried to predict the future free cash flow for upto 10 years. But what would
happen to the company after the 10th year? Would it cease to exist? Well, it would
not. A company is expected to be a ‘going concern’ which continues to exist forever.
This also means as long as the company exists, there is some amount of free cash
being generated. However as companies mature, the rate at which the free cash is
generated starts to diminish.
The rate at which the free cash flow grows beyond 10 years (2024 onwards) is called
the “Terminal Growth Rate”. Usually the terminal growth rate is considered to be
less than 5%. I personally like to set this rate between 3-4%, and never beyond that.
158
The “Terminal Value” is the sum of all the future free cash flow, beyond the
10th year, also called the terminal year. To calculate the terminal value we just have
to take the cash flow of the 10th year and grow it at the terminal growth rate.
However, the formula to do this is different as we are calculating the value literally
to infinity.
Terminal Value = FCF * (1 + Terminal Growth Rate) / (Discount Rate – Terminal

growth rate)
Do note, the FCF used in the terminal value calculation is that of the 10th year. Let us
calculate the terminal value for ARBL considering a discount rate of 9% and terminal
growth rate of 3.5% :
= 517.12 *(1+ 3.5%) / (9% – 3.5%)
= Rs.9731.25 Crs
15.3 – The Net Present Value (NPV)

We know the future free cash flow for the next 10 years and we also know the
terminal value (which is the future free cash flow of ARBL beyond the 10th year and
upto infinity). We now need to find out the value of these cash flows in today’s
terms. As you may recall, this is the present value calculation. Once we find out the
present value, we will add up these present values to estimate the net present value
(NPV) of ARBL.
We will assume the discount rate at 9%.
For example in 2015 – 16 (2 years from now) ARBL is expected to receive Rs.195.29
Crs. At 9% discount rate the present value would be –
= 195.29 / (1+9%)^2
= Rs.164.37 Crs
So here is how the present value of the future cash flows stack up –
Sl No Year Growth rate Future Cash flow (INR Crs) Present Value (INR Crs)
1 2014 – 15 18% 165.62 151.94
2 2015 – 16 18% 195.29 164.37
159
3 2016 – 17 18% 230.45 177.94
4 2017 – 18 18% 271.93 192.72
5 2018 – 19 18% 320.88 208.63
6 2019 – 20 10% 352.96 210.54
7 2020 – 21 10% 388.26 212.48
8 2021 – 22 10% 427.09 214.43
9 2022 – 23 10% 470.11 216.55
10 2023 – 24 10% 517.12 218.54
Net Present Value (NPV) of future free cash flows Rs.1968.14 Crs
Along with this, we also need to calculate the net present value for the terminal
value, to calculate this we simply discount the terminal value by discount rate –
= 9731.25 / (1+9%)^10
= Rs.4110.69 Crs
Therefore, the sum of the present values of the cash flows is = NPV of future free
cash flows + PV of terminal value
= 1968.14 + 4110.69
= Rs.6078.83 Crs
This means standing today and looking into the future, I expect ARBL to generate a
total free cash flow of Rs.6078.83 Crs all of which would belong to the shareholders
of ARBL.
160
15.4 – The Share Price
We are now at the very last step of the DCF analysis. We will now calculate the share
price of ARBL based on the future free cash flow of the firm.
We now know the total free cash flow that ARBL is likely to generate. We also know
the number of shares outstanding in the markets. Dividing the total free cash flow
by the total number of shares would give us the per share price of ARBL.
However before doing that we need to calculate the value of ‘Net Debt’ from the
company’s balance sheet. Net debt is the current year total debt minus current year
cash & cash balance.
Net Debt = Current Year Total Debt – Cash & Cash Balance
For ARBL this would be (based on FY14 Balance sheet) –
Net Debt = 75.94 – 294.5
= (Rs.218.6 Crs)
A negative sign indicates that the company has more cash than debt. This naturally
has to be added to the total present value of free cash flows.
= Rs.6078.83 Crs – (Rs. 218.6 Crs)
= Rs.6297.43 Crs
Dividing the above number by the total number of shares should give us the share
price of the company also called the intrinsic value of the company.
Share Price = Total Present Value of Free Cash flow / Total Number of shares
We know from ARBL’s annual report the total number of outstanding shares is
17.081 Crs. Hence the intrinsic value or the per share value is –
= Rs.6297.43 Crs / 17.081 Crs
~ Rs.368 per share!
This in fact is the final output of the DCF model.
15.5 – Modeling Error & the intrinsic value band

The DCF model though quite scientific is built on a bunch of assumptions. Making
assumptions, especially in finance takes on an art form. You get better at it, as you
progress through and gain more experience. Hence for all practical purposes, it is
advisable for us to assume (yet another assumptionJ ) that we have made a few
161
errors while making the intrinsic value calculation and hence we should
accommodate for modeling errors.
A leeway for the modeling error simply allows us to be a flexible with the calculation
of the per share value. I personally prefer to add + 10% as an upper band and – 10%
as the lower band for what I perceive as the intrinsic value of the stock.
Applying that on our calculation –
Lower intrinsic value = 368 * (1- 10%) = Rs. 331
Upper intrinsic value = Rs.405
Hence, instead of assuming Rs.368 as the fair value of the stock, I would now
assume that the stock is fairly valued between 331 and 405. This would be the
intrinsic value band.
Now keeping this value in perspective, we check the market value of the stock.
Based on its current market price we conclude the following –
1. If the stock price is below the lower intrinsic value band, then we consider the stock
to be undervalued, hence one should look at buying the stock
2. If the stock price is within the intrinsic value band, then the stock is considered fairly
valued. While no fresh buy is advisable, one can continue to hold on to the stock if
not for adding more to the existing positions
3. If the stock price is above the higher intrinsic value band, the stock is considered
overvalued. The investor can either book profits at these levels or continue to stay
put. But should certainly not buy at these levels.
Keeping these guidelines, we could check for the stock price of Amara Raja Batteries
Limited as of today (2nd Dec 2014). Here is a snapshot from the NSE’s website –
162
The stock is trading at Rs.726.70 per share! Way higher than the upper limit of the
intrinsic value band. Clearly buying the stock at these levels implies one is buying at
extremely high valuations.
15.6 –Spotting buying opportunities

Long term investment and activities surrounding long term investing is like a slow
moving locomotive train. Active trading on the other hand is like the fast bullet
train. When long term value opportunity is created, the opportunity lingers in the
market for a while. It does not really disappear in a hurry. For instance, we now
know that Amara Raja Batteries Limited is overvalued at current market price as it is
trading way higher than the upper limit of the intrinsic value band. But the scene
was totally different a year ago. Recall based on FY 2013- 2014, ARBL’s intrinsic value
band is between Rs. 331 and Rs.405.
Here is the chart of ARBL –
163
The blue highlight clearly shows that, the stock was comfortable trading within the
band for almost 5 months! You could have bought the stock anytime during the
year. After buying, all you had to do was stay put for the returns to roll!
In fact this is the reason why they say – Bear markets create value. The whole of last
year (2013) the markets were bearish, creating valuable buying opportunities in
quality stocks.
15.7 – Conclusion
Over the last 3 chapters, we have looked at different aspects of equity research. As
you may have realized, equity research is simply the process of inspecting the
company from three different perspectives (stages).
In stage 1, we looked at the qualitative aspects of the company. At this stage, we

figured out who, what, when, how, and why of the company. I consider this as an
extremely crucial stage of equity research. If something is not really convincing here,
I do not proceed further. Remember markets are an ocean of opportunities, so do
not force yourself to commit on to an opportunity that does not give you the right
vibe.
I proceed to stage 2 only after I am 100% convinced with my findings in stage 1.

Stage 2 is basically the application of the standard checklist, where we evaluate the
performance of the company. The checklist that we have discussed is just my
version, of what I think is a fairly good checklist. I would encourage you to build your
own checklist, but make sure you have a reasonable logic while including each
checklist item.
Assuming the company clears both stage 1 and 2 of equity research, I proceed to
equity research stage 3. In stage 3, we evaluate the intrinsic value of the stock and
164
compare it with the market value. If the stock is trading cheaper than the intrinsic
value, then the stock is considered a good buy. Else it is not.
When all the 3 stages align to your satisfaction, then you certainly would have the
conviction to own the stock. Once you buy, stay put, ignore the daily volatility (that is
in fact the virtue of capital markets) and let the markets take its own course.
Please note, I have included a DCF Model on ARBL, which I have built on excel. You
could download this and use it as a calculator for other companies as well.
1. The free cash flow (FCF) for the company is calculated by deducting the capital
expenditures from the net cash from operating activates
2. The free cash flow tracks the money left over for the investors
3. The latest year FCF is used to forecast the future year’s cash flow
4. The growth rate at which the FCF is grown has to be conservative
5. Terminal growth rate is the rate at which the company’s cash flow is supposed to
grow beyond the terminal year
6. The terminal value is the value of the cash flow the company generates from the
terminal year upto infinity
7. The future cash flow including the terminal value has to be discounted back to
today’s value
8. The sum of all the discounted cash flows (including the terminal value) is the total
net present value of cash flows
9. From the total net present value of cash flows, the net debt has to be adjusted.
Dividing this by the total number of shares gives us the per share value of the
company
10. One needs to accommodate for modeling errors by including a 10% band around
the share price
11. By including a 10% leeway we create a intrinsic value band
12. Stock trading below the range is considered a good buy, while the stock price above
the intrinsic value band is considered expensive
13. Wealth is created by long term ownership of undervalued stocks
14. Thus, the DCF analysis helps the investors to identify whether the current share
price of the company is justified or not.
165
Chapter 16
The Finale
161
16.1 – The follies of DCF Analysis

In this concluding chapter, we will discuss a few important topics that could
significantly impact the way you make your investment decisions. In the previous
chapter, we learnt about the intrinsic value calculation using the Discounted Cash
Flow (DCF) analysis. The DCF method is probably one of the most reliable methods
available to evaluate the intrinsic value of a company’s stock. However, the DCF
method has its fair share of drawbacks which you need to be aware of. The DCF
model is only as good as the assumptions which are fed to it. If the assumptions
used are incorrect, the fair value and stock price computation could be skewed.
1. DCF requires us to forecast – To begin with, the DCF model requires us to predict
the future cash flow and the business cycles. This is a challenge, let alone for a
fundamental analyst but also for the top management of the company
2. Highly sensitive to the Terminal Growth rate – The DCF model is highly sensitive
to the terminal growth rate. A small change in the terminal growth rate would lead
to a large difference in the final output i.e. the per share value. For instance in the
ARBL case, we have assumed 3.5% as the terminal growth rate. At 3.5%, the share
price is Rs.368/- but if we change this to 4.0% (an increase of 50 basis points) the
share price would change to Rs.394/-
166
3. Constant Updates – Once the model is built, the analyst needs to constantly modify
and align the model with new data (quarterly and yearly data) that comes in. Both
the inputs and the assumptions of the DCF model needs to be updated on a regular
basis.
4. Long term focus – DCF is heavily focused on long term investing, and thus it does
not offer anything to investors who have a short term focus. (i.e. 1 year investment
horizon)
Also, the DCF model may make you miss out on unusual opportunities as the model
are based on certain rigid parameters.
Having stated the above, the only way to overcome the drawbacks of the DCF Model
is by being as conservative as possible while making the assumptions. Some
guidelines for the conservative assumptions are –
1. FCF (Free Cash Flow) growth rate – The rate at which you grow the FCF year on
year has to be around 20%. Companies can barely sustain growing their free cash
flow beyond 20%. If a company is young and belongs to the high growth sector, then
probably a little under 20% is justified, but no company deserves a FCF growth rate
of over 20%
2. Number of years – This is a bit tricky, while longer the duration, the better it is. At
the same time longer the duration, there would be more room for errors. I generally
prefer to use a 10 year 2 stage DCF approach
3. 2 stage DCF valuation – It is always a good practice to split the DCF analysis into 2
stages as demonstrated in the ARBL example in the previous chapter. As discussed
,In stage 1 I would grow the FCF at a certain rate, and in stage 2 I would grow the
FCF at a rate lower than the one used in stage 1
4. Terminal Growth Rate – As I had mentioned earlier, the DCF model is highly
sensitive to the terminal growth rate. Simple thumb rule here – keep it as low as
possible. I personally prefer to keep it around 4% and never beyond it.
16.2 – Margin of Safety

Now, despite making some conservative assumptions things could still go wrong.
How do you insulate yourself against that? This is where the concept of ‘Margin of
Safety’ would arrive. The margin of safety thought process was popularized by
Benjamin Graham in his seminal book titled “Intelligent Investor”. The ‘margin of
safety’ simply suggests that an investor should buy stocks only when it is available at
a discount to the estimated intrinsic value calculation. Following the Margin of
Safety does not imply successful investments, but would provide a buffer for errors
in calculation.
Here is how I exercise the ‘Margin of Safety’ principle in my own investment practice.
Consider the case of Amara Raja Batteries Limited; the intrinsic value estimate was
around Rs.368/- per share. Further we applied a 10% modeling error to create the
167
intrinsic value band. The lower intrinsic value estimate was Rs.331/-. At Rs.331/- we
are factoring in modeling errors. The Margin of Safety advocates us to further
discount the intrinsic value. I usually like to discount the intrinsic value by another
30% at least.
But why should we discount it further? Aren’t we being extra conservative you may
ask? Well, yes, but this is the only way you can insulate yourself from the bad
assumptions and bad luck. Think about it, given all the fundamentals, if a stock
looks attractive at Rs.100, then at Rs.70, you can be certain it is indeed a good bet!
This is in fact what the savvy value investors always practice.
Going back to the case of ARBL –
1. Intrinsic value is Rs.368/-

2. Accounting for modeling errors @10% the lower intrinsic band value is Rs.331/-
3. Discounting it further by another 30%, in order to accommodate for the margin of
safety, the intrinsic value would be around Rs.230/-
4. At 230/- I would be a buyer in this stock with great conviction
Of course, when quality stocks falls way below its intrinsic value they get picked up
by value investors. Hence when the margin of safety is at play, you should consider
buying it as soon as you can. As a long term investor, sweet deals like this (as in a
quality stock trading below its intrinsic value) should not be missed.
Also, remember good stocks will be available at great discounts mostly in a bear
market, when people are extremely pessimistic about stocks. So make sure you
have sufficient cash during bear markets to go shopping!
16.3 – When to sell?

Throughout the module we have discussed about buying stocks. But what about
selling? When do we book profits? For instance assume you bought ARBL at around
Rs.250 per share. It is now trading close to Rs.730/- per share. This translates to an
absolute return of 192%. A great rate of return by any yardstick (considering the
return is generated in over a year’s time). So does that mean you actually sell out
this stock and book a profit? Well the decision to sell depends on the disruption in
investible grade attributes.
Disruption in investible grade attributes – Remember the decision to buy the

stock does not stem from the price at which the stock trades. Meaning, we do not
buy ARBL just because it has declined by 15%. We buy ARBL only because it qualifies
through the rigor of the“investible grade attributes”. If a stock does not showcase
investible grade attributes we do not buy. Therefore going by that logic, we hold on
to stocks as long as the investible grade attributes stays intact.
168
The company can continue to showcase the same attributes for years together. The
point is, as long as the attributes are intact, we stay invested in the stock. By virtue
of these attributes the stock price naturally increases, thereby creating wealth for
you. The moment these attributes shows signs of crumbling down, one can consider
selling the stock.
16.4 – How many stocks in the portfolio?

The number of stocks that you need to own in your portfolio is often debated. While
some say holding many stocks help you diversify risk, others say holding far fewer
helps you take concentrated bets which can potentially reap great rewards. Here is
what some of the legendary investors have advised when it comes to the number of
stocks in your portfolio –
Seth Kalrman – 10 to 15 stocks
Warren Buffet – 5 to 10 stocks
Ben Graham – 10 to 30 stocks
John Keynes – 2 to 3 stocks
In my own personal portfolio, I have about 13 stocks and at no point I would be

comfortable owning beyond 15 stocks. While it is hard to comment on what should
be the minimum number of stocks, I do believe there is no point owning a large
number of stocks in your portfolio. When I say large, I have a figure of over 20 in my
mind.
16.5 – Final Conclusion

Over the last 16 chapters, we have learnt and discussed several topics related to the
markets and fundamental analysis. Perhaps it is now the right time to wrap up and
leave you with a few last points that I think are worth remembering –
1. Be reasonable – Markets are volatile; it is the nature of the beast. However if you
have the patience to stay put, markets can reward you fairly well. When I say
“reward you fairly well” I have a CAGR of about 15-18% in mind. I personally think
this is a fairly decent and realistic expectation. Please don’t be swayed by abnormal
returns like 50- 100% in the short term, even if it is achievable it may not be
sustainable
2. Long term approach – I have discussed this topic in chapter 2 as to why investors
need to have a long term approach. Remember, money compounds faster the
longer you stay invested
3. Look for investible grade attributes – Look for stocks that display investible grade
attributes and stay invested in them as long as these attributes last. Book profits
when you think the company no longer has these attributes
169
4. Respect Qualitative Research – Character is more important than numbers.
Always look at investing in companies whose promoters exhibit good character
5. Cut the noise, apply the checklist – No matter how much the analyst on
TV/newspaper brags about a certain company don’t fall prey to it. You have a
checklist, just apply the same to see if it makes any sense
6. Respect the margin of safety – As this literally works like a safety net against bad
luck
7. IPO’s – Avoid buying into IPOs. IPOs are usually overpriced. However if you were
compelled to buy into an IPO then analyze the IPO in the same 3 stage equity
research methodology
8. Continued Learning – Understanding markets requires a lifetime effort. Always
look at learning new things and exploring your knowledge base.
I would like to leave you with 4 book recommendations that I think will help you
develop a great investment mindset.
1. The Essays of Warren Buffet : Lessons for Investors & Managers

2. The Little Book that Beats the Market – By Joel Greenblatt
3. The Little Book of Valuations – By Aswath Damodaran
4. The Little Book that Builds Wealth – By Pat Dorsey
So friends, with these points I would like to close this module on Fundamental
Analysis. I hope you enjoyed reading this as much as I enjoyed writing it.
170
171
ZERODHA
Futures Trading
ZERODHA.COM/VARSITY
TABLE OF CONTENTS
1 Background 1
1.1 Overview 1
1.2 A simple forwards example 2
1.3 3 possible scenarios 3
1.4 3 possible scenarios in one graph 4
1.5 A quick note on settlement 5
1.6 What about risk ? 6
2 Introducing Futures contract 9

2.1 Setting the context 9
2.2 A sneak peak into the futures agreement 10
2.3 Before your first futures trade 13
3 The Futures Trade 15

3.1 Before the Trade 15
3.2 The Futures Trade 19
3.3 3 possible scenarios post the agreement 20
3.4 Exploiting a trading opportunity 22
4 Leverage & Payoff 26

4.1 A quick recap 26
4.2 Leverage in Perspective 27
4.3 Leverage 29
4.4 Leverage Calculation 34
4.5 The Futures Payoff 35
zerodha.com/varsity
5 Margin & M2M 40
5.1 Things you should know by now 40
5.2 Why are margins charged 42
5.3 Mark to Market (M2M) 43
5.4 Margins the bigger perspective 46
5.5 An interesting case of ‘Margin Call’ 51
6 Margin Calculator (Part 1) 54

6.1 The Margin Calculator 54
6.2 Expiry 58
6.3 Sneak peak into spreads 62
7 Margin Calculator (Part 2) 67

7 The trade information 67
7.2 The Product types 69
7.3 Back to the Margin Calculator 72
7.4 BO & CO Margin Calculator 76
7.5 The trailing stoploss 77
8 All about Shorting 80

8.1 Shorting in a nutshell 80
8.2 Shorting stocks in the spot market 81
8.3 Shorting in spot ( The stock exchange’s perspective) 84
8.4 Shorting in the futures market 85
zerodha.com/varsity
9 The Nifty Futures 88
9.1 Basics of Index Futures 88
9.2 Impact cost 90
9.3 Why trading Nifty makes sense 93
10 The Futures pricing 96

10.1 The Pricing Formula 96
10.2 Practical Application 101
10.3 Calendar Spreads 103
11 Hedging with Futures 106

11.1 Hedging, What is it? 106
11.2 Hedge - But Why? 107
11.3 Risk 108
11.4 Hedging a single stock position 110
11.5 Understanding Beta (β) 112
11.6 Understanding Beta in MS Excel 113
11.6 Hedging a stock portfolio 114
12 Open Interest 120

12.1 Open Interest and its calculation 120
12.2 OI & Volume Interpretation 124
zerodha.com/varsity
C H A PT E R 1
Background – Forwards
Market
1.1 Overview
The Futures market is an integral part of the Financial Derivatives world. ‘Derivatives’ as they are
called is a security, whose value is derived from another financial entity referred to as an ‘Underly-
ing Asset’. The underlying asset can be anything a stock, bond, commodity or currency. The finan-
cial derivatives have been around for a long time now. The earliest reference to the application of
derivatives in India dates back to 320 BC in ‘Kautilya’s Arthashastra’. It is believed that in the an-
cient Arthashastra (study of Economics) script, Kautilya described the pricing mechanism of the
standing crops ready to be harvested at some point in the future. Apparently he used this method
to pay the farmers much in advance, thereby structuring a true ‘forwards contract’.
Given the similarities between the forwards and the futures market, I think the best possible way
to introduce the futures market is by first understanding the ‘Forwards market’. The Understand-
ing of Forwards Market would lay a strong foundation for learning the Futures Market.
The forwards contract is the simplest form of derivative. Consider the forwards contract as the
older avatar of the futures contract. Both the futures and the forward contracts share a common
transactional structure, except that over the years the futures contracts have become the default
choice of a trader. The forward contracts are still in use, but are limited to a few participants such
as the industries and banks.
1.2 – A simple Forwards example
The Forward market was primarily started to protect the interest of the farmers from adverse
price movements. In a forward market, the buyer and seller enter into an agreement to exchange
the goods for cash. The exchange happens at a specific price on a specific future date. The price
of the goods is fixed by both the parties on the day they enter into the agreement. Similarly the
date and time of the goods to be delivered is also fixed. The agreement happens face to face with
no intervention of a third party. This is called “Over the Counter or OTC” agreement. Forward con-
tracts are traded only in the OTC (Over the Counter) market, where individuals/ institutions trade
through negotiations on a one to one basis.
Consider this example, there are two parties involved here.
One is a jeweler whose job is to design and manufacture jewelry. Let us call him ‘ABC Jewelers’.
The other is a gold importer whose job is to sell gold at a whole sale price to jewelers, let us call
him’ XYZ Gold Dealers’.
On 9th Dec 2014, ABC enters into an agreement with XYZ to buy 15 kilograms of gold at a certain
purity (say 999 purity) in three months time (9th March 2015). They fix the price of Gold at the cur-
rent market price, which is Rs.2450/- per gram or Rs.24,50,000/- per kilogram. Hence as per this
agreement, on 9th March 2015, ABC is expected to pay XYZ a sum of Rs.3.675 Crs (24,50,000/
Kg*15) in return for the 15 kgs of Gold.
This is a very straightforward and typical business agreement that is prevalent in the market. An
agreement of this sort is called a ‘Forwards Contract’ or a ‘Forwards Agreement’.
Do note, the agreement is executed on 9th Dec 2014, hence irrespective of the price of gold 3
months later i.e 9th March 2015, both ABC and XYZ are obligated to honor the agreement. Before
we proceed further, let us understand the thought process of each party and understand what
compelled them to enter into this agreement.
Why do think ABC entered into this agreement? Well, ABC believes the price of gold would go up
over the next 3 months, hence they would want to lock in today’s market price for the gold.
Clearly, ABC wants to insulate itself form an adverse increase in gold prices.
In a forwards contract, the party agreeing to buy the asset at some point in the future is called the
“Buyer of the Forwards Contract”, in this case it is ABC Jewelers.
Likewise, XYZ believes the price of gold would go down over the next 3 months and hence they
want to cash in on the high price of gold which is available in the market today. In a forwards con-
tract, the party agreeing to sell the asset at some point in the future is called the “Seller of the For-
wards Contract”, in this case it is XYZ Gold Dealers.
Both the parties have an opposing view on gold; hence they see this agreement to be in line with
their future expectation.
1.3 – 3 possible scenarios

While both these parties have their own view on gold, there are only three possible scenarios that
could pan out at the end of 3 months. Let us understand these scenarios and how it could impact
both the parties.
Scenario 1 – The price of Gold goes higher
Assume on 9th March 2015, the price of gold (999 purity) is trading at Rs.2700/- per gram. Clearly,
ABC Jeweler’s view on the gold price has come true. At the time of the agreement the deal was val-
ued at Rs 3.67 Crs but now with the increase in Gold prices, the deal is valued at Rs.4.05 Crs. As
per the agreement, ABC Jewelers is entitled to buy Gold (999 purity) from XYZ Gold Dealers at a
price they had previously agreed upon i.e Rs.2450/- per gram.
The increase in Gold price impacts both the parties in the following way –
Party Action Financial Impact

ABC Jewelers Buys gold from XYZ Gold ABC saves Rs.38 Lakhs ( 4.05 Crs –
Dealers @ Rs.2450/- per gram 3.67 Crs) by virtue of this agreement
Obligated to sell Gold to ABC Incurs a financial loss of Rs.38

XYZ Gold Dealers
@ Rs.2450/- per gram Lakhs.
Hence, XYZ Gold Dealers will have to buy Gold from the open market at Rs.2700/- per gram and
would have to sell it to ABC Jewelers at the rate of Rs.2450/- per gram thereby facing a loss in this
transaction.
Scenario 2 – The price of Gold goes down
Assume on 9th March 2015, the price of gold (999 purity) is trading at Rs.2050/- per gram. Under
such circumstances, XYZ Gold Dealers view on the gold price has come true. At the time of the
agreement the deal was valued at Rs 3.67 Cr but now with the decrease in gold prices, the deal is
valued at Rs.3.075 Cr. However, according to the agreement, ABC Jewelers is obligated to buy
Gold (999 purity) from XYZ Gold Dealers at a price they had previously agreed upon i.e Rs.2450/- per
gram.
This decrease in the gold price would impact both the parties in the following way –
Party Action Financial Impact
ABC Jewelers Is obligated to buy gold from ABC loses Rs.59.5 Lakhs ( 3.67 Crs –
XYZ Gold Dealers @ Rs.2450/- 3.075 Crs) by virtue of this
per gram agreement
XYZ Gold Dealers Entitled to sell Gold to ABC @ XYZ enjoys a profit of Rs.59.5 Lakhs.
Rs.2450/- per gram
Do note, even though Gold is available at a much cheaper rate in the open market, ABC Jewelers is
forced to buy gold at a higher rate from XYZ Gold Dealers hence incurring a loss.
Scenario 3 – The price of Gold stays the same
If on 9th March 2015, the price is the same as on 9th Dec 2014 then neither ABC nor XYZ would benefit
from the agreement.
1.4 – 3 possible scenarios in one graph

Here is a visual representation of the impact of gold prices on ABC Jewelers –
As you can see from the chart above, at Rs.2450/- per gram, there is no financial impact for ABC. How-
ever, as per the graph above we can notice that ABC’s financials are significantly impacted by a direc-
tional movement in the gold prices. Higher the price of gold (above Rs.2450/-), higher is ABC’s sav-
ings or the potential profit. Likewise, as and when the gold price lowers (below Rs.2450/-), ABC is
obligated to buy gold at a higher rate from XYZ, thereby incurring a loss.
Similar observations can be made with XYZ –
At Rs.2450/- per gram, there is no financial impact on XYZ. However as per the graph above, XYZ’s
financials are significantly impacted by a directional movement in the gold prices. As and when
the price of gold increases (above Rs.2450/-), XYZ is forced to sell gold at a lower rate, thereby in-
curring a loss. However, as and when the price of gold decreases (below Rs.2450/-) XYZ would en-
joy the benefit of selling gold at a higher rate, at a time when gold is available at a lower rate in
the market thereby making a profit.
1.5– A quick note on settlement

Assume that on 9th March 2015, the price of Gold is Rs.2700/- per gram. Clearly as we have just
understood, at Rs.2700/- per gram ABC Jewelers stands to benefit from the agreement. At the
time of the agreement (9th Dec 2014) 15 Kgs gold was worth Rs. 3.67Crs, however as on 9th
March 2015 15 kgs Gold is valued at Rs.4.05 Crs. Assuming at the end of 3 months i.e 9th March
2015, both the parties honor the contract, here are two options available to them for settling the
agreement –
1. Physical Settlement – – The full purchase price is paid by the buyer of a forward contract
and the actual asset is delivered by the seller. XYZ buys 15 Kgs of gold from the open market
by paying Rs.4.05Crs and would deliver the same to ABC on the receipt of Rs.3.67 Crs. This is
called physical settlement
2. Cash Settlement – In a cash settlement there is no actual delivery or receipt of a security.
In cash settlement, the buyer and the seller will simply exchange the cash difference. As per
the agreement, XYZ is obligated to sell Gold at Rs.2450/- per gram to ABC. In other words,
ABC pays Rs.3.67 Crs in return for the 15 Kgs of Gold which is worth Rs.4.05Cr in the open
market. However, instead of making this transaction i.e ABC paying Rs.3.67 Crs in return for
the gold worth Rs.4.05Crs, the two parties can agree to exchange only the cash differential.
In this case it would be Rs.4.05 Crs – Rs.3.67 Crs = Rs.38 Lakhs. Hence XYZ would just pay
Rs.38 lakhs to ABC and settle the deal. This is called a cash settlement
We will understand a lot more about settlement at a much later stage, but at this stage you need
to be aware that there are basically two basic types of settlement options available in a Forwards
Contract – physical and cash.
1.6 – What about the risk?

While we are clear about the structure (terms and conditions) of the agreement and the impact of
the price variation on either party, what about the risk involved? Do note, the risk is not just with
price movements, there are other major drawbacks in a forward contract and they are–
1. Liquidity Risk – In our example we have conveniently assumed that, ABC with a certain
view on gold finds a party XYZ who has an exact opposite view. Hence they easily strike a
deal. In the real world, this is not so easy. In a real life situation, the parties would approach
an investment bank and discuss their intention. The investment bank would scout the mar-
ket to find a party who has an opposite view. Of course, the investment bank does this for a
fee.
2. Default Risk/ / Counter party risk – Consider this, assume the gold prices have reached
Rs.2700/- at the end of 3 months. ABC would feel proud about the financial decision they
had taken 3 months ago. They are expecting XYZ to pay up. But what if XYZ defaults?
3. Regulatory Risk – The Forwards contract agreement is executed by a mutual consent of
the parties involved and there is no regulatory authority governing the agreement. In the ab-
sence of a regulatory authority, a sense of lawlessness creeps in, which in turn increases the
incentive to default
4. Rigidity – Both ABC and XZY entered into this agreement on 9th Dec 2014 with a certain
view on gold. However what would happen if their view would strongly change when they
are half way through the agreement? The rigidity of the forward agreement is such that,
they cannot foreclose the agreement half way through.
The forward contracts have a few disadvantages and hence future contracts were designed to re-
duce the risks of the forward agreements.
In India, the Futures Market is a part of a highly vibrant Financial Derivatives Market. During the
course of this module we will learn more about the Futures and methods to efficiently trade this
instrument!
So, let’s hit the road!
1. The forwards contract lays down the basic foundation for a futures contract
2. A Forward is an OTC derivative, which is not traded on an exchange
3. Forward contracts are private agreements whose terms vary from one contract to the
other
4. The structure of a forwards contract is fairly simple
5. In a forward agreement, the party agreeing to buy the asset is called the “Buyer of the For-
wards Contract”
6. In a forward agreement the party agreeing to sell the asset is called the “Seller of the For-
wards Contract”
7. A variation in the price would have an impact on both the buyer and the seller of the for-
wards contract
8. Settlement takes place in two ways in a forward contract – Physical and Cash settlement
9. The risk of a forward contract is reduced by a futures contract
10. The core of a forward and futures contract is the same.
C H A PT E R 2
Introducing Futures Contract

2.1 – Setting the context
In the previous chapter we looked at a very simple Forwards Contract example, where in two par-
ties agreed to exchange cash for goods at some point in the future. We inspected the structure of
the transaction and understood how the variation in price impacts the parties involved. Towards
the end of the chapter, we had listed down 4 key risks (or issues) with respect to the forwards con-
tracts and we concluded that, a futures contract is structured to overcome the critical risks of a
forward agreement namely –
1. Liquidity risk
2. Default Risk
3. Regulatory Risk
4. Rigidity of the transitional structure
We will continue referring to the same example in this chapter as well. Hence you may want to re-
fresh your understanding of the example quoted in the previous chapter.
From the previous chapter one thing is quite clear – If you have a view on the price of an asset,
you can benefit significantly by entering into a forward agreement. All one needs to do is to
find a counterparty willing to take the opposite side. Needless to say, a forward agreement is lim-
ited by the inherent risks involved, all of which is overcome by a futures agreement.
The Futures contract or Futures Agreement is an improvisation of the Forwards Agreement. The
Futures Contract is designed in such a way that it retains the core transactional structure of a For-
wards Market and at the same time, it eliminates the risks associated with the forwards contract.
A Forward Agreement would give you a financial benefit as long as you have an accurate direc-
tional view on the price of an asset, this is what I mean when I say ‘core transactional structure’.
This may seem a bit absurd but think about it – the ‘transaction structure’ of an old generation
car was just to transport you from point ‘A’ to point ‘B’. However, the new generation car comes
with improvisations in terms of the safety features – air bags, seat belts, ABS, power steering etc,
but it still retains the core ‘transaction structure’ i.e to help you move from point ‘A’ to point ‘B’.
This is the same distinction between the forwards and the futures agreement.
2.2 – A sneak peek into the Futures Agreement
As we now know that the core transactional structure of the futures and forwards is the same, I
guess it makes sense to look into the features that distinguishes the Futures from the forwards.
We will have a quick sneak peek into these features in this chapter, but at a later stage we will dig
into each and every feature in greater detail.
Recall, in the example we had quoted in the previous chapter, ABC jeweler enters into an agree-
ment with XYZ to buy a certain quantity of gold at a certain point in the future. Now imagine this,
what if ABC found it really hard to find XYZ as a counter party to the agreement? Under such cir-
cumstances though ABC has a certain view on gold and is also willing to enter into a financial
agreement, they would be left helpless simply because there is no counterparty to take the oppo-
site side of the agreement.
Now further imagine this, what if ABC instead of spending its time and effort to scout for a coun-
terparty, simply decides to walk into a financial supermarket where there are many counterpar-
ties willing to take the opposite view. With such a financial supermarket in place, ABC has to just
announce its intention and the willing counterparties would line up to take the opposing stance.
What more, a true financial supermarket of this sort would not just have people with a view on
gold, but instead will also have people with a view on Silver, Copper, Crude oil, and pretty much
any asset class including stocks!
In fact, this is exactly how the Futures Contracts are made available. They are available and acces-
sible to all of us and not just available to a corporate such as ABC Jewelers. The futures contracts
are available to us in the financial (super) market, often called the “Exchange”. The exchange can
be a stock exchange or a commodity exchange.
As we know a futures contract is structured a little differently compared to a forwards contract.

This is mainly to overcome the risks involved in the forwards market. Let us look at each of these
points that differentiate the futures from the forwards agreement.
Note, after reading through the following points you may still not be very clear about futures,
that’s alright, just keep the following points in perspective. We will shortly consider a futures ex-
ample and with that you should be clear about the way in which Futures agreement works.
Futures Contract mimics the underlying – In the example of ABC jewelers and XYZ Gold Dealers
the forwards agreement was based on gold (as an asset) and its price. However, when it comes to
a Futures Contract, the agreement is based on the ‘future price’ of the asset. The futures price
mimics the asset, which is also called the underlying. For example gold as an asset can have a
‘Gold Futures’ contract. Think of the underlying and its futures contract somewhat as twin sib-
lings. Whatever the underlying asset does, the futures contract does the same. Therefore if the
price of the underlying goes up, the price of the futures contract would also go up. Likewise if the
price of the underlying goes does, the price of the futures contract also goes down.
Standardized Contracts – Again going back to the example of ABC jewelers and XYZ Gold Dealers
the agreement was to deal with 15 kgs of gold of certain purity. If both the parties mutually
agreed, the agreement could have been for 14.5Kgs or 15.25 Kgs or whatever they would think is
convenient for them. However in the futures contract, the parameters are standardized. They are
not negotiable.
Futures Contracts are tradable – The futures contract is easily tradable. Meaning if I get into an
agreement with counterparty, unlike a forward contract, I need not honor the contract till the end
(also called the expiry day). At any point in time if my view changes, I can just transfer the con-
tract to someone else and get out of the agreement.
Futures Market is highly regulated – The Futures markets (or for that matter the entire financial
derivatives market) is highly regulated by a regulatory authority. In India, the regulatory authority
is “Securities and Exchange Board of India (SEBI)”. This means, there is always someone overlook-
ing the activities in the market and making sure things run smoothly. This also means default on
a futures agreement is hardly a possibility.
Contracts are time bound – We will understand this point in detail a bit later but for now, do re-
member that all the futures contracts available to you have different time frames. In the example
from previous chapter, ABC jewelers had a certain view on gold keeping 3 months in perspective.
If ABC were to do a similar agreement in the futures market, contracts would be available to them
in the 1 month, 2 month, and 3 month time frame. The time frame upto which the contract lasts is
called ‘The expiry’ of the contract.
Cash settled – Most of the futures contracts are cash settled. This means only the cash differen-
tial is paid out. There is no worry of moving the physical asset from one place to another. More so
the cash settlement is overseen by the regulatory authority ensuring total transparency in the
cash settlement process.
To sum up, here is a table that quickly summarizes the difference between the “Forwards Con-
tract” and “Futures Contract”
Forwards Contract Futures Contract

Contracts are traded over the counter Futures Contract are traded in the
(OTC) exchange
Contracts can be customized Future Contracts are standardized
High counter party risk No counter party risk
Not regulated Regulated by SEBI (in India)
Contracts are not transferable Transferable hence easily tradable
Time bound to just 1 time frame Multiple time frame contracts available
Settlement is flexible (physical or cash) Cash settled
At this stage, I feel there is a need to stress upon the distinction between the spot price and the
future price. The spot price is the price at which the asset trades in the ‘regular’ market, also
called the ‘spot market’. For example if we are talking about gold as an underlying, then there are
two prices we are referring to – gold in the regular market also called the Spot market and gold in
the Futures market called the Gold Futures. The prices in the spot market and futures market
move in tandem, meaning if one goes up, the other also goes up.
With these points in perspective, let us now move our attention to few other nuances of the fu-
tures contract.
2.3 – Before your first futures trade
Before we dig deeper and understand the working of a futures contract, we need to understand a
few other aspects related to futures trading. Do remember at a later stage we will revisit these
points and discuss them in greater detail. But for now, a good working knowledge on the follow-
ing points is what is required.
Lot size – Futures is a standardized contract where everything related to the agreement is pre-
determined. Lot size is one such parameter. Lot size specifies the minimum quantity that you will
have to transact in a futures contract. Lot size varies from one asset to another.
Contract Value – In our example of ABC jeweler and XYZ Gold Dealers, ABC agreed to buy 15 kgs
of Gold at the rate of Rs.2450/- per gram or Rs.24,50,000/- per kilogram. Since the deal was to buy
15 kgs, the whole deal was valued at Rs.24,50,000 x 15 = Rs.3.675 Crs. In this case it is said that the
‘Contract Value’ is Rs.3.675 Crs. Simply put, the contract value is the quantity times the price of
the asset. We know the futures agreement has a standard pre-determined minimum quantity (lot
size). Going by this, the contract value of a futures agreement can be generalized to “Lot size x
Price”.
Margin – Again, referring back to the example of ABC jeweler and XYZ Gold Dealers, at the time of
agreement i.e on 9th Dec 2014, both the parties would have had a gentleman’s word and nothing
beyond that. Meaning both the parties would have just agreed to honor the contract on the agree-
ment’s expiry day i.e 9th March 2015. Do notice there is no exchange of money on 9th Dec 2014.
However, in a futures agreement the moment a transaction takes place, both the parties involved
will have to deposit some money. Consider this as the token advance required for entering into
an agreement. The money has to be deposited with the broker. Usually, the money that needs to
be deposited is calculated as a % of the contract value. This is called the ‘margin amount’. Mar-
gins play a very pivotal role in futures trading; we will understand this in greater detail at a later
stage. For now, just remember that to enter into a futures agreement a margin amount is re-
quired, which is a certain percentage of the contract value.
Expiry – As we know, all futures contracts are time bound. The expiry or the expiry date of the fu-
tures contract is the date upto which the agreement is valid. Beyond the valid date, the contract
ceases to exist. Also be aware that the day a contract expires, new contracts are introduced by
the exchanges.
With these few points that we have discussed so far, I guess we are now equipped to understand
a simple example of futures trading.
1. The forwards and futures markets gives you a financial benefit if you have an accurate di-
rectional view on the price of an asset
2. The Futures contract is an improvisation over the Forwards contract
3. The Futures price generally mimics the underlying price in the spot market
4. Unlike a forwards contract, the futures contract is tradable
5. The futures contract is a standardized contract wherein all the variables of the agreement
is predetermined
6. Futures contracts are time bound and the contracts are available over different time-
frames
7. Most of the futures contracts are cash settled
8. The futures market is regulated by SEBI in India
9. Lot size is the minimum quantity specified in the futures contract
10. Contract value = Lot size times the Futures price
11. To enter into a futures agreement one has to deposit a margin amount, which is a cer-
tain % of the contract value.
12. Every futures contract has an expiry date beyond which the contact would seize to exist.
Upon expiry old contracts cease and new ones are created
C H A PT E R 3
The Futures Trade

3.1 – Before the Trade
In the last chapter, we learnt various concepts related to the futures market. Remember, the mo-
tivation for any trader entering into a futures agreement is to benefit financially, and for
which the trader needs to have a directional view on the price of the underlying asset. Per-
haps it is time we take up a practical example of a futures trade to demonstrate how this is done.
Also, I guess we should move away from the Gold example and look into an example related to
the stocks.
Today (15th Dec 2014) the management of Tata Consultancy Services (TCS), a leading Indian Soft-
ware Company had an investors meet, wherein the TCS management announced that they are
cautious about the revenue growth for the December Quarter. The markets do not like such cau-
tious statements, especially from the company’s management. After the statement, the markets
reacted to it and as we can see from the TCS’s spot market quote, the stock went down by over
3.6%. In the snapshot below, the price per share is highlighted in blue. Ignore the red highlight,
we will discuss about it shortly.
I as trader believe that, the TCS stock price reaction to the management’s statement is a bit exag-
gerated. Here is my rational – If you follow TCS or any Indian IT sector company in general, you
will know that December is usually a lackluster month for the Indian IT companies. December is
the financial year end in the US (the biggest market for the Indian IT companies), and also the
holiday season, hence the business moves quite slowly for such companies. This furlough has a
significant impact on the IT sector revenues. This information is already known and factored in
by the market. Hence, I believe the stock sinking by 3.6% is unwarranted for. I also feel this could
be an opportunity to buy TCS, as I believe the stock price will eventually go up. Hence I would be
a buyer in TCS after such an announcement.
Notice, based on my thoughts (which I perceive as rational) I have developed a ‘directional

view’ on the price of the asset (TCS). From my analysis, I believe the TCS (underlying asset) stock
price will increase in due course of time. In other words, I am bullish about TCS at the current
market price.
Now, instead of buying TCS shares in the spot market, I decide to buy the TCS Futures (for rea-
sons I will discuss in the next chapter). Having decided to buy futures, all I need to see is price at
which the TCS Futures is trading at. The contract details are readily available on the NSE’s web-
site. In fact, the link to get details for a TCS futures contract is available on the spot market quote.
I have highlighted the same in red in the image above.
Recall, the futures price should always mimic the spot price, meaning if the spot price has gone
down, the futures price should also go down. Here is a snapshot from NSE’s website showing the
TCS Futures price.
As expected, the futures price has mimicked the spot price and therefore the TCS Futures is also
down by 3.77%. You may have two questions at this point –
1. TCS in the spot market is down by 3.61%, however TCS futures is down by 3.77%? Why
the difference?
2. TCS spot price is at Rs.2362.35, but Futures price is at Rs.2374.90? Why the difference?
Both these are valid questions at this point, and the answer to these questions depends upon the
“Futures Pricing Formula”, a topic we will deal with at a later point in time. But the most impor-
tant point to note at this stage is that, the futures price has moved in line with the spot price, and
both of them are down for the day. Now, before we proceed any further let us relook at the fu-
tures contract and inspect a few key elements. Allow me to repost the futures contract with a few
important features highlighted.
Starting from top, the box highlighted in red has three important bits of information –
1. Instrument Type – Remember, the underlying asset is the stock of a company and we are
interested in the asset’s future contract. Hence, the instrument type here is the ‘stock fu-
tures’
2. Symbol – This highlights the name of the stock, TCS in this case
3. Expiry Date – This is the date on which the contract ceases to exist. As we can see, the
TCS futures contract specifies 24th Dec 2014 as the expiry. You may be interested to know
that, all derivative contracts in India expire on the last Thursday of the month. We will dis-
cuss more on what happens on the expiry date at a later point
We had looked at the blue box a little earlier, it just highlights the future price.
Lastly the black box highlights two important parameters – the underlying value and the market
lot.
1. Underlying Value – This is the same as the price at which the underlying is trading in the
spot market. From the earlier snapshot, we know TCS was trading at Rs.2362.35 per share,
however when I took the above snapshot, TCS fell by another few points, hence the price we
see here is Rs.2359.95. per share
2. Market lot (lot size) – Remember, a futures contract is a standardized contract. The pa-
rameters are prefixed. Lot size is the minimum number of shares that we need to buy/sell if
we wish to enter into an agreement. The lot size for the TCS futures is 125, which means a
minimum of 125 shares (or a multiple of 125 shares) have to be transacted while trading the
TCS futures.
Recall, in the previous chapter we had discussed about the ‘Contract value’, which is simply ‘Lot
size’ multiplied by the futures price. We can now calculate the contract value for TCS futures as
follows–
Contract Value = Lot size x Price of futures
125 x Rs.2374.90 = Rs. 296,862.5
Now before we proceed to discuss about the TCS futures trade, let us quickly look at another ‘Fu-
tures Contract’ just to rivet our understanding so far. Here, is the snapshot of the futures contract
of ‘State Bank of India (SBI)’.
With the help of the above snapshot you can perhaps answer the following questions –
1. What is the instrument type?

2. What is SBI’s futures price?
3. How does SBI’s future price compare with its spot price?
4. What is the expiry date of the Futures contract?
5. What is the lot size and the contract value of SBI futures?
3.2 – The Futures Trade

Now going back to the TCS futures trade, the idea is to buy a futures contract as I expect the TCS
stock price to go up. The price at which I would buy TCS Futures is Rs.2374.9/- per share. Remem-
ber the minimum number of shares that I need to buy is 125. The minimum number of shares is
also colloquially called ‘one lot’.
So how do we buy the ‘Futures Contract’? Well, this is quite simple we can call our broker and ask
him to buy 1 lot of TCS futures at Rs.2374.9/- or we can buy it ourselves through the broker’s trad-
ing terminal.
I prefer to place trades myself through the trading terminal. If you are new to the trading termi-
nal, I would suggest you read through the chapter on the Trading terminal. Once TCS Futures is
loaded on my market watch, all I need to do is just press F1 and buy the contract.
The moment I press the F1 key (expressing my interest to buy TCS futures) on my trading termi-
nal, a couple of things happen in the background.
1. Margin Validation – Remember, whenever we enter into a futures agreement we need to

deposit a margin amount (sort of a token advance), which is simply a percentage of the con-
tract value. We will discuss margins shortly. If there is insufficient margin, we cannot enter
into the agreement. So as the first step, the broker’s risk management system/ software
checks if I have sufficient money in my trading account (to suffice the margin requirement)
to enter into a futures agreement
2. The counterparty search – After validating the margins, the system scouts for a relevant
counterparty match. The match has to be made between me – the buyer of the TCS futures
and the seller of the TCS futures. Remember, the stock exchange is a ‘Financial supermar-
ket’ where one can find many participants with different views on the price of an asset. The
seller of TCS futures obviously thinks, TCS futures price will go further down. Just like my ra-
tional as to why the TCS stock price will go higher, the seller has his own rational for his di-
rectional view, hence he wants to be a seller.
3. The signoff – Once Step 1 and 2 are through i.e. the margin validation and finding the
counterparty, the buyer and the seller digitally sign the futures agreement. This is mainly a
symbolic process. By agreeing to buy (or sell) the futures agreement, one gives consent to
the other to honor the contract specifications.
4. The margin block – After the signoff is done, the required margin is blocked in our trad-
ing account. We cannot use the blocked margin for any other purpose. The money will be
blocked as long as we hold the futures contract.
With the completion of these 4 steps, I now own 1 lot of TCS Futures Contract. You may be sur-
prised to know, in the real markets, all the above mentioned steps happen sequentially in a mat-
ter of a few seconds!
Here is a critical question – What does it mean by “I now own 1 lot of TCS Futures Contract”? Well,
it simply means by purchasing TCS futures on 15th Dec 2014, I have digitally entered into an
agreement with a certain counterparty agreeing to buy 125 TCS shares from me (counterparty) at
Rs.2374.9/- per share. This futures agreement between me and the counterparty expires on 24th
Dec 2014.
3.3 –The 3 possible scenarios post the agreement

After entering into the agreement, there are 3 possible scenarios that can pan out by 24th Dec
2014. We know what these scenarios are (we studied them in chapter 1) – the price of TCS can go
up, the price of TCS can come down, or the price of TCS could stay the same. Let us just arbitrarily
take up a few possible price situations and see what would be the impact of the price on both the
parties involved.
Scenario 1 – TCS stock price goes up by 24th Dec
This is a case where my directional view on TCS shares has come true, therefore I stand to bene-
fit.
Assume on 24th Dec 2014, the stock price of TCS has gone up from Rs.2374.9/- to Rs.2450/- per
share, by virtue of the increase in spot price, the futures price would also increase. This means as
per the agreement, I am entitled to buy the TCS shares at Rs.2374.9/- per share which is a much
lower price compared to what is available in the market. My profit will be Rs.75.1/- per share
(Rs.2450 – Rs.2374.9). Since the deal is for 125 shares, my overall profit will be Rs.9387.5/-
(Rs.75.1/- * 125).
The seller obviously incurs a loss, as he is forced to sell TCS shares at Rs.2374.9 per share as op-
posed to selling it in the open market at a much higher price of Rs.2450/- per share. Clearly, the
buyer’s gain is the seller loss.
Scenario 2 – TCS stock price goes down by 24th Dec
This is a case where my directional view on TCS shares has gone wrong, therefore I would stand
to lose.
Assume on 24th Dec 2014, the stock price of TCS goes down from Rs.2374.9/- to Rs.2300/- per
share, by virtue of this decrease the futures price will also be around the same level. This means
as per the agreement, I am obligated to buy the TCS shares at Rs.2374.9/- per share which is a
much higher price compared to what is available in the market. My loss will be Rs.75./- per share
(Rs.2374.9 – Rs.2300). Since the deal is for 125 shares my overall loss will be Rs.9375/- (Rs.75/- *
125).
I would obviously incur a loss as I’m forced to buy the TCS shares at Rs.2374.9/- per share as op-
posed to buying it in the open market at a much lower price of Rs.2300/- per share. Clearly, the
sellers gain is the buyer’s loss.
Scenario 3 – TCS stock price remains unchanged
Under such a situation, neither the buyer nor the seller benefit, hence there is no financial impact
on either party.
3.3 – Exploiting a trading opportunity
So here is a situation – after buying the TCS futures on 15th Dec 2014 at Rs.2374.9/- the very next
day i.e 16th Dec 2014, TCS price shot up. It is now trading at Rs.2460/-. What do I do? Clearly with
the price increase, I stand to benefit significantly. To be precise, at the time of taking the snap-
shot, I am sitting at a profit of Rs.85.1/- per share or Rs.10,637.5/- (Rs.85.1/- * 125) as an overall
profit.
Suppose I am happy with the money that I have made overnight, can I close out the agreement?
Or rather at Rs.2460 per share what if my view changes? What if I no longer feel bullish about TCS
at Rs.2460? Do I really need to hold on to the agreement until the contract expiry date i.e. 24th
Dec 2014, by which time if the price goes down it could lead to a loss?
Well, as I had mentioned in the previous chapter the futures agreement is tradable. Meaning, at
any point after entering into a futures agreement I can easily get out of the agreement by transfer-
ring the agreement to someone else. This means I can close the existing TCS futures position and
book a profit of Rs.10,637.5/-. Not bad for a 1 day job right? J
Closing an existing futures position is called “square off”. By squaring off, I offset an existing open
position. In case of the TCS example, initially I bought 1 lot of TCS futures and when I square off I
have to sell 1 lot of TCS futures (so that my initial buy position is offset). The following table sum-
marizes the concept of square off in general –
View at the time View at the time of
Serial No Initial Leg Square off leg
of initial leg squaring off
No longer expect the
price to go higher or one
Expect price to go
1 Buy / Long Sell just wants to get out of
higher – Bullish
the existing position (for
whatever reason)
No longer expect the
price to go lower or one
Expect price to go
2 Sell/Short Buy just wants to get out of
lower – Bearish
the existing position (for
whatever reason)
When I intend to square off a position I can either call my broker asking him to square off the
open position or I can do it myself on the trading terminal. In the example we have a buy open po-
sition in TCS futures (1 lot), to offset this open position the square off position would be to “sell 1
lot of TCS futures”. The following things happen when I opt to square off the TCS position –
1. The broker (via trading terminal) scouts for a counterparty that would be willing to buy
the futures position from me. In simpler words “my existing buy position will simply be
transferred to someone else”. That ‘someone else’ by virtue of buying the contract from
me, now bears the risk of the TCS price going up or down. Hence this is simply referred to as
the “Risk Transfer”
2. Note, the transfer will happen at the current futures price in the market i.e. 2460/- per
share
3. My position is considered offset (or squared off) after the trade is executed
4. Once the trade is executed, the margins that were initially blocked would now be un-
blocked. I can utilize this cash for other transactions
5. The profit or loss made on the transaction will be credited or debited to my trading ac-
count the same evening itself
And with this, the futures trade is now set to be complete.
Note, if at Rs.2460 I develop a view that the price is going to be much higher, I could continue to
hold the stock futures. In fact, I can continue to hold the futures till the contract’s expiry i.e. 24th
Dec 2014. As long as I continue to hold the futures, I continue to hold the risk of TCS price fluctua-
tion. In fact, here is the snapshot of TCS futures taken on 23rd Dec 2014, just 1 day before the ex-
piry of the contract, had I opted to hold the futures till 23rd Dec my profits would have been
much higher – TCS futures is trading at Rs.2519.25/- per share.
In fact on 16th Dec 2014 when I decided to book profits at Rs.2460/- , ‘someone else’ bought the
TCS futures from me. In other words, I transferred my buy position to someone else, and even
that ‘someone else’ (the counterparty) would also have made money on this contract by buying
the contract at Rs.2460/- from me and holding it until 23rd Dec 2014. Now here are two simple
questions for you –
1. What would be my Profit & Loss (P&L) on a per share and on an overall basis had I held
the TCS futures from 15th Dec 2014 (Rs.2374.9) to 23rd Dec 2015 (Rs.2519.25)
2. On 16th Dec 2014 I squared off my position at Rs.2460/-, obviously by virtue of the square
off the contract was transferred to a counterparty. Assuming the counterparty held on to the
TCS futures position until 23rd Dec 2014, what would be his Profit & Loss (P&L) on a per
share basis and on an overall basis ?
If you are unable to answer the above two questions, you can drop in a query in the comment box
below and I will be happy to explain the answer. But I sincerely hope, you get the answers to the
questions above yourself
In the next chapter we will discuss about margins, a very important aspect of futures trading.
1. If you have a directional view on an assets price, you can financially benefit from it by en-
tering into a futures agreement
2. To transact in a futures contract one needs to deposit a token advance called the margin
3. When we transact in a futures contract, we digitally sign the agreement with the counter
party, this obligates us to honor the contract
4. The futures price and the spot price of an asset are different, this is attributable to the fu-
tures pricing formula (we will discuss this topic later)
5. One lot refers to the minimum number of shares that needs to be transacted
6. Once we enter into a futures agreement there is no obligation to stick to the agreement
until the contract expires
7. Every futures trade requires a margin amount, the margins are blocked the moment you
enter a futures trade
8. We can exit the agreement anytime, which means you can exit the agreement within sec-
onds of entering the agreement
9. When we square off an agreement we are essentially transferring the risk to someone else
10. Once we square off the futures position, margins are unblocked
11. The money that you make or lose in a futures transaction is credited or debited to your
trading account the same day
12. In a futures contract, the buyer’s gain is the sellers loss and vice versa
C H A PT E R 4
Leverage & Payoff

4.1 – A quick recap
With the help of the Tata Consultancy Services (TCS) example in the previous chapter we got a
working knowledge on how Futures trading works. The futures trade example required us to go
long on TCS futures as the expectation was that the TCS stock price would increase in due course.
Further we decided to square off the contract the very next day for a profit. However, if you recall,
right at the beginning of the example we posed a very important question, let me rephrase and
repost the same for your ready reference.
A rational to go long on TCS was built – the thought was that TCS stock price had over reacted to
the management’s statement. I expected the stock price to increase in due course of time. A direc-
tional view was established and hence a futures trade was initiated. Now, the question was – any-
way the expectation is that the stock price will go higher, why should one bother about buying fu-
tures and why not the stock in spot market?
In fact buying futures requires one to enter a digital agreement with the counterparty. Besides, a
futures agreement is time bound, meaning the directional view has to pan out within the speci-
fied time period. If it does not pan out within the specified time (as in the expiry) then one has to
suffer a loss. Contrast this (futures buying) with just buying stock and letting it reside in your DE-
MAT account. There is no obligation of an agreement or the pressure of time. So why does one
really need futures? What makes it so attractive? Why not just buy the stock and stay oblivious to
the stock price and the time?
The answers to all these questions lie in the ‘financial leverage’ which is inherent in financial de-
rivatives, including futures. Leverage as they say is a true financial innovation, if used in the right
context and spirit leverage can create wealth. Without much ado, let us explore this angle of fu-
tures trading.
4.2 – Leverage in perspective
Leverage is something we use at some point or the other in our lives. It is just that we don’t think
about it in the way it is supposed to be thought about. We miss seeing through the numbers and
therefore never really appreciate the essence of leverage.
Here is a classic example of leverage – many of you may relate to this one.
A friend of mine is a real estate trader, he likes to buy apartments, sites, and buildings holds them
for a while and then sells them for a profit at a later stage. He believes this is better than trading
in equities, I beg to differ – I could go on and on debating this, but maybe some other time.
Anyway, here is a summary of a recent real estate transaction he carried out. In November 2013,
Prestige Builders (popular builders in Bangalore) identified a piece of land in South Bangalore
and announced a new project – A luxurious apartment complex with state of the art amenities.
My friend jumped in and booked a 2 bedroom, hall, and kitchen apartment, expected to come up
on the 9th floor for a sum of Rs.10,000,000/-. The project is expected to be completed by mid
2018. Since the apartment was just notified and no work had started, the potential buyers were
only required to pay 10% of the actual buy value. This is pretty much the norm when it comes to
buying brand new apartments. The remaining 90% was scheduled to be paid as the construction
progressed.
So back in Nov 2013, for an initial cash outlay of Rs.10,00,000/- (10% of 10,000,000/-) my friend
was entitled to buy a property worth Rs.10,000,000/-. In fact the property was so hot; all the 120
apartments were sold out like hot cakes just within 2 months of Prestige Builder announcing the
brand new project.
Fast forward to Dec 2014, my friend had a potential buyer for his apartment. Being a real estate
trader, my friend jumped into the opportunity. A quick survey revealed that the property value in
the area had appreciated by at least 25% (well, that’s how crazy real estate is in Bangalore). So
my friend’s 9th floor apartment was now valued at Rs.12,500,000/-. My friend and the potential
buyer struck a deal and settled on the sale at Rs.12,500,000/-.
Here is a table summarizing the transaction –
Particulars Details
Initial Value of Apartment Rs. 10,000,000/-
Date of Purchase November 2013
Initial Cash outlay @ 10% of apartment
Rs.10,00,000/-
value
Balance Payment to Builder Rs.90,00,000/-
Appreciation in apartment value 25%
Value of the apartment in Dec 2014 Rs.12,500,000/-
New buyer agrees to pay the balance
Rs.90,00,000/- to the builder
payment
12,500,000 – 9000000 = Rs.
My friend gets paid
35,00,000/-
Rs.35,00,000/- minus Rs.10,00,000/-
My friend’s profit on the transaction
= Rs.25,00,000/-
Return on investment 25,00,000 / 10,00,000 = 250%
Clearly, few things stand out in this transaction.
1. My friend was able to participate in a large transaction by paying only 10% of the trans-
action value
2. To enter into the transaction, my friend had to pay 10% of the actual value (call it the
contract value)
3. The initial value he pays (10 lakhs) can be considered as a token advance or in terms of
‘Futures Agreement’ it would be the initial margin deposit
4. A small change in the asset value impacts the return massively
5. This is quite obvious – a 25% increase in asset value resulted in a 250% return on invest-
ment
6. A transaction of this type is called a “Leveraged Transaction”
Do make sure you understand this example thoroughly because this is very similar to a futures
trade, as all futures transactions are leveraged. Do keep this example in perspective as we will
now move back to the TCS trade.
4.3 – Leverage
While we looked at the overall structure of the futures trade in the previous chapter, let us
now re-work on the TCS example with some specific details. The trade details are as follows,
for the sake of simplicity we will assume the opportunity to buy TCS occurs on 15th of Dec at
Rs.2362/- per share. Further we will assume the opportunity to square off this position oc-
curs on 23rd Dec 2014 at Rs.2519/-. Also, we will assume there is no difference between the
spot and future price.
Particulars Details
Underlying TCS Limited
Directional View Bullish
Action Buy
Capital available for the trade Rs.100,000/-
Trade Type Short term
The expectation is that the stock price will
Remarks
increase over the next few days
Buy Date 15th Dec 2014
Approximate buy Price Rs.2362/- per share
Sell Date 23rd Dec 2014
Approximate Sell Price Rs.2519/- per share
So with a bullish view on TCS stock price and Rs.100,000/ in hand we have to decide be-
tween the two options at our disposal – Option 1 – Buy TCS stock in the spot market or Op-
tion 2 – Buy TCS futures from the Derivatives market. Let us evaluate each option to understand
the respective dynamics.
Option 1 – Buy TCS Stock in spot market
Buying TCS in spot market requires us to check for the price at which the stock is trading, calcu-
late the number of stocks we can afford to buy (with the capital at our disposal). After buying the
stock in the spot market we have to wait for at least two working days (T+2) for the stock to get
credited to our DEMAT account. Once the stocks resides in the DEMAT account we just have to
wait for the right opportunity to sell the stocks.
Few salient features of buying the stock in the spot market (delivery based buying) –
1. Once we buy the stock (for delivery to DEMAT) we have to wait for at least 2 working days
before we can decide to sell it. This means even if the very next day if a good opportunity to
sell comes up, we cannot really sell the stock
2. We can buy the stock to the extent of the capital at our disposal. Meaning if our dispos-
able cash is Rs.100,000/- we can only buy to the extent of Rs.100,000/- not beyond this
3. There is no pressure of time – as long as one has the time and patience one can wait for
really long time before deciding to sell
Specifically with Rs.100,000/- at our disposal, on 15th Dec 2014 we can buy –
= 100,000 / 2362
~ 42 shares
Now, on 23rd Dec 2014, when TCS is trading at Rs.2519/- we can square off the position for a
profit –
= 42 * 2519
= Rs.105,798/-
So Rs.100,000/- invested in TCS on 14th Dec 2014 has now turned into Rs.105,798/- on 23rd Dec
2014, generating Rs.5,798/- in profits. Interesting, let us check the return generated by this trade –
= [5798/100,000] * 100
= 5.79 %
A 5.79% return over 9 days is quite impressive. In fact a 9 day return of 5.79% when annualized
yields about 235%. This is phenomenal!
But how does this contrast with option 2?
Option 2 – Buy TCS Stock in the futures market
Recall in futures market variables are pre determined. For instance the minimum number of
shares (lot size) that needs to be bought in TCS is 125 or in multiples of 125. The lot size multi-
plied by the futures price gives us the ‘contract value’. We know the futures price is Rs.2362/- per
share, hence the contract value is –
= 125 * 2362
= Rs.295,250/-
Now, does that mean to participate in the futures market I need Rs.295,250/- in total cash? Not
really, Rs.295,250/- is the contract value, however to participate in the futures market one just
needs to deposit a margin amount which is a certain % of the contract value. In case of TCS fu-
tures, we need about 14% margin. At 14% margin, (14% of Rs.295,250/-) Rs.41,335/- is all we
need to enter into a futures agreement. At this stage, you may get the following questions in your
mind –
a. What about the balance money? i.e Rs.253,915/- ( Rs.295,250/ minus Rs.41,335/-)
๏ Well, that money is never really paid out
b. What do I mean by ‘never really paid out’?
๏ We will understand this in greater clarity when we take up the chapter on “Settle-
ment – mark 2 markets”
c. Is 14% fixed for all stocks?
๏ No, it varies from stock to stock
So, keeping these few points in perspective let us explore the futures trade further. The cash avail-
able in hand is Rs.100,000/-. However the cash requirement in terms of margin amount is just Rs.
Rs.41,335/-.
This means instead of 1 lot, maybe we can buy 2 lots of TCS futures. With 2 lots of TCS futures the
number of shares would be 250 (125 * 2) – at the cost of Rs.82,670/- as margin requirement. After
committing Rs.82,670/- as margin amount for 2 lots, we would still be left with Rs.17,330/- in
cash. But we cannot really do anything with this money hence it is best left untouched.
Now here is how the TCS futures equation stacks up –
Lot Size – 125
No of lots – 2
Futures Buy price – Rs. 2362/-
Futures Contract Value at the time of buying = Lot size *number of lots* Futures Buy Price
= 125 * 2 * Rs. 2362/-
= Rs. 590,500/-
Margin Amount – Rs.82,670/-
Futures Sell price = Rs.2519/-
Futures Contract Value at the time of selling = 125 * 2 * 2519
= Rs.629,750/-
This translates to a profit of Rs. 39,250/- !
Can you see the difference? A move from 2361 to 2519 generated a profit of Rs.5,798/- in spot mar-
ket, but the same move generated a profit of Rs. 39,250/- . Let us see how juicy this looks in terms
of % return.
Remember our investment for the Futures trade is Rs.82,670/-, hence the return has to be calcu-
lated keeping this as the base –
[39,250 / 82,670]*100
Well, this translates to a whopping 47% over 9 days! Contrast that with 5.79% in the spot market.
For sake of annualizing, this translates to an annual return of 1925 % …and with this; hopefully I
should have convinced you why short term traders prefer transactions in Futures market as op-
posed to spot market transactions.
Futures offer something more than a plain vanilla spot market transaction. Thanks the existence
of ‘Margins’ you require a much lesser amount to enter into a relatively large transaction. If you’re
directional view is right, your profits can be really large.
By virtue of margins, we can take positions much bigger than the capital available; this is called
“Leverage”. Leverage is a double edged sword. If used in the right spirit and knowledge, leverage
can create wealth, if not it can destroy wealth.
Before we proceed further, let us just summarize the contrast between the spot and futures mar-
ket in the following table –
Particulars Spot Market Futures Markets

Capital Available Rs.100,000/- Rs.100,000/-
Buy Date 15th Dec 2014 15th Dec 2014
Buy Price Rs.2362 per share Rs.2362 per share
Qty 100,000 / 2362 = 42 shares Depends on Lot size
Lot Size Not Applicable 125
Margin Not Applicable 14%
Contract value per lot Not Applicable 125 * 2362 = 295,250/-
Margin Deposit per lot Not Applicable 14% * 295,250 = 41,335/-
How many lots can be bought Not Applicable 100,000/41,335= 2.4 or 2 Lots
Margin Deposit Not Applicable 41,335 * 2 = 82,670/-
No of shares bought 42 (as calculated above) 125 * 2 = 250
Buy Value (Contract Value) 42 * 2362 = 100,000/- 2 * 125 * 2362 = 590,500/-
Sell Date 23rd Dec 2014 23rd Dec 2014
No of days trade was live 9 days 9 days
Sell Price Rs.2519/- per share Rs.2519/- per share
Sell Value 42 * 2519 = 105,798 250 * 2519 = 629,750/-
Profit earned 105798 – 100000 = Rs.5798/- 629750 – 590500 = Rs.39,250/-
Absolute Return for 9 days 5798 / 100,000 = 5.79 % 39250 / 82670 = 47%
% Return annualized 235% 1925%
All through we have discussed about rewards of transacting in futures, but what about the risk in-
volved? What if the directional view does not pan out as expected? To understand both the sides
of futures trade, we need to understand how much money we stand to make (or lose) based on
the movement in the underlying. This is called the “Futures Payoff”.
4.4 – Leverage Calculation
Usually when we talk about leverage, the common questions one gets asked is – “How many
times leverage are you exposed to?” The higher the leverage, higher is the risk, and the higher is
the profit potential.
Calculating leverage is quite easy –
Leverage = [Contract Value/Margin].
Hence for TCS trade the leverage is
= [295,250/41,335]
= 7.14, which is read as 7.14 times or simply as a ratio – 1: 7.14.
This means every Rs.1/- in the trading account can buy upto Rs.7.14/- worth of TCS. This is a very
manageable ratio. However if the leverage increases then the risk also increases. Allow me to ex-
plain.
At 7.14 times leverage, TCS has to fall by 14% for one to lose all the margin amount, this can be cal-
culated as –
1 / Leverage
= 1/ 7.14
= 14%
Now for a moment assume the margin requirement was just Rs.7000/- instead of Rs.41,335/-. In
this case, the leverage would be –
= 295,250 / 7000
= 42.17 times
This is clearly is a very high leverage ratio, one would lose all his capital if TCS falls by –
1/41.17
= 2.3%.
So, the higher the leverage, the higher is the risk. When leverage is high, only a small move in the
underlying is required to wipe out the margin deposit.
Alternatively, at roughly 42 times leverage you just need a 2.3% move in the underlying to double
your money.
I personally don’t like to over leverage, I stick to trades where the leverage is about 1 :10 or about
1:12, not beyond this.
4.5 – The Futures payoff

Imagine this – when I bought TCS futures the expectation was that TCS stock price would go
higher and therefore I would financially benefit from the futures transaction. But what if instead
of going up, TCS stock price went down? I would obviously make a loss. Think about it after initiat-
ing a futures trade, at every price point I would either stand to make a profit or loss. The payoff
structure of a futures transaction simply highlights the extent to which I either make a profit or
loss at various possible price points.
To understand the payoff structure better, let us build one for the TCS trade. Remember it is a
long trade initiated at Rs.2362/- on 16thof Dec. After initiating the trade, by 23rd Dec the price of
TCS can go anywhere. Like I mentioned, at every price point I will either make a profit or a loss.
Hence while building the pay off structure; I will assume various possible price point situations
that can pan out by 23rdDec, and I will analyze the P&L situation at each of these possibilities. In
fact the table below does the same –
Table 4.4 -Table showing the possible price point situation
Buyer P&L (Price on 23rd Dec – Buy

Possible Price on 23rd Dec
Price)
2160 -202
2180 -182
2200 -162
2220 -142
2240 -122
2260 -102
2280 -82
2300 -62
2320 -42
2340 -22
2360 -2
2380 18
2400 38
2420 58
2440 78
2460 98
2480 118
2500 138
2520 158
2540 178
2560 198
2580 218
2600 238
This is the way you need to read this table, – considering you are a buyer at Rs.2362/- , what
would be the P&L by 23rd Dec assuming TCS is trading is Rs.2160/-. As the table suggest, you
would make a loss of Rs.202/-per share (2362 – 2160).
Likewise, what would be your P&L if TCS is trading at 2600? Well, as the table suggest you would
make a profit of Rs.238/- per share (2600 – 2362). So on and so forth.
In fact if you recollect from the previous chapter we stated that if the buyer is making Rs.X/- as
profit then the seller is suffering a loss to the extent of Rs.X/-. So assuming 23rd Dec TCS is Trad-
ing at 2600, the buyer makes a profit of Rs.238/- per share and the seller would be making a loss
of Rs.238/- per share, provided that the seller has shorted the share at Rs.2362/-.
Another way to look at this is that the money is being transferred from the seller’s pocket to the
buyer’s pocket. It is just a transfer of money and not creation of money!
There is a difference between the transfer of money and creation of money. Money is generated
when value is created. For example you have bought TCS shares form a long term perspective,
TCS as a business does well, profits and margins improve then obviously you as a shareholder
will benefit by virtue of appreciation in share price. This is money creation or wealth generation.
If you contrast this with Futures, money is not being created but rather moving from one pocket
to another.
Precisely for this reasons Futures (rather financial derivatives in general) is called a “Zero Sum
Game”.
Further, let us now plot a graph of the possible price on 23rd December versus the buyers P&L.
This is also called the “Payoff Structure”.
As you can see, any price above the buy price (2362) results in a profit and any price below the
buy price results in a loss. Since the trade involved purchasing 2 lots of futures (250 shares) a 1
point positive movement (from 2362 to 2363) results in a gain of Rs.250. Likewise a 1 point nega-
tive movement (from 2362 to 2361) results in a loss of Rs.250. Clearly there is a sense of propor-
tionality here. The proportionality comes from the fact that the money made by the buyer is the
loss suffered by the seller (provided they have bought/short the same price), and vice versa.
Most importantly, because the P&L is a smooth straight line, it is said that the futures is a “Linear
Payoff Instrument”.
1. Leverage plays a key role in futures trading
2. Margins allow us to deposit a small amount money and take exposure to a large value
transaction
3. Margins charged is usually a % of the contract value
4. Spot market transactions are not leveraged, we can transact to the extent of the capital
that we have
5. By virtue of leverage a small change in the underlying results in a massive impact on the
P&L
6. The profits made by the buyer is equivalent to the loss made by the seller and vice versa
7. The higher the leverage, the higher is the risk and therefore the higher the chance of mak-
ing money.
8. Futures Instrument simply allows one to transfer money from one pocket to another,
hence it is called a “Zero Sum Game”
9. The payoff structure of a futures instrument is linear.
C H A PT E R 5
Margin & M2M
5.1 – Things you should know by now

Margins clearly play a very crucial role in futures trading as it enables one to leverage. In fact, mar-
gins are the one that gives a ‘Futures Agreement’ the required financial twist (as compared to the
spot market transaction). For this reason, understanding the margins and many facets of margins
is extremely important.
However before we proceed any further, let us list down a list of things you should know by now.
These are concepts we had learnt over the last 4 chapters, reiterating these crucial takeaways will
help us consolidate all the learning. At this, if you are not clear about any of the following points
you will need to revisit the previous chapters and refresh your understanding.
1. Futures is an improvisation over the Forwards

2. The futures agreement inherits the transactional structure of the forwards market
3. A futures agreement enables you to financially benefit if you have an accurate directional
view on the asset price
4. The futures agreement derives its value from its corresponding underlying in the spot
market
a. For example TCS Futures derives its value from the underlying in the TCS Spot mar-
ket
5. The Futures price mimics the underlying price in the spot market
a. The futures price and the spot price of an asset are different, this is attributable to
the futures pricing formula. We will discuss this point at a later stage in the module
6. The futures contract is a standardized contract wherein the variables of the agreement is
predetermined – lot size and expiry date
a. Lot size is the minimum quantity specified in the futures contract
b. Contract value = Futures Price * Lot Size
c. Expiry is the last date up to which one can hold the futures agreement
7. To enter into a futures agreement one has to deposit a margin amount, which is calcu-
lated as a certain % of the contract value
a. Margins allow us to deposit a small amount of money and take exposure to a large
value transaction, thereby leveraging on the transaction
8.When we transact in a futures contract, we digitally sign the agreement with the counter
party, this obligates us to honor the contract upon expiry
9.The futures agreement is tradable. Which means you need not hold on to the agreement
till the expiry
a. You can hold the futures contract till you have a conviction on the directional view
on the asset, once your view changes you can get out of the futures agreement
b. You can even hold the futures agreement for a few minutes and financially benefit if
the price moves in your favor
c. An example of the above point would be to buy Infosys Futures at 9:15 AM at a price
of 1951 and sell it by 9:17AM at 1953. Since Infosys lot size is 250, one would stand to
make Rs.500/- (2 * 250) within a matter of 2 minutes
d. You can even choose to hold it overnight for a few days or hold on to it till expiry.
10. Equity futures contracts are cash settled
11. By virtue of leverage a small change in the underlying, results in a massive impact on the
P&L
12. The profits made by the buyer is equivalent to the loss made by the seller and vice versa
13. Futures Instrument allows one to transfer money from one pocket to another, hence it is
called a “Zero Sum Game”
14. The higher the leverage, the higher the risk
15. The payoff structure of a futures instrument is linear
16. The futures market is regulated by Securities and Exchange Board of India (SEBI).
Thanks to the watchful eye of SEBI, there have been no incidence of counterparty default in
the futures market
If you can clearly understand the points mentioned above then I’d assume you are on the right
track so far. If you have any questions on any of the above mentioned points then you need to re-
visit the previous four chapters to get the concept right.
Anyway, assuming you are clear so far let us now focus more on concept of margins and mark to
market.
5.2 – Why are Margins charged?

Let us now rewind back to the example we quoted in the forwards market (chapter 1). In the ex-
ample quoted, 3 months from now ABC Jewelers agrees to buy 15Kgs of Gold at Rs.2450/- per
gram from XYZ Gold Dealers.
We can now clearly appreciate that any variation in the price of gold will either affect ABC or XYZ
negatively. If the price of gold increases then XYZ suffers a loss and ABC makes a profit. Likewise,
if the price of gold decreases ABC suffers a loss and XYZ makes a profit. Also we know that a for-
wards agreement works on a gentleman’s word. Consider a situation where the price of gold has
drastically gone up placing XYZ Gold Dealers in a difficult spot. Clearly XYZ can say they cannot
make the necessary payment and thereby default on the deal. Obviously what follows will be a
long and grueling legal chase, but that is outside our focus area. The point to be noted here is
that, in a forwards agreement the scope and the incentive to default is very high.
Since futures market is an improvisation over the forwards market, the angle of default is care-
fully and intelligently dealt with. This is where the margins play a role.
In the forwards market there is no regulator. The agreement takes place between two parties
with literally no intermediary watching over their transaction. However, in the futures market, all
trades are routed through an exchange. The exchange in return takes the onus of guaranteeing
the settlement of all the trades. When I say ‘onus of guaranteeing’, it literally means the exchange
makes sure you get your money if you are entitled. This also means they ensure they collect the
money from the party who is supposed to pay up.
So how does the exchange make sure this works seamlessly? Well, they make this happen by
means of –
1. Collecting the margins

2. Marking the daily profits or losses to market (also called M2M)
We briefly looked into the concept of Margin in the previous chapter. The concept of Margin and
M2M is something that you need to know in parallel to fully appreciate the dynamics of futures
trading. However since it is difficult to explain both the concepts at the same time, I would like to
pause a bit on margins and proceed to M2M. We will understand M2M completely and come back
again to margins. We will then relook at margins keeping M2M in perspective. But before we
move to M2M, I would like you to keep the following points in the back of your mind –
1. At the time of initiating the futures position, margins are blocked in your trading account
2. The margins that get blocked is also called the “Initial Margin”
3. The initial margin is made up of two components i.e. SPAN margin and the Exposure Mar-
gin
4. Initial Margin = SPAN Margin + Exposure Margin
5. Initial Margin will be blocked in your trading account for how many ever days you choose
to hold the futures trade
a. The value of initial margin varies daily as it depends on the futures price
b. Remember, Initial Margin = % of Contract Value
c. Contract Value = Futures Price * Lot Size
d. Lot size is a fixed, but the futures price varies every day. This means the margins
also vary everyday
So for now, remember just these points. We will go ahead to understand M2M and then we will
come back to margins to complete this chapter.
5.3 – Mark to Market (M2M)

As we know the futures price fluctuates on a daily basis, by virtue of which you either stand to
make a profit or a loss. Marking to market, or mark to market (M2M) is a simple accounting proce-
dure which involves adjusting the profit or loss you have made for the day and entitling you the
same. As long as you hold the futures contract, M2M is applicable. Let us take up a simple ex-
ample to understand this.
Assume on 1st Dec 2014 at around 11:30 AM, you decide to buy Hindalco Futures at Rs.165/-.
The Lot size is 2000. 4 days later on 4th Dec 2014 you decide to square off the position at
2:15 PM at Rs.170.10/-. Clearly as the calculation below shows, this is a profitable trade –
Buy Price = Rs.165
Sell Price = Rs.170.1
Profit per share = (170.1 – 165) = Rs.5.1/-
Total Profit = 2000 * 5.1
= Rs.10,200/-
However, the trade was held for 4 working days. Each day the futures contract is held, the
profits or loss is marked to market. While marking to market, the previous day closing price
is taken as the reference rate to calculate the profit or losses.
Day Closing Price

1st Dec 2014 168.3
2nd Dec 2014 172.4
3rd Dec 2014 171.6
4th Dec 2014 169.9
The table above shows the futures price movement over the 4 days the contract was held.
Let us look at what happens on a day to day basis to understand how M2M works –
On Day 1 at 11:30AM the futures contract was purchased at Rs.165/-, clearly after the con-
tract was purchased the price has gone up further to close at Rs.168.3/-. Hence profit for the
day is 168.3 minus 165 = Rs.3.3/- per share. Since the lot size is 2000, the net profit for the
day is 3.3*2000 = Rs.6600/-.
Hence the exchange ensures (via the broker) that Rs.6600/- is credited to your trading ac-
count at the end of the day.
1. But where is this money coming from?
a. Obviously it is coming from the counterparty. Which means the exchange is also en-
suring that the counterparty is paying up Rs.6600/- towards his loss
2. But how does the exchange ensure they get this money from the party who is supposed
to pay up?
a. Obviously through the margins that are deposited at the time of initiating the trade.
But more on this later.
Now here is another important aspect you need to note – from an accounting perspective, the fu-
tures buy price is no longer treated as Rs.165 but instead it will be considered as Rs.168.3/- (clos-
ing price of the day). Why is that so you may ask? Well, the profit that was earned for the day has
been given to you already by means of crediting the trading account. So you are fair and square
for the day, and the next day is considered a fresh start. Hence the buy price is now considered at
Rs. 168.3, which is the closing price of the day.
On day 2, the futures closed at Rs.172.4/-, clearly another day of profit. The profit earned for the
day would be Rs.172.4/ – minus Rs.168.3/- i.e. Rs.4.1/- per share or Rs.8,200/- net profit. The prof-
its that you are entitled to receive is credited to your trading account and the buy price is reset to
the day’s closing price i.e. 172.4/-.
On day 3, the futures closed at Rs.171.6/- which means with respect to the previous day’s close
price there is a loss to the extent of Rs.1600 /- (172.4 – 171.6 * 2000 ). The loss amount will be auto-
matically debited from your trading account. Also, the buy price is now reset to Rs.171.6/-.
On day 4, the trader did not continue to hold the position through the day, but rather decided to
square off the position mid day 2:15 PM at Rs.170.10/-. Hence with respect to the previous day’s
close he again made a loss. That would be a loss of Rs.171.6/- minus Rs.170.1/- = Rs.1.5/- per
share and Rs.3000/- (1.5 * 2000) net loss. Needless to say after the square off, it does not matter
where the futures price goes as the trader has squared off his position. Also, Rs.3000/- is debited
from the trading account by end of the day.
Now, let us just tabulate the value of the daily mark to market and see how much money has
come in and how much money has gone out –
Day Ref Price for M2M Closing Price Daily M2M

1st Dec 2014 165 168.3 + Rs.6,600/-
2nd Dec 2014 172.4 +Rs.8,200/-
3rd Dec 2014 168.3 171.6 -Rs.1,600/-
4th Dec 2014 171.6 & 170.1 169.9 – Rs.3,000/-
Total +Rs.10,200/-
Well, if you summed up all the M2M cash flow you will end up the same amount that we origi-
nally calculated, which is –
Buy Price = Rs.165/-
Sell Price = Rs.170.1/-
Profit per share = (170.1 – 165) = Rs.5.1/-
Total Profit = 2000 * 5.1
= Rs.10,200/-
So, the mark to market is just a daily accounting adjustment where –
1. Money is either credited or debited (also called daily obligation) based on how the fu-
tures price behaves
2. The previous day close price is taken into consideration to calculate the present day
M2M
Why do you think M2M is required in the first place? Well, think about it – M2M is a daily cash ad-
justment by means of which the exchange drastically reduces the counterparty default risk. As
long a trader holds the contract, the exchange by virtue of the M2M ensures both the parties
are fair and square on a daily basis.
Now, keeping this basic concept of M2M, let us now move back to relook at margins and see
how the trade evolves during its life.
5.4 – Margins, the bigger perspective

Let us now relook at margins keeping M2M in perspective. As mentioned earlier, the margins re-
quired at the time of initiating a futures trade is called “Initial Margin (IM)”. Initial margin is a
certain % of the contract value. We also know –
Initial Margin (IM) = SPAN Margin + Exposure Margin
Each and every time a trader initiates a futures trade (for that matter any trade) there are few
financial intermediaries who work in the background making sure that the trade carries out
smoothly. The two prominent financial intermediaries are the broker and the exchange.
Now if the client defaults on an obligation, obviously it has a financial repercussion on both the
broker and the exchange. Hence if both the financial intermediaries have to be insulated against
a possible client default, then both of them need to be covered adequately by means of a margin
deposit.
In fact this is exactly how it works – ‘SPAN Margin’ is the minimum requisite margins blocked as
per the exchange’s mandate and ‘Exposure Margin’ is the margin blocked over and above the
SPAN to cushion for any MTM losses. Do note both SPAN and Exposure margin are specified by
the exchange. So at the time of initiating a futures trade the client has to adhere to the initial mar-
gin requirement. The entire initial margin (SPAN + Exposure) is blocked by the exchange.
Between the two margins, SPAN Margin is more important as not having this in your account
means a penalty from the exchange. The SPAN margin requirement has to be strictly maintained
as long as the trader wishes to carry his position overnight/next day. In fact for this reason, SPAN
margin is also sometimes referred to as the “Maintenance Margin”.
So how does the exchange decide what should be the SPAN margin requirement for a particular
futures contract? Well, they use an advance algorithm to calculate the SPAN margins on a daily
basis. One of the key inputs that goes into this algorithm is the ‘Volatility’ of the stock. Volatility
is a very crucial concept; we will discuss it at length in the next module. For now just remember
this – if volatility is expected to go up, the SPAN margin requirement also goes up.
Exposure margin, which is an additional margin, varies between 4% -5% of the contract value.
Now, let us look at a futures trade keeping both the margin and the M2M in perspective. The
trade details are as shown below –
Particular Details
Symbol HDFC Bank Limited
Trade Type Long
Buy Date 10th Dec 2014
Buy Price Rs.938.7/- per share
Particular Details
Sell Date 19th Dec
Sell Price Rs.955/- per share
Lot Size 250
Contract Value 250*938.7 = Rs.234,675/-
SPAN Margin 7.5% of CV = Rs.17,600/-
Exp Margin 5.0% of CV = Rs.11,733/-
IM (SPAN + Exposure) 17600 + 11733 = Rs.29,334/-
P&L per share Profit of Rs.16.3/- per share (955 – 938.7)
Net Profit 250 * 16.3 = Rs.4,075/-
If you are trading with Zerodha, you may know that we provide a Margin calculator that explic-
itly states the SPAN and Exposure margin requirements. Of course, at a later stage we will dis-
cuss in detail the utility of this extremely useful tool. But for now, you could check out this mar-
gin calculator.
So keeping the above trade details in perspective, let us look at how the margins and M2M plays
a role simultaneously during the life of the trade. The table below shows how the dynamics
change on a day to day basis –
I hope you don’t get intimidated looking at the table above, in fact it is quite easy to under-
stand. Let us go through it sequentially, day by day.
10th Dec 2014
Sometime during the day, HDFC Bank futures contract was purchased at Rs.938.7/-. Lot size is
250, hence the contract value is Rs.234,675/-. As we can see from the box on the right, SPAN is
7.5% and Exposure is 5% of CV respectively.
Hence 12.5% of CV is blocked as margins (SPAN + Exposure), this works up to a total margin of
Rs.29,334/-. The initial margin is also considered as the initial cash blocked by the broker.
Going ahead, HDFC closes at 940 for the day. At 940, the CV is now Rs.235,000/- and therefore
the total margin requirement is Rs.29,375/- which is a marginal increase of Rs.41/- when com-
pared to the margin required at the time of the trade initiation. The client is not required to in-
fuse this money into his account as he is sufficiently covered with a M2M profit of Rs.325/-
which will be credited to his account.
The total cash balance in the trading account = Cash Balance + M2M
= Rs.29,334 + Rs.325
= Rs.29,659/-
Clearly, the cash balance is more than the total margin requirement of Rs.29,375/- hence there
is no problem. Further, the reference rate for the next day’s M2M is now set to Rs.940/-.
11th Dec 2014
The next day, HDFC Bank drop by Rs.1/- to Rs.939/- per share impacting the M2M by negative
Rs.250/-. This money is taken out from the cash balance (and will be credited to the person
making this money). Hence the new cash balance will be –
= 29659 – 250
= Rs.29,409/-
Also, the new margin requirement is calculated as Rs.29,344/-. Clearly the cash balance is
higher than the margin required, hence there is nothing to worry about. Also, the reference
rate for the next day’s M2M is reset at Rs.939/-
12th Dec 2014
This is an interesting day. The futures price fell by Rs.9/- taking the price to Rs.930/- per share.
At Rs.930/- the margin requirement also falls to Rs.29,063/-. However because of an M2M loss
of Rs.2250/- the cash balance drops to Rs.27,159/- (29409 – 2250), which is less than the total
margin requirement. Now since the cash balance is less than the total margin requirement, is
the client required to pump in the additional money? Not really.
Remember between the SPAN and Exposure margin, the most sacred one is the SPAN margin.
Most of the brokers allow you to continue to hold your positions as long as you have the SPAN
Margin (or maintenance margin). Moment the cash balance falls below the maintenance margin,
they will call you asking you to pump in more money. In the absence of which, they will force
close the positions themselves. This call, that the broker makes requesting you to pump in the
required margin money is also popularly called the “Margin Call”. So, if you are getting a margin
call from your broker, it means your cash balance is dangerously low to continue the position.
Going back to the example, the cash balance of Rs.27,159/- is above the SPAN margin
(Rs.17,438/-) hence there is no problem. The M2M loss is debited from the trading account and
the reference rate for the next day’s M2M is reset to Rs.930/-.
Well, I hope you have got a sense of how both margins and M2M come into play simultaneously. I
also hope you are able to appreciate how by virtue of the margins and M2M, the exchange can ef-
ficiently tackle the threat of a possible default by a client. The margin + M2M combination is virtu-
ally a fool proof method to ensure defaults don’t occur.
Assuming you are getting a sense of the dynamics of margins and M2M calculation, I will now
take the liberty to cut through the remaining days and proceed directly to the last day of trade.
19th Dec 2014
At 955, the trader decides to cash out and square off the trade. The reference rate for M2M is the
previous day’s closing rate which is Rs.938. So the M2M profit would Rs.4250/- which gets added
to the previous day cash balance of Rs.29,159/-. The final cash balance of Rs.33,409/- (Rs.29,159 +
Rs.4250) will be released by the broker as soon as the trader squares off the trade.
So what about the overall P&L of the trade? Well, there are many ways to calculate this –
Method 1) – Sum up all the M2M’s
P&L = Sum of all M2M’s
= 325 – 250 – 2250 + 4750 – 4000 – 2000 + 3250 + 4250
= Rs.4,075/-
Method 2) – Cash Release
P&L = Final Cash balance (released by broker) – Cash Blocked Initially (initial margin)
= 33409 – 29334
= Rs.4,075/-
Method 3) – Contract Value
P&L = Final Contract Value – Initial Contract Value
= Rs.238,750 – Rs.234,675
=Rs.4,075/-
Method 4) – Futures Price
P&L = (Difference b/w the futures buy & sell price ) * Lot Size
Buy Price = 938.7, Sell Price = 955, Lot size = 250
= 16.3 * 250
= Rs. 4,075/-
As you can notice, either which ways you calculate, you arrive at the same P&L value.
5.5 – An interesting case of ‘Margin Call’

For a moment, let us assume the trade was not closed on 19th Dec, and in fact carried forward to
the next day i.e 20th Dec. Also, let us assume HDFC Bank drops heavily on 20th December –
maybe a 8% drop, dragging the price to 880 all the way from 955. What do you think will happen?
In fact, can you answer the following questions?
1. What is the M2M P&L?

2. What is the impact on cash balance?
3. What is the SPAN and Exposure margin required?
4. What action does the broker take?
I hope you are able to calculate and answer these questions yourself, if not here are the answers
for you –
1. The M2M loss would be Rs.18,750/- = (955 – 880)*250. The cash balance on 19th Dec was
Rs. 33,409/- from which the M2M loss would be deducted making the cash balance
Rs.14,659/- (Rs.33,409 – Rs.18,750).
2. Since the price has dropped the new contract value would be Rs.220,000/- (250*880)
a. SPAN = 7.5% * 220000 = Rs.16,500/-
b. Exposure = Rs.11,000/-
c. Total Margin = Rs.27,500/-
3. Clearly, since the cash balance (Rs.14,659/-) is less than SPAN Margin (Rs.16,500/-), the
broker will give a Margin Call to the client, or in fact some brokers will even cut the position
real time as and when the cash balance drops below the SPAN requirement.
1. A margin payment is required (which will be blocked by your broker) as long as the fu-
tures trade is live
2. The margin blocked by the broker at the time of initiating the futures trade is called the
initial margin
3. Both the buyer and the seller of the futures agreement will have to deposit the initial mar-
gin amount.
4. The margin amount collected acts as a leverage, as it allows you to deposit a small
amount of money and take exposure to a large value transaction
5. M2M is a simple accounting adjustment, the process involves crediting or debiting the
daily obligation money in your trading account based on how the futures price behaves
6. The previous day closing price figure is taken to calculate the current day’s M2M
7. SPAN Margin is the margin collected as per the exchanges instruction and the Exposure
Margin is collected as per the broker’s requirement
8. The SPAN and Exposure Margin is determined as per the norms of the exchange
9. The SPAN Margin is popularly referred to as the Maintenance Margin
10. If the margin account goes below the SPAN, the investor must deposit more cash into his
account if he aspires to carry forward the future position
11. The Margin Call is when the broker requests the trader to infuse the required margin
money when the cash balance goes below the required level
C H A PT E R 6
Margin Calculator (Part 1)
6.1 The Margin Calculator

In continuation with our discussion on margins in the previous chapter, we will now discuss about
the margin calculator. Over the next two chapters we will discuss about the margin calculator and
also learn few associated topics related to margins.
Do recollect, in the previous chapter we learnt about the various types of margins required at the
time of initiating a futures trade. Margins vary from one future contract to another as the margins
depend on the volatility of the underlying. We will talk about volatility in the next module, but for
now just remember that the volatility changes from one underlying to another, hence the margins
vary from one underlying to another. So how do we know what is the margin requirement of a par-
ticular contract? Well, if you are trading with Zerodha, chances are you would have come across
the ‘Margin Calculator’.
Zerodha’s margin calculator is one of our popular offering, and rightly so. It is a simple to use tool
that has a very sophisticated engine in the background. In this chapter I will just introduce you to
the margin calculator and help you understand the margin requirement for the contract you
choose. We will revisit this topic on the margin calculator when we take up the chapter on Options
in the next module, at that point we will understand the complete versatility of Zerodha’s margin
calculator.
Let us take up a case where one decides to buy the futures contract of IDEA Cellular Limited, expir-
ing on 29th January 2015. Now in order to initiate this trade one needs to deposit the initial mar-
gin amount. We also know that the Initial Margin (IM) = SPAN Margin + Exposure Margin. In order
to find out the IM requirement, all you need to do is this –
Step 1 – Visit https://zerodha.com/technology. Once you land here, click on ‘Margins’, I have high-
lighted the same in the image below
Step 2 – You will be taken to the margin calculator section. As you can see from the image below,
there are many different options that are available (I have highlighted the same in black). How-
ever our focus for now will be on the first two options called ‘SPAN’ and ‘Equity Futures”. In fact
by default you will land on the SPAN Margin Calculator sub page, highlighted in red.
Step 3 – The SPAN Margin Calculator has two main sections within it, let us inspect the same –
The resection has 3 drop down menu options. The ‘Exchange’ drop down option basically re-
quires you to choose the exchange in which you wish to operate. Select –
1. NFO if you wish to trade Futures on NSE

2. MCX if you wish to trade commodity futures on MCX
3. CDS if you wish to trade currency derivatives on NSE
The next drop down on your right is the ‘Product’; choose Futures if you wish to trade a futures
contract, or if you wish to trade options, select Options. The third drop down menu is the list of
symbols where all the futures and option contracts are made available. From this drop down
menu, simply choose the contract you wish to trade. Since we are interested in IDEA Cellular Lim-
ited expiring on 29th Jan, I have selected the same, please see the image below –
Step 4 – Once you select the futures contract, the Net Quantity automatically gets pre populated
to 1 lot. If you wish to trade more than one lot, then you need to enter the new quantity manu-
ally. Notice in the image below, as soon as I select IDEA futures contract, the net quality has
changed to the respective lot size, which is 2000. If I wish to trade say 3 lots, then I have to type in
6000 (2000 * 3). Once this is done simply click on the radio button, either a buy or sell (depending
on what you wish to do) and finally click on the blue “add” button
Once you instruct the SPAN calculator to add the margins, it will do the same and it will give you
the split up between the SPAN, Exposure, and the total Initial margin. This is as shown below,
highlighted in the red box –
The SPAN calculator is suggesting the following –
SPAN Margin = Rs.22,160/-
Exposure Margin = Rs.14,730/-
Initial Margin (SPAN + Exp) = Rs.36,890/-
With this, you know how much money is required to initiate the futures trade on IDEA Cellular; it
is as simple as that! The next interesting section within the margin calculator is the “Equity Fu-
tures”. We will discuss the same in the next chapter, however, before we proceed to understand
this, let us quickly understand 3 more topics namely the Expiry, Spreads, and Intraday order
types. Once we understand these topics, we will be placed better to understand the “Equity Fu-
tures” on the margin calculator.
6.2 – Expiry
In the earlier chapters, we briefly figured out what the ‘Expiry’ of a futures contract means. Expiry
specifies the last date up to which the contract lasts, beyond which it will cease to exist. Consider
this, if I buy IDEA Cellular Limited futures contract at 149/- expiring on 29th January 2015, with an
expectation that it will hit 155, it simply means that this move to 155 has to pan out by 29th Janu-
ary 2015. Obviously if the price of IDEA is below 149 before the expiry then I have to book a loss.
Even if the price of IDEA futures hits 155 (or in fact any price above 149) on 30th January 2015 (1
day after the expiry) it is of no use to me as the contract has already expired. In simple words,
when I buy a futures contract, it has to move in my favor on or before the expiry day, else there is
no point.
Does it really have to be so rigid? Is there any flexibility in terms of going beyond the stated expiry
date? Let me illustrate what I mean –
I know that the Central Government budget is expected sometime around the last week of Febru-
ary 2015, which is a little more than a month away (considering today is 19th Jan 2015). I person-
ally expect a good budget this time around, and I’m also hopeful that the manufacturing sector
will significantly benefit from the budget in the backdrop of the ‘Make in India’ campaign. Given
this, I would like to bet that Bharat Forge, a manufacturing major will significantly benefit from
the upcoming budget. To be precise I expect Bharat Forge to rally from now, all the way till the
budget (pre budget rally). Therefore in order to exploit my directional point of view on Bharat
Forge, I would like to buy its futures today. Have a look at the snapshot below –
Bharat Forge January 2015 contract is trading at Rs.1022/-, but here is a situation – my view is
that Bharat Forge will rally from now, all the way till the last week of Feb 2015. But If I buy the fu-
tures contract as shown above, then it expires on 29th Jan 2015, leaving me stranded half way
through.
Clearly since my directional view goes beyond the January expiry period, I need not be bound to
buy the January expiry contract. In fact for reasons similar to this, NSE allows you to select a con-
tract that suites the expiry requirement.
At any given point, NSE allows us to buy a futures contract with 3 different expiries. For example
we are in the month of January; hence we have 3 contracts of Bharat Forge with different expiry –
1. 29th January 2015 – This is called the near month contract or the current month con-
tract
2. 26th February 2015 – This is called the mid month contract
3. 26th March 2015 – This is called the far month contract
Have a look at the image below –
As you can see, from the expiry drop-down menu, I can choose any contract between the current
month, mid month, or far month based on my specific requirement. Needless to say, I would
choose the mid month contract expiring on 26th Feb 2015 in this particular case (as shown be-
low) –
One thing that stands out clearly is the change in futures price. The contract expiring on 26th Feb
2015 is trading at Rs.1,032/- while at the same time the contract expiring on 29th Jan is trading at
Rs.1,022.8/-. Which means the mid month contract is more expensive compared to the current
month contract. This is always the case; the larger the time to expiry, the higher is the price. In
fact as I write this, Bharat Forge Limited’s March contract expiring on 29th March 2015 is trading
at Rs.1,037.4/-.
For now just remember this – The current month futures price should be less than mid month fu-
tures price, which should be less than far month futures price. There is a mathematical reason for
this, the same will be discussed when we take up the futures pricing formula.
Also, here is another important concept you need to remember – As I had mentioned earlier, at
any given point the NSE ensures there are 3 future contracts (current, mid, and far month) avail-
able to trade. For now we know, Bharat Forge contract is expiring on 29th January 2015. This
means the January contract can be traded till 3:30PM on 29th January 2015, after which it will
cease to exist. So does that mean from 29th January 2015 onwards, the January contract goes
out of the system leaving behind just the February and March contract?
Not really, till 3:30PM on January 29th 2015 the January contract is available, after which it will
expire. On 9:15AM 30th January 2015, NSE will introduce April 2015 contract. So on 30th January
we will have three contracts –
1. The February contract would now graduate as the current month contract from being the
mid month contract until the previous day
2. The March contract would now be considered the mid month contract (graduated from
being far month the previous day to mid month now)
3. The April contract, which is newly introduced, becomes the far month contract.
Likewise when the February contract expires, NSE will introduce the May contract. Hence the mar-
ket will have March, April, and May contracts to trade. So on and so forth.
Anyway, continuing with Bharat Forge Limited futures contract example, because I have a slightly
long term view, I can buy the futures contract expiring on 26th February 2015 and hold the Febru-
ary contract till I deem appropriate. However, there is another alternative as well – instead of
buying the February contract, I can go ahead and buy the January contract, hold on to it till
around expiry, and very close to expiry, I can square off the January contract and buy the Febru-
ary contract. This is called a ‘rollover’.
If you watch business news regularly, around the expiry time the TV anchor’s usually talk about
the ‘rollover data’. Well, don’t get too confused about this, in fact it is quite straight forward. All
they are trying to convey is a % measure on how many traders have ‘rolled over’ (or carried over)
their existing positions from the current month to the mid month. If there are many traders roll-
ing over their existing long positions to the next month then it is considered bullish, likewise if a
lot of traders are rolling over their existing short positions to the next month then it is considered
bearish. This is as simple as that. Now is this a proven technique to draw any concrete inference
about the markets? Not really, it is just a perception of the market.
So under what circumstances would one want to rollover rather than buy a long dated futures
contract? Well, one of the main reasons for this is the ease of buying and selling aka ‘The liquid-
ity’. In simple words, at any given point there are more number of traders who prefer to trade cur-
rent month contract as compared to the mid or far month contract. Obviously when there are
more traders trading the same contract the ease of buying and selling gets better.
6.3 – Sneak Peak into Spreads

We are now at a very interesting stage. You may find some of the discussion below a bit confus-
ing, but just read through this and try to grasp as much as you can. At the right time in future we
will talk more about this in detail.
Just think about these two contracts –
1. Bharat Forge Limited Futures, expiring on 29th January 2015

2. Bharat Forge Limited Futures, expiring on 26th February 2015
For all practical purposes these are two different contracts, priced slightly differently, both de-
rives its value from the same underlying i.e. Bharat Forge Limited, hence they behave exactly the
same. Meaning if Bharat Forge stock price in the spot market goes up, then both January futures
and February futures price would go up. Likewise if Bharat Forge stock price in the spot market
goes down, then both January futures and February futures price would go down.
At times there are opportunities created where by simultaneously buying the current month con-
tract and selling the mid month contract or vice versa, one can make money. Opportunities of
this type are called ‘Calendar Spreads’. How to identify such opportunities and setup trades is a
different topic altogether. We will discuss this soon. But at this moment, I want to draw your atten-
tion to the margins aspect.
We know why margins are charged – mainly from the risk management perspective. Now, what
kind of risk would exist if we are buying the contract on one hand and selling the same type of
contract on the other? The risk is drastically reduced. Let me illustrate this with numbers –
Scenario 1 – Trader buys only Bharat Forge Limited’s January Futures
Bharat Forge Spot Price = Rs.1021/- per share
Bharat Forge January contract Price= Rs.1023/- per share
Lot Size = 250
After buying, assume the spot price drops to Rs.1011/- (10 point fall)
Approximate futures price = Rs.1013/-
P&L = (10 * 250) = Rs.2500/- loss
Scenario 2 – Trader buys January and sells February Futures
Long on Bharat Forge January contract at Rs.1023/- per share
Short on Bharat Forge February contract at Rs.1033/- per share
Lot Size = 250
After setting up this trade, assume the spot price drops to 1011 (10 point fall)
Approximate price of January Futures = Rs.1013/-
Approximate price of February Futures = Rs.1023/-
P&L on January Contract = (10*250) = Rs.2500/- loss
P&L on February Contract = 10*250 = Rs.2500/- profit
Net P&L = – 2500 + 2500 = 0
Scenario 3 – Trader sells January and buys February Futures
Short on Bharat Forge January contract at Rs.1023/- per share
Long on Bharat Forge February contract at Rs.1033/- per share
Lot Size = 250
After setting up this trade, assume the spot price increases to 1031 (10 point increase)
Approximate price of January Futures = Rs.1033/-
Approximate price of February Futures = Rs.1043/-
P&L on January Contract = 10*250 = Rs.2500/- Profit
P&L on February Contract = (10*250) = Rs.2500/- Loss
Net P&L = + 2500 – 2500 = 0
Clearly, the point that I’m trying to make here is that when you are long on one contract and
short on another contract, the risk is virtually reduced to zero. However it is not completely risk
free, one has to account for the liquidity, volatility, and execution risk etc. But by and large the
risk reduces drastically. So when risk reduces drastically, the margins should also reduce drasti-
cally.
In fact this is what happens, have a look at the following snapshots –
This is the margin requirement (Rs.37,362/-) when we intend to buy January contracts of Bharat
Forge
This is the margin requirement (Rs.37,629/-) when we intend to sell February contracts of Bharat
Forge
And this is the margin requirement (Rs.7,213/-) when we intend to buy January contract and sell
February contract simultaneously.
As you can see, individually the January and February contracts require Rs.37,362/- and
Rs.37,629/- respectively. Hence a total of Rs.74,991/-. However when a futures contract is bought
and sold simultaneously the risk reduces drastically, hence the margin requirement. As we can
see from the image above, the combined position just requires a margin of Rs.7,213/- only. An-
other way to look at it would be from a total of Rs.74,991/-, Rs.67,658/- i.e. Margin Benefit (high-
lighted in black) is reduced and the benefit is passed on to the client. But do remember this – A
simultaneous long and short position is built only when opportunities arise. These opportunities
are called the ‘Calendar Spread’. If the calendar spread opportunity is not there, then there is no
point initiating such trades.
Key Takeaways from this chapter
1. Zerodha’s margin calculator is a simple tool that lets you calculate the margin required
for a futures contract
2. The margin calculator has many versatile features inbuilt
3. The margin calculator gives the split up between the SPAN and Exposure margin
4. At any given point, NSE ensures there are three contracts of the same underlying which
expire on 3 different (but consecutive) months
5. A trader can choose the contract of his choice based on the expiry data
6. The contract belonging to the present month is called ‘Current Month Contract’, the next
month contract is called ‘Mid Month’, and the 3rd one is called “Far Month Contract’
7. On every expiry the current month contract expires and a new far month contract is intro-
duced. In the process, the mid month contract would graduate to the current month con-
tract
8. Calendar spread is trading technique which involves buying a certain month contract and
selling another month contract simultaneously for the same underlying
9. When a calendar spread is initiated, the margins required are lower since the risk is drasti-
cally reduced
C H A PT E R 7
Margin Calculator (Part 2)

7.1 – The trade information
I’m going to start this chapter by posting the same old question again – Why do you think mar-
gins are charged? Before you get annoyed and come chasing me, let me post the answer
Margins are charged from a risk management perspective. It helps in preventing any undesired
counter party default. The risk management system at the broker’s office (often called the RMS
system) is responsible for overseeing the overall risk management. You may be interested to
know that the RMS is a computer program, and all orders placed by the clients reach the ex-
change only once this program approves it (which takes a fraction of a second), and there are peo-
ple monitoring if everything done is right/wrong.
When you place a trade, let us say to buy a futures contract (via a buy order entry form) you are
essentially conveying the following details to the risk management system (RMS) –
1. The contract you wish to buy (like TCS futures, IDEA futures etc)
2. The quantity you wish to buy ( number of lots)
3. The price at which you want to buy (market or limit)
Once you place the order, the RMS system evaluates the margin requirement and allows your
trade to go through (provided you have the required margin amount).
However, the information that you don’t normally provide to the RMS system is the following –
1. The duration up to which you wish to hold your trade – is your trade intraday or you
would wish to hold on to it over multiple days?
2. The stoploss point – In case the trade goes against you, at what price point you would
wish to book a loss and square off the position.
Now what would happen if you provided these additional details to the RMS system? Obviously,
with the additional information flowing to the RMS system; it would develop a better clarity on
your risk appetite.
For example, the detail on the duration of the trade would let the system know how much vola-
tility you are exposed to. If your trade is intraday, you are only exposed to 1 day volatility. How-
ever if your trade is for multiple days then you are not only exposed to multiple days volatility,
you are also exposed to the ‘overnight risk’.
Overnight risk is risk of carrying the position overnight. For example assume I’m holding a long
BPCL (a major oil marketing company in India) futures position overnight. BPCL is highly sensi-
tive to fluctuations in crude oil prices. While I’m holding the BPCL futures, assume overnight the
crude oil market shoots up by 5%. This will obviously have a negative impact on BPCL the next
day as it becomes more expensive for BPCL to buy crude oil from the international markets.
Hence by virtue of holding BPCL position overnight, I will suffer a loss, therefore a M2M cut. This
is called ‘overnight risk’. Anyway, the point that I’m trying to make here is straightforward – from
the RMS system’s perspective the longer you wish to hold the trade, the higher is the risk you are
exposed to.
Likewise think about the stoploss for the trade. By not expressing your intended stoploss you
are keeping the RMS system in total darkness with respect to your risk appetite. Do note, this is
not mandatory information that you need to reveal. However, if you do, the RMS system gets
more clarity on your trade. For example assume I buy BPCL futures Rs.649/-, in the absence of
specifying a stoploss, I’m virtually exposed to an unlimited risk. However if I specify my stoploss
as let us say Rs.9/-, then when BPCL falls to Rs.640/- (649 – 9) I would book a loss and get out of
the trade. Hence there is complete clarity on the amount of risk I’m willing to take, which from
the RMS system’s perspective is a valuable information.
So both – the duration and the stoploss of the trade gives more clarity about your risk appetite to
the RMS system. So what does this mean to you as a trader?
Well, think about it – the more clarity you provide in terms of the risk you face, the higher clarity
the RMS system develops. The more clarity it has, the lesser the margins required!
Very loosely put, think about this as an equivalent to shopping for a television at a consumer elec-
tronic store. I know this may not be very apt, but I hope the following analogy gives you the right
message.
If you go to a consumer electronic store and enquire about the price of a television, the seller will
assume you are a regular customer and he will quote the normal selling price. However if you tell
him that you are likely to purchase 50 televisions, he will instantly drop the price.
In addition if you tell him you are carrying the cash with you and are willing to finish the transac-
tion right away, he will drop both his jaws and the prices even lower. The point is – as and when
the shop keeper gets more information about the transaction, the more attractive the price gets.
7.2 – The Product types

So far, one thing is clear, the more information (in terms of risk) you are willing to convey to the
RMS system, the lesser is the margin required. Needless to say, the lesser the margins required,
the more you can do with your capital. So, how does a trader convey this information to the RMS
system? Well, there are specific product types that are meant for this purpose. While placing an
order (to either buy or sell) you can specify the product type. There are many Product types and
they vary from one another mainly in terms of their functionality and the information they con-
vey to the RMS system. While the core functionality of these product types is standard, every bro-
ker calls them with different names. I will of course talk about the product types used at Zerodha,
if you are still trading with another broker, I would request you to speak to them and identify the
nomenclature used.
NRML – NRML is a standard product type. Use this when you intend to buy and hold the futures
trade.
Remember when you use NRML, the risk management system has no additional information on
the length of your trade (as you can continue to hold the contract till expiry) nor does it have any
information on the stoploss. You suffer losses (and therefore continue to pump in the required
margins). Hence because of the lack of clarity the broker’s RMS system charges you the full mar-
gins (i.e. SPAN and Exposure).
Use NRML when you intend to buy and hold the futures position over multiple days. However do
remember you can use NRML product type for intraday as well.
Margin Intraday Square off (MIS) – Zerodha’s MIS is a pure intraday product, meaning all trades
placed as MIS product type will indicate that the trade will last only for the day. You cannot select
MIS as an order type and expect the position to be carried forward to the next day. You have to
mandatorily cut the position by 3:20PM, failing which the RMS system will do the same.
Now because the product type is MIS, the RMS system clearly knows that it is an intraday trade,
which is a notch better than NRML in terms of information flow. Remember, when the trade is
intraday, the trader is exposed to only 1 day’s volatility. Hence the margin requirement is lower
compared to the NRML margins.
Cover order (CO) – The concept of cover order is simple. To begin with, similar to MIS, the cover
order (CO) is also an intraday product. However the CO conveys additional information in terms
of stoploss. This means, at the time of placing a CO, you will have to specify the stoploss as well.
Hence CO conveys both the vital information –
1. The length of the trade which is intraday
2. The stoploss, which is the maximum loss you will bear in case the trade moves against
you
The snapshot below shows the buy CO form –
The area highlighted in black is where one is required to specify the stoploss. Of course, I will not
get into the logistics bit, explaining how to place a CO from the trading terminal, as we have al-
ready done that through an article in z-connect.
The point that I want you to be aware is this – by placing a CO, you are not only conveying that
your trade is intraday, but also conveying the maximum loss you are willing to bear. Hence by vir-
tue of this, the margins should drop considerably (even lower than MIS).
Bracket Order (BO) – The bracket order is quite versatile. Consider the BO as an improvisation
over the cover order. Needless to say, a BO is an intraday order, which means all BO orders have
to be squared off within the day on or before 3:20PM. While placing a BO, you will have to men-
tion a few other things –
1. The stoploss – At what place you would like to get out of the trade in case the trade
moves against you
2. The Trailing stoploss – This is an optional feature where you can trail your stoploss. We
have not spoken about “The trailing stoploss” so far. We will discuss the same towards the
end of this chapter. But for now just remember the BO gives you an option to trail your sto-
ploss, in fact this is one of the most popular feature of a BO
3. Target – If the trade moves in your favor, the BO also requires you to specify the price at
which you would like to book the profits
The BO sends your order to the exchange where simultaneously you can specify the target and
the stoploss. This is a huge relief to active traders as it helps them in many ways. Of course for the
logistics bit on how to place a BO, you can check out this article as it beautifully explains what
needs to be done.
The snapshot below shows the BO buy order form, the green box highlights the SL placements –
If you think about the Bracket Order, the trader is conveying to the RMS system the same set of in-
formation as that of the CO. In addition through the BO, the trader is also conveying the target
price. Now what difference does the information on the target price make to the RMS system?
Well, it literally makes no difference to it from the risk management perspective. Remember the
RMS is only worried about your risk, and not your reward. Hence for this reason, the margin
charged for BO and CO is the same.
Let us now keep the above discussion in perspective and look into few other options available on
Zerodha’s margin calculator.
7.3 – Back to the Margin Calculator

Here is a quick recap – in the previous chapter we introduced Zerodha’s margin calculator. The
objective of the margin calculator is straight forward. It helps the trader figure out how much mar-
gin is required for the contract he wishes to trade. In our quest to understand the same we also
understood concepts of expiry, rollover, and spread margins. With the help of this chapter, we are
now clear about the information flow to the RMS system and its impact on the applicable mar-
gins. Let us keep these in perspective and look at the other two options highlighted in red pro-
vided in the margin calculator – “Equity Futures” and “BO&CO”. Here is a snapshot, highlighting
these features –
Equity Futures – The equity futures section in the margin calculator is a ready reckoner, as it
helps the trader understand the following –
1. The NRML margin required for a particular contract

2. The MIS margin required for a particular contract
3. The number of lots that a trader can buy for the given amount of money in his trading ac-
count
The Equity Futures section contains nearly 475 contracts (as of January 2015). To understand this
better, let us take up a few tasks. We will solve these tasks by using the Equity Futures section of
the margin calculator. And hopefully in the process you will understand how to use the section
better.
Task 1 – A trader has Rs.80,000/- in his trading account. He wants to buy ACC Cements Limited Fu-
tures expiring 26th February 2015 and hold the same for 3 trading sessions. Find out the margin
requirement for this contract. He also wants to trade Infosys January futures for intraday, what is
the margin required? Does he have sufficient margins to initiate both the trades?
Solution – Let us deal with the ACC futures first. Since the trader intends to hold the futures con-
tract for 3 working days, we need to look for NRML margins. Do note, this task can be achieved by
using the SPAN calculator as well. We discussed this in the previous chapter. However the Equity
Futures calculator has a few more advantages over a SPAN calculator.
Visit the Equity Futures section and you can see all the contracts listed here, scroll till you find the
desired contract. I have highlighted the same in green. Do notice, the calculator is also listing the
contract’s expiry date, lot size, and the price at which the contract is trading.
The black vertical box highlights the NRML margin for each contract.
From the table, it is clear that the ACC Feb 2015 requires a margin of Rs.48,686/-.
To find out the margin requirement for Infosys, I need to scroll down till I spot Infosys January
contracts or simply type “Infy” in the search box provided.
As we can see, Infy’s NRML margin is Rs.67,698/-(highlighted in the black arrow) and MIS margin
is Rs.27,079/-(highlighted in the red arrow) . Do note the MIS margin amount is drastically lower
compared to the NRML margin,
Clearly since the trade is for intraday the trader can choose MIS product type and benefit from a
lower margin requirement, which is Rs.27,079/-. Do note, the trader can select NRML product
type even for intraday, there is no harm doing so. But when one does this, the NRML margin
amount gets blocked. If one is clear in his mind about the trade being intraday, then it makes
sense to opt for MIS and efficiently use the capital available.
Anyway, the trader’s total margin requirement would be –
1. 48,686/- towards the ACC contract (NRML margin as the trader wishes to hold the position
for 3 days)
2. 27,079/- towards the Infosys contract (MIS margins as it is a pure intraday product).
3. Total margin of Rs.75,765/- (48,686 + 27079)
Clearly since the trader has Rs.80,000/- in his account, he can initiate both the trades.
Task 2 – A trader has Rs.120,000/- in his trading account. How many lots of Wipro January Fu-
tures can he buy on an intraday basis and on a multiple day basis?
Solution – Search for Wipro in the search box provided. Next to the MIS margin column, there is an
option to click on “Calculate” (highlighted in green arrow). Click on the same.
After you click on it, a form sort of window opens up, you just need to enter –
1. The amount of cash in your trading account (by default this is set to Rs.100,000/- you can
edit the same to meet your requirement)
2. The price at which the contract is trading (in fact this is pre-populated)
Have a look at the screen shot below –
The calculator suggests that I can trade up to 3 lots of Wipro futures under the NRML product
type, considering NRML margin is Rs.36,806/- per lot. Also, under the MIS product type, I can trade
up to 8 lots, considering the margin requirement is just Rs.14,722/- per lot.
And with that, we know all the functionalities of the Equity Futures section of the margin calcula-
tor, as easy as thatJ. We now move over to the BO&CO calculator.
7.4 – BO & CO Margin Calculator

Both bracket order and cover order have similar margin requirements for reasons we discussed
earlier. Using the BO&CO calculator is quite simple; in fact it is quite similar to the SPAN calcula-
tor. In the following snapshot, I’m trying to calculate the margin requirement for Biocon Futures
expiring on February 2015. Notice, I have selected everything that I need to, except for the sto-
ploss.
Without selecting the stoploss, I proceed and press the ‘calculate’ button. Notice when I do so,
the calculator calculates the default stoploss that one can choose and the margin required. Now
once I mention the stop loss, the calculator calculates the amount as shown below
As per the BO&CO calculator, the stoploss one can choose is Rs.403. Of course you can vary the
stoploss to any point, and the margins will change accordingly. Anyway, the margin required is
Rs.9,062/-, which is remarkably lower compared to NRML margin of Rs.26,135/- and MIS margin of
Rs.11,545.
7.5 – The trailing stoploss

Before we conclude this chapter, let us briefly discuss the ‘trailing stoploss’. The concept of trail-
ing stoploss finds its application in bracket orders and in general plays a crucial role while trad-
ing. Hence I guess it is important to know how to trail your stoploss. Consider this situation (in
fact most of us would have been in this situation) – you buy a stock at Rs.250, with an expectation
that the stock price will hit Rs.270 sooner or later. You keep a stoploss at Rs.240 (just in case the
trade goes against you), and hope for the best.
Things move as expected, the stock rallies all the way from Rs.250 to Rs.265 (just a few Rupees
away from your target of Rs.270), however thanks to market volatility it starts to retrace back…all
the way to hit your stoploss at Rs.240. So in essence you saw profits coming in for a brief while,
but were eventually forced to book a loss. How do you deal with such a situation? More often
than not we are always put in such a spot, where we are right about the overall direction but get
‘stopped out’ due to market volatility.
Well, thanks to the technique of ‘trailing your stoploss’ you can prevent yourself from being in
this situation. In fact at times trailing stoploss gives you a chance of making a better profit than
you originally thought about.
Trailing stoploss is a simple concept. All one needs to do is adjust the stoploss based on the move-
ment in the stock. Let me illustrate this with an example. Here is a typical trade setup –
Trade type Long

Script Infosys
Instrument Futures
Futures Price Rs.2175/-
Target Rs.2220/-
Stoploss Rs.2150/-
Risk Rs.25 (2175 – 2150)
Reward Rs.45 (2220 – 2175)
Clearly the idea is to go long at Rs.2175 and keep a stoploss at Rs.2150. The idea is to adjust the
stoploss as and when the price moves in the direction of the trade. To be precise, for every 15
points of price move in the direction of the trade the SL can be adjusted accordingly. The SL can
be adjusted to any level with an idea of locking in the profits. When you adjust the SL with an in-
tention to lock the profits, it is called “Trailing Stop Loss”. Do note, in this example I have ran-
domly opted for a 15 point move, but in reality it can be any kind of price move. Have a look at
the following table, as and when the price moves 15 points in the trades favor, I trail my SL and
thereby lock in certain amount of profit.
Do note, the original price target was Rs.2220, but thanks to the trailing SL technique, I can ride
the momentum and close in on a higher profit.
1. The more information one conveys to the RMS system in terms of trade duration and sto-
ploss the lesser is the margin requirement
2. Use NRML product type when you want to initiate a trade and carry it overnight
3. NRML margins are the highest (SPAN + Exposure)
4. MIS is a pure intraday trade, hence the MIS margin is lesser than the NRML margin
5. In a MIS trade only time information is conveyed (intraday) but not the information about
the stoploss
6. A cover order (CO) is also an intraday product, besides in a CO one has to specify the sto-
ploss
7. A CO conveys both the time and the SL information, hence margins are lesser than MIS
8. The margins for a Bracket Order (BO) is similar to a CO
9. In a BO product type one has the option to specify both the SL and target price at one go.
Besides one can also trail the stop loss
10. A trailing SL technique requires one to adjust the SL as and when the script moves in fa-
vor of the trade
11. A trailing SL is a great way to ride the momentum in a script
12. There are no fixed rules for trailing, one can choose the trailing SL based on the market
situation
C H A PT E R 8
All about Shorting
8.1 – Shorting in a nutshell

We briefly discussed shorting in Module 1. However in this chapter we will look at shorting in
greater detail. Shorting is a tricky concept because we are not used to shorting in our day to day
transaction. For example imagine this transaction – You buy an apartment today for let us say
Rs.X, sell it 2 years later for Rs.X+Y. The profit made on the transaction is the incremental value
over and above Rs.X, which happens to be Rs.Y. This is a simple and a highly intuitive transaction.
In fact most of the day to day transactions requires us to buy something first and sell it later
(maybe for a profit or a loss). These are simple to understand transactions and we are used to it.
However in a short sale or a just ‘shorting’ we carry out the transactions in the exact opposite di-
rection i.e. to sell first and buy later.
So what would compel a trader to sell something first and then buy it later? Well, it is quite simple
– When we believe the price of an asset such as a stock is likely to increase we buy the stock first
and sell it later. However, when we believe the price of the stock is going to decline, we usually
sell it first and buy it later!
Confused? Well, let me try giving you a rudimentary analogy just so that you can get the gist of
the concept at this stage. Imagine your friend and you are watching a nail biting India Pakistan
cricket match. Both of you are in a mood for a little wager.
You bet that India is going to win the match, and your friend bets that India will lose the match.
Quite naturally this means you make money if India wins. Likewise your friend would make
money if India were to lose the match. Now for a minute think of the India (as in the Indian cricket
team in this context) as a stock trading in the stock market. When you do so, your bet is equiva-
lent to saying that you would make money if the stock goes up (India wins the match), and your
friend would make money if the stock goes down (India loses the match). In market parlance, you
are long on India and your friend is short on India.
Still confused? May not be I suppose, but I would imagine a few unanswered questions crawling
in your mind. If you are completely new to shorting, just remember this one point for now – When
you feel the price of a stock is likely to decline, you can make money by shorting the stock.
To short stock or futures, you will have to sell first and buy later. In fact the best way to learn
shorting is by actually shorting a stock/futures and experiencing the P&L. However in this chap-
ter, I will try and explain all the things you need to know before you go ahead and short the stock/
futures.
8.2 – Shorting stocks in the spot market

Before we understand how one can short a stock in the futures market, we need to understand
how shorting works in the spot market. Think about the following hypothetical situation –
1. A trader looks at the daily chart of HCL Technologies Limited and identifies the formation
of a bearish Marubuzo
2. Along with the bearish Marubuzo, other checklist items (as discussed in TA module) com-
plies as well
a. Above average volumes
b. Presence of the resistance level
c. Indicators confirm
d. The Risk & Reward ratio is satisfactory
3. Based on the analysis the trader is convinced that HCL Technologies will decline by at
least 2.0% the following day
Now given this outlook, the trader wants to profit by the expected price decline. Hence he de-
cides to short the stock. Let us understand this better by defining the trade –
Stock HCL Technologies
Trade Type Short (sell first and buy later)
Trade Duration Intra day
Short Price Rs.1990/-
Number of shares 50
Target Price Rs.1950/-
% Profit Expected 2.0%
Stoploss Rs.2000/-
Risk Rs.10/-
Reward Rs.40/-
As we know, when one shorts a stock or stock futures, the expectation is that the stock price goes down
and therefore one can profit out of the falling prices. So from the table above the idea is to short the
stock at Rs.1990.
On the trading platform when you are required to short, all you need to do is highlight the stock (or fu-
tures contract) you wish to short and press F2 on your trading platform. Doing so invokes the sell order
form; enter the quantity and other details before you hit Submit. When you hit submit, the order hits the
exchange and assuming it gets filled, you would have created a short open position for yourself.
Anyway, now think about this – When you enter a trading position, under what circumstances would you
make a loss? Well, quite obviously you would lose money when the stock price goes against your ex-
pected direction. So,
1. When you short a stock what is the expected directional move?

a. The expectation is that the stock price would decline, so the directional view is downwards
2. So when would you start making a loss?
a. When the stock moves against the expected direction
3. And what would that be?
a. This means you will start making a loss if the stock price instead of going down starts to
move up
For this reason whenever you short, the stoploss price is always higher than the price at which
you have shorted the stock. Therefore from the table above you can see that the short trade en-
try is Rs.1990/- and the stoploss is Rs.2000/-, which is Rs.10/- higher than the entry price.
Now, after initiating the short trade at Rs.1990/- let us now hypothetically imagine 2 scenarios.
Scenario 1 – The stock price hits the target of Rs.1950/-
In this case the stock has moved as per the expectation. The stock has fallen from Rs.1990/- to
Rs.1950/-. Since the target has been achieved, the trader is expected to close the position. As we
know in a short position the trader is required to –
1. First sell @ Rs.1990/- and

2. Later buy @ Rs.1950/-
In the whole process, the trader would have made a profit equal to the differential between the
selling and buying price – i.e. Rs.40/- (1990 – 1950).
If you look at it from another angle (i.e. the usual buy first and sell later angle), this is as good as
buying at Rs.1950 and selling at Rs.1990. It is just that the trader has reversed the transaction or-
der by selling first and buying later.
Scenario 2 – The stock price increases to Rs.2000/-
In this case the stock has gone higher than the short price of Rs.1990/-. Recollect when you short,
for you to profit the stock needs to decline in price. If the stock price goes up instead then there
would be a loss. In this case the stock has gone up, hence there would be a loss –
1. The trader shorted @ Rs.1990/-. After shorting, the stock went up as opposed to the
trader’s expectation
2. The stock hits Rs.2000/- and triggers the stoploss. To prevent further losses, the trader
will have to close the position by buying the stock back.
In the whole process the trader would have suffered a loss of Rs.10/- (2000 – 1990). If you look at
it from the regular buy first sell later angle – this transaction is as good as buying at Rs.2000/- and
selling at Rs.1990/ , and again if we reverse the order it would be sell first and buy later.
Hopefully the above two scenarios should have convinced you about the fact that, when you
short you make money when the price goes down and you lose when the price increases.
8.3 – Shorting in spot (The stock exchange’s perspective)
Shorting in the spot market has one restriction – it strictly has to be done on an intraday basis.
Meaning you can initiate the short trade anytime during the day, but you will have to buy back
the shares (square off) by end of the day before the market closes. You cannot carry forward the
short position for multiple days. To understand why shorting in the spot market is strictly an intra-
day affair we need to understand how the exchange treats the short position.
When you short in the spot market, you obviously sell first. The moment you sell a stock, the back-
end process would alert the exchange that you have sold a particular stock. The exchange does
not differentiate between a regular selling of stock (from DEMAT account) and a short sale. From
their perspective they are of the opinion that you have sold the shares which would obligate you
to deliver the same. In order to do so, you need to keep the shares ready in your DEMAT account
by next day. However the exchange would know about your obligation only after the market
closes and not during the market hours.
Keep the above discussion in the back of your mind. Now for a moment let us assume you have
shorted a stock and hope to benefit from the price decline. After you short, the price has not de-
clined as expected and hence you decide to wait for another day. However at the end of the day,
exchange would figure out that you have sold shares during the day, hence you would be re-
quired to keep these shares ready for delivery. However you do not have these shares for meeting
your delivery obligation. This means you will default against your obligation; hence there would
be a hefty penalty for this default. This situation is also referred to as “Short Delivery”.
Under a short delivery situation, the exchange would take up the issue and settle it in the auction
market. I would encourage you to read this article on Z-Connect which beautifully explains the
auction market procedures and how penalty is imposed on the client defaulting on delivery obli-
gation. A piece of advice here, never get into the ‘short delivery’ situation, always make sure you
close your short trade before the market close, else the penalty could be as high as 20% above
your short price.
Also, this leads us to an important thought – the exchange anyway checks for the obligations af-
ter the market closes. Hence before the exchange can run the ‘obligation check’ if one were to
cover the short position (by squaring off) then there would be no obligation at all by end of the
day. Hence for this reason, shorting in spot market has to be done strictly as an intraday trade
without actually carrying forward the delivery obligation.
So does that mean all short positions have to be closed within the day? Not really. A short posi-
tion created in the futures market can be carried forward overnight.
8.4 – Shorting in the Futures Market

Shorting a stock in the futures segment has no restrictions like shorting the stock in the spot mar-
ket. In fact this is one of the main reasons why trading in futures is so popular. Remember the ‘fu-
tures’ is a derivative instrument that just mimics the movement of its respective underlying. So if
the underlying value is going down, so would the futures. This means if you are bearish about a
stock then you can initiate a short position on its futures and hold on to the position overnight.
Similar to depositing a margin while initiating a long position, the short position also would re-
quire a margin deposit. The margins are similar for both the long and short positions and they do
not really change.
To help you understand the market to market (M2M) perspective when you short futures, let us
take up the following example. Imagine you have shorted HCL Technologies Limited at Rs.1990/-.
The lot size is 125. The table below shows the stock price movement over the next few days and
the respective M2M –
Day Ref price for M2M Closing Price P&L for the day
01 – (Initiate
1990 1982 125 x 8 = 1000
short)
2 1982 1975 125 x 7 + 875
3 1975 1980 125 x 5 = 625
4 1980 1989 125 x 9 = 1125
5 1989 1970 125 x 19 = 2375
06 – (Square off) 1970 1965 125 x 5 = 625
The two lines marked in red highlights the fact that they are loss making days. To get the overall
profitability of the trade we could just add up all the M2M values –
+ 1000 + 875 – 625 – 1125 + 2375 + 625
= Rs.3125/-
Alternatively we could look at it as –
(Selling Price – Buying price) * Lot Size
= (1990 – 1965) * 125
= 25*125
=Rs.3125/-
So, shorting futures is very similar to initiating a long futures position, except that when you short
you profit only if the price declines. Besides this, the margin requirement and the M2M calcula-
tion remains the same.
Shorting is a very integral part of active trading. I would suggest you get as comfortable with initi-
ating a short trade as you would with a long trade.
1. Shorting requires us to sell first and buy later
2. Short trade is profitable only when the closing price is lower than the entry price
3. When the price goes higher than the price at which one has shorted, then there would be
a loss
4. The stoploss in a short trade is always higher than the price at which one has shorted
5. One can only short on an intraday basis in the spot market
6. The short positions cannot be carried overnight in the spot market
7. The short position in the futures market can be carried forward overnight
8. The margins requirement for both short and long trades are similar
9. The M2M computation is also similar for both short and long trades
C H A PT E R 9
The Nifty Futures

9.1 – Basics of the Index Futures
Within the Indian derivatives world, the Nifty Futures has a very special place. The ‘Nifty Futures’
is the most widely traded futures instrument, thus making it the most liquid contract in the In-
dian derivative markets. In fact you may be surprised to know that Nifty Futures is easily one of
the top 10 index futures contracts traded in the world. Once you get comfortable with futures trad-
ing I would imagine, like many of us you too would be actively trading the Nifty Futures. For this
reason, it would make sense to understand Nifty futures thoroughly. However before we proceed
any further, I would request you to refresh your memory on the Index, we have discussed the
same here.
I assume you are comfortable with the basic understanding of the index; therefore I will proceed
to discuss the Index Futures or the Nifty Futures.
As we know the futures instrument is a derivative contract that derives its value from an underly-
ing asset. In the context of Nifty futures, the underlying is the Index itself. Hence the Nifty Futures
derives its value from the Nifty Index. This means if the value of Nifty Index goes up, then the
value of Nifty futures also goes up. Likewise if the value of Nifty Index declines, so would the Index
futures.
Here is the snapshot of Nifty Futures Contract –
Like any other futures contract, Nifty Futures is also available in three variants – current month,
mid month, and far month. I have highlighted the same in red for your reference. Further in blue I
have highlighted the Nifty Futures price which at the time of taking this snapshot was Rs.8631 per
unit of Nifty. The corresponding underlying value (index value in spot) was Rs. 8602.29. Of course
there is a difference between the spot price and the futures price, which is due to the futures pric-
ing formula. We will understand the concepts related to futures pricing in the next chapter.
Further, if you notice the lot size here is 25 (this has been reduced to 25 from 50). We know the
contract value is –
CV = Futures Price * Lot Size
= 8631 * 25
= Rs.215,775/-
Here are the margin requirements for trading Nifty Futures; I’ve used Zerodha Margin Calculator
to get the margin values –
Order Type Margin
NRML Rs.17,323/-
MIS Rs.6,937/-
BO & CO Rs.6,233/-
These details should give you a basic overview of the Nifty Futures. One of the main features of
Nifty Futures that makes it so popular is its liquidity. Let us now proceed to understand what li-
quidity is and how one would measure it.
9.2 – Impact Cost
You would often hear the term ‘liquidity’ while trading the markets. Liquidity is the ease at which
one can buy or sell a particular stock or futures. If a stock is highly liquid (read it as very easy to
buy/sell) then it would attract seasoned traders to trade in large quantities at ease, without really
affecting the stock prices. A highly liquid stock/contract invariably attracts a lot of institutional in-
terest as well. Besides if stock/futures is highly liquid then it usually translates to lesser volatility.
Most importantly, if the stock is liquid then placing a ‘market order’ is hassle free.
Let us take up the example of MRF Limited to understand liquidity. Assume a foreign institutional
investor intends to buy 5000 shares of MRF Limited. As you may know MRF Limited is probably the
most expensive stock (in terms of price and not valuation) in the Indian markets. MRF stock is cur-
rently trading at Rs.38,351/- per share. Therefore buying 5000 shares at this price would translate
to a transaction worth around 20 Crs (38351*5000). Do note a transaction of 20 Crs is not really a
large one for a typical Foreign Institution. Anyway given that they want to buy 5000 shares let us
look into MRF’s liquidity in the market. Here is the snapshot of MRF Limited’s order book / market
depth as taken from NSE India website –
If you wish to buy large quantity of shares, then you need to look at how many shares are being
offered in the market. As you can see from the snapshot above there are only about 4313 shares in
the market (highlighted by blue arrow). Clearly the number of shares in the market is lesser than
what is required, hence the MRF counter is considered shallow or illiquid. Liquidity can also be
measured by looking at the bid-ask spread and estimating the impact cost. Knowing about the im-
pact cost is particularly helpful while placing a market order.
Impact cost is the loss associated by executing a ‘round-trip’ trade. The loss is expressed as a per-
centage of the average of the bid and ask price. Round-tripping is an instantaneous arbitrary
trade you carry out by buying at the first best available sell price and selling at the first best avail-
able buy price. Let us execute this on MRF (please refer to the order book snapshot above) –
Buy Price – Rs.38,364.95
Sell Price – Rs.38,266.25
So if I were to do a round trip, I would clearly lose money on it. In fact all round – trip trades result
in a loss. The loss in this case would be –
= 38,364.95 – 38,266.25
= Rs. 98.7
Further, the average of bid and ask is calculated as follows –
= (38,364.95 + 38,266.25) / 2
= Rs.38,315.60
Hence the impact cost would be –
= Round Trip loss / Average of bid ask spread
= 98.7 / 38315.6
~ 0.3%
So how do you use this information? Well, it simply means if you were to place a market order to
either buy or sell the stock, you are likely to lose 0.3% due to impact cost. This may not always
be true but you need to be aware that based on the number of shares you wish to transact in, you
are likely lose about 0.3% owing to impact cost while placing a market order. Next time you call
your broker to buy or sell a stock at market, the price you see on your screen and the price at
which the trade executes may vary, do remember this is attributable to the impact cost!
Now a 0.3% loss due to impact cost is extremely high. To give you a perspective, let us run
through the same exercise on Nifty futures –
Price at which you can Buy = Rs. 8,769.9
Price at which you can sell = Rs. 8,768.8
Round trip Loss = Rs. 1.1 (8769.9 – 8768.8)
Average of Bid Ask = (8769.9 + 8768.8)/2
= 8769.35
Impact Cost = 1.1 / 8769.35
= 0.0125%
This means if you buy or sell nifty futures at market price, you are likely to lose just about
0.0125%. Contrast Nifty’s impact cost of 0.0125% with MRF’s impact cost of 0.3% and you will
know the importance of liquidity. The few key messages that I want you to take away from this dis-
cussion are these –
1. Impact cost gives a sense of liquidity

2. The higher the liquidity in a stock, the lesser is the impact cost
3. The spread between the buying and selling price is also an indicator of liquidity
a. Higher the spread, the higher the impact cost
b. Lower the spread, the lower is the impact cost
4. Higher the liquidity, lesser the volatility
5. If the stock is not liquid, placing market orders is not a great idea
Considering Nifty Futures is the most liquid contract in India, it is safe to set 0.0125% as a bench-
mark for impact cost. Going by this, MRF’s 0.3% is way higher than Nifty’s impact cost hence it is
right to say that MRF is highly illiquid.
You may also be interested to know that besides Nifty Futures there are few other future con-
tracts that are quite liquid in the Indian markets such as the Bank Nifty Futures, Reliance Indus-
tries, Tata Motors, SBIN, Infosys, TCS, ITC, DLF, Cipla etc. Maybe you can calculate the impact cost
for a few of these futures contracts to get a sense of their liquidity.
9.3 – Why trading Nifty makes sense

As you know the Nifty Index is a basket of 50 stocks. These stocks are selected to represent a wide
section of the India economic sectors. This makes Nifty a good representative of the broader eco-
nomic activity in India. This naturally means if the general economic activity is going up or at
least expected to go up then Nifty’s value also goes up, and vice versa. This also makes trading
Nifty Futures a much better choice as compared to single stock futures. There are many reasons
for this, here are some –
1. It is diversified – At times taking a directional call on a single stock can be a tough task,
this is mainly from the risk perceptive. For example let us just say I decide to buy Infosys Lim-
ited with a hope that the quarterly results would be good. In case the results don’t impress
the markets, then obviously the stock would take a knock and so would my P&L. Nifty fu-
tures on the other hand has a diversified portfolio of 50 stocks. As it is a portfolio of stocks,
the movement of the Index does not really depend on a single stock. Of course occasionally
a few stocks (index heavy weights) can influence Nifty to some extent but not on an every-
day basis. In other words when you trade Nifty futures you completely eliminate ‘unsystem-
atic risk’ and deal with only with ‘systematic risk’. I know these are new jargons being intro-
duced here, we will discuss these terms in more detail at a later stage when we talk about
hedging.
2. Hard to manipulate – The movement in Nifty is a response to the collective movement in
the top 50 companies in India (by market capitalization). Hence there is virtually no scope to
manipulate the Nifty index. However the same cannot be said about individual stocks (re-
member Satyam, DHCL, Bhushan Steel etc)
3. Highly Liquid (easy fills, less slippage) – We discussed liquidity earlier in the chapter.
Since the Nifty is so highly liquid you can literally transact any quantity of Nifty without wor-
rying about losing money on the impact cost. Besides there is so much liquidity that you can
literally transact any number of contracts that you wish.
4. Lesser margins – Nifty futures require much lesser margins as compared to individual
stock futures. To give you a perspective Nifty’s margin requirement varies between 12-15%,
however individual stock margins can go as high as 45-60%.
5. Broader economic call – Trading the Nifty futures requires one to take a broad based eco-
nomic call rather than company specify directional calls. From my experience, doing the for-
mer is much easier than the latter.
6. Application of Technical Analysis – Technical Analysis works best on liquid instruments.
Liquid stocks are hard to manipulate, hence they usually move based on the demand sup-
ply dynamics of the market, which obviously is what a TA mainly relies on
7. Less volatile – Nifty futures are less volatile compared to individual stock futures. To give
you perspective the Nifty futures has an annualized volatility of around 16-17%, where as in-
dividual stocks like say Infosys has annualized volatility of upwards of 30%.
1. Nifty Futures derives its value based on the Nifty Index in spot, which is its underlying
2. At present the Nifty futures lot size is 25
3. The Nifty futures is the most liquid futures contract in India
4. Just like other future contracts, Nifty Futures contracts are also available with three differ-
ent expiry options (Current month, Mid Month, and Far Month)
5. A round trip trade is an arbitrary quick instantaneous trade which involves buying at the
best available sell price and selling at the best available buy price
6. A round trip trade always results in a loss
7. Impact cost measures the loss of a round trip as a % of average of bid and ask
8. Higher the impact cost, lesser the liquidity and vice versa
9. When you place a market order to transact, you may lose some money owing to impact
cost
10. Nifty has an impact cost close to 0.0125%, which makes it the most liquid contract to
trade
C H A PT E R 10
The Futures Pricing
10.1 – The Pricing Formula

If you were to take a conventional course on Futures trading, you would probably be introduced
to the futures pricing formula right at the very beginning of the course. However we have deliber-
ately opted to talk about it now, at a much later stage. The reason is simple – if you are trading fu-
tures based on technical analysis (I assume a vast majority of you are doing this) then you would
not really need to know how the futures are priced, although a good working knowledge would
help. However if you aspire to trade futures by employing quantitative strategies such as Calen-
dar Spreads or Index Arbitrage then you certainly need to know this. In fact we will have a module
dedicated to ‘Trading Strategies’ where we would discuss some of these strategies, hence the dis-
cussion in this chapter will lay down a foundation for the forthcoming modules.
If you recall, in some of the earlier chapters occasionally we discussed the ‘Futures Pricing For-
mula’ as the prime reason for the difference between the spot price and the futures price. Well, I
guess it is time now to lift the veil and introduce the ‘Future Pricing Formula’.
We know the futures instrument derives its value from its respective underlying. We also know
that the futures instrument moves in sync with its underlying.
If the underlying price falls, so would the futures price and vice versa. However, the underlying
price and the futures price differs and they are not really the same. To give you a perspective as I
write this, Nifty Spot is at 8,845.5 whereas the corresponding current month contract is trading at
8,854.7, please refer to the snap shot below. This difference in price between the futures price and
the spot price is called the “basis or spread”. In case of the Nifty example below, the spread is
9.2 points (8854.7 – 8845.5).
The difference in price is attributable to the ‘Spot – Future Parity’. The spot future parity the dif-
ference between the spot and futures price that arises due to variables such as interest rates, divi-
dends, time to expiry etc. In a very loose sense it is simply is a mathematical expression to equate
the underlying price and its corresponding futures price. This is also known as the futures pric-
ing formula.
The futures pricing formula simply states –
Futures Price = Spot price *(1+ rf – d)
Where,
rf = Risk free rate
d – Dividend
Note, ‘rf’ is the risk free rate that you can earn for the entire year (365 days); considering the ex-
piry is at 1, 2, and 3 months one may want to scale it proportionately for time periods other than
the exact 365 days. Therefore a more generic formula would be –
Futures Price = Spot price * [1+ rf*(x/365) – d]
Where,
x = number of days to expiry.
One can take the RBI’s 91 day Treasury bill as a proxy for the short term risk free rate. You can find
the same on the RBI’s home page, as shown in the snapshot below –
As we can see from the image above, the current rate is 8.3528%. Keeping this in perspective let
us work on a pricing example. Assume Infosys spot is trading at 2,280.5 with 7 more days to ex-
piry, what should Infosys’s current month futures contract be priced at?
Futures Price = 2280.5 * [1+8.3528 %( 7/365)] – 0
Do note, Infosys is not expected to pay any dividend over the next 7 days, hence I have assumed
dividend as 0. Solving the above equation, the future price turns out to be 2283. This is called the
‘Fair value’ of futures. However the actual futures price as you can see from the image below is
2284. The actual price at which the futures contract trades is called the ‘Market Price’.
The difference between the fair value and market price mainly occurs due to market costs such as
transaction charges, taxes, margins etc. However by and large the fair value reflects where the fu-
tures should be trading at a given risk free rate and number of days to expiry. Let us take this fur-
ther, and figure out the futures price for mid month and far month contracts.
Mid month calculation
Number of days to expiry = 34 (as the contract expires on 26th March 2015)
Futures Price = 2280.5 * [1+8.3528 %( 34/365)] – 0
= 2299
Far month calculation
Number of days to expiry = 80 (as the contract expires on 30th April 2015)
Futures Price = 2280.5 * [1+8.3528 %( 80/365)] – 0
= 2322
From NSE website let us take a look at the actual market prices –
Snapshot of Infosys’s mid month contract
Snapshot of Infosys’s mid month contract
Clearly there is a difference between the calculated fair value and the market price. I would attrib-
ute this to the applicable costs. Besides, the market could be factoring in some financial yearend
dividends as well. However the key point to note is as the number of days to expiry increases, the
difference between the fair value and market value widens.
In fact this leads us to another important commonly used market terminology – the discount
and the premium.
If the futures is trading higher than the spot, which mathematically speaking is the natural order
of things, then the futures market is said to be at ‘premium’. While ‘Premium’ is a term used in
the Equity derivatives markets, the commodity derivatives market prefer to refer to the same phe-
nomenon as ‘Contango’. However, both contango and premium refer to the same fact – The Fu-
tures are trading higher than the Spot.
Here is a plot of Nifty spot and its corresponding futures for the January 2015 series. As you can
see the Nifty futures is trading above the spot during the entire series.
I specifically want to draw your attention to the following few points –
1. At the start of the series (highlighted by a black arrow) the spread between the spot and
futures is quite high. This is because the number of days to expiry is high hence the x/365 fac-
tor in the futures pricing formula is also high.
2. The futures remained at premium to the spot throughout the series
3. At the end of the series (highlighted by a blue arrow) the futures and the spot have con-
verged. In fact this always happens. Irrespective of whether the future is at a premium or a
discount, on the day of the expiry, the futures and spot will always converge.
4. If you have a futures position and if you fail to square off the position by expiry, then the
exchange will square off the position automatically and it will be settled at the spot price as
both futures and spot converges on the day of the expiry
Not always does the futures trade richer than the spot. There could be instances – mainly owing
to short term demand and supply imbalances where the futures would trade cheaper than its cor-
responding spot. This situation is when the futures is said to be trading at a discount to the spot.
In the commodities world, the same situation is referred to as the “backwardation”.
10.2 – Practical Application

Before we conclude this chapter, let us put the futures pricing formula to some practical use.
Like I had mentioned earlier, futures pricing formula comes very handy when you aspire to trade em-
ploying quantitative trading techniques. Please note, the following discussion is only a preview win-
dow into the world of trading strategies. We will discuss all these things plus more in greater detail
when we take up the module on “Trading Strategies”. Consider this situation –
Wipro Spot = 653
Rf – 8.35%
x = 30
d=0
Given this, the futures should be trading at –
Futures Price = 653*(1+8.35 %( 30/365)) – 0
= 658
Accommodate for market charges, the futures should be trading in and around 658. Now what if in-
stead the futures contract is trading at a drastically different price? Let’s say 700? Clearly there is a
trade here. The difference between the spot and futures should ideally be just 5 points, but due to
market imbalances the difference has shot up to 47 points. This is a spread that we can capture by
deploying a trade.
Here is how one can do this – since the future contract is trading above its fair value, we term the fu-
tures market price as expensive relative to its fair value. Alternatively we can say, the spot is trad-
ing cheaper with respect to the futures.
The thumb rule in any sort of ‘spread trade’ is to buy the cheaper asset and sell the expensive one.
Hence going by this, we can sell Wipro Futures on one hand and simultaneously buy Wipro in the
spot market. Let us plug in the numbers and see how this goes –
Buy Wipro in Spot @ 653
Sell Wipro in Futures @ 700
Now we know that on the expiry day, both the spot and the futures converge into one single price
(refer to the Nifty graph posted above). Let us assume a few random values at which the futures and
the spot converge – 675, 645, 715 and identify what happens to the trade –
Spot Trade P&L Futures Trade
Expiry Value Net P&L
(Long) P&L (Short)
675 675 – 653 = +22 700 – 675 = +25 +22 + 25 = +47
645 645 – 653 = -08 700 – 645 = +55 -08 + 55 = +47
715 715 – 653 = +62 700 – 715 = -15 +62 – 15 = +47
As you can notice, once you have executed the trade at the expected price you have essentially
locked in the spread. So irrespective of where the market goes by expiry, the profits are guaran-
teed! Of course, it goes without saying that it makes sense to square off the positions just before
the expiry of the futures contract. This would require you to sell Wipro in spot market and buy
back Wipro in Futures market.
This kind of trade between the futures and the spot to extract and profit from the spread is also
called the ‘Cash & Carry Arbitrage’.
10.3 – Calendar Spreads

The calendar spread is a simple extension of the cash & carry arbitrage. In a calendar spread, we
attempt to extract and profit from the spread created between two futures contracts of the same
underlying but with different expiries. Let us continue with the Wipro example and understand
this better –
Wipro Spot is trading at = 653
Current month futures fair value (30 days to expiry) = 658
Actual market value of current month futures = 700
Mid month futures fair value (65 days to expiry) = 663
Actual market value of mid month futures = 665
From the above example, clearly the current month futures contract is trading way above its ex-
pected theoretical fair value. However the mid month contract is trading close to its actual fair
value estimate. With these observations, I will make an assumption that the current month con-
tract’s basis will eventually narrow down and the mid month contract will continue to trade close
to its fair value.
Now with respect to the mid month contract, the current month contract appears to be expen-
sive. Hence we sell the expensive contract and buy the relatively cheaper one. Therefore the
trade set up would require me to buy the mid month futures contract @ 665 and sell the current
month contract @ 700.
What do you think is the spread here? Well, the spread is the difference between the two future
contracts i.e 700 – 665 = 35 points.
The trade set up to capture the spread goes like this –
Sell the current month futures @ 700
Buy the mid month futures @ 665
Do note – because you are buying and selling the same underlying futures of different expiries,
the margins are greatly reduced as this is a hedged position.
Now after initiating the trade, one has to wait for the current month’s futures to expire. Upon ex-
piry, we know the current month futures and the spot will converge to a single price. Of course on
a more practical note, it makes sense to unwind the trade just before the expiry.
Let us arbitrarily take a few scenarios as below and see how the P&L pans out -
Current month Mid Month P&L

Expiry Value Net P&L
P&L (Short) (Long)
660 700 – 660 = +40 660 – 665 = -5 +40 – 5 = +35
690 700 – 690 = +10 690 – 665 = +25 +10 + 25 = +35
725 700 – 725 = -25 725 – 665 = +60 -25 + 60 = +35
Of course, do recall the critical assumption we have made here is that i.e. the mid month contract
will stick close to its fair value. From my trading experience this happens most of the times.
Most importantly please do bear in mind the discussion with respect to spreads in this chapter is
just a sneak peek into the world of trading strategies. We will discuss these strategies in a sepa-
rate module which would give you an in depth analysis on how one can professionally deploy
these strategies.
1. The futures pricing formula states that the Futures Price = Spot price *(1+Rf (x/365)) – d
2. The difference between futures and spot is called the basis or simply the spread
3. The futures price as estimated by the pricing formula is called the “Theoretical fair value”
4. The price at which the futures trade in the market is called the ‘market value’
5. The theoretical fair value of futures and market value by and large should be around the
same value. However there could be slight variance mainly due to the associated costs
6. If the futures is rich to spot then the futures is said to be at premium else it is said to be at
a discount
7. In commodity parlance Premium = Contango and Discount = Backwardation
8. Cash and carry is a spread where one can buy in the spot and sell in the futures
9. Calendar spread is an extension of a cash and carry where one buys a contract and simul-
taneously sells another contract (with a different expiry) but of the same underlying
C H A PT E R 11
Hedging with Futures
11.1 – Hedging, what is it?

One of the most important and practical applications of Futures is ‘Hedging’. In the event of any
adverse market movements, hedging is a simple work around to protect your trading positions
from making a loss. Let me to attempt giving you an analogy to help you understand what hedg-
ing really is.
Imagine you have a small bit of vacant barren land just outside your house, instead of seeing it lie
vacant and barren you decide to lawn the entire plot and plant few nice flowering plants. You nur-
ture the little garden, water it regularly, and watch it grow. Eventually your efforts are paid off
and the lawn grows lush green and the flowers finally start to blossom. As the plants grow and
flowers start to bloom it starts to attract attention of the wrong kind. Soon you realize your little
garden has become a hot destination for a few stray cows. You notice these stray cows merrily
gazing away the grass and spoiling the nice flowers. You are really annoyed with this and decide
to protect your little garden? A simple work around is what you have in mind – you erect a fence
(maybe a wooden hedge) around the garden to prevent the cows from entering your garden. This
little work around ensures your garden stays protected and also lets your garden flourish.
Let us now correlate this analogy to the markets –
๏ Imagine you nurture a portfolio by picking each stock after careful analysis. Slowly you in-
vest a sizable corpus in your portfolio. This is equivalent to the garden you grow
๏ At some point after your money is invested in the markets you realize that the markets
may soon enter a turbulent phase which would result in portfolio losses. This is equivalent
to the stray cow grazing your lawn and spoiling your flower plants
๏ To prevent your market positions from losing money you construct a portfolio hedge by
employing futures. This is equivalent to erecting a fence (wooden hedge) around your gar-
den
I hope the above analogy gave you got a fair sense of what ‘hedging’ is all about. Like I had men-
tioned earlier, hedging is a technique to ensure your position in the market is not affected by any
adverse movements. Please don’t be under the impression that hedging is done only to protect a
portfolio of stocks, in fact you can employ a hedge to protect individual stock positions, albeit
with some restrictions.
11.2 – Hedge – But why?

A common question that gets asked frequently when one discusses about hedging is why really
hedge a position? Imagine this – A trader or an investor has a stock which he has purchased at
Rs.100. Now he feels the market is likely to decline and so would his stock. Given this, he can
choose to do one of the following –
1. Take no action and let his stock decline with a hope it will eventually bounce back
2. Sell the stock and hope to buy it back later at a lower price
3. Hedge the position
Firstly let us understand what really happens when the trader decides not to hedge. Imagine the
stock you invested declines from Rs.100 to let us say Rs.75. We will also assume eventually as
time passes by the stock will bounce back to Rs.100. So the point here is when the stock eventu-
ally moves back to its original price, why should one really hedge?
Well, you would agree the drop from Rs.100/- to Rs.75/- is a 25% drop. However when the stock
has to move back from Rs.75/- to Rs.100/- it is no longer a scale back of 25% instead it works out
to that the stock has to move by 33.33% to reach the original investment value! This means when
the stock drops it takes less effort do to so, but it requires extra efforts to scale back to the origi-
nal value. Also, from my experience I can tell you stocks do not really go up that easily unless it is
a raging bull market. Hence for this reason, whenever one anticipates a reasonably massive ad-
verse movement in the market, it is always prudent to hedge the positions.
But what about the 2nd option ? Well, the 2nd option where the investor sells the position and
buys back the same at a later stage requires one to time the market, which is not something easy
to do. Besides when the trader transacts frequently, he will also not get the benefit of Long term
capital tax. Needless to say, frequent transaction also incurs additional transactional fees.
For all these reasons, hedging makes sense as he is virtually insulates the position in the market
and is therefore becomes indifferent to what really happens in the market. It is like taking vaccine
shot against a virus. Hence when the trader hedges he can be rest assured the adverse movement
in the market will not affect his position.
11.3 – Risk
Before we proceed to understand how we could hedge our positions in the market, I guess it is im-
portant to understand what is that we are trying to hedge. Quite obviously as you can imagine,
we are hedging the risk, but what kind of risk?
When you buy the stock of a company you are essentially exposed to risk. In fact there are two
types of risk – Systematic Risk and Unsystematic Risk. When you buy a stock or a stock future,
you are automatically exposed to both these risks.
The stock can decline (resulting in losses for you) for many reasons. Reasons such as –
1. Declining revenue
2. Declining profit margins
3. Higher financing cost
4. High leverage
5. Management misconduct
All these reasons represent a form of risk, in fact there could be many other similar reasons and
this list can go on. However if you notice, there is one thing common to all these risks – they are
all company specific risk. For example imagine you have an investable capital of Rs.100,000/-.
You decide to invest this money in HCL Technologies Limited. Few months later HCL makes a
statement that their revenues have declined. Quite obviously HCL stock price will decline. Which
means you will lose money on your investment. However this news will not impact HCL’s competi-
tor’s (Tech Mahindra or Mindtree) stock price. Likewise if the management is guilty of any miscon-
duct, then Tech Mahindra’s stock price will go down and not its competitors. Clearly these risks
which are specific to the company affect only the company in question and not others. Such risks
are often called the “Unsystematic Risk”.
Unsystematic risk can be diversified, meaning instead of investing all the money in one company,
you can choose to diversify and invest in 2-3 different companies (preferably from different sec-
tors). When you do so, unsystematic risk is drastically reduced. Going back to the above example
imagine instead of buying HCL for the entire capital, you decide to buy HCL for Rs.50,000/- and
maybe Karnataka Bank Limited for the other Rs.50,000/-. Under such a circumstance, even if HCL
stock price declines (owing to the unsystematic risk) the damage is only on half of the investment
as the other half is invested in a different company. In fact instead of just two stocks you can have
a 5 stock or 10 or maybe 20 stock portfolio. The higher the number of stocks in your portfolio,
higher the diversification and therefore lesser the unsystematic risk.
This leads us to a very important question – how many stocks should a good portfolio have so
that the unsystematic risk is completely diversified. Research has it that up to 21 stocks in the
portfolio will have the required necessary diversification effect and anything beyond 21 stocks
may not help much in diversification.
The graph below should give you a fair sense of how diversification works –
As you can notice from the graph above, the unsystematic risk drastically reduces when you diver-
sify and add more stocks. However after about 20 stocks the unsystematic risk is not really diversi-
fiable, this is evident as the graph starts to flatten out after 20 stocks. In fact the risk that remains
even after diversification is called the “Systematic Risk”.
Systematic risk is the risk that is common to all stocks. These are usually the macroeconomic
risks which tend to affect the whole market. Example of systematic risk include –
1. De-growth in GDP
2. Interest rate tightening
3. Inflation
4. Fiscal deficit
5. Geo political risk
Of course the list can go on but I suppose you got a fair idea of what constitutes systematic risk.
Systematic risk affects all stocks. So assuming you have a well diversified 20 stocks portfolio, a
de-growth in GDP will certainly affect all 20 stocks and hence they are all likely to decline. System-
atic risk is inherent in the system and it cannot really be diversified. However systematic risk can
be ‘hedged’. So when we are talking about hedging, do bear in mind that it is not the same as di-
versification.
Remember, we diversify to minimize unsystematic risk and we hedge to minimize systematic risk.
11.4 – Hedging a single stock position

We will first talk about hedging a single stock future as it is relatively simple and straight forward
to implement. We will also understand its limitation and then proceed to understand how to
hedge a portfolio of stocks.
Imagine you have bought 250 shares of Infosys at Rs.2,284/- per share. This works out to an invest-
ment of Rs.571,000/-. Clearly you are ‘Long’ on Infosys in the spot market. After you initiated this
position, you realize the quarterly results are expected soon. You are worried Infosys may an-
nounce a not so favorable set of numbers, as a result of which the stock price may decline consid-
erably. To avoid making a loss in the spot market you decide to hedge the position.
In order to hedge the position in spot, we simply have to enter a counter position in the futures
market. Since the position in the spot is ‘long’, we have to ‘short’ in the futures market.
Here are the short futures trade details –
Short Futures @ 2285/-
Lot size = 250
Contract Value = Rs.571,250/-
Now on one hand you are long on Infosys (in spot market) and on the other hand we are short on
Infosys (in futures price), although at different prices. However the variation in price is not of con-
cern as directionally we are ‘neutral’. You will shortly understand what this means.
After initiating this trade, let us arbitrarily imagine different price points for Infosys and see what
will be the overall impact on the positions.
Arbitrary Price Long Spot P&L Short Futures P&L Net P&L
2200 2200 – 2284 = – 84 2285 – 2200 = +85 -84 + 85 = +1
2290 2290 – 2284 = +6 2285 – 2290 = -5 +6 – 5 = +1
2500 2500 – 2284 = +216 2285 – 2500 = -215 +216 – 215 = +1
The point to note here is – irrespective of where the price is headed (whether it increases or de-
creases) the position will neither make money nor lose money. It is as if the overall position is fro-
zen. In fact the position becomes indifferent to the market, which is why we say when a position
is hedged it stays ‘neutral’ to the overall market condition. As I had mentioned earlier, hedging
single stock positions is very straight forward with no complications. We can use the stock’s fu-
tures contract to hedge the position. But to use the stocks futures position one must have the
same number of shares as that of the lot size. If they vary, the P&L will vary and position will no
longer be perfectly hedged. This leads to a few important questions –
1. What if I have a position in a stock that does not have a futures contract? For example
South Indian Bank does not have a futures contract, does that mean I cannot hedge a spot
position in South Indian Bank?
2. The example considered the spot position value was Rs.570,000/-, but what if I have rela-
tively small positions – say Rs.50,000/- or Rs.100,000/- is it possible to hedge such positions?
In fact the answer to both these questions is not really straight forward. We will understand how
and why shortly. For now we will proceed to understand how we can hedge multiple spot posi-
tions (usually a portfolio). In order to do so, we first need to understand something called as
“Beta” of a stock.
11.5 – Understanding Beta (β)
Beta, denoted by the Greek symbol β, plays a very crucial concept in market finance as it finds its
application in multiple aspects of market finance. I guess we are at a good stage to introduce
beta, as it also finds its application in hedging portfolio of stocks.
In plain words Beta measures the sensitivity of the stock price with respect to the changes in the
market, which means it helps us answer these kinds of questions –
1. If market moves up by 2% tomorrow, what is the likely movement in stock XYZ?

2. How risky (or volatile)is stock XYZ compared to market indices (Nifty, Sensex)?
3. How risky is stock XYZ compared to stock ABC?
The beta of a stock can take any value greater or lower than zero. However, the beta of the mar-
ket indices (Sensex and Nifty) is always +1. Now for example assume beta of BPCL is +0.7, the fol-
lowing things are implied –
1. For every +1.0% increase in market, BPCL is expected to move up by 0.7%
a. If market moves up by 1.5%, BPCL is expected to move up by 1.05%

b. If market decreases by 1.0%, BPCL is expected to decline by 0.7%
2. Because BPCL’s beta is less than the market beta (0.7% versus 1.0%) by 0.3%, it is be-
lieved that BPCL is 30% less risky than markets
a. One can even say, BPCL relatively carries less systematic risk
3. Assuming HPCL’s beta is 0.85%, then BPCL is believed to be less volatile compared HPCL,
therefore less risky
The following table should help you get a perspective on how to interpret beta value for stock –
If Beta of a stock is Interpretation

A -ve sign indicates the stock price and markets move
in the opposite direction. If market moves up by 1%,
Less than 0, Ex : -0.4
then –ve beta stock of -0.4 is expected to decline by
0.4%
It means the stock is independent of the market
movement.The variation in the market is not likely to
Equal to 0
affect the movement in the stock. However, stocks
with 0 beta is hard to find
If Beta of a stock is Interpretation
It means the stock and the market move in the same
Higher than 0 lesser than 1, Ex : direction;however the stock is relatively less risky. A
0.6 move of 1% in the market influences the stock to
move up by 0.6%. These are generally called the low
beta stocks.
It means the stock moves in the same direction as the
markets;however the stock tends to move 20% more
Higher than 1, Ex : 1.2 than the market.Meaning, if the market increases by
1.0%, the stock is expected to go up by 1.2%. Likewise
if the market declines by 1% the stock is expected to
decline by 1.2%. These are generally called the high
beta stocks.
As of January 2015, here is the Beta value for a few blue chip stocks –
Stock Name Beta Value

ACC Limited 1.22
Axis Bank Limited 1.40
BPCL 1.42
Cipla 0.59
DLF 1.86
Infosys 0.43
LT 1.43
Maruti Suzuki 0.95
Reliance 1.27
SBI Limited 1.58
11.6 – Calculating beta in MS Excel

You can easily calculate the beta value of any stock in excel by using a function called ‘=SLOPE’.
Here is a step by step method to calculate the same; I have taken the example of TCS.
1. Download the last 6 months daily close prices of Nifty and TCS. You can get this from the
NSE website
2. Calculate the daily return of both Nifty and TCS.
a. Daily return = [Today Closing price / Previous day closing price]-1
3. In a blank cell enter the slope function
a. Format for the slope function is =SLOPE(known_y’s,known_x’s), where known_y’s is
the array of daily return of TCS, and known_x’s is the array of daily returns of Nifty.
d. TCS 6 month beta (3rd September 2014 to 3rd March 2015) works out to 0.62
You can refer to this excel sheet for the above calculation
11.7 – Hedging a stock Portfolio

Let us now focus back to hedging a portfolio of stocks by employing Nifty futures. However before
we proceed with this, you may have this question – why should we use Nifty Futures to hedge a
portfolio? Why not something else?
Do recall there are 2 types of risk – systematic and unsystematic risk. When we have a diversified
portfolio we are naturally minimizing the unsystematic risk. What is left after this is the system-
atic risk. As we know systematic risk is the risk associated with the markets, hence the best way
to insulate against market risk is by employing an index which represents the market. Hence the
Nifty futures come as a natural choice to hedge the systematic risk.
Assume I have Rs.800,000/- invested across the following stocks –
Sl No Stock Name Stock Beta Investment Amount

1 ACC Limited 1.22 Rs.30,000/-
2 Axis Bank Limited 1.40 Rs.125,000/-
3 BPCL 1.42 Rs.180,000/-
4 Cipla 0.59 Rs.65,000/-
5 DLF 1.86 Rs.100,000/-
6 Infosys 0.43 Rs.75,000/-
7 LT 1.43 Rs.85,000/-
8 Maruti Suzuki 0.95 Rs.140,000/-
Total Rs.800,000/-
Step 1 – Portfolio Beta
There are a few steps involved in hedging a stock portfolio. As the first step we need to calculate
the overall “Portfolio Beta”.
๏ Portfolio beta is the sum of the “weighted beta of each stock”.

๏ Weighted beta is calculated by multiplying the individual stock beta with its respective
weightage in the portfolio
๏ Weightage of each stock in the portfolio is calculated by dividing the sum invested in each
stock by the total portfolio value
๏ For example, weightage of Axis Bank is 125,000/800,000 = 15.6%
๏ Hence the weighted beta of Axis Bank on the portfolio would be 15.6% * 1.4 = 0.21
The following table calculates the weighted beta of each stock in the portfolio –
Weight in Weighted
Sl No Stock Name Beta Investment
Portfolio Beta
1 ACC Limited 1.22 Rs.30,000/- 3.8% 0.046
Axis Bank
2 1.40 Rs.125,000/- 15.6% 0.219
Limited
3 BPCL 1.42 Rs.180,000/- 22.5% 0.320
4 Cipla 0.59 Rs.65,000/- 8.1% 0.048
5 DLF 1.86 Rs.100,000/- 12.5% 0.233
6 Infosys 0.43 Rs.75,000/- 9.4% 0.040
7 LT 1.43 Rs.85,000/- 10.6% 0.152
8 Maruti Suzuki 0.95 Rs.140,000/- 17.5% 0.166
Total Rs.800,000/- 100% 1.223
The sum of the weighted beta is the overall Portfolio Beta. For the portfolio above the beta hap-
pens to be 1.223. This means, if Nifty goes up by 1%, the portfolio as a whole is expected to go up
by 1.223%. Likewise if Nifty goes down, the portfolio is expected to go down by 1.223%.
Step 2 – Calculate the hedge value
Hedge value is simply the product of the Portfolio Beta and the total portfolio investment
= 1.223 * 800,000
= 978,400/- 115 zerodha.com/varsity

Remember this is a long only portfolio, where we have purchased these stocks in the spot market.
We know in order to hedge we need to take a counter position in the futures markets. The hedge
value suggests, to hedge a portfolio of Rs.800,000/- we need to short futures worth Rs.978,400/-.
This should be quite intuitive as the portfolio is a ‘high beta portfolio’.
Step 3 – Calculate the number of lots required
At present Nifty futures is trading at 9025, and with the current lot size of 25, the contract value per
lot works out to –
= 9025 * 25
= Rs.225,625/-
Hence the number of lots required to short Nifty Futures would be
= Hedge Value / Contract Value
= 978,400 / 225625
= 4.33
The calculation above suggests that, in order to perfectly hedge a portfolio of Rs.800,000/- with a
beta of 1.223, one needs to short 4.33 lots of Nifty futures. Clearly we cannot short 4.33 lots as we
can short either 4 or 5 lots, fractional lot sizes are not available.
If we choose to short 4 lots, we would be slightly under hedged. Likewise if we short 5 units we
would be over hedged. In fact for this reason, we cannot always perfectly hedge a portfolio.
Now, let as assume after employing the hedge, Nifty in fact goes down by 500 points (or about
5.5%). With this we will calculate the effectiveness of the portfolio hedge. Just for the purpose of
illustration, I will assume we can short 4.33 lots.
Nifty Position
Short initiated at – 9025
Decline in Value – 500 points
Nifty value – 8525
Number of lots – 4.33
P & L = 4.33 * 25 * 500 = Rs.54,125
The short position has gained Rs.54,125/-. We will look into what could have happened on the
portfolio.
Portfolio Position
Portfolio Value = Rs.800,000/-
Portfolio Beta = 1.223
Decline in Market = 5.5%
Expected Decline in Portfolio = 5.5% * 1.233 = 6.78%
= 6.78% * 800000
= Rs. 54,240
Hence as you can see, one hand the Nifty short position has gained Rs.54,125 and on the other
hand the long portfolio has lost Rs.54,240/-. As a net result, there is no loss or gain (please ignore
the minor difference) in the net position in the market. The loss in portfolio is offset by the gain in
the Nifty futures position.
With this, I hope you are now in a position to understand how you could hedge a portfolio of
stocks. I would encourage you to replace 4.33 lots by either 4 or 5 lots and run the same exercise.
Finally before we wrap up this chapter, let us revisit two unanswered questions that we posted
when we discussed hedging single stock positions. I will repost the same here for your conven-
ience –
1. What if I have a position in a stock that does not have a futures contract? For example
South Indian Bank does not have a futures contract, does that mean I cannot hedge a spot
position in South Indian Bank?
2. The example considered, the spot position value was Rs.570,000/-, but what if I have rela-
tively small positions – say Rs.50,000/- or Rs.100,000/- is it possible to hedge such posi-
tions?
Well, you can hedge stocks that do not have stock futures. For example assume you have
Rs.500,000/- worth of South Indian Bank. All you need to do is multiply the stocks beta with the
investment value to identify the hedge value. Assuming the stock has a beta of 0.75, the hedge
value would be
500000*0.75
= 375,000/-
Once you arrive at this, directly divide the hedge value by the Nifty’s contract value to estimate
the number of lots required (to short) in the futures market, and hence with this you can hedge
the spot position safely.
As far as the 2nd question goes – no, you cannot hedge small positions whose value is relatively
lower than the contract value of Nifty. However you can hedge such positions by employing op-
tions. We will discuss the same when we take up options.
1. Hedging allows you to insulate your market position against any adverse movements in
the market
2. When you hedge your loss in the spot market it is offset by gains in the futures market
3. There are two types of risk – systematic and unsystematic risk
4. Systematic risk is risk specific to macroeconomic events. Systematic risk can be hedged.
Systematic risk is common to all stocks
5. Unsystematic risk is the risk associated with the company. This is unique to each com-
pany. Unsystematic risk cannot be hedge, but can be diversified
6. Research suggests, beyond 21 stocks unsystematic risk cannot be diversified any further
7. To hedge a single stock position in spot we simply have to take a counter position in the
futures market. But the extent of spot value and futures value have to be same
8. Market beta is always +1.0
9. Beta measures the sensitivity of stock
a. Stock with Beta of less than 1 is called low beta stock
b. Stocks with Beta higher than 1 is called a high beta stock
10. One can easily estimate the stock beta in MS Excel by employing the ‘Slope’ function
11. To hedge a portfolio of stocks we need to follow the following steps
a. Calculate individual stock beta
b. Calculate individual weightage of each stock in the portfolio
c. Estimate the weighted beta of each stock
d. Sum up the weighted beta to get the portfolio beta
e. Multiply the portfolio beta with Portfolio value to get the hedge value
f. Divide the hedge value by Nifty Contract Value to get the number of lots
g. Short the required number of lots in the futures market
12. Remember a perfect hedge is difficult to construct, for this reason we are forced to either
under hedge or over hedge.
C H A PT E R 12
Open Interest
12.1 – Open Interest and its calculation

Before we conclude this module on “Futures Trading”, we must address one of the questions that
is often asked- “What is Open Interest (OI)?”, “How is it different from Volumes?”, and “How can
we benefit from the Volumes and Open interest data?” Let me attempt to answer these questions
and more in this chapter. After reading this, you will be able to interpret OI data in conjunction
with the Volumes to make better decisions while trading. Also, I would suggest you refresh your
understanding on Volumes from here.
Open Interest (OI) is a number that tells you how many futures (or Options) contracts are cur-
rently outstanding (open) in the market. Remember that there are always 2 sides to a trade – a
buyer and a seller. Let us say the seller sells 1 contract to the buyer. The buyer is said to be long
on the contract and the seller is said to be short on the same contract. The open interest in this
case is said to be 1.
Let me illustrate OI with an example. Assume the market consists of 5 traders who trade NIFTY fu-
tures. We will name them Arjun, Neha, Varun, John, and Vikram. Let us go through their day to
day trading activity and observe how open interest varies. Please note, you need to exercise
some patience while understanding the flow of events below, else you can quite easily get frus-
trated!
Lets get started.
Monday: Arjun buys 6 futures contracts and Varun buys 4 futures contracts, while Neha sells all of
those 10 contracts. After this transaction, there are 10 contracts in total with 10 on the long side
(6 + 4) and another 10 on the short side; hence the open interest is 10. This is summarized in the
table below.
Tuesday: Neha wants to get rid of 8 contracts out of the 10 contracts she holds, which she does.
John comes into the market and takes on the 8 shorts contracts from her. You must realize
that this transaction did not create any new contracts in the market. It was a simple transfer
from one person to another. Hence the OI will still stand at 10. Tuesday’s transaction is summa-
rized in the table below.
Wednesday: To the existing 8 short contracts, John wants to add 7 more short positions, while at
the same time both Arjun and Varun decide to increase their long position. Hence John sold 3 con-
tracts to Arjun and 2 contracts to Varun. Note, these are 5 new contracts created. Neha decides to
close out her open positions. By going long on 2 contracts, she effectively transferred 2 of her
short contracts to John and hence Neha holds no more contracts. The table now looks like this:
By the end of Wednesday, there are 15 long (9+6) and 15 short positions in the market, hence OI
stands at 15!
Thursday: A big guy named Vikram comes to the market and sells 25 contracts. John decides to
liquidate 10 contracts, and hence buys 10 contracts from Vikram, effectively transferring his 10
contracts to Vikram. Arjun adds 10 more contracts from Vikram and finally Varun decides to buy
the remaining 5 contracts from Vikram. In summary, 15 new contracts got added to the system.
OI would now stands at 30.
Friday: Vikram decides to square off 20 of the 25 contracts he had sold previously. So he buys 10
contracts each from Arjun and Varun. This means, 20 contracts in system got squared off, hence
OI reduces by 20 contracts. The new OI is 30-20 = 10. The final summary is listed in the table be-
low.
So on and so forth; I hope the above discussion is giving you a fair sense of what Open Interest
(OI) is all about. The OI information just indicates how many open positions are there in the mar-
ket. Here is something you should have noticed by now. In the ‘contracts held’ column, if you as-
sign a +ve sign to a long position and a –ve sign to a short position and add up the long and short
positions, it always equates to zero. In fact this is one of the primary reasons derivatives is often
termed as a zero sum game!
Have a look at the following snapshot –
As of 4th March 2015, OI on Nifty futures is roughly 2.78 Crores. It means that there are 2.78 crore
Long Nifty positions and 2.78 crore Short Nifty positions. Also, about 55,255 (or 0.2% over 2.78
Crs) new contracts have been added today. OI is very useful in understanding how liquid the mar-
ket is. Bigger the open interest, more liquid the market is. And hence it will be easier to enter or
exit trades at competitive bid / ask rates.
12.2 – OI and Volume interpretation

Open interest information tells us how many contracts are open and live in the market. Volume
on the other hand tells us how many trades were executed on the given day. For every 1 buy and
1 sell, volume adds up to 1. For instance, on a given day, 400 contracts were bought and 400 were
sold, then the volume for the day is 400 and not 800. Clearly volumes and open interest are two
different; buy seemingly similar set of information. The volume counter starts from zero at the
start of the day and increments as and when new trades occur. Hence the volume data always in-
creases on an intra-day basis. However, OI is not discrete like volumes, OI stacks up or reduces
based on the entry and exit of traders. In fact for the example we have just discussed, let us sum-
marize the OI and volume information.
Notice how OI and volume change on a daily basis. Today’s volume has no implication on tomor-
row’s volume. However, it is not true for OI. From a stand-alone perspective both OI and volume
numbers are pretty useless. However traders generally associate these numbers with prices to
draw an inference about the market.
The following tables summarizes the trader’s perspective with respect to changes in volume and
prices –
Price OI Trader’s Perception

Increase Increase Bullish
Bearish trend could probably end, expect
Decrease Decrease
reversal
Decrease Increase Bearish
Bullish trend could probably end, expect
Increase Decrease
reversal
Unlike volumes, the change in Open interest does not really convey any directional view on mar-
kets. However it does give a sense of strength between bullish and bearish positions. The follow-
ing tables summarizes the trader’s perspective with respect to changes in the OI and prices –
Price Volume Trader’s Perception

Increase Increase Bullish
Bearish trend could probably end, expect
Decrease Decrease
reversal
Decrease Increase Bearish
Bullish trend could probably end, expect
Increase Decrease
reversal
Unlike volumes, the change in Open interest does not really convey any directional view on mar-
kets. However it does give a sense of strength between bullish and bearish positions. The follow-
ing tables summarizes the trader’s perspective with respect to changes in the OI and prices –
Increase Increase More trades on the long side
Longs are covering their position, also called long

Decrease Decrease
unwinding
Decrease Increase More trades on the short side
Shorts are covering their position, also called short

Increase Decrease
covering
Do note, if there is an abnormally high OI backed by a rapid increase or decrease in prices then be
cautious. This situation simply means that there is a lot of euphoria and leverage being built up
in the market. In situations like this, even a small trigger could lead to a lot of panic in the market.
And with this, I would like to conclude this module on Futures Trading. I hope you enjoyed read-
ing through this module as much as I enjoyed writing it!
Onwards to Option Theory now!
1. Open Interest (OI) is a number that tells you how many contracts are currently outstand-
ing (open) in the market
2. OI increases when new contracts are added. OI decreases when contracts are squared off
3. OI does not change when there is transfer of contracts from one party to another
4. Unlike volumes, OI is continuous data
5. On a stand along basis OI and Volume information does not convey information, hence it
makes sense to always pair it with the price to understand the impact of their respective
variation
6. Abnormally high OI indicates high leverage, beware of such situations.
Module 5
Options Theory for Professional Trading

Module 5 — Options Theory for Professional Trading
Chapter 1
Call Option Basics

246
1.1– Breaking the Ice

As with any of the previous modules in Varsity, we will again make the same old
assumption that you are new to options and therefore know nothing about options.
For this reason we will start from scratch and slowly ramp up as we proceed. Let us
start with running through some basic background information.
The options market makes up for a significant part of the derivative market,
particularly in India. I would not be exaggerating if I were to say that nearly 80% of
the derivatives traded are options and the rest is attributable to the futures market.
Internationally, the option market has been around for a while now, here is a quick
background on the same –
o Custom options were available as Over the Counter (OTC) since the 1920’s. These
options were mainly on commodities
o Options on equities began trading on the Chicago Board Options Exchange (CBOE)
in 1972
o Options on currencies and bonds began in late 1970s. These were again OTC trades
o Exchange-traded options on currencies began on Philadelphia Stock Exchange in
1982
o Interest rate options began trading on the CME in 1985
Clearly the international markets have evolved a great deal since the OTC days.
However in India from the time of inception, the options market was facilitated by
the exchanges. However options were available in the off market ‘Badla’ system.
Think of the ‘badla system’ as a grey market for derivatives transactions. The badla
system no longer exists, it has become obsolete. Here is a quick recap of the history
of the Indian derivative markets –
o June 12th 2000 – Index futures were launched

o June 4th 2001 –Index options were launched
o July 2nd 2001 – Stock options were launched
o November 9th 2001 – Single stock futures were launched.
Though the options market has been around since 2001, the real liquidity in the
Indian index options was seen only in 2006! I remember trading options around that
time, the spreads were high and getting fills was a big deal. However in 2006, the
Ambani brothers formally split up and their respective companies were listed as
1
separate entities, thereby unlocking the value to the shareholders. In my opinion
this particular corporate event triggered vibrancy in the Indian markets, creating
some serious liquidity. However if you were to compare the liquidity in Indian stock
options with the international markets, we still have a long way to catch up.
1.2 – A Special Agreement

There are two types of options – The Call option and the Put option. You can be a
buyer or seller of these options. Based on what you choose to do, the P&L profile
changes. Of course we will get into the P&L profile at a much later stage. For now,
let us understand what “The Call Option” means. In fact the best way to understand
the call option is to first deal with a tangible real world example, once we
understand this example we will extrapolate the same to stock markets. So let’s get
started.
Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively
evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued
at Rs.500,000/-. Ajay has been informed that in the next 6 months, a new highway
project is likely to be sanctioned near the land that Venu owns. If the highway
indeed comes up, the valuation of the land is bound to increase and therefore Ajay
would benefit from the investment he would make today. However if the ‘highway
news’ turns out to be a rumor- which means Ajay buys the land from Venu today
and there is no highway tomorrow, then Ajay would be stuck with a useless piece of
land!
So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is
uncertain whether to buy the land from Venu or not. While Ajay is muddled in this
thought, Venu is quite clear about selling the land if Ajay is willing to buy.
2
Ajay wants to play it safe, he thinks through the whole situation and finally proposes
a special structured arrangement to Venu, which Ajay believes is a win-win for both
of them, the details of the arrangement is as follows –
1. Ajay pays an upfront fee of Rs.100,000/- today. Consider this as a non refundable
agreement fees that Ajay pays
2. Against this fees, Venu agrees to sell the land after 6 months to Ajay
3. The price of the sale( which is expected 6 months later) is fixed today at Rs.500,000/-
4. Because Ajay has paid an upfront fee, only he can call off the deal at the end of 6
months (if he wants to that is), Venu cannot
5. In the event Ajay calls off the deal at the end of 6 months, Venu gets to keep the
upfront fees
So what do you think about this special agreement? Who do you think is smarter
here – Is it Ajay for proposing such a tricky agreement or Venu for accepting such an
agreement? Well, the answer to these questions is not easy to answer, unless you
analyze the details of the agreement thoroughly. I would suggest you read through
the example carefully (it also forms the basis to understand options) – Ajay has
plotted an extremely clever deal here! In fact this deal has many faces to it.
Let us break down Ajay’s proposal to understand some details –
o By paying an agreement fee of Rs.100,000/-, Ajay is binding Venu into an obligation.

He is forcing Venu to lock the land for him for the next 6 months
o Ajay is fixing the sale price of the land based on today’s price i.e Rs.500,000/- which
means irrespective of what the price would be 6 months later he gets to buy the
land at today’s price. Do note, he is fixing a price and paying an additional
Rs.100,000/- today
o At the end of the 6 months, if Ajay does not want to buy the land he has the right to
say ‘no’ to Venu, but since Venu has taken the agreement fee from Ajay, Venu will
not be in a position to say no to Ajay
o The agreement fee is non negotiable, non refundable
Now, after initiating this agreement both Ajay and Venu have to wait for the next 6
months to figure out what would actually happen. Clearly, the price of the land will
vary based on the outcome of the ‘highway project’. However irrespective of what
happens to the highway, there are only three possible outcomes –
1. Once the highway project comes up, the price of the land would go up, say it shoots
up to Rs.10,00,000/-
2. The highway project does not come up, people are disappointed, the land price
collapses, say to Rs.300,000/-
3. Nothing happens, price stays flat at Rs.500,000/-
3
I’m certain there could be no other possible outcomes that can occur apart from the
three mentioned above.
We will now step into Ajay’s shoes and think through what he would do in each of
the above situations.
Scenario 1 – Price goes up to Rs.10,00,000/-
Since the highway project has come up as per Ajay’s expectation, the land price has
also increased. Remember as per the agreement, Ajay has the right to call off the
deal at the end of 6 months. Now, with the increase in the land price, do you think
Ajay will call off the deal? Not really, because the dynamics of the sale are in Ajay’s
favor –
Current Market price of the land = Rs.10,00,000/-
Sale agreement value = Rs.500,000/-
This means Ajay now enjoys the right to buy a piece of land at Rs.500,000/- when in
the open market the same land is selling at a much higher value of – Rs.10,00,000/-.
Clearly Ajay is making a steal deal here. Hence he would go ahead and demand
Venu to sell him the land. Venu is obligated to sell him the land at a lesser value,
simply because he had accepted Rs.100,000/- agreement fees from Ajay 6 months
earlier.
So how much money is Ajay making? Well, here is the math –
Buy Price = Rs.500,000/-
Add: Agreement Fees = Rs.100,000/- (remember this is a non refundable amount)
Total Expense = 500,000 + 100,000 = 600,000/-
Current Market of the land = Rs.10,00,000/-
Hence his profit is Rs.10,00,000 – Rs.600,000 = Rs.400,000/-
Another way to look at this is – For an initial cash commitment of Rs.100,000/- Ajay
is now making 4 times the money! Venu even though very clearly knows that the
value of the land is much higher in the open market, is forced to sell it at a much
lower price to Ajay. The profit that Ajay makes (Rs.400,000/-) is exactly the notional
loss that Venu would incur.
Scenario 2 – Price goes down to Rs.300,000/-
It turns out that the highway project was just a rumor, and nothing really is
expected to come out of the whole thing. People are disappointed and hence there
4
is a sudden rush to sell out the land. As a result, the price of the land goes down to
Rs.300,000/-.
So what do you think Ajay will do now? Clearly it does not make sense to buy the
land, hence he would walk away from the deal. Here is the math that explains why it
does not make sense to buy the land –
Remember the sale price is fixed at Rs.500,000/-, 6 months ago. Hence if Ajay has to
buy the land he has to shell out Rs.500,000/- plus he had paid Rs.100,000/- towards
the agreement fees. Which means he is in effect paying Rs.600,000/- to buy a piece
of land worth just Rs.300,000/-. Clearly this would not make sense to Ajay, since he
has the right to call of the deal, he would simply walk away from it and would not
buy the land. However do note, as per the agreement Ajay has to let go of
Rs.100,000/-, which Venu gets to pocket.
Scenario 3 – Price stays at Rs.500,000/-
For whatever reasons after 6 months the price stays at Rs.500,000/- and does not
really change. What do you think Ajay will do? Well, he will obviously walk away from
the deal and would not buy the land. Why you may ask, well here is the math –
Cost of Land = Rs.500,000/-
Agreement Fee = Rs.100,000/-
Total = Rs.600,000/-
Value of the land in open market = Rs.500,000/-
Clearly it does not make sense to buy a piece of land at Rs.600,000/- when it is
worth Rs.500,000/-. Do note, since Ajay has already committed 1lk, he could still buy
the land, but ends up paying Rs 1lk extra in this process. For this reason Ajay will call
off the deal and in the process let go of the agreement fee of Rs.100,000/- (which
Venu obviously pockets).
I hope you have understood this transaction clearly, and if you have then it is good
news as through the example you already know how the call options work! But let
us not hurry to extrapolate this to the stock markets; we will spend some more time
with the Ajay-Venu transaction.
Here are a few Q&A’s about the transaction which will throw some more light on the
example –
1. Why do you think Ajay took such a bet even though he knows he will lose his 1 lakh
if land prices does not increase or stays flat?
1. Agreed Ajay would lose 1 lakh, but the best part is that Ajay knows his maximum loss (which is 1
lakh) before hand. Hence there are no negative surprises for him. Also, as and when the land
5
prices increases, so would his profits (and therefore his returns). At Rs.10,00,000/- he would be
making Rs.400,000/- profit on his investment of Rs.100,000/- which is 400%.
2. Under what circumstances would a position such as Ajay’s make sense?
1. Only that scenario when the price of the land increases
3. Under what circumstances would Venu’s position makes sense
1. Only that scenario when the price of the land decreases of stays flat
4. Why do you think Venu is taking such a big risk? He would lose a lot of money if the
land prices increases after 6 months right?
1. Well, think about it. There are only 3 possible scenarios, out which 2 indeed benefit Venu.
Statistically, Venu has 66.66% chances of winning the bet as opposed to Ajay’s 33.33% chance
Let us summarize a few important points now –
o The payment from Ajay to Venu ensures that Ajay has a right (remember only he
can call off the deal) and Venu has an obligation (if the situation demands, he has to
honor Ajay’s claim)
o The outcome of the agreement at termination (end of 6 months) is determined by
the price of the land. Without the land, the agreement has no value
o Land is therefore called an underlying and the agreement is called a derivative
o An agreement of this sort is called an “Options Agreement”
o Since Venu has received the advance from Ajay, Venu is called the ‘agreement seller
or Writer’ and Ajay is called the ‘agreement buyer’
o In other words since this agreement is called “an options agreement”, Ajay can be
called an Options Buyer and Venu the Options Seller/writer.
o The agreement is entered after the exchange of 1 lakh, hence 1 lakh is the price of
this option agreement. This is also called the “Premium” amount
o Every variable in the agreement – Area of the land, price and the date of sale is
fixed.
o As a thumb rule, in an options agreement the buyer always has a right and the seller
has an obligation
I would suggest you be absolutely thorough with this example. If not, please go
through it again to understand the dynamics involved. Also, please remember this
example, as we will revisit the same on a few occasions in the subsequent chapters.
Let us now proceed to understand the same example from the stock market
perspective.
1.3 – The Call Option

Let us now attempt to extrapolate the same example in the stock market context
with an intention to understand the ‘Call Option’. Do note, I will deliberately skip the
nitty-gritty of an option trade at this stage. The idea is to understand the bare bone
structure of the call option contract.
6
Assume a stock is trading at Rs.67/- today. You are given a right today to buy the
same one month later, at say Rs. 75/-, but only if the share price on that day is more
than Rs. 75, would you buy it?. Obviously you would, as this means to say that after
1 month even if the share is trading at 85, you can still get to buy it at Rs.75!
In order to get this right you are required to pay a small amount today, say Rs.5.0/-.
If the share price moves above Rs. 75, you can exercise your right and buy the
shares at Rs. 75/-. If the share price stays at or below Rs. 75/- you do not exercise
your right and you do not need to buy the shares. All you lose is Rs. 5/- in this case.
An arrangement of this sort is called Option Contract, a ‘Call Option’ to be precise.
After you get into this agreement, there are only three possibilities that can occur.
And they are-
1. The stock price can go up, say Rs.85/-

2. The stock price can go down, say Rs.65/-
3. The stock price can stay at Rs.75/-
Case 1 – If the stock price goes up, then it would make sense in exercising your right
and buy the stock at Rs.75/-.
The P&L would look like this –
Price at which stock is bought = Rs.75
Premium paid =Rs. 5
Expense incurred = Rs.80
Current Market Price = Rs.85
Profit = 85 – 80 = Rs.5/-
Case 2 – If the stock price goes down to say Rs.65/- obviously it does not makes
sense to buy it at Rs.75/- as effectively you would spending Rs.80/- (75+5) for a stock
that’s available at Rs.65/- in the open market.
Case 3 – Likewise if the stock stays flat at Rs.75/- it simply means you are spending
Rs.80/- to buy a stock which is available at Rs.75/-, hence you would not invoke your
right to buy the stock at Rs.75/-.
This is simple right? If you have understood this, you have essentially understood
the core logic of a call option. What remains unexplained is the finer points, all of
which we will learn soon.
At this stage what you really need to understand is this – For reasons we have
discussed so far whenever you expect the price of a stock (or any asset for that
matter) to increase, it always makes sense to buy a call option!
7
Now that we are through with the various concepts, let us understand options and
their associated terms
Ajay – Venu Stock

Variable Remark
Transaction Example
Do note the concept of lot size is applicable in options. So

just like in the land deal where the deal was on 1 acre
Underlying 1 acre land Stock
land, not more or not less, the option contract will be the
lot size
Expiry 6 months 1 month Like in futures there are 3 expiries available
Reference
Rs.500,000/- Rs.75/- This is also called the strike price
Price
Do note in the stock markets, the premium changes on a

Premium Rs.100,000/- Rs.5/-
minute by minute basis. We will understand the logic soon
None, based on Stock All options are cash settled, no defaults have occurred
Regulator
good faith Exchange until now.
Finally before I end this chapter, here is a formal definition of a call options contract
–
“The buyer of the call option has the right, but not the obligation to buy an agreed
quantity of a particular commodity or financial instrument (the underlying) from the
seller of the option at a certain time (the expiration date) for a certain price (the strike
price). The seller (or “writer”) is obligated to sell the commodity or financial instrument
should the buyer so decide. The buyer pays a fee (called a premium) for this right”.
In the next chapter we will look into a few finer details with regard to the ‘Call
Option’.
8
Key takeaways form this chapter
1. Options are traded in the Indian markets for over 15 years, but the real liquidity was
available only since 2006
2. An Option is a tool for protecting your position and reducing risk
3. A buyer of the call option has the right and the seller has an obligation to make
delivery
4. The option is only given to one party in the transaction ( buyer of an option)
5. The option seller is also called the option writer
6. At the time of agreement the option buyer pays a certain amount to the option
seller, this is called the ‘Premium’ amount
7. The agreement happens at a pre specified price, often called the ‘Strike Price’
8. The option buyer benefits only if the price of the asset increases higher than the
strike price
9. If the asset price stays at or below the strike, the buyer does not benefit, for this
reason it always makes sense to buy options when you expect the price to increase
10. Statistically the option seller has higher odds of winning in an typical option contract
11. The directional view has to pan out before the expiry date, else the option will
expire worthless
9
Chapter 2
Basic Option Jargons

165
2.1– Decoding the basic jargons

In the previous chapter, we understood the basic call option structure. The idea of
the previous chapter was to capture a few essential ‘Call Option’ concepts such as –
1. It makes sense to be a buyer of a call option when you expect the underlying price
to increase
2. If the underlying price remains flat or goes down then the buyer of the call option
loses money
3. The money the buyer of the call option would lose is equivalent to the premium
(agreement fees) the buyer pays to the seller/writer of the call option.
In the next chapter i.e. Call Option (Part 2), we will attempt to understand the call
option in a bit more detail. However before we proceed further let us decode a few
basic option jargons. Discussing these jargons at this stage will not only strengthen
our learning, but will also make the forthcoming discussion on the options easier to
comprehend.
Here are a few jargons that we will look into –
1. Strike Price
2. Underlying Price
3. Exercising of an option contract
4. Option Expiry
5. Option Premium
6. Option Settlement
Do remember, since we have only looked at the basic structure of a call option, I
would encourage you to understand these jargons only with respect to the call
option.
Strike Price
10
Consider the strike price as the anchor price at which the two parties (buyer and
seller) agree to enter into an options agreement. For instance, in the previous
chapter’s ‘Ajay – Venu’ example the anchor price was Rs.500,000/-, which is also the
‘Strike Price’ for their deal. We also looked into a stock example where the anchor
price was Rs.75/-, which is also the strike price. For all ‘Call’ options the strike price
represents the price at which the stock can be bought on the expiry day.
For example, if the buyer is willing to buy ITC Limited’s Call Option of Rs.350 (350
being the strike price) then it indicates that the buyer is willing to pay a premium
today to buy the rights of ‘buying ITC at Rs.350 on expiry’. Needless to say he will
buy ITC at Rs.350, only if ITC is trading above Rs.350.
In fact here is a snap shot from NSE’s website where I have captured different strike
prices of ITC and the associated premium.
The table that you see above is called an ‘Option Chain’, which basically lists all the
different strike prices available for a contract along with the premium for the same.
11
Besides this information, the option chain has a lot more trading information such
as Open Interest, volume, bid-ask quantity etc. I would suggest you ignore all of it
for now and concentrate only on the highlighted information –
1. The highlight in maroon shows the price of the underlying in the spot. As we can see
at the time of this snapshot ITC was trading at Rs.336.9 per share
2. The highlight in blue shows all the different strike prices that are available. As we
can see starting from Rs.260 (with Rs.10 intervals) we have strike prices all the way
up to Rs.480
3. Do remember, each strike price is independent of the other. One can enter into an
options agreement , at a specific strike price by paying the required premium
4. For example one can enter into a 340 call option by paying a premium of Rs.4.75/-
(highlighted in red)
1. This entitles the buyer to buy ITC shares at the end of expiry at Rs.340. Of course, you now know
under which circumstance it would make sense to buy ITC at 340 at the end of expiry
Underlying Price
As we know, a derivative contract derives its value from an underlying asset. The
underlying price is the price at which the underlying asset trades in the spot market.
For example in the ITC example that we just discussed, ITC was trading at
Rs.336.90/- in the spot market. This is the underlying price. For a call option, the
underlying price has to increase for the buyer of the call option to benefit.
Exercising of an option contract
Exercising of an option contract is the act of claiming your right to buy the options
contract at the end of the expiry. If you ever hear the line “exercise the option
contract” in the context of a call option, it simply means that one is claiming the
right to buy the stock at the agreed strike price. Clearly he or she would do it only if
the stock is trading above the strike. Here is an important point to note – you can
exercise the option only on the day of the expiry and not anytime before the expiry.
12
Hence, assume with 15 days to expiry one buys ITC 340 Call option when ITC is
trading at 330 in the spot market. Further assume, after he buys the 340 call option,
the stock price increases to 360 the very next day. Under such a scenario, the option
buyer cannot ask for a settlement (he cannot exercise) against the call option he
holds. Settlement will happen only on the day of the expiry, based on the price the
asset is trading in the spot market on the expiry day.
Option Expiry
Similar to a futures contract, options contract also has expiry. In fact both equity
futures and option contracts expire on the last Thursday of every month. Just like
futures contracts, option contracts also have the concept of current month, mid
month, and far month. Have a look at the snapshot below –
13
This is the snapshot of the call option to buy Ashok Leyland Ltd at the strike price of
Rs.70 at Rs.3.10/-. As you can see there are 3 expiry options – 26th March 2015
(current month), 30th April 2015 (mid month), and 28th May 2015 (far month). Of
course the premium of the options changes as and when the expiry changes. We
will talk more about it at an appropriate time. But at this stage, I would want you to
remember just two things with respect to expiry – like futures there are 3 expiry
options and the premium is not the same across different expiries.
Option Premium
Since we have discussed premium on a couple instances previously, I guess you

would now be clear about a few things with respect to the ‘Option Premium’.
Premium is the money required to be paid by the option buyer to the option
seller/writer. Against the payment of premium, the option buyer buys the right to
exercise his desire to buy (or sell in case of put options) the asset at the strike price
upon expiry.
If you have got this part clear till now, I guess we are on the right track. We will now
proceed to understand a new perspective on ‘Premiums’. Also, at this stage I guess it
is important to let you know that the whole of option theory hinges upon ‘Option
Premium’. Option premiums play an extremely crucial role when it comes to trading
options. Eventually as we progress through this module you will see that the
discussions will be centered heavily on the option premium.
Let us revisit the ‘Ajay-Venu’ example, that we took up in the previous chapter.
Consider the circumstances under which Venu accepted the premium of
Rs.100,000/- from Ajay –
1. News flow – The news on the highway project was only speculative and no one
knew for sure if the project would indeed come up
1. Think about it, we discussed 3 possible scenarios in the previous chapter out of which 2 were
favorable to Venu. So besides the natural statistical edge that Venu has, the fact that the highway
news is speculative only increases his chance of benefiting from the agreement
2. Time – There was 6 months time to get clarity on whether the project would fructify
or not.
1. This point actually favors Ajay. Since there is more time to expiry the possibility of the event
working in Ajay’s favor also increases. For example consider this – if you were to run 10kms, in
which time duration are you more likely to achieve it – within 20 mins or within 70 mins?
Obviously higher the time duration higher is the probability to achieve it.
14
Now let us consider both these points in isolation and figure out the impact it would
have on the option premium.
News – When the deal was done between Ajay and Venu, the news was purely
speculative, hence Venu was happy to accept Rs.100,000/- as premium. However for
a minute assume the news was not speculative and there was some sort of bias.
Maybe there was a local politician who hinted in the recent press conference that
they may consider a highway in that area. With this information, the news is no
longer a rumor. Suddenly there is a possibility that the highway may indeed come
up, albeit there is still an element of speculation.
With this in perspective think about this – do you think Venu will accept Rs.100,000/-
as premium? Maybe not, he knows there is a good chance for the highway to come
up and therefore the land prices would increase. However because there is still an
element of chance he may be willing to take the risk, provided the premium will be
more attractive. Maybe he would consider the agreement attractive if the premium
was Rs.175,000/- instead of Rs.100,000/-.
Now let us put this in stock market perspective. Assume Infosys is trading at
Rs.2200/- today. The 2300 Call option with a 1 month expiry is at Rs.20/-. Put
yourself in Venu’s shoes (option writer) – would you enter into an agreement by
accepting Rs.20/- per share as premium?
If you enter into this options agreement as a writer/seller, then you are giving the
right (to the buyer) of buying Infosys option at Rs. 2300 one month down the lane
from now.
Assume for the next 1 month there is no foreseeable corporate action which will
trigger the share price of Infosys to go higher. Considering this, maybe you may
accept the premium of Rs.20/-.
However what if there is a corporate event (like quarterly results) that tends to
increase the stock price? Will the option seller still go ahead and accept Rs.20/- as
the premium for the agreement? Clearly, it may not be worth to take the risk at
Rs.20/-.
Having said this, what if despite the scheduled corporate event, someone is willing
to offer Rs.75/- as premium instead of Rs.20/-? I suppose at Rs.75/-, it may be worth
taking the risk.
Let us keep this discussion at the back of our mind; we will now take up the 2nd point
i.e. ‘time’
When there was 6 months time, clearly Ajay knew that there was ample time for the
dust to settle and the truth to emerge with respect to the highway project. However
instead of 6 months, what if there was only 10 days time? Since the time has shrunk
there is simply not enough time for the event to unfold. Under such a circumstance
15
(with time not being on Ajay’s side), do you think Ajay will be happy to pay
Rs.100,000/- premium to Venu?. I don’t think so, as there is no incentive for Ajay to
pay that kind of premium to Venu. Maybe he would offer a lesser premium, say
Rs.20,000/- instead.
Anyway, the point that I want to make here keeping both news and time in
perspective is this – premium is never a fixed rate. It is sensitive to several factors.
Some factors tend to increase the premium and some tend to decrease it, and in
real markets, all these factors act simultaneously affecting the premium. To be
precise there are 5 factors (similar to news and time) that tends to affect the
premium. These are called the ‘Option Greeks’. We are too early to understand
Greeks, but will understand the Greeks at a much later stage in this module.
For now, I want you to remember and appreciate the following points with respect
to option premium –
1. The concept of premium is pivotal to the Option Theory

2. Premium is never a fixed rate, it is a function of many (influencing) factors
3. In real markets premiums vary almost on a minute by minute basis
If you have gathered and understood these points so far, I can assure that you are
on the right path.
Options Settlement
Consider this Call option agreement –
16
As highlighted in green, this is a Call Option to buy JP Associates at Rs.25/-. The
expiry is 26th March 2015. The premium is Rs.1.35/- (highlighted in red), and the
market lot is 8000 shares.
Assume there are 2 traders – ‘Trader A’ and ‘Trader B’. Trader A wants to buy this
agreement (option buyer) and Trader B wants to sell (write) this agreement.
Considering the contract is for 8000 shares, here is how the cash flow would look
like –
Since the premium is Rs.1.35/- per share, Trader A is required to pay the total of
= 8000 * 1.35
= Rs.10,800/- as premium amount to Trader B.
Now because Trader B has received this Premium form Trader A, he is obligated to
sell Trader A 8000 shares of JP Associates on 26th March 2015, if Trader A decides to
exercise his agreement. However, this does not mean that Trader B should have
8000 shares with him on 26th March. Options are cash settled in India, this means on
26th March, in the event Trader A decides to exercise his right, Trader B is obligated
to pay just the cash differential to Trader A.
17
To help you understand this better, consider on 26th March JP Associates is trading
at Rs.32/-. This means the option buyer (Trader A) will exercise his right to buy 8000
shares of JP Associates at 25/-. In other words, he is getting to buy JP Associates at
25/- when the same is trading at Rs.32/- in the open market.
Normally, this is how the cash flow should look like –
o On 26th Trader A exercises his right to buy 8000 shares from Trader B
o The price at which the transaction will take place is pre decided at Rs.25 (strike
price)
o Trader A pays Rs.200,000/- (8000 * 25) to Trader B
o Against this payment Trader B releases 8000 shares at Rs.25 to Trader A
o Trader A almost immediately sells these shares in the open market at Rs.32 per
share and receives Rs.256,000/-
o Trader A makes a profit of Rs.56,000/- (256000 – 200000) on this transaction
Another way to look at it is that the option buyer is making a profit of Rs.7/- per
shares (32-25) per share. Because the option is cash settled, instead of giving the
option buyer 8000 shares, the option seller directly gives him the cash equivalent of
the profit he would make. Which means Trader A would receive
= 7*8000
= Rs.56,000/- from Trader B.
Of course, the option buyer had initially spent Rs.10,800/- towards purchasing this
right, hence his real profits would be –
= 56,000 – 10,800
= Rs.45,200/-
In fact if you look at in a percentage return terms, this turns out to be a whopping
return of 419% (without annualizing).
The fact that one can make such large asymmetric return is what makes options an
attractive instrument to trade. This is one of the reasons why Options are massively
popular with traders.
1. It makes sense to buy a call option only when one anticipates an increase in the
price of an asset
18
2. The strike price is the anchor price at which both the option buyer and option writer
enter into an agreement
3. The underlying price is simply the spot price of the asset
4. Exercising of an option contract is the act of claiming your right to buy the options
contract at the end of the expiry
5. Similar to futures contract, options contract also have an expiry. Option contracts
expire on the last Thursday of every month
6. Option contracts have different expiries – the current month, mid month, and far
month contracts
7. Premiums are not fixed, in fact they vary based on several factors that act upon it
8. Options are cash settled in India.
19
Chapter 3
Buying a Call Option

323
3.1 – Buying call option

In the previous chapters we looked at the basic structure of a call option and
understood the broad context under which it makes sense to buy a call option. In
this chapter, we will formally structure our thoughts on the call option and get a
firm understanding on both buying and selling of the call option. Before we move
ahead any further in this chapter, here is a quick recap of what we learnt in the first
chapter –
to increase
loses money
(agreement fees) the buyer pays to the seller/writer of the call option
We will keep the above three points in perspective (which serves as basic guidelines)
and understand the call option to a greater extent.
3.2 – Building a case for a call option

There are many situations in the market that warrants the purchase of a call option.
Here is one that I just discovered while writing this chapter, thought the example
would fit well in the context of our discussions. Have a look at the chart below –
20
The stock in consideration is Bajaj Auto Limited. As you may know, they are one of
the biggest manufacturers of two wheelers in India. For various reasons the stock
has been beaten down in the market, so much so that the stock is trading at its 52
week low price. I believe there could be an opportunity to initiate a trade here. Here
are my thoughts with respect to this trade –
1. Bajaj Auto is a quality fundamental stock, there is no denying this.

2. The stock has been beaten down so heavily, makes me believe this could be the
market’s over reaction to volatility in Bajaj Auto’s business cycle.
3. I expect the stock price to stop falling sometime soon and eventually rise.
4. However I do not want to buy the stock for delivery (yet) as I’m worried about a
further decline of the stock.
5. Extending the above point, the worry of M2M losses prevents me from buying Bajaj
Auto’s futures as well.
6. At the same time I don’t want to miss an opportunity of a sharp reversal in the stock
price.
To sum up, I’m optimistic on the stock price of Bajaj Auto (the stock price to
eventually increase) but I’m kind of uncertain about the immediate outlook on the
stock. The uncertainty is mainly due the fact that my losses in the short term could
21
be intense if the weakness in the stock persists. However as per my estimate the
probability of the loss is low, but nevertheless the probability still exists. So what
should I do?
Now, if you realize I’m in a similar dilemma that was Ajay was in (recall the Ajay –
Venu example from chapter 1). A circumstance such as this, builds up for a classic
case of an options trade.
In the context of my dilemma, clearly buying a call option on Bajaj Auto makes sense
for reasons I will explain shortly. Here is a snapshot of Bajaj Auto’s option chain –
As we can see the stock is trading at Rs.2026.9 (highlighted in blue). I will choose to
buy 2050 strike call option by paying a premium of Rs.6.35/- (highlighted in red box
and red arrow). You may be wondering on what basis I choose the 2050 strike price
when in fact there are so many different strike prices available (highlighted in
green)?. Well, the process of strike price selection is a vast topic on its own, we will
eventually get there in this module, but for now let us just believe 2050 is the right
strike price to trade.
3.3 – Intrinsic value of a call option (upon expiry)

So what happens to the call option now considering the expiry is 15 days away?
Well, broadly speaking there are three possible scenarios which I suppose you are
familiar with by now –
Scenario 1 – The stock price goes above the strike price, say 2080
22
Scenario 2 – The stock price goes below the strike price, say 2030
Scenario 3 – The stock price stays at 2050
The above 3 scenarios are very similar to the ones we had looked at in chapter 1,
hence I will also assume that you are familiar with the P&L calculation at the specific
value of the spot in the given scenarios above (if not, I would suggest you read
through Chapter 1 again).
The idea I’m interested in exploring now is this –
1. You will agree there are only 3 broad scenarios under which the price movement of
Bajaj Auto can be classified (upon expiry) i.e. the price either increases, decreases,
or stays flat
2. But what about all the different prices in between? For example if as per Scenario 1
the price is considered to be at 2080 which is above the strike of 2050. What about
other strike prices such as 2055, 2060, 2065, 2070 etc? Can we generalize anything
here with respect to the P&L?
3. In scenario 2, the price is considered to be at 2030 which is below the strike of 2050.
What about other strike prices such as 2045, 2040, 2035 etc? Can we generalize
anything here with respect to the P&L?
What would happen to the P&L at various possible prices of spot (upon expiry) – I
would like to call these points as the “Possible values of the spot on expiry” and sort
of generalize the P&L understanding of the call option.
In order to do this, I would like to first talk about (in part and not the full concept)
the idea of the ‘intrinsic value of the option upon expiry’.
The intrinsic value (IV) of the option upon expiry (specifically a call option for now)
is defined as the non – negative value which the option buyer is entitled to if he
were to exercise the call option. In simple words ask yourself (assuming you are the
buyer of a call option) how much money you would receive upon expiry, if the call
option you hold is profitable. Mathematically it is defined as –
IV = Spot Price – Strike Price
So if Bajaj Auto on the day of expiry is trading at 2068 (in the spot market) the 2050
Call option’s intrinsic value would be –
= 2068 – 2050
= 18
Likewise, if Bajaj Auto is trading at 2025 on the expiry day the intrinsic value of the
option would be –
= 2025 – 2050
23
= -25
But remember, IV of an option (irrespective of a call or put) is a non negative

number; hence we leave the IV at 2025
=0
Now our objective is to keep the idea of intrinsic value of the option in perspective,
and to identify how much money I will make at every possible expiry value of Bajaj
Auto and in the process make some generalizations on the call option buyer’s P&L.
3.4 – Generalizing the P&L for a call option buyer

Now keeping the concept of intrinsic value of an option at the back of our mind, let
us work towards building a table which would help us identify how much money, I
as the buyer of Bajaj Auto’s 2050 call option would make under the various possible
spot value changes of Bajaj Auto (in spot market) on expiry. Do remember the
premium paid for this option is Rs 6.35/–. Irrespective of how the spot value
changes, the fact that I have paid Rs.6.35/- remains unchanged. This is the cost that I
have incurred in order to buy the 2050 Call Option. Let us keep this in perspective
and work out the P&L table –
Please note – the negative sign before the premium paid represents a cash out flow from
my trading account.
Serial No. Possible values of spot Premium Paid Intrinsic Value (IV) P&L (IV + Premium)
01 1990 (-) 6.35 1990 – 2050 = 0 = 0 + (– 6.35) = – 6.35
02 2000 (-) 6.35 2000 – 2050 = 0 = 0 + (– 6.35) = – 6.35
03 2010 (-) 6.35 2010 – 2050 = 0 = 0 + (– 6.35) = – 6.35
04 2020 (-) 6.35 2020 – 2050 = 0 = 0 + (– 6.35) = – 6.35
05 2030 (-) 6.35 2030 – 2050 = 0 = 0 + (– 6.35) = – 6.35
24
06 2040 (-) 6.35 2040 – 2050 = 0 = 0 + (– 6.35) = – 6.35
07 2050 (-) 6.35 2050 – 2050 = 0 = 0 + (– 6.35) = – 6.35
08 2060 (-) 6.35 2060 – 2050 = 10 = 10 +(-6.35) = + 3.65
09 2070 (-) 6.35 2070 – 2050 = 20 = 20 +(-6.35) = + 13.65
10 2080 (-) 6.35 2080 – 2050 = 30 = 30 +(-6.35) = + 23.65
11 2090 (-) 6.35 2090 – 2050 = 40 = 40 +(-6.35) = + 33.65
12 2100 (-) 6.35 2100 – 2050 = 50 = 50 +(-6.35) = + 43.65
So what do you observe? The table above throws out 2 strong observations –
1. Even if the price of Bajaj Auto goes down (below the strike price of 2050), the
maximum loss seems to be just Rs.6.35/-
1. Generalization 1 – For a call option buyer a loss occurs when the spot price moves below the
strike price. However the loss to the call option buyer is restricted to the extent of the premium
he has paid
2. The profit from this call option seems to increase exponentially as and when Bajaj
Auto starts to move above the strike price of 2050
1. Generalization 2 – The call option becomes profitable as and when the spot price moves over
and above the strike price. The higher the spot price goes from the strike price, the higher the
profit.
3. From the above 2 generalizations it is fair for us to say that the buyer of the call
option has a limited risk and a potential to make an unlimited profit.
Here is a general formula that tells you the Call option P&L for a given spot price –
P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid
Going by the above formula, let’s evaluate the P&L for a few possible spot values on
expiry –
1. 2023
2. 2072
25
3. 2055
The solution is as follows –
@2023
= Max [0, (2023 – 2050)] – 6.35
= Max [0, (-27)] – 6.35
= 0 – 6.35
= – 6.35
The answer is in line with Generalization 1 (loss restricted to the extent of premium
paid).
@2072
= Max [0, (2072 – 2050)] – 6.35
= Max [0, (+22)] – 6.35
= 22 – 6.35
= +15.65
The answer is in line with Generalization 2 (Call option gets profitable as and when
the spot price moves over and above the strike price).
@2055
= Max [0, (2055 – 2050)] – 6.35
= Max [0, (+5)] – 6.35
= 5 – 6.35
= -1.35
So, here is a tricky situation, the result what we obtained here is against the
2nd generalization. Despite the spot price being above the strike price, the trade is
resulting in a loss! Why is this so? Also if you observe the loss is much lesser than
the maximum loss of Rs.6.35/-, it is in fact just Rs.1.35/-. To understand why this is
happening we should diligently inspect the P&L behavior around the spot value
which is slightly above the strike price (2050 in this case).
26
01 2050 (-) 6.35 2050 – 2050 = 0 = 0 + (– 6.35) = – 6.35
02 2051 (-) 6.35 2051 – 2050 = 1 = 1 + (– 6.35) = – 5.35
03 2052 (-) 6.35 2052 – 2050 = 2 = 2 + (– 6.35) = – 4.35
04 2053 (-) 6.35 2053 – 2050 = 3 = 3 + (– 6.35) = – 3.35
05 2054 (-) 6.35 2054 – 2050 = 4 = 4 + (– 6.35) = – 2.35
06 2055 (-) 6.35 2055 – 2050 = 5 = 5 + (– 6.35) = – 1.35
07 2056 (-) 6.35 2056 – 2050 = 6 = 6 + (– 6.35) = – 0.35
08 2057 (-) 6.35 2057 – 2050 = 7 = 7 +(- 6.35) = + 0.65
09 2058 (-) 6.35 2058 – 2050 = 8 = 8 +(- 6.35) = + 1.65
10 2059 (-) 6.35 2059 – 2050 = 9 = 9 +(- 6.35) = + 2.65
As you notice from the table above, the buyer suffers a maximum loss (Rs. 6.35 in
this case) till the spot price is equal to the strike price. However, when the spot price
starts to move above the strike price, the loss starts to minimize. The losses keep
getting minimized till a point where the trade neither results in a profit or a loss.
This is called the breakeven point.
The formula to identify the breakeven point for any call option is –
B.E = Strike Price + Premium Paid
For the Bajaj Auto example, the ‘Break Even’ point is –
27
= 2050 + 6.35
= 2056.35
In fact let us find out find out the P&L at the breakeven point
= Max [0, (2056.35 – 2050)] – 6.35
= Max [0, (+6.35)] – 6.35
= +6.35 – 6.35
=0
As you can see, at the breakeven point we neither make money nor lose money. In
other words, if the call option has to be profitable it not only has to move above the
strike price but it has to move above the breakeven point.
3.5 – Call option buyer’s payoff

So far we have understood a few very important features with respect to a call
option buyer’s payoff; I will reiterate the same –
1. The maximum loss the buyer of a call option experiences is, to the extent of the
premium paid. The buyer experiences a loss as long as the spot price is below the
strike price
2. The call option buyer has the potential to realize unlimited profits provided the spot
price moves higher than the strike price
3. Though the call option is supposed to make a profit when the spot price moves
above the strike price, the call option buyer first needs to recover the premium he
has paid
28
4. The point at which the call option buyer completely recovers the premium he has
paid is called the breakeven point
5. The call option buyer truly starts making a profit only beyond the breakeven point
(which naturally is above the strike price)
Interestingly, all these points can be visualized if we plot the chart of the P&L. Here
is the P&L chart of Bajaj Auto’s Call Option trade –
From the chart above you can notice the following points which are in line with the
discussion we have just had –
1. The loss is restricted to Rs.6.35/- as long as the spot price is trading at any price
below the strike of 2050
2. From 2050 to 2056.35 (breakeven price) we can see the losses getting minimized
3. At 2056.35 we can see that there is neither a profit nor a loss
4. Above 2056.35 the call option starts making money. In fact the slope of the P&L line
clearly indicates that the profits start increasing exponentially as and when the spot
value moves away from the strike
Again, from the graph one thing is very evident – A call option buyer has a limited
risk but unlimited profit potential. And with this I hope you are now clear with the
call option from the buyer’s perspective. In the next chapter we will look into the Call
Option from the seller’s perspective.
29
to increase
loses money
(agreement fees) the buyer pays to the seller/writer of the call option
4. Intrinsic value (IV) of a call option is a non negative number
5. IV = Max[0, (spot price – strike price)]
6. The maximum loss the buyer of a call option experiences is to the extent of the
premium paid. The loss is experienced as long as the spot price is below the strike
price
7. The call option buyer has the potential to make unlimited profits provided the spot
price moves higher than the strike price
8. Though the call option is supposed to make a profit when the spot price moves
above the strike price, the call option buyer first needs to recover the premium he
has paid
9. The point at which the call option buyer completely recovers the premium he has
paid is called the breakeven point
10. The call option buyer truly starts making a profit only beyond the breakeven point
(which naturally is above the strike price).
30
Chapter 4
Selling/Writing a Call Option

458
4.1 – Two sides of the same coin

Do you remember the 1975 Bollywood super hit flick ‘Deewaar’, which attained a
cult status for the incredibly famous ‘Mere paas maa hai’ dialogue ? The movie
is about two brothers from the same mother. While one brother, righteous in life
grows up to become a cop, the other brother turns out to be a notorious criminal
whose views about life is diametrically opposite to his cop brother.
Well, the reason why I’m taking about this legendary movie now is that the option
writer and the option buyer are somewhat comparable to these brothers. They are
the two sides of the same coin. Of course, unlike the Deewaar brothers there is no
view on morality when it comes to Options trading; rather the view is more on
markets and what one expects out of the markets. However, there is one thing that
you should remember here – whatever happens to the option seller in terms of the
P&L, the exact opposite happens to option buyer and vice versa. For example if the
option writer is making Rs.70/- in profits, this automatically means the option buyer
is losing Rs.70/-. Here is a quick list of such generalisations –
o If the option buyer has limited risk (to the extent of premium paid), then the option
seller has limited profit (again to the extent of the premium he receives)
31
o If the option buyer has unlimited profit potential then the option seller potentially
has unlimited risk
o The breakeven point is the point at which the option buyer starts to make money,
this is the exact same point at which the option writer starts to lose money
o If option buyer is making Rs.X in profit, then it implies the option seller is making a
loss of Rs.X
o If the option buyer is losing Rs.X, then it implies the option seller is making Rs.X in
profits
o Lastly if the option buyer is of the opinion that the market price will increase (above
the strike price to be particular) then the option seller would be of the opinion that
the market will stay at or below the strike price…and vice versa.
To appreciate these points further it would make sense to take a look at the Call
Option from the seller’s perspective, which is the objective of this chapter.
Before we proceed, I have to warn you something about this chapter – since there is
P&L symmetry between the option seller and the buyer, the discussion going
forward in this chapter will look very similar to the discussion we just had in the
previous chapter, hence there is a possibility that you could just skim through the
chapter. Please don’t do that, I would suggest you stay alert to notice the subtle
difference and the huge impact it has on the P&L of the call option writer.
4.2 – Call option seller and his thought process

Recall the ‘Ajay-Venu’ real estate example from chapter 1 – we discussed 3 possible
scenarios that would take the agreement to a logical conclusion –
1. The price of the land moves above Rs.500,000 (good for Ajay – option buyer)
2. The price stays flat at Rs.500,000 (good for Venu – option seller)
3. The price moves lower than Rs.500,000 (good for Venu – option seller)
If you notice, the option buyer has a statistical disadvantage when he buys options
– only 1 possible scenario out of the three benefits the option buyer. In other words
2 out of the 3 scenarios benefit the option seller. This is just one of the incentives
for the option writer to sell options. Besides this natural statistical edge, if the
option seller also has a good market insight then the chances of the option seller
being profitable are quite high.
Please do note, I’m only talking about a natural statistical edge here and by no way
am I suggesting that an option seller will always make money.
Anyway let us now take up the same ‘Bajaj Auto’ example we took up in the previous
chapter and build a case for a call option seller and understand how he would view
the same situation. Allow me repost the chart –
32
o The stock has been heavily beaten down, clearly the sentiment is extremely weak
o Since the stock has been so heavily beaten down – it implies many investors/traders
in the stock would be stuck in desperate long positions
o Any increase in price in the stock will be treated as an opportunity to exit from the
stuck long positions
o Given this, there is little chance that the stock price will increase in a hurry –
especially in the near term
o Since the expectation is that the stock price won’t increase, selling the Bajaj Auto’s
call option and collecting the premium can be perceived as a good trading
opportunity
With these thoughts, the option writer decides to sell a call option. The most
important point to note here is – the option seller is selling a call option because he
believes that the price of Bajaj Auto will NOT increase in the near future. Therefore
he believes that, selling the call option and collecting the premium is a good
strategy.
As I mentioned in the previous chapter, selecting the right strike price is a very
important aspect of options trading. We will talk about this in greater detail as we go
forward in this module. For now, let us assume the option seller decides to sell Bajaj
33
Auto’s 2050 strike option and collect Rs.6.35/- as premiums. Please refer to the
option chain below for the details –
Let us now run through the same exercise that we ran through in the previous
chapter to understand the P&L profile of the call option seller and in the process
make the required generalizations. The concept of an intrinsic value of the option
that we discussed in the previous chapter will hold true for this chapter as well.
Serial No. Possible values of spot Premium Received Intrinsic Value (IV) P&L (Premium – IV)
01 1990 + 6.35 1990 – 2050 = 0 = 6.35 – 0 = + 6.35
02 2000 + 6.35 2000 – 2050 = 0 = 6.35 – 0 = + 6.35
03 2010 + 6.35 2010 – 2050 = 0 = 6.35 – 0 = + 6.35
04 2020 + 6.35 2020 – 2050 = 0 = 6.35 – 0 = + 6.35
34
05 2030 + 6.35 2030 – 2050 = 0 = 6.35 – 0 = + 6.35
06 2040 + 6.35 2040 – 2050 = 0 = 6.35 – 0 = + 6.35
07 2050 + 6.35 2050 – 2050 = 0 = 6.35 – 0 = + 6.35
08 2060 + 6.35 2060 – 2050 = 10 = 6.35 – 10 = – 3.65
09 2070 + 6.35 2070 – 2050 = 20 = 6.35 – 20 = – 13.65
10 2080 + 6.35 2080 – 2050 = 30 = 6.35 – 30 = – 23.65
11 2090 + 6.35 2090 – 2050 = 40 = 6.35 – 40 = – 33.65
12 2100 + 6.35 2100 – 2050 = 50 = 6.35 – 50 = – 43.65
Before we proceed to discuss the table above, please note –
1. The positive sign in the ‘premium received’ column indicates a cash inflow (credit) to
the option writer
2. The intrinsic value of an option (upon expiry) remains the same irrespective of
call option buyer or seller
3. The net P&L calculation for an option writer changes slightly, the logic goes like this
1. When an option seller sells options he receives a premium (for example Rs.6.35/).
He would experience a loss only after he losses the entire premium. Meaning after
receiving a premium of Rs.6.35, if he loses Rs.5/- it implies he is still in profit of
Rs.1.35/-. Hence for an option seller to experience a loss he has to first lose the
premium he has received, any money he loses over and above the premium
received, will be his real loss. Hence the P&L calculation would be ‘Premium –
Intrinsic Value’
2. You can extend the same argument to the option buyer. Since the option buyer
pays a premium, he first needs to recover the premium he has paid, hence he
would be profitable over and above the premium amount he has received, hence
the P&L calculation would be ‘ Intrinsic Value – Premium’.
35
The table above should be familiar to you now. Let us inspect the table and make a
few generalizations (do bear in mind the strike price is 2050) –
1. As long as Bajaj Auto stays at or below the strike price of 2050, the option seller gets
to make money – as in he gets to pocket the entire premium of Rs.6.35/-. However,
do note the profit remains constant at Rs.6.35/-.
1. Generalization 1 – The call option writer experiences a maximum profit to the extent of the
premium received as long as the spot price remains at or below the strike price (for a call option)
2. The option writer experiences an exponential loss as and when Bajaj Auto starts to
move above the strike price of 2050
1. Generalization 2 – The call option writer starts to lose money as and when the spot price moves
over and above the strike price. Higher the spot price moves away from the strike price, larger
the loss.
3. From the above 2 generalizations it is fair to conclude that, the option seller can
earn limited profits and can experience unlimited loss
We can put these generalizations in a formula to estimate the P&L of a Call option
seller –
P&L = Premium – Max [0, (Spot Price – Strike Price)]
Going by the above formula, let’s evaluate the P&L for a few possible spot values on
expiry –
1. 2023
2. 2072
3. 2055
The solution is as follows –
@2023
= 6.35 – Max [0, (2023 – 2050)]
= 6.35 – Max [0, -27]
= 6.35 – 0
= 6.35
The answer is in line with Generalization 1 (profit restricted to the extent of

premium received).
@2072
= 6.35 – Max [0, (2072 – 2050)]
= 6.35 – 22
36
= -15.56
The answer is in line with Generalization 2 (Call option writers would experience a
loss as and when the spot price moves over and above the strike price)
@2055
= 6.35 – Max [0, (2055 – 2050)]
= 6.35 – Max [0, +5]
= 6.35 – 5
= 1.35
Though the spot price is higher than the strike, the call option writer still seems to
be making some money here. This is against the 2nd generalization. I’m sure you
would know this by now, this is because of the ‘breakeven point’ concept, which we
discussed in the previous chapter.
Anyway let us inspect this a bit further and look at the P&L behavior in and around
the strike price to see exactly at which point the option writer will start making a
loss.
01 2050 + 6.35 2050 – 2050 = 0 = 6.35 – 0 = 6.35
02 2051 + 6.35 2051 – 2050 = 1 = 6.35 – 1 = 5.35
03 2052 + 6.35 2052 – 2050 = 2 = 6.35 – 2 = 4.35
04 2053 + 6.35 2053 – 2050 = 3 = 6.35 – 3 = 3.35
05 2054 + 6.35 2054 – 2050 = 4 = 6.35 – 4 = 2.35
06 2055 + 6.35 2055 – 2050 = 5 = 6.35 – 5 = 1.35
37
07 2056 + 6.35 2056 – 2050 = 6 = 6.35 – 6 = 0.35
08 2057 + 6.35 2057 – 2050 = 7 = 6.35 – 7 = – 0.65
09 2058 + 6.35 2058 – 2050 = 8 = 6.35 – 8 = – 1.65
10 2059 + 6.35 2059 – 2050 = 9 = 6.35 – 9 = – 2.65
Clearly even when the spot price moves higher than the strike, the option writer still
makes money, he continues to make money till the spot price increases more
than strike + premium received. At this point he starts to lose money, hence calling
this the ‘breakdown point’ seems appropriate.
Breakdown point for the call option seller = Strike Price + Premium Received
For the Bajaj Auto example,
= 2050 + 6.35
= 2056.35
So, the breakeven point for a call option buyer becomes the breakdown point for
the call option seller.
4.3 – Call Option seller pay-off

As we have seen throughout this chapter, there is a great symmetry between the
call option buyer and the seller. In fact the same can be observed if we plot the P&L
graph of an option seller. Here is the same –
38
The call option sellers P&L payoff looks like a mirror image of the call option buyer’s
P&L pay off. From the chart above you can notice the following points which are in
line with the discussion we have just had –
1. The profit is restricted to Rs.6.35/- as long as the spot price is trading at any price
below the strike of 2050
2. From 2050 to 2056.35 (breakdown price) we can see the profits getting minimized
3. At 2056.35 we can see that there is neither a profit nor a loss
4. Above 2056.35 the call option seller starts losing money. In fact the slope of the P&L
line clearly indicates that the losses start to increase exponentially as and when the
spot value moves away from the strike price
4.4 – A note on margins

Think about the risk profile of both the call option buyer and a call option seller. The
call option buyer bears no risk. He just has to pay the required premium amount to
the call option seller, against which he would buy the right to buy the underlying at
a later point. We know his risk (maximum loss) is restricted to the premium he has
already paid.
However when you think about the risk profile of a call option seller, we know that
he bears an unlimited risk. His potential loss can exponentially increase as and
when the spot price moves above the strike price. Having said this, think about the
stock exchange – how can they manage the risk exposure of an option seller in the
backdrop of an ‘unlimited loss’ potential? What if the loss becomes so huge that the
option seller decides to default?
39
Clearly the stock exchange cannot afford to permit a derivative participant to carry
such a huge default risk, hence it is mandatory for the option seller to park some
money as margins. The margins charged for an option seller is similar to the margin
requirement for a futures contract.
Here is the snapshot from the Zerodha Margin calculator for Bajaj Auto futures and
Bajaj Auto 2050 Call option, both expiring on 30th April 2015.
And here is the margin requirement for selling 2050 call option.
As you can see the margin requirements are somewhat similar in both the cases
(option writing and trading futures). Of course there is a small difference; we will
deal with it at a later stage. For now, I just want you to note that option selling
40
requires margins similar to futures trading, and the margin amount is roughly the
same.
4.5 – Putting things together

I hope the last four chapters have given you all the clarity you need with respect to
call options buying and selling. Unlike other topics in Finance, options are a little
heavy duty. Hence I guess it makes sense to consolidate our learning at every
opportunity and then proceed further. Here are the key things you should
remember with respect to buying and selling call options.
With respect to option buying
o You buy a call option only when you are bullish about the underlying asset. Upon
expiry the call option will be profitable only if the underlying has moved over and
above the strike price
o Buying a call option is also referred to as ‘Long on a Call Option’ or simply ‘Long Call’
o To buy a call option you need to pay a premium to the option writer
o The call option buyer has limited risk (to the extent of the premium paid) and an
potential to make an unlimited profit
o The breakeven point is the point at which the call option buyer neither makes
money nor experiences a loss
o P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid
o Breakeven point = Strike Price + Premium Paid
With respect to option selling
o You sell a call option (also called option writing) only when you believe that upon
expiry, the underlying asset will not increase beyond the strike price
o Selling a call option is also called ‘Shorting a call option’ or simply ‘Short Call’
o When you sell a call option you receive the premium amount
o The profit of an option seller is restricted to the premium he receives, however his
loss is potentially unlimited
o The breakdown point is the point at which the call option seller gives up all the
premium he has made, which means he is neither making money nor is losing
money
o Since short option position carries unlimited risk, he is required to deposit margin
o Margins in case of short options is similar to futures margin
o P&L = Premium – Max [0, (Spot Price – Strike Price)]
o Breakdown point = Strike Price + Premium Received
Other important points
41
o When you are bullish on a stock you can either buy the stock in spot, buy its futures,
or buy a call option
o When you are bearish on a stock you can either sell the stock in the spot (although
on a intraday basis), short futures, or short a call option
o The calculation of the intrinsic value for call option is standard, it does not change
based on whether you are an option buyer/ seller
o However the intrinsic value calculation changes for a ‘Put’ option
o The net P&L calculation methodology is different for the call option buyer and seller.
o Throughout the last 4 chapters we have looked at the P&L keeping the expiry in
perspective, this is only to help you understand the P&L behavior better
o One need not wait for the option expiry to figure out if he is going to be profitable
or not
o Most of the option trading is based on the change in premiums
o For example, if I have bought Bajaj Auto 2050 call option at Rs.6.35 in the morning
and by noon the same is trading at Rs.9/- I can choose to sell and book profits
o The premiums change dynamically all the time, it changes because of many
variables at play, we will understand all of them as we proceed through this module
o Call option is abbreviated as ‘CE’. So Bajaj Auto 2050 Call option is also referred to as
Bajaj Auto 2050CE. CE is an abbreviation for ‘European Call Option’.
4.6 – European versus American Options

Initially when option was introduced in India, there are two types of options
available – European and American Options. All index options (Nifty, Bank Nifty
options) were European in nature and the stock options were American in nature.
The difference between the two was mainly in terms of ‘Options exercise’.
European Options – If the option type is European then it means that the option
buyer will have to mandatory wait till the expiry date to exercise his right. The
settlement is based on the value of spot market on expiry day. For example if
he has bought a Bajaj Auto 2050 Call option, then for the buyer to be profitable
Bajaj Auto has to go higher than the breakeven point on the day of the expiry. Even
not it the option is worthless to the buyer and he will lose all the premium money
that he paid to the Option seller.
American Options – In an American Option, the option buyer can exercise his right
to buy the option whenever he deems appropriate during the tenure of the options
expiry. The settlement is dependent of the spot market at that given moment
and not really depended on expiry. For instance he buys Bajaj Auto 2050 Call
option today when Bajaj is trading at 2030 in spot market and there are 20 more
days for expiry. The next day Bajaj Auto crosses 2050. In such a case, the buyer of
Baja Auto 2050 American Call option can exercise his right, which means the seller is
obligated to settle with the option buyer. The expiry date has little significance here.
42
For people familiar with option you may have this question – ‘Since we can anyway
buy an option now and sell it later, maybe in 30 minutes after we purchase, how
does it matter if the option is American or European?’.
Valid question, well think about the Ajay-Venu example again. Here Ajay and Venu
were to revisit the agreement in 6 months time (this is like a European Option). If
instead of 6 months, imagine if Ajay had insisted that he could come anytime during
the tenure of the agreement and claim his right (like an American Option). For
example there could be a strong rumor about the highway project (after they signed
off the agreement). In the back of the strong rumor, the land prices shoots up and
hence Ajay decides exercise his right, clearly Venu will be obligated to deliver the
land to Ajay (even though he is very clear that the land price has gone up because of
strong rumors). Now because Venu carries addition risk of getting ‘exercised’ on any
day as opposed to the day of the expiry, the premium he would need is also higher
(so that he is compensated for the risk he takes).
For this reason, American options are always more expensive than European
Options.
Also, you maybe interested to know that about 3 years ago NSE decided to get rid of
American option completely from the derivatives segment. So all options in India
are now European in nature, which means the buyer can exercise his option
based on the spot price on the expiry day.
We will now proceed to understand the ‘Put Options’.
1. You sell a call option when you are bearish on a stock

2. The call option buyer and the seller have a symmetrically opposite P&L behavior
3. When you sell a call option you receive a premium
4. Selling a call option requires you to deposit a margin
5. When you sell a call option your profit is limited to the extent of the premium you
receive and your loss can potentially be unlimited
6. P&L = Premium – Max [0, (Spot Price – Strike Price)]
7. Breakdown point = Strike Price + Premium Recieved
8. In India all options are European in nature
43
Chapter 5
The Put Option Buying

103
5.1 – Getting the orientation right

I hope by now you are through with the practicalities of a Call option from both the
buyers and sellers perspective. If you are indeed familiar with the call option then
orienting yourself to understand ‘Put Options’ is fairly easy. The only change in a
put option (from the buyer’s perspective) is the view on markets should be bearish
as opposed to the bullish view of a call option buyer.
The put option buyer is betting on the fact that the stock price will go down (by the
time expiry approaches). Hence in order to profit from this view he enters into a Put
Option agreement. In a put option agreement, the buyer of the put option can buy
the right to sell a stock at a price (strike price) irrespective of where the
underlying/stock is trading at.
Remember this generality – whatever the buyer of the option anticipates, the seller
anticipates the exact opposite, therefore a market exists. After all, if everyone
expects the same a market can never exist. So if the Put option buyer expects the
market to go down by expiry, then the put option seller would expect the market (or
the stock) to go up or stay flat.
A put option buyer buys the right to sell the underlying to the put option writer at
a predetermined rate (Strike price. This means the put option seller, upon expiry will
have to buy if the ‘put option buyer’ is selling him. Pay attention here – at the time
of the agreement the put option seller is selling a right to the put option buyer
where in the buyer can ‘sell’ the underlying to the ‘put option seller’ at the time of
expiry.
Confusing? well, just think of the ‘Put Option’ as a simple contract where two parties
meet today and agree to enter into a transaction based on the price of an
underlying –
o The party agreeing to pay a premium is called the ‘contract buyer’ and the party
receiving the premium is called the ‘contract seller’
o The contract buyer pays a premium and buys himself a right
o The contract seller receives the premium and obligates himself
o The contract buyer will decide whether or not to exercise his right on the expiry day
44
o If the contract buyer decides to exercise his right then he gets to sell the underlying
(maybe a stock) at the agreed price (strike price) and the contract seller will be
obligated to buy this underlying from the contract buyer
o Obviously the contract buyer will exercise his right only if the underlying price is
trading below the strike price – this means by virtue of the contract the buyer holds,
he can sell the underlying at a much higher price to the contract seller when the
same underlying is trading at a lower price in the open market.
Still confusing? Fear not, we will deal with an example to understand this more
clearly.
Consider this situation, between the Contract buyer and the Contract seller –
o Assume Reliance Industries is trading at Rs.850/-

o Contract buyer buys the right to sell Reliance to contract seller at Rs.850/- upon
expiry
o To obtain this right, contract buyer has to pay a premium to the contract seller
o Against the receipt of the premium contract seller will agree to buy Reliance
Industries shares at Rs.850/- upon expiry but only if contract buyer wants him to
buy it from him
o For example if upon expiry Reliance is at Rs.820/- then contract buyer can demand
contract seller to buy Reliance at Rs.850/- from him
o This means contract buyer can enjoy the benefit of selling Reliance at Rs.850/- when
it is trading at a lower price in the open market (Rs.820/-)
o If Reliance is trading at Rs.850/- or higher upon expiry (say Rs.870/-) it does not
make sense for contract buyer to exercise his right and ask contract seller to buy
the shares from him at Rs.850/-. This is quite obvious since he can sell it at a higher
rate in the open market
o A agreement of this sort where one obtains the right to sell the underlying asset
upon expiry is called a ‘Put option’
o Contract seller will be obligated to buy Reliance at Rs.850/- from contract buyer
because he has sold Reliance 850 Put Option to contract buyer
45
I hope the above discussion has given you the required orientation to the Put
Options. If you are still confused, it is alright as I’m certain you will develop more
clarity as we proceed further. However there are 3 key points you need to be aware
of at this stage –
o The buyer of the put option is bearish about the underlying asset, while the seller of
the put option is neutral or bullish on the same underlying
o The buyer of the put option has the right to sell the underlying asset upon expiry at
the strike price
o The seller of the put option is obligated (since he receives an upfront premium) to
buy the underlying asset at the strike price from the put option buyer if the buyer
wishes to exercise his right.
5.2 – Building a case for a Put Option buyer

Like we did with the call option, let us build a practical case to understand the put
option better. We will first deal with the Put Option from the buyer’s perspective
and then proceed to understand the put option from the seller’s perspective.
Here is the end of day chart of Bank Nifty (as on 8th April 2015) –
46
Here are some of my thoughts with respect to Bank Nifty –
1. Bank Nifty is trading at 18417

2. 2 days ago Bank Nifty tested its resistance level of 18550 (resistance level
highlighted by a green horizontal line)
3. I consider 18550 as resistance since there is a price action zone at this level which is
well spaced in time (for people who are not familiar with the concept of resistance I
would suggest you read about it here
4. I have highlighted the price action zone in a blue rectangular boxes
5. On 7th of April (yesterday) RBI maintained a status quo on the monetary rates – they
kept the key central bank rates unchanged (as you may know RBI monetary policy is
the most important event for Bank Nifty)
6. Hence in the backdrop of a technical resistance and lack of any key fundamental
trigger, banks may not be the flavor of the season in the markets
7. As result of which traders may want to sell banks and buy something else which is
the flavor of the season
8. For these reasons I have a bearish bias towards Bank Nifty
9. However shorting futures maybe a bit risky as the overall market is bullish, it is only
the banking sector which is lacking luster
10. Under circumstances such as these employing an option is best, hence buying a Put
Option on the bank Nifty may make sense
11. Remember when you buy a put option you benefit when the underlying goes down
47
Backed by this reasoning, I would prefer to buy the 18400 Put Option which is
trading at a premium of Rs.315/-. Remember to buy this 18400 Put option, I will
have to pay the required premium (Rs.315/- in this case) and the same will be
received by the 18400 Put option seller.
Of course buying the Put option is quite simple – the easiest way is to call your
broker and ask him to buy the Put option of a specific stock and strike and it will be
done for you in matter of a few seconds. Alternatively you can buy it yourself
through a trading terminal such as Zerodha Pi We will get into the technicalities of
buying and selling options via a trading terminal at a later stage.
Now assuming I have bought Bank Nifty’s 18400 Put Option, it would be interesting
to observe the P&L behavior of the Put Option upon its expiry. In the process we
can even make a few generalizations about the behavior of a Put option’s P&L.
5.3 – Intrinsic Value (IV) of a Put Option

Before we proceed to generalize the behavior of the Put Option P&L, we need to
understand the calculation of the intrinsic value of a Put option. We discussed the
concept of intrinsic value in the previous chapter; hence I will assume you know the
concept behind IV. Intrinsic Value represents the value of money the buyer will
receive if he were to exercise the option upon expiry.
The calculation for the intrinsic value of a Put option is slightly different from that of
a call option. To help you appreciate the difference let me post here the intrinsic
value formula for a Call option –
48
IV (Call option) = Spot Price – Strike Price
The intrinsic value of a Put option is –
IV (Put Option) = Strike Price – Spot Price
I want you to remember an important aspect here with respect to the intrinsic value
of an option – consider the following timeline –
The formula to calculate the intrinsic value of an option that we have just looked at,
is applicable only on the day of the expiry. However the calculation of intrinsic
value of an option is different during the series. Of course we will understand how
to calculate (and the need to calculate) the intrinsic value of an option during the
expiry. But for now, we only need to know the calculation of the intrinsic value upon
expiry.
5.4 – P&L behavior of the Put Option buyer

Keeping the concept of intrinsic value of a put option at the back of our mind, let us
work towards building a table which would help us identify how much money, I as
the buyer of Bank Nifty’s 18400 put option would make under the various possible
spot value changes of Bank Nifty (in spot market) on expiry. Do remember the
premium paid for this option is Rs 315/–. Irrespective of how the spot value
changes, the fact that I have paid Rs.315/- will remain unchanged. This is the cost
that I have incurred in order to buy the Bank Nifty 18400 Put Option. Let us keep
this in perspective and work out the P&L table –
Please note – the negative sign before the premium paid represents a cash outflow from
my trading account.
49
01 16195 -315 18400 – 16195 = 2205 2205 + (-315) = + 1890
02 16510 -315 18400 – 16510 = 1890 1890 + (-315)= + 1575
03 16825 -315 18400 – 16825 = 1575 1575 + (-315) = + 1260
04 17140 -315 18400 – 17140 = 1260 1260 + (-315) = + 945
05 17455 -315 18400 – 17455 = 945 945 + (-315) = + 630
06 17770 -315 18400 – 17770 = 630 630 + (-315) = + 315
07 18085 -315 18400 – 18085 = 315 315 + (-315) = 0
08 18400 -315 18400 – 18400 = 0 0 + (-315)= – 315
09 18715 -315 18400 – 18715 = 0 0 + (-315) = -315
10 19030 -315 18400 – 19030 = 0 0 + (-315) = -315
11 19345 -315 18400 – 19345 = 0 0 + (-315) = -315
12 19660 -315 18400 – 19660 = 0 0 + (-315) = -315
Let us make some observations on the behavior of the P&L (and also make a few
P&L generalizations). For the above discussion, set your eyes at row number 8 as
your reference point –
50
1. The objective behind buying a put option is to benefit from a falling price. As we can
see, the profit increases as and when the price decreases in the spot market (with
reference to the strike price of 18400).
1. Generalization 1 – Buyers of Put Options are profitable as and when the spot price
goes below the strike price. In other words buy a put option only when you are
bearish about the underlying
2. As the spot price goes above the strike price (18400) the position starts to make a
loss. However the loss is restricted to the extent of the premium paid, which in this
case is Rs.315/-
1. Generalization 2 – A put option buyer experiences a loss when the spot price goes
higher than the strike price. However the maximum loss is restricted to the extent
of the premium the put option buyer has paid.
Here is a general formula using which you can calculate the P&L from a Put Option
position. Do bear in mind this formula is applicable on positions held till expiry.
P&L = [Max (0, Strike Price – Spot Price)] – Premium Paid
Let us pick 2 random values and evaluate if the formula works –
1. 16510
2. 19660
@16510 (spot below strike, position has to be profitable)
= Max (0, 18400 -16510)] – 315
= 1890 – 315
= + 1575
@19660 (spot above strike, position has to be loss making, restricted to premium
paid)
= Max (0, 18400 – 19660) – 315
= Max (0, -1260) – 315
= – 315
Clearly both the results match the expected outcome.
Further, we need to understand the breakeven point calculation for a Put Option
buyer. Note, I will take the liberty of skipping the explanation of a breakeven point
as we have already dealt with it in the previous chapter; hence I will give you the
formula to calculate the same –
Breakeven point = Strike Price – Premium Paid
51
For the Bank Nifty breakeven point would be
= 18400 – 315
= 18085
So as per this definition of the breakeven point, at 18085 the put option should
neither make any money nor lose any money. To validate this let us apply the P&L
formula –
= Max (0, 18400 – 18085) – 315
= Max (0, 315) – 315
= 315 – 315
=0
The result obtained in clearly in line with the expectation of the breakeven point.
Important note – The calculation of the intrinsic value, P&L, and Breakeven point
are all with respect to the expiry. So far in this module, we have assumed that you
as an option buyer or seller would set up the option trade with an intention to hold
the same till expiry.
But soon you will realize that that more often than not, you will initiate an options
trade only to close it much earlier than expiry. Under such a situation the
calculations of breakeven point may not matter much, however the calculation of
the P&L and intrinsic value does matter and there is a different formula to do the
same.
To put this more clearly let me assume two situations on the Bank Nifty Trade, we
know the trade has been initiated on 7th April 2015 and the expiry is on 30th April
2015–
1. What would be the P&L assuming spot is at 17000 on 30th April 2015?
2. What would be the P&L assuming spot is at 17000 on 15th April 2015 (or for that
matter any other date apart from the expiry date)
Answer to the first question is fairly simple, we can straight way apply the P&L
formula –
= Max (0, 18400 – 17000) – 315
= Max (0, 1400) – 315
= 1400 – 315
= 1085
52
Going on to the 2nd question, if the spot is at 17000 on any other date apart from the
expiry date, the P&L is not going to be 1085, it will be higher. We will discuss why
this will be higher at an appropriate stage, but for now just keep this point in the
back of your mind.
5.5 – Put option buyer’s P&L payoff

If we connect the P&L points of the Put Option and develop a line chart, we should
be able to observe the generalizations we have made on the Put option buyers P&L.
Please find below the same –
Here are a few things that you should appreciate from the chart above, remember
18400 is the strike price –
1. The Put option buyer experienced a loss only when the spot price goes above the
strike price (18400 and above)
2. However this loss is limited to the extent of the premium paid
3. The Put Option buyer will experience an exponential gain as and when the spot
price trades below the strike price
4. The gains can be potentially unlimited
5. At the breakeven point (18085) the put option buyer neither makes money nor
losses money. You can observe that at the breakeven point, the P&L graph just
recovers from a loss making situation to a neutral situation. It is only above this
point the put option buyer would start to make money.
53
1. Buy a Put Option when you are bearish about the prospects of the underlying. In
other words a Put option buyer is profitable only when the underlying declines in
value
2. The intrinsic value calculation of a Put option is slightly different when compared to
the intrinsic value calculation of a call option
3. IV (Put Option) = Strike Price – Spot Price
4. The P&L of a Put Option buyer can be calculated as P&L = [Max (0, Strike Price –
Spot Price)] – Premium Paid
5. The breakeven point for the put option buyer is calculated as Strike – Premium
Paid
54
Chapter 6
The Put Option selling

149
6.1 – Building the case

Previously we understood that, an option seller and the buyer are like two sides of
the same coin. They have a diametrically opposite view on markets. Going by this, if
the Put option buyer is bearish about the market, then clearly the put option seller
must have a bullish view on the markets. Recollect we looked at the Bank Nifty’s
chart in the previous chapter; we will review the same chart again, but from the
perspective of a put option seller.
The typical thought process for the Put Option Seller would be something like this –
1. Bank Nifty is trading at 18417

2. 2 days ago Bank Nifty tested its resistance level at 18550 (resistance level is
highlighted by a green horizontal line)
3. 18550 is considered as resistance as there is a price action zone at this level which is
well spaced in time (for people who are not familiar with the concept of resistance I
would suggest you read about it here)
4. I have highlighted the price action zone in a blue rectangular boxes
55
5. Bank Nifty has attempted to crack the resistance level for the last 3 consecutive
times
6. All it needs is 1 good push (maybe a large sized bank announcing decent results –
HDFC, ICICI, and SBI are expected to declare results soon)
7. A positive cue plus a move above the resistance will set Bank Nifty on the upward
trajectory
8. Hence writing the Put Option and collecting the premiums may sound like a good
idea
You may have a question at this stage – If the outlook is bullish, why write (sell) a put
option and why not just buy a call option?
Well, the decision to either buy a call option or sell a put option really depends on
how attractive the premiums are. At the time of taking the decision, if the call option
has a low premium then buying a call option makes sense, likewise if the put option
is trading at a very high premium then selling the put option (and therefore
collecting the premium) makes sense. Of course to figure out what exactly to do
(buying a call option or selling a put option) depends on the attractiveness of the
premium, and to judge how attractive the premium is you need some background
knowledge on ‘option pricing’. Of course, going forward in this module we will
understand option pricing.
So, with these thoughts assume the trader decides to write (sell) the 18400 Put
option and collect Rs.315 as the premium. As usual let us observe the P&L behavior
for a Put Option seller and make a few generalizations.
Do Note – when you write options (regardless of Calls or Puts) margins are blocked
in your account. We have discussed this perspective here, request you to go
through the same.
56
6.2 – P&L behavior for the put option seller
Please do remember the calculation of the intrinsic value of the option remains the
same for both writing a put option as well as buying a put option. However the P&L
calculation changes, which we will discuss shortly. We will assume various possible
scenarios on the expiry date and figure out how the P&L behaves.
01 16195 + 315 18400 – 16195 = 2205 315 – 2205 = – 1890
02 16510 + 315 18400 – 16510 = 1890 315 – 1890 = – 1575
03 16825 + 315 18400 – 16825 = 1575 315 – 1575 = – 1260
04 17140 + 315 18400 – 17140 = 1260 315 – 1260 = – 945
05 17455 + 315 18400 – 17455 = 945 315 – 945 = – 630
06 17770 + 315 18400 – 17770 = 630 315 – 630 = – 315
07 18085 + 315 18400 – 18085 = 315 315 – 315 = 0
08 18400 + 315 18400 – 18400 = 0 315 – 0 = + 315
09 18715 + 315 18400 – 18715 = 0 315 – 0 = + 315
10 19030 + 315 18400 – 19030 = 0 315 – 0 = + 315
11 19345 + 315 18400 – 19345 = 0 315 – 0 = + 315
57
12 19660 + 315 18400 – 19660 = 0 315 – 0 = + 315
I would assume by now you will be in a position to easily generalize the P&L
behavior upon expiry, especially considering the fact that we have done the same
for the last 3 chapters. The generalizations are as below (make sure you set your
eyes on row 8 as it’s the strike price for this trade) –
1. The objective behind selling a put option is to collect the premiums and benefit
from the bullish outlook on market. Therefore as we can see, the profit stays flat at
Rs.315 (premium collected) as long as the spot price stays above the strike price.
1. Generalization 1 – Sellers of the Put Options are profitable as long as long as the
spot price remains at or higher than the strike price. In other words sell a put option
only when you are bullish about the underlying or when you believe that the
underlying will no longer continue to fall.
2. As the spot price goes below the strike price (18400) the position starts to make a
loss. Clearly there is no cap on how much loss the seller can experience here and it
can be theoretically be unlimited
1. Generalization 2 – A put option seller can potentially experience an unlimited loss
as and when the spot price goes lower than the strike price.
Here is a general formula using which you can calculate the P&L from writing a Put
Option position. Do bear in mind this formula is applicable on positions held till
expiry.
P&L = Premium Recieved – [Max (0, Strike Price – Spot Price)]
Let us pick 2 random values and evaluate if the formula works –
o 16510
o 19660
@16510 (spot below strike, position has to be loss making)
= 315 – Max (0, 18400 -16510)
= 315 – 1890
= – 1575
@19660 (spot above strike, position has to be profitable, restricted to premium

paid)
= 315 – Max (0, 18400 – 19660)
= 315 – Max (0, -1260)
58
= 315
Clearly both the results match the expected outcome.
Further, the breakdown point for a Put Option seller can be defined as a point
where the Put Option seller starts making a loss after giving away all the premium
he has collected –
Breakdown point = Strike Price – Premium Received
For the Bank Nifty, the breakdown point would be
= 18400 – 315
= 18085
So as per this definition of the breakdown point, at 18085 the put option seller
should neither make any money nor lose any money. Do note this also means at
this stage, he would lose the entire Premium he has collected. To validate this, let us
apply the P&L formula and calculate the P&L at the breakdown point –
= 315 – Max (0, 18400 – 18085)
= 315 – Max (0, 315)
= 315 – 315
=0
The result obtained in clearly in line with the expectation of the breakdown point.
6.3 – Put option seller’s Payoff

If we connect the P&L points (as seen in the table earlier) and develop a line chart,
we should be able to observe the generalizations we have made on the Put option
seller’s P&L. Please find below the same –
59
Here are a few things that you should appreciate from the chart above, remember
18400 is the strike price –
1. The Put option seller experiences a loss only when the spot price goes below the
strike price (18400 and lower)
2. The loss is theoretically unlimited (therefore the risk)
3. The Put Option seller will experience a profit (to the extent of premium received) as
and when the spot price trades above the strike price
4. The gains are restricted to the extent of premium received
5. At the breakdown point (18085) the put option seller neither makes money nor
losses money. However at this stage he gives up the entire premium he has
received.
6. You can observe that at the breakdown point, the P&L graph just starts to buckle
down – from a positive territory to the neutral (no profit no loss) situation. It is only
below this point the put option seller starts to lose money.
And with these points, hopefully you should have got the essence of Put Option
selling. Over the last few chapters we have looked at both the call option and the
put option from both the buyer and sellers perspective. In the next chapter we will
quickly summarize the same and shift gear towards other essential concepts of
Options.
60
1. You sell a Put option when you are bullish on a stock or when you believe the stock
price will no longer go down
2. When you are bullish on the underlying you can either buy the call option or sell a
put option. The decision depends on how attractive the premium is
3. Option Premium pricing along with Option Greeks gives a sense of how attractive
the premiums are
4. The put option buyer and the seller have a symmetrically opposite P&L behavior
5. When you sell a put option you receive premium
6. Selling a put option requires you to deposit margin
7. When you sell a put option your profit is limited to the extent of the premium you
receive and your loss can potentially be unlimited
8. P&L = Premium received – Max [0, (Strike Price – Spot Price)]
9. Breakdown point = Strike Price – Premium Paid
61
Chapter 7
Summarizing Call & Put Options

131
7.1 – Remember these graphs

Over the last few chapters we have looked at two basic option type’s i.e. the ‘Call
Option’ and the ‘Put Option’. Further we looked at four different variants originating
from these 2 options –
1. Buying a Call Option

2. Selling a Call Option
3. Buying a Put Option
4. Selling a Put Option
With these 4 variants, a trader can create numerous different combinations and
venture into some really efficient strategies generally referred to as ‘Option
Strategies’. Think of it this way – if you give a good artist a color palette and canvas
he can create some really interesting paintings, similarly a good trader can use
these four option variants to create some really good trades. Imagination and
intellect is the only requirement for creating these option trades. Hence before we
get deeper into options, it is important to have a strong foundation on these four
variants of options. For this reason, we will quickly summarize what we have learnt
so far in this module.
Please find below the pay off diagrams for the four different option variants –
62
Arranging the Payoff diagrams in the above fashion helps us understand a few
things better. Let me list them for you –
1. Let us start from the left side – if you notice we have stacked the pay off diagram of
Call Option (buy) and Call option (sell) one below the other. If you look at the payoff
diagram carefully, they both look like a mirror image. The mirror image of the payoff
emphasis the fact that the risk-reward characteristics of an option buyer and seller
are opposite. The maximum loss of the call option buyer is the maximum profit of
the call option seller. Likewise the call option buyer has unlimited profit potential,
mirroring this the call option seller has maximum loss potential
2. We have placed the payoff of Call Option (buy) and Put Option (sell) next to each
other. This is to emphasize that both these option variants make money only when
the market is expected to go higher. In other words, do not buy a call option or do
not sell a put option when you sense there is a chance for the markets to go down.
You will not make money doing so, or in other words you will certainly lose money
in such circumstances. Of course there is an angle of volatility here which we have
63
not discussed yet; we will discuss the same going forward. The reason why I’m
talking about volatility is because volatility has an impact on option premiums
3. Finally on the right, the pay off diagram of Put Option (sell) and the Put Option (buy)
are stacked one below the other. Clearly the pay off diagrams looks like the mirror
image of one another. The mirror image of the payoff emphasizes the fact that the
maximum loss of the put option buyer is the maximum profit of the put option
seller. Likewise the put option buyer has unlimited profit potential, mirroring this
the put option seller has maximum loss potential
Further, here is a table where the option positions are summarized.
Your Market View Option Type Position also called Other Alternatives Premium
Bullish Call Option (Buy) Long Call Buy Futures or Buy Spot Pay
Flat or Bullish Put Option (Sell) Short Put Buy Futures or Buy Spot Receive
Flat or Bearish Call Option (Sell) Short Call Sell Futures Receive
Bearish Put Option (Buy) Long Put Sell Futures Pay
It is important for you to remember that when you buy an option, it is also called a
‘Long’ position. Going by that, buying a call option and buying a put option is called
Long Call and Long Put position respectively.
Likewise whenever you sell an option it is called a ‘Short’ position. Going by that,
selling a call option and selling a put option is also called Short Call and Short Put
position respectively.
Now here is another important thing to note, you can buy an option under 2
circumstances –
1. You buy with an intention of creating a fresh option position

2. You buy with an intention to close an existing short position
The position is called ‘Long Option’ only if you are creating a fresh buy position. If
you are buying with and intention of closing an existing short position then it is
merely called a ‘square off’ position.
Similarly you can sell an option under 2 circumstances –
64
1. You sell with an intention of creating a fresh short position
2. You sell with an intention to close an existing long position
The position is called ‘Short Option’ only if you are creating a fresh sell (writing an
option) position. If you are selling with and intention of closing an existing long
position then it is merely called a ‘square off’ position.
7.2 – Option Buyer in a nutshell

By now I’m certain you would have a basic understanding of the call and put option
both from the buyer’s and seller’s perspective. However I think it is best to reiterate
a few key points before we make further progress in this module.
Buying an option (call or put) makes sense only when we expect the market to move
strongly in a certain direction. If fact, for the option buyer to be profitable the
market should move away from the selected strike price. Selecting the right strike
price to trade is a major task; we will learn this at a later stage. For now, here are a
few key points that you should remember –
1. P&L (Long call) upon expiry is calculated as P&L = Max [0, (Spot Price – Strike Price)] –
Premium Paid
2. P&L (Long Put) upon expiry is calculated as P&L = [Max (0, Strike Price – Spot Price)] –
Premium Paid
3. The above formula is applicable only when the trader intends to hold the long
option till expiry
4. The intrinsic value calculation we have looked at in the previous chapters is only
applicable on the expiry day. We CANNOT use the same formula during the series
5. The P&L calculation changes when the trader intends to square off the position well
before the expiry
6. The buyer of an option has limited risk, to the extent of premium paid. However he
enjoys an unlimited profit potential
65
7.2 – Option seller in a nutshell
The option sellers (call or put) are also called the option writers. The buyers and
sellers have exact opposite P&L experience. Selling an option makes sense when
you expect the market to remain flat or below the strike price (in case of calls) or
above strike price (in case of put option).
I want you to appreciate the fact that all else equal, markets are slightly favorable to
option sellers. This is because, for the option sellers to be profitable the market has
to be either flat or move in a certain direction (based on the type of option).
However for the option buyer to be profitable, the market has to move in a certain
direction. Clearly there are two favorable market conditions for the option seller
versus one favorable condition for the option buyer. But of course this in itself
should not be a reason to sell options.
Here are few key points you need to remember when it comes to selling options –
1. P&L for a short call option upon expiry is calculated as P&L = Premium Received – Max
[0, (Spot Price – Strike Price)]
2. P&L for a short put option upon expiry is calculated as P&L = Premium Received – Max
(0, Strike Price – Spot Price)
3. Of course the P&L formula is applicable only if the trader intends to hold the
position till expiry
4. When you write options, margins are blocked in your trading account
5. The seller of the option has unlimited risk but very limited profit potential (to the
extent of the premium received)
Perhaps this is the reason why Nassim Nicholas Taleb in his book “Fooled by
Randomness” says “Option writers eat like a chicken but shit like an elephant”. This
means to say that the option writers earn small and steady returns by selling
options, but when a disaster happens, they tend to lose a fortune.
66
Well, with this I hope you have developed a strong foundation on how a Call and Put
option behaves. Just to give you a heads up, the focus going forward in this module
will be on moneyness of an option, premiums, option pricing, option Greeks, and
strike selection. Once we understand these topics we will revisit the call and put
option all over again. When we do so, I’m certain you will see the calls and puts in a
new light and perhaps develop a vision to trade options professionally.
7.3 – A quick note on Premiums

Have a look at the snapshot below –
This is the snapshot of how the premium has behaved on an intraday basis
(30th April 2015) for BHEL. The strike under consideration is 230 and the option type
is a European Call Option (CE). This information is highlighted in the red box. Below
the red box, I have highlighted the price information of the premium. If you notice,
the premium of the 230 CE opened at Rs.2.25, shot up to make a high of Rs.8/- and
closed the day at Rs.4.05/-.
Think about it, the premium has gyrated over 350% intraday! i.e. from Rs.2.25/- to
Rs.8/-, and it roughly closed up 180% for the day i.e. from Rs.2.25/- to Rs.4.05/-.
67
Moves like this should not surprise you. These are fairly common to expect in the
options world.
Assume in this massive swing you managed to capture just 2 points while trading
this particular option intraday. This translates to a sweet Rs.2000/- in profits
considering the lot size is 1000 (highlighted in green arrow). In fact this is exactly
what happens in the real world. Traders just trade premiums. Hardly any traders
hold option contracts until expiry. Most of the traders are interested in initiating a
trade now and squaring it off in a short while (intraday or maybe for a few days) and
capturing the movements in the premium. They do not really wait for the options to
expire.
In fact you might be interested to know that a return of 100% or so while trading
options is not really a thing of surprise. But please don’t just get carried away with
what I just said; to enjoy such returns consistently you need develop a deep insight
into options.
Have a look at this snapshot –
This is the option contract of IDEA Cellular Limited, strike price is 190, expiry is on
30th April 2015 and the option type is a European Call Option . These details are
68
marked in the blue box. Below this we can notice the OHLC data, which quite
obviously is very interesting.
The 190CE premium opened the day at Rs.8.25/- and made a low of Rs.0.30/-. I will
skip the % calculation simply because it is a ridiculous figure for intraday. However
assume you were a seller of the 190 call option intraday and you managed to
capture just 2 points again, considering the lot size is 2000, the 2 point capture on
the premium translates to Rs.4000/- in profits intraday, good enough for that nice
dinner at Marriot with your better half J.
The point that I’m trying to make is that, traders (most of them) trade options only
to capture the variations in premium. They don’t really bother to hold till expiry.
However by no means I am suggesting that you need not hold until expiry, in fact I
do hold options till expiry in certain cases. Generally speaking option sellers tend to
hold contracts till expiry rather than option buyers. This is because if you have
written an option for Rs.8/- you will enjoy the full premium received i.e. Rs.8/- only
on expiry.
So having said that the traders prefer to trade just the premiums, you may have a
few fundamental questions cropping up in your mind. Why do premiums vary?
What is the basis for the change in premium? How can I predict the change in
premiums? Who decides what should be the premium price of a particular option?
Well, these questions and therefore the answers to these form the crux of option
trading. If you can master these aspects of an option, let me assure you that you
would set yourself on a professional path to trade options.
To give you a heads up – the answers to all these questions lies in understanding
the 4 forces that simultaneously exerts its influence on options premiums, as a
result of which the premiums vary. Think of this as a ship sailing in the sea. The
speed at which the ship sails (assume its equivalent to the option premium)
depends on various forces such as wind speed, sea water density, sea pressure, and
the power of the ship. Some forces tend to increase the speed of the ship, while
some tend to decrease the speed of the ship. The ship battles these forces and
finally arrives at an optimal sailing speed.
Likewise the premium of the option depends on certain forces called as the ‘Option
Greeks’. Crudely put, some Option Greeks tends to increase the premium, while
some try to reduce the premium. A formula called the ‘Black & Scholes Option
Pricing Formula’ employs these forces and translates the forces into a number,
which is the premium of the option.
Try and imagine this – the Option Greeks influence the option premium however
the Option Greeks itself are controlled by the markets. As the markets change on a
minute by minute basis, therefore the Option Greeks change and therefore the
option premiums!
69
Going forward in this module, we will understand each of these forces and its
characteristics. We will understand how the force gets influenced by the markets
and how the Option Greeks further influences the premium.
So the end objective here would be to be –
1. To get a sense of how the Option Greeks influence premiums

2. To figure out how the premiums are priced considering Option Greeks and their
influence
3. Finally keeping the Greeks and pricing in perspective, we need to smartly select
strike prices to trade
One of the key things we need to know before we attempt to learn the option
Greeks is to learn about the ‘Moneyness of an Option’. We will do the same in the
next chapter.
A quick note here – the topics going forward will get a little complex, although we
will try our best to simplify it. While we do that, we would request you to please be
thorough with all the concepts we have learnt so far.
1. Buy a call option or sell a put option only when you expect the market to go up
2. Buy a put option or sell a call option only when you expect the market to go down
3. The buyer of an option has an unlimited profit potential and limited risk (to the
extent of premium paid)
4. The seller of an option has an unlimited risk potential and limited reward (to the
extent of premium received)
5. Majority of option traders prefer to trade options only to capture the variation in
premiums
6. Option premiums tend to gyrate drastically – as an options trader you can expect
this to happen quite frequently
7. Premiums vary as a function of 4 forces called the Option Greeks
8. Black & Sholes option pricing formula employs four forces as inputs to give out a
price for the premium
9. Markets control the Option Greeks and the Greek’s variation itself
70
Chapter 8
Moneyness of an Option Contract

161
8.1 – Intrinsic Value

The moneyness of an option contract is a classification method wherein each option
(strike) gets classified as either – In the money (ITM), At the money (ATM), or Out of
the money (OTM) option. This classification helps the trader to decide which strike
to trade, given a particular circumstance in the market. However before we get into
the details, I guess it makes sense to look through the concept of intrinsic value
again.
The intrinsic value of an option is the money the option buyer makes from an
options contract provided he has the right to exercise that option on the given day.
Intrinsic Value is always a positive value and can never go below 0. Consider this
example –
Underlying CNX Nifty
Spot Value 8070
Option strike 8050
Option Type Call Option (CE)
Days to expiry 15
Position Long
Given this, assume you bought the 8050CE and instead of waiting for 15 days to
expiry you had the right to exercise the option today. Now my question to you is –
How much money would you stand to make provided you exercised the contract
today?
71
Do remember when you exercise a long option, the money you make is equivalent
to the intrinsic value of an option minus the premium paid. Hence to answer the
above question we need to calculate the intrinsic value of an option, for which we
need to pull up the call option intrinsic value formula from Chapter 3.
Here is the formula –
Intrinsic Value of a Call option = Spot Price – Strike Price
Let us plug in the values
= 8070 – 8050
= 20
So, if you were to exercise this option today, you are entitled to make 20 points
(ignoring the premium paid).
Here is a table which calculates the intrinsic value for various options strike (these
are just random values that I have used to drive across the concept) –
Option Type Strike Spot Formula Intrinsic Value Remarks
Long Call 280 310 Spot Price – Strike Price 310 – 280 = 30
Long Put 1040 980 Strike Price – Spot Price 1040 -980 = 60
Long Call 920 918 Spot Price – Strike Price 918 – 920 = 0 Since IV cannot be -ve
Long Put 80 88 Strike Price – Spot Price 80 – 88 = 0 Since IV cannot be -ve
With this, I hope you are clear about the intrinsic value calculation for a given option
strike. Let me summarize a few important points –
1. Intrinsic value of an option is the amount of money you would make if you were to
exercise the option contract
2. Intrinsic value of an options contract can never be negative. It can be either zero or
a positive number
3. Call option Intrinsic value = Spot Price – Strike Price
4. Put option Intrinsic value = Strike Price – Spot price
72
Before we wrap up this discussion, here is a question for you – Why do you think the
intrinsic value cannot be a negative value?
To answer this, let us pick an example from the above table – Strike is 920, spot is
918, and option type is long call. Let us assume the premium for the 920 Call option
is Rs.15.
Now,
1. If you were to exercise this option, what do you get?

1. Clearly we get the intrinsic value.
2. How much is the intrinsic value?
1. Intrinsic Value = 918 – 920 = -2
3. The formula suggests we get ‘– Rs.2’. What does this mean?
1. This means Rs.2 is going from our pocket
4. Let us believe this is true for a moment, what will be the total loss?
1. 15 + 2 = Rs.17/-
5. But we know the maximum loss for a call option buyer is limited to the extent of
premium one pays, in this case it will be Rs.15/-
1. However if we include a negative intrinsic value this property of option payoff is not
obeyed (Rs.17/- loss as opposed to Rs.15/-). Hence in order to maintain the non
linear property of option payoff, the Intrinsic value can never be negative
6. You can apply the same logic to the put option intrinsic value calculation
Hopefully this should give you some insights into why the intrinsic value of an
option can never go negative.
8.2 – Moneyness of a Call option

With our discussions on the intrinsic value of an option, the concept of moneyness
should be quite easy to comprehend. Moneyness of an option is a classification
method which classifies each option strike based on how much money a trader is
likely to make if he were to exercise his option contract today. There are 3 broad
classifications –
1. In the Money (ITM)

2. At the Money (ATM)
3. Out of the Money (OTM)
And for all practical purposes I guess it is best to further classify these as –
1. Deep In the money

2. In the Money (ITM)
73
3. At the Money (ATM)
4. Out of the Money (OTM)
5. Deep Out of the Money
Understanding these option strike classification is very easy. All you need to do is
figure out the intrinsic value. If the intrinsic value is a non zero number, then the
option strike is considered ‘In the money’. If the intrinsic value is a zero the option
strike is called ‘Out of the money’. The strike which is closest to the Spot price is
called ‘At the money’.
Let us take up an example to understand this well. As of today (7th May 2015) the
value of Nifty is at 8060, keeping this in perspective I’ve take the snapshot of all the
available strike prices (the same is highlighted within a blue box). The objective is to
classify each of these strikes as ITM, ATM, or OTM. We will discuss the ‘Deep ITM’
and ‘Deep OTM’ later.
74
As you can notice from the image above, the available strike prices trade starts from
7100 all the way upto 8700.
We will first identify ‘At the Money Option (ATM)’ as this is the easiest to deal with.
From the definition of ATM option that we posted earlier we know, ATM option is
that option strike which is closest to the spot price. Considering the spot is at 8060,
the closest strike is probably 8050. If there was 8060 strike, then clearly 8060 would
be the ATM option. But in the absence of 8060 strike the next closest strike
becomes ATM. Hence we classify 8050 as, the ATM option.
Having established the ATM option (8050), we will proceed to identify ITM and OTM
options. In order to do this we will pick few strikes and calculate the intrinsic value.
1. 7100
2. 7500
75
3. 8050
4. 8100
5. 8300
Do remember the spot price is 8060, keeping this in perspective the intrinsic value
for the strikes above would be –
@ 7100
Intrinsic Value = 8060 – 7100
= 960
Non zero value, hence the strike should be In the Money (ITM) option
@7500
= 560
Non zero value, hence the strike should be In the Money (ITM) option
@8050
We know this is the ATM option as 8050 strike is closest to the spot price of 8060. So
we will not bother to calculate its intrinsic value.
@ 8100
= – 40
Negative intrinsic value, therefore the intrinsic value is 0. Since the intrinsic value is
0, the strike is Out of the Money (OTM).
@ 8300
= – 240
Negative intrinsic value, therefore the intrinsic value is 0. Since the intrinsic value is
0, the strike is Out of the Money (OTM).
You may have already sensed the generalizations (for call options) that exists here,
however allow me to restate the same again
1. All option strikes that are higher than the ATM strike are considered OTM
76
2. All option strikes that are below the ATM strike are considered ITM
In fact I would suggest you relook at the snapshot we just posted –
NSE presents ITM options with a pale yellow background and all OTM options have
a regular white background. Now let us look at 2 ITM options – 7500 and 8000. The
intrinsic value works out to be 560 and 60 respectively (considering the spot is at
8060). Higher the intrinsic value, deeper the moneyness of the option. Therefore
7500 strike is considered as ‘Deep In the Money’ option and 8000 as just ‘In the
money’ option.
I would encourage you to observe the premiums for all these strike prices
(highlighted in green box). Do you sense a pattern here? The premium decreases as
you traverse from ‘Deep ITM’ option to ‘Deep OTM option’. In other words ITM
options are always more expensive compared to OTM options.
77
8.3 – Moneyness of a Put option
Let us run through the same exercise to find out how strikes are classified as ITM
and OTM for Put options. Here is the snapshot of various strikes available for a Put
option. The strike prices on the left are highlighted in a blue box. Do note at the
time of taking the snap shot (8th May 2015) Nifty’s spot value is 8202.
As you can see there are many strike prices available right from 7100 to 8700. We
will first classify the ATM option and then proceed to identify ITM and OTM option.
Since the spot is at 8202, the nearest strike to spot should be the ATM option. As we
can see from the snapshot above there is a strike at 8200 which is trading at
Rs.131.35/-. This obviously becomes the ATM option.
We will now pick a few strikes above and below the ATM and figure out ITM and
OTM options. Let us go with the following strikes and evaluate their respective
intrinsic value (also called the moneyness) –
78
1. 7500
2. 8000
3. 8200
4. 8300
5. 8500
@ 7500
We know the intrinsic value of put option can be calculated as = Strike – Spot
= – 700
Negative intrinsic value, therefore the option is OTM
@ 8000
= – 200
Negative intrinsic value, therefore the option is OTM
@8200
8200 is already classified as ATM option, hence we will skip this and move ahead.
@ 8300
= +100
Positive intrinsic value, therefore the option is ITM
@ 8500
= +300
Positive intrinsic value, therefore the option is ITM
Hence, an easy generalization for Put options are –
1. All strikes higher than ATM options are considered ITM

2. All strikes lower than ATM options are considered OTM
79
And as you can see from the snapshot, the premiums for ITM options are much
higher than the premiums for the OTM options.
I hope you have got a clear understanding of how option strikes are classified based
on their moneyness. However you may still be wondering about the need to classify
options based on their moneyness. Well the answer to this lies in ‘Option Greeks’
again. As you briefly know by now, Option Greeks are the market forces which act
upon options strikes and therefore affect the premium associated with these
strikes. So a certain market force will have a certain effect on ITM option while at the
same time it will have a different effect on an OTM option. Hence classifying the
option strikes will help us in understanding the Option Greeks and their impact on
the premiums better.
8.4 – The Option Chain

The Option chain is a common feature on most of the exchanges and trading
platforms. The option chain is a ready reckoner of sorts that helps you identify all
the strikes that are available for a particular underlying and also classifies the strikes
based on their moneyness. Besides, the option chain also provides information such
as the premium price (LTP), bid –ask price, volumes, open interest etc for each of
the option strikes.
Have a look at the option chain of Ashoka Leyland Limited as published on NSE –
Few observations to help you understand the option chain better –
1. The underlying spot value is at Rs.68.7/- (highlighted in blue)

2. The Call options are on to the left side of the option chain
80
3. The Put options are on to the right side of the option chain
4. The strikes are stacked on an increasing order in the center of the option chain
5. Considering the spot at Rs.68.7, the closest strike is 67.5, hence that would be an
ATM option (highlighted in yellow)
6. For Call options – all option strikes lower than ATM options are ITM option, hence
they have a pale yellow background
7. For Call options – all option strikes higher than ATM options are OTM options, hence
they have a white background
8. For Put Options – all option strikes higher than ATM are ITM options, hence they
have a pale yellow background
9. For Put Options – all option strikes lower than ATM are OTM options, hence they
have a white background
10. The pale yellow and white background from NSE is just a segregation method to
bifurcate the ITM and OTM options. The color scheme is not a standard convention.
Here is the link to check the option chain for Nifty Options.
8.4 – The way forward

Having understood the basics of the call and put options both from the buyers and
sellers perspective and also having understood the concept of ITM, OTM, and ATM I
suppose we are all set to dwell deeper into options.
The next couple of chapters will be dedicated to understand Option Greeks and the
kind of impact they have on option premiums. Based on the Option Greeks impact
on the premiums, we will figure out a way to select the best possible strike to trade
for a given circumstance in the market. Further we will also understand how
options are priced by briefly running through the ‘Black & Scholes Option Pricing
Formula’. The ‘Black & Scholes Option Pricing Formula’ will help us understand
things like – Why Nifty 8200 PE is trading at 131 and not 152 or 102!
I hope you are as excited to learn about all these topics as we are to write about the
same. So please stay tuned.
Onwards to Option Greeks now!
81
1. The intrinsic value of an option is equivalent to the value of money the option buyer
makes provided if he were to exercise the contract
2. Intrinsic Value of an option cannot be negative, it is a non zero positive value
3. Intrinsic value of call option = Spot Price – Strike Price
4. Intrinsic value of put option = Strike Price – Spot Price
5. Any option that has an intrinsic value is classified as ‘In the Money’ (ITM) option
6. Any option that does not have an intrinsic value is classified as ‘Out of the Money’
(OTM) option
7. If the strike price is almost equal to spot price then the option is considered as ‘At
the money’ (ATM) option
8. All strikes lower than ATM are ITM options (for call options)
9. All strikes higher than ATM are OTM options (for call options)
10. All strikes higher than ATM are ITM options (for Put options)
11. All strikes lower than ATM are OTM options (for Put options)
12. When the intrinsic value is very high, it is called ‘Deep ITM’ option
13. Likewise when the intrinsic value is the least, it is called ‘Deep OTM’ option
14. The premiums for ITM options are always higher than the premiums for OTM option
15. The Option chain is a quick visualization to understand which option strike is ITM,
OTM, ATM (for both calls and puts) along with other information relevant to options.
82
Chapter 9
The Option Greeks (Delta) Part 1

161
9.1 – Overview
Yesterday I watched the latest bollywood flick ‘Piku’. Quite nice I must say. After
watching the movie I was casually pondering over what really made me like Piku –
was it the overall storyline, or Amitabh Bachchan’s brilliant acting, or Deepika
Padukone’s charming screen presence, or Shoojit Sircar’s brilliant direction? Well, I
suppose it was a mix of all these factors that made the movie enjoyable.
This also made me realize, there is a remarkable similarity between a bollywood

movie and an options trade. Similar to a bollywood movie, for an options trade to
be successful in the market there are several forces which need to work in the
option trader’s favor. These forces are collectively called ‘The Option Greeks’. These
forces influence an option contract in real time, affecting the premium to either
increase or decrease on a minute by minute basis. To make matters complicated,
these forces not only influence the premiums directly but also influence each
another.
To put this in perspective think about these two bollywood actors – Aamir Khan and
Salman Khan. Movie buffs would recognize them as two independent acting forces
(similar to option Greeks) of Bollywood. They can independently influence the
outcome of the movie they act in (think of the movie as an options premium).
However if you put both these guys in a single flick, chances are that they will try to
pull one another down while at the same time push themselves up and at the same
time try to make the movie a success. Do you see the juggling around here? This
may not be a perfect analogy, but I hope it gives you a sense of what I’m trying to
convey.
Options Premiums, options Greeks, and the natural demand supply situation of the
markets influence each other. Though all these factors work as independent agents,
yet they are all intervened with one another. The final outcome of this mixture can
be assessed in the option’s premium. For an options trader, assessing the variation
in premium is most important. He needs to develop a sense for how these factors
play out before setting up an option trade.
83
So without much ado, let me introduce the Greeks to you –
1. Delta – Measures the rate of change of options premium based on the directional
movement of the underlying
2. Gamma – Rate of change of delta itself
3. Vega – Rate of change of premium based on change in volatility
4. Theta – Measures the impact on premium based on time left for expiry
We will discuss these Greeks over the next few chapters. The focus of this chapter is
to understand the Delta.
9.2 – Delta of an Option

Notice the following two snapshots here – they belong to Nifty’s 8250 CE option. The
first snapshot was taken at 09:18 AM when Nifty spot was at 8292.
84
A little while later…
85
Now notice the change in premium – at 09:18 AM when Nifty was at 8292 the call
option was trading at 144, however at 10:00 AM Nifty moved to 8315 and the same
call option was trading at 150.
In fact here is another snapshot at 10:55 AM – Nifty declined to 8288 and so did
the option premium (declined to 133).
86
From the above observations one thing stands out very clear – as and when the
value of the spot changes, so does the option premium. More precisely as we
already know – the call option premium increases with the increase in the spot
value and vice versa.
Keeping this in perspective, imagine this – you have predicted that Nifty will reach
8355 by 3:00 PM today. From the snapshots above we know that the premium will
certainly change – but by how much? What is the likely value of the 8250 CE
premium if Nifty reaches 8355?
Well, this is exactly where the ‘Delta of an Option’ comes handy. The Delta measures
how an options value changes with respect to the change in the underlying. In
simpler terms, the Delta of an option helps us answer questions of this sort – “By
how many points will the option premium change for every 1 point change in the
underlying?”
Therefore the Option Greek’s ‘Delta’ captures the effect of the directional movement
of the market on the Option’s premium.
87
The delta is a number which varies –
1. Between 0 and 1 for a call option, some traders prefer to use the 0 to 100 scale. So
the delta value of 0.55 on 0 to 1 scale is equivalent to 55 on the 0 to 100 scale.
2. Between -1 and 0 (-100 to 0) for a put option. So the delta value of -0.4 on the -1 to 0
scale is equivalent to -40 on the -100 to 0 scale
3. We will soon understand why the put option’s delta has a negative value associated
with it
At this stage I want to give you an orientation of how this chapter will shape up,
please do keep this at the back of your mind as I believe it will help you join the dots
better –
1. We will understand how we can use the Delta value for Call Options
2. A quick note on how the Delta values are arrived at
3. Understand how we can use the Delta value for Put Options
4. Delta Characteristics – Delta vs. Spot, Delta Acceleration (continued in next chapter)
5. Option positions in terms of Delta (continued in next chapter)
So let’s hit the road!
9.3 – Delta for a Call Option

We know the delta is a number that ranges between 0 and 1. Assume a call option
has a delta of 0.3 or 30 – what does this mean?
Well, as we know the delta measures the rate of change of premium for every unit
change in the underlying. So a delta of 0.3 indicates that for every 1 point change in
the underlying, the premium is likely change by 0.3 units, or for every 100 point
change in the underlying the premium is likely to change by 30 points.
The following example should help you understand this better –
Nifty @ 10:55 AM is at 8288
88
Option Strike = 8250 Call Option
Premium = 133
Delta of the option = + 0.55
Nifty @ 3:15 PM is expected to reach 8310
What is the likely option premium value at 3:15 PM?
Well, this is fairly easy to calculate. We know the Delta of the option is 0.55, which
means for every 1 point change in the underlying the premium is expected to
change by 0.55 points.
We are expecting the underlying to change by 22 points (8310 – 8288), hence the
premium is supposed to increase by
= 22*0.55
= 12.1
Therefore the new option premium is expected to trade around 145.1 (133+12.1)
Which is the sum of old premium + expected change in premium
Let us pick another case – what if one anticipates a drop in Nifty? What will happen
to the premium? Let us figure that out –
Nifty @ 10:55 AM is at 8288
Premium = 133
Delta of the option = 0.55
What is the likely premium value at 3:15 PM?
We are expecting Nifty to decline by – 88 points (8200 – 8288), hence the change in
premium will be –
= – 88 * 0.55
= – 48.4
Therefore the premium is expected to trade around
= 133 – 48.4
89
= 84.6 (new premium value)
As you can see from the above two examples, the delta helps us evaluate the
premium value based on the directional move in the underlying. This is extremely
useful information to have while trading options. For example assume you expect a
massive 100 point up move on Nifty, and based on this expectation you decide to
buy an option. There are two Call options and you need to decide which one to buy.
Call Option 1 has a delta of 0.05
Call Option 2 has a delta of 0.2
Now the question is, which option will you buy?
Let us do some math to answer this –
Change in underlying = 100 points
Call option 1 Delta = 0.05
Change in premium for call option 1 = 100 * 0.05
=5
Call option 2 Delta = 0.2
Change in premium for call option 2 = 100 * 0.2
= 20
As you can see the same 100 point move in the underlying has different effects on
different options. In this case clearly the trader would be better off buying Call
Option 2. This should give you a hint – the delta helps you select the right option
strike to trade. But of course there are more dimensions to this, which we will
explore soon.
At this stage let me post a very important question – Why is the delta value for a call
option bound by 0 and 1? Why can’t the call option’s delta go beyond 0 and 1?
To help understand this, let us look at 2 scenarios wherein I will purposely keep the
delta value above 1 and below 0.
Scenario 1: Delta greater than 1 for a call option
Nifty @ 10:55 AM at 8268
Premium = 133
90
Delta of the option = 1.5 (purposely keeping it above 1)
Change in Nifty = 42 points
Therefore the change in premium (considering the delta is 1.5)
= 1.5*42
= 63
Do you notice that? The answer suggests that for a 42 point change in the
underlying, the value of premium is increasing by 63 points! In other words, the
option is gaining more value than the underlying itself. Remember the option is a
derivative contract, it derives its value from its respective underlying, hence it can
never move faster than the underlying.
If the delta is 1 (which is the maximum delta value) it signifies that the option is
moving in line with the underlying which is acceptable, but a value higher than 1
does not make sense. For this reason the delta of an option is fixed to a maximum
value of 1 or 100.
Let us extend the same logic to figure out why the delta of a call option is lower
bound to 0.
Scenario 2: Delta lesser than 0 for a call option
Nifty @ 10:55 AM at 8288
Premium = 9
Delta of the option = – 0.2 (have purposely changed the value to below 0, hence
negative delta)
Change in Nifty = 88 points (8288 -8200)
Therefore the change in premium (considering the delta is -0.2)
= -0.2*88
= -17.6
91
For a moment we will assume this is true, therefore new premium will be
= -17.6 + 9
= – 8.6
As you can see in this case, when the delta of a call option goes below 0, there is a
possibility for the premium to go below 0, which is impossible. At this point do
recollect the premium irrespective of a call or put can never be negative. Hence for
this reason, the delta of a call option is lower bound to zero.
9.4 – Who decides the value of the Delta?

The value of the delta is one of the many outputs from the Black & Scholes option
pricing formula. As I have mentioned earlier in this module, the B&S formula takes
in a bunch of inputs and gives out a few key outputs. The output includes the
option’s delta value and other Greeks. After discussing all the Greeks, we will also go
through the B&S formula to strengthen our understanding on options. However for
now, you need to be aware that the delta and other Greeks are market driven
values and are computed by the B&S formula.
However here is a table which will help you identify the approximate delta value for
a given option –
Option Type Approx Delta value (CE) Approx Delta value (PE)
Deep ITM Between + 0.8 to + 1 Between – 0.8 to – 1
Slightly ITM Between + 0.6 to + 1 Between – 0.6 to – 1
ATM Between + 0.45 to + 0.55 Between – 0.45 to – 0.55
Slightly OTM Between + 0.45 to + 0.3 Between – 0.45 to -0.3
Deep OTM Between + 0.3 to + 0 Between – 0.3 to – 0
Of course you can always find out the exact delta of an option by using a B&S option
pricing calculator.
92
9.5 – Delta for a Put Option
Do recollect the Delta of a Put Option ranges from -1 to 0. The negative sign is just
to illustrate the fact that when the underlying gains in value, the value of premium
goes down. Keeping this in mind, consider the following details –
Parameters Values
Underlying Nifty
Strike 8300
Spot value 8268
Premium 128
Delta -0.55
Expected Nifty Value (Case 1) 8310
Expected Nifty Value (Case 2) 8230
Note – 8268 is a slightly ITM option, hence the delta is around -0.55 (as indicated
from the table above).
The objective is to evaluate the new premium value considering the delta value to
be -0.55. Do pay attention to the calculations made below.
Case 1: Nifty is expected to move to 8310
Expected change = 8310 – 8268
= 42
Delta = – 0.55
= -0.55*42
93
= -23.1
Current Premium = 128
New Premium = 128 -23.1
= 104.9
Here I’m subtracting the value of delta since I know that the value of a Put option
declines when the underlying value increases.
Case 2: Nifty is expected to move to 8230
Expected change = 8268 – 8230
= 38
Delta = – 0.55
= -0.55*38
= -20.9
Current Premium = 128
New Premium = 128 + 20.9
= 148.9
Here I’m adding the value of delta since I know that the value of a Put option gains
when the underlying value decreases.
I hope with the above two Illustrations you are now clear on how to use the Put
Option’s delta value to evaluate the new premium value. Also, I will take the liberty
to skip explaining why the Put Option’s delta is bound between -1 and 0.
In fact I would encourage the readers to apply the same logic we used while
understanding why the call option’s delta is bound between 0 and 1, to understand
why Put option’s delta is bound between -1 and 0.
In the next chapter we will dig deeper into Delta and understand some of its
characteristics.
94
1. Option Greeks are forces that influence the premium of an option

2. Delta is an Option Greek that captures the effect of the direction of the market
3. Call option delta varies between 0 and 1, some traders prefer to use 0 to 100.
4. Put option delta varies between -1 and 0 (-100 to 0)
5. The negative delta value for a Put Option indicates that the option premium and
underlying value moves in the opposite direction
6. ATM options have a delta of 0.5
7. ITM option have a delta of close to 1
8. OTM options have a delta of close to 0.
95
Chapter 10
Delta (Part 2)
146
10.1 – Model Thinking

The previous chapter gave you a sneak peek into the first option Greek – the Delta.
Besides discussing the delta, there was another hidden agenda in the previous
chapter – to set you on a ‘model thinking’ path. Let me explain what I mean by this –
the previous chapter opened up a new window to evaluate options. The window
threw open different option trading perspectives – hopefully you now no longer
think about options in a one-dimensional perspective.
For instance going forward if you have view on markets (bullish for example)
you may not strategize your trade this way – ‘My view is bullish, therefore it makes
sense to either buy a call option or collect premium by selling a put option’.
Rather you may strategize this way – “My view is bullish as I expect the market to
move by 40 points, therefore it makes sense to buy an option which has a delta of
0.5 or more as the option is expected to gain at least 20 points for the given 40 point
move in the market”.
See the difference between the two thought processes? While the former is a bit
naïve and casual, the latter is well defined and quantitative in nature. The
expectation of a 20 point move in the option premium was an outcome of a formula
that we explored in the previous chapter –
Expected change in option premium = Option Delta * Points change in

underlying
The above formula is just one piece in the whole game plan. As and when we
discover the other Greeks, the evaluation metric becomes more quantitative and in
the process the trade selection becomes more scientifically streamlined. Point is –
the thinking going forward will be guided by equations and numbers and ‘casual
trading thoughts’ will have very little scope. I know there are many traders who
trade just with a few random thoughts and some may even be successful. However
this is not everybody’s cup of tea. The odds are better when you put numbers in
perspective – and this happens when you develop ‘model thinking’.
So please do keep model thinking framework in perspective while analyzing options,

as this will help you setup systematic trades.
96
10.2 – Delta versus spot price
In the previous chapter we looked at the significance of Delta and also understood
how one can use delta to evaluate the expected change in premium. Before we
proceed any further, here is a quick recap from the previous chapter –
1. Call options has a +ve delta. A Call option with a delta of 0.4 indicates that for every
1 point gain/loss in the underlying the call option premium gains/losses 0.4 points
2. Put options has a –ve delta. A Put option with a delta of -0.4 Indicates that for every
1 point loss/gain in the underlying the put option premium gains/losses 0.4 points
3. OTM options have a delta value between 0 and 0.5, ATM option has a delta of 0.5,
and ITM option has a delta between 0.5 and 1.
Let me take cues from the 3rd point here and make some deductions. Assume Nifty
Spot is at 8312, strike under consideration is 8400, and option type is CE (Call
option, European).
1. What is the approximate Delta value for the 8400 CE when the spot is 8312?
1. Delta should be between 0 and 0.5 as 8400 CE is OTM. Let us assume Delta is 0.4
2. Assume Nifty spot moves from 8312 to 8400, what do you think is the Delta value?
1. Delta should be around 0.5 as the 8400 CE is now an ATM option
3. Further assume Nifty spot moves from 8400 to 8500, what do you think is the Delta
value?
1. Delta should be closer to 1 as the 8400 CE is now an ITM option. Let us say 0.8.
4. Finally assume Nifty Spot cracks heavily and drops back to 8300 from 8500, what
happens to delta?
1. With the fall in spot, the option has again become an OTM from ITM, hence the
value of delta also falls from 0.8 to let us say 0.35.
5. What can you deduce from the above 4 points?
1. Clearly as and when the spot value changes, the moneyness of an option changes,
and therefore the delta also changes.
Now this is a very important point here – the delta changes with changes in the
value of spot. Hence delta is a variable and not really a fixed entity. Therefore if an
option has a delta of 0.4, the value is likely to change with the change in the value of
the underlying.
Have a look at the chart below – it captures the movement of delta versus the spot
price. The chart is a generic one and not specific to any particular option or strike as
such. As you can see there are two lines –
1. The blue line captures the behavior of the Call option’s delta (varies from 0 to 1)
2. The red line captures the behavior of the Put option’s delta (varies from -1 to 0)
Let us understand this better –
97
This is a very interesting chart, and to begin with I would suggest you look at only
the blue line and ignore the red line completely. The blue line represents the delta
of a call option. The graph above captures few interesting characteristics of the
delta; let me list them for you (meanwhile keep this point in the back of your mind –
as and when the spot price changes, the moneyness of the option also changes) –
1. Look at the X axis – starting from left the moneyness increases as the spot price
traverses from OTM to ATM to ITM
2. Look at the delta line (blue line) – as and when the spot price increases so does the
delta
98
3. Notice at OTM the delta is flattish near 0 – this also means irrespective of how much
the spot price falls ( going from OTM to deep OTM) the option’s delta will remain at
0
1. Remember the call option’s delta is lower bound by 0
4. When the spot moves from OTM to ATM the delta also starts to pick up (remember
the option’s moneyness also increases)
1. Notice how the delta of option lies within 0 to 0.5 range for options that are less
than ATM
5. At ATM, the delta hits a value of 0.5
6. When the spot moves along from the ATM towards ITM the delta starts to move
beyond the 0.5 mark
7. Notice the delta starts to fatten out when it hits a value of 1
1. This also implies that as and when the delta moves beyond ITM to say deep ITM the
delta value does not change. It stays at its maximum value of 1.
You can notice similar characteristics for the Put Option’s delta (red line).
10.3 – The Delta Acceleration

If you are fairly involved in the options world you may have heard of bizarre stories
of how traders double or triple their money by trading OTM option. If you have not
heard such stories, let me tell you one – It was 17th May 2009 (Sunday), the election
results were declared, the UPA Government got re-elected at the center and
Dr.Manmohan Singh came back as the country’s Prime Minister to serve his
2nd term. Stock markets likes stability at the center and we all knew that the market
would rally the next day i.e. 18th May 2009. The previous day Nifty had closed at
3671.
Zerodha was not born then, we were just a bunch of traders trading our own capital
along with a few clients. One of our associates had taken a huge risk few days prior
to 17th May – he bought far off options (OTM) worth Rs.200,000/-. A dare devil act
this was considering the fact that nobody can really predict the outcome of a
99
general election. Obviously he would benefit if the market rallied, but for the market
to rally there were many factors at play. Along with him, we too were very anxious
to figure out what would happen. Finally the results were declared and we all knew
he would make money on 18th May – but none of us really knew to what extent he
would stand to benefit.
18th May 2009, a day that I cannot forget – markets opened at 9:55 AM (that was the
market opening time back then), it was a big bang open for market, Nifty
immediately hit an upper circuit and the markets froze. Within a matter of few
minutes Nifty rallied close to 20% to close the day at 4321! The exchanges decided
to close the market at 10:01 AM as it was overheated…and thus it was the shortest
working day of my life.
Here is the chart that highlights that day’s market move –
In the whole process our dear associate had made a sweet fortune. At 10:01 AM on
that glorious Monday morning, his option were valued at Rs.28,00,000/- a whopping
1300% gain all achieved overnight! This is the kind of trades that almost all traders
including me aspire to experience.
Anyway, let me ask you a few questions regarding this story and that will also bring
us back to the main topic –
1. Why do you think our associate choose to buy OTM options and not really ATM or
ITM options?
100
2. What would have happened if he had bought an ITM or ATM option instead?
Well the answers to these questions lies in this graph –
This graph talks about the ‘Delta Acceleration’ – there are 4 delta stages mentioned
in the graph, let us look into each one of them.
Before we move ahead with the following discussion some points for you here –
o I would advise you to pay a lot of attention to the following discussion, these are
some of the really important points to know and remember
o Do recollect and revise the delta table (option type, approximate delta value etc)
from the previous chapter
o Please do bear in mind the delta and premium numbers used here is an intelligent
assumption for the sake of this illustration –
Predevelopment – This is the stage when the option is OTM or deep OTM. The
delta here is close to 0. The delta will remain close to 0 even when the option moves
from deep OTM to OTM. For example when spot is 8400, 8700 Call Option is Deep
OTM, which is likely to have a delta of 0.05. Now even if the spot moves from 8400
to let us say 8500, the delta of 8700 Call option will not move much as 8700 CE is still
an OTM option. The delta will still be a small non – zero number.
101
So if the premium for 8700 CE when spot is at 8400 is Rs.12, then when Nifty moves
to 8500 (100 point move) the premium is likely to move by 100 * 0.05 = 5 points.
Hence the new premium will be Rs.12 + 5 = Rs.17/-. However the 8700 CE is now
considered slightly OTM and not really deep OTM.
Most important to note – the change in premium value in absolute terms maybe
small (Rs.5/-) but in percentage terms the Rs.12/- option has changed by 41.6% to
Rs.17/-
Conclusion – Deep OTM options tends to put on an impressive percentage however

for this to happen the spot has to move by a large value.
Recommendation – avoid buying deep OTM options because the deltas are really
small and the underlying has to move massively for the option to work in your favor.
There is more bang for the buck elsewhere. However for the very same reason
selling deep OTM makes sense, but we will evaluate when to sell these options
when we take up the Greek ‘Theta’.
Take off & Acceleration – This is the stage when the option transitions from OTM
to ATM. This is where the maximum bang for the buck lies, and therefore the risk.
Consider this – Nifty spot @ 8400, Strike is 8500 CE, option is slightly OTM, delta is
0.25, Premium is Rs.20/-.
Spot moves from 8400 to 8500 (100 point), to figure out what happens on the
premium side, let us do some math –
Change in underlying = 100
Delta for 8500 CE = 0.25
Premium change = 100 * 0.25 = 25
New premium = Rs.20 + 25 = Rs.45/-
Percentage change = 125%
Do you see that? For the same 100 point move slightly OTM options behaves very
differently.
Conclusion – The slightly OTM option which usually has a delta value of say 0.2 or
0.3 is more sensitive to changes in the underlying. For any meaningful change in the
underlying the percentage change in the slightly OTM options is very impressive. In
fact this is exactly how option traders double or triple their money i.e. by buying
slightly OTM options when they expect big moves in the underlying. But I would like
to remind you that this is just one face of the cube, there are other faces we still
need to explore.
102
Recommendation – Buying slightly OTM option is more expensive than buying
deep OTM options, but if you get your act right you stand to make a killing.
Whenever you buy options, consider buying slightly OTM options (of course
assuming there is plenty of time to expiry, we will talk about this later).
Let us take this forward and see how the ATM option would react for the same 100
point move.
Spot = 8400
Strike = 8400 (ATM)
Premium = Rs.60/-
Change in underlying = 100
Delta for 8400 CE = 0.5
Premium change = 100 * 0.5 = 50
New premium = Rs.60 + 50 = Rs.110/-
Percentage change = 83%
Conclusion – ATM options are more sensitive to changes in the spot when
compared to OTM options. Now because the ATM’s delta is high the underlying
need not really move by a large value. Even if the underlying moves by a small value
the option premium changes. However buying ATM options are more expensive
when compared to OTM options.
Recommendation – Buy ATM options when you want to play safe. The ATM option
will move even if the underlying does not move by a large value. Also as a corollary,
do not attempt to sell an ATM option unless you are very sure about what you are
doing.
Stabilization – When the option transitions from ATM to ITM and Deep ITM the
delta starts to stabilize at 1. As we can see from the graph, the delta starts to flatten
out when hits the value of 1. This means the option can be ITM or deep ITM but the
delta gets fixed to 1 and would not change in value.
Let us see how this works –
Nifty Spot = 8400
Option 1 = 8300 CE Strike, ITM option, Delta of 0.8, and Premium is Rs.105
Option 2 = 8200 CE Strike, Deep ITM Option, Delta of 1.0, and Premium is Rs.210
Change in underlying = 100 points, hence Nifty moves to 8500.
103
Given this let us see how the two options behave –
Change in premium for Option 1 = 100 * 0.8 = 80
New Premium for Option 1 = Rs.105 + 80 = Rs.185/-
Percentage Change = 80/105 = 76.19%
Change in premium for Option 2 = 100 * 1 = 100
New Premium for Option 2 = Rs.210 + 100 = Rs.310/-
Percentage Change = 100/210 = 47.6%
Conclusion – In terms of the absolute change in the number of points, the deep ITM
option scores over the slightly ITM option. However in terms of percentage change it
is the other way round. Clearly ITM options are more sensitive to the changes in the
underlying but certainly most expensive.
Most importantly notice the change in the deep ITM option (delta 1) for a change of
100 points in the underlying there is a change of 100 points in the option
premium. This means to say when you buy a deep ITM option it is as good as
buying the underlying itself. This is because whatever is the change in the
underlying, the deep ITM option will experience the same change.
Recommendation – Buy the ITM options when you want to play very safe. When I
say safe, I’m contrasting the deep ITM option with deep OTM option. The ITM
options have a high delta, which means they are most sensitive to changes in the
underlying.
Deep ITM option moves in line with the underlying, this means you can substitute a
deep ITM option to a futures contract!
Think about this –
Nifty Spot @ 8400
Nifty Futures = 8409
Strike = 8000 (deep ITM)
Premium = 450
Delta = 1.0
Change in spot = 30 points
New Spot value = 8430
104
Change in Futures = 8409 + 30 = 8439 à Reflects the entire 30 point change
Change Option Premium = 1*30 = 30
New Option Premium = 30 + 450 = 480 à Reflects the entire 30 point change
So the point is, both futures and Deep ITM options react very similar to the changes
in the underlying. Hence you are better off buying a Deep ITM option and therefore
lessen your margin burden. However if you opt to do this, you need to constantly
make sure that the Deep ITM option continues to remain Deep ITM (in other words
make sure the delta is always 1), plus do keep an eye on the liquidity of the contract.
I would suspect that at this stage the information contained in this chapter could be
an overdose, especially if you are exploring the Greeks for the first time. I would
suggest you take your time to learn this one bit at a time.
There are few more angles we need to explore with respect to the delta, but will do
that in the next chapter. However before we conclude this chapter let us summarize
the discussion with the help of a table.
This table will help us understand how different options behave differently given a
certain change in the underlying.
I’ve considered Bajaj Auto as the underlying. The price is 2210 and the expectation is
a 30 point change in the underlying (which means we are expecting Bajaj Auto to hit
2240). We will also assume there is plenty of time to expiry; hence time is not really
a concern.
Moneyness Strike Delta Old Premium Change in Premium New Premium % Change
Deep OTM 2400 0.05 Rs.3/- 30* 0.05 = 1.5 3+1.5 = 4.5 50%
Slightly OTM 2275 0.3 Rs.7/- 30*0.3 = 9 7 +9 = 16 129%
ATM 2210 0.5 Rs.12/- 30*0.5 = 15 12+15 = 27 125%
Slightly ITM 2200 0.7 Rs.22/- 30*0.7 = 21 22+21 = 43 95.45%
Deep ITM 2150 1 Rs.75/- 30*1 = 30 75 + 30 =105 40%
105
As you can see each option behaves differently for the same move in the
underlying.
Before I wrap this chapter – I narrated a story to you earlier in this chapter following
which I posted few questions. Perhaps you can now revisit the questions and you
will hopefully know the answers .
1. Model Thinking helps in developing a scientifically streamlined approach to trading

2. The Delta changes as and when the spot value changes
3. As the option transitions from OTM to ATM to ITM, so does the delta
4. Delta hits a value of 0.5 for ATM options
5. Delta predevelopment is when the option transitions from Deep OTM to OTM
6. Delta Take off and acceleration is when the option transitions from OTM to ATM
7. Delta stabilization is when the option transitions from ATM to ITM to Deep ITM
8. Buying options in the take off stage tends to give high % return
9. Buying Deep ITM option is as good as buying the underlying.
106
Chapter 11
Delta (Part 3)
118
11.1 – Add up the Deltas

Here is an interesting characteristic of the Delta – The Deltas can be added up!
Let me explain – we will go back to the Futures contract for a moment. We know for
every point change in the underlying’s spot value the futures also changes by 1
point. For example if Nifty Spot moves from 8340 to 8350 then the Nifty Futures will
also move from 8347 to 8357 (i.e. assuming Nifty Futures is trading at 8347 when
the spot is at 8340). If we were to assign a delta value to Futures, clearly the future’s
delta would be 1 as we know for every 1 point change in the underlying the futures
also changes by 1 point.
Now, assume I buy 1 ATM option which has a delta of 0.5, then we know that for
every 1 point move in the underlying the option moves by 0.5 points. In other words
owning 1 ATM option is as good as holding half futures contract. Given this, if I hold
2 such ATM contracts, then it as good as holding 1 futures contract because the
delta of the 2 ATM options i.e. 0.5 and 0.5, which adds up to total delta of 1! In other
words the deltas of two or more option contracts can be added to evaluate the total
delta of the position.
Let us take up a few case studies to understand this better –
Case 1 – Nifty spot at 8125, trader has 3 different Call option.
Sl No Contract Classification Lots Delta Position Delta
107
1 8000 CE ITM 1 -Buy 0.7 + 1 * 0.7 = + 0.7
2 8120 CE ATM 1 -Buy 0.5 + 1 * 0.5 = + 0.5
3 8300 CE Deep OTM 1- Buy 0.05 + 1 * 0.05 = + 0.05
Total Delta of positions = 0.7 + 0.5 + 0.05 = + 1.25
Observations –
1. The positive sign next to 1 (in the Position Delta column) indicates ‘Long’ position
2. The combined positions have a positive delta i.e. +1.25. This means both the
underlying and the combined position moves in the same direction
3. For every 1 point change in Nifty, the combined position changes by 1.25 points
4. If Nifty moves by 50 points, the combined position is expected to move by 50 * 1.25
= 62.5 points
Case 2 – Nifty spot at 8125, trader has a combination of both Call and Put
options.
1 8000 CE ITM 1- Buy 0.7 + 1*0.7 =0.7
2 8300 PE Deep ITM 1- Buy – 1.0 + 1*-1.0 = -1.0
3 8120 CE ATM 1- Buy 0.5 + 1*0.5 = 0.5
4 8300 CE Deep OTM 1- Buy 0.05 + 1*0.05 = 0.05
Total Delta of positions 0.7 – 1.0 + 0.5 + 0.05 = + 0.25
Observations –
108
1. The combined positions have a positive delta i.e. +0.25. This means both the
underlying and the combined position move in the same direction
2. With the addition of Deep ITM PE, the overall position delta has reduced, this means
the combined position is less sensitive to the directional movement of the market
3. For every 1 point change in Nifty, the combined position changes by 0.25 points
4. If Nifty moves by 50 points, the combined position is expected to move by 50 * 0.25
= 12.5 points
5. Important point to note here – Deltas of the call and puts can be added as long as it
belongs to the same underlying.
Case 3 – Nifty spot at 8125, trader has a combination of both Call and Put
options. He has 2 lots Put option here.
1 8000 CE ITM 1- Buy 0.7 + 1 * 0.7 = + 0.7
2 8300 PE Deep ITM 2- Buy -1 + 2 * (-1.0) = -2.0
3 8120 CE ATM 1- Buy 0.5 + 1 * 0.5 = + 0.5
4 8300 CE Deep OTM 1- Buy 0.05 + 1 * 0.05 = + 0.05
Total Delta of positions 0.7 – 2 + 0.5 + 0.05 = – 0.75
Observations –
1. The combined positions have a negative delta. This means the underlying and the
combined option position move in the opposite direction
2. With an addition of 2 Deep ITM PE, the overall position has turned delta negative,
this means the combined position is less sensitive to the directional movement of
the market
3. For every 1 point change in Nifty, the combined position changes by – 0.75 points
4. If Nifty moves by 50 points, the position is expected to move by 50 * (- 0.75) = -37.5
points
Case 4 – Nifty spot at 8125, the trader has Calls and Puts of the same strike,
same underlying.
109
1 8100 CE ATM 1- Buy 0.5 + 1 * 0.5 = + 0.5
2 8100 PE ATM 1- Buy -0.5 + 1 * (-0.5) = -0.5
Total Delta of positions + 0.5 – 0.5 = 0
Observations –
1. The 8100 CE (ATM) has a positive delta of + 0.5

2. The 8100 PE (ATM) has a negative delta of – 0.5
3. The combined position has a delta of 0, which implies that the combined position
does not get impacted by any change in the underlying
1. For example – If Nifty moves by 100 points, the change in the options positions will be 100 * 0 = 0
4. Positions such as this – which have a combined delta of 0 are also called ‘Delta
Neutral’ positions
5. Delta Neutral positions do not get impacted by any directional change. They behave
as if they are insulated to the market movements
6. However Delta neutral positions react to other variables like Volatility and Time. We
will discuss this at a later stage.
Case 5 – Nifty spot at 8125, trader has sold a Call Option
1 8100 CE ATM 1- Sell 0.5 – 1 * 0.5 = – 0.5
2 8100 PE ATM 1- Buy -0.5 + 1 * (-0.5) = – 0.5
Total Delta of positions – 0.5 – 0.5 = – 1.0
Observations –
1. The negative sign next to 1 (in the Position Delta column) indicates ‘short’ position
110
2. As we can see a short call option gives rise to a negative delta – this means the
option position and the underlying move in the opposite direction. This is quite
intuitive considering the fact that the increase in spot value results in a loss to the
call option seller
3. Likewise if you short a PUT option the delta turns positive
1. -1 * (-0.5) = +0.5
Lastly just consider a case wherein the trader has 5 lots long deep ITM option. We
know the total delta of such position would + 5 * + 1 = + 5. This means for every 1
point change in the underlying the combined position would change by 5 points in
the same direction.
Do note the same can be achieved by shorting 5 deep ITM PUT options –
–5*–1=+5
-5 indicate 5 short positions and -1 is the delta of deep ITM Put options.
The above case study discussions should give you a perspective on how to add up
the deltas of the individual positions and figure out the overall delta of the
positions. This technique of adding up the deltas is very helpful when you have
multiple option positions running simultaneously and you want to identify the
overall directional impact on the positions.
In fact I would strongly recommend you always add the deltas of individual position
to get a perspective – this helps you understand the sensitivity and leverage of your
overall position.
Also, here is another important point you need to remember –
Delta of ATM option = 0.5
If you have 2 ATM options = delta of the position is 1
So, for every point change in the underlying the overall position also changes by 1
point (as the delta is 1). This means the option mimics the movement of a Futures
contract. However, do remember these two options should not be considered as a
surrogate for a futures contract. Remember the Futures contract is only affected by
the direction of the market, however the options contracts are affected by many
other variables besides the direction of the markets.
There could be times when you would want to substitute the options contract
instead of futures (mainly from the margins perspective) – but whenever you do so
be completely aware of its implications, more on this topic as we proceed.
111
11.2 – Delta as a probability
Before we wrap up our discussion on Delta, here is another interesting application
of Delta. You can use the Delta to gauge the probability of the option contract to
expire in the money.
Let me explain – when a trader buys an option (irrespective of Calls or Puts), what is
that he aspires? For example what do you expect when you buy Nifty 8000 PE when
the spot is trading at 8100? (Note 8000 PE is an OTM option here). Clearly we expect
the market to fall so that the Put option starts to make money for us.
In fact the trader hopes the spot price falls below the strike price so that the option
transitions from an OTM option to ITM option – and in the process the premium
goes higher and the trader makes money.
The trader can use the delta of an option to figure out the probability of the option
to transition from OTM to ITM.
In the example 8000 PE is slightly OTM option; hence its delta must be below 0.5, let
us fix it to 0.3 for the sake of this discussion.
Now to figure out the probability of the option to transition from OTM to ITM,
simply convert the delta to a percentage number.
When converted to percentage terms, delta of 0.3 is 30%. Hence there is only 30%
chance for the 8000 PE to transition into an ITM option.
Interesting right? Now think about this situation – although an arbitrary situation,
this in fact is a very real life market situation –
1. 8400 CE is trading at Rs.4/-

2. Spot is trading at 8275
3. There are two day left for expiry – would you buy this option?
Well, a typical trader would think that this is a low cost trade, after all the premium
is just Rs.4/- hence there is nothing much to lose. In fact the trader could even
convince himself thinking that if the trade works in his favor, he stands a chance to
make a huge profit.
Fair enough, in fact this is how options work. But let’s put on our ‘Model Thinking’
hat and figure out if this makes sense –
1. 8400 CE is deep OTM call option considering spot is at 8275

2. The delta of this option could be around 0.1
3. Delta suggests that there is only 10% chance for the option to expire ITM
4. Add to this the fact that there are only 2 more days to expiry – the
case against buying this option becomes stronger!
112
A prudent trader would never buy this option. However don’t you think it makes
perfect sense to sell this option and pocket the premium? Think about it – there is
just 10% chance for the option to expire ITM or in other words there is 90% chance
for the option to expire as an OTM option. With such a huge probability favoring the
seller, one should go ahead and take the trade with conviction!
In the same line – what would be the delta of an ITM option? Close to 1 right? So this
means there is a very high probability for an already ITM option to expire as ITM. In
other words the probability of an ITM option expiring OTM is very low, so beware
while shorting/writing ITM options as the odds are already against you!
Remember smart trading is all about taking trades wherein the odds favor you, and
to know if the odds favor you, you certainly need to know your numbers and don
your ‘Model Thinking’ hat.
And with this I hope you have developed a fair understanding on the very first
Option Greek – The delta.
The Gamma beckons us now.
1. The delta is additive in nature

2. The delta of a futures contract is always 1
3. Two ATM option is equivalent to owning 1 futures contract
4. The options contract is not really a surrogate for the futures contract
5. The delta of an option is also the probability for the option to expire ITM
113
Chapter 12
Gamma (Part 1)
44
12.1 – The other side of the mountain

How many of you remember your high school calculus? Does the word
differentiation and integration ring a bell? The word ‘Derivatives’ meant something
else to all of us back then – it simply referred to solving lengthy differentiation and
integration problems.
Let me attempt to refresh your memory – the idea here is to just drive a certain
point across and not really get into the technicalities of solving a calculus problem.
Please note, the following discussion is very relevant to options, so please do read
on.
Consider this –
A car is set into motion; it starts from 0 kms travels for 10 minutes and reaches the
3rd kilometer mark. From the 3rd kilometer mark, the car travels for another 5
minutes and reaches the 7th kilometer mark.
Let us focus and note what really happens between the 3rd and 7th kilometer, –
1. Let ‘x’ = distance, and ‘dx’ the change in distance

2. Change in distance i.e. ‘dx’, is 4 (7 – 3)
3. Let ‘t’ = time, and ‘dt’ the change in time
4. Change in time i.e. ‘dt’, is 5 (15 – 10)
If we divide dx over dt i.e. change in distance over change in time we get ‘Velocity’
(V)!
V = dx / dt
= 4/5
This means the car is travelling 4Kms for every 5 Minutes. Here the velocity is being
expressed in Kms travelled per minute, clearly this is not a convention we use in our
114
day to day conversation as we are used to express speed or velocity in Kms
travelled per hour (KMPH).
We can convert 4/5 to KMPH by making a simple mathematical adjustment –
5 minutes when expressed in hours equals 5/60 hours, plugging this back in the
above equation
= 4 / (5/ 60)
= (4*60)/5
= 48 Kmph
Hence the car is moving at a velocity of 48 kmph (kilometers per hour).
Do remember Velocity is change in distance travelled divided over change in

time. In the calculus world, the Speed or Velocity is called the ‘1st order derivative’
of distance travelled.
Now, let us take this example forward – In the 1st leg of the journey the car reached
the 7th Kilometer after 15 minutes. Further assume in the 2nd leg of journey, starting
from the 7th kilometer mark the car travels for another 5 minutes and reaches the
15th kilometer mark.
We know the velocity of the car in the first leg was 48 kmph, and we can easily
calculate the velocity for the 2nd leg of the journey as 96 kmph (here dx = 8 and dt =
5).
It is quite obvious that the car travelled twice as fast in the 2nd leg of the journey.
Let us call the change in velocity as ‘dv’. Change in velocity as we know is also called
‘Acceleration’.
We know the change in velocity is
= 96KMPH – 48 KMPH
= 48 KMPH /??
The above answer suggests that the change in velocity is 48 KMPH…. but over what?
Confusing right?
Let me explain –
115
** The following explanation may seem like a digression from the main topic about
Gamma, but it is not, so please read on, if not for anything it will refresh your high school
physics **
When you want to buy a new car, the first thing the sales guy tells you is something
like this – “the car is really fast as it can accelerate 0 to 60 in 5 seconds”. Essentially
he is telling you that the car can change velocity from 0 KMPH (from the state of
complete rest) to 60 KMPH in 5 seconds. Change in velocity here is 60KMPH (60 –
0) over 5 seconds.
Likewise in the above example we know the change in velocity is 48KMPH but over
what? Unless we answer “over what” part, we would not know what the acceleration
really is.
To find out the acceleration in this particular case, we can make some assumptions
–
1. Acceleration is constant
2. We can ignore the 7th kilometer mark for time being – hence we consider the fact
that the car was at 3rdkilometer mark at the 10th minute and it reached the
15th kilometer mark at the 20th minute
Using the above information, we can further deduce more information (in the
calculus world, these are called the ‘initial conditions’).
o Velocity @ the 10th minute (or 3rd kilometer mark) = 0 KMPS. This is called the initial
velocity
o Time lapsed @ the 3rd kilometer mark = 10 minutes
o Acceleration is constant between the 3rd and 15th kilometer mark
o Time at 15th kilometer mark = 20 minutes
o Velocity @ 20th minute (or 15th kilometer marks) is called ‘Final Velocity”
o While we know the initial velocity was 0 kmph, we do not know the final velocity
o Total distance travelled = 15 – 3 = 12 kms
o Total driving time = 20 -10 = 10 minutes
o Average speed (velocity) = 12/10 = 1.2 kmps per minute or in terms of hours it would
be 72 kmph
Now think about this, we know –
116
o Initial velocity = 0 kmph
o Average velocity = 72 kmph
o Final velocity =??
By reverse engineering we know the final velocity should be 144 Kmph as the
average of 0 and 144 is 72.
Further we know acceleration is calculated as = Final Velocity / time (provided

acceleration is constant).
Hence the acceleration is –
= 144 kmph / 10 minutes
10 minutes when converted to hours is (10/60) hours, plugging this back in the
above equation
= 144 kmph / (10/60) hour
= 864 Kilometers per hour.
This means the car is gaining a speed of 864 kilometers every hour, and if a
salesman is selling you this car, he would say the car can accelerate 0 to 72kmph in
5 secs (I’ll let you do this math).
We simplified this problem a great deal by making one assumption – acceleration is

constant. However in reality acceleration is not constant, you accelerate at different
speeds for obvious reasons. Generally speaking, to calculate such
problems involving change in one variable due to the change in another
variable one would have to dig into derivative calculus, more precisely one needs to
use the concept of ‘differential equations’.
Now just think about this for a moment –
We know change in distance travelled (position) = Velocity, this is also called the
1st order derivative of distance position.
Change in Velocity = Acceleration
Acceleration = Change in Velocity over time, which is in turn the change in position
over time.
Hence it is apt to call Acceleration as the 2nd order derivative of the position or the
1st derivative of Velocity!
Keep this point about the 1st order derivative and 2nd order derivative in perspective
as we now proceed to understand the Gamma.
117
12.2 – Drawing Parallels
Over the last few chapters we understood how Delta of an option works. Delta as
we know represents the change in premium for the given change in the underlying
price.
For example if the Nifty spot value is 8000, then we know the 8200 CE option is
OTM, hence its delta could be a value between 0 and 0.5. Let us fix this to 0.2 for the
sake of this discussion.
Assume Nifty spot jumps 300 points in a single day, this means the 8200 CE is no
longer an OTM option, rather it becomes slightly ITM option and therefore by virtue
of this jump in spot value, the delta of 8200 CE will no longer be 0.2, it would be
somewhere between 0.5 and 1.0, let us assume 0.8.
With this change in underlying, one thing is very clear – the delta itself changes.
Meaning delta is a variable, whose value changes based on the changes in the
underlying and the premium! If you notice, Delta is very similar to velocity whose
value changes with change in time and the distance travelled.
The Gamma of an option measures this change in delta for the given change in the
underlying. In other words Gamma of an option helps us answer this question – “For
a given change in the underlying, what will be the corresponding change in the delta
of the option?”
Now, let us re-plug the velocity and acceleration example and draw some parallels
to Delta and Gamma.
1st order Derivative
o Change in distance travelled (position) with respect to change in time is captured by

velocity, and velocity is called the 1st order derivative of position
118
o Change in premium with respect to change in underlying is captured by delta, and
hence delta is called the 1st order derivative of the premium
2nd order Derivative
o Change in velocity with respect to change in time is captured by acceleration, and

acceleration is called the 2nd order derivative of position
o Change in delta is with respect to change in the underlying value is captured by
Gamma, hence Gamma is called the 2nd order derivative of the premium
As you can imagine, calculating the values of Delta and Gamma (and in fact all other
Option Greeks) involves number crunching and heavy use of calculus (differential
equations and stochastic calculus).
Here is a trivia for you – as we know, derivatives are called derivatives because the
derivative contracts derives its value based on the value of its respective underlying.
This value that the derivatives contracts derive from its respective underlying is
measured using the application of “Derivatives” as a mathematical concept, hence
the reason why Futures & Options are referred to as ‘Derivatives’ .
You may be interested to know there is a parallel trading universe out there where
traders apply derivative calculus to find trading opportunities day in and day out. In
the trading world, such traders are generally called ‘Quants’, quite a fancy
nomenclature I must say. Quantitative trading is what really exists on the other side
of this mountain called ‘Markets’.
From my experience, understanding the 2nd order derivative such as Gamma is not
an easy task, although we will try and simplify it as much as possible in the
subsequent chapters.
1. Financial derivatives are called Financial derivatives because of its dependence on

calculus and differential equations (generally called Derivatives)
2. Delta of an option is a variable and changes for every change in the underlying and
premium
3. Gamma captures the rate of change of delta, it helps us get an answer for a
question such as “What is the expected value of delta for a given change in
underlying”
4. Delta is the 1st order derivative of premium
5. Gamma is the 2nd order derivative of premium
119
Chapter 13
Gamma (Part 2)
129
13.1 – The Curvature

We now know for a fact that the Delta of an option is a variable, as it constantly
changes its value relative to the change in the underlying. Let me repost the graph
of the delta’s movement here –
120
If you look at the blue line representing the delta of a call option, it is quite clear that
it traverses between 0 and 1 or maybe from 1 to 0 as the situation would demand.
Similar observations can be made on the red line representing the put option’s delta
(except the value changes between 0 to -1). This graph reemphasizes what we
already know i.e the delta is a variable and it changes all the time. Given this, the
question that one needs to answer is –
1. I know the delta changes, but why should I care about it?
2. If the change in delta really matters, how do I estimate the likely change in delta?
We will talk about the 2nd question first as I’m reasonably certain the answer to the
first question will reveal itself as we progress through this chapter.
As introduced in the previous chapter, ‘The Gamma’ (2nd order derivative of

premium) also referred to as the curvature of the option gives the rate at which
the option’s delta changes as the underlying changes. The gamma is usually
expressed in deltas gained or lost per one point change in the underlying – with the
delta increasing by the amount of the gamma when the underlying rises and falling
by the amount of the gamma when the underlying falls.
For example consider this –
o Nifty Spot = 8326

o Strike = 8400
o Option type = CE
o Moneyness of Option = Slightly OTM
o Premium = Rs.26/-
o Delta = 0.3
o Gamma = 0.0025
o Change in Spot = 70 points
o New Spot price = 8326 + 70 = 8396
o New Premium =??
o New Delta =??
o New moneyness =??
Let’s figure this out –
o Change in Premium = Delta * change in spot i.e 0.3 * 70 = 21

o New premium = 21 + 26 = 47
o Rate of change of delta = 0.0025 units for every 1 point change in underlying
o Change in delta = Gamma * Change in underlying i.e 0.0025*70 = 0.175
o New Delta = Old Delta + Change in Delta i.e 0.3 + 0.175 = 0.475
121
o New Moneyness = ATM
When Nifty moves from 8326 to 8396, the 8400 CE premium changed from Rs.26 to
Rs.47, and along with this the Delta changed from 0.3 to 0.475.
Notice with the change of 70 points, the option transitions from slightly OTM to ATM
option. Which means the option’s delta has to change from 0.3 to somewhere close
to 0.5. This is exactly what’s happening here.
Further let us assume Nifty moves up another 70 points from 8396; let us see what
happens with the 8400 CE option –
o Old spot = 8396

o New spot value = 8396 + 70 = 8466
o Old Premium = 47
o Old Delta = 0.475
o Change in Premium = 0.475 * 70 = 33.25
o New Premium = 47 + 33.25 = 80.25
o New moneyness = ITM (hence delta should be higher than 0.5)
o Change in delta =0.0025 * 70 = 0.175
o New Delta = 0.475 + 0.175 = 0.65
Let’s take this forward a little further, now assume Nifty falls by 50 points, let us see
what happens with the 8400 CE option –
o Old spot = 8466

o New spot value = 8466 – 50 = 8416
o Old Premium = 80.25
o Old Delta = 0.65
o Change in Premium = 0.65 *(50) = – 32.5
o New Premium = 80.25 – 32. 5 = 47.75
o New moneyness = slightly ITM (hence delta should be higher than 0.5)
o Change in delta = 0.0025 * (50) = – 0.125
o New Delta = 0.65 – 0.125 = 0.525
Notice how well the delta transitions and adheres to the delta value rules we
discussed in the earlier chapters. Also, you may wonder why the Gamma value is
kept constant in the above examples. Well, in reality the Gamma also changes with
the change in the underlying. This change in Gamma due to changes in underlying is
captured by 3rd derivative of underlying called “Speed” or “Gamma of Gamma” or
“DgammaDspot”. For all practical purposes, it is not necessary to get into the
discussion of Speed, unless you are mathematically inclined or you work for an
Investment Bank where the trading book risk can run into several $ Millions.
122
Unlike the delta, the Gamma is always a positive number for both Call and Put
Option. Therefore when a trader is long options (both Calls and Puts) the trader is
considered ‘Long Gamma’ and when he is short options (both calls and puts) he is
considered ‘Short Gamma’.
For example consider this – The Gamma of an ATM Put option is 0.004, if the
underlying moves 10 points, what do you think the new delta is?
Before you proceed I would suggest you spend few minutes to think about the
solution for the above.
Here is the solution – Since we are talking about an ATM Put option, the Delta must
be around – 0.5. Remember Put options have a –ve Delta. Gamma as you notice is a
positive number i.e +0.004. The underlying moves by 10 points without specifying
the direction, so let us figure out what happens in both cases.
Case 1 – Underlying moves up by 10 points
o Delta = – 0.5
o Gamma = 0.004
o Change in underlying = 10 points
o Change in Delta = Gamma * Change in underlying = 0.004 * 10 = 0.04
o New Delta = We know the Put option loses delta when underlying increases, hence –
0.5 + 0.04 = – 0.46
Case 2 – Underlying goes down by 10 points
o Delta = – 0.5
o Gamma = 0.004
o Change in underlying = – 10 points
o Change in Delta = Gamma * Change in underlying = 0.004 * – 10 = – 0.04
o New Delta = We know the Put option gains delta when underlying goes down, hence
– 0.5 + (-0.04) = – 0.54
Now, here is trick question for you – In the earlier chapters, we had discussed that
the Delta of the Futures contract in always 1, so what do you think the gamma of
the Futures contract is? Please leave your answers in the comment box below :).
13.2 – Estimating Risk using Gamma

I know there are many traders who define their risk limits while trading. Here is
what I mean by a risk limit – for example the trader may have a capital of
Rs.300,000/- in his trading account. Margin required for each Nifty Futures is
approximately Rs.16,500/-. Do note you can use Zerodha’s SPAN calculator to
figure out the margin required for any F&O contract. So considering the margin and
123
the M2M margin required, the trader may decide at any point he may not want to
exceed holding more than 5 Nifty Futures contracts, thus defining his risk limits,
this seems fair enough and works really well while trading futures.
But does the same logic work while trading options? Let’s figure out if it is the right
way to think about risk while trading options.
Here is a situation –
o Number of lots traded = 10 lots (Note – 10 lots of ATM contracts with delta of 0.5
each is equivalent to 5 Futures contract)
o Option = 8400 CE
o Spot = 8405
o Delta = 0.5
o Gamma = 0.005
o Position = Short
The trader is short 10 lots of Nifty 8400 Call Option; this means the trader is within
his risk boundary. Recall the discussion we had in the Delta chapter about adding
up the delta. We can essentially add up the deltas to get the overall delta of the
position. Also each delta of 1 represents 1 lot of the underlying. So we will keep this
in perspective and we can figure out the overall position’s delta.
o Delta = 0.5
o Number of lots = 10
o Position Delta = 10 * 0.5 = 5
So from the overall delta perspective the trader is within his risk boundary of
trading not more than 5 Futures lots. Also, do note since the trader is short options,
he is essentially short gamma.
The position’s delta of 5 indicates that the trader’s position will move 5 points for
every 1 point movement in the underlying.
Now, assume Nifty moves 70 points against him and the trader continues to hold
his position, hoping for a recovery. The trader is obviously under the impression
that he is holding 10 lots of options which is within his risk appetite…
Let’s do some forensics to figure out behind the scenes changes –
o Delta = 0.5
o Gamma = 0.005
o Change in underlying = 70 points
o Change in Delta = Gamma * change in underlying = 0.005 * 70 = 0.35
o New Delta = 0.5 + 0.35 = 0.85
124
o New Position Delta = 0.85*10 = 8.5
Do you see the problem here? Although the trader has defined his risk limit of 5
lots, thanks to a high Gamma value, he has overshot his risk limit and now holds
positions equivalent to 8.5 lots, way beyond his perceived risk limit. An
inexperienced trader can be caught unaware of this and still be under the
impression that he is well under his risk radar. But in reality his risk exposure is
getting higher.
Now since the delta is 8.5, his overall position is expected to move 8.5 points for
every 1 point change in the underlying. For a moment assume the trader is long on
the call option instead of being short – obviously he would enjoy the situation here
as the market is moving in his favor. Besides the favorable movement in the market,
his positions is getting ‘Longer’ since the ‘long gamma’ tends to add up the deltas,
and therefore the delta tends to get bigger, which means the rate of change on
premium with respect to change in underlying is faster.
Suggest you read that again in small bits if you found it confusing.
But since the trader is short, he is essentially short gamma…this means when the
position moves against him (as in the market moves up while he is short) the deltas
add up (thanks to gamma) and therefore at every stage of market increase, the
delta and gamma gang up against the short option trader, making his position
riskier way beyond what the plain eyes can see. Perhaps this is the reason why they
say – shorting options carry huge amount of risk. In fact you can be more precise
and say “shorting options carries the risk of being short gamma”.
Note – By no means I’m suggesting that you should not short options. In fact a
successful trader employs both short and long positions as the situation demands.
I’m only suggesting that when you short options you need to be aware of the Greeks
and what they can do to your positions.
125
Also, I’d strongly suggest you avoid shorting option contracts which has a large
Gamma.
This leads us to another interesting topic – what is considered as ‘large gamma’.
13.3 – Gamma movement

Earlier in the chapter we briefly discussed that the Gamma changes with respect to
change in the underlying. This change in Gamma is captured by the 3 rd order
derivative called ‘Speed’. I won’t get into discussing ‘Speed’ for reasons stated earlier.
However we need to know the behavior of Gamma movement so that we can avoid
initiating trades with high Gamma. Of course there are other advantages of
knowing the behavior of Gamma, we will talk about this at a later stage in this
module. But for now we will look into how the Gamma behaves with respect to
changes in the underlying.
Have a look at the chart below,
The chart above has 3 different CE strike prices – 80, 100, and 120 and their
respective Gamma movement. For example the blue line represents the Gamma of
the 80 CE strike price. I would suggest you look at each graph individually to avoid
confusion. In fact for sake of simplicity I will only talk about the 80 CE strike option,
represented by the blue line.
Let us assume the spot price is at 80, thus making the 80 strike ATM. Keeping this in
perspective we can observe the following from the above chart –
1. Since the strike under consideration is 80 CE, the option attains ATM status when
the spot price equals 80
2. Strike values below 80 (65, 70, 75 etc) are ITM and values above 80 (85, 90, 95 etx)
are OTM options.
3. Notice the gamma value is low for OTM Options (80 and above). This explains why
the premium for OTM options don’t change much in terms of absolute point terms,
126
however in % terms the change is higher. For example – the premium of an OTM
option can change from Rs.2 to Rs.2.5, while absolute change in is just 50 paisa, the
% change is 25%.
4. The gamma peaks when the option hits ATM status. This implies that the rate of
change of delta is highest when the option is ATM. In other words, ATM options are
most sensitive to the changes in the underlying
1. Also, since ATM options have highest Gamma – avoid shorting ATM options
5. The gamma value is also low for ITM options (80 and below). Hence for a certain
change in the underlying, the rate of change of delta for an ITM option is much
lesser compared to ATM option. However do remember the ITM option inherently
has a high delta. So while ITM delta reacts slowly to the change in underlying (due to
low gamma) the change in premium is high (due to high base value of delta).
6. You can observe similar Gamma behavior for other strikes i.e 100, and 120. In fact
the reason to show different strikes is to showcase the fact that the gamma behaves
in the same way for all options strikes
Just in case you found the above discussion bit overwhelming, here are 3 simple
points that you can take home –
o Delta changes rapidly for ATM option

o Delta changes slowly for OTM and ITM options
o Never short ATM or ITM option with a hope that they will expire worthless upon
expiry
o OTM options are great candidates for short trades assuming you intend to hold
these short trades upto expiry wherein you expect the option to expire worthless
13.4 – Quick note on Greek interactions

One of the keys to successful options trading is to understand how the individual
option Greeks behave under various circumstances. Now besides understanding
the individual Greek behavior, one also needs to understand how these individual
option Greeks react with each other.
So far we have considered only the premium change with respect to the changes in
the spot price. We have not yet discussed time and volatility. Think about the
markets and the real time changes that happen. Everything changes – time,
volatility, and the underlying price. So an option trader should be in a position to
understand these changes and its overall impact on the option premium.
You will fully appreciate this only when you understand the cross interactions of the
option Greeks. Typical Greek cross interactions would be – gamma versus time,
gamma versus volatility, volatility vs time, time vs delta etc.
127
Finally all your understanding of the Greeks boils down to a few critical decision
making factors such as –
1. For the given market circumstances which is the best strike to trade?
2. What is your expectation of the premium of that particular strike – would it increase
or decrease? Hence would you be a buyer or a seller in that option?
3. If you plan to buy an option – is there a realistic chance for the premium to
increase?
4. If you plan to short an option – is it really safe to do so? Are you able to see risk
beyond what the naked eyes can spot?
The answers to all these questions will evolve once you fully understand individual
Greeks and their cross interactions.
Given this, here is how this module will develop going further –
1. So far we have understood Delta and Gamma

2. Over the next few chapters we will understand Theta and Vega
3. When we introduce Vega (change in premium with respect to change in volatility) –
we will digress slightly to understand volatility based stoploss
4. Introduce Greek cross interactions – Gamma vs time, Gamma vs spot, Theta vs
Vega, Vega vs Spot etc
5. Overview of Black and Scholes option pricing formula
6. Option calculator
So as you see, we have miles to walk before we sleep .
1. Gamma measures the rate of change of delta

2. Gamma is always a positive number for both Calls and Puts
3. Large Gamma can translate to large gamma risk (directional risk)
4. When you buy options (Calls or Puts) you are long Gamma
5. When you short options (Calls or Puts) you are short Gamma
6. Avoid shorting options which have large gamma
7. Delta changes rapidly for ATM option
8. Delta changes slowly for OTM and ITM options
Special thanks to our good friend Prakash Lekkala for providing the Greek graphs in this
and other chapters.
128
Chapter 14
Theta
127
14.1 – Time is money

Remember the adage “Time is money”, it seems like this adage about time is highly
relevant when it comes to options trading. Forget all the Greek talk for now, we shall
go back to understand one basic concept concerning time. Assume you have
enrolled for a competitive exam, you are inherently a bright candidate and have the
capability to clear the exam, however if you do not give it sufficient time and brush
up the concepts, you are likely to flunk the exam – so given this what is the
likelihood that you will pass this exam? Well, it depends on how much time you
spend to prepare for the exam right? Let’s keep this in perspective and figure out
the likelihood of passing the exam against the time spent preparing for the exam.
Number of days for preparation Likelihood of passing
30 days Very high
20 days High
15 days Moderate
10 days Low
5 days Very low
1 day Ultra low
Quite obviously higher the number of days for preparation, the higher is the
likelihood of passing the exam. Keeping the same logic in mind, think about the
following situation – Nifty Spot is 8500, you buy a Nifty 8700 Call option – what is the
129
likelihood of this call option to expire In the Money (ITM)? Let me rephrase this
question in the following way –
o Given Nifty is at 8500 today, what is the likelihood of Nifty moving 200 points over
the next 30 days and therefore 8700 CE expiring ITM?
o The chance for Nifty to move 200 points over next 30 days is quite high, hence the
likelihood of option expiring ITM upon expiry is very high
o What if there are only 15 days to expiry?

o An expectation that Nifty will move 200 points over the next 15 days is reasonable,
hence the likelihood of option expiring ITM upon expiry is high (notice it is not very
high, but just high).
o What if there are only 5 days to expiry?

o Well, 5 days, 200 points, not really sure hence the likelihood of 8700 CE expiring in
the money is low
o What if there was only 1 day to expiry?

o The probability of Nifty to move 200 points in 1 day is quite low, hence I would be
reasonably certain that the option will not expire in the money, therefore the
chance is ultra low.
Is there anything that we can infer from the above? Clearly, the more time for expiry
the likelihood for the option to expire In the Money (ITM) is higher. Now keep this
point in the back of your mind as we now shift our focus on the ‘Option Seller’. We
know an option seller sells/writes an option and receives the premium for it. When
he sells an option he is very well aware that he carries an unlimited risk and limited
reward potential. The reward is limited to the extent of the premium he receives. He
gets to keep his reward (premium) fully only if the option expires worthless. Now,
think about this – if he is selling an option early in the month he very clearly knows
the following –
1. He knows he carries unlimited risk and limited reward potential

2. He also knows that by virtue of time, there is a chance for the option he is selling to
transition into ITM option, which means he will not get to retain his reward
(premium received)
In fact at any given point, thanks to ‘time’, there is always a chance for the option to
expiry in the money (although this chance gets lower and lower as time progresses
towards the expiry date). Given this, an option seller would not want to sell options
at all right? After all why would you want to sell options when you very well know
that simply because of time there is scope for the option you are selling to expire in
the money. Clearly time in the option sellers context acts as a risk. Now, what if the
option buyer in order to entice the option seller to sell options offers to compensate
for the ‘time risk’ that he (option seller) assumes? In such a case it probably makes
130
sense to evaluate the time risk versus the compensation and take a call right? In fact
this is what happens in real world options trading. Whenever you pay a premium for
options, you are indeed paying towards –
1. Time Risk
2. Intrinsic value of options.
In other words – Premium = Time value + Intrinsic Value Recall earlier in this
module we defined ‘Intrinsic Value’ as the money you are to receive, if you were to
exercise your option today. Just to refresh your memory, let us calculate the intrinsic
value for the following options assuming Nifty is at 8423 –
1. 8350 CE
2. 8450 CE
3. 8400 PE
4. 8450 PE
We know the intrinsic value is always a positive value or zero and can never be
below zero. If the value turns out to be negative, then the intrinsic value is
considered zero. We know for Call options the intrinsic value is “Spot Price – Strike
Price” and for Put options it is “Strike Price – Spot Price”. Hence the intrinsic values
for the above options are as follows –
1. 8350 CE = 8423 – 8350 = +73

2. 8450 CE = 8423 – 8450 = -ve value hence 0
3. 8400 PE = 8400 – 8423 = -ve value hence 0
4. 8450 PE = 8450 – 8423 = + 27
So given that we know how to calculate the intrinsic value of an option, let us
attempt to decompose the premium and extract the time value and intrinsic value.
Have a look at the following snapshot –
131
Details to note are as follows –
o Spot Value = 8531

o Strike = 8600 CE
o Status = OTM
o Premium = 99.4
o Today’s date = 6th July 2015
o Expiry = 30th July 2015
Intrinsic value of a call option – Spot Price – Strike Price i.e 8531 – 8600 = 0 (since it’s
a negative value) We know – Premium = Time value + Intrinsic value 99.4 = Time
Value + 0 This implies Time value = 99.4! Do you see that? The market is willing to
pay a premium of Rs.99.4/- for an option that has zero intrinsic value but ample
time value! Recall time is money Here is snapshot of the same contract that I
took the next day i.e 7th July –
132
Notice the underlying value has gone up slightly (8538) but the option premium has
decreased quite a bit! Let’s decompose the premium into its intrinsic value and time
value – Spot Price – Strike Price i.e 8538 – 8600 = 0 (since it’s a negative value) We
know – Premium = Time value + Intrinsic value 87.9 = Time Value + 0 This implies
Time value = 87.9! Notice the overnight drop in premium value? We will soon
understand why this happened. Note – In this example, the drop in premium value
is 99.4 minus 87.9 = 11.5. This drop is attributable to drop in volatility and time.
We will talk about volatility in the next chapter. For the sake of argument, if both
volatility and spot were constant, the drop in premium would be completely
attributable to the passage of time. I would suspect this drop would be around Rs.5
133
or so and not really Rs.11.5/-. Let us take another example –
o Spot Value = 8514.5

o Strike = 8450 CE
o Status = ITM
o Premium = 160
o Today’s date = 7th July 2015
o Expiry = 30th July 2015
Intrinsic value of call option – Spot Price – Strike Price i.e 8514.5 – 8450 = 64.5 We
know – Premium = Time value + Intrinsic value 160 = Time Value + 64.5 This implies
the Time value = 160 – 64.5 = 95.5 Hence out of the total premium of Rs.160, traders
are paying 64.5 towards intrinsic value and 95.5 towards the time value. You can
repeat the calculation for all options (both calls and puts) and decompose the
premium into the Time value and intrinsic value.
14.2 – Movement of time

Time as we know moves in one direction. Keep the expiry date as the target time
and think about the movement of time. Quite obviously as time progresses, the
number of days for expiry gets lesser and lesser. Given this let me ask you this
134
question – With roughly 18 trading days to expiry, traders are willing to pay as much
as Rs.100/- towards time value, will they do the same if time to expiry was just 5
days? Obviously they would not right? With lesser time to expiry, traders will pay a
much lesser value towards time. In fact here is a snap shot that I took from the
earlier months –
o Date = 29th April

o Expiry Date = 30th April
o Time to expiry = 1 day
o Strike = 190
o Spot = 179.6
o Premium = 30 Paisa
o Intrinsic Value = 179.6 – 190 = 0 since it’s a negative value
o Hence time value should be 30 paisa which equals the premium
With 1 day to expiry, traders are willing to pay a time value of just 30 paisa.
However, if the time to expiry was 20 days or more the time value would probably
be Rs.5 or Rs.8/-. The point that I’m trying to make here is this – with every passing
day, as we get closer to the expiry day, the time to expiry becomes lesser and lesser.
This means the option buyers will pay lesser and lesser towards time value. So if the
option buyer pays Rs.10 as the time value today, tomorrow he would probably pay
135
Rs.9.5/- as the time value. This leads us to a very important conclusion – “All other
things being equal, an option is a depreciating asset. The option’s premium
erodes daily and this is attributable to the passage of time”. Now the next
logical question is – by how much would the premium decrease on a daily basis
owing to the passage of time? Well, Theta the 3rd Option Greek helps us answer this
question.
14.3 – Theta
All options – both Calls and Puts lose value as the expiration approaches. The Theta
or time decay factoris the rate at which an option loses value as time passes. Theta
is expressed in points lost per day when all other conditions remain the same. Time
runs in one direction, hence theta is always a positive number, however to remind
traders it’s a loss in options value it is sometimes written as a negative number. A
Theta of -0.5 indicates that the option premium will lose -0.5 points for every day
that passes by. For example, if an option is trading at Rs.2.75/- with theta of -0.05
then it will trade at Rs.2.70/- the following day (provided other things are kept
constant). A long option (option buyer) will always have a negative theta meaning all
else equal, the option buyer will lose money on a day by day basis. A short option
(option seller) will have a positive theta. Theta is a friendly Greek to the option seller.
Remember the objective of the option seller is to retain the premium. Given that
options loses value on a daily basis, the option seller can benefit by retaining the
premium to the extent it loses value owing to time. For example if an option writer
has sold options at Rs.54, with theta of 0.75, all else equal, the same option is likely
to trade at – =0.75 * 3 = 2.25 = 54 – 2.25 = 51.75 Hence the seller can choose to close
the option position on T+ 3 day by buying it back at Rs.51.75/- and profiting Rs.2.25
…and this is attributable to theta! Have a look at the graph below –
136
This is the graph of how premium erodes as time to expiry approaches. This is also
called the ‘Time Decay’graph. We can observe the following from the graph –
1. At the start of the series – when there are many days for expiry the option does not
lose much value. For example when there were 120 days to expiry the option was
trading at 350, however when there was 100 days to expiry, the option was trading
at 300. Hence the effect of theta is low
2. As we approach the expiry of the series – the effect of theta is high. Notice when
there was 20 days to expiry the option was trading around 150, but when we
approach towards expiry the drop in premium seems to accelerate (option value
drops below 50).
So if you are selling options at the start of the series – you have the advantage of
pocketing a large premium value (as the time value is very high) but do remember
the fall in premium happens at a low rate. You can sell options closer to the expiry –
you will get a lower premium but the drop in premium is high, which is
advantageous to the options seller. Theta is a relatively straightforward and easy
Greek to understand. We will revisit theta again when we will discuss cross
dependencies of Greeks. But for now, if you have understood all that’s being
discussed here you are good to go. We shall now move forward to understand the
last and the most interesting Greek – Vega!
137
1. Option sellers are always compensated for the time risk

2. Premium = Intrinsic Value + Time Value
3. All else equal, options lose money on a daily basis owing to Theta
4. Time moves in a single direction hence Theta is a positive number
5. Theta is a friendly Greek to option sellers
6. When you short naked options at the start of the series you can pocket a large time
value but the fall in premium owing to time is low
7. When you short option close to expiry the premium is low (thanks to time value) but
the fall in premium is rapid
138
Chapter 15
Volatility Basics
79
15.1 – Background
Having understood Delta, Gamma, and Theta we are now at all set to explore one of
the most interesting Option Greeks – The Vega. Vega, as most of you might have
guessed is the rate of change of option premium with respect to change in volatility.
But the question is – What is volatility? I have asked this question to quite a few
traders and the most common answer is “Volatility is the up down movement of the
stock market”. If you have a similar opinion on volatility, then it is about time we
fixed that .
So here is the agenda, I suppose this topic will spill over a few chapters –
1. We will understand what volatility really means

2. Understand how to measure volatility
3. Practical Application of volatility
4. Understand different types of volatility
5. Understand Vega
So let’s get started.
15.2 – Moneyball
Have you watched this Hollywood movie called ‘Moneyball’? It’s a real life story Billy
Beane – manager of a base ball team in US. The movie is about Billy Beane and his
young colleague, and how they leverage the power of statistics to identify relatively
low profile but extremely talented baseball players. A method that was unheard of
during his time, and a method that proved to be both innovative and disruptive.
You can watch the trailer of Moneyball here.
I love this movie, not just for Brad Pitt, but for the message it drives across on topics
related to life and business. I will not get into the details now, however let me draw
some inspiration from the Moneyball method, to help explain volatility :).
The discussion below may appear unrelated to stock markets, but please don’t get
discouraged. I can assure you that it is relevant and helps you relate better to the
term ‘Volatility’.
139
Consider 2 batsmen and the number of runs they have scored over 6 consecutive
matches –
Match Billy Mike
1 20 45
2 23 13
3 21 18
4 24 12
5 19 26
6 23 19
You are the captain of the team, and you need to choose either Billy or Mike for the
7th match. The batsman should be dependable – in the sense that the batsman you
choose should be in a position to score at least 20 runs. Whom would you choose?
From my experience I have noticed that people approach this problem in one of the
two ways –
1. Calculate the total score (also called ‘Sigma’) of both the batsman – pick the
batsman with the highest score for next game. Or..
2. Calculate the average (also called ‘Mean’) number of scores per game – pick the
batsman with better average.
Let us calculate the same and see what numbers we get –
o Billy’s Sigma = 20 + 23 + 21 + 24 + 19 + 23 = 130

o Mike’s Sigma = 45 + 13 + 18 + 12 + 26 + 19 = 133
So based on the sigma you are likely to select Mike. Let us calculate the mean or
average for both the players and figure out who stands better –
o Billy = 130/6 = 21.67

o Mike = 133/6 = 22.16
140
So it seems from both the mean and sigma perspective, Mike deserves to be
selected. But let us not conclude that yet. Remember the idea is to select a player
who can score at least 20 runs and with the information that we have now (mean
and sigma) there is no way we can conclude who can score at least 20 runs.
Therefore, let’s do some further investigation.
To begin with, for each match played we will calculate the deviation from the mean.
For example, we know Billy’s mean is 21.67 and in his first match Billy scored 20
runs. Therefore deviation from mean form the 1st match is 20 – 21.67 = – 1.67. In
other words, he scored 1.67 runs lesser than his average score. For the 2ndmatch it
was 23 – 21.67 = +1.33, meaning he scored 1.33 runs more than his average score.
Here is the diagram representing the same (for Billy) –
The middle black line represents the average score of Billy, and the double arrowed
vertical line represents the the deviation from mean, for each of the match played.
We will now go ahead and calculate another variable called ‘Variance’.
Variance is simply the ‘sum of the squares of the deviation divided by the total
number of observations’. This may sound scary, but its not. We know the total
number of observations in this case happens to be equivalent to the total number
of matches played, hence 6.
So variance can be calculated as –
Variance = [(-1.67) ^2 + (1.33) ^2 + (-0.67) ^2 + (+2.33) ^2 + (-2.67) ^2 + (1.33) ^2] / 6

= 19.33 / 6
= 3.22
Further we will define another variable called ‘Standard Deviation’ (SD) which is
calculated as –
141
std deviation = √ variance
So standard deviation for Billy is –

= SQRT (3.22)
= 1.79
Likewise Mike’s standard deviation works out to be 11.18.
Lets stack up all the numbers (or statistics) here –
Statistics Billy Mike
Sigma 130 133
Mean 21.6 22.16
SD 1.79 11.18
We know what ‘Mean’ and ‘Sigma’ signifies, but what about the SD? Standard
Deviation simply generalizes and represents the deviation from the average.
Here is the text book definition of SD “In statistics, the standard deviation (SD, also
represented by the Greek letter sigma, σ) is a measure that is used to quantify the
amount of variation or dispersion of a set of data values”.
Please don’t get confused between the two sigma’s – the total is also called sigma
represented by the Greek symbol ∑ and standard deviation is also sometimes
referred to as sigma represented by the Greek symbol σ.
One way to use SD is to make a projection on how many runs Billy and Mike are
likely to score in the next match. To get this projected score, you simply need to add
and subtract the SD from their average.
Player Lower Estimate Upper Estimate
Billy 21.6 – 1.79 = 19.81 21.6 + 1.79 = 23.39
142
Mike 22.16 – 11.18 = 10.98 22.16 + 11.18 = 33.34
These numbers suggest that in the upcoming 7th match Billy is likely to get a score
anywhere in between 19.81 and 23.39 while Mike stands to score anywhere
between 10.98 and 33.34. Because Mike has a wide range, it is difficult to figure out
if he is going to score at least 20 runs. He can either score 10 or 34 or anything in
between.
However Billy seems to be more consistent. His range is smaller, which means he
will neither be a big hitter nor a lousy player. He is expected to be a consistent and
is likely to score anywhere between 19 and 23. In other words – selecting Mike over
Billy for the 7th match can be risky.
Going back to our original question, which player do you think is more likely to score
at least 20 runs? By now, the answer must be clear; it has to be Billy. Billy is
consistent and less risky compared to Mike.
So in principal, we assessed the riskiness of these players by using “Standard

Deviation”. Hence ‘Standard Deviation’ must represent ‘Risk’. In the stock market
world, we define ‘Volatility’ as the riskiness of the stock or an index. Volatility is a %
number as measured by standard deviation.
I’ve picked the definition of Volatility from Investopedia for you – “A statistical
measure of the dispersion of returns for a given security or market index. Volatility can
either be measured by using the standard deviation or variance between returns from
that same security or market index. Commonly higher the standard deviation, higher is
the risk”.
143
Going by the above definition, if Infosys and TCS have volatility of 25% and 45%
respectively, then clearly Infosys has less risky price movements when compared to
TCS.
15.3 – Some food for thought

Before I wrap this chapter, let’s do some prediction –
Today’s Date = 15th July 2015
Nifty Spot = 8547
Nifty Volatility = 16.5%
TCS Spot = 2585
TCS Volatility = 27%
Given this information, can you predict the likely range within which Nifty and TCS
will trade 1 year from now?
Of course we can, let us put the numbers to good use –
Asset Lower Estimate Upper Estimate
Nifty 8547 – (16.5% * 8547) = 7136 8547 + (16.5% * 8547) = 9957
TCS 2585 – (27% * 2585) = 1887 2585 + (27% * 2585) = 3282
So the above calculations suggest that in the next 1 year, given Nifty’s volatility, Nifty
is likely to trade anywhere between 7136 and 9957 with all values in between
having varying probability of occurrence. This means to say on 15th July 2016 the
probability of Nifty to be around 7500 could be 25%, while 8600 could be around
40%.
This leads us to a very interesting platform –
1. We estimated the range for Nifty for 1 year; similarly can we estimate the range
Nifty is likely to trade over the next few days or the range within which Nifty is likely
to trade upto the series expiry?
1. If we can do this, then we will be in a better position to identify options that are
likely to expire worthless, meaning we could sell them today and pocket the
premiums.
2. We figured the range in which Nifty is likely to trade in the next 1 year as 7136 and
9957 – but how sure are we? Is there any degree of confidence while expressing this
range?
144
3. How do we calculate Volatility? I know we discussed the same earlier in the chapter,
but is there an easier way? Hint – we could use MS Excel!
4. We calculated Nifty’s range estimating its volatility as 16.5% , what if the volatility
changes?
Over the next few chapters we will answer all these questions and more!
1. Vega measures the rate of change of premium with respect to change in volatility
2. Volatility is not just the up down movement of markets
3. Volatility is a measure of risk
4. Volatility is estimated by standard deviation
5. Standard Deviation is the square root of variance
6. We can estimate the range of the stock price given its volatility
7. Larger the range of a stock, higher is its volatility aka risk.
145
Chapter 16
Volatility Calculation (Historical)

227
16.1 – Calculating Volatility on Excel

In the previous chapter, we introduced the concept of standard deviation and how it
can be used to evaluate ‘Risk or Volatility’ of a stock. Before we move any further on
this topic I would like to discuss how one can calculate volatility. Volatility data is not
easily available, hence its always good to know how to calculate the same yourself.
Of course in the previous chapter we looked into this calculation (recall the Billy &
Mike example), we outlined the steps as follows –
1. Calculate the average

2. Calculate the deviation – Subtract the average from the actual observation
3. Square and add up all deviations – this is called variance
4. Calculate the square root of variance – this is called standard deviation
The purpose of doing this in the previous chapter was to show you the mechanics
behind the standard deviation calculation. In my opinion it is important to know
what really goes beyond a formula, it only enhances your insights. In this chapter
however, we will figure out an easier way to calculate standard deviation or the
volatility of a given stock using MS Excel. MS Excel uses the exact same steps we
outlined above, just that it happens at a click of a button.
I’ll give you the border steps involved first and then elaborate on each step –
1. Download the historical data of closing prices
146
2. Calculate the daily returns
3. Use the STDEV function
So let us get to work straight away.
Step 1 – Download the historical closing prices
You can do this from any data source that you have. Some of the free and reliable
data sources are NSE India website and Yahoo Finance.
I will take the data from NSE India for now. At this point I must tell you that NSE’s
website is quite resourceful, and in terms of information provided, I guess NSE’s
website is one of the best stock exchange websites in the world.
Anyway, in this chapter let us calculate Wipro’s volatility. To download the historical
closing prices, visit
– http://www.nseindia.com/products/content/equities/equities/equities.htm and
click on historical data and select the search option.
Here is a snapshot where I have highlighted the search option –
Once you hit search, a set of fields open up, filling them up is quite self explanatory
– just fill in the required details and hit ‘Get Data’. Do make sure you get the data for
the last 1 year. The dates that I have selected here is from 22nd July 2014 to 21st July
2015.
Once you hit ‘get data’, NSE’s website will query your request and fetch you the
required data. At this point you should see the following screen –
147
Once you get this, click on ‘Download file in CSV format’ (highlighted in the green
box), and that’s it.
You now have the required data on Excel. Of course along with the closing prices,
you have tons of other information as well. I usually like to delete all the other
unwanted data and stick to just the date and closing price. This makes the sheet
look clutter free and crisp.
Here is a snapshot of how my excel sheet looks at this stage –
Do note, I have deleted all the unnecessary information. I have retained just the
date and closing prices.
Step 2 – Calculate Daily Returns
We know that the daily returns can be calculated as –
Return = (Ending Price / Beginning Price) – 1
148
However for all practical purposes and ease of calculation, this equation can be
approximated to:
Return = LN (Ending Price / Beginning Price), where LN denotes Logarithm to

Base ‘e’, note this is also called ‘Log Returns’.
Here is a snap shot showing you how I’ve calculated the daily log returns of WIPRO –
I have used the Excel function ‘LN’ to calculate the long returns.
Step 3 – Use the STDEV Function
Once the daily returns are calculated, you can use an excel function called ‘STDEV’ to
calculate the standard deviation of daily returns, which if you realize is the daily
Volatility of WIPRO.
Note – In order to use the STDEV function all you need to do is this –
1. Take the cursor an empty cell

2. Press ‘=’
3. Follow the = sign by the function syntax i.e STDEV and open a bracket, hence the
empty cell would look like =STEDEV(
4. After the open bracket, select all the daily return data points and close the bracket
5. Press enter
Here is the snapshot which shows the same –
149
Once this is done, Excel will instantly calculate the daily standard deviation aka
volatility of WIPRO for you. I get the answer as 0.0147 which when converted to a
percentage reads as 1.47%.
This means the daily volatility of WIPRO is 1.47% !
The value we have calculated is WIPRO’s daily volatility, but what about its annual
volatility?
Now here is a very important convention you will have to remember – in order to
convert the daily volatility to annual volatility just multiply the daily volatility number
with the square root of time.
Likewise to convert the annual volatility to daily volatility, divide the annual volatility
by square root of time.
So in this case we have calculated the daily volatility, and we now need WIPRO’s
annual volatility. We will calculate the same here –
o Daily Volatility = 1.47%

o Time = 365
o Annual Volatility = 1.47% * SQRT (365)
o = 28.08%
In fact I have calculated the same on excel, have a look at the image below –
150
So with this, we know WIPRO’s daily volatility is 1.47% and its annual volatility is
about 28%.
Lets double check these numbers with what the NSE has published on their website.
NSE publishes these numbers only for F&O stocks and not other stocks. Here is the
snapshot of the same –
151
Our calculation is pretty much close to what NSE has calculated – as per NSE’s
calculation Wipro’s daily volatility is about 1.34% and Annualized Volatility is about
25.5%.
So why is there a slight difference between our calculation and NSE’s? – One
possible reason could be that we are using spot price while NSE is using Futures
price. However I really don’t want to get into investigating why this slight difference
exists. The agenda here is to know how to calculate the volatility of the security
given its daily returns.
Before we wrap up this chapter, let us just do one more calculation. Assume we
directly get the annual volatility of WIPRO as 25.5%, how do we figure out its daily
volatility?
Like I mentioned earlier, to convert annual volatility to daily volatility you simply
have to divide the annual volatility by the square root of time, hence in this
particular case –
152
= 25.5% / SQRT (365)
= 1.34%
So far we have understood what volatility is and how to calculate the same. In the
next chapter we will understand the practical application of volatility.
Do remember we are still in the process of understanding volatility; however the

final objective is to understand the option greek Vega and that really means. So
please do not lose sight of our end objective.
Please click here to download the excel sheet.
1. Standard Deviation represents volatility, which in turn represents risk

2. We can use NSE website to get the daily closing prices of securities
3. Daily return can be calculated as log returns
4. Log function in excel is LN
5. Daily return formula = LN (Today’s Value / Yesterday’s Value) expressed as a
percentage
6. Excel function to calculate volatility is STDEV
7. Standard Deviation of daily return is equivalent of daily volatility
8. To convert daily volatility to annual volatility multiply the daily volatility by the
square root of time
9. Likewise to convert annual volatility to daily volatility, divide the annual volatility by
the square root of time
153
Chapter 17
Volatility & Normal Distribution

214
17.1 – Background
In the earlier chapter we had this discussion about the range within which Nifty is
likely to trade given that we know its annualized volatility. We arrived at an upper
and lower end range for Nifty and even concluded that Nifty is likely to trade within
the calculated range.
Fair enough, but how sure are we about this? Is there a possibility that Nifty would
trade outside this range? If yes, what is the probability that it will trade outside the
range and what is the probability that Nifty will trade within the range? If there is an
outside range, then what are its values?
Finding answers to these questions are very important for several reasons. If not for
anything it will lay down a very basic foundation to a quantitative approach to
markets, which is very different from the regular fundamental and technical analysis
thought process.
So let us dig a bit deeper and get our answers.
17.2 – Random Walk

The discussion we are about to have is extremely important and highly relevant to
the topic at hand, and of course very interesting as well.
154
What you see is called a ‘Galton Board’. A Galton Board has pins stuck to a board.
Collecting bins are placed right below these pins.
The idea is to drop a small ball from above the pins. Moment you drop the ball, it
encounters the first pin after which the ball can either turn left or turn right before it
encounters another pin. The same procedure repeats until the ball trickles down
and falls into one of the bins below.
Do note, once you drop the ball from top, you cannot do anything to artificially
control the path that the ball takes before it finally rests in one of the bins. The path
that the ball takes is completely natural and is not predefined or controlled. For this
particular reason, the path that the ball takes is called the ‘Random Walk’.
Now, can you imagine what would happen if you were to drop several such balls
one after the other? Obviously each ball will take a random walk before it falls into
one of the bins. However what do you think about the distribution of these balls in
the bins?.
o Will they all fall in the same bin? or

o Will they all get distributed equally across the bins? or
o Will they randomly fall across the various bins?
I’m sure people not familiar with this experiment would be tempted to think that the
balls would fall randomly across various bins and does not really follow any
particular pattern. But this does not happen, there seems to be an order here.
155
It appears that when you drop several balls on the Galton Board, with each ball
taking a random walk, they all get distributed in a particular way –
o Most of the balls tend to fall in the central bin

o As you move further away from the central bin (either to the left or right), there are
fewer balls
o The bins at extreme ends have very few balls
A distribution of this sort is called the “Normal Distribution”. You may have heard
of the bell curve from your school days, bell curve is nothing but the normal
distribution. Now here is the best part, irrespective of how many times you repeat
this experiment, the balls always get distributed to form a normal distribution.
This is a very popular experiment called the Galton Board experiment; I would
strongly recommend you to watch this beautiful video to understand this discussion
better –
So why do you think we are discussing the Galton Board experiment and the
Normal Distribution?
Well many things in real life follow this natural order. For example –
o Gather a bunch of adults and measure their weights – segregate the weights across
bins (call them the weight bins) like 40kgs to 50kgs, 50kgs to 60kgs, 60kgs to 70kgs
156
etc. Count the number of people across each bin and you end up getting a normal
distribution
o Conduct the same experiment with people’s height and you will end up getting a
normal distribution
o You will get a Normal Distribution with people’s shoe size
o Weight of fruits, vegetables
o Commute time on a given route
o Lifetime of batteries
This list can go on and on, however I would like to draw your attention to one more
interesting variable that follows the normal distribution – the daily returns of a
stock!
The daily returns of a stock or an index cannot be predicted – meaning if you were
to ask me what will be return on TCS tomorrow I will not be able to tell you, this is
more like the random walk that the ball takes. However if I collect the daily returns
of the stock for a certain period and see the distribution of these returns – I get to
see a normal distribution aka the bell curve!
To drive this point across I have plotted the distribution of the daily returns of the
following stocks/indices –
o Nifty (index)
o Bank Nifty ( index)
o TCS (large cap)
o Cipla (large cap)
o Kitex Garments (small cap)
o Astral Poly (small cap)
157
As you can see the daily returns of the stocks and indices clearly follow a normal
distribution.
Fair enough, but I guess by now you would be curious to know why is this important
and how is it connected to Volatility? Bear with me for a little longer and you will
know why I’m talking about this.
158
17.3 – Normal Distribution
I think the following discussion could be a bit overwhelming for a person exploring
the concept of normal distribution for the first time. So here is what I will do – I will
explain the concept of normal distribution, relate this concept to the Galton board
experiment, and then extrapolate it to the stock markets. I hope this will help you
grasp the gist better.
So besides the Normal Distribution there are other distributions across which data
can be distributed. Different data sets are distributed in different statistical ways.
Some of the other data distribution patterns are – binomial distribution, uniform
distribution, poisson distribution, chi square distribution etc. However the normal
distribution pattern is probably the most well understood and researched
distribution amongst the other distributions.
The normal distribution has a set of characteristics that helps us develop insights
into the data set. The normal distribution curve can be fully described by two
numbers – the distribution’s mean (average) and standard deviation.
The mean is the central value where maximum values are concentrated. This is the
average value of the distribution. For instance, in the Galton board experiment the
mean is that bin which has the maximum numbers of balls in it.
159
So if I were to number the bins (starting from the left) as 1, 2, 3…all the way upto 9
(right most), then the 5thbin (marked by a red arrow) is the ‘average’ bin. Keeping the
average bin as a reference, the data is spread out on either sides of this average
reference value. The way the data is spread out (dispersion as it is called) is
quantified by the standard deviation (recollect this also happens to be the volatility
in the stock market context).
Here is something you need to know – when someone says ‘Standard Deviation (SD)’
by default they are referring to the 1st SD. Likewise there is 2nd standard deviation
(2SD), 3rd standard deviation (SD) etc. So when I say SD, I’m referring to just the
standard deviation value, 2SD would refer to 2 times the SD value, 3 SD would refer
to 3 times the SD value so on and so forth.
For example assume in case of the Galton Board experiment the SD is 1 and
average is 5. Then,
o 1 SD would encompass bins between 4th bin (5 – 1 ) and 6th bin (5 + 1). This is 1 bin to
the left and 1 bin to the right of the average bin
o 2 SD would encompass bins between 3rd bin (5 – 2*1) and 7th bin (5 + 2*1)
o 3 SD would encompass bins between 2nd bin (5 – 3*1) and 8th bin (5 + 3*1)
Now keeping the above in perspective, here is the general theory around the
normal distribution which you should know –
o Within the 1st standard deviation one can observe 68% of the data
160
o Within the 2nd standard deviation one can observe 95% of the data
o Within the 3rd standard deviation one can observe 99.7% of the data
The following image should help you visualize the above –
Applying this to the Galton board experiment –
o Within the 1st standard deviation i.e between 4th and 6th bin we can observe that 68%
of balls are collected
o Within the 2nd standard deviation i.e between 3rd and 7th bin we can observe that 95%
of balls are collected
o Within the 3rd standard deviation i.e between 2nd and 8th bin we can observe that
99.7% of balls are collected
Keeping the above in perspective, let us assume you are about to drop a ball on the
Galton board and before doing so we both engage in a conversation –
You – I’m about to drop a ball, can you guess which bin the ball will fall into?
Me – No, I cannot as each ball takes a random walk. However, I can predict the
range of bins in which it may fall
You – Can you predict the range?
Me – Most probably the ball will fall between the 4th and the 6th bin
You – Well, how sure are you about this?
Me – I’m 68% confident that it would fall anywhere between the 4th and the 6th bin
You – Well, 68% is a bit low on accuracy, can you estimate the range with a greater
accuracy?
161
Me – Sure, I can. The ball is likely to fall between the 3rd and 7th bin, and I’m 95% sure
about this. If you want an even higher accuracy then I’d say that the ball is likely to
fall between the 2nd and 8th bin and I’m 99.5% sure about this
You – Nice, does that mean there is no chance for the ball to fall in either the 1st or
10th bin?
Me – Well, there is certainly a chance for the ball to fall in one of the bins outside
the 3rd SD bins but the chance is very low
You – How low?
Me – The chance is as low as spotting a ‘Black Swan’ in a river. Probability wise, the
chance is less than 0.5%
You – Tell me more about the Black Swan
Me – Black Swan ‘events’ as they are called, are events (like the ball falling in 1st or
10th bin) that have a low probability of occurrence. But one should be aware that
black swan events have a non-zero probability and it can certainly occur – when and
how is hard to predict. In the picture below you can see the occurrence of a black
swan event –
In the above picture there are so many balls that are dropped, but only a handful of
them collect at the extreme ends.
162
17.4 – Normal Distribution and stock returns
Hopefully the above discussion should have given you a quick introduction to the
normal distribution. The reason why we are talking about normal distribution is that
the daily returns of the stock/indices also form a bell curve or a normal distribution.
This implies that if we know the mean and standard deviation of the stock return,
then we can develop a greater insight into the behavior of the stock’s returns or its
dispersion. For sake of this discussion, let us take up the case of Nifty and do
some analysis.
To begin with, here is the distribution of Nifty’s daily returns is –
As we can see the daily returns are clearly distributed normally. I’ve calculated the
average and standard deviation for this distribution (in case you are wondering how
to calculate the same, please do refer to the previous chapter). Remember to
calculate these values we need to calculate the log daily returns.
o Daily Average / Mean = 0.04%

o Daily Standard Deviation / Volatility = 1.046%
o Current market price of Nifty = 8337
Do note, an average of 0.04% indicates that the daily returns of nifty are centered at
0.04%. Now keeping this information in perspective let us calculate the following
things –
o The range within which Nifty is likely to trade in the next 1 year
o The range within which Nifty is likely to trade over the next 30 days.
For both the above calculations, we will use 1 and 2 standard deviation meaning
with 68% and 95% confidence.
Solution 1 – (Nifty’s range for next 1 year)
163
Average = 0.04%
SD = 1.046%
Let us convert this to annualized numbers –
Average = 0.04*252 = 9.66%

SD = 1.046% * Sqrt (252) = 16.61%
So with 68% confidence I can say that the value of Nifty is likely to be in the range of
–
= Average + 1 SD (Upper Range) and Average – 1 SD (Lower Range)

= 9.66% + 16.61% = 26.66%
= 9.66% – 16.61% = -6.95%
Note these % are log percentages (as we have calculated this on log daily returns),
so we need to convert these back to regular %, we can do that directly and get the
range value (w.r.t to Nifty’s CMP of 8337) –
Upper Range
= 8337 *exponential (26.66%)
= 10841
And for lower range –
= 8337 * exponential (-6.95%)

= 7777
The above calculation suggests that Nifty is likely to trade somewhere between 7777
and 10841. How confident I am about this? – Well as you know I’m 68% confident
about this.
Let us increase the confidence level to 95% or the 2 nd standard deviation and check
what values we get –
Average + 2 SD (Upper Range) and Average – 2 SD (Lower Range)

= 9.66% + 2* 16.61% = 42.87%
= 9.66% – 2* 16.61% = -23.56%
Hence the range works out to –
Upper Range
= 8337 *exponential (42.87%)
= 12800
164
= 8337 * exponential (-23.56%)
= 6587
The above calculation suggests that with 95% confidence Nifty is likely to trade
anywhere in the range of 6587 and 12800 over the next one year. Also as you can
notice when we want higher accuracy, the range becomes much larger.
I would suggest you do the same exercise for 99.7% confidence or with 3SD and
figure out what kind of range numbers you get.
Now, assume you do the range calculation of Nifty at 3SD level and get the lower
range value of Nifty as 5000 (I’m just quoting this as a place holder number here),
does this mean Nifty cannot go below 5000? Well it certainly can but the chance of
going below 5000 is low, and if it really does go below 5000 then it can be termed as
a black swan event. You can extend the same argument to the upper end range as
well.
Solution 2 – (Nifty’s range for next 30 days)
We know the daily mean and SD –
Average = 0.04%
SD = 1.046%
Since we are interested in calculating the range for next 30 days, we need to convert
the same for the desired time period –
Average = 0.04% * 30 = 1.15%

SD = 1.046% * sqrt (30) = 5.73%
So with 68% confidence I can say that, the value of Nifty over the next 30 days is
likely to be in the range of –
= Average + 1 SD (Upper Range) and Average – 1 SD (Lower Range)

= 1.15% + 5.73% = 6.88%
= 1.15% – 5.73% = – 4.58%
Note these % are log percentages, so we need to convert them back to regular %,
we can do that directly and get the range value (w.r.t to Nifty’s CMP of 8337) –
= 8337 *exponential (6.88%)

= 8930
= 8337 * exponential (-4.58%)

= 7963
165
The above calculation suggests that with 68% confidence level I can estimate Nifty to
trade somewhere between 8930 and 7963 over the next 30 days.
Let us increase the confidence level to 95% or the 2 nd standard deviation and check
what values we get –
Average + 2 SD (Upper Range) and Average – 2 SD (Lower Range)

= 1.15% + 2* 5.73% = 12.61%
= 1.15% – 2* 5.73% = -10.31%
Hence the range works out to –
= 8337 *exponential (12.61%)

= 9457 (Upper Range)
= 8337 * exponential (-10.31%)

= 7520
I hope the above calculations are clear to you. You can also download the MS excel
that I’ve used to make these calculations.
Of course you may have a very valid point at this stage – normal distribution is fine,
but how do I get to use the information to trade? I guess as such this chapter is
quite long enough to accommodate more concepts. Hence we will move the
application part to the next chapter. In the next chapter we will explore the
applications of standard deviation (volatility) and its relevance to trading. We will
discuss two important topics in the next chapter (1) How to select strikes that can be
sold/written using normal distribution and (2) How to set up stoploss using volatility.
Of course, do remember eventually the idea is to discuss Vega and its effect on
options premium.
1. The daily returns of the stock is a random walk, highly difficult to predict
2. The returns of the stock is normally distributed or rather close to normal
distribution
3. In a normal distribution the data is centered around the mean and the dispersion is
measured by the standard deviation
4. Within 1 SD we can observe 68% of the data
5. Within 2 SD we can observe 95% of the data
6. Within 3 SD we can observe 99.5% of the data
166
7. Events occurring outside the 3rd standard deviation are referred to as Black Swan
events
8. Using the SD values we can calculate the upper and lower value of stocks/indices
167
Chapter 18
Volatility Applications
251
18.1 – Striking it right

The last couple of chapters have given a basic understanding on volatility, standard
deviation, normal distribution etc. We will now use this information for few practical
trading applications. At this stage I would like to discuss two such applications –
1. Selecting the right strike to short/write

2. Calculating the stoploss for a trade
However at a much later stage (in a different module altogether) we will explore the
applications under a different topic – ‘Relative value Arbitrage (Pair Trading) and
Volatility Arbitrage’. For now we will stick to trading options and futures.
One of the key challenges an option writer always faces is to select the right strike
so that he can write that option, collect the premium, and not really be worried
about the possibility of the spot moving against him. Of course, the worry of spot
moving against the option writer will always exist, however a diligent trader can
minimize this.
Normal Distribution helps the trader minimize this worry and increase his
confidence while writing options.
Let’s have a quick recap –
168
The bell curve above suggests that with reference to the mean (average) value –
1. 68% of the data is clustered around mean within the 1st SD, in other words there is a
68% chance that the data lies within the 1st SD
2. 95% of the data is clustered around mean within the 2nd SD, in other words there is a
95% chance that the data lies within the 2nd SD
3. 99.7% of the data is clustered around mean within the 3rd SD, in other words there
is a 99.7% chance that the data lies within the 3rd SD
Since we know that Nifty’s daily returns are normally distributed, the above set of
properties is applicable to Nifty. So what does it mean?
This means, if we know Nifty’s mean and SD then we can pretty much make an
‘educated guess’ about the range within which Nifty is likely to trade over the
selected time frame. Take this for example –
o Date = 11th August 2015

o Number of days for expiry = 16
o Nifty current market price = 8462
o Daily Average Return = 0.04%
o Annualized Return = 14.8%
o Daily SD = 0.89%
o Annualized SD = 17.04%
Given this I would now like to identify the range within which Nifty will trade until
expiry i.e 16 days from now –
16 day SD = Daily SD *SQRT (16)

= 0.89% * SQRT (16)
= 3.567%
169
16 day average = Daily Avg * 16
= 0.04% * 16 = 0.65%
These numbers will help us calculate the upper and lower range within which Nifty
is likely to trade over the next 16 days –
Upper Range = 16 day Average + 16 day SD
= 0.65% + 3.567%
= 4.215%, to get the upper range number –
= 8462 * (1+4.215%)
= 8818
Lower Range = 16 day Average – 16 day SD
= 0.65% – 3.567%
= 2.920% to get the lower range number –
= 8462 * (1 – 2.920%)
= 8214
The calculation suggests that Nifty is likely to trade anywhere in the region of 8214
to 8818. How sure are we about this, well we know that there is a 68% probability
for this calculation to work in our favor. In other words there is 32% chance for Nifty
to trade outside 8214 and 8818 range. This also means all strikes outside the
calculated range ‘may’ go worthless.
Hence –
o You can sell all call options above 8818 and collect the premiums because they are
likely to expire worthless
o You can sell all put options below 8214 and collect the premiums because they are
likely to expire worthless
Alternatively if you were thinking of buying Call options above 8818 or Put options
below 8214 you may want to think twice, as you now know that there is a very little
chance for these options to expire in the money, hence it makes sense to avoid
buying these strikes.
Here is the snapshot of all Nifty Call option strikes above 8818 that you can choose
to write (short) and collect premiums –
170
If I were to personally select a strike today it would be either 8850 or 8900 or
probably both and collect Rs.7.45 and Rs.4.85 in premium respectively. The reason
to select these strikes is simple – I see an acceptable balance between risk (1 SD
away) and reward (7.45 or 4.85 per lot).
I’m certain many of you may have this thought – if I were to write the 8850 Call
option and collect Rs.7.45 as premium, it does not really translate to any meaningful
amount. After all, at Rs.7.45 per lot it translates to –
= 7.45 * 25 (lot size)
= Rs.186.25
Well, this is exactly where many traders miss the plot. I know many who think about
the gains or loss in terms of absolute value and not really in terms of return on
investment.
Think about it, margin amount required to take this trade is roughly Rs.12,000/-. If
you are not sure about the margin requirement then I would suggest you use
Zerodha’s margin calculator.
The premium amount of Rs.186.25/- on a margin deposit of Rs.12,000/- works out to

a return of 1.55%, which by any stretch on imagination is not a bad return,
especially for a 16 day holding period! If you can consistently achieve this every
month, then we are talking about a return of over 18% annualized just by means of
option writing.
171
I personally use this strategy to write options and I’d like to share some of my
thoughts regarding this –
Put Options – I don’t like to short PUT options for the simple reason that panic
spreads faster than greed. If there is panic in the market, the fall in market can be
much quicker than you can imagine. Hence even before you can realize the OTM
option that you have written can soon become ATM or ITM. Therefore it is better to
avoid than regret.
Call Options – You inverse the above point and you will understand why writing call
options are better than writing put options. For example in the Nifty example above,
for the 8900 CE to become ATM or ITM Nifty has to move 438 points over 16 days.
For this to happen, there has to be excess greed in the market…and like I said
earlier a 438 up move takes a bit longer than 438 down move. Therefore my
preference to short only call options.
Strike identification – I do the whole exercise of identifying the strike (SD, mean
calculation, converting the same w.r.t to number days to expiry, selecting
appropriate strike only the week before expiry and not before that. The timing here
is deliberate
Timing – I prefer to short options only on the last Friday before the expiry week. For
example given the August 2015 series expiry is on 27th, I’d short the call option only
on 21st August around the closing. Why do I do this? This is to mainly ensure that
theta works in my favor. Remember the ‘time decay’ graph we discussed in the theta
chapter? The graph makes it amply evident that theta kicks in full force as we
approach expiry.
Premium Collected – Because I write call options very close to expiry, the
premiums are invariably low. The premium that I collect is around Rs.5 or 6 on Nifty
Index, translating to about 1.0% return. But then I find the trade quite comforting
for two reasons – (1) For the trade to work against me Nifty has to move 1 SD over 4
days, something that does not happen frequently (2) Theta works in my favor, the
premiums erode much faster during the last week of expiry favoring the option
seller
Why bother ? – Most of you may have this thought that the premiums are so low,
why should I even bother? Honestly I too had this thought initially; however over
time I have realized that trades with the following characteristics makes sense to me
–
o Visibility on risk and reward – both should be quantifiable

o If a trade is profitable today then I should be able to replicate the same again
tomorrow
o Consistency in finding the opportunities
172
o Assessment of worst case scenarios
This strategy ticks well on all counts above, hence my preference.
SD consideration – When I’m writing options 3-4 days before expiry I prefer to write
1 SD away, however for whatever reason when I’m writing the option much earlier
then I prefer to go 2 SD away. Remember higher the SD consideration, higher is the
confidence level but lower is the premium that you can collect. Also, as a thumb rule
I never write options when there is more than 15 days for expiry.
Events – I avoid writing options whenever there are important market events such
as monetary policy, policy decision, corporate announcement etc. This is because
the markets tend to react sharply to events and therefore a good chance of getting
caught on the wrong side. Hence it is better safe than sorry.
Black Swan – I’m completely aware that despite all the precaution, markets can
move against me and I could get caught on the wrong side. The price you pay for
getting caught on the wrong side, especially for this trade is huge. Imagine you
collect 5 or 6 points as premium but if you are caught on the wrong side you end up
paying 15 or 20 points or more. So all the small profits you made over 9 to 10
months is given away in 1 month. In fact the legendary Satyajit Das in his highly
insightful book “Traders, Guns, and Money” talks about option writing as “eating like
a hen but shitting like an elephant’.
The only way to make sure you minimize the impact of a black swan event is to be
completely aware that it can occur anytime after you write the option. So here is my
advice to you in case you decide to adopt this strategy – track the markets and
gauge the market sentiment all along. The moment you sense things are going
wrong be quick to exit the trade.
Success Ratio – Option writing keeps you on the edge of the seat. There are times
when you feel that markets are going against you (fear of black swan creeps in) but
only to cool off eventually. When you write options such roller coaster feelings are
bound to emerge. The worst part is that during this roller coaster ride you may be
forced to believe that the market is going against you (false signal) and hence you
get out of a potentially profitable trade.
In fact there is a very thin line between a false signal and an actual black swan
event. The way to overcome this is by developing conviction in your trades.
Unfortunately I cannot teach you conviction; you will have to develop that on your
own J. However your conviction improves as and when you do more of these trades
(and all trades should be backed by sound reasoning and not blind guesses).
Also, I personally get out of the trade when the option transitions from OTM to ATM.
Expenses – The key to these trades is to keep your expense to bear minimum so
that you can retain maximum profits for yourself. The expenses include brokerage
173
and applicable charges. If you short 1 lot of Nifty options and collect Rs.7 as
premium then you will have to let go few points as expense. If you are trading with
Zerodha, your expense will be around 1.95 for 1 lot. The higher the number of lots
the lesser is your expense. So if I were trading 10 lots (with Zerodha) instead of 1,
my expense drastically comes down to 0.3 points. You can use Zerodha’s brokerage
calculator to get the details.
The cost varies broker to broker so please do make sure your broker is not greedy
by charging you ridiculous brokerage fees. Even better, if you are not with Zerodha,
it is about time you join us and become a part of our beautiful family
Capital Allocation – An obvious question you might have at this stage – how much
money do I deploy to this trade? Do I risk all my capital or only a certain %? If it’s a %,
then how much would it be? There is no straight forward answer to this; hence I’ll
take this opportunity to share my asset allocation technique.
I’m a complete believer in equities as an asset class, so this rules out investment in
Gold, Fixed Deposit, and Real Estate for me. 100% of my capital (savings) is invested
in equity and equity based products. However it is advisable for any individual to
diversify capital across multiple asset classes.
So within Equity, here is how I split my money –
o 35% of my money is invested in equity based mutual funds via SIP (systematic
investment plan) route. I have further divided this across 4 funds.
o 40% of my capital in an equity portfolio of about 12 stocks. I consider both mutual
funds and equity portfolio as long term investments (5 years and beyond).
o 25% is earmarked for short term strategies.
The short term strategies include a bunch of trading strategies such as –
o Momentum based swing trades (futures)

o Overnight futures/options/stock trades
o Intraday trades
o Option writing
I make sure that I do not expose more than 35% of the 25% capital for any particular
strategy. Just to make it more clear, assume I have Rs.500,000/- as my capital, here
is how I would split my money –
o 35% of Rs.500,000/- i.e Rs.175,000/- goes to Mutual Funds

o 40% of Rs.500,000/- i.e Rs.200,000/- goes to equity portfolio
o 25% of Rs.500,000/- i.e Rs.125,000/- goes to short term trading
o 35% of Rs.125,000/- i.e Rs.43,750/- is the maximum I would allocate per trade
174
o Hence I will not short more than 4 lots of options
o 43,750/- is about 8.75% of the overall capital of Rs.500,000/-
So this self mandated rule ensures that I do not expose more than 9% of my over all
capital to any particular short term strategies including option writing.
Instruments – I prefer running this strategy on liquid stocks and indices. Besides
Nifty and Bank Nifty I run this strategy on SBI, Infosys, Reliance, Tata Steel, Tata
Motors, and TCS. I rarely venture outside this list.
So here is what I would suggest you do. Run the exercise of calculating the SD and
mean for Nifty, Bank Nifty on the morning of August 21st (5 to 7 days before expiry).
Identify strikes that are 1 SD away from the market price and write them virtually.
Wait till the expiry and experience how this trade goes. If you have the bandwidth
you can run this across all the stocks that I’ve mentioned. Do this diligently for few
expiries before you can deploy capital.
Lastly, as a standard disclaimer I have to mention this – the thoughts expressed

above suits my risk reward temperament, which could be very different from yours.
Everything that I mentioned here comes from my own personal trading experience,
these are not standard practices.
I would suggest you note these points, understand your own risk-reward
temperament, and calibrate your strategy. Hopefully the pointers here should help
you develop that orientation.
This is quite contradicting to this chapter but I have to recommend you to read
Nassim Nicholas Taleb’s “Fooled by Randomness” at this point. The book makes you
question and rethink everything that you do in markets (and life in general). I think
just being completely aware of what Taleb writes in his book along with the actions
you take in markets puts you in a completely different orbit.
18.2 – Volatility based stoploss

The discussion here is a digression from Options, in fact this would have been more
apt in the futures trading module, but I think we are at the right stage to discuss this
topic.
The first thing you need to identify before you initiate any trade is to identify the
stop-loss (SL) price for the trade. As you know, the SL is a price point beyond which
you will not take any further losses. For example, if you buy Nifty futures at 8300,
you may identify 8200 as your stop-loss level; you will be risking 100 points on this
particular trade. The moment Nifty falls below 8200, you exit the trade taking the
loss. The question however is – how to identify the appropriate stop-loss level?
One standard approach used by many traders is to keep a standard pre-fixed

percentage stop-loss. For example one could have a 2% stop-loss on every trade. So
175
if you are to buy a stock at Rs.500, then your stop-loss price is Rs.490 and you risk
Rs.10 (2% of Rs.500) on this trade. The problem with this approach lies in the rigidity
of the practice. It does not account for the daily noise / volatility of the stock. For
example the nature of the stock could be such that it could swing about 2-3% on a
daily basis. As a result you could be right about the direction of the trade but could
still hit a ‘stop-loss’. More often than not, you would regret keeping such tight stops.
An alternate and effective method to identify a stop-loss price is by estimating the

stock’s volatility. Volatility accounts for the daily ‘expected’ fluctuation in the stock
price. The advantage with this approach is that the daily noise of the stock is
factored in. Volatility stop is strategic as it allows us to place a stop at the price
point which is outside the normal expected volatility of the stock. Therefore a
volatility SL gives us the required logical exit in case the trade goes against us.
Let’s understand the implementation of the volatility based SL with an example.
This is the chart of Airtel forming a bullish harami, people familiar with the pattern
would immediately recognize this is an opportunity to go long on the stock, keeping
the low of the previous day (also coinciding with a support) as the stoploss. The
target would be the immediate resistance – both S&R points are marked with a blue
line. Assume you expect the trade to materialize over the next 5 trading sessions.
The trade details are as follows –
o Long @ 395
o Stop-loss @ 385
176
o Target @ 417
o Risk = 395 – 385 = 10 or about 2.5% below entry price
o Reward = 417 – 385 = 32 or about 8.1% above entry price
o Reward to Risk Ratio = 32/10 = 3.2 meaning for every 1 point risk, the expected
reward is 3.2 point
This sounds like a good trade from a risk to reward perspective. In fact I personally
consider any short term trade that has a Reward to Risk Ratio of 1.5 as a good trade.
However everything hinges upon the fact that the stoploss of 385 is sensible.
Let us make some calculations and dig a little deeper to figure out if this makes
sense –
Step 1: Estimate the daily volatility of Airtel. I’ve done the math and the daily
volatility works out to 1.8%
Step 2: Convert the daily volatility into the volatility of the time period we are
interested in. To do this, we multiply the daily volatility by the square root of time. In
our example, our expected holding period is 5 days, hence the 5 day volatility is
equal to 1.8%*Sqrt(5). This works out to be about 4.01%.
Step 3. Calculate the stop-loss price by subtracting 4.01% (5 day volatility) from the
expected entry price. 395 – (4.01% of 395) = 379. The calculation above indicates
that Airtel can swing from 395 to 379 very easily over the next 5 days. This also
means, a stoploss of 385 can be easily knocked down. So the SL for this trade has be
a price point below 379, lets say 375, which is 20 points below the entry price of 395.
Step 4 : With the new SL, the RRR works out to 1.6 (32/20), which still seems ok to
me. Hence I would be happy to initiate the trade.
Note : In case our expected holding period is 10 days, then the 10 day volatility
would be 1.6*sqrt(10) so on and so forth.
Pre-fixed percentage stop-loss does not factor in the daily fluctuation of the stock
prices. There is a very good chance that the trader places a premature stop-loss,
well within the noise levels of the stock. This invariably leads to triggering the stop-
loss first and then the target.
Volatility based stop-loss takes into account all the daily expected fluctuation in the
stock prices. Hence if we use a stocks volatility to place our stop-loss, then we would
be factoring in the noise component and in turn placing a more relevant stop loss.
o You can use SD to identify strikes that you can write
177
o Avoid shorting PUT options
o Strikes 1 SD away offers 68% flexibility, if you need higher flexibility you could opt
for 2SD
o Higher the SD, higher is the range, and lower is the premium collected
o Allocate capital based on your belief in asset classes. It is always advisable to invest
across asset classes
o It always makes sense to place SL based on daily volatility of the stock
178
Chapter 19
Vega
168
19.1 – Volatility Types

The last few chapters have laid a foundation of sorts to help us understand Volatility
better. We now know what it means, how to calculate the same, and use the
volatility information for building trading strategies. It is now time to steer back to
the main topic – Option Greek and in particular the 4th Option Greek “Vega”. Before
we start digging deeper into Vega, we have to discuss one important topic – Quentin
Tarantino .
I’m huge fan of Quentin Tarantino and his movies. For people not familiar with
Quentin Tarantino let me tell you, he is one of the most talented directors in
Hollywood. He is the man behind super cult flicks such as Pulp Fiction, Kill Bill,
Reservoir Dogs, Django Unchained etc. If you’ve not watched his movies, I’d suggest
you do, you may just love these movies as much as I do.
It is a known fact that when Quentin Tarantino directs a movie, he keeps all the
production details under wraps until the movies trailer hits the market. Only after
the trailer is out people get to know the name of movie, star cast details, brief story
line, movie location etc. However, this is not the case with the movie he is directing
these days, titled “The Hateful Eight”, due to be released in December 2015.
Somehow everything about ‘The Hateful Eight’ – the star cast, storyline, location etc
is leaked, hence people already know what to expect from Tarantino. Now given
that most of the information about the movie is already known, there are wild
speculations about the box office success of his upcoming movie.
We could do some analysis on this –
1. Past movies – We know almost all of Tarantino’s previous movies were successful.
Based on his past directorial performance we can be reasonably certain that ‘The
Hateful Eight’ is likely to be a box office hit
2. Movie Analyst’s forecast – There are these professional Hollywood movie analysts,
who understand the business of cinema very well. Some of these analysts are
forecasting that ‘The Hateful Eight’ may not do well (unlike his previous flicks) as
most of the details pertaining to the movie is already, failing to enthuse the
audience
3. Social Media – If you look at the discussions on ‘The Hateful Eight’ on social media
sites such as Twitter and Facebook, you’d realize that a lot of people are indeed
179
excited about the movie, despite knowing what to expect from the movie. Going by
the reactions on Social Media, ‘The Hateful Eight’ is likely to be a hit.
4. The actual outcome – Irrespective of what really is being expected, once the movie
is released we would know if the movie is a hit or a flop. Of course this is the final
verdict for which we have to wait till the movie is released.
Tracking the eventual fate of the movie is not really our concern, although I’m
certainly going to watch the movie .
Given this, you may be wondering why we are even discussing Quentin Tarantino in
a chapter concerning Options and Volatility! Well this is just my attempt (hopefully
not lame) to explain the different types of volatility that exist – Historical Volatility,
Forecasted Volatility, and Implied Volatility. So let’s get going.
Historical Volatility is similar to us judging the box office success of ‘The Hateful
Eight’ based on Tarantino’s past directorial ventures. In the stock market world, we
take the past closing prices of the stock/index and calculate the historical volatility.
Do recall, we discussed the technique of calculating the historical volatility in
Chapter 16. Historical volatility is very easy to calculate and helps us with most of
the day to day requirements – for instance historical volatility can ‘somewhat’ be
used in the options calculator to get a ‘quick and dirty’ option price (more on this in
the subsequent chapters).
Forecasted Volatility is similar to the movie analyst attempting to forecast the fate
of ‘The Hateful Eight’. In the stock market world, analysts forecast the volatility.
Forecasting the volatility refers to the act of predicting the volatility over the desired
time frame.
However, why would you need to predict the volatility? Well, there are many option
strategies, the profitability of which solely depends on your expectation of volatility.
If you have a view of volatility – for example you expect volatility to increase by
12.34% over the next 7 trading sessions, then you can set up option strategies which
can profit this view, provided the view is right.
Also, at this stage you should realize – to make money in the stock markets it is NOT
necessary to have a view on the direction on the markets. The view can be on
volatility as well. Most of the professional options traders trade based on volatility
and not really the market direction. I have to mention this – many traders find
forecasting volatility is far more efficient than forecasting market direction.
Now clearly having a mathematical/statistical model to predict volatility is much

better than arbitrarily declaring “I think the volatility is going to shoot up”. There are
a few good statistical models such as ‘Generalized AutoRegressive Conditional
Heteroskedasticity (GARCH) Process’. I know it sounds spooky, but that’s what it’s
called. There are several GARCH processes to forecast volatility, if you are venturing
180
into this arena, I can straightaway tell you that GARCH (1,1) or GARCH (1,2) are
better suited processes for forecasting volatility.
Implied Volatility (IV) is like the people’s perception on social media. It does not
matter what the historical data suggests or what the movie analyst is forecasting
about ‘The Hateful Eight’. People seem to be excited about the movie, and that is an
indicator of how the movie is likely to fare. Likewise the implied volatility represents
the market participant’s expectation on volatility. So on one hand we have the
historical and forecasted volatility, both of which are sort of ‘manufactured’ while on
the other hand we have implied volatility which is in a sense ‘consensual’. Implied
volatility can be thought of as consensus volatility arrived amongst all the market
participants with respect to the expected amount of underlying price fluctuation
over the remaining life of an option. Implied volatility is reflected in the price of the
premium.
For this reason amongst the three different types of volatility, the IV is usually more
valued.
You may have heard or noticed India VIX on NSE website, India VIX is the official
‘Implied Volatility’ index that one can track. India VIX is computed based on a
mathematical formula, here is a whitepaper which explains how India VIX is
calculated –
If you find the computation a bit overwhelming, then here is a quick wrap on what
you need to know about India VIX (I have reproduced some of these points from the
NSE’s whitepaper) –
1. NSE computes India VIX based on the order book of Nifty Options
2. The best bid-ask rates for near month and next-month Nifty options contracts are
used for computation of India VIX
3. India VIX indicates the investor’s perception of the market’s volatility in the near
term (next 30 calendar days)
4. Higher the India VIX values, higher the expected volatility and vice-versa
5. When the markets are highly volatile, market tends to move steeply and during such
time the volatility index tends to rise
6. Volatility index declines when the markets become less volatile. Volatility indices
such as India VIX are sometimes also referred to as the ‘Fear Index’, because as the
volatility index rises, one should become careful, as the markets can move steeply
into any direction. Investors use volatility indices to gauge the market volatility and
make their investment decisions
7. Volatility Index is different from a market index like NIFTY. NIFTY measures the
direction of the market and is computed using the price movement of the
underlying stocks whereas India VIX measures the expected volatility and is
181
computed using the order book of the underlying NIFTY options. While Nifty is a
number, India VIX is denoted as an annualized percentage
Further, NSE publishes the implied volatility for various strike prices for all the
options that get traded. You can track these implied volatilities by checking the
option chain. For example here is the option chain of Cipla, with all the IV’s marked
out.
The Implied Volatilities can be calculated using a standard options calculator. We

will discuss more about calculating IV, and using IV for setting up trades in the
subsequent chapters. For now we will now move over to understand Vega.
Realized Volatility is pretty much similar to the eventual outcome of the movie,
which we would get to know only after the movie is released. Likewise the realized
volatility is looking back in time and figuring out the actual volatility that occurred
during the expiry series. Realized volatility matters especially if you want to compare
today’s implied volatility with respect to the historical implied volatility. We will
explore this angle in detail when we take up “Option Trading Strategies”.
182
19.2 – Vega
Have you noticed this – whenever there are heavy winds and thunderstorms, the
electrical voltage in your house starts fluctuating violently, and with the increase in
voltage fluctuations, there is a chance of a voltage surge and therefore the
electronic equipments at house may get damaged.
Similarly, when volatility increases, the stock/index price starts swinging heavily. To
put this in perspective, imagine a stock is trading at Rs.100, with increase in
volatility, the stock can start moving anywhere between 90 and 110. So when the
stock hits 90, all PUT option writers start sweating as the Put options now stand a
good chance of expiring in the money. Similarly, when the stock hits 110, all CALL
option writers would start panicking as all the Call options now stand a good chance
of expiring in the money.
Therefore irrespective of Calls or Puts when volatility increases, the option

premiums have a higher chance to expire in the money. Now, think about this –
imagine you want to write 500 CE options when the spot is trading at 475 and 10
days to expire. Clearly there is no intrinsic value but there is some time value. Hence
assume the option is trading at Rs.20. Would you mind writing the option? You may
write the options and pocket the premium of Rs.20/- I suppose. However, what if the
volatility over the 10 day period is likely to increase – maybe election results or
corporate results are scheduled at the same time. Will you still go ahead and write
the option for Rs.20? Maybe not, as you know with the increase in volatility, the
option can easily expire ‘in the money’ hence you may lose all the premium money
you have collected. If all option writers start fearing the volatility, then what would
compel them to write options? Clearly, a higher premium amount would. Therefore
instead of Rs.20, if the premium was 30 or 40, you may just think about writing the
option I suppose.
183
In fact this is exactly what goes on when volatility increases (or is expected to
increase) – option writers start fearing that they could be caught writing options that
can potentially transition to ‘in the money’. But nonetheless, fear too can be
overcome for a price, hence option writers expect higher premiums for writing
options, and therefore the premiums of call and put options go up when volatility is
expected to increase.
The graphs below emphasize the same point –
X axis represents Volatility (in %) and Y axis represents the premium value in
Rupees. Clearly, as we can see, when the volatility increases, the premiums also
increase. This holds true for both call and put options. The graphs here go a bit
184
further, it shows you the behavior of option premium with respect to change in
volatility and the number of days to expiry.
Have a look at the first chart (CE), the blue line represents the change in premium
with respect to change in volatility when there is 30 days left for expiry, likewise the
green and red line represents the change in premium with respect to change in
volatility when there is 15 days left and 5 days left for expiry respectively.
Keeping this in perspective, here are a few observations (observations are common
for both Call and Put options) –
1. Referring to the Blue line – when there are 30 days left for expiry (start of the series)
and the volatility increases from 15% to 30%, the premium increases from 97 to 190,
representing about 95.5% change in premium
2. Referring to the Green line – when there are 15 days left for expiry (mid series) and
the volatility increases from 15% to 30%, the premium increases from 67 to 100,
representing about 50% change in premium
3. Referring to the Red line – when there are 5 days left for expiry (towards the end of
series) and the volatility increases from 15% to 30%, the premium increases from 38
to 56, representing about 47% change in premium
Keeping the above observations in perspective, we can make few deductions –
1. The graphs above considers a 100% increase of volatility from 15% to 30% and its
effect on the premiums. The idea is to capture and understand the behavior of
increase in volatility with respect to premium and time. Please be aware that
observations hold true even if the volatility moves by smaller amounts like maybe
20% or 30%, its just that the respective move in the premium will be proportional
2. The effect of Increase in volatility is maximum when there are more days to expiry –
this means if you are at the start of series, and the volatility is high then you know
premiums are plum. Maybe a good idea to write these options and collect the
premiums – invariably when volatility cools off, the premiums also cool off and you
could pocket the differential in premium
3. When there are few days to expiry and the volatility shoots up the premiums also
goes up, but not as much as it would when there are more days left for expiry. So if
you are a wondering why your long options are not working favorably in a highly
volatile environment, make sure you look at the time to expiry
So at this point one thing is clear – with increase in volatility, the premiums increase,
but the question is ‘by how much?’. This is exactly what the Vega tells us.
The Vega of an option measures the rate of change of option’s value (premium) with
every percentage change in volatility. Since options gain value with increase in
volatility, the vega is a positive number, for both calls and puts. For example – if the
option has a vega of 0.15, then for each % change in volatility, the option will gain or
lose 0.15 in its theoretical value.
185
19.3 – Taking things forward
It is now perhaps time to revisit the path this module on Option Trading has taken
and will take going forward (over the next few chapters).
We started with the basic understanding of the options structure and then
proceeded to understand the Call and Put options from both the buyer and sellers
perspective. We then moved forward to understand the moneyness of options and
few basic technicalities with respect to options.
We further understood option Greeks such as the Delta, Gamma, Theta, and Vega
along with a mini series of Normal Distribution and Volatility.
At this stage, our understanding on Greeks is one dimensional. For example we

know that as and when the market moves the option premiums move owing to
delta. But in reality, there are several factors that works simultaneously – on one
hand we can have the markets moving heavily, at the same time volatility could be
going crazy, liquidity of the options getting sucked in and out, and all of this while
the clock keeps ticking. In fact this is exactly what happens on an everyday basis in
markets. This can be a bit overwhelming for newbie traders. It can be so
overwhelming that they quickly rebrand the markets as ‘Casino’. So the next time
you hear someone say such a thing about the markets, make sure you point them
to Varsity .
Anyway, the point that I wanted to make is that all these Greeks manifest itself on
the premiums and therefore the premiums vary on a second by second basis. So it
becomes extremely important for the trader to fully understand these ‘inter Greek’
interactions of sorts. This is exactly what we will do in the next chapter. We will also
have a basic understanding of the Black & Scholes options pricing formula and how
to use the same.
19.4 – Flavors of Inter Greek Interactions

(The following article was featured in Business Line dated 31st August 2015)
Here is something that happened very recently. By now everyone remotely

connected with the stock market would know that on 24th August 2015, the Indian
markets declined close to 5.92% making it one of the worse single day declines in
the history of Indian stock markets. None of the front line stocks survived the
onslaught and they all declined by 8-10%. Panic days such as these are a common
occurrence in the equity markets.
However something unusual happened in the options markets on 24th August 2015,
here are some data points from that day –
Nifty declined by 4.92% or about 490 points –
186
India VIX shot up by 64% –
But Call option Premiums shot up!
187
Traders familiar with options would know that the call option premiums decline
when market declines. In fact most of the call option premiums (strikes below 8600)
did decline in value but option strikes above 8650 behaved differently – their
premium as opposed to the general expectation did not decline, rather increased by
50-80%. This move has perplexed many traders, with many of the traders
attributing this move to random theories such as rate rigging, market manipulation,
technological inefficiency, liquidity issues etc. But I suspect any of this is true; in fact
this can be explained based on the option theory logic.
We know that option premiums are influenced by sensitivity factors aka the Option
Greeks. Delta as we know captures the sensitivity of options premium with respect
to the movement of the underlying. Here is a quick recap – if the Delta of a
particular call option is 0.75, then for every 1 point increase/decrease in the
underlying the premium is expected to increase/decrease by 0.75 points. On
24th August, Nifty declined by 490 points, so all call options which had ‘noticeable
Delta’ (like 0.2, 0.3, 0.6 etc) declined. Typically ‘in the money’ options (as on 24th Aug,
all strike below 8600) tend to have noticeable Delta, therefore all their premiums
declined with the decline in the underlying.
‘Out of the money’ options usually have a very low delta like 0.1 or lower. This
means, irrespective of the move in the underlying the moment in the option
premium will be very restrictive. As on August 24th, all options above 8600 were ‘out
of the money’ options with low delta values. Hence irrespective of the massive fall in
the market, these call options did not lose much premium value.
188
The above explains why certain call options did not lose value, but why did the
premiums go up? The answer to this is lies in Vega – the option Greek which
captures the sensitivity of market volatility on options premiums.
With increase in volatility, the Vega of an option increases (irrespective of calls and
puts), and with increase in Vega, the option premium tends to increase. On
24th August the volatility of Indian markets shot up by 64%. This increase in volatility
was totally unexpected by the market participants. With the increase in volatility, the
Vega of all options increases, thereby their respective premiums also increased. The
effect of Vega is particularly high for ‘Out of the money’ options. So on one hand the
low delta value of ‘out of the money’ call options prevented the option premiums
from declining while on the other hand, high Vega value increased the option
premium for these out of the money options.
Hence on 24th August 2015 we got to witness the unusual – call option premium
increasing 50 – 80% on a day when markets crashed 5.92%.
1. Historical Volatility is measured by the closing prices of the stock/index

2. Forecasted Volatility is forecasted by volatility forecasting models
3. Implied Volatility represents the market participants expectation of volatility
4. India VIX represents the implied volatility over the next 30 days period
5. Vega measures the rate of change of premium with respect to change in volatility
6. All options increase in premium when volatility increases
7. The effect of volatility is highest when there are more days left for expiry
189
Chapter 20
Greek Interactions
178
20.1 – Volatility Smile

We had briefly looked at inter Greek interactions in the previous chapter and how
they manifest themselves on the options premium. This is an area we need to
explore in more detail, as it will help us select the right strikes to trade. However
before we do that we will touch upon two topics related to volatility called ‘Volatility
Smile’ and ‘Volatility Cone’.
Volatility Smile is an interesting concept, something that I consider ‘good to know’

kind of concept. For this reason I will just touch upon this and not really dig deeper
into it.
Theoretically speaking, all options of the same underlying, expiring on the same
expiry day should display similar ‘Implied Volatilities’ (IV). However in reality this
does not happen.
Have a look at this image –
190
This is the option chain of SBI as of 4th September 2015. SBI is trading around 225,
hence the 225 strike becomes ‘At the money’ option, and the same is highlighted
with a blue band. The two green bands highlight the implied volatilities of all the
other strikes. Notice this – as you go away from the ATM option (for both Calls and
Puts) the implied volatilities increase, in fact further you move from ATM, the higher
is the IV. You can notice this pattern across all the different stocks/indices. Further
you will also observe that the implied volatility of the ATM option is the lowest. If
you plot a graph of all the options strikes versus their respective implied volatility
you will get to see a graph similar to the one below –
191
The graph appears like a pleasing smile; hence the name ‘Volatility Smile’
20.2 – Volatility Cone

(All the graphs in this chapter and in this section on Volatility Cone has been authored
by Prakash Lekkala)
So far we have not touched upon an option strategy called ‘Bull Call Spread’, but for
the sake of this discussion I will make an assumption that you are familiar with this
strategy.
For an options trader, implied volatility of the options greatly affects the
profitability. Consider this – you are bullish on stock and want to initiate an option
strategy such as a Bull Call Spread. If you initiate the trade when the implied
volatility of options is high, then you will have to incur high upfront costs and lower
profitability potential. However if you initiate the position when the option implied
volatility is low, your trading position will incur lower costs and higher potential
profit.
For instance as of today, Nifty is trading at 7789. Suppose the current implied
volatility of option positions is 20%, then a 7800 CE and 8000 CE bull call spread
would cost 72 with a potential profit of 128. However if the implied volatility is 35%
instead of 20%, the same position would cost 82 with potential profit of 118. Notice
with higher volatility a bull call spread not only costs higher but the profitability
greatly reduces.
So the point is for option traders , it becomes extremely crucial to assess the level of
volatility in order to time the trade accordingly. Another problem an option trader
192
has to deal with is, the selection of the underlying and the strike (particularly true if
your strategies are volatility based).
For example – Nifty ATM options currently have an IV of ~25%, whereas SBI ATM
options have an IV of ~52%, given this should you choose to trade Nifty options
because IV is low or should you go with SBI options?
This is where the Volatility cone comes handy – it addresses these sorts of questions
for Option traders. Volatility Cone helps the trader to evaluate the costliness of an
option i.e. identify options which are trading costly/cheap. The good news is, you
can do it not only across different strikes of a security but also across different
securities as well.
Let’s figure out how to use the Volatility Cone.
Below is a Nifty chart for the last 15 months. The vertical lines mark the expiry dates
of the derivative contracts, and the boxes prior to the vertical lines mark the price
movement of Nifty 10 days prior to expiry.
If you calculate the Nifty’s realized volatility in each of the boxes, you will get the
following table –
Expiry Date Annualized realized volatility
Jun-14 41%
Jul-14 38%
Aug-14 33%
Sep-14 28%
193
Oct-14 28%
Nov-14 41%
Dec-14 26%
Jan-15 22%
Feb-15 56%
Mar-15 19%
Apr-15 13%
May-15 34%
Jun-15 17%
Jul-15 41%
Aug-15 21%
From the above table we can observe that Nifty’s realized volatility has ranged from
a maximum of 56% (Feb 2015) to a minimum of 13% (April 2015).
We can also calculate mean and variance of the realized volatility, as shown below –
Particulars Details
Maximum Volatility 56%
194
+2 Standard Deviation (SD) 54%
+1 Standard Deviation (SD) 42%
Mean/ Average Volatility 31%
-1 Standard Deviation (SD) 19%
-2 Standard Deviation (SD) 7%
Minimum Volatility 13%
If we repeat this exercise for 10, 20, 30, 45, 60 & 90 day windows, we would get a
table as follows –
Days to Expiry 10 20 30 45 60 90
Max 56% 49% 41% 40% 37% 35%
+2 SD 54% 46% 42% 41% 40% 38%
+1 SD 42% 38% 36% 36% 35% 33%
Mean/Average 30% 29% 30% 30% 30% 29%
-1 SD 19% 21% 23% 24% 24% 24%
-2 SD 7% 13% 17% 19% 19% 19%
195
Min 13% 16% 21% 22% 21% 20%
The graphical representation of the table above would look like a cone as shown
below, hence the name ‘Volatility Cone’ –
The way to read the graph would be to first identify the ‘Number of days to Expiry’
and then look at all the data points that are plotted right above it. For example if the
number of days to expiry is 30, then observe the data points (representing realized
volatility) right above it to figure out the ‘Minimum, -2SD, -1 SD, Average implied
volatility etc’. Also, do bear in mind; the ‘Volatility Cone’ is a graphical representation
on the ‘historical realized volatility’.
Now that we have built the volatility cone, we can plot the current day’s implied
volatility on it. The graph below shows the plot of Nifty’s near month (September
2015) and next month (October 2015) implied volatility on the volatility cone.
Each dot represents the implied volatility for an option contract – blue are for call
options and black for put options.
For example starting from left, look at the first set of dots – there are 3 blue and
black dots. Each dot represents an implied volatility of an option contract – so the
first blue dot from bottom could be the implied volatility of 7800 CE, above that it
could be the implied volatility of 8000 CE and above that it could be the implied
volatility of 8100 PE etc.
196
Do note the first set of dots (starting form left) represent near month options
(September 2015) and are plotted at 12 on x-axis, i.e. these options will expire 12
days from today. The next set of dots is for middle month (October 2015) plotted at
43, i.e. these options will expire 43 days from today.
Interpretation
Look at the 2nd set of dots from left. We can notice a blue dot above the +2SD line
(top most line, colored in maroon) for middle month option. Suppose this dot is for
option 8200 CE, expiring 29-Oct-2015, then it means that today 8200 CE is
experiencing an implied volatility, which is higher (by +2SD) than the volatility
experienced in this stock whenever there are “43 days to expiry” over the last 15
months [remember we have considered data for 15 months]. Therefore this option
has a high IV, hence the premiums would be high and one can consider designing a
trade to short the ‘volatility’ with an expectation that the volatility will cool off.
Similarly a black dot near -2 SD line on the graph, is for a Put option. It suggests that,
this particular put option has very low IV, hence low premium and therefore it could
be trading cheap. One can consider designing a trade so as to buy this put option.
A trader can plot volatility cone for stocks and overlap it with the option’s current IV.
In a sense, the volatility cone helps us develop an insight about the state of current
implied volatility with respect to the past realized volatility.
Those options which are close to + 2SD line are trading costly and options near -2
SD line are considered to be trading cheap. Trader can design trades to take
advantage of ‘mispriced’ IV. In general, try to short options which are costlier and go
long on options which are trading cheap.
197
Please note: Use the plot only for options which are liquid.
With this discussion on Volatility Smile and Volatility Cone, hopefully our
understanding on Volatility has come to a solid ground.
20.3 – Gamma vs Time

Over the next two sections let us focus our attention to inter greek interactions.
Let us now focus a bit on greek interactions, and to begin with we will look into the
behavior of Gamma with respect to time. Here are a few points that will help refresh
your memory on Gamma –
o Gamma measures the rate of change of delta

o Gamma is always a positive number for both Calls and Puts
o Large Gamma can translate to large gamma risk (directional risk)
o When you buy options (Calls or Puts) you are long Gamma
o When you short options (Calls or Puts) you are short Gamma
o Avoid shorting options which have a large gamma
The last point says – avoid shorting options which have a large gamma. Fair enough,
however imagine this – you are at a stage where you plan to short an option which
has a small gamma value. The idea being you short the low gamma option and hold
the position till expiry so that you get to keep the entire option premium. The
question however is, how do we ensure the gamma is likely to remain low
throughout the life of the trade?
The answer to this lies in understanding the behavior of Gamma versus time to
expiry/maturity. Have a look at the graph below –
198
The graph above shows how the gamma of ITM, ATM, and OTM options behave as
the ‘time to expiry’ starts to reduce. The Y axis represents gamma and the X axis
represents time to expiry. However unlike other graphs, don’t look at the X – axis
from left to right, instead look at the X axis from right to left. At extreme right, the
value reads 1, which suggests that there is ample time to expiry. The value at the left
end reads 0, meaning there is no time to expiry. The time lapse between 1 and 0 can
be thought of as any time period – 30 days to expiry, 60 days to expiry, or 365 days
to expiry. Irrespective of the time to expiry, the behavior of gamma remains the
same.
The graph above drives across these points –
o When there is ample time to expiry, all three options ITM, ATM, OTM have low
Gamma values. ITM option’s Gamma tends to be lower compared to ATM or OTM
options
o The gamma values for all three strikes (ATM, OTM, ITM) remain fairly constant till
they are half way through the expiry
o ITM and OTM options race towards zero gamma as we approach expiry
o The gamma value of ATM options shoot up drastically as we approach expiry
From these points it is quite clear that, you really do not want to be shorting “ATM”
options, especially close to expiry as ATM Gamma tends to be very high.
In fact if you realize we are simultaneously talking about 3 variables here – Gamma,
Time to expiry, and Option strike. Hence visualizing the change in one variable with
respect to change in another makes sense. Have a look at the image below –
199
The graph above is called a ‘Surface Plot’, this is quite useful to observe the behavior
of 3 or more variables. The X-axis contains ‘Time to Expiry’ and the ‘Y axis’ contains
the gamma value. There is another axis which contains ‘Strike’.
There are a few red arrows plotted on the surface plot. These arrows are placed to
indicate that each line that the arrow is pointing to, refers to different strikes. The
outermost line (on either side) indicates OTM and ITM strikes, and the line at the
center corresponds to ATM option. From these lines it is very clear that as we
approach expiry, the gamma values of all strikes except ATM tends to move towards
zero. The ATM and few strikes around ATM have non zero gamma values. In fact
Gamma is highest for the line at the center – which represents ATM option.
We can look at it from the perspective of the strike price –
200
This is the same graph but shown from a different angle, keeping the strike in
perspective. As we can see, the gamma of ATM options shoot up while the Gamma
of other option strikes don’t.
In fact here is a 3D rendering of Gamma versus Strike versus Time to Expiry. The
graph below is a GIF, in case it refuses to render properly, please do click on it to see
it in action.
201
Hopefully the animated version of the surface plot gives you a sense of how gamma,
strikes, and time to expiry behave in tandem.
20.4 – Delta versus implied volatility

These are interesting times for options traders, have a look at the image below –
202
The snapshot was taken on 11th September when Nifty was trading at 7,794. The
snapshot is that of 6800 PE which is currently trading at Rs.8.3/-.
Figure this, 6800 is a good 1100 points way from the current Nifty level of 7794. The
fact that 6800 PE is trading at 5.5 implies there are a bunch of traders who expect
the market to move 1100 points lower within 11 trading sessions (do note there are
also 2 trading holidays from now to expiry).
Given the odds of Nifty moving 1100 (14% lower from present level) in 11 trading
sessions are low, why is the 6800 PE trading at 8.3? Is there something else driving
the options prices higher besides pure expectations? Well, the following graph may
just have the answer for you –
203
The graph represents the movement of Delta with respect to strike price. Here is
what you need to know about the graph above –
o The blue line represents the delta of a call option, when the implied volatility is 20%
o The red line represents the delta of a call option, when the implied volatility is 40%
o The green line represents the delta of a Put option, when the implied volatility is
20%
o The purple line represents the delta of a Put option, when the implied volatility is
40%
o The call option Delta varies from 0 to 1
o The Put option Delta varies from 0 to -1
o Assume the current stock price is 175, hence 175 becomes ATM option
With the above points in mind, let us now understand how these deltas behave –
o Starting from left – observe the blue line (CE delta when IV is 20%), considering 175
is the ATM option, strikes such as 135, 145 etc are all Deep ITM. Clearly Deep ITM
options have a delta of 1
o When IV is low (20%), the delta gets flattened at the ends (deep OTM and ITM
options). This implies that the rate at which Delta moves (further implying the rate
at which the option premium moves) is low. In other words deep ITM options tends
to behave exactly like a futures contract (when volatility is low) and OTM option
prices will be close to zero.
o You can observe similar behavior for Put option with low volatility (observe the
green line)
o Look at the red line (delta of CE when volatility is 40%) – we can notice that the end
(ITM/OTM) is not flattened, in fact the line appears to be more reactive to underlying
price movement. In other words, the rate at which the option’s premium change
204
with respect to change in underlying is high, when volatility is high. In other words, a
large range of options around ATM are sensitive to spot price changes, when
volatility is high.
o Similar observation can be made for the Put options when volatility is high (purple
line)
o Interestingly when the volatility is low (look at the blue and green line) the delta of
OTM options goes to almost zero. However when the volatility is high, the delta of
OTM never really goes to zero and it maintains a small non zero value.
Now, going back to the initial thought – why is the 6800 PE, which is 1100 points
away trading at Rs.8.3/-?
Well that’s because 6800 PE is a deep OTM option, and as the delta graph above
suggests, when the volatility is high (see image below), deep OTM options have non
zero delta value.
I would suggest you draw your attention to the Delta versus IV graph and in
particular look at the Call Option delta when implied volatility is high (maroon line).
As we can see the delta does not really collapse to zero (like the blue line – CE delta
when IV is low). This should explain why the premium is not really low. Further add
to this the fact that there is sufficient time value, the OTM option tends to have a
‘respectable’ premium.
Download the Volatility Cone excel.
205
1. Volatility smile helps you visualize the fact that the OTM options usually have high
IVs
2. With the help of a ‘Volatility Cone’ you can visualize today’s implied volatility with
respect to past realized volatility
3. Gamma is high for ATM option especially towards the end of expiry
4. Gamma for ITM and OTM options goes to zero when we approach expiry
5. Delta has an effect on lower range of options around ATM when IV is low and its
influence increases when volatility is high.
6. When the volatility is high, the far OTM options do tend to have a non zero delta
value
206
Chapter 21
Greek Calculator
127
21.1 – Background
So far in this module we have discussed all the important Option Greeks and their
applications. It is now time to understand how to calculate these Greeks using the
Black & Scholes (BS) Options pricing calculator. The BS options pricing calculator is
based on the Black and Scholes options pricing model, which was first published by
Fisher Black and Myron Scholes (hence the name Black & Scholes) in 1973, however
Robert C Merton developed the model and brought in a full mathematical
understanding to the pricing formula.
This particular pricing model is highly revered in the financial market, so much so
that both Robert C Merton and Myron Scholes received the 1997 Noble Prize for
Economic Sciences. The B&S options pricing model involves mathematical concepts
such as partial differential equations, normal distribution, stochastic processes etc.
The objective in this module is not to take you through the math in B&S model; in
fact you could look at this video from Khan Academy for the same –
My objective is to take you through the practical application of the Black & Scholes
options pricing formula.
21.2 – Overview of the model

Think of the BS calculator as a black box, which takes in a bunch of inputs and gives
out a bunch of outputs. The inputs required are mostly market data of the options
contract and the outputs are the Option Greeks.
The framework for the pricing model works like this:
1. We input the model with Spot price, Strike price, Interest rate, Implied volatility,
Dividend, and Number of days to expiry
2. The pricing model churns out the required mathematical calculation and gives out a
bunch of outputs
3. The output includes all the Option Greeks and the theoretical price of the call and
put option for the strike selected
The illustration below gives the schema of a typical options calculator:
207
On the input side:
Spot price – This is the spot price at which the underlying is trading. Note we can
even replace the spot price with the futures price. We use the futures price when
the option contract is based on futures as its underlying. Usually the commodity
and in some cases the currency options are based on futures. For equity option
contacts always use the spot price.
Interest Rate – This is risk free rate prevailing in the economy. Use the RBI 91 day
Treasury bill rate for this purpose. You can get the rate from the RBI website, RBI
has made it available on their landing page, as highlighted below.
208
As of September 2015 the prevailing rate is 7.4769% per annum.
Dividend – This is the dividend per share expected in the stock, provided the stock
goes ex dividend within the expiry period. For example, assume today is
11th September and you wish to calculate the Option Greeks for the ICICI Bank
option contract. Assume ICICI Bank is going ex dividend on 18th Sept with a dividend
of Rs.4. The expiry for the September series is 24th September 2015, hence the
dividend would be Rs.4. in this case.
Number of days to expiry – This the number of calendar days left to expiry
Volatility – This is where you need to enter the option’s implied volatility. You can
always look at the option chain provided by NSE to extract the implied volatility
data. For example, here is the snap shot of ICICI Bank’s 280 CE, and as we can see,
the IV for this contract is 43.55%.
209
Let us use this information to calculate the option Greeks for ICICI 280 CE.
o Spot Price = 272.7

o Interest Rate = 7.4769%
o Dividend = 0
o Number of days to expiry = 1 (today is 23rd September, and expiry is on
24th September)
o Volatility = 43.55%
Once we have this information, we need to feed this into a standard Black & Scholes
Options calculator. We do have this calculator on our website
– https://zerodha.com/tools/black-scholes , you can use the same to calculate the
Greeks.
210
Once you enter the relevant data in the calculator and click on ‘calculate’, the
calculator displays the Option Greeks –
On the output side, notice the following –
o The premium of 280 CE and 280 PE is calculated. This is the theoretical option price
as per the B&S options calculator. Ideally this should match with the current option
price in the market
o Below the premium values, all the Options Greeks are listed.
I’m assuming that by now you are fairly familiar with what each of the Greeks
convey, and the application of the same.
One last note on option calculators – the option calculator is mainly used to
calculate the Option Greeks and the theoretical option price. Sometimes small
211
difference arises owing to variations in input assumptions. Hence for this reason, it
is good to have room for the inevitable modeling errors. However by and large, the
option calculator is fairly accurate.
21.3 – Put Call Parity

While we are discussing the topic on Option pricing, it perhaps makes sense to
discuss ‘Put Call Parity’ (PCP). PCP is a simple mathematical equation which states –
Put Value + Spot Price = Present value of strike (invested to maturity) + Call
Value.
The equation above holds true assuming –
1. Both the Put and Call are ATM options

2. The options are European
3. They both expire at the same time
4. The options are held till expiry
For people who are not familiar with the concept of Present value, I would suggest
you read through this – http://zerodha.com/varsity/chapter/dcf-primer/ (section
14.3).
Assuming you are familiar with the concept of Present value, we can restate the
above equation as –
P + S = Ke(-rt) + C
Where, Ke(-rt) represents the present value of strike, with K being the strike itself. In
mathematical terms, strike K is getting discounted continuously at rate of ‘r’ over
time‘t’
Also, do realize if you hold the present value of the strike and hold the same to
maturity, you will get the value of strike itself, hence the above can be further
restated as –
Put Option + Spot Price = Strike + Call options
So why should the equality hold? To help you understand this better think about
two traders, Trader A and Trader B.
o Trader A holds ATM Put option and 1 share of the underlying stock (left hand side of
PCP equation)
o Trader B holds a Call option and cash amount equivalent to the strike (right hand
side of PCP equation)
212
This being the case, as per the PCP the amount of money both traders make
(assuming they hold till expiry) should be the same. Let us put some numbers to
evaluate the equation –
Underlying = Infosys
Strike = 1200
Spot = 1200
Trader A holds = 1200 PE + 1 share of Infy at 1200

Trader B holds = 1200 CE + Cash equivalent to strike i.e 1200
Assume upon expiry Infosys expires at 1100, what do you think happens?
Trader A’s Put option becomes profitable and he makes Rs.100 however he loses
100 on the stock that he holds, hence his net pay off is 100 + 1100 = 1200.
Trader B’s Call option becomes worthless, hence the option’s value goes to 0,
however he has cash equivalent to 1200, hence his account value is 0 + 1200 = 1200.
Let’s take another example, assume Infy hits 1350 upon expiry, lets see what
happens to the accounts of both the trader’s.
Trader A = Put goes to zero, stock goes to 1350/-

Trader B = Call value goes to 150 + 1200 in cash = 1350/-
So clearly, irrespective of where the stock expires, the equations hold true, meaning
both trader A and trader B end up making the same amount of money.
All good, but how would you use the PCP to develop a trading strategy? Well, for
that you will have to wait for the next module which is dedicated to “Option
Strategies” J. Before we start the next module on Option Strategies, we have 2 more
chapters to go in this module.
1. The options calculator is based on the Black & Scholes model

2. The Black & Scholes model is used to estimate the option’s theoretical price along
with the option’s Greek
3. The interest rate in the B&S calculator refers to the risk free rate as available on the
RBI site
4. The implied volatility can be fetched from the option chain from the NSE website
5. The put call parity states that the payoff from a put option plus the spot equals the
payoff from call option plus the strike.
213
Chapter 22
Re-introducing Call & Put Options

115
22.1 – Why now?

I suppose this chapter’s title may confuse you. After rigorously going through the
options concept over the last 21 chapters, why are we now going back to “Call & Put
Options” again? In fact we started the module by discussing the Call & Put options,
so why all over again?
Well, this is because I personally believe that there are two learning levels in options
– before discovering option Greeks and after discovering the option Greeks. Now
that we have spent time learning Option Greeks, perhaps it is time to take a fresh
look at the basics of the call and put options, keeping the option Greeks in
perspective.
Let’s have a quick high-level recap –
1. You buy a Call option when you expect the underlying price to increase (you are out
rightly bullish)
2. You sell a Call option when you expect the underlying price not to increase (you
expect the market to either stay flat or go down but certainly not up)
214
3. You buy a Put option when you expect the underlying price to decrease (you are out
rightly bearish)
4. You sell a Put option when you expect the underlying price not to decrease (you
expect the market to stay flat or go up but certainly not down)
Of course the initial few chapters gave us an understanding on the call and put
option basics, but the agenda now is to understand the basics of call and put
options keeping both volatility and time in perspective. So let’s get started.
22.2 – Effect of Volatility

We know that one needs to buy a Call Option when he/she expects the underlying
asset to move higher. Fair enough, for a moment let us assume that Nifty is
expected to go up by a certain percent, given this would you buy a Call option if –
1. The volatility is expected to go down while Nifty is expected to go up?

2. What would you do if the time to expiry is just 2 days away?
3. What would you do if the time to expiry is more than 15 days away?
4. Which strike would you choose to trade in the above two cases – OTM, ATM, or ITM
and why would you choose the same?
These questions clearly demonstrate the fact that buying a call option (or put
option) is not really a straightforward task. There is a certain degree of ground work
required before you buy an option. The ground work mainly revolves around
assessment of volatility, time to expiry, and of course the directional movement of
the market itself.
I will not talk about the assessment of market direction here; this is something you
will have to figure out yourself based on theories such as technical analysis,
quantitative analysis, or any other technique that you deem suitable.
For instance you could use technical analysis to identify that Nifty is likely to move
up by 2-3% over the next few days. Having established this, what would you do?
Would you buy an ATM option or ITM option? Given the fact that Nifty will move up
by 2-3% over the next 2 days, which strike gives you maximum bang for the buck?
This is the angle I would like to discuss in this chapter.
Let’s start by looking at the following graph, if you recollect we discussed this in the
chapter on Vega –
215
The graph above depicts how a call option premium behaves with respect to
increase in volatility across different ‘time to expiry’ time frames. For example the
blue line shows how the call option premium behaves when there are 30 days to
expiry, green for 15 days to expiry, and red for 5 days to expiry.
With help of the graph above, we can arrive at a few practical conclusions which we
can incorporate while buying/selling call options
1. Regardless of time to expiry, the premium always increases with increase in

volatility and the premium decreases with decrease in volatility
2. For volatility to work in favor of a long call option one should time buying a call
option when volatility is expected to increase and avoid buying call option when
volatility is expected to decrease
3. For volatility to work in favor of a short call option, one should time selling a call
option when volatility is expected to fall and avoid selling a call option when the
volatility is expected to increase
Here is the graph of the put option premium versus volatility –
216
This graph is very similar to the graph of call premium versus volatility – therefore
the same set of conclusions hold true for put options as well.
These conclusions make one thing clear – buy options when you expect volatility to
increase and short options when you expect the volatility to decrease. Now the next
obvious question is – which strike to choose when you decide to buy or sell options?
This is where the assessment of time to expiry comes into play.
22.3 – Effect of Time

Let us just assume that the volatility is expected to increase along with increase in
the underlying prices. Clearly buying a call option makes sense. However the more
important aspect is to identify the right strike to buy. Infact when you wish to buy an
option it is important to analyze how far away we are with respect to market expiry.
Selection of strike depends on the time to expiry.
Do note – understanding the chart below may seem a bit confusing in the
beginning, but it is not. So don’t get disheartened if you don’t get it the first time you
read, just give it another shot 
Before we proceed we need to get a grip on the timelines first. A typical F&O series
has about 30 days before expiry (barring February series). To help you understand
better, I have divided the series into 2 halves – the first half refers to the first 15
days of the series and the 2nd half refers to the last 15 days of the F&O series. Please
do keep this in perspective while reading through below.
Have a look at the image below; it contains 4 bar charts representing the
profitability of different strikes. The chart assumes –
1. The stock is at 5000 in the spot market, hence strike 5000 is ATM
217
2. The trade is executed at some point in the 1st half of the series i.e between the start
of the F&O series and 15th of the month
3. We expect the stock to move 4% i.e from 5000 to 5200
Given the above, the chart tries to investigate which strike would be the most
profitable given the target of 4% is achieved within –
1. 5 days of trade initiation

4. On expiry day
So let us start from the first chart on the left top. This chart shows the profitability
of different call option strikes given that the trade is executed in the first half of the
F&O series. The target is expected to be achieved within 5 days of trade execution.
Here is a classic example – today is 7th Oct, Infosys results are on 12th Oct, and you
are bullish on the results. You want to buy a call option with an intention of squaring
it off 5 days from now, which strike would you choose?
From the chart it is clear – when there is ample time to expiry (remember we are at
some point in the 1sthalf of the series), and the stock moves in the expected
direction, then all strikes tend to make money. However, the strikes that make
maximum money are (far) OTM options. As we can notice from the chart, maximum
money is made by 5400 and 5500 strike.
Conclusion – When we are in the 1st half of the expiry series, and you expect the
target to be achieved quickly (say over few days) buy OTM options. In fact I would
suggest you buy 2 or 3 strikes away from ATM and not beyond that.
Look at the 2nd chart (top right) – here the assumption is that the trade is executed
in the 1st half the series, the stock is expected to move by 4%, but the target is
218
expected to be achieved in 15 days. Except for the time frame (target to be
achieved) everything else remains the same. Notice how the profitability changes,
clearly buying far OTM option does not makes sense. In fact you may even lose
money when you buy these OTM options (look at the profitability of 5500 strike).
Conclusion – When we in the 1st half of the expiry series, and you expect the target
to be achieved over 15 days, it makes sense to buy ATM or slightly OTM options. I
would not recommend buying options that are more than 1 strike away from ATM.
One should certainly avoid buying far OTM options.
In the 3rd chart (bottom left) the trade is executed in the 1st half the series and
target expectation (4% move) remains the same but the target time frame is
different. Here the target is expected to be achieved 25 days from the time of trade
execution. Clearly as we can see OTM options are not worth buying. In most of the
cases one ends up losing money with OTM options. Instead what makes sense is
buying ITM options.
Also, at this stage I have to mention this – people end up buying OTM options simply
because the premiums are lower. Do not fall for this, the low premium of OTM
options creates an illusion that you won’t lose much, but in reality there is a very
high probability for you to lose all the money, albeit small amounts. This is
especially true in cases where the market moves but not at the right speed. For
example the market may move 4% but if this move is spread across 15 days, then it
does not make sense holding far OTM options. However, far OTM options make
money when the movement in the market is swift – for example a 4% move within 1
or say 2 days. This is when far OTM options moves smartly.
Conclusion – When we are at the start of the expiry series, and you expect the
target to be achieved over 25 days, it makes sense to buy ITM options. One should
certainly avoid buying ATM or OTM options.
The last chart (bottom right) is quite similar to the 3rd chart, except that you expect
the target to be achieved on the day of the expiry (over very close to expiry).
The conclusion is simple – under such a scenario all option strikes, except ITM lose
money. Traders should avoid buying ATM or OTM options.
Let us look at another set of charts – the idea here is to figure out which strikes to
choose given that the trade is executed in the 2nd half of the series i.e at any point
from 15th of the month till the expiry. Do bear in mind the effect of time decay
accelerates in this period; hence as we are moving closer to expiry the dynamic of
options change.
The 4 charts below help us identify the right strike for different time frames during
which the target is achieved. Of course we do this while keeping theta in
perspective.
219
Chart 1 (top left) evaluates the profitability of different strikes wherein the trade is
executed in the 2nd half of the series and the target is achieved the same day of
trade initiation. News driven option trade such as buying an option owing to a
corporate announcement is a classic example. Buying an index option based on the
monetary policy decision by RBI is another example. Clearly as we can see from the
chart all strikes tend to make money when the target is achieved the same day,
however the maximum impact would be on (far) OTM options.
Do recall the discussion we had earlier – when market moves swiftly (like 4% in 1
day), the best strikes to trade are always far OTM.
Conclusion – When you expect the target to be achieved the same day (irrespective
of time to expiry) buy far OTM options. I would suggest you buy 2 or 3 strikes away
from ATM options and not beyond that. There is no point buying ITM or ATM
options.
Chart 2 (top right) evaluates the profitability of different strikes wherein the trade
is executed in the 2ndhalf of the series and the target is achieved within 5 days of
trade initiation. Notice how the profitability of far OTM options diminishes. In the
above case (chart 1) the target is expected to be achieved in 1 day therefore buying
(far) OTM options made sense, but here the target is achieved in 5 days, and
because the trade is kept open for 5 days especially during the 2nd half of the series,
the impact of theta is higher. Hence it just does not make sense risking with far OTM
options. The safest bet under such a scenario is strikes which are slightly OTM.
Conclusion – When you are in the 2nd half of the series, and you expect the target to
be achieved around 5 days from the time of trade execution buy strikes that are
slightly OTM. I would suggest you buy 1 strike away from ATM options and not
beyond that.
220
Chart 3 (bottom right) and Chart 4 (bottom left) – both these charts are similar
expect in chart 3 the target is achieved 10 days from the trade initiation and in chart
4, the target is expected to be achieved on the day of the expiry. I suppose the
difference in terms of number of days won’t be much, hence I would treat them to
be quite similar. From both these charts we can reach 1 conclusion – far OTM
options tend to lose money when the target is expected to be achieved close to
expiry. In fact when the target is achieved closer to the expiry, the heavier the far
OTM options bleed. The only strikes that make money are ATM or slightly ITM
option.
While the discussions we have had so far are with respect to buying a call option,
similar observations can be made for PUT options as well. Here are two charts that
help us understand which strikes to buy under various situations –
These charts help us understand which strikes to trade when the trade is initiated in
the first half of the series, and the target is achieved under different time frames.
While these charts help us understand which strikes to trade when is the trade is
executed in the 2nd half of the series and the target is achieved under different time
frames.
221
If you go through the charts carefully you will realize that the conclusions for the
Call options holds true for the Put options as well. Given this we can generalize the
best practices for buying options –
Position Initiation Target Expectation Best strike to trade
1st half of the series 5 days from initiation Far OTM (2 strikes away from ATM)
1st half of the series 15 days from initiation ATM or slightly OTM (1 strike away from ATM)
1st half of the series 25 days from initiation Slightly ITM options
1st half of the series On expiry day ITM
2nd half of the series Same day Far OTM (2 or 3 strikes away from ATM)
2nd half of the series 5 days from initiation Slightly OTM (1 strike away from ATM)
2nd half of the series 10 days from initiation Slightly ITM or ATM
222
2nd half of the series On expiry day ITM
So the next time you intend to buy a naked Call or Put option, make sure you map
the period (either 1st half or 2nd half of the series) and the time frame during which
the target is expected to be achieved. Once you do this, with the help of the table
above you will know which strikes to trade and more importantly you will know
which strikes to avoid buying.
With this, we are now at the verge of completion of this module. In the next chapter
I would like to discuss some of the simple trades that I initiated over the last few
days and also share my trade rationale behind each trade. Hopefully the case
studies that I will present in the next chapter will give you a perspective on the
general thought process behind simple option trades.
1. Volatility plays a crucial role in your decision to buy options

2. In general buy options when you expect the volatility to go higher
3. Sell options when you expect the volatility to decrease
4. Besides volatility the time to expiry and the time frame during which the target is
expected to be achieved also matters
223
Chapter 23
Case studies – wrapping it all up!

295
23.1 – Case studies

We are now at the very end of this module and I hope the module has given you a
fair idea on understanding options. I’ve mentioned this earlier in the module, at this
point I feel compelled to reiterate the same – options, unlike futures is not a straight
forward instrument to understand. Options are multi dimensional instruments
primarily because it has many market forces acting on it simultaneously, and this
makes options a very difficult instrument to deal with. From my experience I’ve
realized the only way to understand options is by regularly trading them, based on
options theory logic.
To help you get started I would like to discuss few simple option trades executed
successfully. Now here is the best part, these trades are executed by Zerodha
Varsity readers over the last 2 months. I believe these are trades inspired by reading
through the contents of Zerodha Varsity, or at least this is what I was told.
Either ways I’m happy because each of these trades has a logic backed by a mutli
disciplinary approach. So in that sense it is very gratifying, and it certainly makes a
perfect end to this module on Options Theory.
Do note the traders were kind enough to oblige to my request to discuss their
trades here, however upon their request I will refrain from identifying them.
Here are the 4 trades that I will discuss –
1. CEAT India – Directional trade, inspired by Technical Analysis logic

2. Nifty – Delta neutral, leveraging the effect of Vega
3. Infosys – Delta neutral, leveraging the effect of Vega
4. Infosys – Directional trade, common sense fundamental approach
For each trade I will discuss what I like about it and what could have been better. Do
note, all the snapshots presented here are taken by the traders themselves, I just
specified the format in which I need these snapshots.
So, let’s get started.
224
23.2 – CEAT India
The trade was executed by a 27 year old ‘Options newbie’. Apparently this was his
first options trade ever.
Here is his logic for the trade: CEAT Ltd was trading around Rs.1260/- per share.
Clearly the stock has been in a good up trend. However he believed the rally would
not continue as there was some sort of exhaustion in the rally.
My thinking is that he was encouraged to believe so by looking at the last few

candles, clearly the last three day’s trading range was diminishing.
To put thoughts into action, he bought the 1220 (OTM) Put options by paying a
premium of Rs.45.75/- per lot. The trade was executed on 28th September and expiry
for the contract was on October 29th. Here is the snapshot of the same –
225
I asked the trader few questions to understand this better –
1. Why did you choose to trade options and not short futures?
1. Shorting futures would be risky, especially in this case as reversals could be sharp
and MTM in case of sharp reversals would be painful
2. When there is so much time to expiry, why did I choose to trade a slightly OTM
option and not really far OTM option?
1. This is because of liquidity. Stock options are not really liquid, hence sticking to
strikes around ATM is a good idea
3. What about stoploss?
1. The plan is to square off the trade if CEAT makes a new high. In other words a new
high on CEAT indicates that the uptrend is still intact, and therefore my contrarian
short call was flawed
4. What about target?
1. Since the stock is in a good up trend, the idea is to book profits as soon as it’s
deemed suitable. Reversals can be sharp, so no point holding on to short trades. In
fact it would not be a bad idea to reverse the trade and buy a call option.
5. What about holding period?
226
1. The trade is a play on appreciation in premium value. So I will certainly not look at
holding this to expiry. Given that there is ample time to expiry, a small dip in stock
price will lead to a decent appreciation in premium.
Note – the QnA is reproduced in my own words, the idea here is to produce the gist
and not the exact word to word conversation.
So after he bought CEAT PE, this is what happened the very next day –
Stock price declined to 1244, and the premium appreciated to 52/-. He was right
when he said “since there is ample time to expiry, a small dip in the stock price will
lead to a good increase in option premium”. He was happy with 7/- in profits (per
lot) and hence he decided to close the trade.
Looking back I guess this was probably a good move.
227
Anyway, I guess this is not bad for a first time, overnight options trade.
My thoughts on this trade – Firstly I need to appreciate this trader’s clarity of

thought, more so considering this was his first options trade. If I were to set up a
trade on this, I would have done this slightly differently.
1. From the chart perspective the thought process was clear – exhaustion in the rally.
Given this belief I would prefer selling call options instead of buying them. Why
would I do this? – Well, exhaustion does not necessarily translate to correction in
stock prices. More often than not, the stock would enter a side way movement
making it attractive to option sellers
2. I would select strikes based on the normal distribution calculation as explained
earlier in this module (needless to say, one had to keep liquidity in perspective as
well)
3. I would have executed the trade (selling calls) in the 2nd half of the series to benefit
from time decay
Personally I do not prefer naked directional trades as they do not give me a visibility
on risk and reward. However the only time when I initiate a naked long call option
(based on technical analysis) trade is when I observe a flag formation –
1. Stock should have rallied (prior trend) at least 5-10%

2. Should have started correcting (3% or so) on low volumes – indicates profit booking
by week hands
I find this a good setup to buy call options.
228
23.3 – RBI News play (Nifty Options)
This is a trade in Nifty Index options based on RBI’s monetary policy announcement.
The trade was executed by a Varsity reader from Delhi. I considered this trade
structured and well designed.
Here is the background for this trade.
Reserve Bank of India (RBI) was expected to announce their monetary policy on
29th September. While it is hard for anyone to guess what kind of decision RBI would
take, the general expectation in the market was that RBI would slash the repo rates
by 25 basis points. For people not familiar with monetary policy and repo rates, I
would suggest you read this –
http://zerodha.com/varsity/chapter/key-events-and-their-impact-on-markets/
RBI’s monetary policy is one of the most eagerly awaited events by the market
participants as it tends to have a major impact on market’s direction.
Here are few empirical market observations this trader has noted in the backdrop
market events –
1. The market does not really move in any particular direction, especially 2 – 3 days
prior to the announcement. He find this applicable to stocks as well – ex : quarterly
results
2. Before the event/announcement market’s volatility invariably shoots up
3. Because the volatility shoots up, the option premiums (for both CE and PE) also
shoot up
While, I cannot vouch for his first observations, the 2nd and 3rd observation does
make sense.
So in the backdrop of RBI’s policy announcement, ample time value, and increased
volatility (see image below) he decided to write options on 28th of September.
229
Nifty was somewhere around 7780, hence the strike 7800 was the ATM option. The
7800 CE was trading at 203 and the 7800 PE was trading at 176, both of which he
wrote and collected a combined premium of Rs.379/-.
Here is the option chain showing the option prices.
I had a discussion with him to understand his plan of action; I’m reproducing the
same (in my own words) for your understanding –
1. Why are you shorting 7800 CE and 7800 PE?

1. Since there was ample time to expiry and increased volatility, I believe that the
options are expensive, and premiums are higher than usual. I expect the volatility to
230
decrease eventually and therefore the premiums to decrease as well. This would
give me an opportunity to buyback both the options at a lower price
2. Why did you choose to short ATM option?
1. There is a high probability that I would place market orders at the time of exit, given
this I want to ensure that the loss due to impact cost is minimized. ATM options
have lesser impact cost, therefore it was a natural choice.
3. For how long do you plan to hold the trade?
1. Volatility usually drops as we approach the announcement time. From empirical
observation I believe that the best time to square of these kinds of trade would be
minutes before the announcement. RBI is expected to make the announcement
around 11:00 AM on September29th; hence I plan to square off the trade by 10:50
AM.
4. What kind of profits do you expect for this trade?
1. I expect around 10 – 15 points profits per lot for this trade.
5. What is you stop loss for this trade?
1. Since the trade is a play on volatility, its best to place SL based on Volatility and not
really on the option premiums. Besides this trade comes with a predefined ‘time
based stoploss’ – remember no matter what happens, the idea is to get out minutes
before RBI makes the announcement.
So with these thoughts, he initiated the trade. To be honest, I was more confident
about the success of this trade compared to the previous trade on CEAT. To a large
extent I attribute the success of CEAT trade to luck, but this one seemed like a more
rational set up.
Anyway, as per plan the next day he did manage to close the trade minutes before
RBI could make the policy announcement.
Here is the screenshot of the options chain –
231
As expected the volatility dropped and both the options lost some value. The 7800
CE was trading at 191 and the 7800 PE was trading at 178. The combined premium
value was at 369, and he did manage to make a quick 10 point profit per lot on this
trade. Not too bad for an overnight trade I suppose.
Just to give you a perspective – this is what happened immediately after the news hit
the market.
232
My thoughts on this trade – In general I do subscribe to the theory of volatility
movement and shorting options before major market events. However such trades
are to be executed couple of days before the event and not 1 day before.
Let me take this opportunity to clear one misconception with respect to the
news/announcement based option trades. Many traders I know usually set up the
opposite trade i.e buy both Call and Put option before major events. This strategy is
also called the “Long Straddle”. The thought process with a long straddle is straight
forward – after the announcement the market is bound to move, based on the
direction of the market movement either Call or Put options will make money. Given
this the idea is simple – hold the option which is making money and square off the
option that is making a loss. While this may seem like a perfectly logical and intuitive
trade, what people usually miss out is the impact of volatility.
When the news hits the market, the market would certainly move. For example if
the news is good, the Call options will definitely move. However more often than
not the speed at which the Put option premium will lose value is faster than
the speed at which the call option premium would gain value. Hence you will
end up losing more money on the Put option and make less money on Call option.
For this reasons I believe selling options before an event to be more meaningful.
23.4 – Infosys Q2 Results

This trade is very similar to the previous RBI trade but better executed. The trade
was executed by another Delhiite.
Infosys was expected to announce their Q2 results on 12th October. The idea was
simple – news drives volatility up, so short options with an expectation that you can
buy it back when the volatility cools off. The trade was well planned and the position
was initiated on 8th Oct – 4 days prior to the event.
Infosys was trading close to Rs.1142/- per share, so he decided to go ahead with the
1140 strike (ATM).
Here is the snapshot at the time of initiating the trade –
233
On 8th October around 10:35 AM the 1140 CE was trading at 48/- and the implied
volatility was at 40.26%. The 1140 PE was trading at 47/- and the implied volatility
was at 48%. The combined premium received was 95 per lot.
I repeated the same set of question (asked during the earlier RBI trade) and the
answers received were very similar. For this reason I will skip posting the question
and answer extract here.
Going back to Infosys’s Q2 results, the market’s expectation was that Infosys would
announce fairly decent set of number. In fact the numbers were better than
expected, here are the details –
“For the July-September quarter, Infosys posted a net profit of $519 million,
compared with $511 million in the year-ago period. Revenue jumped 8.7 % to $2.39
billion. On a sequential basis, revenue grew 6%, comfortably eclipsing market
expectations of 4-4.5% growth.
In rupee terms, net profit rose 9.8% to Rs.3398 crore on revenue of Rs. 15,635 crore,
which was up 17.2% from last year”. Source: Economic Times.
The announcement came in around 9:18 AM, 3 minutes after the market opened,
and this trader did manage to close the trade around the same time.
Here is the snapshot –
234
The 1140 CE was trading at 55/- and the implied volatility had dropped to 28%. The
1140 PE was trading at 20/- and the implied volatility had dropped to 40%.
Do pay attention to this – the speed at which the call option shot up was lesser than
the speed at which the Put option dropped its value. The combined premium was
75 per lot, and he made a 20 point profit per lot.
My thoughts on this trade – I do believe this trader comes with some experience;
it is quite evident with the trade’s structure. If I were to execute this trade I would
probably do something very similar.
23.5 – Infosys Q2 aftermath (fundamentals based)

This trade was executed by a fellow Bangalorean. I know him personally. He comes
with impressive fundamental analysis skills. He has now started experimenting with
235
options with the intention of identifying option trading opportunities backed by his
fundamental analysis skills. It would certainly be interesting to track his story going
forward.
Here is the background to the trade –
Infosys had just announced an extremely good set of numbers but the stock was
down 5% or so on 12thOct and about 1% on 13th Oct.
Upon further research, he realize that the stock was down because Infosys cut down
their revenue guidance. Slashing down the revenue guidance is a very realistic
assessment of business, and he believed that the market had already factored this.
However the stock going down by 6% was not really the kind of reaction you would
expect even after markets factoring in the news.
He believed that the market participants had clearly over reacted to guidance value,
so much so that the market failed to see through the positive side of the results.
His belief – if you simultaneously present the markets good news and bad news,
market always reacts to bad news first. This was exactly what was going on in
Infosys.
He decided to go long on a call option with an expectation that the market will
eventually wake up and react to the Q2 results.
236
He decided to buy Infosys’s 1100 CE at 18.9/- which was slightly OTM. He planned to
hold the trade till the 1100 strike transforms to ITM. He was prepared to risk Rs.8.9/-
on this trade, which meant that if the premium dropped to Rs.10, he would be
getting out of the trade taking a loss.
After executing the trade, the stock did bounce back and he got an opportunity to
close the trade on 21stOct.
237
He more than doubled his money on this trade. Must have been a sweet trade for
him
Do realize the entire logic for the trade was developed using simple understanding
of financial statements, business fundamentals, and options theory.
My thoughts on this trade – Personally I would not be very uncomfortable

initiating naked trades. Besides in this particular while the entry was backed by
logic, the exit, and stoploss weren’t. Also, since there was ample time to expiry the
trader could have risked with slightly more OTM options.
And with this my friends, we are at the end of this module on Options Theory!
I hope you found this material useful and I really hope this makes a positive impact
on your options trading techniques.
Good luck.
238
zerodha.com/varsity
TABLE OF CONTENTS
1 Orientation 1
1.1 Setting the context 1
1.2 What should you know? 3
2 Bull Call Spread 6

2.1 Background 6
2.2 Strategy notes 8
2.3 Strike selection 14
3 Bull Put spread 22

3.1 Why Bull Put Spread? 22
3.3 Other strike combinations 28
4 Call ratio back spread 32

4.1 Background 32
4.3 Strategy generalization 38
4.4 Welcome back the Greeks 39
5 Bear call ladder 46

5.1 Background 46
5.4 Effect of Greeks 54
6 Synthetic long & arbitrage 57

6.1 Background 57
zerodha.com/varsity
6.3 The Fish market Arbitrage 62
6.4 The options arbitrage 65
7 Bear put spread 70

7.1 Spreads versus naked positions 70
7.3 Strategy critical levels 75
7.4 Quick notes on Delta 76
7.5 Strike selection and effect of volatility 78
8 Bear call spread 83

8.1 Choosing Calls over Puts 83
8.4 Strike selection and impact of volatility 88
9 Put ratio back spread 94

9.1 Background 94
9.4 Delta, strike selection, and effect of volatility 100
10 The long straddle 104

10.1 The directional dilemma 104
10.2 Long straddle 105
10.3 Volatility matters 109
10.4 What can go wrong with the straddle? 111
zerodha.com/varsity
11 The short straddle 113
11.1 Context 113
11.2 The short straddle 114
11.3 Case study 116
11.4 The Greeks 119
12 The long & short straddle 121

12.1 Background 121
12..3 Delta and Vega 128
12.4 Short strangle 129
13 Max pain & PCR ratio 130

13.1 My experience with option theory 130
13.2 Max pain theory 130
13.3 Max pain calculation 132
13.4 A few modifications 137
13.5 The put call ratio 138
13.6 Final thoughts 140
zerodha.com/varsity
CHAPTER 1
Orientation
1.1 – Setting the context
Before we start this module on Option Strategy, I would like to share with you a
Behavioral Finance article I read couple of years ago. The article was titled “Why
winning is addictive”.
Here is the article, authored by B.Venkatesh (a regular columnist for HBL) –
“To buy and bet on a lottery ticket – a game that you typically avoid because you
understand the odds of winning the jackpot is really low. However, if you do win the
ticket, you will be most likely tempted to buy a lottery ticket regularly thereafter!
We exhibit similar behavior when it comes to our investments as well. What drives such
behavior? As humans, our life is governed by anticipation. So, looking forward to
winning a lottery is exciting and so is realizing that expectation.
Research in neuroscience has however shown that anticipating a win is more exciting
than actual winning! Nevertheless, once you experience the excitement of winning a
lottery you feel the need to indulge. That is, your brain compels you to buy a lottery
ticket, even though you are aware of the odds of winning the second one.
This happens because we tend to use more of reflexive brain than reflective brain. The
reflective brain performs calculation that helps you analyze and think. The reflexive
brain helps you feel and is more intuitive. When you feel an urge to buy a lottery ticket,
it is your reflexive brain that is pushing you to do so. Your reflective brain is likely to tell
you that the odds of winning the jackpot for the second time are low!
Now consider trading in equity options. You know that buying calls and puts has its risk,
as options often expire worthless. Yet we may choose to buy them regularly, especially if
we have already experienced large gains from such investments, for it is the reflexive
brain in action. With trading options there is another factor at play. We know that
zerodha.com/varsity
1
options carry the risk of losing capital when our view on the underlying stock or the
index turns wrong.
The fact that we can lose money makes our experience of winning against such odds
even more exciting! This is not so much true of lottery because a lottery is a game of
chance while investments, we believe, require some degree of skill”
You maybe be wondering, why I chose to post the above article right at the beginning of
this module. Well, this article echoes some of my own thoughts; in fact it goes a step
further to put things in the behavioral finance context. From the many interactions that
I’ve have had with both experienced and aspiring options traders, one point is quite
common - most options traders treat options trading as a ‘hit or miss” kind of a trade.
There is always a sense of amusement when one initiates an option trade, many don’t
realize how fatal this naïve amusement can be.
Traders buy options (month after month) with a hope they would double their
investment. Trading options with such a mindset is a perfect recipe for a P&L disaster.
The bottom line is this – if you aspire to trade options, you need to do it the right way
and follow the right approach. Else you can be rest assured the gambling attitude will
eventually consume your entire trading capital and you will end up having a short, self
destructive option trading career.
zerodha.com/varsity
2
I do have to mention this now - the common phrase that goes like this (w.r.t options)
“limited risk, unlimited profit potential” is a silent P&L killer. Newbie traders are
disillusioned by this ‘theoretically correct’ but practically disastrous fact and thereby end
up blowing up their books, slowly and steadily. Hence I do believe that trading options
blindly without a strategy is a “dangerous but irresistible pass time” (courtesy - Pink
Floyd).
I don’t intend to scare you with this note; I’m only trying to set the context here. With
the previous module on Options Theory, I’m sure you would have realized that unlike
other topics in the markets, the science involved in Options is heavy duty. It can be quite
overwhelming, but you will have to trust me here – the only way to understand and
master options trading is by structuring your learning path with a good judicious mix of
theory and practice.
In this module, I will attempt to give you a good overview of what you really need to
know about some of the popular options strategies. Like always, I will try and stick to
the practical aspect and ignore the unwanted (and confusing) theory part.
zerodha.com/varsity
3
As far as I’m aware, there are close to 475 options strategies out there in the public
domain and I’m sure at least another 100 odd strategies are hidden in the proprietary
books of brokers, bankers, and traders. Given this should you know all these strategies
put up in the public domain?
Answer is a simple no.
1.2 – What should you know?

You only need to know a handful of strategies but you need to know them really well.
Once you know these strategies all you need to do is analyze the current state of markets
(or the stock) and map it with the right option strategy from your strategy quiver.
Keeping this in perspective we will discuss certain strategies.
Bullish Strategies Bearish Spreads Neutral Strategies
1. Bull Call Spread 1. Bear Call Spread 1. Long & Short Straddles
2. Bull Put Spread 2. Bear Put Spread 2. Long & Short Strangles
3. Call Ratio Back Spread 3. Bull Put Ladder 3. Long & Short Iron
4. Bear Call Ladder 4. Put Ratio Back spread Condor
5. Call Butterfly 5. Strip 4. Long & Short Butterfly
6. Synthetic Call 6. Synthetic Put 5. Box
7. Straps
Besides discussing the above strategies I also intend to discuss –
1. Max Pain for option writing – (some key observations and practical aspects)
2. Volatility Arbitrage employing Dynamic Delta hedging
zerodha.com/varsity
4
The plan is to discuss one option strategy per chapter so that there is ample clarity about
the strategy, without any mix up or confusion. This means to say we will have roughly
about 20 chapters in this module, although I suppose each chapter would not be too
lengthy. For each of the strategy I will discuss the background, implementation, payoff,
breakeven, and perhaps the right strikes to use considering the time to expiry. I also
intend to share a working excel model which would come handy if you intent to employ
the strategy.
Do note, while I will discuss all these strategies keeping the Nifty Index as reference, you
can use the same for any stock options.
Now here is the most important thing I want you to be aware of – do not expect a holy
grail in this module. None of the strategies that we discuss here in the module is sure
shot money making machine; in fact nothing is in the markets. The objective here in this
module is to ensure that we discuss few basic but important strategies, if you deploy
them right you can make money.
Think about this way – if you have a nice car and drive it properly, you can use it to
commute and ensure comfort of yourself and your family. However if you are rash with
the car, then it can be dangerous to you and everyone else around you.
Likewise these strategies make money if you use it right; if you don’t then they can
create a hole in your P&L. My job here is to help you understand these strategies (help
you learn how to drive the car) and I will also attempt to explain the best condition
under which you can use these strategies. But making sure it works for you is in your
control, this really depends on your discipline and reading of markets. Having said this,
I’m reasonably certain your application of strategies will improve as and when you
spend more ‘quality’ time in the markets.
So starting from the next chapter we focus on the Bullish strategies with the ‘Bull Call
Spread’ making its debut.
Stay tuned.
zerodha.com/varsity
5
CHAPTER 2
Bull Call Spread

2.1 – Background
The spread strategies are some of the simplest option strategies that a trader can
implement. Spreads are multi leg strategies involving 2 or more options. When I say
multi leg strategies, it implies the strategy requires 2 or more option transactions.
Spread strategy such as the ‘Bull Call Spread’ is best implemented when your outlook on
the stock/index is ‘moderate’ and not really ‘aggressive’. For example the outlook on a
particular stock could be ‘moderately bullish’ or ‘moderately bearish’.
Some of the typical scenarios where your outlook can turn ‘moderately bullish’ are
outlined as below –
Fundamental perspective - Reliance Industries is expected to make its Q3 quarterly

results announcement. From the management’s Q2 quarterly guidance you know that
the Q3 results are expected to be better than both Q2 and Q3 of last year. However you
do not know by how many basis points the results will be better. This is clearly the
missing part of the puzzle.
Given this you expect the stock price to react positively to the result announcement.
However because the guidance was laid out in Q2 the market could have kind of
factored in the news. This leads you to think that the stock can go up, but with a limited
upside.
Technical Perspective – The stock that you are tracking has been in the down trend
for a while, so much so that it is at a 52 week low, testing the 200 day moving average,
and also near a multi-year support. Given all this there is a high probability that the
stock could stage a relief rally. However you are not completely bullish as whatever said
and done the stock is still in a downtrend.
zerodha.com/varsity
6
Quantitative Perspective – The stock is consistently trading between the 1st standard
deviation both ways (+1 SD & -1 SD), exhibiting a consistent mean reverting behavior.
However there has been a sudden decline in the stock price, so much so that the stock
price is now at the 2nd standard deviation. There is no fundamental reason backing the
stock price decline, hence there is a good chance that the stock price could revert to
mean. This makes you bullish on the stock, but the fact that it there is a chance that it
could spend more time near the 2nd SD before reverting to mean caps your bullish
outlook on the stock.
The point here is – your perspective could be developed from any theory (fundamental,
technical, or quantitative) and you could find yourself in a ‘moderately bullish’ stance. In
fact this is true for a ‘moderately bearish’ stance as well. In such a situation you can
simply invoke a spread strategy wherein you can set up option positions in such a way
that
1. You protect yourself on the downside (in case you are proved wrong)
2. The amount of profit that you make is also predefined (capped)
3. As a trade off (for capping your profits) you get to participate in the market for a lesser
cost
The 3rd point could be a little confusing at this stage; you will get clarity on it as we
proceed.
zerodha.com/varsity
7
2.2 – Strategy notes
Amongst all the spread strategies, the bull call spread is one the most popular one. The
strategy comes handy when you have a moderately bullish view on the stock/index.
The bull call spread is a two leg spread strategy traditionally involving ATM and OTM
options. However you can create the bull call spread using other strikes as well.
To implement the bull call spread –
1. Buy 1 ATM call option (leg 1)

2. Sell 1 OTM call option (leg 2)
When you do this ensure –
1. All strikes belong to the same underlying

2. Belong to the same expiry series
zerodha.com/varsity
8
3. Each leg involves the same number of options
For example –
Date – 23rd November 2015
Outlook – Moderately bullish (expect the market to go higher but the expiry around the
corner could limit the upside)
Nifty Spot – 7846
ATM – 7800 CE, premium – Rs.79/-
OTM – 7900 CE, premium – Rs.25/-
Bull Call Spread, trade set up -
1. Buy 7800 CE by paying 79 towards the premium. Since money is going out of my
account this is a debit transaction
2. Sell 7900 CE and receive 25 as premium. Since I receive money, this is a credit
transaction
3. The net cash flow is the difference between the debit and credit i.e 79 – 25 = 54.
Generally speaking in a bull call spread there is always a ‘net debit’, hence the bull call
spread is also called referred to as a ‘debit bull spread’.
After we initiate the trade, the market can move in any direction and expiry at any level.
Therefore let us take up a few scenarios to get a sense of what would happen to the bull
call spread for different levels of expiry.
Scenario 1 - Market expires at 7700 (below the lower strike price i.e ATM
option)
The value of the call options would depend upon its intrinsic value. If you recall from the
previous module, the intrinsic value of a call option upon expiry is –
Max [0, Spot-Strike]
In case of 7800 CE, the intrinsic value would be –
zerodha.com/varsity
9
Max [0, 7700 – 7800]
= Max [0, -100]
=0
Since the 7800 (ATM) call option has 0 intrinsic value we would lose the entire
premium paid i.e Rs.79/-
The 7900 CE option also has 0 intrinsic value, but since we have sold/written this
option we get to retain the premium of Rs.25.
So our net payoff from this would be –
-79 + 25
= 54
Do note, this is also the net debit of the overall strategy.
Scenario 2 - Market expires at 7800 (at the lower strike price i.e the ATM
option)
I will skip the math here, but you need to know that both 7800 and 7900 would have 0
intrinsic value, therefore the net loss would be 54.
Scenario 3 - Market expires at 7900 (at the higher strike price, i.e the OTM
option)
The intrinsic value of the 7800 CE would be –
Max [0, Spot-Strike]
= Max [0, 7900 – 7800]
= 100
Since we are long on this option by paying a premium of 79, we would make a profit of –
zerodha.com/varsity
10
100 -79
= 21
The intrinsic value of 7900 CE would be 0, therefore we get to retain the premium
Rs.25/-
Net profit would be 21 + 25 = 46
Scenario 4 - Market expires at 8000 (above the higher strike price, i.e the
OTM option)
Both the options would have a positive intrinsic value
7800 CE would have an intrinsic value of 200, and the 7900 CE would have an intrinsic
value of 100.
On the 7800 CE we would make 200 – 79 = 121 in profit
And on the 7900 CE we would lose 100 – 25 = 75
The overall profit would be
121 – 75
= 46
To summarize –
Market Expiry LS – IV HS – IV Net pay off

7700 0 0 (54)
7800 0 0 (54)
7900 100 0 +46
8000 200 100 +46
From this, 2 things should be clear to you –
1. Irrespective of the down move in the market, the loss is restricted to Rs.54, the
maximum loss also happens to be the ‘net debit’ of the strategy
zerodha.com/varsity
11
2. The maximum profit is capped to 46. This also happens to be the difference between the
spread and strategy’s net debit
We can define the ‘Spread’ as -
Spread = Difference between the higher and lower strike price
We can calculate the overall profitability of the strategy for any given expiry value. Here
is screenshot of the calculations that I made on the excel sheet –
 LS – IV - Lower Strike - Intrinsic value (7800 CE, ATM)

 PP – Premium Paid
 LS Payoff – Lower Strike Payoff
 HS-IV – Higher strike - Intrinsic Value (7900 CE, OTM)
 PR – Premium Received
 HS Payoff – Higher Strike Payoff
As you can notice, the loss is restricted to Rs.54, and the profit is capped to 46. Given
this,we can generalize the Bull Call Spread to identify the Max loss and Max profit levels
as -
zerodha.com/varsity
12
Bull Call Spread Max loss = Net Debit of the Strategy
Net Debit = Premium Paid for lower strike – Premium Received for higher strike
Bull Call Spread Max Profit = Spread – Net Debit
This is how the pay off diagram of the Bull Call Spread looks like –
There are three important points to note from the payoff diagram –
1. The strategy makes a loss in Nifty expires below 7800. However the loss is restricted to
Rs.54.
2. The breakeven point (where the strategy neither make a profit or loss) is achieved when
the market expires at 7854 (7800 + 54). Therefore we can generalize the breakeven point
for a bull call spread as Lower Strike + Net Debit
3. The strategy makes money if the market moves above 7854, however the maximum
profit achievable is Rs.46 i.e the difference between the strikes minus the net debit
a. 7900 – 7800 = 100
b. 100 – 54 = 46
I suppose at this stage you may be wondering why anyone would choose to implement a
bull call spread versus buying a plain vanilla call option. Well, the main reason is the
reduced strategy cost.
zerodha.com/varsity
13
Do remember your outlook is ‘moderately bullish’. Given this buying an OTM option is
ruled out. If you were to buy the ATM option you would have to pay Rs.79 as the option
premium and if the market proves you wrong, you stand to lose Rs.79. However by
implementing a bull call spread you reduce the overall cost to Rs.54 from Rs.79. As a
tradeoff you also cap your upside. In my view this is a fair deal considering you are not
aggressively bullish on the stock/index.
2.3 – Strike Selection

How would you quantify moderately bullish/bearish? Would you consider a 5% move on
Infosys as moderately bullish move, or should it be 10% and above? What about the
index such as Bank Nifty and Nifty 50? What about mid caps stocks such as Yes Bank,
Mindtree, Strides Arcolab etc? Well, clearly there is no one shoe fits all solution here.
One can attempt to quantify the ‘moderate-ness’ of the move by evaluating the
stock/index volatility.
Based on volatility I have devised a few rules (works alright for me) you may want to
improvise on it further - If the stock is highly volatile, then I would consider a move of 5-
8% as ‘moderate’. However if the stock is not very volatile I would consider sub 5% as
‘moderate’. For indices I would consider sub 5% as moderate.
Now consider this - you have a ‘moderately bullish’ view on Nifty 50 (sub 5% move),
given this which are the strikes to select for the bull call spread? Is the ATM + OTM
combo the best possible spread?
The answer to this depends on good old Theta!
Here are a bunch of graphs that will help you identify the best possible strikes based on
time to expiry.
zerodha.com/varsity
14
Before understanding the graphs above a few things to note –
1. Nifty spot is assumed to be at 8000

2. Start of the series is defined as anytime during the first 15 days of the series
3. End of the series is defined as anytime during the last 15 days of the series
4. The bull call spread is optimized and the spread is created with 300 points difference
The thought here is that the market will move up moderately by about 3.75% i.e from
8000 to 8300. So considering the move and the time to expiry, the graphs above suggest
–
1. Graph 1 (top left) - You are at the start of the expiry series and you expect the move
over the next 5 days, then a bull spread with far OTM is most profitable i.e 8600 (lower
strike long) and 8900 (higher strike short)
zerodha.com/varsity
15
2. Graph 2 (top right) - You are at the start of the expiry series and you expect the move
over the next 15 days, then a bull spread with slightly OTM is most profitable i.e 8200
and 8500
3. Graph 3 (bottom left) - You are at the start of the expiry series and you expect the
move in 25 days, then a bull spread with ATM is most profitable i.e 8000 and 8300. It
is also interesting to note that the strikes above 8200 (OTM options) make a loss.
4. Graph 4 (bottom right) - You are at the start of the expiry series and you expect the
move to occur by expiry, then a bull spread with ATM is most profitable i.e 8000 and
8300. Do note, the losses with OTM and far OTM options deepen.
Here are another bunch of charts; the only difference is that for the same move (i.e
3.75%) these charts suggest the best possible strikes to select assuming you are in the
2nd half of the series.
zerodha.com/varsity
16
1. Graph 1 (top left) – If you expect a moderate move during the 2nd half of the series,
and you expect the move to happen within a day (or two) then the best strikes to opt
are far OTM i.e 8600 (lower strike long) and 8900 (higher strike short)
2. Graph 2 (top right) - If you expect a moderate move during the 2nd half of the series,
and you expect the move to happen over the next 5 days then the best strikes to opt are
far OTM i.e 8600 (lower strike long) and 8900 (higher strike short). Do note, both
Graph 1 and 2 are suggesting the same strikes, but the profitability of the strategy
reduces, thanks to the effect of Theta!
3. Graph 3 (bottom right) - If you expect a moderate move during the 2nd half of the
series, and you expect the move to happen over the next 10 days then the best strikes to
opt are slightly OTM (1 strike away from ATM)
4. Graph 4 (bottom left) - If you expect a moderate move during the 2nd half of the
series, and you expect the move to happen on expiry day, then the best strikes to opt
are ATM i.e 8000 (lower strike, long) and 8300 (higher strike, short). Do note, far OTM
options lose money even if the market moves up.
2.3 – Creating Spreads
Here is something you should know, wider the spread, higher is the amount of money
you can potentially make, but as a trade off the breakeven also increases.
To illustrate –
Today is 28th November, the first day of the December series. Nifty spot is at 7883,
consider 3 different bull call spreads –
Set 1 – Bull call spread with ITM and ATM strikes
Lower Strike (ITM, Long) 7700

Higher Strike (ATM, short) 7800
Spread 7800 – 7700 = 100
Lower Strike Premium Paid 296
Higher Strike Premium Received 227
Net Debit 296 – 227 = 69
Max Loss (same as net debit) 69
Max Profit (Spread – Net Debit) 100 – 69 = 31
Breakeven 7700 + 69 = 7769
zerodha.com/varsity
17
Remarks Considering the outlook is moderately bullish,
7769 breakeven is easily achievable,
however the max profit is 31,
skewing the risk (69 pts) to reward (31 pts) ratio.
Set 2 – Bull call spread with ATM and OTM strikes (classic combo)
Lower Strike (ATM, Long) 7800

Spread 7900 – 7800 = 100
Net Debit 227 - 167 = 60
Breakeven 7800 + 60 = 7860
Remarks Risk reward is better, but the breakeven is higher
Set 3 – Bull call spread with OTM and OTM strikes
Lower Strike (ATM, Long) 7900

Spread 8000 – 7900 = 100
Net Debit 167 - 116 = 51
Breakeven 7900 + 51 = 7951
Remarks Risk reward is attractive, but the breakeven is higher
So the point is that, the risk reward changes based on the strikes that you choose.
However don’t just let the risk reward dictate the strikes that you choose. Do note you
can create a bull call spread with 2 options, for example - buy 2 ATM options and sell 2
OTM options.
Like other things in options trading, do consider the Greeks, Theta in particular!
zerodha.com/varsity
18
I suppose this chapter has laid a foundation for understanding basic ‘spreads’. Going
forward I will assume you are familiar with what a moderately bullish/bearish move
would mean, hence I would probably start directly with the strategy notes.
1. A moderate move would mean you expect a movement in the stock/index but the outlook
is not too aggressive
2. One has to quantify ‘moderate’ by evaluating the volatility of the stock/index
3. Bull Call spread is a basic spread that you can set up when the outlook is moderately
bullish
4. Classic bull call spread involves buying ATM option and selling OTM option – all
belonging to same expiry, same underlying, and equal quantity
5. The theta plays an important role in strike selection
6. The risk reward gets skewed based on the strikes you choose
Download the Bull Call Spread Excel sheet.
zerodha.com/varsity
19
CHAPTER 3
Bull Put Spread
3.1 – Why Bull Put Spread?

Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy invoked
when the view on the market is ‘moderately bullish’. The Bull Put Spread is similar to
the Bull Call Spread in terms of the payoff structure; however there are a few differences
in terms of strategy execution and strike selection. The bull put spread involves creating
a spread by employing ‘Put options’ rather than ‘Call options’ (as is the case in bull call
spread).
You may have a fundamental question at this stage – when the payoffs from both Bull
call spread and Bull Put spread are similar, why should one choose a certain strategy
over the other?
zerodha.com/varsity
20
Well, this really depends on how attractive the premiums are. While the Bull Call spread
is executed for a debit, the bull put spread is executed for a credit. So if you are at a
point in the market where –
1. The markets have declined considerably (therefore PUT premiums have swelled)
2. The volatility is on the higher side
3. There is plenty of time to expiry
And you have a moderately bullish outlook looking ahead, then it makes sense to invoke
a Bull Put Spread for a net credit as opposed to invoking a Bull Call Spread for a net
debit. Personally I do prefer strategies which offer net credit rather than strategies
which offer net debit.
3.2 – Strategy Notes

The bull put spread is a two leg spread strategy traditionally involving ITM and OTM
Put options. However you can create the spread using other strikes as well.
To implement the bull put spread –
1. Buy 1 OTM Put option (leg 1)

2. Sell 1 ITM Put option (leg 2)
When you do this ensure –

For example –
Date – 7th December 2015
Outlook – Moderately bullish (expect the market to go higher)
Nifty Spot – 7805
Bull Put Spread, trade set up -
zerodha.com/varsity
21
1. Buy 7700 PE by paying Rs.72/- as premium; do note this is an OTM option. Since
money is going out of my account this is a debit transaction
2. Sell 7900 PE and receive Rs.163/- as premium, do note this is an ITM option. Since I
receive money, this is a credit transaction
3. The net cash flow is the difference between the debit and credit i.e 163 – 72 = +91, since
this is a positive cashflow, there is a net credit to my account.
Generally speaking in a bull put spread there is always a ‘net credit’, hence the bull put
spread is also called referred to as a ‘Credit spread’.
After we initiate the trade, the market can move in any direction and expiry at any level.
Therefore let us take up a few scenarios to get a sense of what would happen to the bull
put spread for different levels of expiry.
Scenario 1 - Market expires at 7600 (below the lower strike price i.e OTM
option)
The value of the Put options at expiry depends upon its intrinsic value. If you recall from
the previous module, the intrinsic value of a put option upon expiry is –
Max [Strike-Spot, o]
In case of 7700 PE, the intrinsic value would be –
Max [7700 - 7600 – 0]
= Max [100, 0]
= 100
Since we are long on the 7700 PE by paying a premium of Rs.72, we would make
= Premium Paid – Intrinsic Value
= 100 – 72
= 28
zerodha.com/varsity
22
Likewise, in case of the 7900 PE option it has an intrinsic value of 300, but since we
have sold/written this option at Rs.163
Payoff from 7900 PE this would be –
163 - 300
= - 137
Overall strategy payoff would be –
+ 28 – 137
= - 109
Scenario 2 - Market expires at 7700 (at the lower strike price i.e the OTM
option)
The 7700 PE will not have any intrinsic value, hence we will lose all the premium that
we have paid i.e Rs.72.
The 7900 PE’s intrinsic value will be Rs.200.
Net Payoff from the strategy would be –
Premium received from selling 7900PE - Intrinsic value of 7900 PE – Premium lost on
7700 PE
= 163 – 200 – 72
= - 109
Scenario 3 - Market expires at 7900 (at the higher strike price, i.e ITM
option)
The intrinsic value of both 7700 PE and 7900 PE would be 0, hence both the potions
would expire worthless.
Net Payoff from the strategy would be –
zerodha.com/varsity
23
Premium received for 7900 PE - Premium Paid for 7700 PE
= 163 – 72
= + 91
Scenario 4 - Market expires at 8000 (above the higher strike price, i.e the
ITM option)
Both the options i.e 7700 PE and 7900 PE would expire worthless, hence the total
strategy payoff would be
Premium received for 7900 PE - Premium Paid for 7700 PE
= 163 – 72
= + 91
To summarize –
Market Expiry 7700 PE (intrinsic value) 7900 PE (intrinsic value) Net pay off
7600 100 300 -109
7700 0 200 -109
7900 0 0 91
8000 0 0 91
From this analysis, 3 things should be clear to you –
1. The strategy is profitable as and when the market moves higher

2. Irrespective of the down move in the market, the loss is restricted to Rs.109, the
maximum loss also happens to be the difference between “Spread and net credit’ of
the strategy
3. The maximum profit is capped to 91. This also happens to be the net credit of the
strategy.
We can define the ‘Spread’ as -
Spread = Difference between the higher and lower strike price
zerodha.com/varsity
24
We can calculate the overall profitability of the strategy for any given expiry value. Here
is screenshot of the calculations that I made on the excel sheet –
 LS – IV --- Lower Strike - Intrinsic value (7700 PE, OTM)

 PP --- Premium Paid
 LS Payoff --- Lower Strike Payoff
 HS-IV --- Higher strike - Intrinsic Value (7900 PE, ITM)
 PR --- Premium Received
 HS Payoff --- Higher Strike Payoff
As you can notice, the loss is restricted to Rs.109, and the profit is capped to Rs.91.
Given this, we can generalize the Bull Put Spread to identify the Max loss and Max profit
levels as -
Bull PUT Spread Max loss = Spread – Net Credit
Net Credit = Premium Received for higher strike – Premium Paid for lower strike
Bull Put Spread Max Profit = Net Credit
This is how the pay off diagram of the Bull Put Spread looks like –
zerodha.com/varsity
25
There are three important points to note from the payoff diagram –
1. The strategy makes a loss if Nifty expires below 7700. However the loss is restricted to
Rs.109.
2. The breakeven point (where the strategy neither make a profit or loss) is achieved when
the market expires at 7809. Therefore we can generalize the breakeven point for a Bull
Put spread as Higher Strike - Net Credit
3. The strategy makes money if the market moves above 7809, however the maximum
profit achievable is Rs.91 i.e the difference between the Premium Received for ITM PE
and the Premium Paid for the OTM PE
1. Premium Paid for 7700 PE = 72

2. Premium Received for 7900 PE = 163
3. Net Credit = 163 – 72 = 91
3.3 – Other Strike combinations

Remember the spread is defined as the difference between the two strike prices. The
Bull Put Spread is always created with 1 OTM Put and 1 ITM Put option, however the
strikes that you choose can be any OTM and any ITM strike. The further these strikes
are the larger the spread, the larger the spread the larger is possible reward.
Let us take some examples considering spot is at 7612 –
zerodha.com/varsity
26
Bull Put spread with 7500 PE (OTM) and 7700 PE (ITM)
Lower Strike (OTM, Long) 7500

Higher Strike (ITM, short) 7700
Spread 7700 – 7500 = 200
Net Credit 137 – 62 = 75
Max Loss (Spread – Net Credit) 200 – 75 = 125
Max Profit (Net Credit) 75
Breakeven (Higher Strike – Net Credit) 7700 – 75 = 7625

Spread 7800 – 7400 = 400
Net Credit 198 – 40 = 158

Spread 7800 – 7500 = 300
Net Credit 198 – 62 = 136
zerodha.com/varsity
27
So the point here is that, you can create the spread with any combination of OTM and
ITM option. However based on the strikes that you choose (and therefore the spread you
create), the risk reward ratio changes. In general, if you have a high conviction on a
‘moderately bullish’ view then go ahead and create a larger spread; else stick to a smaller
spread.
Download the Bull Put Spread excel.
1. The Bull Put Spread is an alternative to the Bull Call Spread. Its best executed when the
outlook on the market is ‘moderately bullish’
2. Bull Put Spread results in a net credit
3. The Bull Put Spread is best executed when the market has cracked, put premiums are
high, the volatility is on the higher side, and you expect the market to hold up (without
cracking further)
4. The Bull Put strategy involves simultaneously buying a OTM Put option and selling a
ITM Put option
5. Maximum profit is limited to the extent of the net credit
6. Maximum loss is limited to the Spread minus Net credit
7. Breakeven is calculated as Higher Strike – Net Credit
8. One can create the spread by employing any OTM and ITM strikes
9. Higher the spread, higher the profit potential, and higher the breakeven point.
zerodha.com/varsity
28
CHAPTER 4
Call Ratio Back Spread

4.1 – Background
The Call Ratio Back Spread is an interesting options strategy. I call this interesting
keeping in mind the simplicity of implementation and the kind of pay off it offers the
trader. This should certainly have a spot in your strategy arsenal. The strategy is
deployed when one is out rightly bullish on a stock (or index), unlike the bull call spread
or bull put spread where one is moderately bullish.
At a broad level this is what you will experience when you implement the Call Ratio Back
Spread-
1. Unlimited profit if the market goes up

2. Limited profit if market goes down
3. A predefined loss if the market stay within a range
In simpler words you can get to make money as long as the market moves in either
direction.
zerodha.com/varsity
29
Usually, the Call Ratio Back Spread is deployed for a ‘net credit’, meaning money flows
into your account as soon as you execute Call Ratio Back Spread. The ‘net credit’ is what
you make if the market goes down, as opposed to your expectation (i.e market going up).
On the other hand if the market indeed goes up, then you stand to make an unlimited
profit. I suppose this should also explain why the call ratio spread is better than buying a
plain vanilla call option.
So let’s go ahead and figure out how this works.

The Call Ratio Back Spread is a 3 leg option strategy as it involves buying two
OTM call option and selling one ITM Call option. This is the classic 2:1 combo. In fact
the call ratio back spread has to be executed in the 2:1 ratio meaning 2 options bought
for every one option sold, or 4 options bought for every 2 option sold, so on and so forth.
Let take an example - assume Nifty Spot is at 7743 and you expect Nifty to hit 8100 by
the end of expiry. This is clearly a bullish outlook on the market. To implement the Call
Ratio Back Spread -
zerodha.com/varsity
30
1. Sell one lot of 7600 CE (ITM)
2. Buy two lots of 7800 CE (OTM)
Make sure –
1. The Call options belong to the same expiry

2. Belongs to the same underlying
3. The ratio is maintained
The trade set up looks like this –
1. 7600 CE, one lot short, the premium received for this is Rs.201/-
2. 7800 CE, two lots long, the premium paid is Rs.78/- per lot, so Rs.156/- for 2 lots
3. Net Cash flow is = Premium Received – Premium Paid i.e 201 – 156 = 45 (Net Credit)
With these trades, the call ratio back spread is executed. Let us check what would
happen to the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry as the strategy
payoff is quite versatile.
Scenario 1 – Market expires at 7400 (below the lower strike price)
We know the intrinsic value of a call option (upon expiry) is –
Max [Spot – Strike, 0]
The 7600 would have an intrinsic value of
Max [7400 – 7600, 0]
=0
Since we have sold this option, we get to retain the premium received i.e Rs.201
The intrinsic value of 7800 call option would also be zero; hence we lose the total
premium paid i.e Rs.78 per lot or Rs.156 for two lots.
Net cash flow would Premium Received – Premium paid
zerodha.com/varsity
31
= 201 – 156
= 45
Scenario 2 – Market expires at 7600 (at the lower strike price)
The intrinsic value of both the call options i.e 7600 and 7800 would be zero, hence both
of them expire worthless.
We get to retain the premium received i.e Rs.201 towards the 7600 CE however we lose
Rs.156 on the 7800 CE resulting in a net payoff of Rs.45.
Scenario 3 – Market expires at 7645 (at the lower strike price plus net
credit)
You must be wondering why I picked the 7645 level, well this is to showcase the fact that
the strategy break even is at this level.
The intrinsic value of 7600 CE would be –
= [7645 – 7600, 0]
= 45
Since, we have sold this option for 201 the net pay off from the option would be
201 – 45
= 156
On the other hand we have bought two 7800 CE by paying a premium of 156. Clearly the
7800 CE would expire worthless hence, we lose the entire premium.
Net payoff would be –
156 – 156
zerodha.com/varsity
32
=0
So at 7645 the strategy neither makes money or loses any money for the trader, hence
7645 is treated as a breakeven point for this trade.
Scenario 4 – Market expires at 7700 (half way between the lower and higher
strike price)
The 7600 CE would have an intrinsic value of 100, and the 7800 would have no intrinsic
value.
On the 7600 CE we get to retain 101, as we would lose 100 from the premium received of
201 i.e 201 – 100 = 101.
We lose the entire premium of Rs.156 on the 7800 CE, hence the total payoff from the
strategy would be
= 101 – 156
= - 55
Scenario 5 – Market expires at 7800 (at the higher strike price)
This is an interesting market expiry level, think about it –
1. At 7800 the 7600 CE would have an intrinsic value of 200, and hence we have to let go of
the entire premium received i.e 201
2. At 7800, the 7800 CE would expire worthless hence we lose the entire premium paid for
the 7800 CE i.e Rs.78 per lot, since we have 2 of these we lose Rs.156
So this is like a ‘double whammy’ point for the strategy!
The net pay off for the strategy is –
Premium Received for 7600 CE – Intrinsic value of 7600 CE – Premium Paid for 7800
CE
= 201 – 200 - 156
zerodha.com/varsity
33
= -155
This also happens to be the maximum loss of this strategy.
Scenario 6 – Market expires at 7955 (higher strike i.e 7800 + Max loss)
I’ve deliberately selected this strike to showcase the fact that at 7955 the strategy
breakeven!
But we dealt with a breakeven earlier, you may ask?
Well, this strategy has two breakeven points – one on the lower side (7645) and another
one on the upper side i.e 7955.
At 7955 the net payoff from the strategy is –
Premium Received for 7600 CE – Intrinsic value of 7600 CE + (2* Intrinsic value of
7800 CE) – Premium Paid for 7800 CE
= 201 – 355 + (2*155) – 156
= 201 – 355 + 310 – 156
=0
Scenario 7 – Market expires at 8100 (higher than the higher strike price,
your expected target)
The 7600 CE will have an intrinsic value of 500, and the 7800 CE will have an intrinsic
value of 300.
The net payoff would be –
Premium Received for 7600 CE – Intrinsic value of 7600 CE + (2* Intrinsic value of
7800 CE) – Premium Paid for 7800 CE
= 201 – 500 + (2*300) – 156
= 201 – 500 + 600 -156
zerodha.com/varsity
34
= 145
Here are various other levels of expiry, and the eventual payoff from the strategy. Do
note, as the market goes up, so does the profits, but when the market goes down, you
still make some money, although limited.
4.3 – Strategy Generalization

Going by the above discussed scenarios we can make few generalizations –
 Spread = Higher Strike – Lower Strike

 Net Credit = Premium Received for lower strike – 2*Premium of higher strike
 Max Loss = Spread – Net Credit
 Max Loss occurs at = Higher Strike
 The payoff when market goes down = Net Credit
 Lower Breakeven = Lower Strike + Net Credit
 Upper Breakeven = Higher Strike + Max Loss
Here is a graph that highlights all these important points –
zerodha.com/varsity
35
Notice how the payoff remains flat even when the market goes down, the maximum loss
at 7800, and the way the payoff takes off beyond 7955.
4.4 – Welcome back the Greeks

I suppose you are familiar with these graphs by now. The following graphs show the
profitability of the strategy considering the time to expiry and therefore these graphs
help the trader select the right strikes.
zerodha.com/varsity
36
Before understanding the graphs above, note the following –
1. Nifty spot is assumed to be at 8000

2. Start of the series is defined as anytime during the first 15 days of the series
3. End of the series is defined as anytime during the last 15 days of the series
4. The Call Ratio Back Spread is optimized and the spread is created with 300 points
difference
The thought here is that the market will move up by about 6.25% i.e from 8000 to 8500.
So considering the move and the time to expiry, the graphs above suggest –
1. Graph 1 (top left) and Graph 2 (top right) - You are at the start of the expiry series
and you expect the move over the next 5 days (and 15 days in case of Graph 2), then a
Call Ratio Spread with 7800 CE (ITM) and 8100 CE (OTM) is the most
profitable wherein you would sell 7800 CE and buy 2 8100 CE. Do note - even though
zerodha.com/varsity
37
you would be right on the direction of movement, selecting other far OTM strikes call
options tend to lose money
2. Graph 3 (bottom left) and Graph 4 (bottom right) - You are at the start of the
expiry series and you expect the move in 25 days (and expiry day in case of Graph 3),
then a Call Ratio Spread with 7800 CE (ITM) and 8100 CE (OTM) is the most profitable
wherein you would sell 7800 CE and buy 2 8100 CE.
You must be wondering that the selection of strikes is same irrespective of time to
expiry. Well yes, in fact this is the point – Call ratio back spread works best when you
sell slightly ITM option and buy slightly OTM option when there is ample time to
expiry. In fact all other combinations lose money, especially the ones with far OTM
options and especially when you expect the target to be achieved closer to the expiry.
Here are another bunch of charts; the only difference is that the move (i.e 6.25%) occurs
during the 2nd half of the series -
zerodha.com/varsity
38
1. Graph 1 (top left) & Graph 2 (top right) – If you expect the move during the 2nd half
of the series, and you expect the move to happen within a day (or within 5 days,
graph 2) then the best strikes to opt are deep ITM and slightly ITM i.e 7600 (lower
strike short) and 7900 (higher strike long). Do note, this is not the classic combo of an
ITM + OTM spread, instead this is an ITM and ITM spread! In fact all other
combinations don’t work.
2. Graph 3 (bottom right) & Graph 4 (bottom left) - If you expect the move during
the 2nd half of the series, and you expect the move to happen within 10 days (or on
expiry day, graph 4) then the best strikes to opt are deep ITM and slightly ITM i.e
7600 (lower strike short) and 7900 (higher strike long). This is similar to what graph 1
and graph 2 suggest.
Again, the point to note here is besides getting the direction right, the strike selection is
the key to the profitability of this strategy. One needs to be diligent enough to map the
time to expiry to the right strike to make sure that the strategy works in your favor.
What about the effect of volatility on this strategy? Well, volatility plays a key role here,
have a look at the image below –
zerodha.com/varsity
39
There are three colored lines depicting the change of “net premium” aka the strategy
payoff versus change in volatility. These lines help us understand the effect of increase
in volatility on the strategy keeping time to expiry in perspective.
1. Blue Line – This line suggests that an increase in volatility when there is ample time to
expiry (30 days) is beneficial for the Call ratio back spread. As we can see the strategy
payoff increases from -67 to +43 when the volatility increase from 15% to 30%. Clearly
this means that when there is ample time to expiry, besides being right on the direction
of stock/index you also need to have a view on volatility. For this reason, even though
I’m bullish on the stock, I would be a bit hesitant to deploy this strategy at the start of the
series if the volatility is on the higher side (say more than double of the usual volatility
reading)
2. Green line - This line suggests that an increase in volatility when there are about 15
days time to expiry is beneficial, although not as much as in the previous case. As we can
see the strategy payoff increases from -77 to -47 when the volatility increase from 15% to
30%.
3. Red line – This is an interesting, counter intuitive outcome. When there are very few
days to expiry, increase in volatility has a negative impact on the strategy! Think about it,
increase in volatility when there are few days to expiry enhances the possibility of the
option to expiry OTM, hence the premium decreases. So, if you are bullish on a stock /
index with few days to expiry, and you also expect the volatility to increase during this
period then thread cautiously.
Download the Call Ratio Back spread Excelsheet.
1. The Call Ratio Backspread is best executed when your outlook on the stock/index is
bullish
2. The strategy requires you to sell 1 ITM CE and buy 2 OTM CE, and this is to be executed
in the same ratio i.e for every 1 sold option, 2 options have to be purchased
3. The strategy is usually executed for a ‘net Credit’
4. The strategy makes limited money if the stock price goes down, and unlimited profit if
the stock price goes up. The loss is pre defined
5. There are two break even points – lower breakeven and upper breakeven points
zerodha.com/varsity
40
6. Spread = Higher Strike – Lower Strike
7. Net Credit = Premium Received for lower strike – 2*Premium of higher strike
8. Max Loss = Spread – Net Credit
9. Max Loss occurs at = Higher Strike
10. The payoff when market goes down = Net Credit
11. Lower Breakeven = Lower Strike + Net Credit
12. Upper Breakeven = Higher Strike + Max Loss
13. Irrespective of the time to expiry opt for slightly ITM + Slightly OTM combination of
strikes
14. Increase in volatility is good for this strategy when there is more time to expiry, but when
there is less time to expiry, increase in volatility is not really good for this strategy.
zerodha.com/varsity
41
zerodha.com/varsity
42
CHAPTER 5
Bear Call Ladder

5.1 – Background
The ‘Bear’ in the “Bear Call Ladder” should not deceive you to believe that this is a
bearish strategy. The Bear Call Ladder is an improvisation over the Call ratio back
spread; this clearly means you implement this strategy when you are out rightly bullish
on the stock/index.
In a Bear Call Ladder, the cost of purchasing call options is financed by selling an ‘in the
money’ call option. Further, the Bear Call Ladder is also usually setup for a ‘net credit’,
where the cash flow is invariably better than the cash flow of the call ratio back spread.
However, do note that both these strategies showcase similar payoff structures but differ
slightly in terms of the risk structure.

The Bear Call Ladder is a 3 leg option strategy, usually setup for a “net credit”, and it
involves –
1. Selling 1 ITM call option

2. Buying 1 ATM call option
3. Buying 1 OTM call option
This is the classic Bear Call Ladder setup, executed in a 1:1:1 combination. The bear Call
Ladder has to be executed in the 1:1:1 ratio meaning for every 1 ITM Call option sold, 1
ATM and 1 OTM Call option has to be bought. Other combination like 2:2:2 or 3:3:3 (so
on and so forth) is possible.
Let’s take an example - assume Nifty Spot is at 7790 and you expect Nifty to hit 8100 by
the end of expiry. This is clearly a bullish outlook on the market. To implement the Bear
Call Ladder -
zerodha.com/varsity
43
1. Sell 1 ITM Call option
2. Buy 1 ATM Call option
3. Buy 1 OTM Call option
Make sure –
1. The Call options belong to the same expiry

2. Belongs to the same underlying
1. 7600 CE, one lot short, the premium received for this is Rs.247/-
2. 7800 CE, one lot long, the premium paid for this option is Rs.117/-
3. 7900 CE, one lot long, the premium paid for this option is Rs.70/-
4. The net credit would be 247-117-70 = 60
With these trades, the bear call ladder is executed. Let us check what would happen to
the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry as the strategy
payoff is quite versatile.
We know the intrinsic value of a call option (upon expiry) is –
Max [7600 – 7600, 0]
=0
Since we have sold this option, we get to retain the premium received i.e Rs.247/-
Likewise the intrinsic value of 7800 CE and 7900 CE would also be zero; hence we lose
the premium paid i.e Rs.117 and Rs.70 respectively.
zerodha.com/varsity
44
Net cash flow would Premium Received – Premium paid
= 247 – 117 - 70
= 60
Scenario 2 – Market expires at 7660 (lower strike + net premium received)
The 7600 CE would have an intrinsic value of –
Max [7660 – 7600, 0]
= 60
Since the 7600 CE is short, we will lose 60 from 247 and retain the balance
= 247 – 60
= 187
The 7800 and 7900 CE would expire worthless, hence we lose the premium paid i.e 117
and 70 respectively.
The total strategy payoff would be -
= 187 – 117 – 70
=0
Hence at 7660, the strategy would neither make money nor lose money. Hence this is
considered a (lower) breakeven point.
Scenario 3 – Market expires at 7700 (between the breakeven point and

middle strike i.e 7660 and 7800)
The intrinsic value of 7600 CE would be –
zerodha.com/varsity
45
= [7700 – 7600, 0]
= 100
Since, we have sold this option for 247 the net pay off from the option would be
247 – 100
= 147
On the other hand we have bought 7800 CE and 7900 CE, both of which would expire
worthless, hence we lose the premium paid for these options i.e 117 and 70 respectively -
Net payoff from the strategy would be –
147 – 117 – 70
= - 40
Scenario 4 – Market expires at 7800 (at the middle strike price)
Pay attention here, as this is where the tragedy strikes!
The 7600 CE would have an intrinsic value of 200, considering we have written this
option for a premium of Rs.247, we stand to lose the intrinsic value which is Rs.200.
Hence on the 7600 CE, we lose 200 and retain -
247 – 200
= 47/-
Both 7800 CE and 7900 CE would expire worthless, hence the premium that we paid
goes waste, i.e 117 and 70 respectively. Hence our total payoff would be –
47 – 117 – 70
= -140
zerodha.com/varsity
46
Scenario 5 – Market expires at 7900 (at the higher strike price)
Pay attention again, tragedy strikes again
The 7600 CE would have an intrinsic value of 300, considering we have written this
option for a premium of Rs.247, we stand to lose all the premium value plus more.
Hence on the 7600 CE, we lose -
247 - 300
= -53
Both 7800 CE would have an intrinsic value of 100, considering we have paid a
premium of Rs.117, the pay off for this option would be -
100 – 117
= - 17
Finally 7900 CE would expire worthless, hence the premium paid i.e 70 would go waste.
The final strategy payoff would be –
-53 – 17 – 70
= -140
Do note, the loss at both 7800 and 7900 is the same.
Scenario 6 – Market expires at 8040 (sum of long strike minus short strike
minus net premium)
Similar to the call ratio back spread, the bear call ladder has two breakeven points i.e the
upper and lower breakeven. We evaluated the lower breakeven earlier (scenario 2), and
this is the upper breakeven point. The upper breakeven is estimated as –
(7900 + 7800) – 7600 – 60
= 15700 – 7600 - 60
zerodha.com/varsity
47
= 8100 – 60
= 8040
Do note, both 7900 and 7800 are strikes we are long on, and 7600 is the strike we are
short on. 60 is the net credit.
So at 8040, all the call options would have an intrinsic value –
7600 CE would have an intrinsic value of 8040 – 7600 = 440, since we are short on this
at 247, we stand to lose 247 - 440 = -193.
7800 CE would have an intrinsic value of 8040 – 7800 = 240, since we are long on this
at 117, we make 240 – 117 = +123
at 70, we make 140 – 70 = +70
Hence the total payoff from the Bear Call Ladder would be –
-193 + 123 + 70
=0
Hence at 8040, the strategy would neither make money nor lose money. Hence this is
considered a (upper) breakeven point.
Do note, at 7800 and 7900 the strategy was making a loss and at 8040 the strategy
broke even. This should give you a sense that beyond 8040, the strategy would make
money. Lets just validate this with another scenario.
Scenario 7 – Market expires at 8300
At 8300 all the call options would have an intrinsic value.
7600 CE would have an intrinsic value of 8300 – 7600 = 700, since we are short on this
at 247, we stand to lose 247 - 700 = -453.
zerodha.com/varsity
48
at 117, we make 500 – 117 = +383
at 70, we make 400 - 70 = +330
Hence the total payoff from the Bear Call Ladder would be –
-453 + 383 + 330
= 260
As you can imagine, the higher the market move, the higher is the profit potential. Here
is a table that gives you the payoffs at various levels.
Do notice, when the market goes below you stand to make a modest gain of 60 points,
but when the market moves up the profits are uncapped.

Going by the above discussed scenarios we can make few generalizations –
 Spread = technically this is a ladder and not really a spread. However the 1st two option
legs creates a classic “spread” wherein we sell ITM and buy ATM. Hence the spread could
zerodha.com/varsity
49
be taken as the difference between the ITM and ITM options. In this case it would be 200
(7800 – 7600)
 Net Credit = Premium Received from ITM CE – Premium paid to ATM & OTM CE
 Max Loss = Spread (difference between the ITM and ITM options) – Net Credit
 Max Loss occurs at = ATM and OTM Strike
 The payoff when market goes down = Net Credit
 Lower Breakeven = Lower Strike + Net Credit
 Upper Breakeven = Sum of Long strike minus short strike minus net premium
Here is a graph that highlights all these important points –
Notice how the strategy makes a loss between 7660 and 8040, but ends up making a
huge profit if the market moves past 8040. Even if the market goes down you still end
up making a modest profit. But you are badly hit if the market does not move at all.
Given this characteristics of the Bear Call Ladder, I would suggest you implement the
strategy only when you are absolutely sure that the market will move, irrespective of the
direction.
From my experience, I believe this strategy is best executed on stocks (rather than
index) when the quarterly results are due.
zerodha.com/varsity
50
5.4 – Effect of Greeks
The effect of Greeks on this strategy is very similar to the effect of Greeks on Call Ratio
Back spread, especially the volatility bit. For your easy reference, I’m reproducing the
discussion on volatility we had in the previous chapter.
There are three colored lines depicting the change of “net premium” aka the strategy
payoff versus change in volatility. These lines help us understand the effect of increase
in volatility on the strategy keeping time to expiry in perspective.
1. Blue Line – This line suggests that an increase in volatility when there is ample time to
expiry (30 days) is beneficial for the Bear Call Ladder spread. As we can see the strategy
payoff increases from -67 to +43 when the volatility increase from 15% to 30%. Clearly
this means that when there is ample time to expiry, besides being right on the direction
of stock/index you also need to have a view on volatility. For this reason, even though
I’m bullish on the stock, I would be a bit hesitant to deploy this strategy at the start of the
zerodha.com/varsity
51
series if the volatility is on the higher side (say more than double of the usual volatility
reading)
2. Green line - This line suggests that an increase in volatility when there are about 15
days time to expiry is beneficial, although not as much as in the previous case. As we can
see the strategy payoff increases from -77 to -47 when the volatility increase from 15% to
30%.
3. Red line – This is an interesting, counter intuitive outcome. When there are very few
days to expiry, increase in volatility has a negative impact on the strategy! Think about it,
increase in volatility when there are few days to expiry enhances the possibility of the
option to expiry OTM, hence the premium decreases. So, if you are bullish on a stock /
index with few days to expiry, and you also expect the volatility to increase during this
period then thread cautiously.
Download the Bear Call Ladder excel.
1. Bear Call Ladder is an improvisation over the Call Ratio Spread

2. Invariably the cost of executing a bear call ladder is better than the Call Ratio Spread, but
the range above which the market has to move also becomes large
3. The Bear Call Ladder is executed by selling 1 ITM CE, buying 1 ATM CE, and 1 OTM CE
4. Net Credit = Premium Received from ITM CE – Premium paid to ATM & OTM CE
5. Max Loss = Spread (difference between the ITM and ITM options) – Net Credit
6. Max Loss occurs at = ATM and OTM Strike
7. The payoff when market goes down = Net Credit
8. Lower Breakeven = Lower Strike + Net Credit
9. Upper Breakeven = Sum of Long strike minus short strike minus net premium
10. Execute the strategy only when you are convinced that the market will move significantly
higher.
zerodha.com/varsity
52
CHAPTER 6
Synthetic Long & Arbitrage

6.1 – Background
Imagine a situation where you would be required to simultaneously establish a long and
short position on Nifty Futures, expiring in the same series. How would you do this and
more importantly why would you do this?
We will address both these questions in this chapter. To begin with let us understand
how this can be done and later move ahead to understand why one would want to do
this (if you are curious, arbitrage is the obvious answer).
Options as you may have realized by now, are highly versatile derivative instruments;
you can use these instruments to create any kind of payoff structure including that of the
futures (both long and short futures payoff).
In this chapter we will understand how we can artificially replicate a long futures pay off
using options. However before we proceed, you may want to just review the long
Future’s ‘linear’ payoff here
Alternatively, here is a quick overview –
zerodha.com/varsity
53
As you can see, the long futures position has been initiated at 2360, and at that point
you neither make money nor lose money, hence the point at which you initiate the
position becomes the breakeven point. You make a profit as the futures move higher
than the breakeven point and you make a loss the lower the futures move below the
breakeven point. The amount of profit you make for a 10 point up move is exactly the
same as the amount of loss you’d make for a 10 point down move. Because of this
linearity in payoff, the future is also called a linear instrument.
The idea with a Synthetic Long is to build a similar long Future’s payoff using options.

Executing a Synthetic Long is fairly simple; all that one has to do is –
1. Buy the ATM Call Option

2. Sell the ATM Put Option
When you do this, you need to make sure –
1. The options belong to the same underlying

2. Belongs to the same expiry
zerodha.com/varsity
54
Let us take an example to understand this better. Assume Nifty is at 7389, which would
make 7400 the ATM strike. Synthetic Long would require us to go long on 7400 CE, the
premium for this is Rs.107 and we would short the 7400 PE at 80.
The net cash outflow would be the difference between the two premiums i.e 107 – 80
= 27.
Let us consider a few market expiry scenarios –
Scenario 1 – Market expires at 7200 (below ATM)
At 7200, the 7400 CE would expire worthless, hence we would lose the premium paid i.e
Rs.107/-. However the 7400 PE would have an intrinsic value, which can be calculated
as follows –
Intrinsic value of Put Option = Max [Strike-Spot, 0]
= Max [7400 – 7200, 0]
=Max [200, 0]
= 200.
Clearly, since we are short on this option, we would lose money from the premium we
have received. The loss would be –
80 – 200 = -120
Total payoff from the long Call and short Put position would be –
= -107 – 120
= -227
Scenario 2 – Market expires at 7400 (At ATM)
If the market expires exactly at 7400, both the options would expire worthless and
hence –
zerodha.com/varsity
55
1. We lose the premium paid for the 7400 CE option i.e 107
2. We get the retain the premium for the 7400 PE option i.e 80
3. Net payoff from both the positions would be -27e 80 – 107
Do note, 27 also happens to be the net cash outflow of the strategy, which is also the
difference between the two premiums
Scenario 3 – Market expires at 7427 (ATM + Difference between the two

premiums)
7427 is an interesting level, this is the breakeven point for the strategy, where we neither
make money nor lose money.
1. 7400 CE – the option is ITM and has an intrinsic value of 27. However we have paid 107
as premium hence we experience a total loss of 80
2. 7400 PE – the option would expire OTM, hence we get to retain the entire premium of
80.
3. On one hand we make 80 and the other we lose 80. Hence we neither make nor lose any
money, making 7427 the breakeven point for this strategy.
Scenario 4 – Market expires at 7600 (above ATM)
At 7600, the 7400 CE would have an intrinsic value of 200, we would make -
Intrinsic value – Premium
= 200 – 107
= 93
The 7400 PE would expire worthless; hence we get to retain the entire premium of
Rs.80.
Total payoff from the strategy would be –
= 93 + 80
= 173
zerodha.com/varsity
56
With the above 4 scenarios, we can conclude that the strategy makes money while the
market moves higher and loses money while the market goes lower, similar to futures.
However this still does not necessarily mean that the payoff is similar to that of futures.
To establish that the synthetic long payoff behaves similar to futures, we need evaluate
the payoff of the strategy with reference to the breakeven point; let’s say 200 point
above and below the breakeven point. If the payoff is identical, then clearly there is
linearity in the payoff, similar to futures.
So let’s figure this out.
We know the breakeven point for this is –
ATM + difference between the premiums
= 7400 + 27
= 7427
The payoff around this point should be symmetric. We will consider 7427 + 200 =
7627 and 7427-200 = 7227 for this.
At 7627 –
1. The 7400 CE would have an intrinsic value of 227, hence we get to make 227 – 107 = 120
2. The 7400 PE would expire worthless, hence we get to keep the entire premium of 80
3. In all we experience a payoff of 120 + 80 = 200
At 7227 –
1. The 7400 CE would not have any intrinsic value, hence we lose the entire premium paid
i.e 107
2. The 7400 PE would have an intrinsic value of 7400 – 7227 = 173, since we have received
80 as premium the net loss would be 80 – 173 = -93.
3. In all we experience a payoff of -93-107 = -200
Clearly, there is payoff symmetry around the breakeven, and for this reason,
the Synthetic Long mimics the payoff of the long futures instrument.
zerodha.com/varsity
57
Further, here is the payoff at various expiry levels –
And when you plot the Net Payoff, we get the payoff structure which is similar to the
long call futures.
zerodha.com/varsity
58
Having figured out how to set up a Synthetic long, we need to figure out the typical
circumstances under which setting up a synthetic long is required.
6.3 – The Fish market Arbitrage

I’ll assume that you have a basic understanding on Arbitrage. In easy words, arbitrage is
an opportunity to buy goods/asset in a cheaper market and sell the same in expensive
markets and pocket the difference in prices. If executed well, arbitrage trades are almost
risk free. Let me attempt to give you a simple example of an arbitrage opportunity.
Assume you live by a coastal city with abundant supply of fresh sea fish, hence the rate
at which fish is sold in your city is very low, let’s say Rs.100 per Kg. The neighboring city
which is 125 kms away has a huge demand for the same fresh sea fish. However, in this
neighboring city the same fish is sold at Rs.150 per Kg.
Given this if you can manage to buy the fish from your city at Rs.100 and manage to sell
the same in the neighboring city at Rs.150, then in process you clearly get to pocket the
price differential i.e Rs.50. Maybe you will have to account for transportation and other
logistics, and instead of Rs.50, you get to keep Rs.30/- per Kg. This is still a beautiful
deal and this is a typical arbitrage in the fish market!
zerodha.com/varsity
59
It looks perfect, think about it - if you can do this everyday i.e buy fish from your city at
Rs.100 and sell in the neighboring city at Rs.150, adjust Rs.20 towards expenses then
Rs.30 per KG is guaranteed risk free profit.
This is indeed risk free, provides nothing changes. But if things change, so will your
profitability, let me list few things that could change -
1. No Fish (opportunity risk) – Assume one day you go to the market to buy fish at
Rs.100, and you realize there is no fish in the market. Then you have no opportunity to
make Rs.30/-.
2. No Buyers (liquidity risk) – You buy the fish at Rs.100 and go to the neighboring
town to sell the same at Rs.150, but you realize that there are no buyers. You are left
holding a bag full of dead fish, literally worthless!
3. Bad bargaining (execution risk) – The entire arbitrage opportunity hinges upon the
fact that you can ‘always’ bargain to buy at Rs.100 and sell at Rs.150. What if on a bad
day you happen to buy at 110 and sell at 140? You still have to pay 20 for transport, this
means instead of the regular 30 Rupees profit you get to make only 10 Rupees, and if this
continues, then the arbitrage opportunity would become less attractive and you may not
want to do this at all.
zerodha.com/varsity
60
4. Transport becomes expensive (cost of transaction) – This is another crucial
factor for the profitability of the arbitrage trade. Imagine if the cost of transportation
increases from Rs.20 to Rs.30? Clearly the arbitrage opportunity starts looking less
attractive as the cost of execution goes higher and higher. Cost of transaction is a critical
factor that makes or breaks an arbitrage opportunity
5. Competition kicks in (who can drop lower?) – Given that the world is inherently
competitive you are likely to attract some competition who would also like to make that
risk free Rs.30. Now imagine this –
a. So far you are the only one doing this trade i.e buy fish at Rs.100 and sell at
Rs.150
b. Your friend notices you are making a risk free profit, and he now wants to copy
you. You can’t really prevent his as this is a free market.
c. Both of you buy at Rs.100, transport it at Rs.20, and attempt to sell it in the
neighboring town
d. A potential buyer walks in, sees there is a new seller, selling the same quality of
fish. Who between the two of you is likely to sell the fish to the buyer?
e. Clearly given the fish is of the same quality the buyer will buy it from the one
selling the fish at a cheaper rate. Assume you want to acquire the client, and
therefore drop the price to Rs.145/-
f. Next day your friend also drops the price, and offers to sell fish at Rs.140 per KG,
and therefore igniting a price war. In the whole process the price keeps dropping
and the arbitrage opportunity just evaporates.
g. How low can the price drop? Obviously it can drop to Rs.120 (cost of buying fish
plus transport). Beyond 120, it does not makes sense to run the business
h. Eventually in a perfectly competitive world, competition kicks in and arbitrage
opportunity just ceases to exist. In this case, the cost of fish in neighboring town
would drop to Rs.120 or a price point in that vicinity.
I hope the above discussion gave you a quick overview on arbitrage. In fact we can
define any arbitrage opportunity in terms of a simple mathematical expression, for
example with respect to the fish example, here is the mathematical equation –
[Cost of selling fish in town B - Cost of buying fish in town A] = 20
If there is an imbalance in the above equation, then we essentially have an arbitrage

opportunity. In all types of markets - fish market, agri market, currency market, and
zerodha.com/varsity
61
stock market such arbitrage opportunities exist and they are all governed by simple
arithmetic equations.
6.4 – The Options arbitrage

Arbitrage opportunities exist in almost every market, one needs to be a keen observer of
the market to spot it and profit from it. Typically stock market based arbitrage
opportunities allow you to lock in a certain profit (small but guaranteed) and carry this
profit irrespective of which direction the market moves. For this reason arbitrage trades
are quite a favorite with risk intolerant traders.
I would like to discuss a simple arbitrage case here, the roots of which lie in the concept
of ‘Put Call Parity’. I will skip discussing the Put Call Parity theory but would instead
jump to illustrate one of its applications.
However I’d suggest you watch this beautiful video from Khan Academy to understand
the Put Call Parity –
So based on Put Call Parity, here is an arbitrage equation –
Long Synthetic long + Short Futures = 0
You can elaborate this to –
Long ATM Call + Short ATM Put + Short Futures = 0
The equation states that the P&L upon expiry by virtue of holding a long synthetic long
and short future should be zero. Why should this position result in a zero P&L, well the
answer to this is attributable to the Put Call Parity.
However, if the P&L is a non zero value, then we have an arbitrage opportunity.
Here is an example that will help you understand this well.
zerodha.com/varsity
62
On 21st Jan, Nifty spot was at 7304, and the Nifty Futures was trading at 7316.
zerodha.com/varsity
63
The 7300 CE and PE (ATM options) were trading at 79.5 and 73.85 respectively. Do
note, all the contracts belong to the January 2016 series.
Going by the arbitrage equation stated above, if one were to execute the trade, the
positions would be –
1. Long 7300 CE @ 79.5

2. Short 7300 PE @ 73.85
3. Short Nifty futures @ 7316
Do note, the first two positions together form a long synthetic long. Now as per the
arbitrage equation, upon expiry the positions should result in a zero P&L. Let’s evaluate
if this holds true.
Scenario 1 – Expiry at 7200
 The 7300 CE would expire worthless, hence we lose the premium paid i.e 79.5
 The 7300 PE would have an intrinsic value of 100, but since we are short at 73.85, the
net payoff would be 73.85 – 100 = -26.15
zerodha.com/varsity
64
 We are short on futures at 7316, which would result in a profit of 116 points (7316 –
7200)
 Net payoff would be -79.5 – 26.15 + 116 = +10.35
Clearly, instead of a 0 payoff, we are experiencing a positive non zero P&L.
 The 7300 CE would expire worthless, hence we lose the premium paid i.e 79.5
 The 7300 PE would expire worthless, hence we get to retain 73.85
 We are short on futures at 7316, which would result in a profit of 16 points (7316 – 7300)
 Net payoff would be -79.5 +73.85+16 = +10.35
 The 7300 CE would have an intrinsic value of 100, and therefore the payoff would be 100
– 79.5 = 20.5
 The 7300 PE would expire worthless, hence we get to retain 73.85
 We are short on futures at 7316, which would result in loss of 84 points (7316 – 7400)
 Net payoff would be 20.5 + 73.85 - 84 = +10.35
You could test this across any expiry value (in other words the markets can move in any
direction) but you are likely to pocket 10.35 points, upon expiry. I’d like to stress this
again; this arbitrage lets you make 10.35, upon expiry.
Here is the payoff structure at different expiry values –
zerodha.com/varsity
65
Interesting isn’t it? But what’s the catch you may ask?
Transaction charges!
One has to account for the cost of execution of this trade and figure out if it still makes
sense to take up the trade. Consider this –
 Brokerage – if you are trading with a traditional broker, then you will be charged on a
percentage basis which will eat away your profits. So on one hand you make 10 points,
but you may end up paying 8 – 10 points as brokerage. However if you were to do this
trade with a discount broker like Zerodha, your breakeven on this trade would be around
4-5 points. This should give you more reason to open your account with Zerodha
 STT – Do remember the P&L is realised upon expiry; hence you would have to carry
forward your positions to expiry. If you are long on an ITM option (which you will be)
then upon expiry you will have to pay a hefty STT, which will further eat away your
profits. Please do read this to know more.
 Other applicable taxes – Besides you also have to account for service tax, stamp duty
etc
So considering these costs, the efforts to carry an arbitrage trade for 10 points may not
make sense. But it certainly would, if the payoff was something better, maybe like 15 or
zerodha.com/varsity
66
20 points. With 15 or 20 points you can even maneuver the STT trap by squaring off the
positions just before expiry - although it will shave off a few points.
Download the Synthetic long & Arbitrage excel.
1. You can use options to replicate futures payoff

2. A synthetic long replicates the long futures payoff
3. Simultaneously buying ATM call and selling ATM Put creates a synthetic long
4. The breakeven point for the synthetic long is the ATM strike + net premium paid
5. An arbitrage opportunity is created when Synthetic long + short futures yields a positive
non zero P&L upon expiry
6. Execute the arbitrage trade only if the P&L upon expiry makes sense after accounting for
expenses.
zerodha.com/varsity
67
zerodha.com/varsity
68
CHAPTER 7
Bear Put Spread

7.1 – Spreads versus naked positions
Over the last five chapters we’ve discussed various multi leg bullish strategies. These
strategies ranged to suit an assortment of market outlook - from an outrightly bullish
market outlook to moderately bullish market outlook. Reading through the last 5
chapters you must have realised that most professional options traders prefer initiating
a spread strategy versus taking on naked option positions. No doubt, spreads tend to
shrink the overall profitability, but at the same time spreads give you a greater visibility
on risk. Professional traders value ‘risk visibility’ more than the profits. In simple words,
it’s a much better deal to take on smaller profits as long as you know what would be your
maximum loss under worst case scenarios.
Another interesting aspect of spreads is that invariably there is some sort of financing
involved, wherein the purchase of an option is funded by the sale of another option. In
fact, financing is one of the key aspects that differentiate a spread versus a normal naked
directional position. Over the next few chapters we will discuss strategies which you can
deploy when your outlook ranges from moderately bearish to out rightly bearish. The
composition of these strategies is similar to the bullish strategies that we discussed
earlier in the module.
The first bearish strategy we will look into is the Bear Put Spread, which as you may
have guessed is the equivalent of the Bull Call Spread.
zerodha.com/varsity
69
7.2 – Strategy notes
Similar to the Bull Call Spread, the Bear Put Spread is quite easy to implement. One
would implement a bear put spread when the market outlook is moderately bearish, i.e
you expect the market to go down in the near term while at the same time you don’t
expect it to go down much. If I were to quantify ‘moderately bearish’, a 4-5% correction
would be apt. By invoking a bear put spread one would make a modest gain if the
markets correct (go down) as expected but on the other hand if the markets were to go
up, the trader will end up with a limited loss.
A conservative trader (read as risk averse trader) would implement Bear Put Spread
strategy by simultaneously –
1. Buying an In the money Put option

2. Selling an Out of the Money Put option
There is no compulsion that the Bear Put Spread has to be created with an ITM and
OTM option. The Bear Put spread can be created employing any two put options. The
choice of strike depends on the aggressiveness of the trade. However do note that both
the options should belong to the same expiry and same underlying. To understand the
zerodha.com/varsity
70
implementation better, let’s take up an example and see how the strategy behaves under
different scenarios.
As of today Nifty is at 7485, this would make 7600 PE In the money and 7400 PE Out of
the money. The ‘Bear Put Spread’ would require one to sell 7400 PE, the premium
received from the sale would partially finance the purchase of the 7600 PE. The
premium paid (PP) for the 7600 PE is Rs.165, and the premium received (PR) for the
7400 PE is Rs.73/-. The net debit for this transaction would be –
73 – 165
= -92
To understand how the payoff of the strategy works under different expiry
circumstances, we need to consider different scenarios. Please do bear in mind the
payoff is upon expiry, which means to say that the trader is expected to hold these
positions till expiry.
Scenario 1 – Market expires at 7800 (above long put option i.e 7600)
This is a case where the market has gone up as opposed to the expectation that it would
go down. At 7800 both the put option i.e 7600 and 7400 would not have any intrinsic
value, hence they would expire worthless.
 The premium paid for 7600 PE i.e Rs.165 would go to 0, hence we retain nothing
 The premium received for 7400 PE i.e Rs.73 would be retained entirely
 Hence at 7800, we would lose Rs.165 on one hand but this would be partially
offset by the premium received i.e Rs.73
 The overall loss would be -165 + 73 = -92
Do note the ‘-ve’ sign associated with 165 indicates that this is a money outflow from the
account, and the ‘+ve’ sign associated with 73 indicates that the money is received into
the account.
Also, the net loss of 92 is equivalent to the net debit of the strategy.
Scenario 2 – Market expired at 7600 (at long put option)
zerodha.com/varsity
71
In this scenario we assume the market expires at 7600, where we have purchased a Put
option. But then, at 7600 both 7600 and 7400 PE would expire worthless (similar to
scenario 1) resulting in a loss of -92.
Scenario 3 – Market expires at 7508 (breakeven)
7508 is half way through 7600 and 7400, and as you may have guessed I’ve picked 7508
specifically to showcase that the strategy neither makes money nor loses any money at
this specific point.
 The 7600 PE would have an intrinsic value equivalent to Max [7600 -7508, 0],
which is 92.
 Since we have paid Rs.165 as premium for the 7600 PE, some of the premium
paid would be recovered. That would be 165 – 92 = 73, which means to say the
net loss on 7600 PE at this stage would be Rs.73 and not Rs.165
 The 7400 PE would expire worthless, hence we get to retain the entire premium
of Rs.73
 So on hand we make 73 (7400 PE) and on the other we lose 73 (7600 PE)
resulting in a no loss no profit situation
Hence, 7508 would be the breakeven point for this strategy.
Scenario 4 – Market expires at 7400 (at short put option)
This is an interesting level, do recall when we initiated the position the spot was at 7485,
and now the market has gone down as expected. At this point both the options would
have interesting outcomes.
which is 200
 We have paid a premium of Rs.165, which would be recovered from the intrinsic
value of Rs.200, hence after compensating for the premium paid one would
retain Rs.35/-
 The 7400 PE would expire worthless, hence the entire premium of Rs.73 would
be retained
 The net profit at this level would be 35+73 = 108
zerodha.com/varsity
72
The net payoff from the strategy is in line with the overall expectation from the strategy
i.e the trader gets to make a modest profit when the market goes down.
Scenario 5 – Market expires at 7200 (below the short put option)
This is again an interesting level as both the options would have an intrinsic value. Lets
figure out how the numbers add up –
which is 400
 We have paid a premium of Rs.165, which would be recovered from the intrinsic
value of Rs.400, hence after compensating for the premium paid one would
retain Rs.235/-
which is 200
 We received a premium of Rs.73, however we will have to let go of the premium
and bear a loss over and above 73. This would be 200 -73 = 127
 On one hand we make a profit of Rs.235 and on the other we lose 127, therefore
the net payoff of the strategy would be 235 – 127 = 108.
Summarizing all the scenarios (I’ve put up the payoff values directly after considering
the premiums)
Market Expiry Long Put (7600)_IV Short Put (7400)_IV Net payoff
7800 0 0 -92
7600 0 0 -92
7508 92 0 0
7200 400 200 +108
Do note, the net payoff from the strategy is in line with the overall expectation from the
strategy i.e the trader gets to make a modest profit when the market goes down while at
the same time the losses are capped in case the market goes up.
Have a look at the table below -
zerodha.com/varsity
73
The table below shows the strategy payoff at different expiry levels. The losses are
capped to 92 (when markets go up) and the profits are capped to 108 (when markets go
down).
7.3 – Strategy critical levels

From the above discussed scenarios we can generalize a few things –
1. Strategy makes a loss if the spot moves above the breakeven point, and makes a
profit below the breakeven point
2. Both the profits and loss are capped
3. Spread is difference between the two strike prices.
a. In this example spread would be 7600 – 7400 = 200
4. Net Debit = Premium Paid – Premium Received
a. 165 – 73 = 92
5. Breakeven = Higher strike – Net Debit
a. 7600 – 92 = 7508
6. Max profit = Spread – Net Debit
a. 200 – 92 = 108
7. Max Loss = Net Debit
a. 92
zerodha.com/varsity
74
You can note all these critical points in the strategy payoff diagram -
7.4 – Quick note on Delta

This is something I missed talking about in the earlier chapters, but its better late than
never :-). Whenever you implement an options strategy always add up the deltas. I used
the B&S calculator to calculate the deltas.
The delta of 7600 PE is -0.618
The delta of 7400 PE is – 0.342
zerodha.com/varsity
75
The negative sign indicates that the put option premium will go down if the markets go
up, and premium gains value if the markets go down. But do note, we have written the
7400 PE, hence the Delta would be
-(-0.342)
+ 0.342
Now, since deltas are additive in nature we can add up the deltas to give the combined
delta of the position. In this case it would be –
-0.618 + (+0.342)
= - 0.276
This means the strategy has an overall delta of 0.276 and the ‘–ve’ indicates that the
premiums will go up if the markets go down. Similarly you can add up the deltas of
other strategies we’ve discussed earlier - Bull Call Spread, Call Ratio Back spread etc and
you will realize they all have a positive delta indicating that the strategy is bullish.
When you have more than 2 option legs it gets really difficult to estimate the overall bias
of the strategy (whether the strategy is bullish or bearish), in such cases you can quickly
add up the deltas to know the bias. Further, if in case the deltas add to zero, then it
zerodha.com/varsity
76
means that the strategy is not really biased to any direction. Such strategies are called
‘Delta Neutral’. We will eventually discuss these strategies at a later point in this
module.
Also, you may be interested to know that while the delta neutral strategies are immune
to market’s directional move, they react to changes in volatility and time, hence these
are also sometime called “Volatility based strategies”.
7.5 – Strike selection and effect of volatility

The strike selection for a bear put spread is very similar to the strike selection
methodology of a bull call spread. I hope you are familiar with the ‘1st half of the series’
and ‘2nd half of the series’ methodology. If not I’d suggest you to kindly read
through section 2.3.
Have a look at the graph below –
If we are in the first half of the series (ample time to expiry) and we expect the market to
go down by about 4% from present levels, choose the following strikes to create the
spread
zerodha.com/varsity
77
Expect 4% move to happen within Higher strike Lower strike Refer graph on
5 days Far OTM Far OTM Top left
15 days ATM Slightly OTM Top right
25 days ATM OTM Bottom left
At expiry ATM OTM Bottom right
Now assuming we are in the 2nd half of the series, selecting the following strikes to
create the spread would make sense –
Same day (even specific) OTM OTM Top left
5 days ITM/OTM OTM Top right
10 days ITM/OTM OTM Bottom left
At expiry ITM/OTM OTM Bottom right
I hope you will find the above two tables useful while selecting the strikes for the bear
put spread.
zerodha.com/varsity
78
We will now shift our focus on the effect of volatility on the bear put spread. Have a look
at the following image –
The graph above explains how the premium varies with respect to variation in volatility
and time.
 The blue line suggests that the cost of the strategy does not vary much with the
increase in volatility when there is ample time to expiry (30 days)
 The green line suggests that the cost of the strategy varies moderately with the
increase in volatility when there is about 15 days to expiry
 The red line suggests that the cost of the strategy varies significantly with the
From these graphs it is clear that one should not really be worried about the changes in
the volatility when there is ample time to expiry. However one should have a view on
volatility between midway and expiry of the series. It is advisable to take the bear put
spread only when the volatility is expected to increase, alternatively if you expect the
volatility to decrease, its best to avoid the strategy.
Download the Bear Put Spread excel.
zerodha.com/varsity
79
1. Spread offers visibility on risk but at the same time shrinks the reward
2. When you create a spread, the proceeds from the sale of an option offsets the
purchase of an option
3. Bear put spread is best invoked when you are moderately bearish on the markets
4. Both the profits and losses are capped
5. Classic bear put spread involves simultaneously purchasing ITM put options and
selling OTM put options
6. Bear put spread usually results in a net debit
7. Net Debit = Premium Paid – Premium Received
8. Breakeven = Higher strike – Net Debit
9. Max profit = Spread – Net Debit
10. Max Loss = Net Debit
11. Select strikes based on the time to expiry
12. Implement the strategy only when you expect the volatility to increase (especially
in the 2nd half of the series)
zerodha.com/varsity
80
CHAPTER 8
Bear Call Spread

8.1 – Choosing Calls over Puts
Similar to the Bear Put Spread, the Bear Call Spread is a two leg option strategy invoked
when the view on the market is ‘moderately bearish’. The Bear Call Spread is similar to
the Bear Put Spread in terms of the payoff structure; however there are a few differences
in terms of strategy execution and strike selection. The Bear Call spread involves
creating a spread by employing ‘Call options’ rather than ‘Put options’ (as is the case in
bear put spread).
You may have a fundamental question at this stage – when the payoffs from both Bear
Put spread and Bear Call spread are similar, why should one choose a Bear Call spread
over a Bear Put spread?
zerodha.com/varsity
81
Well, this really depends on how attractive the premiums are. While the Bear Put spread
is executed for a debit, the Bear Call spread is executed for a credit. So if you are at a
point in the market where –
1. The markets have rallied considerably (therefore CALL premiums have swelled)
2. The volatility is favorable
3. Ample time to expiry
And you have a moderately bearish outlook going forward, then it makes sense to invoke
a Bear Call Spread for a net credit as opposed to invoking a Bear Put Spread for a net
debit. Personally I do prefer strategies which offer net credit rather than strategies
which offer net debit.

The Bear Call Spread is a two leg spread strategy traditionally involving ITM and OTM
Call options. However you can create the spread using other strikes as well. Do
remember, the higher the difference between the two selected strikes (spread), larger is
the profit potential.
To implement the bear call spread –
1. Buy 1 OTM Call option (leg 1)

2. Sell 1 ITM Call option (leg 2)
Ensure –

Let us take up example to understand this better -
Date – February 2016
Outlook – Moderately bearish
Nifty Spot – 7222
zerodha.com/varsity
82
Bear Call Spread, trade set up -
1. Buy 7400 CE by paying Rs.38/- as premium; do note this is an OTM option.

Since money is going out of my account this is a debit transaction
2. Sell 7100 CE and receive Rs.136/- as premium, do note this is an ITM option.
Since I receive money, this is a credit transaction
3. The net cash flow is the difference between the debit and credit i.e 136 – 38
= +98, since this is a positive cashflow, there is a net credit to my account.
Generally speaking in a bear call spread there is always a ‘net credit’, hence the bear call
spread is also called referred to as a ‘credit spread’. After we initiate the trade, the
market can move in any direction and expiry at any level. Therefore let us take up a few
scenarios to get a sense of what would happen to the bear put spread for different levels
of expiry.
Scenario 1 – Market expires at 7500 (above the long Call)
At 7500, both the Call options would have an intrinsic value and hence they both would
expire in the money.
 7400 CE would have an intrinsic value of 100, since we have paid a premium of
Rs.38, we would be in a profit of 100 – 38 = 62
 7100 CE would have an intrinsic value of 400, since we have sold this option at
Ra.136, we would incur a loss of 400 – 136 = -264
 Net loss would be -264 + 62 = - 202
Scenario 2 – Market expires at 7400 (at the long call)
At 7400, the 7100 CE would have an intrinsic value and hence would expire in the
money. The 7400 CE would expire worthless.
 7400 CE would expire worthless, hence the entire premium of Rs.38 would be
written of as a loss.
 7100 CE would have an intrinsic value of 300, since we have sold this option at
Ra.136, we would incur a loss of 300 – 136 = -164
 Net loss would be -164 -38 = - 202
zerodha.com/varsity
83
Do note, the loss at 7400 is similar to the loss at 7500 pointing to the fact that above a
certain point loss is capped to 202.
Scenario 3 – Market expires at 7198 (breakeven)
At 7198, the trade neither makes money or losses money, hence this is considered a
breakeven point. Let us see how the numbers play out here –
 At 7198, the 7100CE would expire with an intrinsic value of 98. Since we have
sold the option at Rs.136, we get to retain a portion of the premium i.e 136 – 98
= +38
 7400 CE would expire worthless, hence we will lose the premium paid i.e 38
 Net payoff would -38 + 38 = 0
This clearly indicates that the strategy neither makes money or losses money at 7198.
Scenario 4 – Market expires at 7100 (at the short call)
At 7100, both the Call options would expire worthless, hence it would be out of the
money.
 7400 would not have any value, hence the premium paid would be a complete
loss, i.e Rs.38
 7100 will also not have any intrinsic value, hence the entire premium received i.e
Rs.136 would be retained back
 Net profit would be 136 - 38 = 98
Clearly, as and when the market falls, the strategy makes a profit.
Scenario 5 – Market expires at 7000 (below the short call)
This scenario tests the profitability of the strategy when the market falls further. At
7000, both the call options would expire worthless. While we treat the premium paid for
7400 CE i.e Rs.38 as a loss , we will retain the entire premium received for 7100 CE i.e
Rs.136 as a profit. Hence the net profit from the strategy would be 136-38 = 98. Clearly,
as and when the market falls, the strategy tends to make money, but it is capped to
Rs.98.
zerodha.com/varsity
84
Here is the payoff for the strategy at different expiries –
These payoffs can be plotted to get the graph of the strategy payoff –
As you can observe, the payoff is similar to a bear put spread where both the profits
under best case scenario and losses under worst case scenario is pre defined.
zerodha.com/varsity
85
Going by the above payoff we can generalize the key trigger points for the strategy –
 Spread = Difference between the strikes

o 7400 – 7100 = 300
 Net Credit = Premium Received – Premium Paid
o 136 – 38 = 98
 Breakeven = Lower strike + Net Credit
o 7100 + 98 = 7198
 Max Profit = Net Credit
 Max Loss = Spread – Net Credit
o 300 – 98 = 202
At this stage, we can add up the Deltas to get the overall position delta to know the
strategy’s sensitivity to the directional movement.
From the BS calculator I got the Delta values as follows –
 7400 CE is OTM option and has a delta of +0.32

 7100 CE is ITM option and has a delta of +0.89
 Since we are short 7100 CE, the delta is –(+0.89) = -0.89
 Overall position delta is = +0.32 + (-0.89) = -0.57
The delta of the strategy is negative, and it indicates that the strategy makes money
when the underlying goes down, and makes a loss when the underlying goes up.
8.4 – Strike Selection and impact of Volatility

The following images help us identify the best call option strikes to choose, given the
time to expiry. We have discussed the split up of time frame (1st and 2nd half of the
series) several times before, hence for this reason I will just post the graphs and the
summary table.
Strikes to select when we are in the 1st half of the series –
zerodha.com/varsity
86
5 days Far OTM ATM+2 strikes Top left
15 days Far OTM ATM + 2 strikes Top right
25 days OTM ATM + 1 strike Bottom left
At expiry OTM ATM Bottom right
Strikes to select when we are in the 2nd half of the series –
zerodha.com/varsity
87
5 days Far OTM Far OTM Top left
15 days Far OTM Slightly OTM Top right
25 days Slightly OTM ATM Bottom left
At expiry OTM ATM/ITM Bottom right
The following graph talks about the variation in strategy cost with respect to changes in
the volatility –
zerodha.com/varsity
88
The graph above explains how the premium varies with respect to variation in volatility
and time.
 The blue line suggests that the cost of the strategy does not vary much with the
increase in volatility when there is ample time to expiry (30 days)
 The green line suggests that the cost of the strategy varies moderately with the
 The red line suggests that the cost of the strategy varies significantly with the
From these graphs it is clear that one should not really be worried about the changes in
the volatility when there is ample time to expiry. However one should have a view on
volatility between midway and expiry of the series. It is advisable to take the bear call
spread only when the volatility is expected to increase, alternatively if you expect the
volatility to decrease, its best to avoid the strategy.
Download the Bear Call Spread excel.
zerodha.com/varsity
89
1. Bear call spread is best invoked when you are moderately bearish on the markets
2. You choose a bear call spread over a bear put spread when the call option
premiums are more attractive than put options.
3. Both the profits and losses are capped
4. Classic bear call spread involves simultaneously purchasing OTM call options and
selling ITM call options
5. Bear call spread usually results in a net credit, in fact this is another key reason to
invoke a bear call spread versus a bear put spread
6. Net Credit = Premium Received – Premium Paid
7. Breakeven = Lower strike + Net Credit
8. Max profit = Net Credit
10. Select strikes based on the time to expiry
11. Implement the strategy only when you expect the volatility to increase (especially
in the 2nd half of the series)
zerodha.com/varsity
90
CHAPTER 9
Put Ratio Back Spread

9.1 – Background
We discussed the “Call Ratio Back spread” strategy extensively in chapter 4 of this
module. The Put ratio back spread is similar except that the trader invokes this when he
is bearish on the market or stock.
At a broad level this is what you will experience when you implement the Put Ratio Back
Spread
1. Unlimited profit if the market goes down

2. Limited profit if market goes up
3. A predefined loss if the market stays within a range
In simpler words you make money as long as the market moves in either direction, of
course the strategy is more favorable if market goes down.
zerodha.com/varsity
91
Usually, the Put Ratio Back Spread is deployed for a ‘net credit’, meaning money flows
into your account as soon as you execute Put Ratio Back Spread. The ‘net credit’ is what
you make if the market goes up, as opposed to your expectation (i.e market going down).
On the other hand if the market indeed goes down, then you stand to make an unlimited
profit.
I suppose this should also explain why the put ratio back spread is better than buying a
plain vanilla put option.

The Put Ratio Back Spread is a 3 leg option strategy as it involves buying two
OTM Put options and selling one ITM Put option. This is the classic 2:1 combo. In
fact the put ratio back spread has to be executed in the 2:1 ratio meaning 2 options
bought for every one option sold, or 3 options bought for every 2 options sold, so on and
so forth.
zerodha.com/varsity
92
Let take an example - Nifty Spot is at 7506 and you expect Nifty to hit 7000 by the end
of expiry. This is clearly a bearish expectation. To implement the Put Ratio Back Spread
-
1. Sell one lot of 7500 PE (ITM)

2. Buy two lots of 7200 PE (OTM)
Make sure –
1. The Put options belong to the same expiry

2. Belong to the same underlying
1. 7500 PE, one lot short, the premium received for this is Rs.134/-
2. 7200 PE, two lots long, the premium paid is Rs.46/- per lot, so Rs.92/- for 2 lots
3. Net Cash flow is = Premium Received – Premium Paid i.e 134 – 92 = 42 (Net
Credit)
With these trades, the Put ratio back spread is executed. Let us check what would
happen to the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry, as the
strategy payoff is quite versatile.
Scenario 1 – Market expires at 7600 (above the ITM option)
At 7600, both the Put options would expire worthless. The intrinsic value of options and
the eventual strategy payoff is as below –
 7200 PE, would expire worthless, since we are long 2 lots of this option at Rs.46
per lot, we would lose the entire premium of Rs.92 paid
 7500 PE would also expire worthless, but we have written this option and
received a premium of Rs.134, which in this case can be retained back
 The net payoff from the strategy is 134 – 92 = 42
zerodha.com/varsity
93
Do note, the net payoff of the strategy at 7600 (higher than the ITM strike) is equivalent
to the net credit.
Scenario 2 – Market expires at 7500 (at the higher strike i.e the ITM option)
At 7500 both the options would have no intrinsic value, hence they both would expire
worthless. Hence the payoff would be similar to the payoff we discussed at 7600. Hence
the net strategy payoff would be equal to Rs.42 (net credit).
In fact as you may have guessed, the payoff of the strategy at any point above 7500 is
equal to the net credit.
Scenario 3 – Market expires at 7458 (higher break even)
Like in the call ratio back spread strategy, the put ratio back spread too has two
breakeven points i.e the upper breakeven and the lower breakeven point. 7458 marks
the upper breakeven level; of course we will discuss how we arrived at the upper
breakeven point a little later in the chapter.
 At 7458, the 7500 PE will have an intrinsic value. As you may recall, the put
option intrinsic value can be calculated as Max[Strike – Spot, 0] i.e Max[7500 –
7458, 0] hence 42
 Since we have sold 7500 PE at 134, we will lose a portion of the premium received
and retain the rest. Hence the payoff would be 134 – 42 = 92
 The 7200 PE will not have any intrinsic value, hence the entire premium paid i.e
92 is lost
 So on one hand we made 92 on the 7500 PE and on the other we would lose 92
on the 7200 PE resulting in no loss, no gain. Thus, 7458 marks as one of the
breakeven points.
Scenario 4 – Market expires at 7200 (Point of maximum pain)
This is the point at which the strategy causes maximum pain, let us figure out why.
 At 7200, 7500 PE would have an intrinsic value of 300 (7500 – 7200). Since we
have sold this option and received a premium of Rs.134, we would lose the entire
premium received and more. The payoff on this would be 134 - 300 = - 166
zerodha.com/varsity
94
 7200 PE would expire worthless as it has no intrinsic value. Hence the entire
premium paid of Rs.92 would be lost
 The net strategy payoff would be -166 – 92 = - 258
 This is a point where both the options would turn against us, hence is considered
as the point of maximum pain
Scenario 5 – Market expires at 6942 (lower break even)
At 6942, both the options would have an intrinsic value; however this is the lower
breakeven point. Let’s figure out how this works –
 At 6942, 7500 PE will have an intrinsic value equivalent of 7500 – 6942 = 558.
Since have sold this option at 134, the payoff would be 134 – 558 = - 424
 The 7200 PE will also have an intrinsic value equivalent of 7200 – 6942 = 258
per lot, since we are long two lots the intrinsic value adds upto 516. We have
initially paid a premium of Rs.92 (both lots included), hence this needs to be
deducted to arrive at the payoff would be 516 – 92 = +424
 So on one hand we make 424 on the 7200 PE and on the other we would lose 424
on the 7500 PE resulting in no loss, no gain. Thus, 6942 marks as one of the
breakeven points.
Remember, the put ratio backspread is a bearish strategy. It is supposed to make money
once the market goes below the lower breakeven point. So lets understand how the pay
off behaves at a point lower than the lower breakeven point.
 At 6800, 7500 PE will have an intrinsic value of 700 and since we are short
7500PE at 134, we would lose 134 -700 = - 566
 7200 PE will have an intrinsic value of 400. Since we are long 2 lots, the intrinsic
value would be 800. Premium paid for two lots is Rs.92, hence after adjusting for
the premium paid, we get to make 800 – 92 = +708
 Net strategy payoff would be 708 – 566 = +142
zerodha.com/varsity
95
Likewise, you can evaluate the strategy payoff at different levels of market expiry and
you will realize that the profits are uncapped as long as the market continues to slide.
The following table showcases the same –
Plotting the different payoff points, gives us the strategy payoff graph –
Clearly from the graph above, we can conclude –
1. If markets go down, then the profits are unlimited
zerodha.com/varsity
96
2. There are two breakeven points
3. The point at which maximum loss occurs is at 7200
4. If markets goes up, then the profits are limited
9.3 – Strategy generalization

We can generalize the key strategy levels as below –
1. Spread = Higher Strike – lower strike

a. 7500 – 7200 = 300
2. Max loss = Spread – Net credit
a. 300 – 42 = 258
3. Max Loss occurs at = Lower strike price
4. Lower Breakeven point = Lower strike – Max loss
a. 7200 – 258 = 6942
5. Upper breakeven point = Lower strike + Max loss
a. 7200 + 258 = 7458
9.4 – Delta, strike selection, and effect of volatility

As we know, the strategy gets more profitable as and when the market falls. In other
words this is a directional strategy (profitable when markets go down) and therefore the
delta at overall strategy level should reflect this. Let us do the math to figure this out –
 7500 PE is ITM option, delta is - 0.55. However since we have written the option,
the delta is –(-0.55) = +0.55
 7200 PE is OTM, has a delta of - 0.29, remember we are long two lots here
 The overall position delta would be +0.55 + (-0.29) +(-0.29) = - 0.03
The non zero Delta value clearly indicates that the strategy is sensitive to the directional
movement (although negligible). The negative sign indicates that the strategy makes
money when the market goes down.
As far as the strikes are concerned, I’d suggest you stick to the classic combination of
ITM and OTM options. Remember the trade needs to be executed for a ‘Net Credit’. Do
not initiate this strategy if there is a net outflow of cash at the time of execution.
zerodha.com/varsity
97
Let’s look at the variation in volatility and its effect on the strategy –
There are three colored lines depicting the change of “premium value” versus change in
volatility. These lines help us understand the effect of increase in volatility on the
strategy keeping time to expiry in perspective.
1. Blue Line – This line suggests that an increase in volatility when there is ample
time to expiry (30 days) is beneficial for the Put ratio back spread. As we can see
the strategy payoff increases from -57 to +10 when the volatility increase from
15% to 30%. Clearly this means that when there is ample time to expiry, besides
being right on the direction of stock/index you also need to have a view on
volatility. For this reason, even though I’m bearish on the stock, I would be a bit
hesitant to deploy this strategy at the start of the series if the volatility is on the
higher side (say more than double of the usual volatility reading)
2. Green line - This line suggests that an increase in volatility when there are
about 15 days time to expiry is beneficial, although not as much as in the previous
case. As we can see the strategy payoff increases from -77 to -47 when the
volatility increase from 15% to 30%.
zerodha.com/varsity
98
3. Red line – Clearly increase in volatility when we have a few days to expiry does
not have much impact on the premium value. This means, when you are close to
expiry you only need to worry about the directional movement and need not
really worry much about the variation in volatility.
Download the Put Ratio Back spread excel.
1. The Put Ratio Back spread is best executed when your outlook on the stock/index
is bearish
2. The strategy requires you to sell 1 ITM PE and buy 2 OTM PE, and this is to be
executed in the same ratio i.e for every 1 option sold, 2 options have to be
purchased
3. The strategy is usually executed for a ‘Net Credit’
4. The strategy makes limited money if the stock price goes up, and unlimited profit
when the stock price goes down
5. There are two break even points – lower breakeven and upper breakeven
6. Spread = Higher Strike – Lower Strike
7. Net Credit = Premium Received for Higher strike – 2*Premium paid for lower
strike
9. Max Loss occurs at = Lower Strike
10. The payoff when market goes up = Net Credit
11. Lower Breakeven = Lower Strike – Max Loss
12. Upper Breakeven = Lower Strike + Max Loss
13. Irrespective of the time to expiry opt for ITM and OTM strike combination
14. Increase in volatility is good for this strategy when there is more time to expiry
zerodha.com/varsity
99
CHAPTER 10
The Long Straddle

10.1 – The directional dilemma
How many times have you been in a situation wherein you take a trade after much
conviction, either long or short and right after you initiate the trade the market moves
just the other way round? All your strategy, planning, efforts, and capital go for a toss.
I’m certain this is one situation all of us have been in. In fact this is one of the reasons
why most professional traders go beyond the regular directional bets and set up
strategies which are insulated against the unpredictable market direction. Strategies
whose profitability does not really depend on the market direction are called “Market
Neutral” or “Delta Neutral” strategies. Over the next few chapters we will understand
some of the market neutral strategies and how a regular retail trader can execute such
strategies. Let us begin with a ‘Long Straddle’.
zerodha.com/varsity
100
10.2 – Long Straddle
Long straddle is perhaps the simplest market neutral strategy to implement. Once
implemented, the P&L is not affected by the direction in which the market moves. The
market can move in any direction, but it has to move. As long as the market moves
(irrespective of its direction), a positive P&L is generated. To implement a long straddle
all one has to do is –
1. Buy a Call option

2. Buy a Put option
Ensure –
1. Both the options belong to the same underlying

2. Both the options belong to the same expiry
3. Belong to the same strike
Here is an example which explains the execution of a long straddle and the eventual
strategy payoff. As I write this, the market is trading at 7579, which would make the
strike 7600 ‘At the money’. Long straddle would require us to simultaneously purchase
zerodha.com/varsity
101
the ATM call and put options.As you can see from the snapshot above, 7600CE is
trading at 77 and 7600 PE is trading at 88. The simultaneous purchase of both these
options would result in a net debit of Rs.165. The idea here is – the trader is long on
both the call and put options belonging to the ATM strike. Hence the trader is not really
worried about which direction the market would move. If the market goes up, the trader
would expect to see gains in Call options far higher than the loss made (read premium
paid) on the put option. Similarly, if the market goes down, the gains in the Put option
far exceeds the loss on the call option. Hence irrespective of the direction, the gain in
one option is good enough to offset the loss in the other and still yield a positive P&L.
Hence the market direction here is meaningless. Let us break this down further and
evaluate different expiry scenarios. Scenario 1 – Market expires at 7200, put
option makes money This is a scenario where the gain in the put option not only
offsets the loss made in the call option but also yields a positive P&L over and above. At
7200 –
 7600 CE will expire worthless, hence we lose the premium paid i.e Rs. 77
 7600 PE will have an intrinsic value of 400. After adjusting for the premium paid
i.e Rs.88, we get to retain 400 – 88 = 312
 The net payoff would be 312 – 77 = + 235
As you can see, the gain in put option after adjusting for the premium paid for put
option and after adjusting for the premium paid for the call option still yields a positive
P&L. Scenario 2 – Market expires at 7435 (lower breakeven) This is a situation
where the strategy neither makes money nor loses any money.
 7600 CE would expire worthless; hence the premium paid has to be written off.
Loss would be Rs.77
 7600 PE would have an intrinsic value of 165, hence this is the gain in the put
option
 However the net premium paid for the call and put option is Rs.165, which gets
adjusted with the gain in the put option
If you think about it, with respect to the ATM strike, market has indeed expired at a
lesser value. So therefore the put option makes money. However, the gains made in the
put option adjusts itself against the premium paid for both the call and put option,
eventually leaving no money on the table. Scenario 3 – Market expires at 7600 (at
zerodha.com/varsity
102
the ATM strike) At 7600, the situation is quite straight forward as both the call and
put option would expire worthless and hence the premium paid would be gone. The loss
here would be equivalent to the net premium paid i.e Rs.165. Scenario 4 – Market
expires at 7765 (upper breakeven) This is similar to the 2nd scenario we discussed.
This is a point at which the strategy breaks even at a point higher than the ATM strike.
 7600 CE would have an intrinsic value of 165, hence this is the gain in Call option
 7600 PE would expire worthless, hence the premium paid towards the option is
lost
 The gain made in the 7600 CE is offset against the combined premium paid
Hence the strategy would breakeven at this point. Scenario 5 – Market expires at
8000, call option makes money Clearly the market in this scenario is way above the
7600 ATM mark. The call option premiums would swell, so much so that the gains in
call option will more than offset the premiums paid. Let us check the numbers –
 7600 PE will expire worthless, hence the premium paid i.e Rs.88 is to be written
off
 At 8000, the 7600 CE will have an intrinsic value of 400
 The net payoff here is 400 – 88 – 77 = +235
zerodha.com/varsity
103
So as you can see, the gain in call option is significant enough to offset the combined
premiums paid. Here is the payoff table at different market expiry levels.As you can
observe –
1. The maximum loss (165) occurs at 7600, which is the ATM strike
2. The profits are unlimited in either direction of the market
zerodha.com/varsity
104
We can visualize these points in the payoff structure here –
From
the V shaped payoff graph, the following things are quite clear –
1. With reference to the ATM strike, the strategy makes money in either direction
2. Maximum loss is experienced when markets don’t move and stay at ATM
a. Max loss = Net premium paid
3. There are two breakevens – on either side, equidistant from ATM
a. Upper Breakeven = ATM + Net premium
b. Lower Breakeven = ATM – Net premium
I’m certain, you find this strategy quite straight forward to understand and implement.
In summary, you buy calls and puts, each leg has a limited down side, hence the
combined position also has a limited downside and an unlimited profit potential. So in
essence, a long straddle is like placing a bet on the price action each-way - you make
money if the market goes up or down. Hence the direction does not matter here. But let
me ask you this – if the direction does not matter, what else matters for this strategy?
10.3 – Volatility Matters

Yes, volatility matters quite a bit when you implement the straddle. I would not be
exaggerating if I said that volatility makes or breaks the straddle. Hence a fair
zerodha.com/varsity
105
assessment on volatility serves as the backbone for the straddle’s success. Have a look at
this graph below –The y-axis represents the cost of the strategy, which is simply the
combined premium of both the options and the x-axis represents volatility. The blue,
green, and red line represents how the premium increases when the volatility increases
given that there is 30, 15, and 5 days to expiry respectively. As you can see, this is a
linear graph and irrespective of time to expiry, the strategy cost increases as and when
the volatility increases. Likewise the strategy costs decreases when the volatility
decreases. Have a look at the blue line; it suggests when volatility is 15%, the cost of
setting up a long straddle is 160. Remember the cost of a long straddle represents the
combined premium required to buy both call and put options. So at 15% volatility it
costs Rs.160 to set up the long straddle, however keeping all else equal, when volatility
increases to 30% it costs Rs.340 to set up the same long straddle. In other words, you
are likely to double your money in the straddle provided –
1. You set up the long straddle at the start of the month

2. The volatility at the time of setting up the long straddle is relatively low
3. After you set up the long straddle, the volatility doubles
You can make similar observations with the green and red line which represents the
‘price to volatility’ behavior when the time to expiry is 15 and 5 days respectively. Now,
this also means you will lose money if you execute the straddle when the volatility is
zerodha.com/varsity
106
high which starts to decline after you execute the long straddle. This is an extremely
crucial point to remember. At this point, let us have a quick discussion on the
overall strategy’s delta. Since we are long on ATM strike, the delta of both the options is
close to 0.5.
 The call option has a delta of + 0.5

 The put option has a delta of - 0.5
The delta of call option offsets the delta of put option thereby resulting in a net ‘0’
overall delta. Recall, delta shows the direction bias of the position. A +ve delta indicates
a bullish bias and a -ve delta indicates a bearish bias. Given this, a 0 delta indicates that
there is no bias whatsoever to the direction of the market. So all strategies which have
zero deltas are called ‘Delta Neutral’ and Delta Neutral strategies are insulated against
the market direction.
10.4 – What can go wrong with the straddle?

On the face of it a long straddle looks great. Think about it – you get to make money
whichever way the market decides to move. All you need is the right volatility estimate.
Therefore, what can really go wrong with a straddle? Well, two things come in between
you and the profitability of a long straddle –
1. Theta Decay – All else equal, options are depreciating assets and this
particularly hurts long positions. The closer you get to expiration, the lesser time
value of the option. Time decay accelerates exponentially during the last week
before expiration, so you do not want to hold onto out-of-the-money or at-the-
money options into the last week and lose premiums rapidly.
2. Large breakevens – Recollect, in the example we discussed earlier, the
breakeven points were 165 points away from the ATM strike. The lower
breakeven point was 7435 and the upper breakeven was 7765, considering the
ATM strike was 7600. In percentage terms, the market has to move 2.2% (either
ways) to achieve breakeven. This means that from the time you initiate the
straddle, the market or the stock has to move atleast 2.2% either ways for you to
start making money…and this move has to happen within a maximum of 30 days.
Further if you want to make a profit of atleast 1% on this trade, then we are
talking about a 1% move over and above 2.2% on the index. Such large move on
zerodha.com/varsity
107
the index is quite a challenge in my opinion and I will explain why in the next
chapter.
Keeping the above two points plus the impact on volatility in perspective, we can
summarize what really needs to work in your favor for the straddle to be profitable -
1. The volatility should be relatively low at the time of strategy execution

2. The volatility should increase during the holding period of the strategy
3. The market should make a large move – the direction of the move does not
matter
4. The expected large move is time bound, should happen quickly – well within the
expiry
From my experience trading long straddles, they are profitable when setup around
major market events and the impact of such events should exceed over and above what
the market expects. Let me explain the ‘event and expectation’ part a bit more, please do
read the following carefully. Let us take the Infosys results as an example here. Event -
Quarterly results of Infosys Expectation – ‘Muted to flat’ revenue guideline for the
coming few quarters. Actual Outcome – As expected Infosys announces ‘muted to flat’
revenue guideline for the coming few quarters. If you were the set up a long straddle in
the backdrop of such an event (and its expectation), and eventually the expectation is
matched, then chances are that the straddle would fall apart. This is because around
major events, volatility tends to increase which tends to drive the premium high. So if
you are to buy ATM call and put options just around the corner of an event, then you are
essentially buying options when the volatility is high. When events are announced and
the outcome is known, the volatility drops like a ball, and therefore the premiums. This
naturally breaks the straddle down and the trader would lose money owing to the
‘bought at high volatility and sold at low volatility’ phenomena. I’ve noticed this
happening over and over again, and unfortunately have seen many traders lose money
exactly for this reason. Favorable Outcome – However imagine, instead of ‘muted to
flat’ guideline they announce an ‘aggressive’ guideline. This would essentially take the
market by surprise and drive premiums much higher, resulting in a profitable straddle
trade. This means there is another angle to straddles – your assessment of the event’s
outcome should be couple of notches better than the general market’s assessment. You
cannot setup a straddle with a mediocre assessment of events and its outcome. This may
seem like a difficult proposition but you will have to trust me here – few quality years of
zerodha.com/varsity
108
trading experience will actually get you to assess situations way better than the rest of
the market. So, just for clarity, I’d like to repost all the angles which need to be aligned
for the straddle to be profitable –

matter
expiry
5. Long straddles are to be set around major events, and the outcome of these
events to be drastically different from the general market expectation.
You may be wondering there are far too many points that come in between you and the
long straddle’s profitability. But worry not, I’ll share an antidote in the next chapter –
The Short Straddle, and why it makes sense. Download the long straddle excel.
1. Strategies which are insulated to market direction are called ‘Market Neutral’ or
‘Delta neutral’
2. Market neutral strategies such as long straddle makes money either which way
the market moves
3. Long straddle requires you to simultaneously buy the ATM Call and Put option.
The options should belong to the same underlying, same strike, and same expiry
4. By buying the CE and PE – the trader is placing the bet on either direction
5. The maximum loss is equal to the net premium paid, and it occurs at the strike at
which the long straddle has been initiated
6. The upper breakeven is ‘strike + net premium’. The lower breakeven is ‘strike –
net premium’
7. The deltas in a long straddle adds up to zero
matter
zerodha.com/varsity
109
expiry
12. Long straddles are to be set around major events, and the outcome of these
zerodha.com/varsity
110
CHAPTER 11
The Short Straddle

11.1 – Context
In the previous chapter we understood that for the long straddle to be profitable, we
need a set of things to work in our favor, reposting the same for your quick reference –

matter
expiry
5. Long straddles are to be setup around major events, and the outcome of these
Agreed that the directional movement of the market does not matter in the long
straddle, but the bargain here is quite hard. Considering the 5 points list, getting the
long straddle to work in you favor is quite a challenge. Do recall, in the previous chapter
the breakdown was at 2%, add to this another 1% as desired profits and we are
essentially looking for, at least a 3% move on the index. From my experience expecting
the market to make such moves regularly is quite a challenge. In fact for this reason
alone, I think twice each and every time I need to initiate a long straddle.
I have witnessed many traders recklessly set up long straddles thinking they are
insulated to the market’s directional movement. But in reality they end up losing money
in a long straddle – time delay and the general movement in the market (or the lack of
it) works against them. Please note, I’m not trying to discourage you from employing the
long straddle, no one denies the simplicity and elegance of a long straddle. It works
extremely well when all the 5 points above are aligned. My only issue with long straddle
is the probability of these 5 points aligning with each other.
zerodha.com/varsity
111
Now think about this – there are quite a few factors which prevents the long straddle to
be profitable. So as an extension of this – the same set of factors ‘should’ favor the
opposite of a long straddle, i.e the ‘Short Straddle’.
11.2 – The Short Straddle

Although many traders fear the short straddle (as losses are uncapped), I personally
prefer trading the short straddle on certain occasions over its peer strategies. Anyway let
us quickly understand the set up of a short straddle, and how its P&L behaves across
various scenarios.
Setting up a short straddle is quite straight forward – as opposed to buying the ATM Call
and Put options (like in long straddle) you just have to sell the ATM Call and Put option.
Obviously the short strategy is set up for a net credit, as when you sell the ATM options,
you receive the premium in your account.
Here is any example, consider Nifty is at 7589, so this would make the 7600 strike ATM.
The option premiums are as follows –
zerodha.com/varsity
112
 7600 CE is trading at 77
 7600 PE is trading at 88
So the short straddle will require us to sell both these options and collect the net
premium of 77 + 88 = 165.
Please do note – the options should belong to the same underlying, same expiry, and of
course same strike. So assuming you have executed this short straddle, let’s figure out
the P&L at various market expiry scenarios.
Scenario 1 – Market expires at 7200 (we lose money on put option)
This is a scenario where the loss in the put option is so large that it eats away the
premium collected by both the CE and PE, resulting in an overall loss. At 7200 –
 7600 CE will expire worthless, hence we get the retain the premium received
i.e 77
 7600 PE will have an intrinsic value of 400. After adjusting for the premium
received i.e Rs.88, we lose 400 – 88 = - 312
 The net loss would be 312 – 77 = - 235
As you can see, the gain in call option is offset by the loss in the put option.
Scenario 2 – Market expires at 7435 (lower breakdown)
This is a situation where the strategy neither makes money nor loses any money.
 7600 CE would expire worthless; hence the premium received is retained. Profit
here is Rs.77
 7600 PE would have an intrinsic value of 165, out of which we have received
Rs.88 as premium, hence our loss would be 165 – 88 = -77
 The gain in the call option is completely offset by the loss in the put option.
Hence we neither make money nor lose money at 7435.
Scenario 3 – Market expires at 7600 (at the ATM strike, maximum profit)
This is the most favorable outcome for a short straddle. At 7600, the situation is quite
straight forward as both the call and put option would expire worthless and hence the
zerodha.com/varsity
113
premium received from both the call and put option will be retained. The gain here
would be equivalent to the net premium received i.e Rs.165.
So this means, in a short straddle you make maximum money when the markets don’t
move!
Scenario 4 – Market expires at 7765 (upper breakdown)
This is similar to the 2nd scenario we discussed. This is a point at which the strategy
breaks even at a point higher than the ATM strike.
 7600 CE would have an intrinsic value of 165, hence after adjusting for the
premium received of Rs. 77, we stand to lose Rs.88 (165 – 77)
 7600 PE would expire worthless, hence the premium received i.e Rs.88 is
retained
 The gain made in the 7600 PE is offset against the loss on the 7600 CE, hence we
neither make money nor lose money.
Clearly this is the upper breakdown point.
Scenario 5 – Market expires at 8000 (we lose money on call option)
Clearly the market in this scenario is way above the 7600 ATM mark. The call option
premium would swell, so would the loss –
 7600 PE will expire worthless, hence the premium received i.e Rs.88 is retained
 At 8000, the 7600 CE will have an intrinsic value of 400, hence after adjusting
for the premium received of Rs. 77, we stand to lose Rs. 323( 400 -77)
 We have received Rs.88 as premium for the Put option, therefore the loss would
be 88- 323 = -235
So as you can see, the loss in the call option is significant enough to offset the combined
premiums received.
Here is the payoff table at different market expiry levels.
zerodha.com/varsity
114
As you can observe –
1. The maximum profit 165 occurs at 7600, which is the ATM strike
2. The strategy remains profitable only between the lower and higher breakdown
numbers
3. The losses are unlimited in either direction of the market
We can visualize these points in the payoff structure here –
From the inverted V shaped payoff graph, the following things are quite clear –
zerodha.com/varsity
115
1. The point at which you can experience maximum profits is at ATM, the profits
shrink as you move away from the ATM mark
2. The strategy is profitable as long as the market stays within the breakdown points
3. Maximum loss is experienced when markets move further away from the
breakdown point. The further away the market moves from the breakdown point,
higher the loss
a. Max loss = Unlimited
4. There are two breakdown points – on either side, equidistant from ATM
a. Upper Breakdown = ATM + Net premium
b. Lower Breakdown = ATM – Net premium
zerodha.com/varsity
116
As you may have realized by now, the short straddle works exactly opposite to the long
straddle. Short straddle works best when markets are expected to be in a range and not
really expected to make a large move.
Many traders fear short straddle considering the fact that short straddles have unlimited
losses on either side. However from my experience, short straddles work really well if
you know how exactly to deploy this. In fact in the last chapter of the previous module, I
had posted a case study involving short straddle. Probably that was one of the best
examples of when to implement the short straddle.
I will repost the same again here and I hope you will be able to appreciate the case study
better.
11.3 – Case Study (repost from previous module)

The following case study was a part of Module 5, Chapter 23. I’m reposting the same
here as I assume you would appreciate the example better at this stage. To get the
complete context, I’d request you to read the chapter.
Infosys was expected to announce their Q2 results on 12th October. The idea was simple
– news drives volatility up, so short options with an expectation that you can buy it back
when the volatility cools off. The trade was well planned and the position was initiated
on 8th Oct - 4 days prior to the event.
Infosys was trading close to Rs.1142/- per share, so he decided to go ahead with the 1140
strike (ATM).
Here is the snapshot at the time of initiating the trade -
zerodha.com/varsity
117
On 8th October around 10:35 AM the 1140 CE was trading at 48/- and the implied
volatility was at 40.26%. The 1140 PE was trading at 47/- and the implied volatility was
at 48%. The combined premium received was 95 per lot.
Market’s expectation was that Infosys would announce fairly decent set of numbers. In
fact the numbers were better than expected, here are the details -
“For the July-September quarter, Infosys posted a net profit of $519 million, compared
with $511 million in the year-ago period. Revenue jumped 8.7 % to $2.39 billion. On a
sequential basis, revenue grew 6%, comfortably eclipsing market expectations of 4- 4.5%
growth.
In rupee terms, net profit rose 9.8% to Rs.3398 crore on revenue of Rs. 15,635 crore,
which was up 17.2% from last year”. Source: Economic Times.
zerodha.com/varsity
118
The announcement came in around 9:18 AM, 3 minutes after the market opened, and
this trader did manage to close the trade around the same time.
Here is the snapshot -
The 1140 CE was trading at 55/- and the implied volatility had dropped to 28%. The
1140 PE was trading at 20/- and the implied volatility had dropped to 40%.
Do pay attention to this - the speed at which the call option shot up was
lesser than the speed at which the Put option dropped its value. The
combined premium was 75 per lot, and he made a 20 point profit per lot.
zerodha.com/varsity
119
11.4 – The Greeks
Since we are dealing with ATM options, the delta of both CE and PE would be around
0.5. We could add the deltas of each option and get a sense of how the overall position
deltas behave.
 7600 CE Delta @ 0.5, since we are short, the delta would be -0.5
 7600 PE Delta @ - 0.5, since we are short, the delta would be + 0.5
 Combined delta would be -0.5 + 0.5 = 0
The combined delta indicates that the strategy is directional neutral. Remember both
long and short straddle is delta neutral. In case of long straddle, delta neutral suggests
that the profits are uncapped and in case of short straddle, the losses are uncapped.
Now here is something for you to think about – When you initiate a straddle you are
obviously delta neutral. But as the markets move, will your position still remain delta
neutral? If yes, why do you think so? If no, then is there a way to keep the position delta
neutral?
If you can build your thoughts around these points, then I can guarantee you that your
options knowledge is far greater than 90% of the market participants. To answer these
simple questions, you will need to step a little deeper and get into 2nd level of thinking.
Do post your comments below.
You can download the Short straddle excel.

1. Short straddle requires you to simultaneously Sell the ATM Call and Put option.
The options should belong to the same underlying, same strike, and same expiry
2. By selling the CE and PE – the trader is placing the bet that the market wont
move and would essentially stay in a range
3. The maximum profit is equal to the net premium paid, and it occurs at the strike
at which the long straddle has been initiated
zerodha.com/varsity
120
4. The upper breakdown is ‘strike + net premium’. The lower breakdown is ‘strike –
net premium’
5. The deltas in a short straddle adds up to zero
6. The volatility should be relatively high at the time of strategy execution
7. The volatility should decrease during the holding period of the strategy
8. Short straddles can be set around major events, wherein before the event, the
volatility would drive the premiums up and just after the announcement, the
volatility would cool off, and so would the premiums.
zerodha.com/varsity
121
CHAPTER 12
The Long & Short Straddle

12.1 – Background
If you have understood the straddle, then understanding the ‘Strangle’ is quite
straightforward. For all practical purposes, the thought process behind the straddle and
strangle is quite similar. Strangle is an improvisation over the straddle, mainly to reduce
the cost of implementation. Let me explain this further.
Consider this – Nifty is trading at 5921, which would make 5900 the ATM strike. If you
were to set up the long straddle here, you would be required to buy the 5900 CE and
5900 PE. The premiums for both these options are 66 and 57 respectively.
Net cash outlay = 66 + 57 = 123
Upper breakeven = 5921+123 = 6044
Lower breakeven = 5921 – 123 = 5798
Therefore to set up a straddle, you spend 123 and the breakeven on either side is 2.07%
away. As you know the straddle is delta neutral, meaning the strategy is insulated to the
directional movement of the market. The idea here is that you know that the market will
move to a large extent, but the direction is unknown.
Consider this – from your research you know that the market will move (direction
unknown) hence you have set up the straddle. However the straddle requires you to
make an upfront payment of 123.
How would it be if you were to set up a market neutral strategy - similar to the straddle,
but at a much lower cost?
Well, the ‘Strangle’ does just that.
zerodha.com/varsity
122
The strangle is an improvisation over the straddle. The improvisation mainly helps in
terms of reduction of the strategy cost, however as a tradeoff the points required to
breakeven increases.
In a straddle you are required to buy call and put options of the ATM strike. However
the strangle requires you to buy OTM call and put options. Remember when compared
to the ATM strike, the OTM will always trade cheap, therefore this implies setting up a
strangle is cheaper than setting up a straddle.
Let’s take an example to explain this better –
Nifty is trading at 7921, to set up a strangle we need to buy OTM Call and Put options.
Do note, both the options should belong to the same expiry and same underlying. Also
the execution should happen in the same ratio (missed this point while discussing
straddle).
zerodha.com/varsity
123
Same ratio here means – one should buy the same number of call option as that of put
option. For instance it can be 1:1 ratio meaning 1 lot of call, 1 lot of put option. Or it can
be 5:5, meaning buy 5 lots of call and 5 lots of put option. Something like 2:3 is not
considered strangle (or straddle) as in this case you would be buying 2 lots of call
options and 3 lots of put options.
Going back to the example, considering Nifty is at 5921, we need to buy OTM Call and
Put options. I’d prefer to buy strikes which are 200 points either way (note, there is no
particular reason for choosing strikes 200 points away). So this would mean I would buy
7700 Put option and 8100 Call option. These options are trading at 28 and 32
respectively.
The combined premium paid to execute the ‘strangle’ is 60. Let’s figure out how the
strategies behave under various scenarios. I’ll keep this discussion brief as I do believe
you are now comfortable accessing the P&L across various market scenarios.
Scenario 1 – Market expires at 7500 (much below the PE strike)
At 7500, the premium paid for the call option i.e. 32 will go worthless. However the put
option will have an intrinsic value of 200 points. The premium paid for the Put option is
28, hence the total profit from the put option will be 200 – 28 = +172
We can further deduct for the premium paid for call option i.e. 32 from the profits of Put
option and arrive at the overall profitability i.e. 172 – 32 = +140
Scenario 2 – Market expires at 7640 (lower breakeven)
At 7640, the 7700 put option will have an intrinsic value of 60. The put option’s intrinsic
value offsets the combined premium paid towards both the call and put option i.e.
32+28 = 60. Hence at 7640, the strangle neither makes money nor losses money.
Scenario 3 – Market expires at 7700 (at PE strike)
At 7700, both the call and put options would expire worthless, hence we would lose the
entire premium paid i.e. 32 + 28 = 60. Do note, this also happens to be the maximum
loss the strategy would suffer.
Scenario 4 – Market expires at 7900, 8100 (ATM and CE strike respectively)
zerodha.com/varsity
124
Both the options expire worthless at 7900 and 8100. Hence we would lose the entire
premium paid i.e. 60.
Scenarios 5 – Market expires at 8160 (upper breakeven)
At 8160, the 8100 Call option has an intrinsic value of 60, the gains in the call option
would offset the loss incurred against the premium paid towards the call and put
options.
Scenarios 6 – Market expires at 8300 (much higher than the CE strike)
Clearly at 8300, the 8100 call option would have an intrinsic value of 200 points;
therefore the option would make 200 points. After adjusting for the combined premium
paid of 60 points, we would be left with 140 points profit. Notice the symmetry of payoff
above the upper and below the lower breakeven points.
Here is a table which contains various other market expiry scenarios and the eventual
payoff at these expiry levels –
We can plot the strategy payoff to visualize the payoff diagram of the strangle –
zerodha.com/varsity
125
We can generalize a few things about the ‘Strangle’ –
1. The maximum loss is restricted to the net premium paid

2. The loss would be maximum between the two strike prices
3. Upper Breakeven point = CE strike + net premium paid
4. Lower Breakeven point = PE strike – net premium paid
5. Profit potentially is unlimited
So as long as the market moves (irrespective of the direction) the profits are expected to
follow.
12.3 – Delta and Vega

Both straddles and strangles are similar strategies, therefore the Greeks have a similar
effect on strangle and straddles.
Since we are dealing with OTM options (remember we chose strikes that are equidistant
from ATM), the delta of both CE and PE would be around 0.3, or lesser. We could add
the deltas of each option and get a sense of how the overall position deltas behave.
 7700 PE Delta @ - 0.3

 8100 CE Delta @ + 0.3
 Combined delta would be -0.3 + 0.3 = 0
zerodha.com/varsity
126
Of course, I’ve just assumed 0.3 for both the options for convenience; however both the
deltas could be slightly different, hence we could not be delta neutral in a strict sense.
But then the deltas will certainly not be too high such that it renders a directional bias
on the strategy. Anyway, the combined delta indicates that the strategy is directional
neutral.
The volatility has similar effect on both straddles and strangles. I’d suggest you
refer Chapter 10, section 10.3 to get a sense of how the volatility impacts the
strangles.
To summarize the effect of Greeks on strangles -

matter
expiry
5. Long strangle is to be setup around major events, and the outcome of these
events have to be drastically different from the general market expectation
I suppose you understand why long strangles have to be set up around major market
events; we have discussed this point earlier as well. If you are confused, I’d request you
to read Chapter 10.
12.4 – Short Strangle

The execution of a short strangle is the exact opposite of the long strangle. One needs to
sell OTM Call and Put options which are equidistant from the ATM strike. In fact you
would short the ‘strangle’ for the exact opposite reasons as to why you go long strangle. I
will skip discussing the different expiry scenarios as I assume you are fairly comfortable
with establishing the payoff by now.
I’ve used the same strikes (the one used in long strangle example) for the short strangle
example. Instead of buying these options, you would sell these OTM options to set up a
short strangle. Here is the payoff table of the short strangle –
zerodha.com/varsity
127
As you can notice, the strategy results in a loss as and when the market moves in any
particular direction. However the strategy remains profitable between the lower and
upper breakeven points. Recall –
 Upper breakeven point is at 8160

 Lower breakeven point is at 7640
 Max profit is net premium received, which is 60 points
In other words you get to take home 60 points as long as the market stays within 7640
and 8160. In my opinion this is a fantastic proposition. More often than not market
stays within certain trading ranges and therefore the market presents such beautiful
trading opportunities.
So here is something for you to think about – identify stocks which are in a trading
range, typically stocks in a trading range form double/triple tops and bottom. Setup the
‘strangle’ by writing strikes which are outside the upper and lower range. When you
write strangles in this backdrop make sure you watch closely for breakouts or
breakdowns.
I remember setting up this trade over and over again in Reliance couple of years ago -
Reliance was stuck between 850 and 1000 for the longest time.
zerodha.com/varsity
128
Anyway, here is the payoff graph of the short strangle –
As you can notice –
1. The payoff of the short strangle looks exactly opposite of the long strangle
2. The profits are restricted to the extent of the net premium received
3. The profits are maximum as long as the stock stays within the two strike prices
4. The losses are potentially unlimited
The breakeven point calculation is the same as the breakeven points of a long strangle,
which we have discussed earlier.
You can download the long and short strangle excel here.
1. The strangle is an improvisation over the straddle, the improvisation helps in the
strategy cost reduction
2. Strangles are delta neutral and is insulated against any directional risk
3. To set up a long strangle one needs to buy OTM Call and Put option
4. The maximum loss in a long strangle is restricted to the extent of the premium
received
5. The profit potential is virtually unlimited in the long strangle
zerodha.com/varsity
129
6. The short strangle is the exact opposite of the long strangle. You are required to
sell the OTM call and put option in a short strangle
7. The Greeks have the same effect on strangles and straddles
zerodha.com/varsity
130
CHAPTER 13
Max Pain & PCR

13.1 – My experience with Option Pain theory
In the never ending list of controversial market theories, the theory of ‘Option Pain’
certainly finds a spot. Option Pain, or sometimes referred to as ‘Max Pain’ has a
significant fan following and probably an equal number of people who despise it. I’ll be
honest; I’ve been in both camps! In the initial days of following Option Pain, I was never
able to make money consistently. However, overtime I found methods to improvise on
this theory to suit my own risk appetite, and that yielded a decent result. Later in the
chapter I will discuss this as well.
Anyway, now this is my attempt to present you the Option Pain theory and talk to you
about what I like and what I don’t about Max Pain. You can take cues from this chapter
and decide for yourself which camp you want to be in.
Option Pain theory requires you to be familiar with the concept of ‘Open Interest’.
So, let’s get started.
13.2 – Max Pain Theory

The origins of Option Pain dates back to 2004. So, in a sense, this is still a very young
theory. As far as I know there are no academic/scholastic papers on it, which makes one
wonder why the academia has ignored this concept.
The theory of options pain stems as a corollary to the belief - “90% of the options expire
worthless, hence option writers/sellers tend to make money more often, more
consistently than the option buyers”.
Now if this statement is true, then we can make a bunch of logical deductions -
zerodha.com/varsity
131
1. At any point only one party can make money i.e either the option buyers or
option sellers, but not both. From the above statement, it is clear that the sellers
are the ones making money.
2. If option sellers tend to make maximum money, then it also means that the price
of the option on expiry day should be driven to a point where it would cause least
amount of loss to option writers.
3. If point 2 is true, then it further implies that option prices can be manipulated, at
least on the day of expiry.
4. If point 3 is true, then it further implies that there exists a group of traders who
can manipulate the option prices, at least on the day of expiry.
5. If such a group exists then it must be the option writers/sellers since it is believed
that they are the ones who make maximum money/consistently make money
trading options.
Now considering all the above points, there must exist a single price point at which, if
the market expires, then it would cause least amount of pain to the option writers (or
cause maximum amount of pain to option buyers).
If one can identify this price point, then it’s most likely that this is the point at which
markets will expire. The ‘Option Pain’ theory does just this – identify the price at which
the market is likely to expire considering least amount of pain is caused to option
writers.
zerodha.com/varsity
132
Here is how optionspain.com formally defines Option Pain – “In the options market,
wealth transfer between option buyers and sellers is a zero sum game. On option
expiration days, the underlying stock price often moves toward a point that brings
maximum loss to option buyers. This specific price, calculated based on all outstanding
options in the markets, is called Option Pain. Option Pain is a proxy for the stock price
manipulation target by the option selling group”.
13.3 – Max Pain Calculation

Here is a step by step guide to calculate the Max Pain value. At this stage, you may find
this a bit confusing, but I recommend you read through it all the same. Things ill get
clearer once we take up an example –
Step 1 – List down the various strikes on the exchange and note down the open interest
of both calls and puts for these strikes.
Step 2 – For each of the strike price that you have noted, assume that the market
expires at that strike.
zerodha.com/varsity
133
Step 3 – Calculate how much money is lost by option writers (both call option and put
option writers) assuming the market expires as per the assumption in step 2.
Step 4 – Add up the money lost by call and put option writers.
Step 5 – Identify the strike at which the money lost by option writers is least.
This level, at which least amount of money is lost by option writers is the point at which
maximum pain is caused to option buyers. Therefore this is the price at which the
market is most likely to expire.
Let us take up a very simple example to understand this. For the sake of this example,
I’ll assume there are only 3 Nifty strikes available in the market. I have made a note of
the open interest for both call and put options for the respective strike.
Strike Call Option OI Put option OI

7700 1823400 5783025
7800 3448575 4864125
7900 5367450 2559375
Scenario 1 – Assume markets expires at 7700
Remember when you write a Call option, you will lose money only if the market moves
above the strike. Likewise, when you write a Put option you will lose money only when
the market moves below the strike price.
Therefore if the market expires at 7700, none of the call option writers will lose money.
Which means call option writers of 7700, 7800, and 7900 strikes will retain the
premiums received.
However, the put option writers will be in trouble. Let’s start with the 7900 PE writers –
At 7700 expiry, 7900 PE writers would lose 200 points. Since the OI is 2559375, the
Rupee value of loss would be –
= 200 * 2559375 = Rs.5,11,875,000/-
7800 PE writers would lose 100 points, the Rupee value would be
zerodha.com/varsity
134
= 100 * 4864125 = Rs.4,864,125,000/-
7700 PE writers will not lose any money.
So the combined money lost by option writers if the markets expire at 7700 would be –
Total money lost by Call Option writers + Total money lost by Put Option writers
= 0 + Rs.511875000 + 4,864125000 = Rs.9,98,287,500/-
Keep in mind that total money lost by Call Option writers = money lost by 7700 CE
writer + money lost by 7800 CE + money lost by 7900 CE
Likewise the Total money lost by Put Option writers = money lost by 7700 PE writer +
money lost by 7800 PE + money lost by 7900 PE
At 7800, the following call option writers would lose money –
7700 CE writers would lose 100 points, multiplying with its Open Interest we get the
Rupee value of the loss.
100*1823400 = Rs.1,82,340,000/-
Both 7800 CE and 7900 CE seller would not lose money.
The 7700 and 7800 PE seller wouldn't lose money
The 7900 PE would lose 100 points, multiplying with the Open Interest, we get the
Rupee value of the loss.
100*2559375 = Rs.2,55,937,500/-
So the combined loss for Options writers when market expires at 7800 would be –
= 182340000 + 255937500
= Rs.4,38,277,500/-
zerodha.com/varsity
135
At 7900, the following call option writers would lose money –
7700 CE writer would lose 200 points, the Rupee value of this loss would be –
200 *1823400 = Rs.3,646,800,000/-
7800 CE writer would lose 100 points, the Rupee value of this loss would be –
100*3448575 = Rs.3,44,857,500/-
7900 CE writers would retain the premiums received.
Since market expires at 7900, all the put option writers would retain the premiums
received.
So therefore the combined loss of option writers would be –
= 3646800000 + 344857500 = Rs. 7,095,375,000/-
So at this stage, we have calculated the total Rupee value loss for option writers at every
possible expiry level. Let me tabulated the same for you –
Strike Call Option OI Put option OI Loss value of calls Loss value of Puts Total loss
7700 1823400 5783025 0 998287500 998287500
7800 3448575 4864125 182340000 255937500 438277500
7900 5367450 2559375 7095375000 0 7095375000
Now that we have identified the combined loss the option writers would experience at
various expiry level, we can easily identify the point at which the market is likely to
expire.
As per the option pain theory, the market will expire at such a point where there is least
amount of pain (read it as least amount of loss) to Option sellers.
Clearly, from the table above, this point happens to be 7800, where the combined loss is
around 438277500 or about 43.82 Crores, which is much lesser compared to the
combined loss at 7700 and 7900.
zerodha.com/varsity
136
The calculation is as simple as that. However, I’ve used only 3 strikes in the example for
simplicity. But in reality there are many strikes for a given underlying, especially Nifty.
Calculations become a bit cumbersome and confusing, hence one would have to resort
to a tool like excel.
I’ve calculated the option pain value as of today (10th May 2016) on excel, have a look at
the image –
For all the available strikes, we assume market would expire at that point and then
compute the Rupee value of the loss for CE and PE option writers. This value is shown
in the last column titled “Total Value”. Once you calculate the total value, we simply
have to identify the point at which the least amount of money is lost by the option
writer. You can identify this by plotting the ‘bar graph’ of the total value. The bar graph
would look like this –
zerodha.com/varsity
137
As you can see, the 7800 strike is the point at which option writers would lose the least
amount of money, so as per the option pain theory, 7800 is where the market is likely to
expire for the May series.
Now that you have established the expiry level, how can you use this information? Well,
there are multiple ways you can use this information.
Most traders use this max pain level to identity the strikes which they can write. In this
case, since 7800 is the expected expiry level, one can choose to write call options above
7800 or put options below 7800 and collect all the premiums.
13.4 – A Few Modifications

In the initial days, I was very eager to learn about Option Pain. Everything about it made
absolute sense. I remember crunching numbers, identifying the expiry level, and writing
options to glory. But shockingly the market would expire at some other point leaving me
booking a loss and I wondering if I was wrong with my calculations or if the entire
theory is flawed!
So I eventually improvised on the classic option pain theory to suit my risk appetite.
Here is what I did –
1. The OI values change every day. This means the option pain could suggest 7800
as the expiry level on 10th of May and may very well suggest 8000 on 20th of May.
zerodha.com/varsity
138
I froze on a particular day of the month to run this computation. I preferred
doing this when there were 15 days to expiry.
2. I identified the expiry value as per the regular option pain method.
3. I would add a 5% ‘safety buffer’. So at 15 days to expiry, the theory suggest 7800
as expiry, then I’d add a 5% safety buffer. This would make the expiry value as
7800 + 5% of 7800 = 8190 or 8200 strike.
4. I would expect the market to expire at any point between 7800 to 8200.
5. I would set up strategies keeping this expiry range in mind, my most favorite
being to write call options beyond 8200.
6. I would avoid writing Put option for this simple belief – panic spreads faster than
greed. This means markets can fall faster than it can go up.
7. I would hold the options sold up to expiry, and would usually avoid averaging
during this period.
The results were much better when I followed this method. Unfortunately, I never
tabulated the results, hence I cannot quantify my gains. However if you come from a
programming background, you can easily back test this logic and share the results with
the rest of community here. Anyway, at a much later stage I realized the 5% buffer was
essentially taking to strikes which were approximately 1.5 to 2% standard deviations
away, which meant the probability of markets moving beyond the expected expiry level
was about 34%.
If you are not sure what this means, I’d suggest you read this chapter on standard
deviation and distribution of returns.
You can download the Option Pain computation excel.
13.5 – The Put Call Ratio

The Put Call Ratio is a fairly simple ratio to calculate. The ratio helps us identify extreme
bullishness or bearishness in the market. PCR is usually considered a contrarian
indicator. Meaning, if the PCR indicates extreme bearishness, then we expect the market
to reverse, hence the trader turns bullish. Likewise if PCR indicates extreme bullishness,
then traders expect markets to reverse and decline.
zerodha.com/varsity
139
To calculate PCR, all one needs to do is divide the total open interest of Puts by the total
open interest of the Calls. The resulting value usually varies in and around one. Have a
look at the image below –
As on 10th May, the total OI of both Calls and Puts has been calculated. Dividing the Put
OI by Call OI gives us the PCR ratio –
37016925 / 42874200 = 0.863385
The interpretation is as follows –
 If the PCR value is above 1, say 1.3 – then it suggests that there are more Puts
being bought compared to Calls. This suggests that the markets have turned
extremely bearish, and therefore sort of oversold. One can look for reversals and
expect the markets to go up.
 Low PCR values such as 0.5 and below indicates that there are more calls being
bought compared to puts. This suggests that the markets have turned extremely
bullish, and therefore sort of overbought. Once can look for reversals and expect
the markets to go down.
zerodha.com/varsity
140
 All values between 0.5 and 1 can be attributed to regular trading activity and can
be ignored.
Needless to say, this is a generic approach to PCR. What would really make sense is to
historically plot the daily PCR values for say 1 or 2 years and identify these extreme
values. For example for Nifty value such as 1.3 can indicate extreme bearishness, but for
say Infy something like 1.2 could be extreme bearishness. So you need to be clear about
this, hence back testing helps.
You may wonder why the PCR is used as a contrarian indicator. Well, the explanation to
this is rather tricky, but the general opinion is this – if the traders are bearish/bullish,
then most of them have already taken their respective position (hence a high/low PCR)
and therefore there aren’t many other players who can come in and drive the positions
in the desired direction. Hence the position will eventually be squared off which would
drive the stock/index in the opposite direction.
So that’s PCR for you. You may come across many variants of this – some prefer to take
the total traded value instead of OI, some even prefer to take the volumes. But I
personally don’t think it is required to over-think PCR.
13.6 – Final thoughts

And with this, I’d like to end this module on Options, which has spread across 2
modules and 36 chapters!
We have discussed close to 15 different option strategies in this module, which I

personally think is more than sufficient for retail traders to trade options professionally.
Yes, going forward you will encounter many fancy option strategies, perhaps your friend
will suggest a fancy option strategy and show off the technicalities of the strategy, but do
remember – ‘fancy’ does not really translate to profit. Some of the best strategies are
simple , elegant and easy to implement.
The content we have presented in both, Module 5 and Module 6, is written with an
intention of giving you a clear picture on options trading - what is possible to be achieve
with options trading and what is not possible. We have thought through and discussed
what is required and what isn’t. Frankly these two modules are more than sufficient to
answer most of your concerns/doubts related to options.
zerodha.com/varsity
141
So please do take some time to read through the contents here, at your own pace, and
I’m certain you will you will start trading options the way it is supposed to be done.
Finally, I hope you will enjoy reading this as much as I enjoyed writing this for you.
Good luck and stay profitable!
1. Option Pain theory assumes that the option writers tend to make more money
consistently compared to option buyers.
2. Option pain assumes that option writers can influence the price of options on the
day of expiry.
3. One can use the theory of option pain to identify the price at which the
stock/index is likely to expiry.
4. The strike at which the option writers would experience least amount of loss is
the strike at which the stock/index likely to expire.
5. The PCR is calculated by dividing the total open interest of Puts by the total open
interest of the Calls.
6. The PCR is considered as a contrarian indicator.
7. Generally a PCR value of over 1.3 is considered bearish and a PCR value of less
than 0.5 is considered bullish.
zerodha.com/varsity
142
ZERODHA
Markets and
Taxation
ZERODHA.COM/VARSITY
TABLE OF CONTENTS
1 Introduction ( Setting the context) 1
2 Basics 4
2.1 Overview 4
2.2 What is Income Tax ? 5
2.3 Income tax slabs in India for the financial year 2014/15 6
3 Classifying your Market Activity 9

3.1 Are you a trader or investor or both 9
3.2 Pros and cons of declaring trading as a business income 12
3.3 What are you ? Trader, Investor or Both 14
4 Taxation for Investors 18

4.1 Quick recap 18
4.2 Long term capital gain (LTCG) 19
4.3 Indexation 20
4.4 Short term capital gain 24
4.5 Days of holding 25
4.6 Quick note on STT, Advance Tax, and more 26
4.7 Short and Long term capital losses 28
5 Taxation for Traders 30

5.1 Quick recap 30
5.2 Taxation of trading/business income 31
5.3 Carry forward business loss 32
5.4 Offsetting speculative and non speculative business income 33
zerodha.com/varsity
5.5 What is tax loss harvesting ? 34
5.6 BTST (ATST) - Is it Speculative, Non Speculative or STCG 34
5.7 Advance Tax - Business Income 35
5.8 Balance sheet and P&L Statements 35
5.9 Turnover and Tax audit 36
6 Turnover, Balance Sheet and P&L 39

6.1 Turnover and Tax audit 39
6.2 Section 44AD 44
6.3 Balance sheet, P&L , Book of Accounts 45
7 ITR forms (The Finale) 50

7.1 Income Tax Return (ITR) forms 50
7.2 ITR forms and its uses 51
7.3 Exploring ITR 4S 51
7.4 Quick FAQ and notes 53
zerodha.com/varsity
C H A PT E R 1
Introduction(Setting the Context)

I remember a time (maybe about 6 years ago) I had the opportunity to meet one of those hard to
find Charted Accountants who knew both taxation and markets quite well. It was at a friend’s party
that I got introduced to him. He asked me what I do for a living, to which I promptly replied that I
trade for a living. We immediately struck a chord and had a great conversation going. Somewhere
during that engaging conversation he asked me a few questions –
➡ How would I declare my Profits and/or Losses from my market activity?

➡ Do I bifurcate between speculative business income and non-speculative business income?
➡ Also, he asked me about the books of accounts that I’m supposed to maintain.
Thanks to my ignorance I had no answers to give him.
I was an eager learner, as I spent all my time learning about the markets and trading strategies but
spent very little time learning about taxation and its relevance to market participants.
Probably the reason why I consciously ignored learning about taxation was because I always feared
the heavy usage of jargon, random references to sections, subsections, circulars, and whatnot. To
my defense – I once did honestly try to learn about taxation. I paid a visit to my broker’s office and
met my dealer and questioned him on taxation. This is what he had to say – “Arre, why are you so
worried? Long-term capital tax is 0% and short-term capital gains tax is 10%, that’s it, it is a simple
matter.”
I for sure knew it was not just that, I insisted to meet someone more knowledgeable to understand
the topic in greater detail. To my luck I got to meet the Regional Head of the stock broking company,
enthusiastically I picked his brains about taxation for market participants; unfortunately even he re-
iterated the same thing that my dealer had told me. It seemed even worse as the regional manager
had a sense of pride while he gave me that sloppy answer.
Frustrated, I visited a CA and he essentially said the same thing that my dealer said, but he used
fancy jargon and complicated the whole matter to no end. At that point in time nobody had blogged
about it online, no good articles were written on the topic and thus my quest to learn taxation re-
lated to markets got squashed like a bug.
In retrospect, had I known more about this topic, had I got more information – I would have
clearly benefited in multiple ways.
I’m certain there are many traders and investors in a similar situation as I was few years ago. In
fact this is true considering that our blog on taxation (which was put up a few years ago) has re-
ceived over 2000 questions! This number is besides the numerous emails received and queries
asked on Trading Q&A.
Keeping this in perspective, we are happy to introduce our new module on Zerodha Varsity aptly
titled “Markets & Taxation”. The module deals with literally everything that you need to know
about taxation related to markets – be it short term capital gains, or treating your intraday trades
as speculative business income, or about Section 44AD – we have it all on Zerodha Varsity – in
one place, concise, and simplified.
Now here is the best part – the whole module is authored by Nithin himself, which means that we
get to learn about taxation from a trader/investor’s perspective and not really from the CA’s per-
spective. This makes a huge difference in terms of topic narrative. With a seasoned trader discuss-
ing taxation, we get to learn about the essential topics without digressing into the taxation wilder-
ness.
Lastly, if I look back in time, I could not imagine brokers giving out such valuable information to
clients. In fact, stock brokers were always known to hoard information and pass it only to select
clients. I’m sure you would agree with me on this, especially if you have been trading the Indian
markets for a while now. Stock Brokers in India have always been snobby, expensive, and full of
unwanted attitude.
However the stock broking industry is slowly waking up to the fact that the customer, irrespective
of his size deserves the best. This change in attitude is leading to a revolution of sorts in the indus-
try – and I do believe Zerodha is the epicenter of this revolution – changing the way the Indian
broking industry functions. Be it providing you high quality tools to trade, better trader educa-
tion, or ready to use tax friendly reports – Zerodha has it all for you.
So please do go ahead and explore this unique module on Markets & Taxation. I can assure you
that the content presented here will make you more confident about matters related to taxation,
and with that new-found confidence you will never have to fear the taxman!
Stay connected, stay profitable.
– Karthik Rangappa
C H A PT E R 2
Basics
2.1 – Overview
India needs help from all of us countrymen in developing a tax culture. The fear about income tax
department can be removed only by gaining knowledge on all the basic rules and regulations. In-
come tax rates in India have drastically reduced from over 90% in the early seventies to now
(2015) where no tax has to be paid on annual income upto Rs 2.5lks. But the apathy of taxpayers
towards filing income tax returns and paying taxes continues till today.
With the systems used by the IT department becoming sophisticated every year, the chances of
repercussions in terms of notices and penalties due to non-filing, mis-filing, and hiding informa-
tion while filing your income tax returns (ITR) is going up significantly. Similar to how Income tax
(IT) department has access to all your bank account details, they can also check upon all your
capital market activity easily through the exchanges as they are all mapped to your PAN (Perma-
nent account number).
Even if the intent is there to be compliant, most people including many Chartered Accountants
(CAs) don’t understand the subject of taxation when investing & trading very well. We had put up
blog post, “Taxation Simplified” on Z-Connect a few years back simplifying key aspects of taxa-
tion for market participants. Over the last 2 years we have received a few thousand queries on the
post. Answering all of them it was obvious that we had to do a lot more to simplify all aspects
around taxation while trading or investing in the markets, hence this module.
If you only invest into stocks or mutual funds filing returns is quite simple, but can get tricky if
trading intraday stocks or financial derivatives (futures and options).
We will in this module break all the concepts down into small easy to understand chapters with-
out any of those jargons typically used by CA’s or tax consultant’s. Here is a sneak peak into what
you can expect going forward in this module –
1. Introduction (Setting the Context)

2. Basics
3. Classify your Market Activity
4. Taxation for Investors
5. Taxation for Traders
6. Turnover, Balance Sheet, and P&L
7. ITR Forms (The Finale)
2.2 – What is income tax?

It is a tax levied by the Government of India on the income of every person. The provisions govern-
ing the Income-tax Law are given in the Income-tax Act, 1961. In simpler words, Income Tax is a
portion of money that you earn paid to the government of India.
Why should I pay tax?

Yes India does not offer social security and free medical facilities as being provided in some devel-
oped countries, but the government needs funds collected as taxes to discharge number of re-
sponsibilities like Government hospitals, Education, National defense, Infrastructure develop-
ment just to name a few.
Who is supposed to pay income tax?

Income-tax is to be paid by every person who earns more than the minimum income slab set by
the government. The term ‘person’ as defined under the Income-tax Act covers in its ambit natu-
ral as well as artificial persons (including corporate).
Only 2.9 percent of over 121 crore population are taxpayers in India compared to over 45% in a de-
veloped economy like U.S.A. Part of the reason for such an abysmally low number is also because
many Indians don’t earn enough to qualify to pay income tax, but the larger factor has got to do
with lack of tax culture.
Taxes have to be paid based on how much income you earn every financial year. Financial year in
India starts from April 1st and ends on 31st March. Do note that year can be specified either as fi-
nancial year (FY) or assessment Year (AY).
FY is used to denote the actual year the income was earned for which you are filing taxes. So FY
2014/15 is the financial year starting April 1st 2014 and ending 31st March 2015.
AY is used to denote the year in which you are supposed to file your taxes. So AY 2015/16 is the
year when you file the returns for income earned in FY 2014/15. So AY 2015/16 and FY 2014/15 are
one and the same. So you will use ITR with AY 2015/16 on it to file your taxes for the income earned
in financial year starting April 1st 2014 and ending 31st March 2015.
2.3 – Income tax slabs in India for financial year 2014/15

All Indians have to pay taxes on the total income earned every year as per the below tax slabs they
belong to. If you are salaried, your employer would already be paying taxes on your behalf to the
government and issuing you a ‘Form 16’ as an acknowledgement for having paid the taxes. Your
employer will not have access to all your sources of income, like bank interest, capital gains, rental
income, and others. You are supposed to use the form 16, add all your other income, calculate and
pay any additional tax, and file your income tax returns before due date every year. The tax slab
for individuals (FY 14/15) is as below –
Individual (age upto 60 years)
Income slabs Tax Rates
0 – Rs 2.5 lks NIL
Rs 2.5lks – Rs 5lks 10% of amount by which income exceeds Rs 2.5lks.

Rs. 25,000 + 20% of the amount by which income
Rs 5lks – Rs 10lks
exceeds Rs 5lks
10lks and above
exceeds Rs 10lks
Senior citizen (age 60 to 80 years)

0 – Rs 3 lks NIL
Rs 3lks – Rs 5lks 10% of amount by which income exceeds Rs 3lks.
exceeds Rs 5lks
10lks and above
exceeds Rs 10lks
Super senior citizen (age 80 years and above)

0 – Rs 5 lks NIL
20% of the amount by which income exceeds Rs
5lks
Rs. 100,000 + 30% of the amount by which
10lks and above
income exceeds Rs 10lks
From the next chapter we will start focusing in detail on all aspects of taxation when trading and
investing in the markets.
1. Filing correct Income tax returns is the duty of every Indian resident
2. The Income tax department has access to your market activity
3. Only 2.9 % of Indians are tax payers
4. Financial year (FY) is the year income was earned, Assessment year (AY) is the year you file
your taxes on the income earned
5. Financial year is between 1st of April of the current year and 31st March of the following
year
6. The income tax applicable to you depends on the income tax slab you belong to
7. The income tax slabs vary based on your age group
Disclaimer – Do consult a chartered accountant (CA) before filing your returns. The content
above is for your general knowledge only. Content meant for Individual retail investors/traders in
India.
C H A PT E R 3
Classifying Your Market Activity

3.1 – Are you a trader or investor or both?
Identifying yourself as a trader or an investor is the first step to file your income tax returns. This
may seem like an easy task, but here is what this circular from CBDT (Central board of direct
taxes) says:
“If you buy shares with the intent of earning income through dividends you are an investor, and if
you buy and sell shares with the intent to profit, you are a trader”:) .
Yes, that is how vague it is, and this is a circular dated 2007, released after 18 years of the original
circular. Numerous judicial pronouncements and government was still unable to clear this highly
debatable issue. Thanks to the vagueness of this circular, it has given too much power in the
hands of the assessing Income tax officer (AO) especially considering the fact that most of the
stock purchases are done intending to profit from the price appreciation.
So before filing income tax returns, you will have to first classify yourself as an investor, trader, or
both. We will in this chapter help you figure this out in line with what most AO’s would be expect-
ing. By income I mean both profits and losses.
When trading or investing you need to classify your income under one of these heads, broadly
speaking they are –
1. Long term capital gain (LTCG)

2. Short term capital gain (STCG)
3. Speculative business income
4. Non-speculative business income
Let us understand what each of these mean.
Long term capital (LTCG)
Assume you buy stocks or Mutual Funds today for Rs.50,000/- and sell the same after 365 days at
Rs.55,000/-, then the profit or gain of Rs.5,000/- is considered as Long term capital gain. Generally
speaking, gain or profit earned by investing into stocks or equity mutual funds, and selling after 1
year from date of purchase can be categorized under LTCG. Currently in India any gains realized
and categorized as LTCG (equity & equity MF) is completely exempt from taxes. In other words, tax
on LTCG is at 0%. Do note – the purchase and sale of shares has to be conducted via a recognized
exchange.
Just to reemphasize – if you had bought Infosys shares worth Rs.1,00,000/- 10 years ago, and sold
the same today for Rs 1 crore, you don’t have to pay any taxes on your gain or profit of Rs
99,00,000.
So, taxes on long term capital gain of Rs 99,00,000 = 0 (Zero) or exempt
If the investment and the consequent sale were done via an off-market transaction,
➡ Non listed stocks – Tax on LTCG is 20% (for example purchase and sale of shares belong-
ing to startup companies by Venture Capitalists)
➡ Listed stocks – Tax on LTCG 10%
Short term gain (STCG)
Assume you buy stocks or Mutual Funds today for Rs.50,000/- and sell the same within the com-
pletion of 365 days, say at Rs.55,000/-, then the profit or gain of Rs.5,000/- is considered as a
Short term capital gain(STCG) .
Generally speaking, gain or profit earned by investing into stocks or equity mutual funds holding
for more than 1 day (also called delivery based) and selling them within 1 year from date of pur-
chase can be categorized under STCG.
Currently tax on STCG in India is flat 15% on the gain or profit.
Therefore, if you buy Infosys shares worth Rs 100,000/- today and sell the same 10 days later for
Rs.120,000/-, then you are liable to pay 15% on Rs 20,000 (STCG) or Rs 3000/- as taxes.
So, tax on short term capital gain = flat 15% of the gain/profit.
Speculative Business income
As per section 43(5) of the Income Tax Act, 1961, profits earned by trading equity or stocks for in-
traday or non-delivery is categorized under speculative business income.
There is no fixed rate like capital gains tax rate when you have a business income. If you have a
business income, it has to be added to the rest of your other income and tax has to be paid as per
the tax slab you fall in.
For example, assume for the financial year my profit from trading intraday stocks was Rs.
100,000/-, and my salary for the year was Rs.400,000/-. So my total income for the year is Rs
5,00,000, and I have to pay taxes on this as per my tax slab, Rs 25000 in this case as shown below.
SL No. Slab Taxable Amount Tax Rate Tax Amount

1 0 to Rs.250,000 2,50,000 0% Nil
2 250,000 to 5,00,000 2,50,000 10% 25000
Total Tax applicable Rs. 25,00o
So the point here is that, one needs to club the speculative business income with other income
source and identify the taxable amount. Once this is done, tax has to be paid based on the tax
slab one belongs to.
Non – speculative Business income
Income from trading futures & options on recognized exchanges (equity, commodity, & currency)
is categorized under non-speculative business income as per section 43(5) of the Income Tax Act,
1961.
Like discussed earlier, business income has no fixed tax rate, you are required to add the non-
speculative business income to all your other income, and pay taxes according to the slab applica-
ble to you.
For example, assume a trader cum hotelier earns Rs, 500,000 by trading F&O. Besides this assume
he also earns Rs.20,00,000/- from his hotel business. Therefore his total income for the year is Rs
25,00,000/- (Rs.500,000 + Rs.20,00,000) and therefore his tax obligation is as follows
SL No. Slab Taxable Amount Tax Rate Tax Amount
1 0 to Rs.250,000 2,50,000 0% Nil
2 250,000 to 5,00,000 2,50,000 10% 25000
3 500,000 to 1,000,000 5,00,000 20% 1,00,000
4 10,00,000 to 25,00,000 15,00,000 30% 4,50,000
Total Tax applicable Rs.575,000
Effectively the business man here is paying 30% of his F&O profits as taxes.
You would be wondering why trading equity intraday is considered ‘speculative’ but trading F&O
is considered ‘non speculative’?
When trading intraday there is no intention of taking delivery, and hence it is considered specula-
tive business. F&O is defined as non-speculative by the government, maybe as they can be used
for hedging and also for taking/giving delivery of the underlying contract (even though currently
equity and currency derivatives in India are all cash settled, but by definition they give rise to
giving/taking delivery. Certain commodity F&O contracts like gold have delivery option to it).
3.2 – Pros and cons of declaring trading as a business income

Let us look at the bright side first; here is a list of advantages of declaring trading as a business
income
1. Low tax – If the total income (trading + any other) is less than Rs.250,000/-, then there is
no tax implication and if less than Rs.500,000/- effectively one has to pay less than 10% of
income as tax.
2. Claim expense – One can claim benefit of all expenses incurred for the business of trad-
ing (while for capital gains only charges on your contract note other than STT can be
claimed). For example, brokerage charges, STT, other statutory taxes while trading, inter-
net, phone, newspapers, depreciation of computers and electronics, research reports,
books, advisory, etc.
3. Offset the loss with gains – If one incurs any non-speculative F&O trading loss, this can
be set-off against any income other than salary. For example, if I incur Rs 5,00,000 loss in
trading F&O and my other income (like rent & interest, excluding salary) is Rs 10,00,000 , I
will have to now pay tax only on Rs 5,00,000.
4. Carry forward the F&O loss – If there is net loss any year (non-speculative F&O + any in-
come other than salary), and if income tax returns are filed before due date, loss can be car-
ried forward for the next 8 years. During the next 8 years, this loss can be set-off against any
other business gain (non-speculative business income).For example, if you had net loss of
Rs 5,00,000 this year trading F&O which was declared on time, you can carry forward this
loss next year and assuming you made a profit of Rs 20,00,000 next year, you can set-off the
previous year’s Rs 5,00,000 loss and pay taxes only on Rs 15,00,000.
5. Carry forward your intraday equity loss – Any speculative or intraday equity trading
loss can be set-off only against any other speculative gain (note: you cannot set-off intraday
equity trading loss which is considered speculative with F&O trading which is considered
non-speculative). Speculative losses can be carried forward for 4 years if the returns are
filed on time.So assume an equity intraday trader makes a loss of Rs.100,000/- this year, he
cannot off set this against any other business income. However, he can carry it forward to
the next year (upto 4 years). Assume the next year he makes a profit of Rs.50,000/- by trad-
ing equity intraday, then in that case he can use the previous year’s Rs.100,000/- loss to off-
set the complete gains of this year (Rs.50,000). The balance loss of Rs.50,000/- can still be
carried forward to the next 3 years. So do note, partial offset of losses is possible.
The following table summarizes the above points –
Time limit for

Whether Losses can be carried
Head of income under Whether loss can be set- off carry forward
forward and set-off in subsequent
which Loss is incurred within the same year and set-off of
years
losses
Under the Under any other Under the Under any other
same head Head same head Head
Losses of F&O as a
Yes Yes Yes No 8 years
Trader
Speculation Business Yes No Yes No 4 years
Capital Gain (Short-

Yes No Yes No 8 years
Term)
Now, here is a set of drawbacks for declaring your business income –
1.Potentially high taxes – If you fall under the 30% tax slab, you will effectively pay 30% of
all your trading profits as taxes
2. ITR Forms – Declaring business income would mean having to use an ITR4 or 4S, which
would mean needing help of a CA to file your IT returns. This can be an added effort and cost
especially for those salaried people who might have been using the very easy ITR 1 or ITR 2
(we will discuss more on this topic in the chapter on ITR forms)
3. Audit – Having to maintain the book of accounts which will need to be audited if your
turnover goes above Rs 1 crore for a year or if your profit is less than 8% of your turnover
(we will discuss more on this topic in the chapter on Turnover)
3.3 – What are you? Trader, Investor, or Both?

Coming back to our original discussion, according to CBDT
Investor: anyone who invests with the intention of earning through dividends
Trader: anyone who buys and sells with the intention of profiting from the price rise.
As an investor, you can claim all your delivery based equity gains/profit to be capital gains. But as
a trader, it becomes your business income which has its own pros and cons as discussed above.
The rule is very clear with respect to F&O trading, and intraday equity trading. F&O trading has
to be considered as a non-speculative business, and intraday equity as a speculative business. So
if you trade these instruments, you have to use ITR 4 for filing IT returns. So even if you are sala-
ried, you have to compulsorily use ITR4 and declare this income (profit or loss) from trading as a
business.
Unlike what most people think, losses also have to be declared compulsorily. Hiding trading ac-
tivity on the exchange from the IT department could mean trouble, especially in case of any IT
scrutiny (IT scrutiny is when the assessing income tax officer (AO) demands you to meet him and
give an explanation on your IT returns). The chances of getting a call for scrutiny is higher when
the IT department systems/algorithms pick up trading activity on your PAN, but the same not de-
clared on your ITR.
For equity delivery based investments, if you are holding stocks for more than a year, you
would have received some kind of dividend and even if you didn’t, you can show them all as in-
vestments and claim exemption under the long term capital gain. If you are buying and selling
stocks frequently (yes it is an open statement, but there is no rule which quantifies ‘frequent’)
for shorter terms, it is best to declare that as non-speculative business income instead of STCG.
Another thing to keep in mind is that if investing/trading on the markets is your only source of in-
come, and even if your trading activity is moderate, it is best to classify income from all your eq-
uity trades as a business income instead of capital gains. On the other hand, if you are salaried or
have some other business as your primary source of business, it becomes easier to show your eq-
uity trades as capital gains even if the frequency is slightly higher.
Thankfully one thing that the circular clarified was that you can be a trader and investor both at
the same time. So you can have stocks meant as investment for long term, and stocks meant for
shorter term trades. Just because you indulge in a lot of shorter term trades, wouldn’t necessarily
convert all your longer term holdings or investments into trades and therefore bring those long
term gains under business income. But it is important to clearly demarcate your trading and in-
vestment portfolio while filing returns.
Similarly, if you are trading F&O or intraday equity trading, you compulsorily have to classify your-
self as a trader, but you can still show your long term investments under the capital gains head to
get the benefit of LTCG being exempt from taxes.
So, you can be an investor, trader, or both, but make sure to keep the above points in mind, and
do consult a chartered accountant before filing returns.
Even though this might seem confusing, rules are made for 1% of the population that is trying to
break them. As long as your intent is right, you know the basic concerns of the IT department and
keep those in mind while filing IT returns, it is quite simple. But stay consistent with the way you
classify yourself, don’t keep switching between being an investor or trader to declare your equity
short term trades.
If you follow these simple rules, let me assure you – there is no need to fear the taxman.
Before we wrap this chapter, here are some interesting links that you should read through.
CBDT circular on distinction between trades and investments.
Business Standard – Is your return from stocks capital gains or business income?
Economic Times – Are you a stock trader or an investor?
Taxguru – Income from share trading – Business or capital gain?
Moneycontrol- Investor or trader: The argument continues
Economic Times – Budget 2014 clarifies that commodity trading on recognized exchanges is non-
speculative
Economic times – New data mining tool may access PAN-based information of taxpayers, help
check evasion
1. Trading F&O (Equity, currency, commodity) is considered non-speculative business
2. Trading intraday equity is considered speculative business
3. Equity holdings for more than 1 year is considered Long term capital gain (LTCG)
4. Equity holdings between 1 day to 1 year with low frequency of trades is considered Short
term capital gain (STCG), else in case of high frequency of trades it should be considered as
non-speculative business income
above is in the context of taxation for retail individual investors/traders only.
C H A PT E R 4
Taxation for Investors

4.1 – Quick recap
In continuation of previous chapter: Classifying your market activity
You can consider yourself an investor when –
➡ Buying and selling stocks after taking delivery to your DEMAT account not frequently or
➡ Equity holdings were purchased with an idea to earn dividends or with a plan of holding
it for long term.
If the frequency of transactions (buy/sells) is high, it is best to consider them as trades and not in-
vestments. If considered as trades, any income is non-speculative business income, whereas if
these are investments, then it falls under capital gains.
Keeping this in perspective, you may have few questions –
➡ What is long term?

➡ What is considered high frequency of transactions (buy/sells)?
We discussed this in the previous chapter, but just to refresh your memory – there is no set rule
from the IT department to quantify ‘frequency’ or determine ‘long term’.
As long as your intent is right, and you are consistent across financial years in the way you iden-
tify long term or high frequency, there is nothing to worry.
Do note, if you are indulging in equity delivery based trades as frequent as a few times every
week, it would be best to consider all of them as ‘trades’ and classifying income from them as
business income instead of capital gains.
Reiterating again that if investing/trading on the markets is the only source of income, and even if
you are trading with moderate frequency, it is best to classify income from all your equity trades
as a business income instead of capital gains.
On the other hand, if you are salaried or have some other business as your primary source of busi-
ness, it becomes easier to show your equity trades as capital gains even if the frequency of trades
is slightly higher.
So essentially,
1. Stocks that you hold for more than 1 year can be considered as investments as you would
have most likely received some dividends and also held for longish time
2. Shorter term equity delivery buy/sells can be considered as investments as long as fre-
quency of such buy/sells is low
3. Shorter term equity delivery buy/sells ideally has to be considered as trades (trading/
business income) if your frequency of such trades is as high as few times every week
The focus of this chapter is on investing; hence we will keep the discussion limited to just points 1
and 2. We will talk about taxation when trading/business income in the next chapter.
4.2 – Long term capital gain (LTCG)

When you buy & sell (long trades) or sell & buy (short trades) stocks within a single trading day
then such transactions are called intraday equity/stock trades.
Alternatively if you are buying stocks/equity and wait till it gets delivered to your DEMAT account
before selling it, then it is called ‘equity delivery based’ transactions.
Any gain or profit earned through equity delivery based trades or mutual funds can be catego-
rized under capital gains, which can be subdivided into:
➡ Long term capital gain (LTCG): equity delivery based investments where the holding pe-
riod is more than 1 year
➡ Short term capital gain (STCG): equity delivery based investments where the holding pe-
riod is lesser than 1 year
Taxes on long term capital gains for equity and mutual funds are discussed below –
For stocks/equity – 0% or NIL tax

It is NIL only if the transactions (buy/sells) are executed on recognized stock exchanges where
STT (Security transaction tax) is paid. As discussed above, LTCG is for holding period more than 1
year.
If the transactions (buy/sells) are executed through off-market transfer where shares are trans-
ferred from one person to another via delivery instruction booklet and not via a recognized ex-
change then LTCG is 20% in case of non-listed stocks, and 10% on listed stocks. (Listed are those
which trade on recognized exchanges). Do note that when you carry an off-market transaction Se-
curity Transaction Tax (STT) is not paid, but you end up paying higher capital gains tax. A typical
example of an off-market transaction could be a father transferring equity holdings to his son via
a ‘delivery instruction booklet’.
For equity mutual funds (MF) – 0% or NIL tax

Similar to equity delivery based trades, any gain in investment in equity oriented mutual funds
for more than 1 year is considered as LTCG and exempt from taxes. A mutual fund is considered as
equity oriented if at least 65% of the investible funds are deployed into equity or shares of domes-
tic companies.
For non-equity oriented/Debt MF – flat 20% on the gain with indexation benefit
Union budget 2014 brought in a major change to non-equity mutual funds. As opposed to 1 year
in equity based funds, you have to stay invested for 3 years in non-equity/debt funds for the in-
vestment to be considered as long term capital gain. If you sell the funds within 3 years to realize
a gain, then that gain is considered as STCG.
4.3 – Indexation
When calculating capital gains in case of non-equity oriented mutual funds, property, gold, and
others where you are taxed on LTCG, you get the indexation benefit to determine your net capital
gain.
I guess we would all agree that inflation eats into most of what is earned as profits by investing
into capital assets such as the ones mentioned above.
For someone wondering what that inflation is, here is a simple example to help you understand
the same –
All else equal, if a box of sweets priced at Rs.100 last year, chances are the same could cost Rs.110
this year. The price differential is attributable to Inflation, which in this example is 10%. Inflation
is the % by which purchasing value of your money diminishes.
Assuming the average inflation rate in India of around 6.5%, if you had invested into a debt fund,
wouldn’t a big portion of your long term capital gain at the end of 3 years get eaten away by infla-
tion?
For example assume you had invested Rs.100, 000/- into a debt fund, and you got back Rs
130,000/- at the end of 3 years. You have a long term capital gain of Rs.30,000/-. But in the same
period assume purchasing value of money is dropped by 18k because of inflation. Should you
still pay long term capital gain on the entire 30k? Clearly this does not make sense right?
Indexation is a simple method to determine the true value from sale of an asset after consider-
ing the effect of inflation. This can be done with help of Cost inflation index (CII) which can be
found on the income tax website.
Let me explain this with an example of a purchase/sale of a debt mutual fund.
Purchase value: Rs.100,000/-
Year of purchase: 2005
Sale value: Rs 300,000
Year of sale: 2015
Long term capital gain: Rs 200,000/-
Without indexation I would have to pay tax of 20% on the capital gains of Rs 200,000/-, which
works out to Rs 40,000/-.
But we can reduce the LTCG by considering indexation.
To calculate indexed purchase value, we need to use the cost inflation index (CII). Find below the
cost inflation index from the income tax website until 2014/15.
Financial Year CII
Before 1/4/1981 100
1981-82 100
1982-83 109
1983-84 116
1984-85 125
1985-86 133
1986-87 140
1987-88 150
1988-89 161
1989-90 172
1990-91 182
1991-92 199
1992-93 223
1993-94 244
1994-95 259
1995-96 281
1996-97 305
1997-98 331
1998-99 351
1999-00 389
2000-01 406
2001-02 426
Financial Year CII
2002-03 447
2003-04 463
2004-05 480
2005-06 497
2006-07 519
2007-08 551
2008-09 582
2009-10 632
2010-11 711
2011-12 785
2012-13 852
2013-14 939
2014-15 1024
Going back to the above example,
CII in the year of purchase (2005): 497
CII in the year of sale (2015): 1024
Indexed purchase value = Purchase value * (CII for year of sale/ CII for year of purchase)
So –
Indexed purchase value = Rs 100000 * (1024/497)
= Rs 206036
Long term capital gain = Sale value – Indexed purchase value
Therefore, in our example
LTCG = Rs 300,000 – Rs 206,036
= Rs 93,964/-
So the tax now would be 20% of Rs 93,964 = Rs 18,792, much lesser than Rs 40,000/- you would
have had to pay without the indexation benefit.
Like I had said earlier, the indexed purchase value can be calculated using the above method for
all long term capital gains which are taxable like debt funds, real estate, gold, FD, among others.
You could use the IT department’s Cost inflation index utility to check on indexed purchase value
of your capital assets instead of having to calculate manually.
Interesting thing to note in regards to 20% after indexation for non-equity oriented or debt funds:
Most of these funds return between 8 to 10% and typically inflation in India has been around that
for the last many years. So with the indexation benefit, you typically won’t have to pay any tax on
LTCG of non-equity oriented funds.
4.4 – Short term capital gain (STCG)

Tax on short term capital gains for equity and mutual funds are discussed below –
For stocks/equity: 15% of the gain

It is 15% of the gain if the transactions (buy/sells) are executed on recognized stock exchanges
where STT (Security transaction tax) is paid. STCG is applicable for holding period less than 1 year
(365 days) and more than 1 day.
If the transactions (buy/sells) are executed via off-market transfer (where shares are transferred
from one person to another via delivery instruction booklet and not on the exchange) where STT
is not paid, STCG will be taxable as per your applicable tax slab rate. For example, if you are earn-
ing over Rs.10,00,000/- per year in salary, you will fall in the 30% slab, and hence STCG will also be
taxed at 30%.
For equity mutual funds (MF): 15% of the gain
Similar to STCG for equity delivery based trades, any gain in investment in equity oriented mutual
funds held for lesser than 1 year is considered as STCG and taxed at 15% of the gain. Do note a
fund is considered Equity based if 65% of the funds are invested in domestic companies.
For non-equity oriented/Debt MF: As per your individual tax slab
Union budget 2014 brought in a major change to non-equity mutual funds. You have to now stay
invested for 3 years for the investment to be considered as long term capital gain. All gains made
on investments in such funds held for less than 3 years are now considered as STCG. STCG in this
case has to be added to your other business income and tax paid according to your income tax
slab.
For example, if you are earning around Rs 800,000/- per year in your normal business/salary and
you had STCG of Rs 100,000/- from debt funds, you will fall in the 20% slab as your total income is
Rs 9,00,000/-. So effectively in this example you will pay 20% of STCG as taxes.
4.5 – Days of holding

For an investor, the taxation difference between LTCG and STCG is quite huge. If you sold stocks
360 days from when you had bought, you would have to pay 15% of all gains as taxes on STCG.
The same stock if held for 5 days more (1 year or 365 days), the entire gain would be exempt from
taxation as it would be LTCG now.
It becomes imperative that you as an investor keep a tab on the number of days since you pur-
chased your stock holdings. If you have purchased the same stock multiple times during the hold-
ing period, then the period will be determined using FIFO (First in First out) method.
Let me explain –
Assume on 10th April 2014, you bought 100 shares of Reliance at Rs.800 per share, and on June
1st 2014 another 100 shares were bought at Rs.820 per share.
A year later, on May 1st 2015, you sold 150 shares at 920.
Following FIFO guidelines, 100 shares bought on 10th April 2014 and 50 shares from the 100
bought on June 1st 2014 should be considered as being sold.
Hence, for shares bought on 10th April 2014 gains = Rs 120 (920-800) x 100 = Rs 12,000/- (LTCG and
hence 0 tax).
For shares bought on June 1st, Gain = Rs 100 (920-820) x 50 = Rs 5,000/- (STCG and hence 15%
tax).
Small little sales pitch here – if you are trading at Zerodha the holdings page in our back office as-
sistant Q will keep a tab for you on number of days since your holdings were purchased, and even
a breakdown if bought in multiple trades.
Here is a snapshot of the same –
The highlights shows –
1. Day counter
2. A green arrow signifying holdings more than 365 days, selling which won’t attract any
taxes.
3. If you have bought the same holdings in multiple trades, the split up showing the same.
Besides Zerodha Q, equity tax P&L is probably the only report offered by an Indian brokerage
which gives you a complete breakdown of speculative income, STCG and LTCG.
4.6 – Quick note on STT, Advance Tax, and more

STT (Securities Transaction Tax) is a tax payable to the government of India on trades executed
on recognized stock exchanges. The tax is not applicable on off-market transactions which is
when shares are transferred from one DEMAT to another through delivery instruction slips in-
stead of routing the trades via exchange. But off market transactions attracts higher capital gains
tax as explained previously. Current rate of STT for equity delivery based trades is 0.1% of the
trade value.
When calculating taxes on capital gains, STT can’t be added to the cost of acquisition or sale of
shares/stocks/equity. Whereas brokerage and all other charges (which includes exchange
charges, SEBI charges, stamp duty, service tax) that you pay when buying/selling shares on the
exchange can be added to the cost of share, hence indirectly taking benefit of these expenses
that you incur.
Advance tax when you have realized capital gains (STCG)
Every tax payer with business income or with realized (profit booked) short term capital gains is
required to pay advance tax on 15thSept, 15th December, and 15th March. Advance tax is paid
keeping in mind an approximate income and taxes that you would have to pay on your business
and capital gain income by the end of the year. You as an individual are required to pay 30% of
the expected annual tax that you are likely to pay for that financial year by 15th Sept, 60% by
15th Dec, and 100% by 15th March. Not paying would entail a penalty of annualized interest of
around 12% for the period by which it was delayed.
When you are investing in the stock markets, it is very tough to extrapolate the capital gain
(STCG) or profit that will be earned by selling shares for an entire year just based on STCG earned
for a small period of time. So if you have sold shares and are sitting on profits (STCG), it is best to
pay advance tax only on that profit which is booked until now. Even if you eventually end up mak-
ing a profit for the entire year which is lesser than for what you had paid advance tax, you can
claim for a tax refund. Tax refunds are processed in quick time by the IT department now.
You can make your advance tax payments online by clicking on Challan No./ITNS 280 on
https://incometaxindiaefiling.gov.in/.
Which ITR form to use
You can declare capital gains either on ITR 2 or ITR4
ITR 4: When you have business income and capital gains
ITR 2: When you have salary and capital gains or just capital gains
4.7 – Short and long term capital losses
We pay 15% tax on short term capital gains and 0% on long term capital gains, what if these were
not gains but net losses for the year.
Short term capital losses if filed within time can be carried forward for 8 consecutive years, and
set off against any gains made in those years. For example if the net short term capital loss for
this year is Rs.100,000/-, this can be carried forward to next year, and if net short term capital gain
next year is say Rs.50,000/- then 15% of this gain need not be paid as taxes because this gain can
be set off against the loss which was carried forward. We will still be left with Rs Rs.50,000
(Rs.100,000 – Rs.50,000) loss which be carried forward for another 7 years.
Long term capital losses can’t be used to set off against long term gains as in the first place long
term capital gains is exempt from any tax. So long term capital loss is a dead loss, and can’t be
set off or carried forward.
Key takeaways:
1. LTCG : Equity: 0%, Equity MF: 0%, Debt MF: 20% after indexation benefit
2. STCG: Equity: 15%, Equity MF: 15%, Debt MF: as per individual tax slab
3. You can use cost inflation index to determine and get the benefit from the indexed pur-
chase value
4. Index purchase price = Indexed purchase value = Purchase value * (CII for year of sale/ CII
for year of purchase)
5. If you have bought and sold the same shares multiple times then use FIFO methodology
to calculate holding period and Capital gains
6. STT is payable to the Govt and cannot be claimed as expense when investing
Interesting reads:
Livemint: If you pay STT STCG is 15% otherwise as per tax slab
Income tax India website – Cost inflation index utility
Taxguru – Taxation of income & capital gains for mutual funds
HDFC- Debt mutual funds scenario post finance bill (no2), 2014
C H A PT E R 5
Taxation for Traders

5.1 – Quick Recap
Reiterating from the previous chapter –
You can classify yourself as an Investor if you hold equity investments for more than 1 year and
show income as long term capital gain (LTCG). You can also consider yourself an investor and
gains as short term capital gains (STCG) if your holding period is more than 1 day and less than 1
year. We also discussed on how it is best to show your capital gains as a business income if fre-
quency of trades is higher or if investing/trading is your primary source of income.
In this chapter we will discuss on all aspects of taxation when trading is declared as a business
income, which can be categorized either as:
1. Speculative business income – Income from intraday equity trading is considered as

speculative. It is considered as speculative as you would be trading without the intention
of taking delivery of the contract.
2. Non-speculative business income – Income from trading F&O (both intraday and over-
night) on all the exchanges is considered as non-speculative business income as it has
been specifically defined this way. F&O is also considered as non-speculative as these in-
struments are used for hedging and also for taking/giving delivery of underlying contract.
Even though currently almost all equity, currency, & commodity contracts in India are cash
settled, but by definition they give rise to giving/taking delivery (there are a few commod-
ity future contracts like gold and almost all agri-commodity contracts with delivery option
to it).Income from shorter term equity delivery based trades (held for between 1 day to 1
year) are also best to be considered as non-speculative business income if frequency of
such trades executed by you is high or if investing/trading in the markets is your main
source of income.
5.2 – Taxation of trading/business income
Unlike capital gains there is no fixed taxation rate when you have a business income. Speculative
and non-speculative business income has to be added to all your other income (salary, other busi-
ness income, bank interest, rental income, and others), and taxes paid according to the tax slab
you fall in. You can refer to chapter 1 for tax slabs as applicable for FY 2015-16.
Let me explain this with an example:
➡ My salary – Rs.1,000,000/-
➡ Short term capital gains from deliver based equity – Rs.100,000/-
➡ Profits from F&O trading – Rs.100,000/-
➡ Intraday equity trading – Rs.100,000/-
Gives these incomes for the year, what is my tax liability?
In order to find out my tax liability, I need to calculate my total income by summing up salary, and
all business income (speculative and non-speculative). The reason capital gains is not added is
because capital gains have fixed taxation rates unlike salary, or business income.
Total income (salary + business) = Rs.1,000,000 (salary income) + Rs.100,000 (Profits from F&O
trading) + Rs.100,000 (Intraday equity trading) = Rs 12,000,000/-
I now have to pay tax on Rs 12,000,000/- based on the tax slab –
➡ 0 – Rs.250,000 : 0% – Nil
➡ 250,000 – Rs.500,000 : 10% – Rs.25,000/-
➡ 500,000 – Rs.1,000,000 : 20% – Rs.100,000/-,
➡ 1,000,000 – 1,200,000: 30% – Rs.60,000/-
➡ Hence total tax : 25,000 + Rs.100,000 + Rs.60,000 = Rs.185,000/-
Now, I also have an additional income of Rs.100,000/- classified under short term capital gains
from deliver based equity. The tax rate on this is flat 15%.
STCG: Rs 100,000/-, so at 15%, tax liability is Rs.15,000/-
Total tax = Rs.185,000 + Rs.15,000 = Rs.200,000/-
I hope this example gives you a basic orientation of how to treat your income and evaluate your
tax liability.
We will now proceed to find a list of important factors that have to be kept in mind when declar-
ing trading as a business income for taxation.
5.3 – Carry forward business loss

If you file your income tax returns on time (July 31st for non-audit case – extended to Aug 31st
this year (2015), and Sept 30th for audit case) you can carry forward any business loss that is in-
curred.
Speculative losses can be carried forward for 4 years, and can be set-off only against any specula-
tive gains you make in that period.
Non-speculative losses can be set-off against any other business income except salary income
the same year. So they can be set-off against bank interest income, rental income, capital gains,
but only in the same year.
You carry forward non-speculative losses to the next 8 years; however do remember carried for-
ward non-speculative losses can be set-off only against any non-speculative gains made in that
period.
For example consider this – my hotel business income is Rs 1,500,000/-, my interest income for
the year is Rs.200,000/-, and I make a non-speculative loss of Rs 700,000. In such case my tax li-
ability for the year would be –
My gain is Rs 1,500,000/ from business and Rs.200,000/- from interest, so total of Rs.1,700,000/-.
I have a non speculative business loss of Rs.700,000/-, which I can use to offset my business
gains, and therefore lower my tax liability. Hence
Tax liability = Rs.1,700,000 – 700,000 = Rs.1,000,000/-
So I pay tax on Rs.1,000,000/- as per the tax slab I belong to, which would be –
➡ 0 – Rs.250,000 : 0% – Nil
➡ 250,000 – Rs.500,000 : 10% – Rs.25,000/-
➡ 500,000 – Rs.1,000,000 : 20% – Rs.100,000/-,
Hence, Rs.125,000/- goes out as tax.
5.4 – Offsetting Speculative and non-speculative business in-
come
Speculative (Intraday equity) loss can’t be offset with non-speculative (F&O) gains, but specula-
tive gains can be offset with non-speculative losses.
If you incur speculative (intraday equity) loss of Rs. 100,000/- for a year, and non-speculative
profit of Rs. 100,000/-, then you cannot net-off each other and say zero profits. You would still
have to pay taxes on Rs. 100,000/- from non-speculative profit, and carry forward the speculative
loss.
For example consider this –
➡ Income from Salary = Rs. 500,000/-

➡ Non Speculative profit = Rs. 100,000/-
➡ Speculative loss = Rs. 100,000/-,
I calculate my tax liability as –
Total income = Income from Salary + Gains from Non Speculative Business income
= Rs.500,000 + Rs.100,000 = Rs. 600,000/-
I’m required to pay the tax on Rs.600,000 as per the slab rates –
➡ 0 – Rs.250,000 : 0% – Nil
➡ 250,000 – Rs.500,000 : 10% – Rs. 25,000/-
➡ 500,000 – Rs.600,000 : 20% – Rs. 20,000/-,
Hence total tax = Rs.25,000 + Rs.20,000 = Rs .45,000/-
I can carry forward speculative loss of Rs.100,000/-, which I can set-off against any future (upto 4
years) speculative gains. Also to reiterate, speculative business losses can be set-off only against
other speculative gains either the same year or when carried forward. Speculative losses can’t be
set-off against other business gains.
But if I had speculative gain of Rs. 100,000/- and non-speculative loss of Rs. 100,000/- they can off-
set each other, and hence tax in the above example would be only on the salary of Rs. 500,000/-.
5.5 What is tax loss harvesting?
Towards the end of a financial year you might have realized profits and unrealized losses. If you
let it be, you will end up paying taxes on realized profits, and carrying forward your unrealized
losses to next year. This would mean a higher tax outgo immediately, and hence any interest that
you could have earned on that capital which goes away as taxes.
You can very easily postpone this tax outgo by booking the unrealized loss, and immediately get-
ting back on the same trade. By booking the loss, the tax liability for the financial year would
reduce. We at Zerodha are the only brokerage in India presently giving out a tax loss harvesting
report, which will spot all opportunities for you to harvest losses. Click here to learn more.
5.6 – BTST (ATST) – Is it speculative, non-speculative, or STCG?

BTST (Buy today Sell tomorrow) or ATST (Acquire today sell tomorrow) is quite popular among eq-
uity traders. It is called BTST when you buy today and sell tomorrow without taking delivery of
the stock.
Since you are not taking delivery, should it be considered as speculative similar to intraday equity
trading?
There are both schools of thought, one which considers it to be speculative because no delivery
was taken. However I come from the second school, which is to consider it as non-speculative/
STCG as the exchange itself charges the security transaction tax (STT) for BTST trades similar to
regular delivery based trades. A factor to consider is if such BTST trades are done just a few times
in the year show it as STCG, but if done frequently it is best to show it as speculative business in-
come.
5.7 – Advance tax – business income

Paying advance tax is important when you have a business income. Like we discussed in the previ-
ous chapter, advance tax has to be paid every year – 30% by 15th Sep, 60% by 15th Dec, and
100% by 15th March. I guess the question that will arise is % of what?
The % of the annual tax that you are likely to pay, yes! When you have a business income you
have to pay most of your taxes before the year ends on March 31st. The issue with trading as a
business is that you might have a great year until September, but you can’t extrapolate this to say
that you will continue to earn at the same rate until the end of the financial year. It could be more
or less.
But everything said and done, you are required to pay that advance tax, otherwise the penalty is
12% annualized for the time period it was not paid for. The best way to pay advance tax is by pay-
ing tax for that particular time period, so Sept 15th pay for what was earned until then, and by
March 15th close to the year end, you can make all balance payments as you would have a fair
idea on how you will close the year. You can claim a tax refund if you end up paying more advance
tax than what was required to pay for the financial year. Tax refunds are processed in quick time
by IT department.
You can make your advance tax payments online by clicking on Challan No./ITNS 280 on
https://incometaxindiaefiling.gov.in/
Also, here is an interesting link that helps you calculate your advance tax –
http://www.incometaxindia.gov.in/Pages/tools/advance-tax-calculator.aspx. You can also check
this link to see how exactly interest or penalty is calculated for non-payment of advance tax.
5.8 – Balance sheet and P&L statements –

When you have trading as a business income, you are required to like any other business create a
balance sheet and P&L or income statement for the financial year. Both these financial state-
ments might need an audit based on your turnover and profitability. We will discuss more on this
in the next chapter.
5.9 – Turnover and Tax audit
When is audit required?
An audit is required if you have a business income and if your business turnover is more than Rs.1
Crore for the given financial year. Audit is also required as per section 44AD in cases where turn-
over is less than Rs.1 Crore but profits are lesser than 8% of the turnover.
We will discuss this in detail in the next chapter.
However let us understand what audit really means.
The dictionary meaning of the term “audit” is check, review, inspection, etc. There are various
types of audits prescribed under different laws like company law requires a company audit; cost
accounting law requires a cost audit, etc. Likewise the Income-tax Law requires the taxpayer to
get the audit of the accounts of his business/profession from the view point of Income-tax Law if
he meets the above mentioned turnover criteria.
Check this link for FAQ’s on tax audit on the income tax website for more.
Audit can also be defined as having an accountant verify if you have filed everything right. In this
case it is getting an accountant check if you have created a correct balance sheet and P&L state-
ment for the year. Ideally this audit should be done by the IT department itself, but considering
the number of balance sheets out there it is surely impossible for IT department to audit each one
of them. Hence we need a Chartered accountant (CA), who is a qualified professional and author-
ized by Income tax department to perform audits on balance sheet and P&L statements. You the
tax payer can use any CA of your choice.
What role should a CA play?
Ideally a CA is required to only audit and sign on the balance sheets and P&L statements. But a CA
also typically ends up creating your balance sheets and P&L statements and will audit them only
if required. We will in the next chapter briefly explain how a CA typically creates these two state-
ments.
The importance of the audit process by a CA cannot be understated, apart from all the reporting
requirements an audit also helps traders/investors know their financial health, ensure it faithfully
reflects the income and claims for deduction are correctly made. It also helps lenders evaluate
credibility, and act as a check for any fraudulent practices.
Which ITR form to use? – ITR 4, we will discuss more on this in the last chapter. I have come
across incidents where people have declared both speculative and non-speculative as capital
gains to avoid having to declare business income, and not having to use ITR4. Taking a shortcut
like this could mean a lot of trouble if called for an IT scrutiny.
Business expenses when trading – Advantage of showing trading as a business is that you can
show all expenses incurred as a cost which can then be used to reduce your tax outgo, and if a
net loss for the year after all these costs, it can be carried forward as explained above.
Following are some of the expenses that can be shown as a cost when trading
➡ All charges when trading (STT, Brokerage, Exchange charges, and all other taxes). I hope
you remember that STT can’t be shown as a cost when declaring income as capital gains,
but it can be in case of business income.
➡ Internet/phone bills if used for trading (portion proportionate to your usage on the bill)
➡ Depreciation of computer/other electronics (used for trading)
➡ Rental income (if the place used for trading, if a room used – portion of your rent)
➡ Salary paid to anyone helping you trade
➡ Advisory fees, cost of books, newspapers, subscriptions and more…
1. Speculative business income if trading intraday equity.
2. Non-speculative if trading F&O, or short term equity delivery actively.
3. Speculative losses can’t be set-off against non-speculative gains.
4. Advance tax has to be paid when trading as a business – 30% by Sep 15th, 60% by Dec
15th and 100% by Mar 15th.
5. Can claim all expenses if income from trading shown as a business income.
C H A PT E R 6
Turnover, Balance Sheet, and P&L
6.1 – Turnover & Tax Audit

In the previous chapter, we discussed briefly on tax audit, and when it is required if you are de-
claring trading as a business income. To determine if an audit is required or not, we need to first
determine the turnover of your trading business.
Reiterating – the requirement of calculating turnover arises only when treating trading P&L as a
business income (An audit is not required if you only have capital gains income irrespective of
the turnover). Turnover is only to determine if a tax audit is required or not. Your tax liability
does not get affected by your turnover.
An audit is required if –
➡ 1 Crore mark – Turnover for the year crosses the Rs 1 crore mark
➡ Section 44AD – If the turnover is less than 1 crore, and if profit less than 8% of turnover
I am sure the first thing that came to your mind after reading turnover is contract turnover, i.e
➡ Nifty is at 8000, you buy 100 Nifty
➡ Buy side value = 8000 * 100 = Rs.800,000/-
➡ Nifty goes to 8100, you square off the 100 Nifty
➡ Sell side value = 8100 * 100 = Rs,810,000/-
➡ Turnover = Buy side value + Sell side value = 800,000 + 810,000 = 1,610,000/-
But it is not the contract turnover the IT department is interested in; they are interested in your
business turnover.
Read below on how business turnover can be calculated –
The method of calculating turnover is a debatable issue and what makes it a grey area is that
there is no guideline as such from the IT department. One article of great help though is the guid-
ance note on tax audit under Section 44AB by ICAI (Institute of Chartered accountants of India,
the governing body for CA’s). The article on Page 23, Section 5.12 of this guidance note has a
guideline on how turnover can be calculated. It says:
➡ Delivery based transactions
For all delivery based transactions, where you buy stocks and hold it more than 1 day and sell
them, total value of the sales is to be considered as turnover. So if you bought 100 Reliance
shares at Rs 800 and sold them at Rs 820, the selling value of Rs 82000 (820 x 100) can be consid-
ered as turnover.
But remember that the above calculation of turnover for delivery trades is only applicable if you
are declaring equity delivery based trades also as a business income. If you are declaring them as
capital gains or investments, there is no need to calculate turnover on such transactions. Also,
there is no need of an audit if you have only capital gains irrespective of turnover or profitability.
➡ Speculative transactions (intraday equity trading)
For all speculative transactions, aggregate or absolute sum of both positive and negative differ-
ences from trades is to be considered as a turnover. So if you buy 100 share of Reliance at 800 in
the morning and sell at 820 by afternoon, you make a profit or positive difference of Rs 2000, this
Rs.2000 can be considered as turnover for this trade.
➡ Non-speculative transactions (Futures and options)
For all non-speculative transactions, the article says that turnover to be determined as follows –
➡ The total of favorable and unfavorable differences shall be taken as turnover
➡ Premium received on sale of options is also to be included in turnover
➡ In respect of any reverse trades entered, the difference thereon should also form part of
the turnover.
So if you buy 25 units or 1 lot of Nifty futures at 8000 and sell at 7900, Rs.2500 (25 x 100) the nega-
tive difference or loss on the trade is turnover.
In options, if you buy 100 or 4 lots of Nifty 8200 calls at Rs.20 and sell at Rs.30. Firstly, the favor-
able difference or profit of Rs 1000 (10 x 100) is the turnover. But premium received on sale also
has to be considered turnover, which is Rs 30 x 100 = Rs 3000. So total turnover on this option
trade = 1000 +3000 = Rs 4000.
The above calculations (points 1 to 3) are fairly straight forward; the next important thing to de-
cide though is if you want to calculate turnover scrip wise or trade wise.
Scrip wise is when you calculate the turnover by collating all trades on the particular contract/
scrip for the financial year, find average buy/sell value, and then determine the turnover using the
above 3 rules with the total profit/loss or favorable/unfavorable difference on this average price.
Trade wise is when you calculate the turnover by summing up the absolute value of profit and
loss of every trade done during the year, and following the above rules.
Let me explain both with some examples –
1. 100 Nifty Jan future bought at 8000 and sold at 8100 on 1st Another 100 Nifty Jan future
bought at 8100 and sold at 8050 on 10th Jan. Determine turnover
Using scrip wise:
Average Nifty Jan Fut buy: 200 Nifty Buy at 8050
Average Nifty Jan Fut sell: 200 Nifty Sell at 8075
Total profit/loss = 200 x Rs 25 = Profit of Rs 5000 = Turnover of Nifty Jan Futures
Using trade wise:
100 Nifty Buy at 8000, Sell at 8100, Profit = Rs 10,000
100 Nifty Buy at 8100, Sell at 8050, Loss = Rs 5000
Turnover of Nifty Jan futures = Rs 10,000 + Rs 5000 (absolute sum of the loss) = Rs 15000
2. 100 Nifty Dec 8000 puts bought at 100 and sold at 50 on Dec 3rd. Another 100 Nifty Dec
8000 puts bought at 50 and sold at 30. Determine turnover
Using scripwise:
Average of Nifty Dec 8000 puts buy: 200 puts at 75
Average of Nifty Dec 8000 puts sell: 200 puts at 40
Total profit/loss = 200 x Rs 35 = Loss of Rs 7000
Total Selling value of options = 200 x Rs 40 = Rs 8000
Total Turnover for Dec 8000 puts = Rs 7000 + Rs 8000 = Rs 15000
Using tradewise:
Trade 1
100 Nifty Dec puts bought at 100 and sold at 50, Loss = Rs 5000
Selling value of options =100 x Rs 50 = Rs 5000
Turnover = Rs 10000
Trade 2
100 Nifty Dec puts bought at 50 and sold at 30, Loss = Rs 2000
Selling value of options = 100 x Rs 30 = Rs 3000
Turnover = Rs 5000
Total turnover = turnover of (trade 1+trade2) = Rs 15000
Which of the methods scrip wise or trade wise should I follow?
Calculating turnover trade wise is the most compliant way of determining turnover. The tricky bit
calculating trade wise turnover though is that no broker (other than us at Zerodha) currently
offers trade wise turnover report. All brokers provide a P&L with an average buy/sell price, which
can be used to calculate scrip wise turnover. If you are not trading at Zerodha and are looking at
calculating turnover tradewise, you will have to download all trades done during the year on an
excel sheet and calculate turnover manually.
Here is the scrip wise and trade wise turnover reports on Q (Zerodha’s reporting tool)
Once you determine the turnover, you will know if you need an audit or not, that is if a visit to a
CA and have him verify your balance sheet and P&L statements is compulsory or not.
6.2 – Section 44AD

An audit is also required as discussed above if your profit is less than 8% of the turnover. By turn-
over I am referring to all business turnover (speculative, non-speculative, and any other business
you have), and by profit I am referring to only your net business profits(not including, salary, capi-
tal gains, and others). This means that if you are trading as a business and incur a loss, you will
most likely have to get the books audited.
But an important thing to remember is that if your turnover is less than 1 crore and if your profit
is less than 8% of turnover an audit is not required if your total tax liability for the year is zero.
That means if your total income (Salary + Business income + capital gain) is less than Rs 2.5lks
(minimum tax slab), you have no tax liability and hence audit not required.
Applying section 44AD for trading as a business income is causing huge inconvenience for the retail
trading community. Turnover in an ordinary business to turnover while trading on the markets is
hugely different. Unlike an ordinary business where there is a fixed margin every time there is a
transaction, in the business of trading there is no such guarantee. This section is an unnecessary bur-
den that indirectly gets most small retail traders to have their books audited. We at Zerodha have
petitioned to the government through this campaign on Change.org, make sure to support it and
also get your trading friends to do the same.
When you show trading as a business income, you will have file using ITR4, which would mean
that like any other business you are required to create and maintain –
➡ Balance Sheet
➡ P&L statement
➡ Books of Accounts
Like discussed above, these will need to be audited based on your turnover (either turnover
crosses the 1 Crore mark or in case the turnover is less than 1 Crore and your profits is less than
8% of the total turnover). Creating balance sheet, P&L, and maintaining books of account is quite
simple for individuals with just trading as a business income, it is explained below in brief.
6.3 – Balance sheet, P&L, Book of accounts

Balance sheet
A personal balance sheet provides an overall snapshot of your wealth at a specific period in time.
It is a summary of your assets (what you own), your liabilities (what you owe) and your net worth
(assets minus liabilities).
Creating a personal balance sheet is fairly simple first pull together all of these information:
➡ Your latest bank statements

➡ Loan statement
➡ House loan statement
➡ Personal loan statements
➡ Principal balance of any outstanding loans
➡ Demat holding statement
Once you have all of that information available, start developing your balance sheet by listing all
of your assets (financial and tangible assets) with its respective values. Typical examples of the as-
sets could be –
➡ Cash (in the bank, in hand , deposits with Bank)

➡ All investments (mutual funds, Shares , Debt investment )
➡ Property value ( Cost of Purchase + Duty any paid + Interiors etc)
➡ Automobile value ( Motor Car + Two wheeler )
➡ Personal Property Value ( jewelry, household items, etc)
➡ Other assets ( Computers, Loans to friends , plot of land etc)
The sum of all of those values is the total value of your assets.
Next, you can look at your liabilities, which should be everything you owe. Here are some com-
mon liability categories:
➡ Remaining mortgage balance (Loan Statement)

➡ Car loans
➡ Student loans
➡ Any other personal loans
➡ Credit card balances
The sum of all of the money you owe is your liabilities.
The difference between your assets and your liabilities is your net worth.
That’s it; this is your balance sheet. Instead of creating one at the end of every financial year, it
probably makes sense to update once every few months.
Profit & Loss statement

Profit and loss will summarize your revenue streams and your expenses for the financial year.
To create your P&L for the given Financial Year, you will have to list down all revenues and ex-
penses.
Revenue –
➡ Realized sale value from your stock holdings (Capital gains)

➡ The Income from F&O, Intraday, or Commodity Trades. (Speculative and non-speculative
business income)
Remember that you can’t add your salary income (if you are working elsewhere) into you revenue
stream on the P&L.
Expenses –
➡ Salaries, if you have people helping you trade.

➡ Rent, if you are using an office or any space for trading activity for which you are paying a
rental income
➡ Brokerage charges, taxes, and all other trade related expenses.
➡ Advisory fees, consultancy, depreciation of computer, and etc (read the expenses section
in the chapter on taxation-traders)
Revenue minus the Expense equals profit.
A Balance sheet helps you understand your networth between two dates and the P&L will give
you the reasons why your networth went up or down in that period. Maintaining financial disci-
pline is the key to long term personal wealth creation. A personal balance sheet and P&L will en-
sure that you are constantly in touch with reality – your assets and liabilities.
Book of accounts/Book-keeping
Maintaining book of accounts and Book-keeping seem like very complex tasks, and typical reac-
tions I have seen from traders is to get scared of the word and try postponing the decision to
learn more on the topic. Again for an individual with only trading as a business income and/or sal-
ary, it is super simple- you just need to maintain two books.
Bank book: Take an excel download of all your bank statements, and make a note next to every
entry to identify the nature of the transaction. It is also best to keep a copy of all the bills in case
of expenses.
Trading book: This should be automatically getting maintained for you by the broker where you
trade. The broker should be able to give you a P&L statement including all expenses for the year,
ledger statement, and an online repository of contract notes if required. Unlike what many peo-
ple think, contract notes aren’t really required unless a scrutiny by the IT department, and even
then if only asked for the same.
As a person who has traded with over 10 online brokers in India, the ledger and P&L statements
with all expenses on it will show up any hidden charges by the broker.
At Zerodha, we take great pride in the transparency we bring in as a business. Every charge
other than brokerage is captured on the other credits/debits section on the tax P&L on Q. We also
give you a summary with value of all your open option positions starting April 1st and closing
March 31st. This is extremely useful when you are trying to tally your ledger with your P&L state-
ment.
We are almost done with the taxation module. The last chapter will have an explanation on what
kind of ITR forms to use, and also an excel download of a sample ITR 4 form with all details as an
easy reference.
Key takeaways from this chapter –
1. Audit of the books is required if turnover is more than INR 1 Crore mark
2. Audit of the books is required if turnover is less that INR 1 Crore but if the profits is less
than 8%
3. Audit of the books is NOT required if turnover is less than INR 1 Crore and profits higher
than 8% of the turnover
4. Turnover does not take into consideration the regular contract turnover
5. Turnover refers to the business turnover
6. Business turnover (for trading as a business) can be calculated scripwise or tradewise
7. Trade wise turnover is the most compliant way of declaring turnover.
8. If you are declaring trading as a business then one needs to use the ITR4 form to file tax re-
turns
9. ITR4 requires you to have Balance Sheet and Profit and Loss statement along with books
of account
10. Balance sheet equation states that Net worth = Assets – Liabilities
11. P&L statement details the revenues and expenses
12. If trading as a business maintaining 2 books of account becomes mandatory – Bank
Book and Trade book
13. It is advisable to maintain and update Balance Sheet, P&L, and books of account once in
every quarter.
Disclaimer – Do consult a chartered accountant (CA) before filing your returns. The content above
is in the context of taxation for retail individual investors/traders only.
C H A PT E R 7
ITR Forms (The Finale)

7.1 – Income Tax Return (ITR) Forms
The last step of taxation is filing your Income tax returns (ITR), and this can be done using ITR
forms. Find below brief explanation on everything important on ITR that you need to know as an
investor/trader.
I have noticed from my interactions with many that they are confused between the two actions i.e
‘paying income tax’ and ‘filing income tax’. Many are of the opinion that if they pay income tax the
act of filing income tax is not really necessary. This is not true, let me explain why.
Paying Income tax – If you are employed and draw a salary you very clearly know that your em-
ployer on your behalf deducts tax (based on your tax slab) and pays the income tax on your be-
half. This is usually called ‘Tax Deducted at source (TDS)’. Now what if you have an income
sources besides your salary?
For example for the given year assume besides drawing a salary, you also made a profit by ac-
tively trading delivery based equity trading. As we now know this activity falls under “Non-
speculative Business Income”. Since the employer is not privy to this activity it becomes your re-
sponsibility to declare this source of income to the Income tax department and paying the appro-
priate amount as tax.
Filing Income tax returns – Filing income tax returns is a mandatory way of communicating to
the IT department all the sources of income you have including your salary. An Income Tax Re-
turn Form (ITR) form is simply a form that you need to fill up declaring your sources of income.
There are different ITR forms for different sources of income. You may wonder why I should file
my returns when I don’t have any other source of income besides salary. Well, in such a case by
virtue of filing your income tax returns (via appropriate ITR form) you are officially communicat-
ing to the income tax department that you do not have any other source of income.
So in essence, the act of filing your returns is your official communication to IT department about
all the source of income that you have along with the tax you have paid against that income. You
do this via the prescribed ITR forms.
More formally, an ITR is a prescribed form through which the particulars of income earned by a
person in a financial year and taxes paid on such income are communicated to the Income-tax De-
partment. There are different types of ITR forms, one needs to select the appropriate ITR form,
based on the different sources of income. These forms can be downloaded from here
https://incometaxindiaefiling.gov.in/
7.2 – ITR forms and its uses

In the context of this module, which is focused towards individuals having investments as capital
gains or trading as a business income, the important ITR forms to know about are:
ITR 1 – when you have only salary, interest income, or rental income from only one house prop-
erty, you can use ITR 1 forms to file your income tax returns. This is the most common type, but if
you have capital gains or trading as a business income, you can’t use this ITR form.
ITR 2 – when you have salary, interest income, income from house property or income from capi-
tal gains, you can use ITR 2. So if you are an individual who only invests in the market (remember
investor, hence capital gains), you need to use ITR2
ITR 4 – when you have salary, interest income, income from house property, income from capital
gains, and income from business/profession, you can use ITR 4.
So if you are an individual who is declaring trading as a business income, you have to use ITR 4. If
you are an investor and trader, you can show trading under business income and investments as
capital gains on the same ITR 4 form.
ITR 4S (Sugam) – this is similar to ITR4 but with presumptive scheme if section 44AD and 44AE
used for computation of business income. ITR 4S can’t be used if you have speculative business
income (intraday equity); losses to be carried forward, or short term capital gains tax (STCG). So
you can use ITR 4S only if you have non-speculative trading income, but it is best avoided.
7.3 – Exploring ITR 4S

The advantage of ITR 4S is that it can be used by tax payers who do not maintain regular book of
accounts or want it to be audited (refer chapter 2) provided your turnover is lesser than Rs 1
Crore for the year.
You can get away without maintaining books or getting audited if you firstly calculate turnover
based on section 44AD (check the previous chapter) and then declare 8% of this turnover as your
presumptive income. You have to then pay taxes adding this 8% of the turnover to your other in-
come and pay tax as per the slabs.
So if you are a trader with turnover less than Rs 1 Crore for the year and profit less than 8% of the
turnover with only non-speculative business income (not possible if you have speculative busi-
ness income or short term capital gain), you can declare presumptive income of 8% of the turn-
over, and get away from the need to get your books audited. There is no need to pay advance
taxes if you are using ITR4S, but you are not allowed to deduct any business expenses against
your income.
For example, assume my salary was Rs.500,000/- for the last FY, and I had incurred F&O loss of
Rs.25,000/- on a turnover of Rs.400,000/-. Since my profit is less than 8% (25,000/400,000) of my
turnover I will need to use ITR4, maintain books, and have them audited. Instead of this, I could
use ITR4S and declare 8% of Rs.400,000/- (business turnover) or Rs.32,000/- as my presumptive
trading business income even though I have incurred a loss.
My total income for the year is Rs 500,000 (salary) + R 32,000 (business income) = Rs.532,000/-.
Therefore my tax liability would be as follows –
Upto Rs.250,000 – No Tax

Between Rs.250,000 to Rs.500,000 – 10% – Rs.25,000/-
Between Rs.500,000 to Rs.532,000 – 20% – Rs.6,400
Total tax = Rs.25,000 + Rs.6,400 = Rs.31,400/-
Here, by virtue of declaring a presumptive business income of Rs.32,000/- I’m paying additional
tax of Rs.6,400/-. This works out to be a much cheaper alternative than getting an audit done for
which the CA fees could have been Rs.15,000/- and above. So using ITR4S would make sense only
if your turnover is low, hence declaring 8% of turnover as income would work out cheaper than
paying an audit fees to the CA.
7.4 – Quick FAQ and notes
How to file the return of income electronically?
Income-tax department has established an independent portal for e-filing of return of income.
You can log on to www.incometaxindiaefiling.gov.in for e-filing the return of income. Check this
very nice video on e-filing put by the IT department.
Is it necessary to attach documents along with return of income?

ITR return forms are attachment less forms. Hence along with the ITR form (whether filed manu-
ally or filed electronically), you are not required to attach any document (like proof of invest-
ment, TDS certificates, etc) unless if you fall under the audit case.
However, these documents should be retained by you and should be produced before the tax
authorities when demanded in situations like assessment, inquiry, scrutiny etc. But in audit
cases, soft copy of balance sheets, P&L, and any notes along with the audit report needs to be at-
tached.
What is the difference between e-payment and e-filing?

E-payment is the process of electronic payment of tax (i.e., by net banking or SBI’s debit/credit
card)
E-filing is the process of electronically furnishing (filing) of return of income.
Using the e-payment and e-filing facility, payment of tax and furnishing of return is quick, easy,
and hassle free.
Is it necessary to file return of income when I do not have any positive income?
If you have sustained a loss in the financial year, which you propose to carry forward to the subse-
quent year for adjustment against subsequent year(s) positive income, you must make a claim of
loss by filing your return before the due date.
What are the due dates for filing returns of income/loss?

If no audit: July 31st (Extended to Aug 31 this year of 2015)
If audit: September 30th
If I fail to furnish my return within the due date, will I be fined or penalized?
Yes, if you have not furnished the return within the due date, you will have to pay interest on tax
due. If the return is not filed up to the end of the assessment year, in addition to interest, a pen-
alty of Rs. 5,000 shall be levied under section 271F.
Can return be filed after the due date?
Yes you can. Return filed after the prescribed due date is called as a belated return. If one could
not file the return of income on or before the prescribed due date, then he can file a belated re-
turn. A belated return can be filed within a period of one year from the end of the assessment
year or before completion of the assessment, whichever is earlier. A belated return attracts inter-
est and penalty as discussed in previous FAQ.
For Example – In case of income earned during FY 2013-14, the belated return can be filed up to
31st March, 2016. However, if return is filed after 31st March, 2015, penalty under section 271F
can be levied.
If I have committed any mistake in my original return, am I permitted to file a revised return
to correct the mistake?
Yes, provided the original return has been filed before the due date and the IT Department has
not completed the assessment. It is expected that the mistake in the original return is of a genu-
ine and bona fide nature and not rectification of any deliberate mistake. However, a belated re-
turn (being a return filed after the due date) cannot be revised.
Return can be revised within a period of one year from the end of the relevant assessment year or
before completion of the assessment whichever is earlier.
Example, in case of income earned during FY 2013-14, the due date of filing the return of income
(considering no audit) is 31st July, 2014. If the return of income is filed on or before 31st July,
2014 then the return can be revised upto 31st March, 2016 (assuming assessment is not com-
pleted by that date). However, if return is filed after 31st July, 2014, then it will be a belated return
and a belated return cannot be revised.
ITR forms are typically Microsoft Excel sheets where you can fill all the relevant details, and the
calculations happen automatically.
Find attached an ITR 4 form with all types of income, salary, capital gains, trading as a business,
and rental income. This should act as an easy reference if you are trying to fill this on your own.
This is the ITR4 form from AY 14/15(FY 13/14).
XLS Sample ITR4 Form.
1. The act of paying your taxes is called “Tax Payment”, which can be done via e-payment
2. The act of communicating different sources of income and tax paid against that is called
“Income Tax Return filing”
3. Filing income tax returns is mandatory, even though you have paid taxes
4. An ITR form should be used to file taxes
5. Use different ITRs for different sources of income
6. ITR 4S for presumptive business income. Use this to lower your cash outflow (paying
taxes versus audit fees)
Phew! That brings us to the end of the taxation module. Keeping it simple is most challenging, es-
pecially a topic like this where almost every other word is a jargon. Hopefully I have done a de-
cent job with it, and this module acts as your ready reckoner for everything on taxation when trad-
ing and investing.
Financial discipline is the key to long term wealth creation, and it starts with compliant filing of
your income tax returns. It is best not to avoid or postpone especially with advancement of tech-
nology and reach of our income tax department.
Do help spread the word,
Happy Trading,
Nithin Kamath
Zerodha
Special thanks to Tax IQ for providing valuable inputs throughout this module.
ZERODHA
Currency & Commodity

Futures
ZERODHA.COM/VARSITY
Table of Contents
1 Currency Basics 1
2 Reference Rates & Impact of events 9
3 Impact of events (Brexit) & Interest Rate Parity 20
4 The USD INR Pair (Part 1) 28
5 The USD INR Pair (Part 2) 39
6 EUR, GBP, and JPY 50
7 Gold (Part 1) 63
8 Gold (Part 2) 72
9 Silver 84
10 Crude Oil (Part 1), digging the past 95
11 Crude Oil (Part 2), the crude oil eco system 102
12 Crude Oil (Part 3), the crude oil contract 111
13 Copper & Aluminium 120
14 Lead & Nickel 132
15 Cardamom & Mentha Oil 144
16 Natural Gas 155
17 Commodity Options 164

CHAPTER 1
Currency Basics
1.1 – Module Orientation
At the onset, let me give you a quick orientation, so you can set your expectations for
this module. The focus of this module will be on three main topics –
1. Currencies and currency trading
2. Understanding Commodities
3. Interest Rate Futures
I agree that each of these topics is vast, and commands an entire module on its own.
However, these assets are not as liquid as equities. We are still at a very nascent stage
when it comes to trading these alternate assets in India. Given this, the idea here would
be introducing these assets, familiarize you with what drives these assets, and what
you need to watch out for before placing your trades. So, in a sense, you could consider
this module as a ‘thought starter’ of sorts for trading these alternative assets. Needless
to say, we will try and discuss these topics to a reasonable depth, ensuring you have
more than just the bare basics on these topics.
We’ll begin the module by discussing Currencies. We’ll discuss some of the popular
currency pairs traded in India such as USD-INR, GBP-INR, and INR-JPY. We also discuss
other (non INR) currency pairs such as EUR-USD, GBP-USD, and USD-JPY. The
discussion on currencies would be spread across a few chapters. The objective here
would be to introduce these currency pairs, and familiarize with not just the contract
specification but also with a few fundamental factors that affect these currencies.
Once this is done, we’ll move on to the next part of the module. This’d deal with
Commodities. We’ll follow a similar template here – i.e. introduce the commodities
(both agri and non-agri) and get familiarize you with not just the contract specifications
but also a few fundamental factors which would influence the movement of these
commodities. Some of the commodities we’ll be discussing would be – Gold, Silver,
Zinc, Aluminium, Crude oil, Natural Gas, Turmeric, Cardamom, Pepper, Cotton, etc. Of
course, the formula to calculate the price of commodities such as Gold, based on the
price of Gold in International markets will also be discussed.
Lastly, this module will discuss ‘Interest Rate Futures (IFR)’, which I think is a very
exciting space. The discussion would deal with topics related to RBI’s borrowing
pattern, issuance of sovereign bonds, listing on NSE, and eventually trading them.
Based on how we progress, we can even touch topics related to bond trading and bond
trading strategies.
As you see, we have some really interesting stuff lined up. I believe this’ll be a great
learning experience for you, and me!
Please note, the prerequisites for this course –
1. Futures Trading
2. Options Theory
3. Technical Analysis
The above mentioned topics are absolutely essential before learning about currencies.
I’d suggest you brush up these topics before proceeding.
Let’s now begin this module by discussing few basics about currencies.
1.2 – Currency (in)equality

Before we get started on currencies, let me share with you an interesting conversation
I had with my 6-year-old daughter. Perhaps this could set a good starting point for our
discussion on currencies.
I had recently been to Austria with my family on vacation. As you can imagine, the
country is extremely beautiful. It was my daughter’s first visit to Europe and she was in
complete awe. Needless to say, she was attracted to all the small little stores selling
pretty little things. On one of the days while we were there, she forcibly took me to this
toy store she spotted off the street, and I knew I was in for trouble. After spending about
5-10 minutes scanning through the shop, she finally picked up a colourful wooden
caterpillar, and she wanted me to buy her that. It looked really nice, and I was willing
to buy her that, until I saw the price! The wooden caterpillar had a 25 Euro price tag. I
thought I’d negotiate with her and buy her something else.
I tried telling her that it was 25 Euros, and 25 Euros was quite steep especially for a tiny
wooden caterpillar! She obviously didn’t understand my point, and refused to budge
from her stance. In fact, she said ‘it’s just 25 Euros’, and I realised that she equated 25
Euros to 25 Rupees, completely oblivious to the fact that she needs to multiply each
Euro with 78 to get the exact Rupee equivalent.
However, this got me thinking – why isn’t one Euro or for that matter one Dollar equal
to one Rupee? More generally why isn’t one unit of currency belonging to country A
equivalent to another unit of currency belonging to country B? I understand this may
sound very basic and some of you may already know the answer, but I think it is very
important to discuss this and understand why the inequality between currencies exists.
After all, it is this inequality which allows us to trade the currency pairs.
To understand this, we need to brush up a bit on the history of currencies and how
currency trading evolved. Don’t worry, I won’t get into history lessons here; will restrict
this to a quick recap. For the sake of simplicity, let me break this down into different
stages for you based on my own understanding of the evolution of currency.
Stage 1 – The Barter era
Before the advent of currencies, transactions occurred through something called the
‘barter system’. Barter system is a ‘method of exchange’ which has existed for many
centuries. In a typical barter, people exchange goods for other goods (or services). A
classic example would be – say a farmer has harvested cotton, he could exchange (or
barter) cotton with another farmer giving him wheat. Similarly, a farmer who has
oranges could exchange the oranges he has harvested with someone who agrees to
wash his cows and sheep.
The problem with the barter system was the scale and divisibility of the system. For
example, assume a farmer had 5 bales of cotton and he wants to barter cotton with
someone selling cattle, assuming 2 bales for 1 cow, after the barter he’d be left with 2
cows and a bale of cotton. He would certainly not get half a cow for 1 bale of cotton.
This caused a divisibility issue within the system.
The scalability was also an issue with the barter system – it required our farmer to travel
from one part of the country (with all his produce) to another part of the country to
barter for goods of his choice.
Both these issues were eventually overcome with an improved system – Goods for
metal.
Stage 2 – Goods for Metal era
The problems that plagued the barter system eventually paved way to the next
transaction methodology. People tried to invent a common denominator for the
‘exchange’. The common denominator ranged from food grains to metals. But
eventually metals thrived for obvious reasons. Metal was divisible, easily movable, and
metal had no issue with shelf life. Further, of all the metals, Gold and Silver were the
most popular; therefore, eventually these metals became the standard for
transactions. The direct exchange between gold/silver and goods lasted for many
centuries; however, things started to change when people deposited gold and silver
coins in safe havens and issued a ‘paper’ against the value of gold. This paper derived
its value based on the gold/silver coins deposited in safe haven.
With time, safe havens evolved to banks and the paper transformed to different
currencies. Perhaps this was the start of the book entry of the currency system.
Stage 3 – The Gold Standard era
Over time, as domestic trade flourished, trading across borders also flourished.
Economic sense prevailed and merchants realized producing everything locally did not
make sense. Merchants started exploring cross border trade – simple import and export
of goods thrived. This also meant merchants transacting across border also required to
pay for it in a currency that was acceptable across borders. Banking systems also
evolved, and somewhere around the late 19 th Century exchanging goods for Gold (not
silver) became the norm. Valuing the local currency against the value of gold was called
the ‘Gold Standard’.
As things progressed, geo political situation changed (world wars, civil wars, cold wars
etc.) and so did the economic situation across the world. When it came to cross border
transactions, there was an urgent need for merchants to trust one currency and value
their own currency against that currency. This is when ‘Bretton Woods System’ came to
the picture. You can read more on the Bretton Woods System.
However, here is a simplified version of the Bretton Woods System (BWS). The BWS was
a way of defining the monetary relationship between countries, where the currencies
were pegged to USD at a fixed rate while the value of the USD itself was marked against
the value of Gold. Countries accepted this system with a room for 1% variation either
side (against the pegged value). Needless to say, with BWS in place the USD became the
currency the world transacted in, as USD was backed by Gold!
Developed countries slowly withdrew from the BWS system and eventually BWS
became history. Countries adopted a more market driven approach, where the market
decided the value of one currency against the other. The market drives the value of
currencies based on the political and economic landscape of a country versus the
other.
This brings us to where we are now.
1.3 – International Currency market (Forex)

Internationally, the notional currency trading volume is massive and needs a moment
to digest the figure. As per the April 2013 survey conducted by ‘Bank of International
Settlement’ (BIS) the size of International Markets stands at $5.4 Trillion! Here is
the link for the detailed report. My guess is we could be close to $5.8 – 6 Trillion as of
April 2016. If you can imagine, this is roughly 20% higher than the entire Indian annual
GDP that gets traded on a daily basis!
Probably what really contributes to such massive trading is the fact that currency
markets chase the Sun. Currencies are traded across all the major markets, and
information flows seamlessly.
To understand what I mean, keep the Indian markets as reference and think about it –
before Indian markets are open, the Australian, Japanese, Hong Kong, and Singapore
markets are open. In fact, we get some overlap with these markets. While the Southeast
market closes, Indian markets would have just warmed up with Middle Eastern markets
opening up. This leads to the European markets opening up – London, Frankfurt, and
Paris being the financial nerve center of the Europe. In fact, Indian markets are situated
in a sweet spot as our time zone overlaps with major Southeast Asian markets and the
European markets. Finally, the US markets open, followed by the Japanese markets
and the cycle continues 24 hours a day, 6 days a week!
Having said that, the most active time for currencies is when the US, UK, Japanese, and
Australian markets are open. This is when the order flow gets brim-full.
This leads us to an interesting question – who are these people trading currencies and
why are the notional values so crazy? More importantly how are currencies traded?
Unlike Equity markets, the participation in Forex is not just restricted to investors and
traders. The participants in the Foreign Exchange (Forex) markets are many – Central
Banks, Corporate, Banks, Travelers, and of course traders. Each of these participants
have their own agenda while participating in the Forex markets. For example, the
corporate maybe buying/selling USD to hedge their order book, and a traveller maybe
buying USD for his travel expense. While the trader maybe just speculating on the
movement of the currency. Obviously since participation comes in from many
quarters, the volumes are driven up. More so, Forex trading is highly leveraged, hence
the notional value appears large.
There is no centralized International exchange where the Forex transactions take place.
Transactions occur at different financial institutions (like NSE in India) and information
flows from one platform to another making it borderless.
1.4 – Currency Pairs and quotes

The standard practice while trading currencies is to trade the currency as a ‘pair’. The
value of the pair keeps fluctuating as the trades flow through. An example of the pair
could be USD INR or GBP INR. The currency pair has a standard format, as shown below
Base Currency / Quotation Currency = value
There are three parts here, lets figure out each one of them –
Base Currency – Base Currency is always fixed to 1 unit of a currency (like 1 US Dollar,
1 Indian Rupee, 1 Euro etc.)
Quotation Currency – Refers to another currency which equates to the base currency
(obviously it can be any currency apart from the base currency)
Value – Indicates the value of the Quotation Currency against the Base Currency.
Confusing? Let take an example to make it clearer. Assume USD/INR = 67.
The Base Currency here is USD, and as I mentioned earlier the Base Currency is always
fixed to 1 unit, hence this is fixed to 1 US Dollar.
Quotation Currency is in Indian Rupees (INR)
Value is 67, which means for 1 unit of Base Currency i.e. 1 USD the equivalent quotation
currency is 67. In simpler terms $1 = Rs.67.
The most active currency pairs that get traded across the world and its current value as
on 3rd June 3, 2016 are as follows –
SL No Base Currency Quotation Currency Pair Pair Value
1 Euro US Dollar EUR/USD 1.11
2 US Dollar Japanese Yen USD/JPY 108.94
3 Great Britain Pound US Dollar GBP/USD 1.44
4 Australian Dollar US Dollar AUD/USD 0.72
5 UD Dollar Canadian Dollar USD/CAD 1.31
6 US Dollar Swiss Franc USD/CHF 0.99
Now here is the big question – what makes the pairs move? Why do they move? Are
there events that influence the pairs?
We will explore this in the next chapter.
1. The Gold Standard system of evaluating currencies existed for a long time, but
eventually got phased out
2. The currency inequality between currencies exist because of political and

economic differences between two countries
3. By volumes, the currency markets are easily one of the largest
4. The currency markets are open 24 hours, 6 days a week
5. Currency is traded as pairs
6. Currency Pairs have a standard format to include Base Currency and Quotation
Currency
7. The Base Currency is always fixed to 1 unit
CHAPTER 2
Reference Rates & Impact of events

2.1 – Dual View
Think about a stock, Infosys for example, when you buy or sell Infosys – your view on
the stock is straightforward – you are either bullish or bearish on Infosys therefore you
buy or sell Infosys. Now think about a currency pair – say USD INR, when you buy or sell
USD INR, whether you know or not, you have a dual view on the pair. For instance, when
you buy USD INR; it implies you are bullish on the US Dollar and bearish on the Indian
currency.
Why is it this way you may ask?
Well, the value of a currency is always quoted against another. Recall from the previous
chapter – the currency pair is quoted as –
Base Currency / Quotation Currency = Value
In other words, this format tells us, how many units of quotation currency one can buy
for 1 unit of base currency.
If you buy a currency pair, clearly it implies that you expect the value of the pair to go
up. Consider this example – USD INR = 65, one would buy the pair, hoping for the price
of the pair to hit 68.
Now if the price of the pair is expected to increase, then it implies that going forward 1
unit of base currency can buy more units of quotation currency i.e. 1 USD to buy more
INR.
In other words, if the value of the pair goes up then the power of the Base currency goes
up while at the same time the quotation currency weakens. This translates to you being
bullish on the Base currency and bearish on the quotation currency at the same time.
Similarly, if you sell the USD INR pair, it implies that you anticipate the Base Currency
to buy lesser amount of quotation currency. This translates to you being bearish on
base currency and bullish on the quotation currency.
Given this, “strengthening/weakening of a currency” refers to the following situations–
1. Base currency strengthens when it can buy more units of quotation currency. For
example, USD INR moves from 67 to 68 it means the base currency (USD) strengths and
the quotation currency (INR) weakens.
2. Quotation currency strengths when the base currency buys lesser units of quotation
currency. For example, USD INR moves from 66 to 65 it means the base currency (USD)
weakens and the quotation currency (INR) strengthens.
Note that strengthening and weakening of a currency is equivalent to a currency

appreciating and depreciating. These terminologies are often used interchangeably.
Before we proceed, here is something you need to know. Just like a stock, the currency
(and the currency pair) has a ‘two-way quote’. The two-way quote enables one to
identify the rate at which one can buy and sell the currency (and currency pair).
Don’t get thinking on the ‘two-way quote’, it simply refers to ‘Bid and Ask’ rates J, but
we do need to touch upon this as its vital to know how the two-way quote works.
This is a snap shot of the currency spot rates, as quoted on a Forex trading site. For the
sake of this discussion, I’ve highlighted the two-way quote for EUR USD and GBP USD.
The quote gives you the rate at which you can buy and sell the currency pair.
For example, if you want to buy the EUR/USD – you will have to buy the pair at the ‘Ask’
price i.e. 1.1270. When you buy the pair, technically you are long EUR and short USD.
Likewise, if you want to sell the EUR/USD, then you would do so at 1.1269 (Bid price),
and here you would be short EUR and long USD (remember the dual view concept).
The pairs are sometimes quoted in a short form, which is actually quite a popular way
to quote currencies internationally. The shortened two-way quote would be something
like this for the EUR/USD pair –
EUR/USD – 1.1269/70.
If you notice in the shortened version, the ‘bid’ price is stated in full, but only the last
two digits of ‘ask’ is stated.
Further, in the Forex lingo, digits are referred to as ‘pips’. Therefore, if the EURUSD
moves from 1.1270 to 1.1272, then it means that the pair has moved 2 pips.
2.2 – Rate fixing and conversion path
As of today, the USD/INR rate stands at 67.0737. This rate is fixed by the RBI on a daily
basis, and is called RBI’s ‘Reference Rate’; in fact, RBI publishes these rates on a daily
basis on their website. The Reference rate acts as crucial input for the currency futures
trading as all settlements are based on this Reference rate.
Have a look at this –
The above is a snapshot from the RBI’s site showing the reference rate for 14 th June
2016. Do note, these are spot rates, and not future rates. Future rates are as seen on
NSE’s website.
Anyway, the obvious question is – how does the RBI arrive at this rate?
Well, nothing hi tech here, RBI follows the age-old method of polling to arrive at the
spot rate! Click here to see the RBI circular that explains the rate fixing procedure, but
if you are in no mood to read the circular, you could read the following points that
summarize the procedure.
1. RBI has identified a list of banks based on their market share in the foreign exchange
market. RBI calls them the ‘contributing banks’
2. Every day between 11:30AM and 12:30PM RBI calls a set of banks (randomly selected)
listed under the contributing banks and ask them to give a two-way quote on USD INR
3. RBI collates these rates and averages out the rate based on the bid and ask
4. The average rate is set as the USD INR rate for the day
5. The same process is repeated every day except for weekends and bank holidays
It’s as simple as that!
The procedure is quite simple; however, RBI polls only for the USD INR rates. For the
other major rates i.e. EUR INR, GBP INR, JPY INR RBI adopts a technique called
‘Crossing’ also referred to as the cross rate mechanism.
While crossing, the direct rate of one currency is not available with respect to another.
For example, the direct rate of Euro with respect to INR is not readily available; one
needs to cross these rates with a common denominator to arrive at the rates.
Let me take the example of deriving the EUR INR rate by crossing, keeping USD as the
common denominator, hopefully this will give you a better clarity on the crossing
technique.
Let us begin with getting the spot rate for USD INR, as we can see from snap shot above,
the USD INR spot is –
USD INR – 67.0737
This is the spot rate; the two-way quote for this would be something like this –
USD INR – 67.0730 / 67.0740
This means if I have to buy 1 USD, I need to pay INR 67.0740 and if I have to sell 1 USD,
I’d receive INR 67.0730.
Let’s keep this information aside. We now focus on EUR USD spot rates from the
international markets.
The two-way quote from Bloomberg suggests –
EUR USD – 1.1134/40
This means I need USD 1.1140 (Ask price) to buy 1 Euro. In other words, the cost of 1
Euro in terms of the US Dollar is 1.1140. Hence if I convert the price of 1.1140 US D to
INR, then I will have enough INR to buy 1 Euro and by doing so, I will also get the
EUR/INR rate.
Now going back to the USD INR rate –
1 USD = Rs.67.0740
1.1140 USD = How many Rupees?
= 67.0740 * 1.1140
= 74.72044
Hence to buy 1 Euro I need 74.72400 INR, or EUR INR = 74.72400
Notice how the USD acts as a pivot in the crossing technique.
Now here is a simple task for you – using the crossing technique, we have calculated
the ASK price of the EUR INR pair, can you extend this logic to calculate the Bid p rice
for the EUR INR pair? Feel free to post your answers in the comments section below.
If you think about this, it’s now clear that the reference rates and the cross rates change
every day based the sentiments of the contributing banks. This leads us to a bigger
question – what influences the sentiment of the contributing banks?
The answer is quite simple – domestic and international events.
2.3 – Events that matter

Think about an event that can potentially change the sentiment on a stock. Quarterly
result of company is one such event. Estimating the change in sentiment based on this
event is quite straightforward. If the quarterly result is good, the sentiment is pos itive;
therefore, the stock price is expected to go up. Alternatively, if the quarterly result is
not great, sentiment is hurt and therefore the stock price is expected to go down. The
point here is, there is some sort of linearity between the event and the expected
outcome.
However, when it comes to currency pairs, there is no such linearity, which makes it a
herculean task to assess the impact of events, a.k.a. fundamentals on currencies. The
complexity mainly stems from the fact that currencies are quoted as pairs. While some
factors lead to strengthening of a pair, an event could occur at the exact same time that
weakens the pair.
Let me give you an example to illustrate this – imagine two economic events running in
parallel.
Event 1 – India receives a continuous inflows of Foreign Direct Investments (FDI)

geared towards long term investments, clearly this is a big positive for the economy
and therefore it tends to strengthen the INR.
Event 2 – There is an uptick in the US economy (or a fear of a crash in commodities)

leading to an appreciation in the US Dollar.
Given these two events occur in parallel – which direction will the USD INR currency
pair move? Well, the answer to this is not straightforward. Eventually the currency pair
will take cues from the more dominant of the two factors and head in that direction,
but until this happens the pair invariably exhibits volatile behaviour. Hence, to
successfully trade currencies, it becomes extremely important to track world events
and assess their impact on the currency pair in question.
Here are few such events and data that you should track –
Import/Export Data – These numbers are highly significant, especially for a country
like India, whose economy is highly sensitive to trade deficits. India exports g oods and
services such as rice and software and imports commodities such as crude oil and
bullion. In general, increase in exports tends to strength domestic currency and
increase in imports tends to weaken the domestic currency. Why so you may ask?
When imports are made (crude oil for example), the purchase has to be made in the
International market which requires one to pay in USD. Therefore, one has to sell INR
and buy USD to facilitate this purchase, which in turn causes a demand for USD and
hence USD strengths.
We can extend the same logic to exports. When we export goods, we receive USD; we
sell the USD received and convert to INR. This causes the INR to strength.
The Trade Deficit – the excess of imports over exports is a key factor to track as it
influences the direction in which the currency trades. In general, narrowing the trade
deficit is a positive for the domestic currency. The trade deficit is also referred to as the
‘Current account deficit’. I’d suggest you read this news piece, just to reinforce your
understanding on this topic.
Interest Rates – Typically investors borrow money from countries where the interest
rate is low and invest in countries where the interest rates are high and profit from the
interest rate difference. This is called the ‘carry trade’. Clearly the country offering
higher interest attracts a lot more foreign investment into the country, naturally this
leads to the strengthening of the domestic currency. This clearly implies that the
‘Interest rate’ is one big number currency traders watch out for.
The monetary policy review conducted by the central banks (RBI in India, Federal
Reserves in US, and ECB in Euro region) reviews the interest rates of the country. This
is the reason why there is so much attention paid for the policy review. Besides tracking
the actual change in numbers in the on-going review, the market participants look for
cues regarding the policy stance. The monetary stance helps the participants
understand the future course of action concerning the interest rate.
Dovish – Dovish is a term used to describe the central bank’s stance wherein they are
likely to lower the interest rate in the future. Remember, lower interest rate weakens
the domestic currency. Here is a new headline talking about the relationship between
a dovish stance and the currency.
Click here to see the article.
Hawkish – Hawkish is a term used to describe the central bank’s stance wherein they
are likely to increase the interest rate in the future. Remember, higher interest rates
attract foreign investments to the country and therefore strengthens the domestic
currency.
And here is another new headline which talks about hawkish stance.
Inflation – Inflation, as you may know, is the rate at which the prices of basic goods
and services increase over time. If inflation increases, then it means the cost of basic
necessities is increasing, therefore this affects the day to day living of the common man.
Given this, the central bank strives hard to keep inflation in control. The link between
inflation and currency movement is a bit tricky.
One of the direct mechanisms to curb inflation is by tweaking the interest rates. If the
inflation is perceived as high, then the central bank is likely to take a hawkish stance
and increase the interest rates.
What do you think is the logic here?
Well, easy money in the hands on consumers and corporates increases spending; when
spending increase merchants smell an opportunity to make higher margins and
therefore this leads to rapid increase in prices, and thus the inflation increases. When
inflation increases, the central banks tend to curb the spending by cutting the access
to easy money. And how do they do that? Well, they increase the interest rates!
Therefore, when inflation is on the rise, expect the central banks to take a hawkish
stance and increase the interest rates. When interest rates increase, the domestic
currency strengths!
Therefore, as I mentioned earlier, the relationship between interest rates and

currencies is a little tricky. So traders eagerly track inflation data to figure out what the
central banks are likely to do, and accordingly take positions on the currency pair.
Remember this – if the inflation is high, expect a hawkish stance by the central
government and therefore expect the domestic currency to strengthen. Likewise, if
inflation is low, expect a dovish stance (as the central bankers wants to encourage
spending), therefore the interest rates are likely to come down. This leads to the
domestic currency weakening.
Consumer Price Index (CPI) – The CPI is a time series data, averaged out to capture
the prices of basic goods and services. Hence the CPI is a measure for inflation. A rising
CPI means inflation is increasing, and vice versa. For the most accurate Indian CPI data
and information check this website
Gross Domestic Product (GDP) – The GDP of a country represents the total Rupee
value (for Indian GDP of course) of all the goods and services produced in the country
for a given year. As you can imagine the GDP would be a massive number and it does
not make sense to repeat the GDP number while making estimates or during
conversations. Therefore, one always refers to the GDP as a growth rate. For example,
if the GDP of a country is 7.1%, it means that the GPD number is growing at a rate of
7.1%.
Higher the GDP growth rate, higher is the investor confidence in that country, and
therefore the stronger the countries domestic currency.
The list of events that matter while trading currencies is virtually endless, and at some
point you will realize that every piece of data you can possibly look at is inter-
connected with one another. Honestly, you need not know the details of each event the
way an economist would. Understanding the cause and effect relationship is good
enough. I’ve listed some of the key events/data points that matter while trading
currencies. I guess this would serve as a good start, If nothing more.
Key takeaways form this chapter
1. The base currency is said to strengthen/appreciate against the quotation currency

when it can buy more units of quotation currency.
2. The base currency is said to weaken/depreciate against the quotation currency
when it buys lesser units of the quotation currency.
3. When you go long on a currency pair, you are essentially going long on the base
currency and short on the quotation currency.
4. When you go short on a currency pair, you are essentially going short on the base
currency and long on the quotation currency.
5. The RBI sets the reference rate of USD INR on a daily basis by conducting a poll, the
‘contributing banks’ participate in this poll.
6. The reference rates for other currency pairs are derived by crossing technique.
7. Understanding events and its impact on currencies is complicated, simply because
of the currency is quoted in pairs and impact on the pair could be similar.
8. Eventually the more dominating event will set the direction for the pair.
9. Countries with higher interest rates tend to have stringer currencies and vice versa.
10. Lower the trade deficit of the country, stronger is the country’s currency.
11. Higher inflation leads to strengthening of currency and vice versa.
12. Knowing the cause and effect of events on currencies helps while trading
currencies.
CHAPTER 3
Impact of events (Brexit) & Interest Rate

Parity
3.1 – Brexit, the event extraordinaire!

I originally planned to dedicate this entire chapter to the USD INR pair, which as you
may know is the largest traded currency contract in India. But then, the BREXIT issue
happened today and I can’t help writing about it as it has a huge relevance to what we
just discussed in the previous chapter – events and their impact on currency pairs.
To give you a sense of what happened, have a look at how the Great Britain Pound (GBP)
reacted to the event. It was down a massive 8.64%, which you will eventually reali ze is
a big deal in currencies.
The Guardian UK, had this to say about the event –
Here is the article.
My objective here is to simplify Brexit to the best of my knowledge and help you
understand why the pound reacted the way it did. Obviously, the bigger agenda here is
to help you understand the potential impact of such events on currencies. By doing so,
you’ll get a grip on how to summarize global events such as Brexit and understand what
kind of impact they could have on currencies.
For the sake of simplicity and brevity, let me bullet point Brexit for you. We start with a
bit of history –
1. After the World War 2, Germany and France debated the idea of forming a union of sorts.
The thought process was that if countries traded and did business together, then they
are less likely to wage war against each other.
2. This laid the foundation for forming a bigger union called the ‘European Union’ (EU)
with more European countries agreeing to join the EU.
3. The EU formed a single market of sorts where goods, service, and people moved easily
across countries. So much so that the EU decided to have its own currency called the
‘Euro’.
4. UK, although was a part of the EU, never accepted Euro as their currency. Note there
are many other countries in the EU which still have their own currency, example –
Switzerland, Chez Republic, Denmark etc.
5. There was a growing debate in UK in the recent times on whether the UK should remain
in the EU. Many of UK’s citizens believed that UK was better off outside the union as the
rules laid out by the EU commission was more taxing on UK’s citizen than actually
benefiting them. In simpler words – they believe they would progress faster and better
economically and as a society being outside the EU.
6. Britain option to exit from the EU was called ‘Brexit’.
7. The UK decided to formally seek its citizens’ vote on 23 rd June 2016, where in the citizen
would vote for being in or leaving the EU. This is called a ‘referendum’
8. The outcome of the referendum was a bit of shocker with the UK actually deciding to
opt out of the EU. In fact, many in the UK and the world believed that UK would vote to
stay in the EU.
The referendum’s outcome sent a shiver down the spine for traders and investors round
the globe. The GBP crashed to a 31-year low, the major European indices dove close to
8-10%.
Now why did this happen? Why did the markets fall? What is the connection between
Brexit and the currency markets and the work markets?
Now here is where I’m hoping the previous chapter comes to help us J
Recall in the previous chapter we discussed how a strong economy (defied by inflation,
interest rates, trade deficit etc.) leads to a strong currency.
Given this, think about the UK – clearly UK is one of the strongest economies in the
world and contributes significantly the EU. Now with UK opting out of the EU, things
are set to change both economically and politically.
While UK has a trade deficit with the rest of the world, it maintains a trade surplus with
EU. This should give you a sense of how strongly the UK’s economy is coupled with
EU. With UK opting out of the EU, its finances are certainly going to take a hit.
Further the problem is with clarity. Everyone knows that the economic situation is
bound to change, but to what extent is something no one really knows. How will the
Bank of England react? Will they cut the rates to near zero?
Uncertainty is one thing that the market despises, and given its nature, Brexit has
many. Therefore, as a result, the markets cracked.
You as a currency trader should be in a position to study the event and understand
some basics. From my experience, sometimes the best trades are set up backed by
simple common sense and basic knowledge.
Remember if you had studied the event and arrived at a conclusion to not take on a
trade, then that in itself would have been a good trade, as the rule of thumb says “when
in confusion, do nothing”.
The point is – when you have events of this magnitude around the corner, it is
mandatory for you to know what is happening. Taking on a trade without the perquisite
knowledge is equivalent to a blind speculative bet!
So, that’s about Brexit and how events like this can impact the currencies.
Let us move ahead to figure out few other currency concepts.
3.2 – Fairy Trade

Imagine a perfect world, where in you can borrow money at a certain interest rate,
invest the borrowed money at a higher rate, and earn the differential in the
rates. Confusing? Let me give you an example to simplify this.
The interest rate in the United Sates is about 0.5%, arguably one of the lowest in the
world. Assume you borrow $10,000 from a bank in United Sates at 0.5%; invest this
borrowed money in a country like India where the interest rate is about 6-7%.
To do this, you will have to convert the borrowed money (which is in USD), to INR. At
today’s conversion rate, a US dollar gets you 67 INR. Therefore $10,000 fetches Rest.
670,000/-. We invest the converted money in India at say 7%.
At the end of the invested year, we get back 7% interest plus the initial capital. This
would be –
670000 + 670000*(7%)
= 670000 + 46900
= Rest. 716,900/-
We convert this money to USD, assume the conversion rate is 67, we get back $10,700.
We now have to repay the principle amount plus 0.5% in interest. This would be $10000
plus $50.
So after repaying back $10,050 we get to retain $650, which if you realize is a risk free
gain!
If you realize, $650 is the interest rate differential times the borrowed money –
10000*(7%-0.5%)
10000*(6.5%)
650
This is a simple case of arbitrage, quite easy to implement, don’t you think so?
Given this, imagine a situation where you could borrow large amounts of money from
US and invest this large amount in India and make pot loads of money year on year
right?
Well, sorry to burst the bubble, such trades happen only in fairy tales J. In the world we
live in, such easy risk free profits do not exist. Even if it did, it would vanish before even
you realize.
However, the bigger question we need to answer is – why is this ‘fairy trade’ not
possible?
3.3 – Forward Premia & Interest Rate parity
The problem with the above trade is that there are one too many assumptions, we
assumed–
1. We could borrow unlimited amounts of money in US

2. We could deposit unlimited amounts of money in India
3. There is no cost of transaction, no taxes
4. Easy movement of currency between countries
5. Most importantly we assumed the conversion rate stayed flat at 67 after 1 year
Given that such arbitrage cannot exist for long, the currency rate a year later should be
such that it would prohibit the arbitrage to exist. In other words,
The money we receive from India a year later = Money we repay to banks in US a year
later
From the example we discussed above, we borrowed $10,000 from US, invested the
same in India and a year later we received Rest. 716,900/-.
For the arbitrage to NOT exist, at the end of 1 year, Rest. 716,900/- should be equal to
$10,050.
This means the conversion rate should be –
716900/10050
= 71.33
This is called the ‘Forward Premia’ in the currency world. The approximate formula to
calculate the Forward Premia is –
F = S * (1+ R oc * N) / (1 + R bc * N)
Where,
F = Future Rate
S = Today’s spot rate
N = Period in years
Roc = Interest rate in quotation currency
Rbc = Interest rate in base currency
Let’s apply this formula to check if we get the forward rate right for the above situation.
Remember the spot rate is 67,
F = 67*(1+7%*1) / (1+0.5%*1)
= 71.33
Further, note that the forward premia rate is approximately equal to the spot rate plus
spot times the difference in interest rate i.e. –
F = S*(1+difference in interest rates)
= 67*(1+ 7% – 0.5%)
= 67*(1+6.5%)
= 71.35
This is called the ‘Interest rate parity’.
Think about this – Indian Rupees is trading at 67 today compared to 71.35 in the future,
therefore the Rupee is considered to be at a discount now. Generally speaking, the
future value of any currency which has a higher interest rate is at a discount to a
currency which has a lower interest rate.
So why are we discussing all this and what is the relevance to currency trading? Well,
the forward premia plays an important role in determining the futures price!
We will discuss more on this going forward.
1. Events like Brexit tend to have extra ordinary influence on currencies

2. A country whose economy is expected to suffer tends to have a weaker currency
3. Forward premia is the expected spot rate over a given period
4. Forward premia = S * (1+ R oc * N) / (1 + Rbc * N)
5. Interest Rate parity indicated that the forward premia is approximately equal to the
spot rate plus spot times the difference in interest rate
6. Future value of any currency which has a higher interest rate is at a discount to a
currency which has a lower interest rate
CHAPTER 4
The USD INR Pair (Part 1)
4.1 – The contract

We make an extremely critical assumption at this stage – we will assume you are
familiar with how Future and Option contracts work.
Technical Analysis plays an important role in setting up short term currency trades, so
we’ll assume you know Technical Analysis as well.
If you are not familiar with these topics, then I’d strongly suggest you to read through
these modules before proceeding further. The currency and commodities market is
largely a Futures market; hence a working knowledge of these derivative instruments
is the key.
Now, assuming you understand these concepts fairly well, let us begin by slicing and
dicing the USD INR futures contract. The contract specification of the USD INR futures
gives us insights on the trade logistics.
Here are the salient features of the USD INR pair –
To give you a sense of how this works, let’s take an example –
This is the 15-minute chart of the USD INR pair, as you can see the encircled candle has
formed a bearish Marubuzo. One can initiate a short trade based on this, keeping the
high of the Marubuzo as the stop loss.
Note that I’m not trying to justify a trade here, my objective is to showcase how the USD
INR contract works.
The trade details are as below –
Date: 1st July 2016
Position – Short
Entry – 67.6900
SL – 67.7500
Number of lots to short – 10
1 lot of USD INR = $ 1000
Contract value of 1 lot of USD INR = Lot size * price
=1000 * 67.7000
=67,700
The margin required for this can be fetched from Zerodha’s margin calculator; here is
the snapshot of the same.
As you can see, the margin required to initiate a fresh position in USD INR is about Rs.
1,524/-. Therefore, on a contract size of 67700, this works out to –
1525/67700
= 2.251%
Out of this, I’m guessing about 1.5% would be SAPN margin requirement (read as
minimum margin required as per exchange) and the rest as exposure margin.
Further, the idea is to short 10 lots, hence total margin required is –
10 * 1525
= 15,250/-
A point to note here – when trading equity futures, one has to earmark anywhere
between 15% and 65% of the contract value as margins, this obviously varies from stock
to stock. In contrast to equities, the margin charged in currencies is way lower. This
should give you a sense of how leveraged currency trading really is.
On the other hand, currency sticks to a tight trading range compared to equities. Hence
higher leverage.
4.2 – The contract logistics

Notice how the currency futures are quoted – they go up to the 4 th decimal digit. There
is a reason for this – when it comes to currency futures, a number as small as this –
0.0025 is considered big.
When RBI states the reference rate, they quote up to the 4 th decimal. Even a minor
difference at the 4 thdecimal can alter the foreign reserves by a large degree. In fact, it is
a norm world over to quote the currency to 4 th decimal – in case of USD INR this is
0.0025. This is called the tick size or in currency parlance, a ‘pip’. A pip/tick is the
minimum number of points by which a currency can move.
So when the USD INR moved from 67.9000 to 67.9025, it is said that the currency has
moved up by a pip.
How much money would you make per pip in the USD INR pair? Well, this should be
easy to figure out –
Lot Size * pip (tick size)
= 1000 * 0.0025
= 2.5
This means to say, for every pip or every tick movement you make Rs.2.5/-.
Going back to the short trade, here is how the Marubuzo panned out –
After initiating the short, the currency pair declined 67.6000. If I choose to close this
position, he is how much I would make –
Entry = 67.6900
CMP = 67.6000
Total number of points = 67.6900 – 67.6000 = 0.0900
Position – Short
This could be a bit tricky, do pay attention. A pip as you know is the minimum number
of points the currency can move. To know how many pips a currency has moved when
it moved by 0.09 paise, we divide the total number of points moved by the pip size.
Number of pips = 0.0900/0.0025
= 36
As you can see the trade managed to capture 36 pips, let us now calculate how much
money one would make –
Lot size * number of lots * number of pips * tick size
We know, Number of pips * tick size is as good as the total number of points caught
with this trade, therefore we can restate the above formula –
Lot Size * Number of lots * total number of points
= 1000 * 10 * 0.0900
= 900
Remember this is an intraday trade. What if you were to carry this forward to expiry?
Well, we can carry this forward as long as we maintain the adequate margin
requirements. The July contract will stay in series 2 days prior to the last working day
of the month.
Here is the calendar –
So 29th July happens to be the last working day of the month, hence 27 th July will be the
expiry of this series. In fact, you can hold the contract only till 12:30 PM on 27 th July.
Of course you can always look at the contract to see the exact date of the expiry.
Another question at this stage – at what price will the settlement happen?
The settlement will happen at the RBI reference rate set for 27 th July, and it is important
to note that the P&L will be settled in INR.
So for example if I hold this position till 12:30 PM on 27 th July and let it expiry, assume
the price is 67.4000, then I’d stand to make –
= 1000 * 0.29 * 10
=2900/-
And this money will be credited to my trading account on 28 th July 2016. Needless to
say as long as you hold the contract, your position will be marked to market (M2M). This
is similar to the way it works for equity futures.
Hopefully this example should give you a sense of how the logistics for the currency
futures work.
Let us quickly run through the USDINR options contract.
4.3 – USD INR options contract

Let us have a look at how the USDINR option contract is structured. You may be
interested to know that the option contract is made available only for the USD INR pair.
Hopefully going forward, we could see option contracts on other currency pairs as well.
While most of the parameters are similar to the future contract, there are few features
specific to option contracts.
Option expiry style – European
Premium – Quoted in INR
Contract cycle – While the future contracts are available for 12 months forward, the
option contracts are available just 3 months forward. This is similar to equity
derivatives. So, since we are in July, contracts are available for July, August, and
September.
Strikes available – 12 In the Money, 12 Out of the Money, and 1 Near the money option.
So this is roughly 25 strikes available for you to pick and choose from. Of course, more
options are added based on how the market behaves. Strikes are available at every 0.25
paisa intervals.
Settlement – Settled in INR based on the settlement price (RBI reference rate on expiry
date).
Let’s have a look at the USD INR option contract and figure out the logistics. Have a
look at the following image –
From the option quote, we know the following –
Option type – Call option
Strike – 67.0000
Spot price (see RBI reference rate) – 67.1848
Expiry Date – 27th July 2016
Position – Long
Premium – 0.7400 (quoted in INR)
We know the lot size is $1000, although the lot size has not been mentioned in the quote
above. Usually this information is made available in the quote for equity derivatives.
So if you are seeing this for the first time, just be aware that the lot size is $1000.
Now, if you were to buy this option, what would be the premium outlay? Well, this is
fairly easy to calculate –
Premium to be paid = lot size * premium
= 1000 * 0.7400
= 740
The option contract works similar to the equity derivative contracts. Here is an another
snapshot I captured –
As you can see, the premium has shot up, and I can choose to close my trade right away.
If I did, here is how much I would make –
= 1000 * 0.7750
=775
This translated to a profit of 775 – 740 = 35 per lot.
What if you were to sell/write this option instead? Well, you know that option selling
requires you to deposit margins. You can use Zerodha’s F&O Margin calculator to get
an estimate on the margin required.
Have a look at the snapshot below, I’ve used the calculator to identify the margin
required to write (short) this option –
As you can see, the margin required is Rs. 2,390/-.
I hope this chapter has given you a basic sense of how the USD INR contracts are
designed. In the next chapter, we will try and discuss some quantitative aspects of the
USD INR pair, and perhaps look at the contract specification of other currency pairs.
1. The contract specification specs out the logistics of the USD INR derivative.
2. Lot size is fixed to $1,000 but this can be changed by the exchange anytime.
3. Expiry of the USD INR contract is 2 days prior to the last working day of the month.
The contract can be held/traded till 12:30 PM.
4. Margins applicable = SPAN + Exposure, usually the margins add up to 2.25 – 2.5%.
5. Currency pairs are quoted up to the 4 th decimal place.
6. A pip is the minimum price moment allowed in a currency.
7. Currency options are European in nature.
8. The premium quoted in currency options is in INR.
9. Strikes are available at every 25 paisa price difference.
10. Margins are blocked when you intend to write currency options.
CHAPTER 5
The USD INR Pair (Part 2)
5.1 – Futures Calendar spread

All else equal, the futures contract is always supposed to trade at a premium to the
spot. This, as we know, can be attributed to the interest rate factor (cost of carry) in the
Futures pricing formula. We have discussed this earlier in the Futures module. Any
variation in this equation leads to an arbitrage opportunity.
For a quick low level recap on that, consider this scenario where there is arbitrage
opportunity between Spot and Futures –
Futures trade at a lower price – Assume the spot price is at 100, and the fair value of
its future is at 105. Fair value of the future can be calculated using the futures pricing
formula. The ‘no arbitrage spread’ is the difference between spot and Future’s fair
value i.e. 105 – 100 = 5
Given this, for whatever reasons (read as market mispricing) assume the future is
trading at 98, this leads to a spread of 7 (105-98) between the spot and future, which
can be captured.
All one has to do is buy the future at 98, and simultaneously sell the spot at 100. We
know upon expiry, the futures and the spot will converge and therefore the spread gets
captured.
If you are unable to understand the above clearly, I’d encourage you to read the chapter
from the Futures module (link posted above).
Likewise, if the futures trade at a higher price (over and above its fair value) then one
can capture the spread by selling the futures and buying the spot.
We have learnt this before and this is quite straight forward. However, when it comes
to the USDINR contract, for practical reasons such arbitrage trades involving spot and
futures cannot be executed. This is because the USDINR spot market is not really
accessible to the retail.
So how does one trade the spreads in the currency segment? Well, this is fairly easy –
as opposed to spot-future spread, one has to identify the spread between two different
future contracts expiring over two different dates. This is also known as the ‘Calendar
Spread’.
In a calendar spread, you decide whether the spread between two futures contract is
considered normal or otherwise. All else equal, the long dated futures contract will
always trade at a premium over the ‘short term’ dated futures contract. For example,
August month futures contract is expected to trade at a premium when compared to
July month. Therefore, a certain amount of spread between these two contracts is
deemed ‘normal’. However, there could be situations where the spread goes be yond
normal (either higher or lower) and this is when opportunities arises.
As of today the USD INR July Futures is trading at 67.3075 and the August contract is
trading at 67.6900.
The spread is calculated as the difference between the two futures contrac t –
67.6900 – 67.3075
= 0.3825
Now assume, for whatever reason you think this spread of 0.3825 high, and it should
ideally be 0.2000 as opposed to 0.3825. This means you have an arbitrage opportunity
here, and you stand to make –
0.3825 – 0.2000
= 0.1825
To capture the spread, you are required to buy the July Futures and simultaneously sell
the Aug futures –
Long July Futures at 67.3075
Short August Futures at 67.6900
When you set up a trade wherein you are long current expiry and short a further term
expiry, it is also called a “Future Bull Spread”. Likewise, a ‘Futures Bear spread’ is
when you are required to short the current month expiry and go long on the further
month expiry.
Anyway, once you set up the ‘Future Bull Spread’, you will have to monitor the trade
and close the position when the spread converges to 0.2000 or lower. You will profit
when one of the following things happen –
1. When the July (long) leg rises and Aug (short) leg falls
2. When the long leg rises and the short leg remains unchanged
3. When the long leg rises and short leg rises, albeit at a lower rate
4. When the short leg falls faster than the long leg
5. When the long leg remains unchanged and short leg falls
Will the spread converge? If yes, then when will it converge? Why should it converge?
Will one of the above situations really pan out? Well, the answer to this really depends
on how well you know the spread, and for you to know the spread really well, you need
to back test it. Techniques of back testing are perhaps a topic for another day; however,
I’d like to show you how easy it is to buy sell the spread from your trading terminal.
5.2 – Executing the spread
How would it be if you could directly buy or sell the spread? For example, in the above
case we concluded 0.3825 is an overpriced spread, to capture this spread you execute
two orders i.e. buy July Futures and sell August futures.
Executing these trades has some inefficiency mainly in terms of execution risk – by the
time you buy/sell both the contracts the prices could move and thereby the spread may
no longer look attractive.
Given this, it would be really convenient to buy the spreads directly and not really deal
with two different contracts. If you are a Zerodha customer, you have access to NEST
trader, from which you can trade the spread directly. Of course, going forward this will
also be available in both Pi and Kite.
Here are a series of snapshots which will help you trade the spreads directly.
Look at the part highlighted in red, as you may have realized, this snapshot is from the
market watch. Starting from the left –
1. We select ‘Spread’ from the dropdown which specifies that we are looking at spread
contracts.
2. After selecting spreads, we choose CDS from the dropdown to indicate currency
derivatives as the segment.
3. FUTCUR indicates that within CDS spreads, we are interested in Future contracts.
4. USDINR indicates that we are interested in the USDINR contracts.
5. The full view of the dropdown menu is visible here, as you can see there are many
different spreads available. However, we are only interested in the July-August spread,
which is what we have selected.
Once we configure the above market watch, we submit this to load the spread, here is
how it looks like –
I’ve highlighted the spread’s last traded price. As you can see, this particular spread
instrument just denotes the spread between July and August contract.
Note – the spread should be trading at 0.3825 and not really 0.3700 right? Why do you
think there is a difference in price?
I’ll try and explain this from as per my own understanding, I could be wrong; therefore,
comments are more than welcome! Also, we are digressing a bit here, so try not to lose
focus on the main topic i.e. how to trade the spreads.
The market watch has July, August and the July-August spread contract loaded.
Forget about the spread contract for now, assume you want to set up a Future Bull
Spread (buy July, sell Aug) contract, then you essentially –
Buy July contract at the Ask Rate – 67.3100
Sell Aug contract at the Bid Rate – 67.6775
Spread = 67.6775 – 67.3100 = 0.3675
Now, if you were to set up a Future Bear Spread, then you essentially –
Buy August contract at Ask Rate – 67.6850
Sell July contract at Bid Rate – 67.3075
Spread = 67.6850 – 67.3075 = 0.3775
As you can see, there are two spreads possible based on what you intend to do i.e.
future bull/bear spread.
Now the question is – which price should the spread reflect? Would it be that of the
Future Bull Spread or the Future Bear spread?
My guess is that the spread trades close to the average of the two spreads. In this case
average is 0.3725, and the actual market spread is 0.3700. Why 0.3700 and not really
0.3725? I’d attribute this to one of the two things – the latest quote has not been
captured by the terminal, or lack of liquidity.
A different explanation here could be that the spread itself is mispriced!
Anyway, back to the main topic i.e. buying/selling the spread. Once the spread
instrument is loaded, all you need to do is select the instrument from y our market
watch and press F1 or F2 for buying and selling respectively.
This is what you see upon invoking the buy order window –
The window is pre-populated with the spread details; you may just want to edit the
quantity bit to suit your lot size requirement. Press submit to place the order.
As simple as that!
5.3 – USD INR Stats
I thought it would be interesting to study some statistics on the USD INR pair; I
downloaded the USD INR spot data from the RBI site.
Let us start by looking at the long term chart of the USD INR over the last 8 years (July
2008 to July 2016) –
Clearly the US Dollar has strengthened against the Indian Rupee over the last 8 years.
Quite intuitive as our economy has literally stagnated over these years.
Have a look at the daily return plot of the USD INR –
We can observe few interesting parameters from this –
The average daily return of USD INR is about 0.025%. The maximum and minimum daily
return stands at +4.01% and -2.962%, contrast this with Nifty 50’s maximum and
minimum daily return of +3.81% and -5.92%, you will realize that the USD INR pair is a
lot less volatility compared to Nifty 50 or in fact any other indices. This fact is further
manifested in the volatility numbers –
o Daily Standard deviation (last 8 years) – 0.567%
o Daily standard deviation (2015) – 0.311%
o Annualized standard deviation (2015) – 4.94%
These numbers are clearly much lower compared to the Nifty 50’s daily volatility and
annualized volatility number of 0.82% and 15.71% respectively.
Further, I also ran a correlation function on Nifty 50 and USD INR, before I tell you the
answer I want you to take a guess on what this correlation would be like.
For those of you who don’t know what correlation is, here is a quick explanation –
Correlation between two variables gives us a sense of how two variables move with
respect to each other. Correlation is measured as a number which varies between -1 to
+1. For example, if the correlation between two variables is +0.75, then it tells us two
things –
1. The plus preceding the number tell us that they both are positively correlated i.e. they
move in the same direction
2. The actual number gives us a sense of the strength of this movement. In a loose sense,
the closer it is to +1 (or -1) the higher is the tendency for the two variables to move in
tandem.
3. A correlation of 0 suggests that the two variables are not related to each other.
From the above, we know a correlation of +0.75 suggests that the two variables move
not only in the same direction but also tend to move together closely. Note, the
correlation does not suggest the extent of the move, all is suggesting is that the move
in the same direction is likely to happen. For example, if Stock A moves 3%, and the
correlation between stock A and stock B is +0.75, then it does not mean that Stock B
will also move by 3%, all that the correlation suggests is that Stock B will move up
positively, just like Stock A.
But, there is another twist here – suppose stock A and Stock B are correlated at 0.75,
and the daily average return of Stock A and Stock B is 0.9% a 1.2%, then it can be said
that on any given day, if Stock A moves above its daily average return of 0.9%, then
stock B is also likely to move higher than its daily average return of 1.2%.
Likewise, a correlation of -0.75 indicates that the two variables move in opposite
directions (indicated by the -ve sign). Suppose stock A moves up by +2.5%, then by
virtue of correlation we know that Stock B is likely to come down, but by what degree
will it come down isn’t known.
While we are at it, one more point on correlation. This bit is only for those interested in
the maths of correlation. The correlation data makes sense only if the data series is
‘stationary around the mean’. What does this mean? – Well, it simply means that the
data set should be sticking close the average values. Take another look at the graph of
the daily returns of the USD INR, reposting the same for your convenience –
The daily average return here is 0.025%, and if you notice the daily returns, it is mean
reverting in nature, meaning even if the returns shoots up, or comes down, it eventually
sticks back to the average value. A data series which exhibits such a property is said to
be “stationary around the mean”. Stock/commodity/currency returns are invariably
stationary, but the Stock/commodity/currency prices are not stationary as they tend to
trend.
Confusing? Well, the key point that you need to remember here is that when you run a
correlation test, make sure you run it on the daily returns (as they are stationary) and
not really on the daily prices (as they tend to trend).
Calculating correlation between two variables is quite easy, in fact has just 2 steps –
1. Calculate the daily returns
2. Use the ‘=Correl’ function in excel
Press enter and you get the correlation between the two variables.
Remember correlation between stock A and Stock B is the same as correlation between
Stock B and Stock A.
I hope you’ve had a decent understanding on correlation, its time I repost the question
asked earlier.
If you were to guess the correlation between USDINR and Nifty 50, what would it be?
Forget about the number, can you at least guess whether they are positively correlated
or negatively correlated?
Let us try and deduce this – If the markets (as a representation of the whole economy)
are doing good, then the markets tend to attract investments from overseas. This
means dollars are coming into the country. The dollars get sold to get converted to
Rupee. Essentially this translates to dollars being sold for Rupees, naturally the Rupee
strengths. This means the USDINR goes down while the Nifty 50 increases. The same
logic can be applied when you look at it from the other way i.e. market going down
while USDINR increases.
This means Nifty 50 and the USDINR should be inversely correlated. In fact, this is true,
and the correlation value is -0.12267 (2015 data).
You can download the excel sheet.
In the next chapter we will briefly look into other currency contracts and the role of
Technical Analysis while trading currencies, and with this discussion we will wrap up
currencies and start exploring the world oh commodities!
1. The classic future – spot arbitrage is not really accessible to the retail market,
hence traders tend to look at calendar spreads
2. In a calendar spread you simultaneously buy and sell contracts belonging to two
different expires
3. Future Bull spread is when you buy near month futures and sell the further
month expiry
4. Futures bear spread is when you sell near month futures and buy the further
month expiry
5. You can directly trade the spread from your trading terminal, these are called
the ‘Spread contracts’
6. The USD INR pair tends to have lower volatility when compared to Nifty 50
7. The USD INR and Nifty 50 are inversely correlated
CHAPTER 6
EUR, GBP, and JPY

6.1 – The other currency pairs
We focused on the USD INR pair extensively over the last few chapters, and we now look
into the other currency pairs that are traded in the Indian markets, namely the EUR INR,
GBP INR, and JPY INR. The functioning of the other currency pairs is very similar to the
USD INR. Think about it this way – you know how the Nifty 50 contracts work, then you
pretty much know or are capable of knowing how Bank Nifty works.
Given this, the agenda for this chapter is to quickly run through the contract
specifications of the other three crosses available for us to trade. In the 2 nd part of this
chapter we’ll dwell on some of the common trading techniques, mainly employing
technical analysis, and with this we will conclude our discussion on currencies and start
looking into commodities.
EUR INR
Globally the EUR USD is one of the most actively traded currencies, however we do not
have that contract yet in India, but RBI has given the exchanges a nod to list these
crosses as well. So I guess it is a matter of time before we have the EUR USD pair along
with GBP USD, JPY USD etc. But for now, we do have EUR INR to trade.
The EUR as we know is the currency of the European Union. Unlike other currencies,
the EURO is backed by the economy of many European countries and not just one
economy.
The EUR INR contract structure is quite similar to the USD INR contract. Here are the
key details that you need to know –
So as you see, the contract specifications are similar to that of the USD INR pair. The
only difference is that the lot size in EUR INR is € 1,000 as opposed to $1,000 in USD INR.
Let’s see how this would impact the margins; here is the snapshot of the EUR INR
futures –
As you can see, the last traded price of the contract is 74.8950, with this we can estimate
the contract value –
Contract Value = Lot size * Contract price
= 1000 * 74.8950
=74,895.0
Assuming the margin is approximately 2.5%, the margin should be in the vicinity if Rs.
1,870/-, in fact one can use the margin calculator on Zerodha to get the exact value of
the margin required.
So the margins are slightly higher than the USD INR pair, but still way lower compared
to what is required for any equity derivative contract.
GBP INR
The GBP INR contract is probably the 2 nd most popular currency contract after the USD
INR pair. On the contract specification side of things, everything remains the same
except for the lot size and the underlying. The underlying is the exchange rate of 1 GBP
in Indian Rupees. The lot size is £1,000, which makes the contract value approximately
Rs. 89,345/- considering the futures is trading at 89.3450 as of 5 thAugust 2016.
As you see below, the margin required for this slightly higher compared to the other
two contracts we’ve already discussed–
By the way, did you know in the international markets that the GBP USD pair is also
called the ‘Cable’? So, when you hear a currency trader say he is short cable, he means
he is short GBP USD cross.
JPY INR
The JPY INR contracts are a bit tricky compared to the other currency contracts. The lot
size is not the usual 1000 units, but 100000 and the underlying here is the exchange rate
for 100 Japanese Yen in Indian Rupees.
So when we look at this –
We are essentially looking at the rate of 100 Japanese Yen, stated in Indian Rupees. In
other words, it costs Rs.66.2750 to buy 100 Japanese Yen. Since the lot size is 100,000
the contract value is –
= (100000 *66.2750) / 100
= Rs. 66,275/-
The margin required for the JPY INR contract is Rs. 2,808/-, which translates to about
4.2%.
Clearly, the margins required for JPY INR contract is the highest in the currency
segment, and I guess this is because this contract could be the most volatile (owing to
lower liquidity). Of course, this is just a casual observation, I’d encourage you to
calculate the actual value on Excel to get a perspective on volatility of JPY INR.
Spread contracts are available on all the currency pairs across all the expiries. Here is
the snapshot of the same form NSE’s website –
But as you can see, the spread contracts (apart from USD INR) are not really liquid.
Finally, if you were to select contracts to trade based on liquidity, here is what I’d
suggest you look at, in order of preference–
1. USD INR Futures

2. USD INR ATM Options
3. GBP INR Futures
4. EUR INR Futures
5. JPY INR Futures
With this I’m assuming that you are clear with the logistics involved in currency trading.
We now focus on developing some basic trading approach.
6.2 – The test for seasonality
There is often a lot of debate on the seasonality involved in currencies. By seasonality
I mean things like “USD INR always goes down in December” or something like “USD
INR always goes up a week before expiry”. In fact, many people base their trades based
on this expectation without actually validating for seasonality. Given this, we thought
we should check for the seasonality in currencies, and needless to say we picked the
USD INR spot data to run the required test.
** Warning**
The following discussion can get a bit technical, and this is not meant for regular Varsity
readers. If you want a direct answer for whether any sort of seasonality exists in the
USD INR pair, then the straight forward answer is – no, there is seasonality of any sort
across any time frame. With this conclusion you can jump directly to the next section.
However, if you have a statistical approach to things then you may just want to read
through. Of course, I’ll try my best to keep it brief.
Also, this section is contributed by our good friend Prakash, any queries re garding this
should be directed to prakash.lekkala at gmail dot com.
Seasonality in any time series can be checked by employing a statistical test called
“Holt Winters test”. A typical Holt-Winters method has 3 components –
o Level
o Trend
o Seasonality
Level: this indicator measures the average change in USD INR on a YOY basis
Trend: This indicator measures the average change in USD INR on a month on month
basis
Seasonality: This indicator measures if there is any seasonal impact on price change.
For example – USD INR almost always rises in January, and almost always falls in April
etc.
There are two possibilities for components (level, trend, and seasonality)
 Additive
 Multiplicative
I guess the details of this are beyond the scope of this discussion.
Holt-Winters test for seasonality:
In Holt-Winters test, we check for seasonality in a time series by building a forecast

model (let us call it Model 1) and study its residuals. Model 1 does not have any
seasonality component inbuilt. We then build another forecast model with a
seasonality component (Model 2) and check for the errors of this model.
We compare the errors of both the models and compare to check if model 2 is gives us
a better forecast when compared to Model 1. We do this by employing ‘Chi Square’ test
to determine if accuracies are better. If Model 2 is statistically better than Model 1 then
we conclude that there is some seasonal pattern in data. However, if the accuracies are
same for both models or if Model 1 has better accuracy, there is no seasonality in data.
Seasonality results for USD INR
Check for weekly seasonality:
Model 1 (without seasonality component): The best model is (M, N, N) with coefficients
0.9999
This model indicates that weekly data has only level component and no trend
component. The coefficient of “level” is 0.9999 i.e. next week’s price is about 0.9999
times this week’s price.
For readers who are aware of Random Walk Theory will be able to appreciate these
parameters. The model is suggesting that on a weekly basis USD INR price movement
is a random walk.
Model 2 (with seasonality component): The best model is (M, N, M) with coefficients 0.7
and 0.0786
This model indicates that weekly data has level and seasonality component. The
interpretation is that next week’s price is 0.7 times of this week’s price and the
remaining price is contributed by seasonality.
Conclusion: Chi square test concluded that there is 100% chance that model 2 accuracy
is same as model 1 accuracy i.e. forcing a seasonality model on USD INR isn’t increasing
its accuracy.
This can only happen when there is no seasonality in the data. As the data is prepared
for weekly analysis, we can conclude that there is no seasonality on weekly a basis.
Monthly seasonality:
Model 1: The best model is (A, N, N) with coefficients 0.9999
Like in the case of a weekly model, model on monthly data also suggests a random
walk.
Model 2: The best model is (A, N, A) with coefficients 0.9999 and 0.0001
This model indicates that next month closing price is almost same as this m onth’s
closing price with a small impact of seasonality.
Conclusion: Chi square test concluded that there is a 20% chance that model 2 accuracy
is better than model 1 accuracy. In statistical terms, such improvement in accuracy
might happen due to randomness, like the window period you choose, the sample data
etc.
Typically, in statistics, the norm is to look for at least 95% chance that model 2’s
accuracy is better than model 1’s to conclude there is seasonality in data. So in case of
USD-INR, we can conclude that there is neither monthly nor weekly seasonality.
The last 8 years USD INR spot data for this is taken from RBI’s website.
So the next time you hear someone make a random statement like “the USD INR pair
almost always goes down before Christmas”, then you know he is just trying to sound
smart with no real insights.
6.3 – Classic TA
Think about conducting a fundamental analysis on a company, for example –
Hindustan Unliver Limited. Typically, you would study its business, financial
statements, corporate governance, study its peers, and perhaps build a financial model
to identify if the stock is worth investing in. Fundamental analysis is kind of a straight
forward affair when it comes to equities. However, when you look at currency pairs,
USD INR for example, there a lot more fundamental dimensions – the macro economics
of the USA which is dependent on multiple domestic and international factors and the
macro economics of India which is again dependent on multiple domestic and
international factors. Once you understand these, you need weigh each one of these
against another and build a relative view.
Frankly speaking, this is no easy task and not many are capable of doing this. You need
to be an economist with a trader’s mind-set to pull off quality fundamental analysis on
currency pairs. Perhaps, this is the reason why Technical Analysis (TA) is so much more
popular when it comes to trading currencies and commodities. As you probably aware,
Technical Analysis assumes that the price that you see on the screen discounts
everything including all the complex fundamental views that are panning out at the
moment. With this assumption you go ahead and analyse the charts and develop a view
point.
TA on currencies and commodities works just like it does on equities. If you are not
conversant on how to use Technical Analysis, I’d strongly suggest you read through
this module on TA.
I’ll post few snapshots of TA based trade setups –
The two encircled candles form a classic candlestick pattern called ‘Piercing pattern’ .
The piercing pattern suggests the trader to go long on the USD INR pair. As you can see,
the trade panned out well without triggering the stop loss.
Here is a bearish Marubozu on GBP INR –
The bearish Marubozu suggests you to short the underlying with an expectation that
the asset will continue to slide down.
Naturally, the trade setups can be endless. I know many people are under the belief
that currency and commodities requires one to know a different set of technical
analysis, but this is not true. TA works exactly the same way on any time series data, be
it – stocks, commodities, currencies, or bonds.
And with this, I would like to end our discussion on Currencies and would like to start
our discussion on the 2 nd part of this module i.e. commodity trading.
Key takeaways from the chapter
1. The underlying for EUR INR is the spot rate of 1 Euro in Indian Rupees.
2. The lot size for EUR INR is €
3. The underlying for GBP INR is the spot rate of 1 GBP in Indian Rupees. GBP INR is the
2nd most traded contract in the currency segment.
4. The lot size for GBP INR is £
5. Internationally GBP USD is also referred to as the ‘Cable’.
6. JPY INR has the highest margin requirement in the currency segment, perhaps due to
the higher volatility.
7. Lot size in JPY INR is 100000.
8. The underlying in JPY INR is the rate of 100 Japanese Yen in Indian Rupees.
9. As opposed to popular belief, there is no seasonality in the USD INR pair – either on the
weekly basis or on a monthly basis.
10. TA can be applied to currencies just like the way it can be applied to stocks.
CHAPTER 7
Gold (Part 1)
7.1 – Orientation
As you know, there are two commodity exchanges in India – Multi Commodity Exchange
(MCX) and National Commodity and Derivative Exchange (NCDEX). MCX is particularly
popular for the Metals and Energy commodities while NCDEX for all the agri
commodities. However, there is a lot of activity picking up on MCX for agri commodities
as well. My job over the next few chapters is to discuss these commodities which are
traded on the exchanges, and get you familiar with the commodity contracts.
We will look into each and every commodity that is actively traded on the commodity
exchanges. The idea is to know how the commodity contract works (contract
specification), figure out which contract to trade, and identify the factor which
influences the commodity. I will skip the usual background to commodities market
part, the one which talks about the history, forwards markets, the farmers in US, the
Chicago Mercantile Exchange etc. You will find this in almost any material on
Commodity market. I would like get straight to the heart of the topic by slicing and
dicing the contract specifications of commodities and other details around them.
Here is the list of commodities available on MCX to trade; of course I got this list from
the MCX website –
The idea is to cover all the major commodities that one can trade. Needless to say, one
has to know how ‘Derivative Futures’ function before attempting to understand
Commodities. So if you are not familiar with Futures, I’d encourage you to read
the module on futures trading.
Anyway, assuming you are familiar with Futures, we will now start with Gold.
7.2 – The Gold Contract
Gold is a very actively traded contract in MCX. It has ample liquidity, with daily trades
of roughly 15,000 contracts translating to a Rupee value of over 4500 Crore. Note, these
numbers belong to just one type of Gold contract, often nicknamed “Big Gold”.
Gold comes in quite a few variants that one can choose to trade in. Newbie and
sometimes even the experienced commodity traders often get confused with these
contracts, not knowing which one to trade and the difference between them. To begin
with, let me list down all the different types of Gold contracts –
1. Gold (The Big Gold)

2. Gold Mini
3. Gold Guinea
4. Gold Petal
All these variants belong to the same underlying i.e. Gold. I guess the best way to
understand the difference is by understanding the contract specification of each of
these variants. We will start with the big boy first, i.e. ‘The Gold’.
Here is the contract specification as per MCX, let me list the important things first and
then we will understand them one by one –
Let me discuss these details in the same sequential order, so that it becomes easy for
you to understand the subsequent contracts. We’ll start with the price quotation.
The price quotation as you can see is for 10 grams of Gold. This price includes all the
import duties and taxes, of course we will talk more about this at a later stage. For now,
just be aware that the price on MCX is all inclusive. Have a look at the following
snapshot, it shows the last traded price of Gold futures on MCX –
As you can see, the last traded price of Gold is Rs. 31,331/-. Do note, this is the quote
for 10 grams of gold. Since the lot size is 1 Kg (1000 Grams), we can calculate the
contract value –
(1000 * 31331) / 10
= Rs.31,33,100/-
So what is the margin required to trade this? We can check this from Zerodha’ s margin
calculator –
The margin amount required is Rs.1,25,868/-, which means the margin percentage is
roughly –
1,25,868 / 31,33,100
= 4.017%
As you can see the margin percentage is just about 4%, which is pretty much similar to
the currency contracts. However, the Rupee value of the margin is way too high and it
therefore prohibits many retail traders to initiate positions in Gold. In fact, this is the
reason we have contracts like Gold Mini and Gold Petal, where the Rupee value of the
margins is lower. We will talk about these contracts a little later.
Now assume you buy 1 lot of Gold on MCX, this means you have to park close to 1.25
lakhs as margin and with each tick you will either make Rs.100 or lose Rs.100, and how
did we arrive at that? Well, it is fairly simple –
P&L per tick = (Lot Size / Quotation) * Tick Size
Let us apply this on Gold –
= (1000 Grams / 10 Grams) * 1 Rupee
= 100 Rupees
In fact, you can apply this formula to any futures and options contract to calculate the
P&L per tick. Let me demonstrate this formula for the JPY INR contract. If you recollect
the lot size for this contract is 100000 JPY, and the quotation was for 100 JPY, and the
tick size is 0.0025, using this we can calculate the P&L per tick –
(100000/100) *0.0025
= 2.5 Rupees
Anyway, let us now focus on the expiry. If you look at the expiry of Gold, it simply says
5th day of contract month. Gold contracts are introduced every 2 months and each
contract stays in the system for a year, and at any point you will have 6 contract s to
choose from. Considering we are in August 2016, the following table should give you an
idea of how this works –
Needless to say, the most recent contract is the most liquid contract to trade; in this
case it would be October 2016 contract. Now when the October 2016 contract expires
on 5th Oct 2016, September 2017 contract will be introduced, and the most active
contract from 5 th Oct 2016 would now be the December 2016 contract.
Do recall, settlement in equities is always in cash and not physical. How ever, when it
comes to commodities the settlement is physical and therefore ‘delivery’ is
compulsorily. This means if you hold 10 lots of gold and you opt for delivery then you
will get 10 kg of gold. In order to get the delivery of the commodity, one has to express
his intention to do so. This has to be done any time before 4 days to expiry. So given
that the expiry is on 5 th, one has to express his intent to take delivery anytime on or
before the 4 th (1st, 2nd, 3rd, 4th).
If you are trading with Zerodha then do note, we do not allow you to get into the
physical delivery of commodities. So you will be forced to close the position before
1st of the expiry month. In fact, I personally prefer to close the positions early on and
not really get into the physical delivery of commodities.
For all practical purposes if you know these things about the Gold contract, you pretty
much know what is really required before you trade the big Gold contract.
We will now move on to know the other variants of gold that gets traded on the
exchange.
7.3 – The other contracts (Gold Mini, Gold Guinea, Gold Petal)
The big gold contract as you realize demands a heavy margin requirement in terms of
Rupee value. This prevents a lot of traders from trading the big gold contract and
perhaps this is the reason the exchanges introduced contracts with much lesser margin
requirement.
The other gold contracts that are available to trade is –
 Gold Mini
 Gold Guinea
 Gold Petal
The details for the other gold contracts are as follows –
Price Lot Tick Delivery Delivery

P&L/tick Expiry
Quote Size Size Logic Unit
Gold Rs. per 1

100 gm Rs.10 5th day Compulsory 100 gm
Mini 10 gm rupee
Gold Rs. per 8 1 Last

8 gm Rs.1 Compulsory 8 gm
Guinea gm Rupee day
Gold Rs. per 1 1 Last

1 gm Rs.1 Compulsory 8 gm
Petal gm Rupee day
I’m assuming the table above is a lot easier to understand now considering we have
discussed these details earlier. Let’s dig straight into the margin details.
As you can see, Gold Mini (GoldM) contract requires a margin of Rs. 15,682/-. In terms
of percentage –
= Margin / Contract Value
Contract Value = (Price * Lot size)/Price Quotation
= (31365 * 100)/10
= Rs. 313,650
=15682/313650
= 5%
In terms of margin percentage, this is roughly the same as big Gold. For the sake of
completeness let us quickly calculate the P&L per tick for Gold Mini. We know –
= (100/10) *1
= Rs.10/- per tick.
Beyond the Gold Mini contract, we have Gold Guinea and Gold Petal contract. These are
extremely tiny contracts which demand a very low margin, as low as Rs.1251 (Gold
Guinea) and Rs.154 (Gold Petal). The lot size is small and therefore the contract value
is small as well. You will find few variants like Gold Petal (Delhi), Gold Guinea
(Ahmadabad) etc., I would suggest you ignore these, especially if your idea is to just
trade Gold.
Here is my honest opinion – if you are trading Gold stick to either the Big Gold contract
or the Gold Mini contract, simply because the liquidity is quite bad in all the other
contracts. To give you a perspective on liquidity on a regular trading day (on MCX) –
o 12 – 13K lots of big gold contracts get traded
o 14-15K lots of Gold mini contracts get traded
o 1-1.5K lots of Gold Guinea contracts get traded
o 8-9K lots of Gold Petal contracts get traded
The number of lots in Gold Petal should not entice you believe that the liquidity is high,
do remember Gold Petal lot size is just 8 grams, and therefore 8-9K lots translates to
roughly 2-2.5 Crs.
Another important thing to note – liquidity is highest in the nearest month contract, so
always stick to these. The thumb rule here is – farther the contract expiry, lower is the
liquidity.
With this, I assume you are familiar with the Gold contracts and the logistics. In the next
chapter we will discuss few interesting topics such as the parity in domestic and
International gold contracts, factors influencing Gold, relationship between gold,
equities, and dollar etc.
1. Gold is one of the most popular bullion contracts that gets traded on MCX.
2. Gold contract comes in a few variants – Big Gold, Gold Mini, Gold Guinea, and
Gold Petal.
3. Big Gold is the most popular contract, but requires a margin in excess of
Rs.1,25,000/-.
4. The P&L per tick for the big Gold is Rs.100.
5. P&L per tick can be calculated as = (Lot Size / Quotation) * Tick Size.
6. Gold Mini is the 2 nd most popular Gold contract, requires a margin of roughly
15K.
7. Gold Petal and Guinea are other variants demanding much lower margin
requirement. However, the liquidity in these contracts is quite low.
8. It is always a good idea to stick to the nearest month contract as liquidity is high
in these contracts.
9. Delivery is compulsory for all these contracts; therefore, it makes sense to close
these contracts at least 4 days before the expiry of the contract.
CHAPTER 8
Gold (Part 2)
8.1 – The London fix

In the previous chapter we discussed the various Gold contracts that are available on
MCX. I’d like to begin this chapter by discussing how the prices of Gold in the spot
market are arrived at internationally and in India. However, I have to mention this –
this method to ‘fix’ gold prices are merely symbolic and holds very little relevance to
trading gold futures at MCX. I’m discussing this simply because it is an interesting thing
to know. J
Internationally, the price of Gold is fixed in London on a daily basis, twice a day in two
different sessions. The morning session at 10:30 AM is referred to as ‘AM Fix’ and the
evening session at 3:00 PM is called the ‘PM Fix’. The prices are fixed by the gold dealers
from London’s biggest bullion desk. The whole process is facilitated by Nathan Mayer
Rothschild & Sons.
There are about 10-11 participating banks, which include names like JP Morgan,
Standard Chartered, ScotiaMocatta (Scotiabank), Société Générale etc. Do note, the
general public and other banks are not permitted to participate in this process. The
dealers from these banks call the dedicated conference line at the designated time and
submit their bids to buy and sell gold. From all the bids and offers an average price is
arrived at, and the same price is relayed to the market which then becomes the
benchmark for gold trading. The whole process lasts for about 10-15 minutes. The
process is again repeated in the ‘PM session’ and the gold prices are again discovered
and relayed to the markets.
The gold price that is fixed by the AM and PM sessions is very close to the actual price
of gold that is traded in London and other international markets. So in a sense, the price
that is relayed holds no surprise to traders or bullion dealers, in fact some participants
even believe that like many things in England, even this is conducted more to keep up
with tradition.
India too follows a somewhat similar practice, but less elaborate. India, being one of
the biggest consumers of Gold, imports the yellow metal. The gold is imported by
designated banks and the banks in turn supply this gold to bullion dealers (after adding
the necessary charges; more on this a little later). The Indian Bullion Association then
bids for the gold through its network of bullion dealers. These dealers mainly base their
quotes on how much gold they would like to buy or sell at a given price, the rates are
averaged out, and this roughly sets the floor for the Gold prices in India. In fact, there
is some sort of circularity here because dealers tend to look at the Gold futures price
traded on MCX before placing their bids with the Indian bullion association. Anyway,
this price is relayed to the dealers’ and jewellers’ network and the price for the day is
set.
8.2 – Gold price disparity

Traders tend to compare the Gold futures rate in Chicago Mercantile Exchange (CME)
and the Gold Futures rate on MCX and assume there is an arbitrage opportunity lurking
around. The rationale for this is that Gold being an international commodity should
often trade at around the same price, in the absence of which an arbitrage opportunity
arises. So for example if 10 grams of 995 purity Gold in CME is quoted at $430, then on
MCX the price of 10 grams of 995 purity should be in and around $ 430.
But this is often not the case, they trade at a significantly different price and due to this
a disparity between gold futures in CME and MCX always exists. The question however
is, why does this disparity between the two gold future contracts exist?
Let us figure this out –
To understand the disparity between the two future contracts, one should understand
how the Gold spot rate evolves in India.
Remember, India is a net importer of gold. In the international markets, US especially,

Gold is quoted on a per troy ounce basis. One troy ounce is approximately 31.1035
grams. Assume Gold in the US spot market is traded at $1320 per troy ounce – given
this, what do you think should be the spot price of gold in India. Assume $ 1 = Rs 65.
The general tendency is to identify the cost for 10 gram of gold in USD and multiply the
same with the current USD INR rate and figure out the price. Let us do this math quickly
–
31.1 Grams = $1320, therefore 10 grams = $424.43. Since USD INR is at 65, the price of
Gold in India should be approximately = Rs. 27,588/-.
Unfortunately, in reality this is not so straightforward. Gold when imported (remember

it is the banks which import gold) attracts duties and taxes. The spot price of Gold in
India should include all these charges. In fact, let me list down all the costs that are
applicable when a bank imports gold –
1. CIF applicable in Dollars (CIF stands for cost, insurance, and freight)
2. Custom duty
3. Cess
4. Bank cost
With all these charges, the landed price of Gold tends to increase. In fact, this post on
TradingQ&A beautifully illustrates how the cost adds up.
So for example if the rate of spot Gold in US is $420 per 10 grams, then in India after
adding all the additional costs, the spot rate will be much higher. For the sake of this
discussion, let us assume the rate in India is $435 – leading to a $15 disparity in spot
rates.
Now, this explains the disparity in spot rates, but what about the futures price?
Remember the futures prices is a derived from spot rates, the formula linking futures
price with spot price is –
F = S*e(rt)
You can read more on futures pricing.
So in the US markets, the basis for the future pricing will be the spot price of Gold in
the US, i.e. $420, while at the same time the basis for the future price in India will be
the spot price of gold in India i.e. $435. Given this, naturally the futures price of gold in
CME and MCX will differ. This difference should not be mistaken for an arbitrage
opportunity.
8.3 – What drives the gold price?

Investors across the world have this strange, but predictable behavior – at times of
uncertainties, well at least economic uncertainties, they are all in a hurry to buy gold.
Gold has always been considered a safe haven capable of safeguarding investments
against any sort of economic meltdown.
Consider the Brexit (June 2016) event, the most recent event which kind of shook the
world, and here is how Gold behaved before and after the event –
There was a clear run up in Gold before the event and post the event, in fact the big
candle that you see during this period is on 24 th June, the day after the Brexit verdict
was out. Naturally, gold rallied owing to the outcome of Brexit. In fact, each and every
time there is any sort of global/domestic uncertainty, investors flock to buy gold. This
is mainly driven by the fact that Gold is considered a safe haven, capable of preserving
your wealth.
Almost all the major events in the past has had an impact on Gold, think about it – Oil
crisis, middle eastern uprising, Israel-Palestine, EU migrant crisis, Greek economy, Euro
crisis, Lehman Brothers; the list is never ending. But the point to note is that every
world event impacts the prices of gold.
This leads us to an important conclusion – Gold tends to increase in value in the

backdrop of economic uncertainties. In fact, in the backdrop of economic
uncertainties, demand for risky assets such as equities goes down, and the demand for
safe haven assets such as Gold tends to increase.
Now besides the uncertain events, even on a day to day basis, investors tend to buy
gold considering it a safe hedge against inflation. They believe, in the long run the value
of gold will continue to rise. This perception is justified if you look at a very long term
chart of gold –
Source: http://www.lbma.org.uk/pricing-and-statistics
Take a look at the chart above, in 1970 Gold was at roughly $35 and today in 2016, Gold
is at $1360, translating to a 37x return. However, when you look at it from a CARG
perspective, this translates to about 8% year on year growth. The world average
inflation is roughly between 5-6%. This means if you are an investor in gold, on one
hand you are expected to make 8% and on the other you lose about 6% (owing to
inflation) netting you with an out performance of 2%. However, in countries such as
India where inflation is high, investment in Gold does not really fetch much.
8.4 – Gold, Dollar, Rupee, and Interest rates

The movement in gold is also related to how the currencies and interest rate of the
economy moves. So if you are a trader in Gold, then it is not only important to keep
track of world economics, but also important to keep track of currencies and interest
rates. The equations are simple; let us start with the dollar and build on it.
Have a look at this graph below –
Source: https://fred.stlouisfed.org/graph/?g=33vD
This is the graph of USD versus Gold. The inverse relation between the two is quite
evident. This inverse relation can broadly be attributed to two reasons –
1. When the dollar decreases in values with respect to another currency, then the value of
the other currency increases. With the increase in the currency value, the demand for
commodities including Gold tends to increase. As the demand for gold increases, the
prices too tend to increase.
2. A falling US dollar becomes less attractive to investors; the investors tend to look at
parking their money in safer havens such as gold.
Having said this, one should be aware that this may not always be true. There could be
instances when both gold and USD tends to increase. For example, think about a crisis
in Saudi Arabia (declining oil prices), domestic investors may want to move away from
investments in Saudi and park it in safer assets such as Gold and USD, thereby
increasing the value of both these assets.
Either ways, it must be clear to you now that USD has a role to play in the directional
movement of Gold. Having said, one must study the correlations between various
variables and gold to see if any correlations actually exist. For example, increase in the
US federal rates tends to strengthen the US Dollar, by virtue of this Gold price should
reduce. But this does not necessarily happen all the time, and if I’m right the correlation
between Gold and Federal rates is just under 0.3.
I understand the discussion above is kind of counter intuitive, as in earlier I mentioned

a strong dollar tends to push gold prices down, but the factors that influence USD may
not actually have a strong bearing on Gold itself.
Confusing? Yes it is, I agree.
So how would one actually trade gold? One of the best ways to trade gold is by studying
its demand and supply. Demand and supply factors are many and complex, especially
for an international commodity such as Gold. However, the demand and supply
pressures reflect themselves in prices and in a sense manifest themselves in the form
of charts, and charts can be read by means of ‘Technical Analysis’, and this is how you
can develop trading insights in gold.
I’m a huge fan of Fundamental Analysis when it comes equities, but when it comes to
commodities and currencies, I resort to charts.
8.5 – Technical Analysis on Gold

If you are not familiar with Technical Analysis (TA), then I’d suggest you read
the module on TA.
One of the key attributes of TA is that TA can be applied to any asset class including
currencies and commodities. Let me develop some trading notes on Gold by employing
TA, hopefully this will give you a sense of how to apply TA on Gold.
When I trade Gold, the objective is very clear – it is a short term trade and there are no
intentions to carry the trade for say more than few days.
The very first thing that I do when developing a trading view is to look at the long term
chart of the asset, by long term I mean at least 2 years. I’ll do the same here; I’ll look at
the end of day Gold Bees (ETF) chart for this. Do note, I will use this chart to develop a
rough idea on the primary trend of Gold and also observe critical price points, if any.
From the chart above, I note the following points –
1. Gold declined starting from late 2013, all the way to late 2015.
2. Prices kind of bottomed over the last few months of 2015.
3. Gold in fact formed a double bottom between Sept – Dec 2015.
4. Prices have been trending up since early 2016.
5. Traders have bought Gold at every decline starting from early 2016.
6. Clearly the bearishness in gold is no longer there, this is evident given the fact
that gold has scaled back to 2013 prices.
With all this, I can conclude that I’d be more comfortable with long trades than short,
but this does not mean that I will not short Gold. I would, if the risk to reward is enticing
enough. However, if I short Gold, I will always be aware that traders out there are
looking for opportunities to buy gold at every dip; hence I will be quick to cover my
short position. Do note, until this stage I have only developed a broad based view on
Gold and have not ventured into any specific price levels.
I would now be interested in looking at a short term chart of Gold, to identify trading
opportunities if any. Have a look at the chart below, before we get into identifying
trading opportunities (for which we will have to look at the right side of the chart), let’s
spend a little time on the left side of the chart.
The starting point of this chart is sometime in the late 2015, and till about end of June
2016, there is pretty much no activity. This is evident when you look at both the price
and volume. The volume is almost non-existent, and the prices just tend to gap up and
down. Can you guess why?
Well, remember Gold contracts are introduced almost a year in advance, for example
the Oct 2016 contract (which we are looking at), would have been introduced around
Oct 2015. However, this contract does not attract any liquidity till it nears its actual
expiry i.e. October 2016. If on the other hand, our markets were very vibrant with lots
of liquidity, then probably this contract would have attracted liquidity much earlier.
Anyway, let us now look into the left side of the chart and identify trading opportunities
if any. I’ll repost the chart emphasizing the recent candles; I have overlaid 9 and 21 day
exponential moving averages on the prices –
1. The current market price is below both the short term averages.
2. There are three price action zones in the recent past at around 30956 (I’ve
encircled the same in blue circles), and since the current market price is below
this level, 30956 becomes an immediate resistance.
3. In the recent past, we can see a Bearish Marubuzo formed (circled in black),
which has played out well. Traders may be booking profits on this one.
Considering all the above, I would be looking at buying opportunities in Gold, the
moment it crosses the resistance level of 30956. Notice, this also coincides with the two
short term moving averages, which further encourages me to go long. However, if the
price of gold stays below the resistance level, I would hesitate to short for reasons we
discussed earlier. So in summary my trade would be something like this –
 Position: Long
 Price: Above 30956
 Target: 31418 (have placed a short blue line)
 Stoploss: 30700 (current market price)
 Reward to risk assuming I’m going long at 30956: 1.8
 % move from entry – 1.5%
Not a bad trade from a reward to risk perspective I’d think. Also, since we are looking a
1.5% move, this may pretty much happen in a single day.
Anyway, the whole point here is to elaborately explain to you that TA can easily be
applied to commodities such as Gold.
I hope the last two chapters have given you enough information on Gold, this according
to me is put you in a good spot to get started in trading Gold.
Onwards to Silver!
1. The price of Gold if fixed twice a day in the AM & PM session in London
2. Only designated banks can participate in the London fix
3. India too has a gold fix, similar to London fix – however there is some sort of
circularity here as traders tend to look at the prices of MCX
4. Spot price of gold in US and India differs mainly owing to the additions duties,
taxes, and charges that get added in India
5. Since spot prices vary, so does futures price
6. Dollar and Gold are inversely related
7. Commodity fundamentals are complex to understand, hence traders tend to
look at demand and supply
8. Demand & supply reflects in the current price, and also manifests itself in charts
9. You can apply technical analysis on Gold and other commodities
CHAPTER 9
Silver
9.1 – The Bullion Twins
To begin with, I need to apologise for the delay in putting up this chapter. Perhaps this
is the longest ‘in between chapter’ break I’ve taken from the time I have started writing
for Varsity. I’ve been working on another high priority project which required my time
and attention, hence the delay.
Anyway, let us get straight to work and discuss Silver. Precious metals such as Gold,
Silver, and Platinum are collectively referred to as ‘Bullion’. There is a common
perception that the market price of gold and silver makes similar moves. If this is true,
then it gives raise to many trading opportunities such a ‘pair trading’. We will discuss
pair trading in detail, perhaps in a different module altogether. However, let us go
ahead and investigate if Gold and Silver move in tandem. I did run a correlation check
on Gold and Silver using 30 minutes’ intraday data for the last 3 months (note this is
over a 1000 data points) and here are the results –
The correlation on an intraday basis is 0.7, which is quite remarkable. I’m guessing the
correlation on end of day basis would be even better. So what does this mean? Well,
the correlation suggests that the two metals make similar moves on an intraday basis.
If you recall, we discussed the concept of correlation in detail in the USD INR chapter.
I’d suggest you read up section 5.3 of chapter 5 if you haven’t already done so.
If the intraday correlation is as tight as 0.7, then we can think about explo ring trading
ideas of going long on gold and short on silver or vice versa. This will be a kind of hedged
strategy as you are long and short (on similar assets) at the same time. The idea here is
just to let you know that building such a trading strategy is a possibility, please don’t
jump in and set up a trade just with this information. J
There are lots of other things to take care of when you initiate such trades; more on
pair trading at a later point. Meanwhile, have a look at the intraday graph of both gold
and silver; I’ve normalized it to start at 100 so that the graphs are more comparable –
If you were to just look at the graph and take a call on how closely the two metals move,
then chances are you would have disregarded any sort of correlation between them J,
but the actual numbers paint a completely different picture!
Anyway, as I mentioned earlier, I’ve used intraday data here to develop both the
correlation and the graph. Longer term data will portray more meaningful information.
In fact, I dug up the correlation data between silver and gold from a recent survey by
Thomson Reuters, and here is what they suggest –
The correlations are broken down on a quarterly basis (clearly a longer term approach
here) and as you can see the correlation between Gold and Silver is on average is about
0.8, which is why traders prefer to call this pair the ‘Bullion Twins’.
The tight EOD correlation implies that traders and investors consider both gold and
silver as safe havens in times of economic crisis. This further implies that any global
geo political tensions tend to drive the price of not just gold, but silver as well.
Also, please do note the correlation of Silver with Oil, it is quite erratic and gives a sense
on unreliability here.
9.2 – The Silver Basics

Silver has applications in industrial fabrication, photography, fashion, electrical, and
electronics industries. Hence, there is always a demand for silver. In fact, the recent
survey from ‘‘The Silver Institute’ in the United States suggests that the glo bal silver
demand stands at 1170.5 million ounces. Historically, the demand for silver has grown
at roughly 2.5% year on year. Out of the total global demand, bulk of it comes from
industrial fabrication and manufacturing. This directly suggests that the p rice of silver
is kind of influenced by growth of manufacturing and industrial economies such as
China and, to some extent, India.
On the supply side, global mining production along with scarp and sovereign sales
stands at 1040.6 million ounces, clearly indicating that silver as a commodity is under
slight deficit. The supply has not really improved over the years; in fact, the data
suggests that the growth in supply has just been about 1.4%.
Here is the table which gives you the complete demand supply scenario in silver –
You can read the complete survey report.
Given how the supply and demand scenario plays out, there is a lot of scope to trade
silver as a commodity. This leads us back to the most important question – who decides
the rate of silver? Well, silver rates are fixed the same way as that of gold, in London, by
a pool of participating banks. To know how gold/silver rates are fixed, I’d recommend
you read this.
9.3 – The Silver contracts

There are four variants of silver contracts that are available for you to trade on MCX.
They differ mainly in terms of contract value, and therefore the margin required. These
contracts are as follows –
Price Lot Tick Delivery
Contracts P&L/tick Expiry
Quote Size Size Units
5th day of
Silver 1 kilogram 30 kgs Rs.1/tick Rs.30/tick 30 kgs
expiry month
Last day of
Silver Mini 1 kilogram 5 kgs Rs.1/tick Rs.5/tick 30 kgs
expiry month
Silver Last day of

1 kilogram 1 kg Rs.1/tick Rs.1/tick 30 kgs
Micro expiry month
Last day of
Silver 1000 1 kilogram 1 kg Rs.1/tick Rs.1/tick 1 kg
expiry month
Of all the four contracts, the ‘Silver’ 30 kg contract and ‘Silver Mini’ are most actively
traded on MCX, we shall discuss both these contracts detail. Let us begin with the main
Silver contract.
The price quotation for the Silver contract is 1 kilogram. This means when you check
the price of Silver on MCX or on your trading terminal, the price that you see is for 1 kg
of silver. This price includes the import duties, taxes, and all the other applicable
duties. Have a look at the screenshot below (taken from Kite) –
The current price of Silver December Future is Rs. 42,266/-, note this is quoted on a per
kg basis. Since the contract is for 30 kgs (lot size), the contract value will be –
= 30 * 42,266
= Rs.12,67,980/-
The margins on Silver is roughly 5%, in fact here is the snapshot of the margin required
to trade this contracts –
This works out to –
= 68619/1267980
= 5.41%
The P&L per tick can be calculated using the following formula –
= (30 kgs /1 kg) * Rs.1/-
= Rs. 30/-
So for every tick on Silver, you either make Rs.30/- or lose Rs.30/-.
As far as the contracts expiries are concerned, here are the set of contracts that are
available to trade as of now (as of Oct 2016), note all contracts expire on the 5 th of the
contract month –
 December 2016
 March 2017
 May 2017
 July 2017
 September 2017
When the December 2016 contract expires, the December 2017 contract gets
introduced to the market. You must be aware by now that the most liquid contract to
trade would be the one which has the closest expiry date. For example, we are now in
Oct 2016 and if I were to trade Silver, I’d choose the December 2016 contract.
Do recall, settlement in equities is always in cash and not physical. However, when it
comes to commodities, the settlement is physical and therefore ‘delivery’ is
compulsorily. This means if you hold 10 lots of Silver and you opt for delivery then you
will get delivery on 300 kg of Silver. In order to get the delivery of the commodity, one
has to express his intention to do so. This has to be done any time before 4 days to
expiry. So given that the expiry is on 5th, one has to express his intent to take delivery
anytime on or before the 4th (1st, 2nd, 3rd, 4th).
If you are trading with Zerodha, note that we do not allow you to get into the physical
delivery of commodities. So you will be forced to close the position before 1st of the
expiry month. In fact, I personally prefer to close the positions early on and not really
get into the physical delivery of commodities just because of the logistics involved.
Another important point to note here – while the delivery is mandatory for Silver (30
kgs) contract, delivery is not mandatory for the Silver Mini and Silver Micro contracts.
This means to say that you can let the Silver Mini/Micro contract expire and settle for
cash (or opt for delivery). However, you do not have the option to cash settle the Silver
30 kg contract.
Finally, here is something else you should know. Have a look at this snapshot below –
The table above maps a commodity with a location, for example Silver Micro is mapped
to Ahmedabad. Ever wondered what this really means?
We all know that upon expiry, the price of the underlying in the spot market and its
futures price converge to a single price point. Now in case of equities, the underlying
and its futures are traded on the same platform i.e. NSE (and now BSE as well). So for
example Infosys Spot in NSE will converge with Infosys Futures on NSE. However, in
case of commodities there are many different spot markets. For example, Pepper and
Rubber are prominently traded in Kochi. Gold is traded in both Mumbai and
Ahmedabad and so on. Given this, upon expiry, the futures of Gold should merge with
which spot price? Should it be the one in Mumbai or the one in Ahmedabad? For this
exact reason, MCX has mapped each commodity with a spot market, and upon expiry
the futures price will converge with the price of the designated spot market.
9.4 – The other Silver contracts

If you are comfortable with the contract details of Silver mentioned above, then it is
fairly easy to understand the other silver contracts that are traded on MCX. They vary
mainly in terms of the lot size and therefore the margin requirement.
I’ll skip working out the math, but instead put up the margin numbers and the delivery
option directly for you. The delivery option helps you decided whether you would like
to take delivery of the contract or simply cash settle.
Contract Margin Required Margin as a % Delivery options
Silver Mini Rs.13,158/- 6.27% Cash/Physical
Silver Micro Rs.2,618/- 5.1% Cash/Physical
Silver 1000 Rs.2,711/- 6.2% Physical only
As you can see, the margins required are much lesser (quite naturally) compared to the
big silver contract.
As far as trading is concerned, similar to Gold, the Silver Fundamentals are quite
complex – tracking them on a day to day basis may not really be possible and in fact is
not really required. Most traders I know trade commodities based on technical analysis.
I personally think this a much better way to go about active commodity trading.
Apart from technical analysis, one can even choose to trade based on quantitative
techniques such as ‘Pair Trading’. As stated earlier in this chapter, we’ll discuss this
technique in a separate module altogether.
1. Gold and Silver are correlated both on an intraday basis and on an end of day
basis.
2. Gold and Silver make a good pair for trading based on the ‘Pair trading
technique’.
3. Silver does not have a great correlation with crude oil.
4. There are 4 variants of silver traded on MCX.
5. The main Silver contract has a lot size of 30 kgs and requires a margin close to
Rs. 75,000/-.
6. The average margin requirement for silver is roughly between 5-6% of the
contract value.
7. Technical analysis works quite well on Silver.
CHAPTER 10
Crude Oil (Part 1), digging the past
10.1 – The Commodities super star

If I have to pick one international commodity which can give you all the dramatic ups
and downs of stock markets as portrayed in the movies, then it has to be the ‘Crude
Oil’. Wonder why? Have a look at the chart below –
The dramatic rise to $140 per barrel to the immediate sharp correction, then a recovery
back to near $110 to a merciless crash to sub $30, the crude oil chart can invoke all
human emotions, just like a perfectly well directed movie! The fact that this is an
international commodity, actively traded by hundreds of thousands of traders across
the globe only adds to the complexity of it all.
So what is really going on in crude? Why did crude crack from the highs of $115 all the
way down to $28? What caused this manic panic? What is happening to crude now?
Where are we headed now? To understand this fully, we need to rewind and dig into the
recent history of 2014 – 15.
This is exactly what we will do in this chapter. For the sake of this chapter, let us go
back to first half of 2015 and see how things looked back then.
10.2 – The crisis revisited

From over $110 per barrel in January 2014 to a low of $28 per barrel in January 2016,
the Brent Crude oil has perhaps seen the worst decline in prices over the recent 5 years.
While this dramatic price decline has brought cheer to a few corporate and perhaps few
countries, it has disrupted oil producing economies. Literally nobody saw this coming;
even if someone did, the magnitude of this fall (over 75%) was beyond everybody’s
wildest imagination. Is this the bottom of the crash? Well, your guess is as good as mine,
but the intensity of the crash in crude oil is so severe, it would be hard to believe the
bottom is in sight.
So what really went wrong?
To understand what went wrong, we need to understand the dynamics of crude oil and
how business was carried out before the recent crash. This discussion also doubles up
as ‘oil basics’ for you. Oil rich countries produced several million barrels of crude oil
which were exported to The US, China, India, and European countries on a daily basis.
The oil producing countries are split into two baskets –
1. “Organization of the Petroleum Countries (OPEC)” nations which include countries like
Saudi Arabia, Qatar, Kuwait, UAE, etc., and
2. Other oil producing countries such as – Brazil, Canada, Russia, Mexico, Norway, etc.,
choose not be part of the oil cartel i.e. OPEC. Hence they are just referred to as ‘Non
OPEC countries”.
Between the OPEC and non OPEC countries, close to 90 million barrels of oil were
pumped on a daily basis. The graph below shows the daily oil production split between
OPEC and non OPEC countries –
The Trigger
Different countries produce oil at different rates; this rate at which they produce mainly
depends on the individual country’s finances and technology. While production
depends on internal factors, the sale of oil has always been driven by markets. Clearly
the breakeven point (expressed on a per barrel basis), is the rate at which countries
need to sell per barrel of oil to cover the expense of producing the same, varies from
country to country. Naturally, selling oil below the breakeven point implies that the
country cannot balance their state budget. The table below shows the breakeven
points for the OPEC countries –
In the backdrop of these trade dynamics, a triple digit oil price till early 2013 worked
really well for the oil producing economies. However, the recent developments
changed the landscape of crude oil business dynamics. Specifically, the following three
major events turned the tables around for crude oil prices –
1. American Shale Oil – The American shale oil, which comes from oil shale (sedimentary
rocks containing bituminous material), which is an alternate to crude oil became
technologically viable and the cost of producing the same became relatively cheaper.
The output from the American Shale oil production increased, flooding the market with
cheaper oil. By current estimates, it is believed that US has enough shale oil reserves
to last generations. Shale oil from Texas and North Dakota displaced exports from
OPEC members to The USA. This set the stage for a collapse in crude oil prices.
2. Lack of co-ordinate action – In the backdrop of increased shale oil production in The
USA and the ongoing slide in crude oil price, one of the methods for oil producing
countries to control the situation was to lower the supplies and regulate the demand
supply situation. However, OPEC was not really successful in convincing OPEC and
other non OPEC oil producing countries to cut the crude oil production to support the
crude price. In fact, cutting oil production is considered more expensive than pumping
oil.
3. China Factor – China has been one of the largest consumers of major international
commodities including iron ore, coal, and crude oil. In fact, in 2013 China surpassed
The US in oil imports. However, reports suggest that the Chinese economy is not
growing at the same pace as it used to, resulting in lower demand for international
commodities. Needless to say, this has a significant impact on the spiralling crude oil
prices.
4. Market Dynamics – The above three points triggered a steep sell off in crude oil, adding
fire to this sell off was the heavy short positions built up on Crude Oil contracts.
Generally, when the price of crude oil falls, the US dollar tends to get stronger
especially over the currencies of the emerging economies. This is quite natural as an
increase in oil price widens the US current account deficit (remember US also imports
oil from the Middle East), which obviously is not a great factor for the US Dollar, and
the reverse helps the dollar strengthen. Hence the Dollar and oil share an inverse
relation. Do recollect, in 2008 when Oil hit a peak of $148, US Dollar was trading at 1.6
to the EURO.
The Russian Episode
Russia is one of the largest (non OPEC) producers and exporters of oil. The Russian
federation’s oil exports contribute nearly 40% of the total exports. With a slump in oil
prices, the Russian economy seems considerably weakened. There are three factors
working against Russia, two of which can be directly attributed to the oil prices –
1. Oil Price – Russia needs the oil prices to be approximately in the region of $105 – $107
to balance its budget and keep its finances in order; clearly with oil at $50, Russia gets
a severe blow on its budget.
2. Ruble Trouble – Remember, Russia is an emerging economy. With the slide in oil price,
the Russian Ruble has massively weakened against the US Dollar. So much so, that the
Russian Central Bank increased the interest rate overnight by 7.5% in order to defend
the Ruble (yes, this did happen back in 2015).
3. Crimea Curse – Western countries continue to impose sanction cuts on Russia for its
aggression on Ukraine. This means access to external capital is extremely difficult
(especially when it’s most required) for Russia.
Add to this the Syrian crisis, and a host of other local factors, there is little hope that
that Russia may not actually slip into a financial coma dragging the federation into a
recession.
The India macro angle
On the face of it, the fall in crude oil seems to significantly benefit India as the pressure
on petroleum subsidy eases. India being a net oil importer (nearly two-third of India’s
oil is imported) pays a heavy bill for its oil imports. Naturally the fall in crude oil means
improvement in the fiscal deficit, easing of inflation and possibility of an interest rate
cut. All of which is desirable for India in the backdrop of the current economic
situation.
But there is another angle to low oil prices. While low oil prices help the domestic
import bill, it will also impact our exports receipts. Most of the exports from India are
to countries whose economy depends on oil – UAE, US, Saudi Arabia, Kuwait, Iran,
China etc. Quite naturally, with low oil prices the spending by these countries also
decreases, thereby impacting business with India.
In fact, if you go back and look at the October 2014 import & export data from RBI, it
clearly suggests the same – while the oil import bill reduced by 19% (y-o-y), the exports
also declined by 5%. Clearly the advantage of low oil price is not the boon it seems to
be. In fact, on 6 th January 2015 we got a glimpse into what can happen if the oil price
continues its fall – the NSE Nifty fell over 255 (~ 3.0% decline) points creating a ruckus
on the street.
Impact on the Indian Companies
State owned oil marketing companies (OMC) such as HPCL, BPCL, and IOC are a dir ect
beneficiary of low oil prices. Low oil price has a positive impact on oil marketing
companies (OMC) in terms of reducing the stress on their working capital requirements.
In fact, both BPCL and HPCL have retired over 50% and 30% of their short term
borrowings over the last two years respectively. If the price of crude oil prices stabilizes
around the current level of $50 per barrel, then naturally it will be great for these
companies in term of cleaning up their balance sheets and improving their bottom line.
Is this the end?
Well, this just depends on the supply-demand situation. Clearly as Saudi Prince Al-
Waleed Bin Talal says, “If the supply stays where it is and the demand continues to be
where it is, then there is little hope for the oil prices to bottom out here”. Besides, the
US has withdrawn the 40-year ban on export of oil– which means more supply to the
market, thereby putting more pressure on prices.
Last month, i.e., September 2016, OPEC has finally agreed to cut the production in
order to support the oil price. You can read the article on Bloomberg.
American shale oil has no doubt created a ripple in the market but there is another
angle to this – how strong are the balance sheet of these companies fracking shale oil?
Are they over leveraged? Are they overstating the reserves? These are things the
market will learn sooner or later; which will again impact crude oil prices.
However, at this stage if you ask me – is this the bottom of the oil price crash? Well, your
guess is as good as mine.
Please note, unlike all the previous chapters on Varsity, this chapter will not have any
key take away points as I’ve just narrated what really happened to crude. What we have
discussed today could just be a piece of irrelevant history going forward!
PS: I have taken all the inputs for this chapter form The special report on oil crisis was
published by Dalal Street Investment journal, authored by me.
CHAPTER 11
Crude Oil (Part 2), the crude oil

ecosystem
11.1 – Mapping companies

I’m hoping that the previous chapter gave you some insight into the current situation
of the crude oil fundamentals. Some of you may also be interested in learning how
crude oil is extracted from the ground and supplied to various stakeholders such as the
refineries. The ‘Oil and Gas videos’ channel on YouTube, has done a stellar job in
putting up short animated videos on this topic. If not all the videos, I’d encourage you
to at least watch this one.
This animated video gives a beautiful, high level understanding of how oil is extracted
from the ground and ocean beds. You will also understand what ‘oil rigs’ are in this
video. They are those huge pad-like things, floating in the ocean, with flames spewing
out of the exhaust. Companies such as Aban Offshore, Selan Exploration, Cairn India
etc., are involved in setting this infrastructure up. I know a lot of traders and even
investors investing in these asset heavy companies, without knowing the operational
core of such companies. Personally, I think this is not a great idea; one should always
know what they are dealing with. Given this, and the relevance of crude oil on many
listed companies, I would like to briefly discuss how the oil industry is structured.
11.2 – Upstream, Downstream, and Midstream

A note of warning here – I’m no oil and gas expert; my knowledge is limited to just the
basics. As a crude oil trader, I do think it is extremely important to know the industry
dynamics simply because the trading opportunities may not always be presented to
you directly. For example, there could be some fundamental change brewing in crude
oil, it may not manifest into a trade in crude oil directly, but instead a trade opportunity
may come about in the downstream companies. For you to benefit from this, it
becomes imperative to know the layout of the industry and identify areas of
opportunity. My objective here is to familiarize you with the industry layout and help
you map companies and how they fit into the overall oil and gas ecosystem.
So let us get started.
The oil and gas industry can be segregated into three sections –
1. The upstream industry

2. The downstream industry
3. The midstream industry
Let us briefly discuss each one of the starting from the upstream companies.
Upstream companies
The upstream companies are the ones that do the dirty work – they take on geological
surveys, dig up bore wells to get a sense of what’s in the ground underneath, and if they
find oil reserves, they then begin the drilling and extraction of crude oil. It takes many
years for upstream companies to identify an asset (potential oil well) and convert it into
a fully functional, profitable oil well. Upstream companies manufacture and store
crude oil in barrels (millions of barrels are produced every day). These companies do
R&D and engineering, and are asset heavy. Therefore, they end up spending a lot of
money (read as capital expenditure) to extract oil.
However, the price at which they can sell this oil in the open market is not really in their
control. The price is determined by the markets in which market participants like you
and I participate and influence the international oil price. Every upstream company has
a breakeven point – defined as the cost of producing one barrel of oil. The breakeven
point is also referred to as the ‘full cycle cost’. Naturally, these companies would strive
hard to keep their costs low and bring down the full cycle cost.
Companies such as ONGC, Carin India, Reliance Industries, Oil India are some of the
Indian upstream companies. Internationally companies such as Shell, BP, Chevron etc.,
fall in this category.
The key point to note here is that low oil prices do not really favor upstream companies
in general, especially the ones which have high economies of scale (the ones which
have high full cost cycle). Obviously, higher oil price is good for these companies as
their efforts to extract oil remain the same, but margins improve drastically.
Downstream companies
We will talk about the downstream industry first, and then discuss the mid stream
industry. Generally speaking, the job of the upstream companies ends at producing
crude oil. ‘Crude oil’ as you realize is produced in its raw form. If we have to use it as
petrol or diesel, then the crude oil has to be refined. This is where the downstream
industry comes into the picture. These companies purchase the crude oil from
upstream companies and refine the crude oil to various forms such as – petrol, diesel,
aviation fuel, marine oil, kerosene, lubricants, waxes, asphalts, liquefied petroleum gas
etc.,
Companies in this sector also go the extent of distributing these products across the
value chain, right from business to business (B2B distribution) to business to consumer
(B2C) distribution. In fact, petrol bunks are a good example of this phenomenon. Petrol
bunks are nothing but a retail outlet, retailing petroleum products and owned by
downstream companies.
Good examples of downstream companies in the Indian context are – BPCL, HPCL, IOC
etc. Some companies try and integrate and operate across the value chain i.e., they try
and do both upstream and downstream operations. Companies that successfully
combine these operations are often referred to as the ‘Super Major’. Classic example of
this is the US based ‘Exxon Mobil Corp’. They produce close to 4 million oil barrels per
day and operate around 40 oil refineries across 21 countries. An operation of this scale
is a mammoth management and operational undertaking; clearly not everybody’s cup
of tea.
So, if the oil prices cool off, then it implies that the downstream companies can buy oil
at cheaper prices from the upstream company (which is not so good for upstream boys
as their efforts to produce oil is still the same). However, the benefit of lower oil price
is not passed on to the end user i.e. you and me, but in developed countries like US and
UK, this benefit is passed on to the end users quite quickly.
Anyway, here is what you need to remember at this stage –
 Upstream and downstream companies share a see-saw relationship

 Low oil prices are bad for the upstream boys but good for the downstream fellows
 Higher oil price is good for upstream fellows but bad for downstream boys.
So the next time you see oil prices going down, don’t be in a hurry to short ONGC or
BPCL. Take a minute to understand weather the company is downstream or upstream
company, and analyse the impact of oil prices on the company.
Midstream companies
We will quickly discuss the midstream companies before looking into other aspects.
In very loose terms, midstream companies are the ones act as a courier between the
upstream and downstream companies. They are responsible for the transport of oil
from the oil well to the refineries. They do this via pipelines, road transportation (oil
takers), and by ocean shipments. Consider them as the wholesalers of crude oil. Some
midstream companies try to deliver more on the value chain by refining the crude oil
to some extent, hence their operations sometimes overlap with downstream
companies. Since midstream companies deal with both up and downstream
companies, they are kind of caught in the middle, they neither want oil prices to
increase or decrease, but seek stability in oil prices. If oil price decreases, then
upstream companies are affected, this is not good for them. Likewise, if the prices
increase downstream companies are affected, this is again not so great for them.
Some of the top players in this segment are TransCanada, Spectra Energy, Willams and
Company etc.
Here is a snapshot which gives you a quick overview of all the three industries –
11.2 – Difference between WTI Crude and Brent
Many people tend to speak about ‘Crude Oil’ like as if it is a single uniform entity,
something like Gold. However, this is not true. Did you know there are many varieties
of crude oil which can be extracted from the ground below? The difference comes in
mainly from the geographic variation and its unique characteristics. The impact of
geography is so much that the characteristics of crude oil, right from thickness, colour
(light yellow, golden yellow, deep black), viscosity, sulfur content, volatility etc. ,
change drastically.
Given this, naturally, there are many different types of Crude oil. I’ll not get into details
of the many different types of oil – not that I don’t want to, it’s simply because I don’t
know them myself J. I know the basic difference between to West Texas Intermediate
(WTI) and Brent Blend, which is what matters to most of the crude oil traders and hence
we will stick to it.
Before we get into the difference between the two, let us touch upon two distinct
characteristics of crude oil, which basically define the variation of crude.
API Gravity – API here stands for ‘American Petroleum Institute’, which is essentially a
metric to compare the lightness of crude oil with that of water. If the ‘API Gravity’ of a
particular variety of oil is higher than 10, it simply indicates that the oil is lighter than
water, therefore the oil can float on water. API gravity less than 10 indicates that the oil
is heavier than water; hence the oil will sink in water.
Sweetness – Crude oil of any form will naturally contain sulfur. The lesser the content
(I was told sub 0.5%) the ‘sweeter’ the oil is considered. Higher the content of sulfur,
then the oil is not considered ‘not so sweet’.
The difference between WTI and Brent mainly comes from the API Gravity and its
sweetness.
West Texas Intermediate (WTI) – This is considered a very superior quality of crude,
hence the final refined products are also meant to be of superior quality. The API gravity
is 39.6 (recall higher than 10, then it’s lighter than water) therefore WTI is considered
super light. Further, the sulfur content is just 0.26 percent, making it a very sweet crude
oil
Brent Blend – Much like blended scotch, crude oil can also be blended to create
variants with certain properties. Apparently, the Brent blend is created by blending oil
from over 15 oil wells. Brent has a sulfur content of 0.37%, which makes it sweet, but
not as sweet as WTI. The API gravity is around 38.06, which makes Brent quite ‘light’.
Clearly, due to the variation in the characteristics, the two are traded at different prices.
Have a look at the price quote for these two variants –
Source: Bloomberg
Brent crude is priced higher compared to WTI. Most importantly, you need to know that
crude oil traded on MCX follows the Brent crude and not WTI. In fact, Brent crude is the
benchmark for International crude oil pricing.
11.3 – Crude oil inventory levels

Supply-demand effects crude oil prices and therefore the profitability of many
companies linked at various points in the oil and gas eco-system. This makes tracking
the inventory levels of crude oil prices important on several counts. You can use this
information to trade not just crude at MCX, but also set up trades on companies such
as BPCL, HPCL, IOC, ONGC etc.
There are two organizations which put out the inventory details –
1. US Energy Information Administration (US EIA) – They report the inventory levels on
a weekly basis. You can track the information here. Remember inventories tend to
increase when the demand is low or there is an oversupply, either which way, it is bad
for oil prices, and hence the upstream companies. Likewise, lower inventories mean
either there is a lot of demand or there is a cut in production, both ways it’s good for
crude prices and upstream companies.
2. OECD Crude Oil inventory – OECD stands for ‘Organization of Economic Co-operation
and Development’. OECD also gives out crude oil inventory (but not at a weekly forecast
like EIA). You can track the inventory position on OECD’s website.
11.4 – The relationship between US Dollar and Crude Oil
The crude oil and US Dollar share an inverse relationship with each other. A
strengthening US Dollar tends to drive the price of crude oil down. Likewise, weakening
USD tends to drive the prices of crude oil higher. At this point it is very important to
note that both these assets have their own supply demand dynamics influencing t heir
price movement; however, they are also somewhat linked to one another.
If you do an image search for ‘Crude Oil versus Dollar’, you will find many charts which
display this inverse relationship. Here is one for example –
The interesting thing to note here is, the dollar used in these charts is not the “USD
Dollar Spot” but instead the ‘Dollar index’, which is a representation of dollar against
major world currencies. This makes absolute sense as crude oil is an international
currency priced in dollars, therefore irrespective of who is buying crude oil, payments
happen in US dollars.
Given this, if the Dollar increases (for whatever reasons), then countries tend to
purchase more oil for the same level of dollar (more oil can be purchased for the sam e
dollar level). This leads to quicker depletion of inventory levels, therefore the price of
oil increases.
The argument above is generally true over long time periods. However, please do
remember that both these assets have their own fundamental dynamics playing. So
there could be instances where both of them may break their inverse correlation and
head in same direction.
Also, remember the inverse correlation only suggests that the two assets move in
opposite direction but does not say anything in magnitude. So for example if the dollar
declines 10%, this does not imply that the Crude oil will increase 10%.
In the next chapter, we will discuss the contract specification of Crude oil on MCX.
CHAPTER 12
Crude Oil (Part 3), the crude oil

contract
12.1 – The contract
Crude oil is the most actively traded commodity on MCX. The combined value of crude
oil (across all contracts) traded on MCX, on average, exceeds Rupees 3000 crores on a
daily basis. This translates to roughly 8500 barrels of crude oil traded daily. Active
market participation in crude oil comes in from both corporate and retail individual
traders. On any given day, you can expect both upstream companies (ONGC, CAIRN,
Reliance) and downstream companies (IOC, BPCL, HPCL) placing orders on MCX. If I
were to guess, these institutional orders are mainly to hedge their exposure in the spot
(physical) market. On the other hand, the retail traders mostly speculate on the crude
oil prices.
I’d encourage you to check the MCX ‘Bhav Copy’. This gives you a perspective on a
particular contract’s liquidity and volume.
There are two main Crude oil contracts which are traded on the MCX –
1. Crude Oil (the big crude or the main contract)
2. Crude Oil Mini (the baby version)
In this chapter, we will learn how these contracts are structured – right from expiry to
margins to P&L per tick.
12.2 – Crude Oil, the big contract
With an average daily traded value of Rupees 2500 Cr, the big crude oil contract is
certainly one of the biggest contracts (value wise) that gets traded on MCX. Without
wasting much time, let’s get straight to the contract details of the big crude.
The contract details are as follows –
 Price Quote – Per barrel

 Lot size – 100 barrels
 Tick Size – Rs.1/-
 P&L per tick – Rs.100/-
 Expiry -19/20th of every month
 Delivery units – 50,000 barrels
 Physical Delivery – Mumbai / JNPT Port
Let’s understand this information in better detail. The crude oil on MCX is quoted on a
per barrel basis (one barrel is equal to 42 gallons or about 159 liters). Have a look at the
image below; this is the snap shot of Crude oil’s market depth –
As you can see, the Crude Oil contract expiring on 19 th Dec 2016 is trading at Rs.3197/-
per barrel, quite obviously as we know price quote is on a per barrel basis.
The lot size is 100 barrels, which means to say that if you want to buy (or go long) on
crude oil, the value of such a contract will be –
Lot size * price quote
= 100 * 3198 (offer price to go long)
= Rs. 319,800/-
This is the contract value of the crude oil, but what about the margins? Unlike the
margins on other commodities, the margin on crude oil is slightly higher. If you wish to
carry the position forward overnight, then the margin requirement is roughly 9%.
This means, 1 lot of crude oil (100 barrels) requires a margin deposit of –
9% * 319800
= Rs. 28,782/-
In fact, you can use the margin calculator on Zerodha’s website to get a ready
reference of approximate margin requirement. Here is the snap shot of the same –
The margin requirement under NRLM (for overnight position) is Rs. 29,114/-, assuming
the price of Crude is Rs. 3,253/-. However, if you wish to make an intraday trade using
MIS, then the margin requirement is roughly 4.5%. Clearly, as you can see from the
snapshot above, margin under MIS is just Rs. 14,557/-.
12.3 – Selecting the right contract to trade (expiry logic)

New crude oil contracts are launched every month. The newly introduced crude oil
contracts have an expiry scheduled six months later. For example, the contract
introduced in November 2016, will have its expiry in 6 months i.e., May 2017. MCX puts
up this information regularly in their circulars, but I find it a little confusing to interpret
the expiry table. Here is what MCX intends to convey –
And this is how the table in the circular reads –
So, as I write this, its November 2016, which means to say the November 2016 contract
must have been introduced in May 2016.
Anyway, the point to note here is this –
1. Every month a new contract, 6 months in advance is launched (long dated

contracts).
2. These contracts expire on or around 19 th of the expiry month, 6 months later.
3. Given this, each contract lasts for 6 months in the market.
For active trading, always choose the near month contract. Now, assuming today is
November 5 th 2016, I’d choose the November 2016 contract expiring on 19 th November
to trade. Maybe around 15 th or 16thNovember (as we progress closer to expiry), I’d shift
to the December 2016 contract. The reason for this is simple. Liquidity is highest for the
current month contract (November 2016 in this example). Liquidity picks up in the next
month’s contract (i.e. December 2016) as we move closer to the expiry of current
month’s contract.
All the other contracts, even though exist in the market, pretty much lead a
meaningless life, until they become current.
12.3 – The Crude Oil Mini contract
The Crude Oil mini is quite a favourite amongst the trading community. The reason for
this is straightforward –
1. The margin required is lesser

2. The P&L per tick is lot lesser – did you know people prefer to see lesser loss than
seeing higher profits?
Here are the contract details –
 Price Quote – Per barrel

 Lot size – 10 barrels
 Tick Size – Rs.1/-
 P&L per tick – Rs.10/-
 Expiry -19/20th of every month
 Delivery units – 50,000 barrels
 Physical Delivery – Mumbai / JNPT Port
Have a look at the quote below –
The Crude Oil Mini, December future is trading at Rupees 3,210/- per barrel. The
contract value for this would be –
Rs. 3,210 * 10
= Rs. 32,100/-
The margin required in percentage terms is little higher – around 9.5% for NRML and
4.8% for MIS.
This puts the margin requirement for NRML at Rs. 3,049/- and Rs. 1,540/- for MIS.
Clearly, way lower compared to the margin required for the big Crude oil.
Except for lot size, and therefore the margins, the other remaining features don’t
change for both the crude oil contract contracts.
12.4 – Crude Oil Arbitrage

The first part of the snapshot captures Crude Oil December future (big crude contract)
along with its market depth. The second part of the snapshot captures the Crude Oil
Mini December contract along with its market depth.
All else equal, both these contracts at the same time should trade at the same price.
They are not supposed to trade at different prices, since the underlying is the same. In
fact, this is what we notice here – both Crude oil contracts trade at Rs. 3,221/-.
But, what if they don’t?
Let’s say, for whatever reason, both these contracts trade at different prices? For
example, Crude Oil is trading at Rs. 3,221/- and the Crude Oil Mini is trading at Rs.
3,217/-. Do we have a trading opportunity here? Yes, of course, we do have an arbitrage
opportunity here, and here is how we can trade this.
Crude Oil – 3221
Crude Oil Mini = 3217
Risk free profit potential (arbitrage) = 3221-3217 = 4 points
Trade Setup –
We know the rule of thumb in any arbitrage trade – always buy the cheaper asset and
sell the expensive one. So in this case –
We buy the crude oil mini at 3217 and sell the crude oil at 3221. However, please note,
for a perfect arbitrage opportunity, we should always trade similar values.
The contract value of Crude oil is – 3221 * 100 = Rs. 3,22,100/-
The contract value of Crude oil mini is 3217 * 10 = Rs. 32,170/-
Given this, one should buy 10 lots of Crude oil mini at 3217 and sell 1 lot of crude oil at
3221. By doing so, the contract sizes are similar and therefore the arbitrage holds.
Once we execute this trade (efficiently), the arbitrage profit is locked in. Remember, in
all arbitrage cases, the price will converge to a single price point. So assume the price
finally converges to 3230 –
We make +13 points on the crude oil mini and we lose -9 points on crude oil, and on a
net basis we make 4 points.
In fact, irrespective of where the price heads the 4 points are guaranteed.
It is unlikely you will find such sweet opportunities on a daily basis, and even if you do,
algorithms grab them. However, I have occasionally witnessed such opportunities
lasting for several minutes.
So do watch out for such trading opportunities, and if it indeed comes by, you know
what to do.
This brings us to the end of our conversation on Crude Oil. Over the next few chapters,
we will focus our attention towards ‘Metals’.
1. There are two crude oil contracts available – Crude Oil and Crude Oil mini
2. Both the contracts vary in the lot size. Lot size of the big crude is 100 barrels
while the crude mini’s lot size is 10 barrels.
3. Price quote is on a per barrel basis
4. Every month new crude oil contracts are introduced which expire 6 months later.
5. Expiry is on 19 th of every month.
6. The current month contract attracts maximum liquidity.
7. Arbitrage between the two crude contracts can be executed – but one has to
ensure contract values are similar.
CHAPTER 13
Copper & Aluminium

13.1 – Sumitomo Copper scandal
If you are remotely connected to the commodity world, then this is one story you must
have heard of – ‘The Sumitomo Copper Scandal’. This scandal unfolded in Japan,
around 1995, but the severity of this event sent a ripple down the spine of entire
commodity trading world. So much so, that it’s talked about even today and it gets a
special mention whenever the financial world talks about ‘rouge trading’.
Sumitomo Corporation is a huge conglomerate, incorporated and listed in Japan. The

company is involved in general trading of goods and commodities. Back in the days,
Sumitomo had a significant copper trading division. Sumitomo’s copper trading
involved buying of copper in spot market and physically storing them in its warehouses.
The company also had a large exposure to copper futures on the London Metals
Exchange (LME). Yasuo Hamanaka, was Sumitomo’s chief ‘Copper Trader’. He was
Sumitomo’s go-to man for anything related to Copper.
So here is what happened –
 Yasuo Hamanaka bought copper in physical form (spot market) and hoarded them
in warehouses.
 He bought copper not just in Japan, but across the world and stored it at different
locations/ports.
 Essentially, he was long copper in the spot market.
 His exposure in the spot market was around 5% of the entire world’s outstanding
reserves. At that point, he was probably the only man on the planet with so much
copper. This meant he could control the prices of copper, quite literally.
 At the same time, he also bought Copper Futures at LME.
 Every trader knew that Yasuo Hamanaka was copper bull, but nobody knew the
extent of his exposure (as LME wasn’t publishing open interest data at the time).
 Whenever traders or trading firms shorted copper, Hamanaka would buy. He could
buy because Sumitomo was cash rich and funded these trades.
 Since he bought in such large quantities, copper prices went up.
 Remember, copper is an international commodity and the price is market driven
(LME futures).
 So LME prices went up – short traders were squeezed, Hamanaka made profits on
futures.
 Short traders would eventually default, which meant they had to deliver copper
upon expiry.
 Invariably these traders would end up buying copper from Sumitomo at a premium,
which meant Sumitomo minted crisp profits on their spot position as well.
 The profits snowballed and Yasuo Hamanaka became the undisputed king of
copper.
This set up functioned really well for over a decade. However, sometime around early
90s, China upped their copper production, to an extent where they flooded the market
with excess supply. Naturally, the prices started to cool off and Yasuo Hamanaka
started feeling the heat. His exposure was so large that it was difficult for him to off
load the contracts (especially since he was doing most of the buying)! He went to the
extent of borrowing funds to maintain his long positions. Remember, these were all
leveraged positions, and when you have super large quantities of any leveraged
positions, a small move against you can result in massive losses.
This is exactly what happened – copper prices crashed and Yasuo Hamanaka’s copper
kingdom collapsed. Losses piled to an extent that the Sumitomo Corporation filed for
bankruptcy. The estimated losses were close to a whopping $5 billion, in 1995!
What followed next were the routine blame games, law suits, denials, and all the
resulting drama. However, the key take away from this story is the importance of risk
management. We will talk about this soon in a separate module all together.
Anyway, that was that; let’s move ahead to copper basics.
13.2 – Copper Basics

Copper is a base metal, highly traded on MCX. A metal is classified as a ‘base’ if it is not
precious like gold and silver.
The daily traded value is approximated at INR 2,050 crores across an average of 55,000
lots. So, as you can imagine, copper on MCX is a very liquid contract. The liquidity
matches that of crude oil and gold.
Copper is a very interesting metal. It is the 3 rd most consumed metal after steel and
aluminium. The price of copper (much like aluminium) is directly dependent on gl obal
economics. You may know, copper is one of the best conductors of electricity, and
therefore, copper is the preferred choice of metal in electrical wires. In fact, did you
know, at the core of Tesla’s hybrid car there is a copper motor as opposed a reg ular
engine motor (permanent magnet motor)?
Check this article.
Of course, apart from this, copper finds its application in a whole host of other things
such as –
o Building and construction

o Copper alloy molds
o Electrical and electronics
o Plumbing solutions
o Industrial uses
o Telecom
o Railways
But my favourite application of copper has to be this –
Can you guess what this is? If you can, then probably you and I have a common interest.
The demand – consumption of copper showcases similar trends as aluminium. Have a

look at this snapshot –
Source: Hindalco annual Report (2015-16)
In 2015, the global demand for refined copper was 24 million tons; half of this demand
was from China and Japan. The supply was higher than the demand (look at the last
two bars from right), and thanks to the recent commodity glut, the price has
considerably cooled off over the last few years.
It’s good to know basic fundamentals, but like any other commodity; I’d rely on charts
to trade copper. Given this, let’s focus on the contract specifications. Of course, both
aluminium and copper have two contracts – the big copper contract and its mini
version. Let me list down the contract specs of the big copper contract.
o Price Quote – Per kilogram

o Lot size – 1 metric ton
o Tick size – Rs.0.05
o P&L per tick – Rs.0.05 * 1000 = Rs.50/-
o Expiry –Last day of the month
o Delivery units – 10 MT
Here is the snap quote of copper, expiring in Feb 2017 –
The price as seen here is Rs.389.1 per Kg. The contract value therefore would be –
Lot size * price
= 1000 * 389.1
= Rs. 389,100/-
The NRML margin is as shown below –
Rs. 30,544/-, which works out to 7.8%. MIS margin is half this amount.
The Copper Mini contract has a lesser lot size, therefore lesser P&L per tick, and lesser
margins.

o Lot size – 250 Kgs
o P&L per tick – Rs.0.05 * 250 = Rs.12.5/-
I’d suggest you look at technical analysis to trade copper, and commodities in general.
They work really well on liquid commodities such as copper. So essentially, you just
need to know the contract details to get started.
Onwards to Aluminium!
13.3 – Aluminium Basics

Remember, our objective here is to understand basic information. We are not going
deep into the subject, simply because most of us would be trading this commodity with
an average holding period of not more than 2-3 days. When this is the objective, it
makes more sense to spend time on the price dynamics rather than the fundamentals.
Hence, I’ll stick to basics, and for ease of reading, highlights of the chapter are
presented as bullet points. Post this; we will dig deeper into contract specifications.
Talk about Aluminium and chances are you will think about that wafer thin, silvery foil,
which wraps your leftover food in your refrigerator. Well, Aluminium’s applications go
beyond that.
Here are few things you need to know (have collected this information from various
online sources) –
1. There is plenty of Aluminium (supply is not an issue) – roughly 8% of the earth’s

crust is made up of Aluminium. This makes aluminium the third most abundant,
after oxygen and silicon.
2. The fact that aluminium resists corrosion makes it a very desirable metal
3. Aluminium manufacturing is power intensive – it takes a whopping 17.4
megawatt hour of power to manufacture 1 metric ton of Aluminium. Check this
–
This is power and fuel cost of Hindalco (leading manufacturer of Aluminium), and as
you can see nearly 10% of the expense is on power and fuel. Remember, Hindalco has
its own captive power units. So, I’m guessing this power is consumed over and above
what Hindalco generated internally
1. That said, recycling aluminium is a power friendly affair. It requires just about
5% of the power to recycle.
2. Aluminium has a wide range of applications – right from a smart phone to a
Boeing 747. Did you know you need approximately 70,000 kilograms of
aluminium is used up in a single Boeing 747?
3. Aluminium is also used up in other industries – automotive, building &
construction, defense, electrical, electronic, pharmaceuticals, white goods, etc.,
4. Aluminium is one metal that has abundant supply and demand.
5. Aluminium prices on MCX closely follow the international prices of aluminium
which is traded on the London Metal Exchange (LME).
In fact, here is a snapshot which gives you the trends in production, supply, and average
price of aluminium on LME –
Source: Hindalco Annual Report (2015-2016)
This is a very interesting chart; in fact, based on this chart alone, a few basic trading
principles can be formulated. Let’s break this graph up in smaller bits –
1. The global production (blue bar) of aluminium in 2015 stands at 56 million

tonnes. This represents a growth of about 4% from the previous year.
2. The global production nets a CAGR of 6% over the last 8 years.
3. The demand (yellow bar) on the other side matches up to the global production
– this implies that there are no supply-demand disruptions.
4. In fact, the demand and the supply have remained more or less stable over the
years.
5. The price of aluminium over the last few years has declined. Its averages to
$1,500/- per ton, which is a decline from its recent peak of $2,500/- per ton. You
must have heard about the global commodity glut. Clearly, the Chinese demand
plays a key role to the aluminium’s global pricing
6. The Indian demand on the other hand is better than the global demand (in
percentage terms). Hindalco, in its annual report claims the demand for
aluminium in India is about 2 million tonnes. Much of this demand is met by
importing aluminium.
I guess these basic points should help you get started on Aluminium fundamentals.
However, I’d be happy to trade aluminium based on technical analysis, simply because
of my short holding period, usually not exceeding few trading sessions.
So, with this, I’d like to move ahead and discuss contract specifications, which will help
you understand the practicality of trading aluminium on MCX.
13.4 – Aluminium contract specifications

As you may have guessed, there are two main aluminium contracts to trade on MCX.
They are the big aluminium contract and the aluminium mini contract. Clearly, both of
them differ on the lot size and therefore contract value. We will discuss the big
aluminium contract first.
The daily average traded value of big aluminium is roughly about INR 375 Cr. On a good
day, the volume could reach a little over INR 500 crores. As you may have realized, the
value is not as high as commodities such as gold and crude oil.
The contract details are as follows –

At this point you may have realized that this is a huge contract. A metric ton is 1000
kilograms, so 5MT makes it 5000 kgs. Since the price is quote per kg, and the lot size is
5000 kgs, each tick will cause a P&L of Rs.5000/- PROVIDED the tick is Rs.1/-. Since this
would be very large, especially for retail trading, MCX has reduced the tick size to the
lowest possible value i.e. Rs.0.05

o P&L per tick – Rs.0.05 * 5000 = Rs.250/-
Let’s understand this information in better detail. Aluminium on MCX is quoted on a per
kilogram basis. Have a look at the image below; this is the snap shot of Crude oil’s
market depth –
As you can see, the aluminium expiring in Dec 2016 is trading at Rs.118.4/- per kg/
The lot size is 5 MT (5000 kgs), which means to say that if you want to buy (or go long)
on Aluminium, the value of such a contract will be –
Lot size * price quote
= 5000 * 118.4 (offer price to go long)
= Rs. 592,000/-
The price movement in aluminium is 0.05, which means, if aluminium moves from 118.4
to 118.45, the profit will be –
118.45 – 118.4
=0.05
=0.05*5000
=Rs.250/-
What about the margins? Have a look at the following snapshot –
The NRML margin charged is Rs. 33,719/- which works out to 5.6%. However, MIS margin
is almost half of NRML margin.
Here are the contract details of Aluminium mini –
o P&L per tick – Rs.0.05 * 1000 = Rs.50/-
The contract value is quite small –
= 1000 * 118.4
=Rs. 118,400/-
NRML margin is Rs. 6,779/-, which is 5.7%. MIS margin is much lesser at Rs. 3,389 or just
about 2.8% of the contract value.
P&L per tick is Rs.50/-, a value which is much ‘deal-able’ while trading.
I guess, this info is good enough to get started on trading with Aluminium. Frankly, you
just need to look at the chart, develop a point of view, and place trades based on the
chart pattern. If you are keen on digging deeper into aluminium I’d recommend you
spend time reading up on www.world-aluminium.org and www.aluminium.org.
1. Both Copper and Aluminium are base metals.

2. Aluminium is found in abundance (next only to silicon and oxygen).
3. The demand-consumption of aluminium and copper seem to have some sort of
equilibrium.
4. The prices of both aluminium and copper have declined over the years.
5. The prices of aluminium and copper on the London Metal Exchange (LME) act as
a reference price for these international commodities.
6. Both copper and aluminium have two contracts – the big one and mini.
7. The contracts vary in lot size and therefore contract values and margins.
CHAPTER 14
Lead & Nickel
14.1 – Lead – some history, some basis.

Would you believe, if I said that ‘Lead’, as in the metal Lead, played a role in bringing
down the Roman Empire? Not Gold nor Silver, not diamonds or rubies – but lead, which
is found in abundance.
Don’t worry; I don’t intend to make this a history lesson! However, lead and the Roman
Empire are somewhat related, and I’d like to take this opportunity to share this
interesting information with you.
I don’t intend to take too much of your time – here is an interesting perspective of how
lead could have acted as a catalyst to the fall of the mighty Roman Empire.
The characteristics of Lead make it a very unique metal –
o It’s a lustrous heavy metal
o Highly malleable and ductile
o Poor conductor of electricity
o Quite resistant to corrosion
o Very dense
o Reasonably available
Lead was discovered and has been in use since pre historic times. In fact, lead is the
earliest metal discovered. Lead figurines found in Egypt that date back to 4,000 BC are
testimony to this. Perhaps, the most popular use of lead and the therefore the peak of
lead production was during the Roman Empire. Romans used lead extensively,
especially as water pipes, aqueducts, tank linings, cooking pots, and even as cosmetics.
In fact, here is a picture on a Roman era water pipe –
Source: Welcome Images, UK.
Apparently, during the Roman era, it was a considered ‘aristo’ to have water pipes
running into the residence, directly plumbing water. The owner’s name was inscribed
on the lead water pipe (you can notice this on the picture as well), to showcase the
aristocracy. Talk about customized water pipes
Romans gradually paid a price for such extensive use of lead. Lead, unlike iron has no
use for the human body. It is toxic and carcinogenic. The extensive use of lead,
especially as water pipes proved to be fatal. Lead poisoning eventually claimed the
lives of many people – especially people from the higher strata, involved in decision
making. This mass loss of lives is believed to have played a crucial role in the eventual
collapse of Roman Empire.
Well, there you go, that’s about it – I’m not a historian, so if you want to know more, I’d
advise you to do your research on this, and here is an interesting link to get started.
Humans have evolved since the Roman era, and we have put lead to better use since
then. Here is wide variety of uses for lead –
o Solders
o Industrial lining of sinks, tanks, chambers
o Protective shield against radiation
o Lead acid storage batteries (largest application of lead)
o Lead foil used for covering cables
o Pigments and compounds
o Ship building
By the way, many people think of ‘lead’ and immediately imagine the pencil lead found
at the tip of pencil. Although, the one found in the pencil is called lead, it is not lead. It
is graphite.
The supply demand of lead has more or less been stable over the last few years, have a
look at the data below –
Source: www.ilzsg.org
In fact, the price of lead has more or less remained range bound over these years. Have
a look the long term chart of Lead; do pay attention to the last few years –
If you intend to trade Lead futures on MCX, then it pretty much has to be a play on price
action. I would personally refrain from setting up trades based on news or
fundamentals for Lead.
However, if you do plan to set up trades based on fundamentals, click here to get all
the fundamental data –
14.2 – Contract Specifications

Let’s take a quick look at the contract specifications. Like many other commodities
listed on MCX, Lead too comes in two variants – Lead (big contract) and Lead Mini. Let
me list down the contract specs of the big Lead first and then look into Lead Mini.
The specs are as below –
o Lot size – 5 metric tonnes (5000 kgs)
o Tick size – Rs. 0.05
o P&L per tick – Rs. 0.05 * 5,000 = Rs. 250/-
o Expiry – Last day of the month
Here is the snap quote of the Lead contract expiring in Jan 2017 –
The price, as seen here, is Rs. 137.05 per Kg. Therefore, the contract value would be –
Lot size * price
= 5,000 * 137.05
= Rs. 685,250/-
As you can see, the NRML (for overnight positions) margin is Rs. 80,482/-and MIS (for
intraday) margin is Rs. 40,241/-.
This makes it about 11.7% for NRML and about 5.9% for MIS, clearly one of the highest
margin requirements in the commodities market.
And now for the Lead Mini contract –
o Lot size – 1 metric ton (1000 kgs)
o P&L per tick – Rs. 0.05 * 1,000 = Rs. 50/-
Here is the snap quote of Lead Mini, expiring in Jan 2017 –
The price as seen here is Rs.137.50 per Kg. The contract value therefore would be –
Lot size * price
= 1,000 * 137.50
= Rs. 137,500/-
As you can see, the NRML margin is Rs. 16,442/-and MIS margin is Rs. 8,221/-.
This makes it about 11.7% for NRML and about 5.9% for MIS. The margin for Lead Mini
(for both NRML & MIS) is similar to the margins charged for Lead big contract. However,
because the lot size is smaller, the financial outlay towards margins is lot lesser.
14.3 – Lead contract logic

MCX introduces new contracts every month, and each new contract introduced expires
on the last day of the 5 th month. For example, in January 2017, MCX will introduce May
2017 contract. The May 2017 contract will expire on the last working day of May 2017.
Note, the January 2017 contract would itself expire on the last working day of January
2017. Further, as you can see in the table below, the January contract would have been
introduced 5 months prior, i.e., in September 2016.
This introduction pattern ensures that there is a current month contract available at
any point in the system.
Have a look at the table below –
Although, the contract is commissioned 5 months before expiry, it gains liquidity only
in its last month. Therefore, it makes sense to always trade the current month contract.
Remember, higher liquidity means tighter bid ask spreads, tighter spreads mean lower
impact cost, lower impact cost means, less damage especially when you place market
orders.
14.4 – Nickel basics
Nickel and its alloys find extensive used in our day to day lives. Be it kitchenware,
mobile phones, medical equipment, building, power generation, or even transport –
Nickel is almost always used, either directly or as an alloy. The largest application of
Nickel has to be in the manufacturing of stainless steel. In fact, about 65% of nickel
produced is used towards the manufacturing of stainless steel.
Here is the ‘demand – supply’ situation of Nickel –
As you can see, Nickel production has overtaken the demand. This probably explains
why Nickel prices have been down over the year –
Again, my advice when it comes to trading Nickel would be the same – trade the price
and not really the fundamentals.
14.5 – Contract Specifications of Nickel

No prize for guessing, Nickel too comes in two variants – Nickel (big contract) and
Nickel Mini. Let me list down the contract specs of the big Nickel first and then look into
Nickel Mini.
Nickel (big) specs are as below –

o Lot size – 250 Kgs
o P&L per tick – Rs. 0.10 * 250 = Rs. 25/-
Here is the snap quote of Nickel, expiring in Jan 2017 –
The price as seen here is Rs. 685.50 per Kg. The contract value therefore would be –
Lot size * price
= 250 * 686.5
= Rs. 1,71,625/-
This makes it about 10% for NRML and about 5% for MIS.
And now for the Nickel Mini contract –

o Lot size – 100 kgs
o P&L per tick – Rs. 0.10 * 100 = Rs. 10/-
Here is the snap quote of Nickel Mini, expiring in Jan 2017 –
The price as seen here is Rs. 686/- per Kg. The contract value therefore would be –
Lot size * price
= 100 * 686
= Rs. 68,600/-
This is consistent with the big contract – works out to 10% for NRML and about 5.0% for
MIS.
The contracts are introduced on a monthly basis, in the same exact way as Lead. I’d
suggest you stick to the current month contract for trading as these contracts have the
highest liquidity.
1. There are two contracts for Lead Futures; Lead and Lead Mini.
2. Lot size of Lead is 5000 MT and Lead Mini is 1000 MT.
3. P&L per tick is Rs. 250 for Lead and Rs. 50 for Lead Mini.
4. ‘Demand supply’ has remained stable for Lead over the last few years
5. There are two contracts for Nickel futures; Nickel and Nickel Mini.
6. Lot size of Nickel is 250 Kgs and 100 kgs for Nickel Mini.
7. P&L per tick is Rs. 25 for Nickel and Rs. 10 for Nickel Mini.
8. Nickel production has outstripped its demand.
9. It is advisable to stick to the current month futures of both Lead and Nickel.
10. It makes sense to look at price data to place short term trades in both Lead and
Nickel.
CHAPTER 15
Cardamom & Mentha Oil
15.1 – Monsoon blues

Back in the day, I traded stocks with ICICI Direct. Around the same time, MCX had just
started operations and ICICI was one of the first brokers to get a membership. MCX was
aggressively campaigning and were conducting workshops and seminars to educate
market participants, hoping to get more activity on the exchange. I was in the discovery
phase, curious to know about everything tradable in India. I attended some of these
sessions and, for some reason, believed I would be far more efficient trading an
alternate asset like commodities as opposed to trading equities.
I was quite excited to start trading commodities. I quickly showed up at my broker’s

office with all the necessary documents to open my commodities trading account. To
my surprise, I was one of their earliest clients from Bangalore to open an account with
MCX. It took about 12 days (that seemed like an eternity to set up my account with MCX.
Finally, my broker called me to say I’m good to go live and place trades the next day. I
actually took a day off from work to trade commodities! I was thrilled to put my new
found commodities knowledge (although half-baked) to practice.
I chose to trade ‘Pepper futures’. Though the rationale behind this choice eludes
memory, Pepper futures it was!
So, my first commodities trade was ‘Long pepper’, 10 lots (I guess it was a 1 metric
tonne contract), I don’t remember the exact price, but I suppose it was somewhere
around Rs.7,500/- per quintal. I had bet my entire trading account on Pepper futures!
What followed through was quite predictable. To my dismay, Pepper hit its 52 -week
low over the next two days, I brought in additional capital, but Pepper continued to
crash, as did my account until there was nothing left in it.
Dejected, I did some post-mortem analysis to figure out what went wrong and realised
the monsoons were expected to be great in Kochi, which would result in a very good
harvest of Pepper.
Only now did I understand that one really needs to have some sort of understanding of
monsoons and harvest cycles before trading agri commodities. Unfortunately, I learnt
this lesson at very high price. No wonder I remember it to this day.
Anyway, considering this, we will spend a little time understanding a bit of this topic,
and hopefully, you will not make the same mistakes I did in the past.
And, just so you know – right after I burnt my trading account with my first commodities
trade, what happened next is easy to guess – Pepper futures bottomed out and rallied
nonstop to Rs. 12,500/- per quintal!
15.2 – Understanding Rainfall

The Indian economy’s dependence on agriculture has reduced over the years. A few
decades ago, agriculture contributed to over 30% to our GDP, but this has now reduced
to about 10%. However, agriculture and allied services are still the largest employers
in India. This perhaps explains why the Central Government most often takes a populist
stance when it comes to reforms and policies in this sector.
Have a look at the snapshot below, this gives you an idea of which sector contributes
how much to the Indian economy –
This data is published by RBI and is freely available on RBI website. The data is available
for as long back as the 50s. I’ve just manipulated the data to show the percentage
contribution of each sector. As you can see, the percentage contribution of agriculture
has declined over the years, while the % contribution of services (mainly software and
allied services) has steadily increased.
But, like I just mentioned, agriculture is still the largest employer in India and this entire
industry and workforce is dependent on how the yearly rainfall pans out. This is quite
natural as 2/3rd of India’s arable land is rain-fed.
There are two main rainfalls seasons (monsoons) in India –
1. The Southwest Monsoon (principal rainfall season), and

2. The Northeast Monsoon
I will not get into the technicalities of how these spells are caused, clearly not my area
of expertise. However, these are the things you need to know about these two seasons
–
1. The south-west monsoon occurs from the southern India and covers all the
regions up to central India. This spell is expected to start around June/July
through September/October
2. The North-eastern monsoon covers the north eastern India, North India,
Himalayas, and the western parts, and a large part of Tamil Nadu. This spell
occurs from early December through March.
During each of these monsoon seasons, seeds are sown and crops harvested. Based on
how good or bad the monsoon is, the harvest can be estimated.
o Crops sown during the south-west monsoons is called the Kharif Crop (it is even
referred to as the monsoon crops). These are mainly pulses, millets, rice, urad
dal, moong dal, cotton etc. The sowing of kharif crop takes placed around en d
May-early June (before the south-west spell) and harvesting is done post the
monsoons i.e around October.
o Crops sown during the northeast monsoons is called the Rabi Crop (it is even
referred to as the winter crops). Rabi crops are mainly wheat, gram, coriander,
mustard, oats etc. The sowing of rabi crop occurs at the onset of winter and
harvest of Rabi crops is around end April.
Rice and Wheat are India’s staple, contributes close to 40% of the food grain
production, and hence plays a crucial role in India’s food security. Do note, they are
harvested and sown in Kharif and Rabi season respectively.
The progress of sowing and harvesting is continuously monitored and is reported

across leading publications. Have a look at this –
This one reports the progress of Rabi crops –
In fact, with whatever basic knowledge we have gathered so far, I’d request you to read
this news piece.
The idea is to make sure, we understand what is being discussed here and relate to the
news article. If you are a serious agri trader, I’d expect you to continuously keep track
of such news pieces and strategies your trades.
The following agri commodities are available to trade on MCX –
1. Cardamom
2. Castor Seed
3. Cotton
4. Crude Palm Oil
5. Kapas
6. Mentha Oil
Of all these agri commodities, I’d recommend you trade Cardamom and Mentha Oil,
simply because the liquidity reasons.
Let’s discuss these two commodities. Also, note that agri commodities (especially the
Indian agri commodities) are traded till 5:00 PM.
15.3 – Cardamom
Cardamom is a spice mainly grown in Southern India (Karnataka & Kerala). The
cardamom variety grown in India is called ‘Small Cardamom’. India is the 2 nd largest
producer and 1 st largest consumer of Cardamom, while Guatemala is the world’s largest
producer of Cardamom. The Cardamom produced by Guatemala is mainly for export.
Cardamom, as you may know, is mainly used in India sweets. It also has few therapeutic
applications like skin and dental care – not that savouring sweets is less
therapeutic.
Cardamom, is a Kharif crop, the demand supply dynamics mainly depends on –
1. The southwest monsoons

2. The quality – flavour, colour, size, and aroma of the harvest
3. Production parameters – like inset attack on plantation
4. Stock available at both India and Guatemala
5. Domestic consumption patterns (although this is quite steady over the years)
Let’s take a quick look at the contract specifications. Unlike other commodities listed
on MCX, Cardamom does not have two variants. So don’t go looking for Cardamom and
Cardamom mini. J
The supply and demand for cardamom is kind of steady. Co incidentally, I read a news
piece today related to this, and I thought it would be interesting to shares the same
here –
The contact specs for Cardamom are as below –

o P&L per tick – Rs. 10/-
o Expiry – 15th of every month
o Delivery units – 100 Kgs
Here is the snap quote of the Cardamom expiring in Feb 2017 –
The price, as seen here, is Rs. 1,564 per Kg. Therefore, the contract value would be –
Lot size * price
= 100 * 1564
= Rs. 156,400/-
As you can see, the NRML (for overnight positions) margin is Rs. 16,237/-. This makes it
about 10.5% margin for NRML orders.
Further, as you can notice the MIS margin for Cardamom is not available. In fact, there
is no MIS margin for any agri commodities. There is a reason for this – agri commodities
are quite volatile and they tend to hit the circuit limits frequently, and therefore
unwinding the position by end of day would not easy. For this reason, a trader is better
off trading NRML for intraday as well.
Here is the contract introduction table of Cardamom –
As you can see, every month a six month futures contract is introduced. For example,
in the month of January, June futures are introduced. Hence, June futures will continue
to stay in the system till 15th of June (remember, expiry is on 15 th of every month). For
all practical purposes, it makes sense to always trade the current month contract for
liquidity.
For example, as I write this article (it is 17 th Jan 2017), if I were to trade Cardamom, I’d
opt to trade Feb 2017 Cardamom contract (Jan 2017 contract expired on 15 th Jan).
15.4 – Mentha Oil

Mentha is an aromatic herb which is used in its raw form for Indian cooking. Besides, it
distilled and filtered to produce the Mentha oil. It is Mentha Oil is traded on MCX.
Mentha oil is used in food, pharmaceutical, perfumery, and flavouring industry.
Mentha oil is also imported to countries such as US, China, and Singapore. This clearly
indicates that Mentha Oil contract is sensitive to fluctuations in USD-INR rates. Besides
this, other factors such as rainfall, insect attack, and crop acreage also exer ts its
influence on the contract.
The contact specs for Mentha Oil are as below –

o Expiry – Last day
o Delivery units – 360 Kgs
Of all the things listed in India, probably Mentha Oil is the only asset which has Rs.36/-
P&L per tick
Here is the snap quote of the Mentha Oil, expiring 2017 –
The price, as seen here, is Rs. 1,023.2 per Kg. Therefore the contract value would be –
Lot size * price
= 360 * 1023.2
= Rs. 368,352/-
As you can see, the NRML (for overnight positions) margin is Rs. 29,893/-. This makes it
about 8.5% margin for NRML orders. For reasons mentioned earlier, there is no MIS
margin for Mentha Oil as well.
The contracts are introduced every month, 5 months forward. As usual, I’d suggest you
stick to the current month contract to trade.
1. Agriculture as an industry contributes close to 10% to Indian economy, but it is

still the largest employer in India.
2. India is still very dependent on rainfall when it comes to agriculture.
3. There are two main rainfalls – Southwest monsoon (principal rainfall) and
northeast monsoon.
4. Crops sowed and harvested in southwest monsoon is called Kharif. Rice is a
major Kharif crop.
5. Crops sowed and harvested in northeast monsoon is called Rabi. Wheat is a
major Rabi crop.
6. Agri commodities are traded till 5:00 PM on MCX.
7. India is the largest consumer of cardamom and 2 nd largest producer of
Cardamom, stands 2nd to Guatemala in production.
8. Demand supply for cardamom is quite stable.
9. MIS margin is not available for agri commodities.
10. Mentha oil is distilled and filtered from Mentha leaves.
CHAPTER 16
Natural Gas
16.1 – History and background

I know this chapter on Natural Gas is coming in late; we should have discussed this
much earlier, probably when we discussed Crude oil. Unfortunately, I missed doing this;
but anyway, better late than never!
We will discuss Natural Gas in this chapter, and with that, we will conclude this module
on Currencies and Commodities.
As usual, let us start our discussion with some background information, history, and
how natural gas is extracted.
Natural gas is a naturally occurring, non-renewable, hydrocarbon gas mixture,

primarily consisting of methane. Natural Gas is a fossil fuel and is used as an energy
source. Natural gas has many applications in our day to day lives including electricity
(generation process), heating, and cooking. Besides, natural gas also has a wide var iety
of application in the fertilizer and plastics industry.
Apparently, way back in 1000, B.C., natural gas seeped from the ground, on Mount
Parnassus in ancient Greece, caught fire and a flame was lit.
The Greeks believed this was the Oracle at Delphi, and a temple was built. This has to
be the first ever reference to Natural Gas. By the way, do you wonder how natural gas
can seep through the land surface? Well, have a look at this picture of natural gas
seeping from ground and catching fire –
Source: Daily mail online, UK.
The Chinese discovered Natural Gas around 500 B.C., and they put this to better use –
they started using bamboo “pipelines” to transport natural gas that seeped to the
surface and to use it to boil sea water to get drinkable water.
However, the first commercialized application of natural gas occurred in the Great
Britain. Around 1785, the British used natural gas produced from coal to lighthouses
and streets.
By now, you must have guessed that ‘Natural Gas’ is somewhere hidden deep below
the earth’s surface. The question is – how and why is natural gas present there?
Millions of years ago, when plants and animals died, the remains were buried in sand
and silt. The buried remains mixed further with sand and silt, got buried deeper, and
decayed further. Pressure and heat converted these materials into coal, oil, and natural
gas. This entire process panned across millions of years. In some places, natural gas
moved into large cracks and spaces between layers of overlying rocks, while in o ther
places natural gas just settled on the porous surface of rocks. Natural Gas, in its original
form, is colorless, odorless, and tasteless. Now, practically this can be an issue –
imagine if natural gas leaks and spreads, there is no way one can identify its presence
in the atmosphere, which is a highly hazardous situation. Hence, producer of natural
gas adds a substance called ‘mercaptan’, which gives natural gas a pungent, sulfuric
odor, making it easier to detect in case of a leak.
The search of natural gas is quite similar to the search for crude oil. Geologists identify
land parcels which are likely to contain natural gas. Sometimes, these land parcels are
on the surface of the earth and sometimes this can be offshore, deep inside, on the
ocean floor. Geologists use the seismic surveys to identify the right place to drill in
order to maximize the probability of finding natural gas. If the site seems promising,
then an exploratory well is drilled to investigate further. Further, if the economics favor
then more wells are drilled and the natural gas is extracted from the ground.
India is the 7th largest producer of natural gas in the world, accounting for nearly 2.5%
of the natural gas production in the world. The bulk of the natural gas produced in Indi a
is used towards power generation, industrial fuel, and LPG. A large chunk is also used
in the fertilizer industry as feedstock.
Needless to say, this discussion on Natural Gas – production and application can get
quite vast, but I guess we are good to stop here, considering we are looking at Natural
gas from a short-term trading approach.
We will move ahead to discuss the contract specification.
However, no discussion on Natural gas is complete without talking about the ‘Amarant
Natural Gas gamble’. J
16.2 – Amaranth Natural gas gamble

Amaranth Advisors, established around 2000, was a US-based multi-strategy hedge
fund operating from Greenwich, Connecticut. The fund had its interest in various hedge
fund strategies ranging from convertible bonds, merger arbitrage, leveraged assets,
and energy trading. By mid-2006, the fund had become a $9 Billion behemoth; this
included the profits that were ploughed back to the fund. This positioned Amaranth as
one of US’s top-performing hedge fund.
Amaranth’s energy trading desk picked up activity (and a lot of attention) when a star
trader named Brain Hunter joined Amaranth’s trading team. Hunter had previously
gained a lot of a popularity for his energy trading strategies (mainly natural gas) at
Deutsche Bank. Apparently, he made few millions of dollars as annual bonuses. His
success continued when he joined Amaranth to head the energy desk – where he traded
natural gas for obvious reasons. Hunter ensured profits rolled for Amaranth and its
clients, so much so that Amaranth netted close to $2 Billion by April 2006. Both
Amaranth’s clients and management were quite seduced by Hunter’s trading skills.
At this stage, I have to mention this – although an international commodity, natural gas
trading was highly vulnerable. Any midsized hedge fund could easily corner the market
by taking positions in few thousands of contracts. This made Amaranth one the largest
hedge funds operating in the natural gas market.
Anyway, here is what happened post-April 2006 –
1. Hunter noticed a surplus inventory of natural gas in the US, which would drive
the price of natural gas lower in the US
2. Inventory of Natural gas, unlike oil, cannot be easily moved to cater to supply -
demand pressures
3. He also expected a harsh winter (or perhaps a hurricane) to ensue, which quite
obviously would exert pressure on the supplies and push the price of Natural gas
higher
4. Apparently, Hunter had profited when hurricane Katrina and Rita had hit the US
coastlines in 2005
5. He set up complex strategies at multiple points across multiple contracts to
benefit from his staggered point of view. These were highly leveraged,
speculative futures positions
6. However, nature had a different game plan for Hunter and Amaranth – the
possibilities of a hurricane diminished, supplies continued to pour
7. Bulls started to unwind, triggering the price of Natural Gas below the
psychological support of $5.5
8. This further triggered a panic sell leading to a single day fall of 20% Natural gas’s
price
9. Amaranth was hit quite hard but Hunter’s conviction and reputation were still
intact. They now borrowed money and doubled down on their positions
10. The leverage was as high as 1 to 8, meaning for every 1 USD of their own capital,
they had 8 USD in borrowed capital
11. This didn’t stop natural gas prices to tank further, prices continued to crash, and
along with the price Amaranth too crashed
12. Amaranth was forced to liquidate and take a hit of $6 Billion USD, making it one
of the largest hedge fund fiascos in the world.
If there is one key lesson you get to learn from the Amaranth’s episode, then it has to
be (yet again) the importance of risk management. Risk management sits above all and
has the authority of question every aspect of your trade.
Respect risk and risk respects you back, ignore it and it will show you the corner.
For this reason, we will dedicate the whole of next module to Risk and trading
psychology.
For now, let us proceed to discuss the contract specs of Natural Gas.
16.3 – Contract specifications

The contact specs for Natural Gas are as below –
o Price Quote – Rupee per Million British Thermal Unit (mmBtu)
o Lot size – 1250 mmBtu
o Expiry – 25th of every month
o Delivery units – 10,000 mmBtu
Here is the snap quote of the Natural gas expiring in Feb 2017 –
The price, as seen here, is Rs. 217.3 per mmBtu. Therefore the contract value would be
–
Lot size * price
= 1250 * 217.3
= Rs. 271,625/-
As you can see, the NRML (for overnight positions) margin is Rs. 40,644/-. This makes
it about 15% margin for NRML orders (probably one of the highest in the markets) and
MIS margin is Rs.20,322/- which makes it about 7% for MIS positions.
The contract introduction and expiry logic is quite straightforward, have a look at the
table below –
Every 4 months a new contract is introduced. For example, the January 2017 contract
was introduced in Oct 2016, and this contract expires on 25th of Jan 2017.
Here is something that you need to know – although, Natural Gas in an international
commodity, its spot price in India is also dependent on how the domestic demand and
supply situation pans out. However, the futures contract listed on MCX closely mirrors
the Natural gas listed on NYMEX.
This is the graph of the Natural Gas futures contract on MCX overlaid with NYMEX – quite
evidently, both the futures contracts move in unison. Given this, the following events
have a significant impact on the natural gas prices on NYMEX and therefore MCX natural
gas futures –
o Natural Gas inventory data – increase in inventory tends to lower the futures
price and decrease in inventory data tends to increase the futures price
o US weather conditions – the US is the biggest natural gas market, so US
weather conditions really matter. A harsh winter in the US leads to more natural
gas consumption (as people use natural gas to heat homes) and therefore the
inventory is consumed rapidly leading to increasing in price.
o Hurricane in the US – Hurricane besides disrupting the weather conditions also
tends to disrupt inventories. Hence, if you see a hurricane approaching the US
coast, be prepared to go long in Natural Gas or at least, do not short natural gas
contracts
o The price of Crude oil – Natural gas is not only a cleaner fuel compared to crude
but also costs much lower. Historically, the two contracts are highly correlated,
although the correlation is not holding up over the recent few months. Check
this!
So, next time you are trading natural gas, make sure to check how the sun is shining in
the US!
And with this, folks, we will conclude this chapter on Natural Gas and this module on
Currencies and commodities. We hope you liked reading this module as much as we
enjoyed writing it for you.
Onwards to Risk and Trading psychology!
1. Natural gas occurs naturally and is found deep underground.

2. Natural Gas has been in use since ancient times.
3. Primary use of natural gas includes power generation, heating, cooking etc.,.
4. India is the 7th largest natural producer of natural gas.
5. Lot size of natural gas is 1250 MMBtu, price quote if for 100 mmBtu.
6. P&L per tick is Rs.125/- per tick.
7. Natural gas futures on MCX mimic s the price movement of Natural gas on
NYMEX.
CHAPTER 17
Commodity Options
17.1 – Commodity options, finally!

My first commodity trade was on pepper futures and this was sometime towards the
end of 2005 or early 2006. Since then I’ve closely tracked the developments of the
commodities market and the commodities exchanges in India. MCX has done a
tremendous job in promoting commodities market in India. They have continuously
introduced new contracts and enhanced the market depth. Liquidity too has improved
many fold since then. If I remember right, sometime around 2009, there was an attempt
to introduce options in the commodity market. Needless to say, when I first heard
about this, I was quite excited thinking about all the possibilities that one would have
trading commodity options.
But unfortunately, this never came through and the commodities options were never
introduced in the market. Since then, this topic on commodities options has surfaced
couple of times but each time, it just remained a market rumor.
However, it now appears that options on commodities will finally hit the market
sometime soon. Around June 2017, SEBI cleared the files to permit commodities
options.
You can read the new article here.
Since then commodities exchanges have been working hard to build a good framework
to introduce the commodities options. Given this, I thought it would be good to have
this quick note on what to expect and what to look for in the commodities options
market.
For those who are not too familiar about options, I’d suggest you start reading the
module on Options here.
Just like futures, the options theory for commodities would remain the same. You have
to just pay attention to logistics, and that’s the objective of this chapter.
17.2 – Black 76
One of the important bits that you need to note with commodity options is that these
are options on Futures and not really the spot market.
For example, if you look at a call option on Biocon, the underlying for this option is the
spot price of Biocon. Likewise, if you look at Nifty options, the underlying is the spot
Nifty 50 index value. However, if you were to look at an option on Crude Oil, the
underlying here is not the spot price of Crude Oil. This is quite intuitive as we do not
have a spot market for Crude Oil or for that matter any commodities in India. However,
we do have a vibrant futures market. Hence the commodity options are based on the
commodity futures market.
If one were to talk about the crude oil options, then you need to remember the
following –
1. The underlying for Crude oil option is Crude oil Futures

2. The underlying for crude oil futures is the price of Crude Oil on NYMEX
So in a sense, this can be considered a derivative on a derivative. For all practical
purpose, this should not really matter to you while trading. The only technical
difference between an regular option (with spot as underlying) and option on futures
is the way in which the premium is calculate. For the former, the premium can be
calculated by using a regular Black & Scholes model and for the latter a model called
Black 76 is used.
The difference between these two models is the way in which the continuous
compounded risk-free rate is treated. I will not get into the details at this point. But do
remember this – there are plenty of Black & Scholes calculators online, so don’t be in a
hurry to punch in the commodities variables in a standard B&S calculator to extract the
premium value and Greeks. It simply won’t work
17.3 – Contract Specifications

We still do not know how the exchanges will set up the framework for these options.
However, we did take a look at the mock framework and I’m guessing it won’t be too
different from that.
To begin with, exchanges may roll out Gold options, and would slowly but for surely
introduce options on other commodities. Here are the highlight.
Option Type – Call and Puts
Lot size – Since these are options on futures, the lot size will be similar to the futures
lot size
Order Types – All order types would be permitted (IOC, SL, SLM, GTC, Regular, Limit)
Exercise style – Options are likely to be European in nature
Margins – SPAN + Exposure margin applicable for option writing and full premium to
be paid for option buying. A concept of devilment margin will come into play, I’ve
discussed this towards the end
Last trading day (for Gold) – 3 days prior to the last tender day
Strikes – Considering one ‘At the money strike’ (ATM), there would be 15 strikes above
and 15 strikes below ATM, taking the total to 31 strikes.
This is where it gets a little tricky. Equity option traders are used to the following
‘Option Moneyness’ convention –
1. At the Money (ATM) Options = This is when the spot is in and around the strike.
So in a given series, only 1 strike is considered ATM
2. In the Money (ITM) = All call option strike below the ATM and all put option
strikes above the ATM are considered ITM options
3. Out of the Money (OTM) = All call option strike above the ATM and all put option
strikes below the ATM are considered Out of the Money (OTM) options
However, the commodities options will introduce us to a new terminology – ‘Close to

Money’ (CTM) and this is how it will work –
1. ATM – The strikes closest to the settlement price is considered ATM

2. CTM – Two strikes above and two strikes below ATM are considered CTM
3. OTM and ITM – The definition remains the same as in Equity.
Settlement – For daily M2M settlement in Futures, the exchange considers the
commodities daily settlement price (DSP) as the reference value. The DSP of the
commodity on the expiry day will therefore be the reference value for the options series
as well.
Let’s quickly understand how the settlement works. Consider this example – Assume
the DSP of a commodity is 100. Assume this commodity has a strike interval at every 10
points. Given this, let’s identify the moneyness of strikes –
1. ATM = 100
2. CTM = 80, 90, 100, 110, and 120. Note, we have included two strikes above and
below ATM
3. OTM = All Call option above 100 and all Put options below 100 are considered
OTM and therefore worthless
4. ITM = All Call options below 100 (including 80 and 90, which are CTM) are ITM,
and all Put options above 100 (including 110 and 120, which are CTM) are ITM.
All long option holders which are ‘CTM’, will have to give something called as an
‘explicit instruction’. An explicit instruction will devolve the option into a futures
contract. The futures contract will be at the strike. For example if I hold 80 call option,
then upon an ‘explicit instruction’, the call option will be devolved into a long futures
position at 80. I’m guessing the ‘explicit instruction’, will be tendered via the trading
terminal.
Now, here is an important thing that you need to remember – If you do not give an
explicit instruction to devolve your CTM option, then the option will be deemed
worthless.
All ITM option, except CTM, will get automatically settled. You need to be aware that
settlement in options market is by means of devolving the option into an equivalent
futures position. If you are holding a non-CTM, ITM option and you wish not to settle
this automatically, then you need to give a ‘Contrary instruction’. In the absence of
which, the contract will be automatically settled by means of devolvement.
Now, the question is why would you not want to exercise an ITM option?
There could be an instance where the ITM option that you have may not be worth
exercising given the taxation and other applicable charges. So in this case, you are
better off not exercising your ITM option rather than exercising it. So, this is when you
use the ‘Contrary instruction’, privilege and opt not to exercise your ITM option.
17.4 – Devolvement into Futures contract

So assume you have an ITM (including CTM) option, and upon expiry the option will be
converted (or devolved) into a Futures position. Now, we all know that a futures
position requires margins to be parked with the broker. How do we account for this? I
mean, when I go long on option, I just have to pay for the premium right? Naturally, at
the time of buying the option, I would not park additional margin anticipating that the
option ‘might’ get devolved into a futures position.
To circumvent this, there is a concept of ‘Devolvement Margin’. I will cut through the
technicalities and let you know what you should know and expect –
Commodity options will expire few days before the first tender date of the futures
contract. This means, there will be few days gap between the expiry of the futures
contract and the options contract
Few days before the options can expire, exchanges will conduct a ‘What if scenario’
and generates a ‘Sensitivity Report’ to identify strikes which are likely to be ITM and
CTM
For all such options, exchanges will start assigning ‘Devolvement Margin’, this
means you will have to fund your account with enough margin money to carry
forward the option position. Half of the required margin needs to be available a day
before the expiry and the remaining half on the day of expiry of the options contract
to convert the position to a futures contract
For example, The Expiry of the Gold option contract is on 28 November 2017 and the
futures contract expires on 5 December 2017. Half of the margin needs to be added
to the account on 27 November and the remaining on 28 November
If you holding a deep ITM option, then the profits arising out of this position will be
considered to offset a portion of the margins required
Given the above point, the deeper the option, lesser would be the margin required.
This also means CTM options will attract higher margins
In simpler words, if you are holding a commodity option, and it’s likely to expire
ITM, and you intend to carry to expiry, then you need ensure you bring in margin
money as you approach expiry
How much margin, expiry dates, tender date etc will vary based on the commodity
Here is a quick note on how the options position will be devolved.
Option Position Devolved into
Long Call Long Futures
Short Call Short Futures
Long Put Short Futures
Short Put Long Futures.
I guess as and when the option contracts roll out, we will have greater insight into the
structure. I will update this chapter when the commodity options roll out with the exact
information.
Stay tuned.
1. Options on commodities will be on Futures as underlying

2. One cannot use the regular Black & Scholes Calculator for identifying the
premium and Greeks
3. Black 76 is the model used for Options on futures
4. Upon exercising the option devolves into a futures position
5. CTM options are two strikes above and below ATM
6. If a CTM option holder does not give an explicit instruction, then the option is
deemed worthless
7. An ITM option holder can give a ‘contrary instruction’, to choose not to exercise
the option. You would opt for this if you know that the position is not going to
be profitable owing to taxes and applicable charges
ZERODHA
Risk Management
& Trading Psychology
ZERODHA.COM/VARSITY
Table of Contents
1 Orientation note 1
2 Risk (Part 1) 4
3 Risk (Part 2) – Variance & Covariance 10
4 Risk (Part 3) – Variance & Covariance Matrix 18
5 Risk (Part 4) – Correlation Matrix & Portfolio Variance 27
6 Equity Curve 36
7 Expected Returns 43
8 Portfolio Optimization (Part 1) 50
9 Portfolio Optimization (Part 2) 61
10 Value at Risk 72
11 Position Sizing for active trader 84
12 Position Sizing for active traders (Part 2) 92
13 Position Sizing for active traders (Part 3) 98
14 Kelly’s Criterion 105
15 Trading Biases 114
16 Trading Biases (Part 2) 121

CHAPTER 1
Orientation Note
1.1 – A unique opportunity

I’m excited about this brand new module on Varsity, wherein we will be discussing two
important and closely related market topics – ‘Risk Management and Trading Psychology’.
While risk management may seem straightforward, ‘psychology’ may sound boring. Trust me;
both these topics can potentially open up new realms of trading. Risk management, for
instance, is not what you are thinking – it goes beyond the usual topics of position sizing,
stop loss and leverage. While trading psychology is a reflection of your actions in the markets
– helps you introspect and find answers to why and how you made a profit or a loss in a
particular trade or investment.
Given the exhaustive nature of these topics, I tried looking for ideas on how best I can
structure this module, and what chapters to include, and to my surprise, there are no
contents related to these topics. Of course, you can find tonnes of content online, but they
are all fragmented and lack continuity. This gives us both the opportunity and the
responsibility to develop some dependable content around these topics, centered on the
Indian context. We will have to work as a team here – we will take up the responsibility to
post the content and you will have to take up the responsibility to enrich it by posting queries
and comments.
1.2 – What to expect?
At this stage, I can give you a brief orientation on what to expect, however as we proceed, if
necessary I’ll take the liberty to alter the learning methodology, although not too drastically.
So there are 2 main topics we are dealing with here –
1. Risk Management
2. Trading psychology
Risk management techniques vary based on how you are positioned in the market. For
example, if you have a single position in the market, then your approach to risk management
is very different compared to the risk management techniques of multiple positions, which is
again completely different compared to the risk management techniques of a portfolio.
Given this, we will look at risk management from multiple angles –
1. Risk Management from a single trading position

2. Risk management from multiple trading positions
3. Risk management for a portfolio
In my attempt to explain the above, I will cover the following topics –
1. Risk and its many forms

2. Position sizing – guess this one is mandatory to cover
3. Single position risk
4. Multiple position risk and hedging
5. Hedging with options
6. Portfolio attributes and risk estimation
7. Value at Risk
8. Asset allocation and its impact on risk (and returns)
9. Insights from the portfolio equity curve
I’m guessing these topics will give you a completely different perspective on risk and how
one can manage risk.
Further, we would be discussing trading psychology both from a trader and an investor’s
perspective. The discussion would largely involve cognitive biases, mental models, common
pitfalls, and the thought process which leads you these pitfalls. Here are some of the topics
we would be discussing in this section –
1. Anchoring bias
2. Regency bias
3. Confirmation bias
4. Bandwagon effect
5. Loss aversion
6. Illusion of control
7. Hindsight bias
Of course, we will build upon this as we proceed. This is going to be an exciting discussing
these topics.
Stay tuned.
CHAPTER 2
Risk (Part 1)
2.1. Warming up to risk
For every rupee of profit made by a trader, there must be a trader losing that rupee. As an
extension of this, if there is a group of traders consistently making money, then there must
be another group of traders consistently losing money. Usually, this group making money
consistently is small, as opposed to the group of traders who lose money consistently.
The difference between these two groups is their understanding of Risk and their techniques
of money management. Mark Douglas, in his book ‘The Disciplined Trader’, say s successful
trading is 80% money management and 20% strategy. I could not agree more.
Money management and associated topics largely involve assessment of risk. So in this sense,
understanding risk and its many forms become essential at this point. For this reason, let us
break down risk to its elementary form to get a better understanding of risk.
The usual layman definition of risk in the context of the stock market is the ‘probability of
losing money’. When you transact in the markets, you are exposed to risk, which means you
can (possibly) lose money. For example, when you buy the stock of a company, whether you
like it or not, you are exposed to risk. Further, at a very high level, risk can be broken down
into two types – Systematic Risk and Unsystematic Risk. You are automatically exposed to
both these categories of risks when you own a stock.
Think about it, why do you stand to lose money? Or in other words, what can drag the stock
price down? Many reasons as you can imagine, but let me list down a few –
1. Deteriorating business prospects

2. Declining business margins
3. Management misconduct
4. Competition eating margins
All these represent a form of risk. In fact, there could be many other similar reasons and this
list can go on. However, if you notice, there is one thing common to all these risks – they are
all risks specific to the company. For example, imagine you have an investable capital of
Rs.1,00,000/-. You decide to invest this money in HCL Technologies Limited. A few months
later HCL declares that their revenues have declined. Quite obviously HCL stock price will also
decline. Which means you will lose money on your investment. However, this news will not
impact HCL’s competitor’s stock price (Mindtree or Wipro). Likewise, if HCL’s management is
guilty of any misconduct, then HCL’s stock price will go down and not its competitors. Clearly,
these risks are specific to this one company alone and not its peers.
Let me elaborate on this – I’m not sure how many of you were trading the markets when the
‘Satyam scam’ broke out on the morning of 7th January 2009. I certainly was, and I remember
the day very well. Satyam Computers Limited had been cooking its books, inflating numbers,
mishandling funds, and misleading its investors for many years. The numbers sho wn were
way above the actual, myriads of internal party transactions; all these resulting in inflated
stock prices. The bubble finally burst, when the then Chairman, Mr.Ramalinga Raju made a
bold confession of this heinous financial crime via a letter addressed to the investors,
stakeholders, clients, employees, and exchanges. You have to give him credit for taking such
a huge step; I guess it takes a massive amount of courage to own up to such a crime, especially
when you are fully aware of the ensuing consequences.
Anyway, I remember watching this in utter disbelief – Udayan Mukherjee read out this super
explosive letter, live on TV, as the stock price dropped like a stone would drop off a cliff. This,
for me, was one of the most spine-chilling moments in the market, watch the video here
I want you to notice few things in the above video –
1. The rate at which the stock price drops (btw, the stock price continued to drop to as
low as 8 or 7)
2. If you manage to spot the scrolling ticker, notice how the other stocks are NOT reacting
to Satyam’s big revelation
3. Notice the drop in the indices (Sensex and Nifty), they do not drop as much as that of
Satyam.
The point here is simple – the drop in stock price can be attributed completely to the events
unfolding in the company. Other external factors do not have any influence on the price drop.
Rather, a better way of placing this would be – at that given point, the drop in stock price can
only be attributable to company specific factors or internal factors. The risk of losing money
owing to company specific reasons (or internal reasons) is often termed as “Unsystematic
Risk”.
Unsystematic risk can be diversified, meaning instead of investing all the money in one
company, you can choose to invest in 2-3 different companies (preferably from different
sectors). This is called ‘diversification’. When you diversify your investments, unsystematic
risk drastically reduces. Going back to the above example, imagine instead of buying HCL for
the entire capital, you decide to buy HCL for Rs.50,000/- and maybe Karnataka Bank Limited
for the other Rs.50,000/-, in such circumstances, even if HCL stock price declines (owing to
the unsystematic risk) the damage is only on half of the investment as the other half is
invested in a different company. In fact, instead of just two stocks, you can have a 5 or 10 or
maybe 20 stock portfolio. The higher the number of stocks in your portfolio, higher the
diversification, and therefore lesser the unsystematic risk.
This leads us to a very important question – how many stocks should a good portfolio have
so that the unsystematic risk is completely diversified. Research has it that up to 21 stocks in
the portfolio will have the required necessary diversification effect and anything beyond 21
stocks may not help much in diversification. I personally own about 15 stocks in my equity
portfolio.
The graph below should give you a fair sense of how diversification works –
As you can notice from the graph above, the unsystematic risk drastically reduces when you
diversify and add more stocks. However, after about 20 stocks, the unsystematic risk is not
really diversifiable, this is evident as the graph starts to flatten out after 20 stocks. In fact,
the risk that remains even after diversification is called the “Systematic Risk”.
Systematic risk is the risk that is common to all stocks in the markets. Systematic risk arises
out of common market factors such as the macroeconomic landscape, political situation,
geographical stability, monetary framework etc. A few specific systematic risks which can
drag the stock prices down are: –
1. De-growth in GDP
2. Interest rate tightening
3. Inflation
4. Fiscal deficit
5. Geopolitical risk
The list, as usual, can go on but I suppose you get a fair idea of what constitutes a systematic
risk. Systematic risk affects all stocks. Assuming, you have a well diversified 20 stocks
portfolio, a de-growth in GDP will indiscriminately affect all the 20 stocks and hence the stock
price of stocks across the board will decline. Systematic risk is inherent in the system and it
cannot really be diversified. Remember, ‘unsystematic risk’ can be diversified, but systematic
risk cannot be. However, systematic risk can be ‘hedged’. Hedging is a craft, a technique one
would use to get rid of the systematic risk. Think of hedging as carrying an umbrella with you
on a dark cloudy day. The moment, it starts pouring, you snap your umbrella out and you
instantly have a cover on your head.
So when we are talking about hedging, do bear in mind that it is not the same as
diversification. Many market participants confuse diversification with hedging. They are two
different things. Remember, we diversify to minimise unsystematic risk and we h edge to
minimise systematic risk and notice I use the word ‘minimise’ – this is to emphasise the fact
that no investment/trade in the market should be ever considered safe in the markets.
Not mine, not yours.
2.2 – Expected Return

We will briefly talk about the concept of ‘Expected Return’ before we go back to the topic of
Risk. It is natural for everyone to expect a return on the investments they make. The expected
return on an investment is quite straight forward – the return you would expect from it. If you
invest your money in Infosys and expect to generate 20% return in one year, then the
expected return is just that – 20%.
Why is this important especially when it sounds like a no-brainer? Well, the ‘expected return’
plays a crucial role in finance. This is the number we plug in for various calculations – be it
portfolio optimisation or a simple estimation of equity curve. So in a sense, expecting a
realistic return plays a pivotal role in investment management. Anyway, more on this topic
as we proceed. For now, let us stick to basics.
So continuing with the above example – if you invest Rs.50,000/- in Infy (for a year) and you
expect 20% return, then the expected return on your investment is 20%. What if instead, you
invest Rs.25,000/- in Infy for an expected return of 20% and Rs.25,000/- in Reliance Industries
for an expected return of 15%? – What is the overall expected return here? Is it 20% or 15% or
something else?
As you may have guessed, the expected return is neither 20% nor 15%. Since we made
investments in 2 stocks, we are dealing with a portfolio, hence, in this case, the expected
return is that of a portfolio and not the individual asset. The expected return of a portfolio
can be calculated with the following formula –
E(RP) = W1R1 + W2R2 + W3R3 + ———– + WnRn
Where,
E(RP) = Expected return of the portfolio
W = Weight of investment
R = Expected return of the individual asset
In the above example, the invested is Rs.25,000/- in each, hence the weight is 50% each.
Expected return is 20% and 15% across both the investment. Hence –
E(RP) = 50% * 20% + 50% * 15%
= 10% + 7.5%
= 17.5%
While we have used this across two stocks, you can literally apply this concept across any
number of assets and asset classes. This is a fairly simple concept and I hope yo u’ve had no
problem understanding this. Most importantly, you need to understand that the expected
return is not ‘guaranteed’ return; rather it is just a probabilistic expectatio n of a return on an
investment.
Now that we understand expected returns, we can build on some quantitative concepts like
variance and covariance. We will discuss these topics in the next chapter.
1. When you buy a stock you are exposed to unsystematic and systematic risk
2. Unsystematic risk with respect to a stock is the risk that exists within the company
3. Unsystematic risk affects only the stock and not its peers
4. Unsystematic risk can be mitigated by simple diversification
5. Systematic risk is the risk prevalent in the system
6. Systematic risk is common across all stock
7. One can hedge to mitigate systematic risk
8. No hedge is perfect – which means there is always an element of risk present while
transacting in markets
9. Expected return is the probabilistic expectation of a return
10. Expected return is not a guarantee of return
11. The portfolio’s expected return can be calculated as – E(RP) = W1R1 + W2R2 + W3R3 +
———– + WnRn
CHAPTER 3
Risk (Part 2) – Variance & Covariance
3.1. Variance
In the previous chapter, we touched upon the topic of expected return, continuing on it, we
will understand the concept of ‘Portfolio variance’. Portfolio Variance helps us understand
the risk at a portfolio level. I’m hoping you are familiar with ‘Standard Deviation’ as a measure
of risk. We have discussed standard deviation multiple times in the previous modules (refer
to Module 5, chapter 15 onwards). I’d suggest you get familiar with it if you are not already.
While we can easily measure the risk of a single stock by calculating its standard deviation,
calculating the risk of a portfolio is a whole different ball game. When you put a few individual
stocks together and create a portfolio, it becomes a different animal altogether . The agenda
for this chapter is to help you understand how to estimate risk at a portfolio level.
However, before we proceed, we need to understand the concept of Variance and Covariance.
Both Variance and Covariance are statistical measures. Let’s deal with the Variance first.
The variance of stock returns is a measure of how much a stock’s return varies with respect
to its average daily returns. The formula to calculate variance is quite straight forward –
Where,
σ2 = Variance
X = Daily return
µ = Average of daily return
N = Total number of observation
Note, the variance is measured as sigma squared; I will not get into the reasons for this as the
explanation is quite complex and we could digress. For now, I’d request you to be aware of
the fact that variance is sigma squared. Anyway, calculating variance is quite simple, I’ll take
a simple example to help us understand this better.
Assume the daily return for a stock for 5 consecutive days is as below –
Day 1 – + 0.75%
Day 2 – + 1.25%
Day 3 – -0.55%
Day 4 – -0.75%
Day 5 – +0.8%.
In this case, the average return is +0.3%. We now need to calculate the dispersion of daily
return over its average return, and also square the dispersion.
Daily Return Dispersion from average Dispersion squared
+ 0.75% 0.75% – 0.3% = + 0.45% 0.45%^2 = 0.002025%
+ 1.25% +1.25% – 0.3% = + 0.95% 0.95%^2 = 0.009025%
-0.55% -0.55% – 0.3% = -0.85% -0.85%^2 = 0.007225%
-0.75% -0.75% – 0.3% = -1.05% -1.05%^2 = 0.011025%
Daily Return Dispersion from average Dispersion squared
+0.80% +0.8% – 0.3% = +0.5% 0.50%^2 = 0.002500%
We now sum up the dispersion squared to get 0.0318000%. We divide this over 5 (N) to get
the variance i.e.
0.0318000% / 5
σ2 = 0.0063600%.
So what does this number tell us? It gives us a sense of how the daily returns are spread out
from the average expected returns. So you as an investor should look into the variance to
determine the riskiness of the investment. A large variance indicates that the stock could be
quite risky while a small variance can indicate lesser risk. In the above example, I would
consider the variance high, since we are looking at just 5 days’ worth of data.
Now, here is something you may be interested in knowing. Variance and standard deviation
are related to each other by the following simple mathematical relationship –
Square Root of Variance = Standard Deviation
We can apply this to the example above and calculate the 5-day standard deviation of the
stock,
~ 0.8%
which is the standard deviation a.k.a. the volatility of the stock (over the last 5 days). Anyway,
at this point, I want you to be aware of Variance and what it really means. We will eventually
plug variance along with covariance into the portfolio variance equation.
3.2 – Covariance
Covariance indicates how two (or more) variables move together. It tells us whether the two
variables move together (in which case they share a positive covariance) or they move in the
opposite direction (negatively covariance). Covariance in the context of stock market
measures how the stock prices of two stocks (or more) move together. The two stocks prices
are likely to move in the same direction if they have a positive covariance; likewise, a negative
covariance indicates that they two stocks move in opposite direction.
I understand covariance may sound similar to ‘correlation’, however, the two are different.
We will discuss more on this further in the chapter.
I guess calculating the covariance for two stocks will help us get a grip on understanding
covariance better. The formula to calculate covariance of two stocks is as follows –
Where,
Rt S1 = Daily stock return of stock 1
Avg Rt S1 = Average return of stock 1 over n period
Rt S2 = Daily stock return of stock 2
Avg Rt S2 = Average return of stock 2 over n period
n – The total number of days
In other words, you can calculate the covariance between two stocks by taking the sum
product of the difference between the daily returns of the stock and its average return across
both the stocks.
Sounds confusing? I guess so.
Let us take up an example and see how we can calculate the covariance between two stocks.
For the sake of this illustration, I’ve selected two stocks – Cipla Limited and Idea Cellular
Limited. To calculate the covariance between these two stocks, we need to work around with
the above formula. We will resort to good old excel to help us implement the formula.
Before we proceed, if you were to guess the covariance between Cipla and Idea, what do you
think it would be? Think about it – two large corporate, similar size, but in two completely
unrelated sectors. What do you think would be the covariance? Give it a thought.
Anyway, here are the steps involved in calculating covariance in excel (note, although there
is a direct function in excel to calculate covariance, I’ll take the slightly longer approach, just
to ensure clarity) –
Step 1 – Download the daily stock prices. For the purpose of this illustration, I’ve downloaded
6 months’ data for both the stocks.
Step 2 – Calculate the daily returns for both the stocks. Daily returns can be calculated by
dividing today’s stock price over yesterday’s stock price and subtracting 1 from the result of
this division
Step 3 – Calculate the average of the daily returns
Step 4 – Once the average is calculated, subtract the daily return by its average
Step 5 – Multiply the two series calculated in the previous step
Step 6 – Sum up the calculation made in the previous step. Take a count of the number of
data points. You can do this by using the count function in excel and giving any of the fields
as the input array. I’ve used the count on the dates here.
Step 7 – This is the final step in calculating the covariance. To do so, one needs to divide the
sum by count minus 1 i.e. (n-1). The count, in this case, is 127, so count-1 would be 126. Sum
calculated in the previous step was 0.006642. Hence, covariance would be
= 0.006642/126
= 0.00005230
You can download the excel sheet.
As you can see, the covariance number is quite small. However, that’s not the point here. We
only look at whether the two stocks share a positive or negative covariance. Clearly, since t he
two stocks share a positive covariance, it means that the returns of the two stocks move in
similar directions. It means that for a given situation in the market, both the stocks are likely
to move in the same direction. Note – covariance does not tell us the degree to which the two
stocks move. The degree or magnitude is captured by correlation. The correlation between
Idea and Cipla is 0.106, which indicates that the two stocks are not tightly correlated.
By the way, here is something very interesting fact. The mathematical equation for
correlation between two stocks is as follows –
Where,
Cov (x,y) is the covariance between the two stocks
σx = Standard deviation of stock x
σy = Standard deviation of stock y
Note, the standard deviation of a stock is simply the square root of the variance of the stock.
Here is a task for you – we have calculated the correlation between Idea and Cipla using the
direct excel function. Can you confirm the accuracy by implementing the formula?
Anyway, in the case of building a stock portfolio, do you think a positive covariance is good
or bad? Or rather do portfolio managers desire stocks (in their portfolio) whi ch share a
positive covariance or they don’t? Well, portfolio managers strive to select stocks which share
a negative covariance. The reason is quite simple – they want stocks in the portfolio which
can hold up. Meaning if one stock goes down, they want, at least the other to hold up. This
kind of counter balances the portfolio and reduces the overall risk.
Now, think about a regular portfolio – it will certainly contain more than 2 stocks. In fact, a
good portfolio will contain at least 12-15 stocks. How would one measure covariance in this
case? This is where things start getting complicated. One will have to measure covariance of
each stock with all the other stocks in the portfolio. Let me illustrate this with a 4 stocks
portfolio. Assume the portfolio is like this –
1. ABB
2. Cipla
3. Idea
4. Wipro
In this case, we need to calculate the covariance across –
1. ABB, Cipla
2. ABB, Idea
3. ABB, Wipro
4. Cipla, Idea
5. Cipla, Wipro
6. Idea, Wipro
Note, the covariance between stock 1 and stock 2 is the same as the covariance between
stock 2 and stock 1. So as you can see, 4 stocks require us to compute 6 covariances. You can
imagine the complexity when we have 15 or 20 stocks. In fact, when we have more than 2
stocks in the portfolio, the covariance between them is calculated and tabulated using a
‘Variance – Covariance Matrix’. I would love to talk about this now, but I guess, I’ll will keep it
for the next chapter.
Stay tuned for more!
1. Variance measures the dispersion of returns over the expected average returns
2. Higher variance indicates higher risk, lower variance indicates lower risk
3. Square root of variance is standard deviation
4. Covariance between the returns of two stock measures how the returns of the two
stocks vary
5. A positive covariance indicates that the returns move positively and a negative
covariance indicates that while one stock returns moves up, the other comes down
6. Correlation measures the strength of the movement
7. Covariance between two stocks divided over their individual standard deviations
results in a correlation between two stocks.
8. When we have more than 2 stocks in a portfolio, we compute the variance -covariance
using a matrix
CHAPTER 4
Risk (Part 3) – Variance & Covariance Matrix

Let us begin this chapter with a quick recap of our discussion so far.
We started this module with a discussion on the two kinds of risk a market participant is
exposed to, when he or she purchases a stock – namely the systematic risk and the
unsystematic risk. Having understood the basic difference between these two types of risk,
we proceeded towards understanding risk from a portfolio perspective. In our discussion
leading to portfolio risk or portfolio variance, we discussed two crucial concepts – variance
and co variance. Variance is the deviation of a stock’s return with its own average returns. Co
variance on the other hand is the variance of a stock’s return with respect to another stock’s
return. The discussion on variance and co variance was mainly with respect to a two stock
portfolio; however, we concluded that a typical equity portfolio contains multiple stocks. In
order to estimate the variance co variance and the correlation of a multi stock portfolio, we
need the help of matrix algebra.
So that’s where we are as of now.
In this chapter we will extent this discussion to estimate the ‘variance co variance’ of multiple
stocks; this will introduce us to matrix multiplication and other concepts. However, the
‘variance covariance’ matrix alone does not convey much information. To make sense of this,
we need to develop the correlation matrix. Once we are through with this part, we use the
results of the correlation matrix to calculate the portfolio variance. Remember, our end goal
is to estimate the portfolio variance. Portfolio variance tells us the amount of risk one is
exposed to when he or she holds a set of stocks in the portfolio.
At this stage you should realize that we are focusing on risk from the entire portfolio
perspective. While we are at it we will also discuss ‘asset allocation’ and how it impa cts
portfolio returns and risk. This will also include a quick take on the concept of ‘value at risk’.
Of course, we will also take a detailed look at risk from a trader’s perspective. How one can
identify trading risk and ways to mitigate the same.
4.2 – Variance Covariance matrix
Before we proceed any further, I’ve been talking about ‘Variance Covariance matrix’. Just to
clear up any confusion – is it ‘variance covariance matrix’ or is it a variance matrix and a
covariance matrix? Or is it just one matrix i.e. the ‘Variance Covariance matrix’.
Well, is it just one matrix i.e. the ‘Variance Covariance matrix’. Think about it, if there are 5
stocks, then this matrix should convey information on the variance of a stock and it should
also convey the covariance of between stock 1 and the other 4 stock. Soon we will take up an
example and I guess you will have a lot more clarity on this.
Please do note – it is advisable for you to know some basis on matrix operations. If not, here
is a great video from Khan Academy which introduces matrix multiplication –
Anyway, continuing from the previous chapter, let us now try and calculate the Variance
Covariance matrix followed by the correlation matrix for a portfolio with multiple stocks. A
well-diversified (high conviction) portfolio typically consists of about 10-15 stocks. I’d have
loved to take up a portfolio of this size to demonstrate the calculation of the variance
covariance matrix, but then, it would be a very cumbersome affair on excel and there is a
good a newbie could get intimidated with the sheer size of the matrix, hence for this reason,
I just decided to have a 5 stock portfolio.
The following 5 stocks constitutes my portfolio –
1. Cipla
2. Idea
3. Wonderla
4. PVR
5. Alkem
The size of the variance covariance matrix for a 5 stock portfolio will be 5 x 5. In general, if
there are ‘k’ stocks in the portfolio, then the size of the variance covariance matrix will be k
x k (read this as k by k).
The formula to create a variance covariance matrix is as follows –
Where,
k = number of stocks in the portfolio
n = number of observations
X = this is the n x k excess return matrix. We will understand this better shortly
XT = transpose matrix of X
Here is a quick explanation of what is going on in that formula. You may understand th is
better when we deal with its implementation.
In simple terms, we first calculate the n x k excess return matrix; multiply this matrix by its
own transpose matrix. This is a matrix multiplication and the resulting matrix will be a k x
k matrix. We then divide each element of this k x k matrix by n, where n denotes the number
of observations. The resulting matrix after this division is a k x k variance covariance matrix.
Generating the k x k variance covariance matrix is one step away from our final object ive i.e.
getting the correlation matrix.
So, let us apply this formula and generate the variance covariance matrix for the 5 stocks
listed above. I’m using MS excel for this. I have downloaded the daily closing prices for the 5
stocks for the last 6 months.
Step 1 – Calculated the daily returns. I guess you are quite familiar with this by now. I’m not
going to explain how to calculate the daily returns. Here is the excel snapshot.
As you can see, I’ve lined up the stock’s closing price and next to it I have calculated the daily
returns. I have indicated the formula to calculate the daily return.
Step 2 – Calculate the average daily returns for each stock. You can do this by using the
‘average’ function in excel.
Step 3 – Set up the excess return matrix.
Excess return matrix is defined as the difference between stock’s daily return over its average
return. If you recall, we did this in the previous chapter while discussing covariance between
two stocks.
I’ve set up the excess return matrix in the following way –
Do note, the resulting matrix is of n x k size, where n represents the number of observations
(127 in this case) and k denotes the number of stocks (5 stocks). So in our example the matrix
size is 127 x 5. We have denoted this matrix as X.
Step 4 – Generate the XT X matrix operation to create a k x k matrix
This may sound fancy, but it is not.
XT is a new matrix, formed by interchanging the rows and columns of the original matrix X.
When you interchange the rows and columns of a matrix to form a new one, then it is referred
to as a transpose matrix of X and denoted as X T. Our objective now is to multiply the original
matrix with its transpose. This is denoted as X T X.
Note, the resulting matrix from this operation will result in a k x k matrix, wher e k denotes
the number of stocks in the portfolio. In our case this will be 5 x 5.
We can do this in one shot in excel. I will use the following function steps to create the k x k
matrix –
List down the stocks in rows and columns –
Apply the function = ‘MMULT ((transpose X), X). Remember X is the excess return matrix.
Do note, while applying this formula, you need to ensure that you highlight the k x k matrix.
Once you finish typing the formula, do note – you cannot hit ‘enter’ directly. You will
hit ctrl+shift+enter. In fact, for all array functions in excel, use ctrl+shift+enter.
So once you hit ctrl+shift+enter, excel will present you with a beautiful k x k matrix, which in
this case looks like this –
Step 5 – This is the last step in creating the variance covariance matrix. We now have to divide
each element of the X T X matrix by the total number of observations i.e. n. For your clarity, let
me post the formula for the variance covariance matrix again –
Again, we start by creating the layout for k x k matrix –
Once the layout is set, without deselecting the cells, select the entire X T X matrix and divide
it by n i.e. 127. Do note, this is still an array function; hence you need to
hit ctrl+shift+enter and not just enter.
Once you hit control shift enter, you will get the ‘Variance – Covariance’ matrix. Do note, the
numbers in the matrix will be very small, do not worry about this. Here is the variance co
variance matrix –
Let us spend some time to understand the ‘Variance – Covariance’ matrix better. Suppose I
want to know the covariance between any two stocks, let’s say Wonderla and PVR, then I
simply have to look for Wonderla on the left hand side and in the same row, look for the value
which coincides with PVR. This would be the covariance between the two stocks. I’ve
highlighted the same in yellow –
So the matrix suggests that the covariance between Wonderla and PVR is 0.000034. Do note,
this is the same as the covariance between PVR and Wonderla.
Further, notice the number highlighted in blue. This value corresponds to Cipla and Cipla.
What do you this represents? This represents the covariance between Cipla and Cipla, and if
you realize, covariance of a stock with itself, is nothing but variance!
This is exactly why this matrix is called ‘Variance – Covariance Matrix’, because it gives us
both the values.
Now, here is the bitter pill – the variance and covariance matrix on its own is quite useless.
These are extremely small numbers and it is hard to derive any meaning out of it. What we
really need is the ‘Correlation Matrix’.
In the next chapter, let us deal with generating the correlation matrix, and also work towards
estimating the portfolio variance, which is our end objective. However, before we close this
chapter, here are few tasks for you –
1. Download the last 1-year data for 5 or more stocks.

2. Calculate the Variance – Covariance matrix for the same
3. For a given stock, identify the variance value. Apply the = ‘Var()’ function on excel on
the returns of the same stock and evaluate if both are matching.
You can download the excel sheet used in this chapter.
Key Takeaways from this chapter
1. X is defined as an excess return matrix

2. Excess return matrix is simply the time series difference daily return versus the
average daily return
3. XT is defined as the transpose of X
4. Variable n is defined as the number of observations in the data set. For example, if you
have 6 months’ data, n is 127, for 1-year data n would be 252
5. Excess return matrix is of the size n x k, where k is the number of stocks
6. When you divide the matrix product of X T X by n, we get the variance covariance matrix
7. The variance covariance matrix is of the size k x k
8. The covariance of stock 1 with itself is the variance of stock 1
9. The variance covariance matrix will lead us to the correlation matrix.
CHAPTER 5
Risk (Part 4) – Correlation Matrix & Portfolio

Variance
5.1 – Correlation Matrix

In the previous chapter, we successfully calculated the variance co variance matrix. As we
discussed, these numbers are too small for us to make any sense. Hence, as a practice, it
always makes sense to calculate the correlation matrix when we calculate the variance
covariance matrix.
So let us go ahead and do this.
How is the correlation between two stocks calculated? Well, hopefully from the previous
chapter, you will recall the formula for correlation –
Where,
Cov (x,y) is the covariance between the two stocks
σx = Standard deviation of stock x
σy = Standard deviation of stock y
This works fine if we have 2 stocks in the portfolio, but since we have 5 stocks in the portfolio,
we need to resort to matrix operation to find correlations. So, when we have multiple stocks
in the portfolio, the correlations between stocks are all stacked up in a n x n (read it as n by
n) matrix. For example, if it is a 5 stock portfolio (5 being the n here), then we need to create
a 5 x 5 matrix.
The formula for calculating the correlation remains the same. Recall, from the previous
chapter, we have the variance-covariance matrix. For the sake of convenience, I’ll paste the
image again here –
This takes care of the numerator part of the formula. We need to now calculate the
denominator, which is simply the product of the standard deviation of stock A with the
standard deviation of stock B. If the portfolio has 5 stock, then we need the product of the
standard deviation of all possible combination between the stocks in the portfolio.
Let’s go ahead and set this up.
We first need to calculate the standard deviations of each of the stocks in the portfolio. I’m
assuming you are familiar how to do this. You just need to use the ‘=Stdev()’ function on the
daily returns array to get the standard deviations.
I’ve calculated the same on excel used in the previous chapter. Here is the image –
Given that we have the stock specific standard deviations; we now need to get the product of
the standard deviation of all possible portfolio combination. We resort to matrix
multiplication for this. This can be easily achieved by multiply the standard deviation array
with the transpose of itself.
We first create the matrix skeleton and keep all the cells highlighted –
Now, without deselecting the cells, we apply the matrix multiplication function. Note, we are
multiplying the standard deviation array with the transpose of itself. The image below should
give you an idea, do look at the formula used –
As I mentioned in the previous chapter, whenever you use matrix or array function in excel,
always hold the ‘ctrl+shit+enter’ combo. The resulting matrix looks like this –
At this point let me paste the formula for the correlation again –
The numerator is the variance covariance matrix as seen below, and the denominator is the
product of the standard deviations which we have just calculated above –
Dividing the variance co-variance matrix by the product of the standard deviations should
result in the correlation matrix. Do note, this is an element by element division, which is still
and array function, so the use of ‘ctrl+shit+enter’ is necessary.
The resulting correlation matrix looks like this –
The correlation matrix gives us the correlation between any two stocks. For example, if I have
to know the correlation between Cipla and Alkem, I simply have to look under the intersecting
cell between Cipla and Alkem. There are two ways you can do this –
1. Look at the row belonging to Cipla and scroll till the Alkem column
2. Look at the row belonging to Alkem and scroll till the Cipla column
Both these should reflect the same result i.e. 0.2285. This is quite obvious since correlation
between stock A with Stock B is similar to the correlation of Stock B with Stock A. For this
reason, the matrix displays symmetrically similar values above and below the diagonal.
Check this image below, I have highlighted the correlation between Cipla and Alkem and
Alkem and Cipla –
The correlations along the diagonal represents the correlation of certain stock with itse lf. Do
note, the correlation numbers above the diagonal is symmetrically similar to the correlation
numbers below the diagonal.
Needless to say, correlation of Stock A with Stock A is always 1, which is what we have got in
the diagonal and the same is highlighted in yellow boxes.
5.2 – Portfolio Variance

We are just few steps away from calculating the Portfolio Variance. As I have discussed earlier,
we need the portfolio variance to identify the extent of risk my portfolio is exposed to. With
this information, I’m no longer driving blind. In fact, one can develop many other insights
based on this. Of course, we will talk about this going forward.
The first step in calculating portfolio variance is to assign weights to the stocks. Weights are
simply the amount of cash we decide to invest in each stock. For example, if I have Rs.100,
and I decide to invest all of that money in Stock A, then the weight in stock A is 100%.
Likewise, if I decide to invest Rs.50 in A, Rs.20 in B, and Rs.30 in C, the weights in A, B, and C
would be 50%, 20%, and 30% respectively.
I have arbitrarily assigned weights to the 5 stocks in the portfolio –
o Cipla @ 7%
o Idea @ 16%
o Wonderla @ 25%
o PVR @ 30%
o Alkem @ 22%
Clearly, there is no science to assigning weights at this stage. However, at a later point in the
module I will discuss more about this part.
The next step is to calculate the weighted standard deviation. The Weighted standard
deviation is simply the weight of a stock multiplied by its respective standard deviation. For
example, Cipla’s standard deviation is 1.49%, hence its weighted standard deviation would
be 7% * 1.49% = 0.10%
Here are the weights and the weighted standard deviation of 5 stocks in the portfolio –
Do note, the total weight should add up to 100% i.e. the sum of the individual weights in
stocks should add up to 100%.
At this stage, we have all the individual components needed to calculate the ‘Portfolio
Variance’. The formula to calculate the Portfolio Variance is as shown below –
Portfolio Variance = Sqrt (Transpose (Wt.SD) * Correlation Matrix * Wt. SD)
Where,
Wt.SD is the weights standard deviation array.
We will implement the above formula in 3 steps –
1. Calculate the product of Transpose of Wt.SD with correlation matrix. This will result in a row
matrix with 5 elements
2. Multiply the result obtained above (row matrix) with the weighted standard deviation array.
This will result in a single number
3. Take the square root of the result obtained above to get the portfolio variance
So, let’s jump straight ahead and solve for portfolio variance in the same order –
I will create row matrix called ‘M1’ with 5 elements. This will contain the product of the
Transpose of Wt.SD with correlation matrix.
Do note, you will have to select the empty array space and hold down the ctrl +shift+enter
keys simultaneously.
We now create another value called ‘M2’, which contains the product of M1 and weighted
standard deviation –
We obtain the value of M2 as 0.000123542, the square root of this value is the portfolio
variance.
The result for the above operation yields a value of 1.11%, which is the portfolio variance of
the 5 stocks portfolio.
Phew!!
I need a break at this. Let’s figure out the next steps in the next chapter J
Download the excel sheet used in this chapter.
1. Correlation matrix gives out the correlation between any two stocks in a portfolio
2. Correlation between stock A with stock B is the same as the correlation between stock
B with stock A
3. Correlation of a stock with itself is always 1
4. The diagonals of a correlation matrix should represent the correlation of stock A with
itself
5. The correlation matrix contains symmetrical values above and below the diagonals
CHAPTER 6
Equity Curve
6.1 – Overview
This is off topic – but a little digression hurts no one, I guess. Of all the chapters I have written
in Varsity, I guess this one will be a very special one for me. Not because of the topic that I
will be discussing. It is because of the place where I’m sitting right now and writing this for
you all. Its 6:15 AM – surrounding me 360 degrees are misty mountains; the landscape I guess
cannot get any better. There is only one shack here with a little music player, playing Bob
Marley’s Redemption Song. Can it get any better? At least not for me I guess
Anyway, back to school
We discussed Portfolio Variance in the previous chapter. It would be pointless to crunch all
the numbers to extract the variance of the portfolio, unless we put that to good use. This is
exactly what we will achieve over the next 2 chapters.
Over the next 2 chapters, we will try and do the following –
1. Discuss Equity curve and an alternate method to calculate portfolio variance
2. Estimate the portfolio’s expected returns over 1 year
3. Optimize the portfolio for maximum returns and minimum variance
Note, this chapter is a continuation of the discussion panned out in the previous chapters.
You need to know the context here. If you are reading this chapter without knowing what
happened over the last few chapters, then I’d suggest you go back and read those chapters
first.
6.2 – Equity Curve

We will use this opportunity to develop an equity curve for the 5 stock portfolio that we have.
In a very lose sense, a typical equity curve helps you visualize the performance of the portfolio
on a normalized scale of 100. In other words, it will help you understand how Rs.100/ -
invested in this portfolio would have performed over the given period. You can further use
this to benchmark the portfolio’s performance against its benchmark – say Nifty 50 or BSE
Sensex.
There are certain attributes which can be extracted out of the equity curve to develop deeper
insights on the portfolio. More on that later.
Let us proceed to build an equity curve for the 5 stock portfolio. Remember, we had the
following stocks and we also assigned random weights to these stock to form our portfolio.
Here are the stock names along with the weightages –
So what does ‘Investment weight’ means? – It represents the percentage of your corpus
invested in the stock. For example, out of Rs.100,000/-, Rs.7,000/- has been invested in Cipla
and Rs.22,000/- has been invested in Alkem Lab. So on and so forth.
While developing an equity curve, the usual practice is to normalize the portfolio for Rs.100.
This helps us understand how an investment of Rs.100/- in this portfolio behaved during the
period of investment. I have incorporated this in the excel sheet (please note, the exce l used
here is a continuation of the excel used in the previous chapter)
I have introduced a new column next to the daily return column and included the weight of
the respective stock. At the end, you will find two new column being introduced – starting
value pegged at 100 and total weight at 100%.
Starting value – this is basically the amount of money we are starting with. I have set this to
Rs.100/-. This means, out of the 100 Rupees in total corpus, Rupees 7 is being in vested in
Cipla, Rupees 16 in Idea, Rupee 25 in Wonderla so on and so forth.
Now, if I add up the individual weights, then they should all add up to 100%, indicating that
100% of Rs.100 is being invested.
We now have to see how the investment in each stock has performed. To help you understand
this better, let’s take up the case of Cipla for now. The weight assigned to Cipla is 7%, which
means out of Rs.100, Rs.7 is invested in Cipla. Based on the daily price movement of Cipla,
our money i.e. Rs.7/- either increases or decreases. It is important to note that, if on day 1, if
Rs.7 becomes, Rs.7.5/- then the following day, our starting price is Rs.7.5 and not Rs.7/-. I’ve
done this on excel for Cipla, and this is how the calculation looks.
On 1st Sept, Cipla was trading at 579.15, this is the day we decided to invest Rs.7 in the stock.
I understand that this is technically not possible, but for the sake of this example, let us just
assume this is possible and proceed. So on day one i.e. 1st Sept, 7 is invested, on 2nd Sept
Cipla closed at 577.95, down -0.21% from the previous day. This also means we lose -0.21%
on our investment of Rs.7/- making it Rs.6.985. On 6th Sept Cipla shot up by 0.11% to 578.6,
hence we gain 0.11% on 6.985 to make it 6.993. So on and so forth the rest of the data points.
I’ve done this math for all the stocks in portfolio and here is how the table looks –
I’ve calculated the daily fluctuation in the invested price across all stocks and I’ve highlighted
the same in blue.
Now, think about what is happening here – I’ve basically split Rs.100/- across 5 stocks and
invested in different proportions. If I sum up the daily variation in each stock, I should be able
to get the overall daily fluctuation of Rs.100, right? Doing this gives me the overall perspective
on how my portfolio is moving. Let me add these up and see how Rs.100 invested across 5
stocks moves on a daily basis –
Adding up the values on a daily basis gives me the time series of the daily fluctuation of the
portfolio.
An ‘Equity Curve’ (EQ curve) can be developed if you plot the chart of this – i.e. the time series
data of the daily normalized portfolio value. I say normalized because I’ve scaled down the
investment to Rs.100/-.
So, here is the EQ curve for the portfolio that we have –
As easy as that. Eq curve is a very popular way of visualizing the portfolio performance. It
gives a quick estimate of the returns generated by the portfolio. In this case, we started with
and investment of Rs.100/- and at the end of 6 months the portfolio was valued at 113.84.
So without much thinking, I know the portfolio has done close to 13.8% during the given
period.
6.3 – Portfolio as a whole

Now, here is something I’d like you to think about. In the previous chapter, we calculated the
portfolio variance. While doing so, one of the key things we had to calculate was the standard
deviation of each stock. Standard deviation as you may know, represents the volatility of the
stock which is nothing but the risk associated with the stock.
To calculate the standard deviation, we used the inbuilt excel function ‘=STDEV()’ applied on
the daily return of the stock. Now, think about this – we anyway have the daily value of the
portfolio (although normalized to Rs.100).
Now imagine the portfolio itself in its entirety, as a whole, as a single stock, and calculate its
daily returns. Just like how we calculated the daily returns of the stocks in the previous
chapter. Further, what if I apply the ‘=STDEV()’ function on the portfolio’s daily return? The
resulting value should be the standard deviation of the portfolio which in other words should
represents risk also called as Variance of the portfolio.
Are you able to sense where we are heading? Yes, we are talking about calculating portfolio
variance using a different approach all together
To help you comprehend this better, let me paste the portfolio variance value we calculated
in the previous chapter–
We calculated the above value using the matrix multiplication and the correlation matrix
technique.
We will now look at the portfolio as a whole and calculate the daily returns of the normalized
portfolio value. The standard deviation of the portfolio’s daily returns should yield us a value
equal to or somewhere near the portfolio variance calculated previously.
I’ve included a new column next to the daily normalized portfolio value and calculated the
Portfolio’s daily returns –
Once I have the returns in place, I will apply the standard deviation function on the time s eries
data, this should yield a value close to the portfolio variance value we previously calculated.
So there you go, the STDEV function gives us the exact same value!
You can download the excel sheet used in this chapter. In the next chapter, we will use the
portfolio variance to estimate the expected returns along with optimization.
Quick Task – I’d like to leave you with a quick task here. We have assigned random weights
to the stocks. Go ahead and change the weights of the stocks and see the impact on the
overall returns. Do share your observation in the comment box below.
1. An equity curve is a standard way to visualize the performance of a portfolio

2. A standard industry wide practice is to normalize the portfolio to a starting investment
value of Rs.100/-
3. We assign weights and the respective investment to each stock
4. We need to calculate the daily change in investment value in each stock
5. The sum total of all the variation in each stock adds up to the variation of the entire
portfolio
6. The graph of the change in daily prices of the portfolio yields the equity curve
7. We can look at the portfolio as a whole, as a single stock and calculate its SD
8. The SD of portfolio also yields the portfolio variance
CHAPTER 7
Expected Returns
7.1 – Expected returns
The next two chapter will be very insightful, especially for people who have never been
familiar with portfolio techniques. We will venture into the realms of expected return
framework and portfolio optimization. Portfolio optimization in particular (which we will
discuss in the next chapter) is like a magic wand, it helps you decide how much to invest in a
particular stock (within a portfolio) so that you achieve the best possible results in terms of
risk and return. These are topics which the high priests of finance prefer to keep for
themselves, but today we will discuss them here and truly work towards democratizing
quality financial knowledge.
But please note, to best understand the discussion here, you need to have a sense of all the
things we have discussed over the previous couple of chapters. If you have not read them yet,
please, I’d urge you to read them first. This is good quality information and you would be a
better market participant if you simply spent few hours reading them. The excel sheet used
here is a continuation of the one used in the previous chapters.
So assuming you are all set, let us get started.
It is time we put the portfolio variance to good use. To begin with let us take a good look at
the portfolio variance number calculated in the previous chapters –
What does this number tell you?
The number gives you a sense of the degree of the risk associated with the portfolio.
Remember, we worked on the daily data, hence the Portfolio Variance of 1.11% represents
risk on a daily basis.
Risk or variance or volatility is like a coin with two faces. Any price movement below our
entry price is called risk while at the same time, the same price movement above our entry
price is called return. We will soon use the variance data to establish the expected range
within which the portfolio is likely to move over the year. If you’ve read the Options module
you will probably know where we are headed.
However, before doing that, we need to figure out the expected return of the portfolio. The
expected return of the portfolio is simply, the grand sum of the average return of each stock,
multiplied by its weight and further multiplied by 252 (number of trading days). In simple
terms, we are scaling the daily returns to its annual return, and then scaling it according to
the investment we have made.
Let us calculate the expected return for the portfolio that we have, I’m sure you will
understand this better. To begin with, I’ve lined up the data as follows –
The first 3 columns are fairly easy to understand I suppose. The last column is simply the
multiplication of the daily average return by 252 – this is a step to annualize the return of the
stock.
For example, (Cipla) – 0.06% * 252 = 15.49%.
What does this mean? For a moment assume, I have invested all the money in just Cipla and
no other stocks, then the weight of Cipla would be 100% and I can expect a return of 15.49%.
However, since I’ve invested only 7% of my capital in Cipla, the expected return from Cipla
would be –
Weight * Expected Return
= 7% * 15.49%
=1.08%
We can generalize this at the portfolio level to get the expected return of the portfolio –
Where,
Wt = Weight of each stock
Rt = Expected annual return of the stock
I’ve applied the same formula for the 5 stock portfolio that we’ve got, and here is what we
have –
At this stage, we have arrived at two extremely important portfolio parameters. They are the
expected portfolio return which is 55.14% and the portfolio variance which is 1.11%.
In fact, we can scale the portfolio variance to represent the annual variance, to do this we
simply have to multiply the daily variance by Square root of 252.
Annual variance =
= 1.11% * Sqrt (252)
= 17.64%.
We will keep both these important numbers aside.
It is now time to recall our discussion on normal distribution from the options module.
I’d suggest you quickly read through the ‘Dalton board experiment’ and understand normal
distribution and how one can use this to develop an opinion on future outcome.
Understanding normal distribution and its characteristics is quite crucial at this point . I’d
encourage you to read through it before proceeding.
Portfolio returns are normally distributed, I’ll skip plotting the distribution here, but maybe
you can do this as an exercise. Anyway, if you do plot the distribution of a portfolio, you are
likely to get a normally distributed portfolio. If the portfolio is normally distributed, then we
can estimate the likely return of this portfolio over the next 1 year with certain degree
of confidence.
To estimate the return with certain degree of confidence we simply have to add and subtract
the portfolio variance from the expected annualized return. By doing so we will know how
much the portfolio will generate or lose for the given year.
In other words, based on normal distribution, we can predict (although I hate using the word
predict in markets) the range within which the portfolio is likely to fluctuate. The accuracy of
this predication varies across three levels.
 Level 1 – one standard deviation away, 68% confidence

 Level 2 – Two standard deviation away, 95% confidence
 Level 3 – Three standard deviation away,99% confidence
Remember, variance is measured in terms of standard deviation. So it is important to note

that the annualized portfolio variance of 17.64% is also the 1 standard deviation.
So, 17.64% represents 1 standard deviation. Therefore, two standard deviations are 17.64%
* 2 = 35.28% and 3 standard deviation would be 17.64% * 3 = 52.92%.
If you are reading this for the first time, then yes, I’d agree it would not be making any sense.
Hence it is important to understand normal distribution and its characteristics. I’ve explained
the same in the options chapter (link provided earlier).
7.2 – Estimating the portfolio range
Given the annualized variance (17.64%) and expected annual return (55.14%), we can now go
ahead and estimate the likely range within which the portfolio returns are likely to vary over
the next year. Remember when we are talking about a range, we are taking about a lower and
upper bound number.
To calculate the upper bound number, we simply had to add the annualized portfolio
variance to the expected annual return i.e. 17.64% + 55.15% = 72.79%. To calculate the lower
bound range we simply have to deduct the annualized portfolio variance from the expected
annual return i.e. 55.15% – 17.64% = 37.51%.
So, if you were to ask me – how are the returns likely to be if I decide to hold the 5 stock
portfolio over the next year, then my answer would be that the returns are likely to fluctuate
between +37.51% and +72.79%.
Three quick question may crop up at this stage –
1. The range suggests that the portfolio does not lose money at all, how is this even
possible? In fact, the worst case scenario is still a whopping +37.51%, which in reality
is fantastic.
1. True, I agree it sounds weird. But the fact is, the range calculation is statistics
based. Remember we are in a bull market (April – May 2017, as I write this), and
the stocks that we have selected have trended well. So quite obviously, the
numbers we have got here is positively biased. To get a true sense of the range,
we should have taken at least last 1 year or more data points. However, this is
beside the point here – remember our end objective is to learn the craft and not
debate over stock selection.
2. Alright, I may have convinced you on the range calculation, but what is the guarantee
that the portfolio returns would vary between 37.15% and 72.79%?
1. As I mentioned earlier, since we are dealing with level 1 (1 standard deviation),
the confidence is just about 68%.
3. What if I want a higher degree of confidence?
1. Well, in this case you will have to shift gears to higher standard deviations.
Let us do that now.
To calculate the range with 95% confidence, we have to shift gears and move to the
2nd standard deviation. Which means we have to multiply the 1 standard deviation number
by 2. We have done this math before, so we know the 2 nd SD is 35.28%.
Given this, the range of the portfolio’s return over the next 1 year, with 95% confidence would
be –
Lower bound = 55.15% – 35.28% = 19.87%
Upper bound = 55.15% + 35.28% = 90.43%
We can further increase the confidence level to 99% and check the return’s range for 3
standard deviation, recall at 3 SD, the variance is 52.92% –
Lower bound = 55.15% – 52.92%% = 2.23%
Upper bound = 55.15% + 52.92% = 108.07%
As you may notice, the higher the confidence level, the larger the range. I’ll end this chapter
here with a set of tasks for you –
1. Plot the frequency distribution for this 5 stock portfolio – observe the distribution,
check if you see a bell curve
2. We are dealing with the range for a year, what if you were to estimate the range for 3
months, or maybe 3 weeks? How would you do it?
It will be great if you can attempt these tasks, please do leave your thoughts in the comment
box below.
1. The returns of the portfolio are dependent on the weights of the individual stocks in
the portfolio
2. The calculate the effect of an individual stock on the overall portfolio’s return, one has
to multiply the average return of the stock by its weight
3. The overall expected return of the portfolio is grand sum of the individual stock’s
returns (which is scaled by its weight)
4. The daily variance can be converted to annualized variance by multiplying it by square
root of 252
5. The variance of the portfolio which we calculate is by default the 1 st standard
deviation value
6. To get the 2 nd and 3rd SD, we simply have to multiply it by 2 and 3
7. The expected return of the portfolio can be calculated as a range
8. To get the range, we simply have to add and subtract the variance from the portfolio’s
expected return
9. Each standard deviation comes with a certain confidence level. For higher confidence
level, one has to look at moving higher standard deviation
CHAPTER 8
Portfolio Optimization (Part 1)
8.1 – A tale of 2 stocks

We have spent a great deal of time and efforts towards understanding risk associated with a
portfolio. Our discussion has brought us to a very important stage – it’s time we discuss
portfolio optimization. Perhaps, a good start to this discussion would be to understand what
portfolio optimization is all about and why it makes sense to optimize a given port folio.
Before we proceed, let me ask you a question – what do you think is the overall portfolio
return, considering a portfolio consists investment in Infosys and Biocon (equally weighted).
Assume the expected return of Infosys is 22% and Biocon is 15%.
I know it sounds like a typical MBA class question, but this is an important question and you
should know how to answer this question at this stage J
Since the portfolio is equally weighted across two stocks, it implies we invest 50% in Infosys
and 50% in Biocon. Given this, the expected portfolio return would be –
= Weight of investment in Infosys * Expected return of Infosys + Weight of investment in

Biocon * Expected return of Biocon
Do recall, in the previous chapter we did discuss “Expected Return of a stock” in detail.
Anyway, let us work out the answer –
50% * 22% + 50% * 15%
=11% + 7.5%
= 18.5%
So, the portfolio is expected to yield a return of 18.5% annually.
Great, now what if we change the weights? What if invest 30% in Infosys and 70% in Biocon?
Or let us say 70% in Infosys and 30% in Biocon?
Let’s figure this out, Case 1 –
30% * 22% + 70% * 15%
= 6.6% + 10.5%
17.1%
Case 2 –
70% * 22% + 30% * 15%
=15.4% + 4.5%
=19.9%
Needless to say, we can do this for multiple combinations of weights. In fact, here is the table
with few of the other combinations possible –
As you can notice, as the investment weight varies, the returns also vary. For example, if I had
decided to invest just 40% in Infy and 60% in Biocon, I’d have enjoyed a return of 17.8%.
However, if I had reversed it by investing 60% in Infy and 40% in Biocon, I’d have enjoyed a
return of 19.2%, which is an additional 2% return.
This leads us to a super important conclusion – as the investment weights vary, the returns
vary. In fact, each return has an associated risk profile, so it is prudent to state – as the
weights vary, both the risk and return characteristics vary.
Now imagine this – for a given portfolio with ‘n’ number of stocks, wouldn’t it be awesome if
you were to look at the past data and intelligently identify how much to invest in each stock,
so that the portfolio yields the best possible returns?
This is exactly what happens when you optimize your portfolio. Generally speaking, you can
adjust the weights (or optimize your portfolio) such that, for the given set of stocks –
o You identify the investment weights to achieve the best possible return or
o You identify the investment weights to achieve the least possible risk
Sounds confusing? Fear not, just read ahead!
8.2 – Caution! Jargons ahead

Hopefully by now, you fully appreciate the reason why one should optimize the portfolio. So,
I won’t spend more time convincing you
Let us go ahead and optimize the portfolio we have been working with. However, there are
few important terms I want you to be familiar with at this stage –
Minimum variance portfolio – Assume you have a portfolio of 10 stocks. It must be quite
obvious by now that you can play around with the weights of each stock to achieve different
results. When I say results, I’m talking about the risk and return characteristics. Each unique
set of weights represents a unique portfolio. For example, an equally weighted portfolio (10
stocks, 10% weight in each) is a unique portfolio. A portfolio where you invest 30% in stock 1
and 7.8% each across the remaining 9 stocks is another unique portfolio. The number of
combination possible are many and each combination of weights results in a unique risk and
return characteristics.
Given this, there should be that one set of combination of stock weights possible, such that
the risk for the portfolio is the least possible. More technically, there should be combination
of weights possible such that the variance of the portfolio is minimum. This particular
portfolio is also referred to as the “Minimum Variance Portfolio”. The minimum variance
portfolio represents the least amount of risk you can take. So if you are a highly risk averse
investor, you should aim to create a minimum variance portfolio.
Maximum Return portfolio – This is somewhat the opposite of a minimum variance

portfolio. Just like a minimum variance portfolio, there should be a combination of weights
such that we can achieve a portfolio with maximum return possible. This also means that for
a maximum return portfolio, the risk too will be on the higher side.
Fixed variance, multiple portfolios – This is not really a jargon, but a concept that you need
to be aware of at this stage. It may come across as a little confusing at this point, but I’m
certain, later on in this chapter (or maybe next) you will understand this much better,
especially when we perform portfolio optimization.
For a given level of risk or variance of a portfolio, you can create at least two unique
portfolios. One of such portfolio will yield the highest possible return and the other portfolio
will yield the lowest return for the same given level of risk.
Here is an example on a completely arbitrary basis – let us say the risk or variance of a
portfolio is 15%, given this, there will be a portfolio which can yield 3 0% return (highest
possible return) and another portfolio which can yield 12% return (lowest possible
return). Do note, for both these portfolios, the risk is fixed to 15% but the returns vary.
Between these two portfolios there could be multiple other (unique) portfolios with varying
return profile. In super simple terms – for a fixed amount of risk, there could be multiple
portfolio combinations, and within these possible combinations, there will be a portfolio
with maximum return and another with minimum return.
We will revisit this concept a little later in the chapter, but for now, just keep this thought at
the back of your mind.
8.3 – Portfolio optimization (steps)

Let us recall the portfolio that we have – the stock names and the associated weights are as
follows. Do note, this is a continuation of the portfolio we have been working with over the
previous few chapters.
Do remember, the weights assigned are all random, there was no thought process to it. For
this portfolio with these combination of weights, the annual portfolio variance was estimated
at 17.64% and expected return as 55.14%.
Our objective now is to optimize this portfolio to achieve a desired outcome. To optimize a
portfolio in excel, we need the ‘Solver Tool’ in excel. You will find the solver tool under the
‘Data ribbon’.
Many of you may not find the ‘solver’ tool under the data ribbon. This is because you’ve not
added it from the excel add ins. To add solver, follow these simple steps –
1. Click on Files on the opened excel sheet
2. Select Options
3. Select Add-ins (last but one option)
4. Click on ‘Solver Add Ins’
5. Click on “Go”
6. Check on “Solved Add ins” once again
7. Click Ok and close
8. Close the excel sheet, if required restart your system
9. Check under data ribbon – you should be able to find the solver tool
To begin with, let us optimize the portfolio to get the “Minimum Variance portfolio”. Here are
few simple steps that you can follow to achieve this.
Step 1 – Organize your data. This is the key to using solver. Your cells should be linked; data
should be neatly organized. No hard coding of data. Here is how the data on excel sheet looks
at this stage.
I’ve highlight two important parts, which we will use for optimizing. The top most part has
the weights assigned to each stock. Needless to say, this will change once the portfolio is
optimized. The 2 nd part has the expected return and annual portfolio variance calculation,
which will also change when we optimize the portfolio.
Step 2 – Use the solver tool in excel to optimize the weights. I’m assuming you may be new
to solver, hence will give you a quick overview of this tool. You can use solver to work with
something called as an ‘objective’. An objective, according to solver is essentially a data
point, derived by set of formulas. You can minimize the objective’s value or maximize the
objective’s value or set the value of an objective to a certain desired value. You can do this
while changing certain variables. The variables, according to solver are the elements of the
formulas used in deriving the objective. For example, I can choose to minimize the variance
of the portfolio by changing the weights of each stock. Here, the variance is the objective and
the weights are the variable.
When we command the solver to minimize the objective (variance in this case), then in the
background, excel’s solver will quickly check the formulas used and works around it in such
a way that the objective’s value is least minimum.
Look at the image below, I’m invoking the solver tool and will soon ask it to minimi ze the
variance.
When you click on the data ribbon and click on solver, you will see the solver tool open up,
as seen above. We need to set the objective here. Objective as I mentioned earlier, is the
annual portfolio variance. Remember, we are working towards finding the minimum variance
portfolio here.
Check the image below –
Objective is set to ‘Annual portfolio variance’ – you can notice the cell address is highlighted
in the ‘set objective’ field. The cell containing the annual portfolio variance i tself is
highlighted below, you will find another red arrow here. We are minimizing the objective
here, the same is highlighted by the green arrow.
Once this is set, the next step is to inform the solver tool that we need minimize the objective
by changing the variables. In this case, the variable happens to be the weights assigned to
each stock.
As you can see, in the “By changing variable cells” field, I’ve highlighted the weights assigned
to each stocks.
You can also find “subject to constraints”, field. This essentially means, that solver will
minimize the variance, by change the weights of each stock, and at this stage, it is also asking
us if there are any constraints it needs to keep in mind while solving to minimize the variance.
One constraint that I can think of at this stage is that the total weight of all stocks put together
should be 100%. This essentially means that my capital is 100% deployed across all the 5
stocks. If I do not specific this, then there is a chance that solver may suggest to skip
investments across few stock altogether. Remember, solver is an excel tool, and it does not
appreciate stock picking
To add a constraint, click on ‘add’. When you do so the following window opens up –
Under Cell reference, I will give the sum of weights of stocks – which needs to be equal to
100%. Next to this, you can see a drop down menu with multiple options, I’d pick ‘=’ here.
Finally, the constraint itself will be 100%. Note, I’ve typed out 100% here.
In simple words, I’m asking solver to optimize for minimum variance, keeping the weight of
all stock to 100%. The window now looks like this –
The solver is completely set up now. The final screen before pressing “Solve” looks like this –
I’ve highlighted the weights of each stock for reference. Remember, these are pre optimized
weights that we randomly assigned at the beginning of this discussion. Post optimizing, the
weights will be changed such that the variance is least possible for these set of stocks. Let us
go ahead and press ‘solve’ and check what solver has for us.
And here you go –
Solver has solved for the ‘minimum variance’ portfolio and accordingly it has worked out the
weights for each stock.
For example, it wants us to increase the weight in Cipla from current 7% to 29.58%, whi le it
wants us to reduce the weight in Idea to 5.22% from 16%. So on and so forth. Further, it is
also telling us that the least possible variance with this portfolio is 15.57% (remember, the
variance was earlier at 17.64%). Along with this, the portfolio’s expected return too seem to
have dropped to 36.25% from the earlier 55.14%.
So, no matter what you do, the variance cannot be lowered below 15.57%. In other words, if
these are the 5 stocks that you want to invest in, then the least amount of risk you w ill be
exposed to is 15.57% and absolutely nothing below that!
I’ll leave you at this. In the next chapter, we will optimize the same portfolio for few more
scenarios and work towards building something called as an ‘Efficient Frontier’.
You can download the excel sheet used in this chapter. Do note, the excel contains the
optimized weights for the minimum variance portfolio.
1. The returns of the portfolio are dependent on the weights assigned to each stock
2. Minimum variance portfolio is that portfolio where the variance or risk is least
possible for the given set of stocks
3. Maximum return portfolio is that portfolio where the expected portfolio returns are
maximized for the given set of stocks
4. When we fix the variance of a portfolio we can achieve at least two portfolios where
the expected portfolio returns can be maximum or least
5. One can optimize a given portfolio with ‘n’ number of stocks on excel, by using the
solver tool
6. One of the most important points to remember while using solver is to ensure the
data is well organized. One can do this by linking all the relevant cells and avoiding
hard coding of values
7. You can optimize the portfolio by subjecting the variable to constrains
CHAPTER 9
Portfolio Optimization (Part 2)
9.1 – Working with the weights

In the previous chapter we introduced the concept of portfolio optimization using excel’s
solver tool. We will build on the same concept in this chapter and proceed to understand an
important portfolio concept, often referred to as the ‘Efficient Frontier’.
Recall in the previous chapter, we discussed how a portfolio can produce multiple return
series for a fixed portfolio variance. We will now go ahead and see how this works. This
concept will eventually lead us to understanding portfolio optimization better.
In the previous chapter, we optimized the portfolio to produce the minimum variance
portfolio. The results, in terms of weights of individual stocks were as follows –
And the expected portfolio returns and the portfolio variance is as follows –
Here is where things start to get a little interesting. So far what we have achieved in terms of
portfolio optimization is merely a minimum variance portfolio. Like we discussed in the
previous chapter, for every fixed risk level, there could be multiple unique portfolio with
varying return characteristics. We will now go ahead and explore this in greater detail.
We know at 15.57% portfolio variance, the return expected is 36.35%. We will now go ahead
and increase the risk maybe to 17%, and calculate the highest and lowest possible returns
for this. In other words, we are essentially trying to identify the highest and lowest possi ble
return for a fixed portfolio variance of 17%. Also, do pay attention here – when I say increase
the risk, we are essentially fixing the risk to certain desired level. 17% for now.
9.2 – More optimization

The general direction we are headed is this – we know the minimum risk possible for this
portfolio is 15.57%. We have also noted the return achievable at this level of risk i.e – 36.35%.
Like I mentioned earlier, we will now increase the risk a notch higher and note down the
maximum and minimum return for this risk. Along with the return, we will also note the
investment weights. We will then increase the risk another notch higher and again note the
max and min return along with the weights. We will do few such iterations and note down all
the observation.
Eventually, I would like to plot a scatter plot of fixed risk along with its respective max return
and min return data points and study this scatter plot in greater detail. This scatter plot will
help us understand portfolio optimization.
So let us get started by fixing the risk at 17%. Please note, I’ve opted 17% just like that, it
could very well have been 16% or 18%.
Step 1 – Invoke the solver
As I explained in the previous chapter, I’ve invoked the solver calculator by clicking on the
data ribbon. I’ve highlighted the optimized weights for the minimum variance portfolio, this
is just for your reference.
Step 2 – Set the parameters
To begin with let us find out the maximum return one can achieve for a fixed 17% risk. For
this, we need to set the objective to maximize the ‘expected portfolio return’. The same is
highlighted as shown below –
Step 3 – Select the weights
The next step is to ensure that we tell the solver tool that we want to optimize the portfolio
for maximum return by varying the weights. This is very similar to what we did in the previous
chapter.
Do note, the weights here are the variable cells.
Step 4 – Set the constraints
Now, here is the important part of the optimization where we set the constraints. We now tell
solver that we need to maximize the returns @ 17% risk, by varying the investment weights.
We do these while keeping the following two constraints –
1. The total weights add up to 100%

2. The Portfolio risk is fixed to 17%
The constraints section now looks like this –
With these constraints loaded and rest of the parameters specified, we can go ahead and click
on ‘solve’ to figure out the maximum return possible @ 17%, along with the respective
weights.
The result upon optimization is as follows –
The maximum possible returns @17% portfolio variance happens to be 55.87%. However, to
achieve this, the weights are as show above. Notice how the weights for this portfolio has
changes when compared to the minimum variance portfolio.
We will now proceed to figure out the minimum return possible for the same fixed amount of
risk, which is 17% in our case. Before we proceed, here is a table that I’m compiling of all the
various portfolios that we are building, along with its respective weights and risk return
characteristics.
We are now working on portfolio 3 (P3), which is the minimum risk possible for a fixed risk of
17%. Here is the solver tool, fully loaded and ready to be optimized.
Notice, while other variables remain the same, the objective is shifted to minimize from
maximize. Upon optimization, the return is now minimized to 18.35%. Clearly, for the same
given risk, we have now established two unique portfolios with different possible return
characteristics, all these while just changing the investment weights in the s tocks.
Here are the three unique portfolios that we have generated so far –
Just to recall – P1 is the minimum variance portfolio, P2 max risk @17%, and P3 is min risk at
17%.
9.3 – Efficient Frontier
As discussed earlier, we can now increase the risk a notch higher to maybe 18%, 19%, and
21% and identify the maximum and minimum risk at both these risk levels. Remember, our
end objective is attain a scatter plot of the risk and return profile and study its characteristics.
I’ve gone ahead and optimized the portfolios for all the risk points, and at each point, I’ve
identified the maximum and minimum return possible. Please note, I’ve rounded off the
decimal values here, just so that the table looks pretty
If you notice, I’ve highlighted the risk and return values of each portfolios. I’ll now go ahead
and plot a scatter plot of these data points and see, what I can see.
To plot a scatter plot, simply select the data points and opt for the scatter plot under the
insert ribbon. This is how it looks –
Once you click on the scatter plot, you will be able to see the how the plot appears. Here is
how it looks, of course, I’ve tried to format the graph to make it look more presentable.
This curve that you see above my friend, is called the ‘efficient frontier’ of this portfolio. So
what do we understand from this curve and why is it so important? Well, quite a few things,
lets deal with it one by one –
1. As you can see, the X-axis represents risk and the Y-axis represents returns
2. Starting from the left most point, the one which seems to be a little isolated from the
rest, represents the minimum variance portfolio. We know this portfolio has a risk of
15.57% with a return of 36.25%.
3. We now move focus to 17% risk (notice the x axis), you can find two plots, one at
18.35% and another at 55.87% – what does this tell you?
1. It tells us that at 17% risk (or when we are particular about fixing the risk at 17%), the
best possible portfolio can achieve a return of 55.87%
2. The worst possible portfolio (in terms of return) is 18.35%
3. In simple terms, when you fix a level of risk you are comfortable, you should aim to
maximize the return
4. There are multiple other portfolios that are possible between 18.35% and 55.87%
(when we fix risk at 17%) these would be represented as plots between the minimum
and maximum return. All these portfolios are considered inefficient, the minimum
return portfolio being the worst amongst the rest
5. So as an investor, your aim should be to maximum the return, especially when you
have some clarity on how much risk you are willing to bear
4. You can notice the same behavior for risks at 18%, 19%m and 21%
5. The best possible portfolios, or in other words, the efficient portfolio will always lie on
the line above the minimum variance portfolio. This line is highlighted below
So, you as an investor, should always aim to create a portfolio, which lies on the efficient
frontier, and as you may realize, creating this portfolio is merely a function of rearranging
weights as per the results obtained in portfolio optimization.
Think about it – when you risk your money, you obviously want the best possible return,
right? This is exactly what the curve above is trying to convey to us. Its prompting us to create
portfolios more efficiently.
In the next chapter, we will take a quick look at a concept called “Value at risk” and then
proceed to understanding risk from a trader’s perspective.
1. A portfolio with certain weights to each stock is considered unique

2. When we fix the desired level of risk, we can optimize the portfolio to yield the
minimum return and maximum return portfolios
3. Between the min and max return portfolio (for a given fixed level of risk), we can have
multiple unique portfolios
4. The scatter plot of risk and return gives us the efficient frontier
5. For a given level of risk, the best possible portfolio one can construct would lie on the
efficient frontier, all other portfolios are deemed inefficient
CHAPTER 10
Value at Risk
10.1 – Black Monday

Let’s start this chapter with a flashback. For many of us, when we think of the 70’s, we can
mostly relate to all the great rock and roll music being produced from across the globe.
However, the economists and bankers saw the 70’s very differently.
The global energy crisis of 70’s had drawn the United States of America into an economic
depression of sorts. This lead to a high inflationary environment in the United States followed
by elevated levels of unemployment (perhaps why many took to music and produced great
music). It was only towards the late 70’s that things started to improve again and the
economy started to look up. The Unites States did the right things and took the right steps to
ease the economy, and as a result starting late seventies / early eighties the economy of
United States was back on track. Naturally, as the economy flourished, so did the stock
markets.
Markets rallied continuously starting from the early 1980s all the way to mid-1987. Traders
describe this as one of the dream bull runs in the United Sates. Dow made an all -time high of
2,722 during August 1987. This was roughly a 44% return over 1986. However, around the
same time, there were again signs of a stagnating economy. In economic parlance, this is
referred to as ‘soft landing’ of the economy, where the economy kind of takes a breather.
Post-August 1987’s peak, the market started to take a breather. The months of Aug, Sept, Oct
1987, saw an unprecedented amount of mixed emotions. At every small correction, new
leveraged long positions were taken. At the same time, there was a great deal of unwinding
of positions as well. Naturally, the markets neither rallied nor corrected.
While this was panning on the domestic front, trouble was brewing offshore with Iran
bombing American super tankers stationed near Kuwait’s oil port. The month of October
1987, was one of its kind in the history of financial markets. I find the sequence of events
which occurred during the 2 nd week of October 1987 extremely intriguing, there were way too
much drama and horror panning out across the globe –
 14th Oct 1987 (Wednesday) – Dow dropped nearly 4%, this was a record drop during that
period
 15th Oct 1987 (Thursday) – Dow dropped another 2.5%. Dow was nearly 12% down from
the August 1987’s high. On the other side of the globe, Iran attacked an American super
tanker stationed outside Kuwait’s oil port, with a Silkworm missile
 With these two events, there were enough fear and panic spread across the global
financial markets
 16th Oct 1987 (Friday) – London was engulfed by an unexpected giant storm, winds
blowing at 175 KMPH caused blackouts in London (especially the southern part, which is
the financial hub). London markets were officially closed. Dow opened weak, and crashed
nearly 5%, creating a global concern. Treasury Secretary was recorded stating economic
concerns. Naturally, this would add more panic
 19th Oct 1987 (Black Monday) – Starting from the Hong Kong, markets shaved off points
like melting cheese. Panic spread to London, and then finally to the US. Dow recorded the
highest ever fall with close 508 or 22.61% getting knocked off on a single day, quite
naturally attracting the Black Monday tile.
The financial world had not witnessed such dramatic turn of events. This was perhaps the
very first few ‘Black Swan’ events to hit word hard. When the dust settled, a new breed of
traders occupied Wall Street, they called themselves, “The Quants”.
10.2 – The rise of quants
The dramatic chain of events of October 1987 had multiple repercussion across the financial
markets. Financial regulators were even more concerned about system wide shocks and
firm’s capability to assess risk. Financial firms were evaluating the probability of a ‘firm-wide
survival’ if things of such catastrophic magnitude were to shake up the financial system once
again. After all, the theory suggested that ‘October 1987’ had a very slim chance to occur, but
it did.
It is very typical for financial firms to take up speculative trading positions across
geographies, across varied counterparties, across varied assets and structured assets.
Naturally, assessing risk at such level gets nothing short of a nightmarish task. However, this
was exactly what the business required. They needed to know how much they would stand
to lose, if October 1987 were to repeat. The new breed of traders and risk mangers calling
themselves ‘Quants’, developed highly sophisticated mathematical models to monitor
positions and evaluate risk level on a real-time basis. These folks came in with doctorates
from different backgrounds – statisticians, physicist, mathematicians, and of course
traditional finance. Firms officially recognized ‘Risk management’ as an important layer in
the system, and risk management teams were inducted in the ‘middle office’ segment, across
the banks and trading firms on Wall Street. They were all working towards the common cause
of assessing risk.
Then CEO of JP Morgan Mr.Dennis Weatherstone, commissioned the famous ‘4:15 PM’ report.
A one-page report which gave him a good sense of the combined risk at the firm-wide level.
This report was expected at his desk every day 4:15 PM, just 15 minutes past market close.
The report became so popular (and essential) that JP Morgan published the methodology
and started providing the necessary underlying parameters to other banks. Eventually, JP
Morgan, spun off this team and created an independent company, which goes by the name
‘The Risk Metrics Group’, which was later acquired by the MSCI group.
The report essentially contained what is called as the ‘Value at Risk’ (VaR), a metric which
gives you a sense of the worst case loss, if the most unimaginable were to occur tomorrow
morning.
The focus of this chapter is just that. We will discuss Value at Risk, for your portfolio.
10.3 – Normal Distribution
At the core of Value at Risk (VaR) approach, lies the concept of normal distribution. We have
touched upon this topic several times across multiple modules in Varsity. For this reason, I
will not get into explaining normal distribution at this stage. I’ll just assume you know what
we are talking about. The Value at Risk concept that we are about to discuss is a ‘quick and
dirty’ approach to estimating the portfolio VaR. I’ve been using this for a few years now, and
trust me it just works fine for a simple ‘buy and hold’ equity portfolio.
In simple words, Portfolio VaR helps us answer the following questions –
1. If a black swan event were to occur tomorrow morning, then what is the worst case
portfolio loss?
2. What is the probability associated with the worst case loss?
Portfolio VaR helps us identify this. The steps involved in calculating portfolio VaR are very
simple, and is as stated below –
1. Identify the distribution of the portfolio returns

2. Map the distribution – idea here to check if the portfolio returns are ‘Normally
distributed’
3. Arrange portfolio returns from ascending to descending order
4. Observe out the last 95% observation
5. The least value within the last 95% is the portfolio VaR
6. Average of the last 5% is the cumulative VaR or CVar
Of course, for better understanding, let us apply this to the portfolio we have been dealing
with so far and calculate its Value at Risk.
10.4 – Distribution of portfolio returns

In this section, we will concentrate on the first two steps (as listed above) involved in
calculating the portfolio VaR. The first two steps involve us to identify the distribution of the
portfolio returns. For this, we need to deal with either the normalized returns or the direct
portfolio returns. Do recall, we have already calculated the normalized returns when we
discussed the ‘equity curve’. I’m just using the same here –
You can find these returns in the sheet titled ‘EQ Curve’. I’ve copied these portfolio returns
onto a separate sheet to calculate the Value at Risk for the portfolio. At this stage, the new
sheet looks like this –
Remember, our agenda at this stage is to find out what kind of distribution the portfolio
returns fall under. To do this, we do the following –
Step 1 – From the given time series (of portfolio returns) calculate the maximum and
minimum return. To do this, we can use the ‘=Max()’ and ‘=Min()’ function on excel.
Step 2 – Estimate the number of data points. The number of data points is quite straight
forward. We can use the ‘=count ()’ function for this.
There are 126 data points, please do remember we are dealing with just last six months data
for now. Ideally speaking, you should be running this exercise on at least 1 year of data. But
as of now, the idea is just to push the concept across.
Step 3 – Bin width
We now have to create ‘bin array’ under which we can place the frequency of returns. The
frequency of returns helps up understand the number of occurrence of a particular return. In
simple terms, it helps us answer ‘how many times a return of say 0.5% has occurred over the
last 126 day?’. To do this, we first calculate the bin width as follows –
Bin width = (Difference between max and min return) / 25
I’ve selected 25 based on the number of observations we have.
= (3.26% – (-2.82%))/25
=0.002431
Step 4 – Build the bin array
This is quite simple – we start form the lowest return and increment this with the bin width.
For example, lowest return is -2.82, so the next cell would contain
= -2.82 + 0.002431
= – 2.58
We keep incrementing this until we hit the maximum return of 3.26%. Here is how the table
looks at this stage –
And here is the full list –
We now have to calculate the frequency of these return occurring within the bin array. Let me
just present the data first and then explain what is going on –
I’ve used the ‘=frequency ()’, function on excel to calculate the frequency. The first row,
suggests that out of the 126 return observation, there was only 1 observation where the
return was -2.82%. There were 0 observations between -2.82% and 2.58%. Similarly, there
were 13 observations 0.34% and 0.58%. So on and so forth.
To calculate the frequency, we simply have to select all the cells next to Bin array, without
deselecting, type =frequency in the formula bar and give the necessary inputs. Here is the
image of how this part appears –
Do remember to hit ‘Ctrl + shift + enter’ simultaneously and not just enter. Upon doing this,
you will generate the frequency of the returns.
Step 5 – Plot the distribution
This is fairly simple. We have the bin array which is where all our returns lie and next to that
we have the frequency, which is the number of times a certain return has occurred. We just
need to plot the graph of the frequency, and we get the frequency distribution. Our job now
is to visually estimate if the distribution looks like a bell curve (normal distribution) or not.
To plot the distribution, I simply have to select the all the frequency data and opt for a bar
chart. Here is how it looks –
Clearly what we see above is a bell-shaped curve, hence it is quite reasonable to assume that
the portfolio returns are normally distributed.
10.5 – Value at Risk

Now that we have established that the returns are normally distributed, we proceed to
calculate the Value at Risk. From here on, the process is quite straightforward. To do this, we
have to reorganize the portfolio returns from the ascending to descending order.
I’ve used excels sort function to do this. At this stage, I will go ahead and calculate Portfolio
VaR and Portfolio CVaR. I will shortly explain, the logic behind this calculation.
Portfolio VaR – is defined as the least value within 95% of the observation. We have 126
observations, so 95% of this is 120 observations. Portfolio VaR is essential, the least most
value within the 120 observations. This works out to be -1.48%.
I take the average of the remaining 5% of the observation, i.e the average of the last 6
observations, and that is the Cumulative VaR of CVaR.
The CVaR works out to -2.39%.
You may have many questions at this stage, let me list them down here along with the
answers –
1. Why did we plot the frequency distribution of the portfolio?

1. To establish the fact that the portfolio returns are normally distributed
2. Why should we check for normal distribution?
1. If the data we are studying is normally distributed, then we can characteristics of
normal distribution is applicable to the data set
3. What are the characteristics of normally distributed data?
1. There are quite a few, but you should specifically know that 68% of the data lies within
1 SD, 95% of the data within 2 nd, and 99.7% of the data lies within the 3 rd I’d suggest
you read this chapter to know more about the normal distribution.
4. Why did we sort the data?
1. We have established that the data set is normally distributed. Do remember, we are
only interested in the worst case scenario. Given this, when we sort it from highest to
lowest, we are essentially in a position to look at the returns in a more systematic way.
5. Why did bother to take only 95% observation?
1. Remember, according to the normal distribution theory, 95% of the data lies within
the 2nd standard deviation. This means on any random day, the return on the portfolio
is likely to be any value within the 95% of the observations. Therefore, quite naturally
the least most value within the 95% observation should represent the worst case loss
or the Value at Risk.
6. What does the VaR of -1.48% indicate?
1. It tells that the worst case loss for the given portfolio is -1.49% and we can conclude
this with a confidence of 95%
7. Can’t the loss not exceed -1.48%?
1. Yes, it certainly can and this is where CVaR comes into play. In the case of an extreme
event, there is a 5% chance that the portfolio could experience a loss of -2.39%.
8. Can’t the loss exceed beyond -2.89%?
1. Yes, it can but the probability of this occurring is quite very low.
I hope the above discussion makes sense, do apply this on your equity portfolio and I’m sure
you will gain a greater insight into how your portfolio is positioned.
We have discussed quite a few things with respect to the portfolio and the risk associated
with it. We will now proceed to understand risk with respect to trading positions.
Download the Excel workbook used in this chapter.
1. Events which have a very low probability of occurrence is called ‘Black Swan ’events
2. When a black swan event occurs, a portfolio can experience higher levels of losses
3. Value at Risk is one approach to estimate the worst case loss if a black swan event
were to occur
4. We can estimate the portfolio VaR by studying the distribution of the portfolio returns
5. The average of the last 5% of the observation gives us the Value at Risk of the portfolio.
CHAPTER 11
Position Sizing for active trader
11.1 – Poker face

Last month I got an opportunity to play poker with a few good friends. I was playing poker
after a gap of 6 years and I was quite excited about it. The buy in for this friendly game was
Rs.1000/. For those who are not familiar with poker – it’s a card game where in your skill and
luck are tested in equal measure.
So, the game started, cards were dealt, and in the very first round I bet Rs.200/ - and I saw it
go away, just like that. In the next round, I bet another 200, and again saw it go away. At this
stage I convinced myself that I could make up my losses in the 3 rd round, and with this
thought I increased the bet size to 600, only to watch it go away! So for all practical purposes,
I lost Rs.1000/- in a matter of 10 minutes! In the trading world, this is equivalent to blowing
up your entire trading account.
I didn’t give up, after all, I’m supposed to know trading and poker draws many similarities to
trading. I decided to ‘recover’ my initial loss and stay in the game longer. I bought in for
another 1000 and started fresh. This time, I stayed on the table a bit longer – for a total of 15
minutes!
Clearly, it was not working for me. I had a better memory of me playing poker 6 years ago.
Though not the best, at least, I would stay on the table till the game l asted and even win few
hands. So what was happening this time around? I was confused and I kind of didn’t believe
that this was happening to me? How could I wipe my account twice in a matter of 25 minutes?
With these confusing thoughts on my past poker skills and my current game play, I decided
to buy in again for another 1000 Rupees. This was my 3 rd buy in. In the trading world, this is
equivalent to funding your account 3 rd time over after successfully blowing it up twice.
What advice would you give someone who has blown up his account twice in the markets? –
‘get out of the markets immediately’, would perhaps be the best-suited advice right? Well, I
dint pay any heed to my inner voice, gambler’s fallacy had taken over my rational thinking
abilities and I bought in again for 1000 Rupees more.
For those of you who don’t know gambler’s fallacy – if you are betting on an outcome and
you tend to make a long streak of losses, then at the time of quitting, your mind tells you or
rather tricks you to believe that your losing streak is over and your next bet will be a winner.
This is when you increase your betting size and lose a bigger chunk of money. Gamblers
fallacy is one of the biggest culprits in wiping out many trading accounts clean.
Anyway, back to my poker game. This was my 3 rd buying, I had already lost 2K and was betting
with another 1K. I was confident I’d recover plus make some money and save myself some
shame, but the boys on the table had other plans for me. They knew I was the sucker on the
table and it was easy to allure me to make irrational bets. So they did and wiped me out clean
over the next 7 minutes.
That was it, I called it quits and I got back more after losing 3k.
After the game, I thought through on what went wrong. The answer was very cle ar –
1. I had forgotten to recognize the odds of winning with the cards that were dealt
2. I was not ‘position sizing’ my bets – my bets were way too irrational and random
After a couple of weeks, I had another invite to the game. I had set a bad precedence of giving
away easy money. This time around I had decided to position size my bets well.
I bought in for 1000 and started the game. Each time the cards were dealt – I accessed my
odds fairly well and if I thought my odds were fair, I bet accordingly. In the trading world, this
was equivalent to following a ‘trading system’ backed by position sizing techniques. The
result of this simple systematic approach had a great impact on my game –
1. I won few hands

2. At the peak, I must have had about 4K of winnings
3. I lasted throughout the game and had a lot of fun along the way
4. Towards the end I gave up some gains but was extremely happy with the fact that few
simple techniques helped me manage my game much better
Position sizing made all the difference in this game. It always does and this is the exact reason
for me to narrate this story. I do not want you to speculate in the markets without
understanding your odds or without position sizing your bets. If you do, you will end up
making a fool out of yourself.
Poker is played for fun but when you trade, you are essentially deploying your capital for a
more serious and meaningful outcome. So please do pay attention to some of the things we
will discuss over the next few chapters. I’m certain it will have a positive impact in you r
trading career.
At this point I have to mention this – I myself learned position sizing many years ago by
reading Van Tharp’s books. Van Tharp is one of the most prominent people to bring in the
concept of position sizing to traders. I’d even recommend you buy some of his books to
expand your knowledge on this subject.
11.2 – Gambler’s fallacy

We briefly discussed the gambler’s fallacy early on. I guess it makes sense to discuss a little
more on this at the very beginning especially in the context of markets.
Take a look at this chart –
This is the chart of Nifty – Nifty hit the magical number of 10,000 on 25 th July 2017. As a trader,
how would you trade this?
1. Nifty is at an all-time high – 10K

2. Many market participants may book profits at this point – considering it is a
psychological level
3. All time high implies no resistance points
4. Nifty has been in a great up wards trend over the past few weeks
5. Maybe Nifty would consolidate around these levels?
6. Maybe a correction of 2-3% before the rally continues?
Let us just assume that these are some valid points for now. This means a short position is
justified or for that matter buying of puts. Your analysis could be as simple as this or as
sophisticated as studying the time series data and modeling the same using advanced
statistical or machine learning models.
Irrespective of what you do – there is no certainty in the markets. No one technique will tell
you the outcome in advance. This implies that we are dealing with fairly random draws here.
Of course, based on how meaningful your analysis is, your odds of winning can improve, but
at the end of the day, there is no certainty and you have to acknowledge the fact that markets
are indeed random.
Now imagine this – you have done a state of the art analysis and you place your bet on Nifty
only to see the stop loss trigger. You do not give up, you place another trade and to your
misfortune, you are stopped out again. This cycle repeats for say the next 4 trades.
You know your analysis is bang on – but then your stop loss is continuously getting triggered.
You still have money in your account to take on bets, you are still convinced that your analysis
is rock solid and the markets will turn around, you still have an appetite for risk – given all
these, what do you do?
1. Would you stop trading?

2. Would you risk the same amount of money again?
3. Now that you have lost 6 consecutive bets, would you consider that your odds of
making money on the 7 th trade is higher and therefore increase your bet size to recover
your previous losses plus reap in some profits?
Which option are you likely to take? Take a minute and answer this question honestly to
yourself.
Having been through this situation myself and having interacted with many traders let me
tell you – most traders would take the 3 rd option, the question however is – why?
Traders tend to believe that long streaks will cease when they take the ‘next’ trade. For
instance, in this case, the trader has faced 6 consecutive losses, but at this point his
conviction that the 7 trade will be a winner is very high. This is called ‘Gambler’s fallacy’.
In reality, when you are dealing with random draws, the odds of making a loss on the 7 th trade
is as high (or low) as it was when you placed your first bet. Just because you have made a
series of losses, the odds of making money on the next trade does not improve.
Traders fall prey to ‘Gamblers fallacy’ and often end up increasing their bet sizes without
understanding how the odds stack up. In fact, gamblers fallacy ruins your position sizing
philosophy and therefore is the biggest culprit in wiping out trading accounts.
This works on the other side as well. Imagine, that you are fortunate enough to witness a 6 or
let us say 10 consecutive wins. Whatever you bet on, the trade works out in your favor. You
are on your 11 th trade now, which of the following are you likely to do?
1. Considering that you made enough money, would you stop trading?
2. Would you risk the same amount again?
3. Would you increase your bet size?
4. Will you take a conservative approach, maybe protect you profits, and therefore
reduce your bet size?
Chances are that you will take the 4 th option. You clearly want to protect your profits and do
not want to give back whatever you have earned in the markets and at the same time you
would want to take a trade considering you have had a great winning streak.
This is again ‘gamblers fallacy’ at play. Being completely influenced by the outcome of the
previous 10 trades, you are essentially reducing your position size for the 11 th trade. In reality,
this new trade has a same odds of winning or losing as the previous 10 bets.
Perhaps, this explains why some of the traders, even though get into profitable trading cycle
end up making very little money.
The antidote for ‘Gambler’s Fallacy’, is position sizing.
11.3 – Recovery trauma

In the trading world, the capital we bring on the table is the raw material. If you do not have
enough money to trade with, then how will you make a profit? Hence we need to not just
protect the profits that we make, but also protect the capital.
Extending this thought – if you risk too much capital on any one trade, then you stand a
chance to risk your capital to an extent that you may burn your capital leaving you with very
little money. Now if you are trading with very little money, then every trade that you take will
appear to be too risky. The climb back to where you started will (in terms of capital) will be a
Herculean task.
I have prepared a table to help you understand this fact. Assume you have a trading capital
of Rs.100,000/-. Let us see how the numbers stack up with –
You can download the excel sheet here.
Assume you lose 5% of your capital or Rs.5000/-. Your new starting capital is Rs.95,000/-. Now,
in order to recover to Rs.5000 with a capital of 95000, you need to generate a return of 5.3%,
which is 0.3% more than what you lost.
Now, instead of 5%, assume you lost 10% and your capital becomes 90000, now in order to
recover 10000 or 10% of your original capital, you have to earn back 11.1%. As you can see,
as the loss deepens, you will have to work really hard to bounce back to original starting
capital. For example at 60% loss or original capital, you are staring at a 150% boun ce back.
Unfortunately, the ‘recovery trauma’ affects traders with smaller account size. Assume you
come to the market with Rs.50,000/- capital. Now you would have heard of stories on how
Rakesh Jhunjhunwala, grew his money from 10,000 to 15K Crores. You would want to
replicate at least a small portion of this success. Honestly speaking, if you can manage to
grow Rs.50,000/- to say Rs.60,000 by the end of the year, you would have done a great job.
This translates to a 20% return. But this is not exciting, right? I mean earning Rs.10,000/- over
1 year when you are actively trading somehow does not seem right.
So what do you do? You tend to take bigger risks and hope to make bigger gains, and if the
trade goes against you, then you are essentially falling prey to the ‘recovery trauma’
phenomena.
This is exactly the reason why you should never risk too much on any one trade, especially if
you have a small capital. Remember, your odds of making good money in the markets is high
if you can manage to stay in game for long, and to stay for a longer period, you need to have
enough capital, and to have enough capital, you need to risk the right amount of money on
each trade. This really boils down to working towards longer term ‘consistency’ in
markets, and to be consistent you need to position size your trades really well.
I’m going to close this chapter with a quote from Larry Hite.
Over the next few chapter, we will dig deeper into position sizing techniques.
1. Position sizing forms the corner stone of a trading system

2. Gamblers fallacy is a bias highly applicable to the trading world. It makes the trader
believe that a long streak of a certain outcome can break
3. When there are infinite draws, the odds of making a profit or loss on the N th trade is
similar to the odds of making the same profit or loss on the 1 st trade
4. The recovery of capital is much more difficult task than one can imagine
5. Traders with small accounts have a tendency to take larger bets, which they need to
avoid
CHAPTER 12
Position Sizing for active traders (Part 2)
12.1 –Defining Equity Capital

The last chapter we laid down few key thoughts on position sizing and with that, I guess it is
amply clear as to why one has to incorporate position sizing at the core of every trading
strategy. Position sizing technique helps you identify how much of your equity capital has to
be exposed for a given trade. In this chapter, we will take that discussion forward and explore
ways to position size.
A quick recap of sorts before we proceed. What is position sizing?
Position sizing is all about answering how much capital you will expose to a particula r trade
given that you have ‘x’ amount of trading capital. One classic position sizing strategy which
most people employ is the standard 5% rule. The 5% rule does not permit you to risk more
than 5% of the capital on a given trade. For example, if the capital is Rs.100,000/-, then they
will not risk more Rs.5000/- on any single trade.
Here 5000 is the exposure to a trade and 10000 is the equity capital. You have decided to
invest 5000 a trade based on a position sizing rule or a strategy.
Needless to say, there are many different ways to position size, which by the way, also means
(unfortunately) that there is no single guided technique to position size. You as a trader need
to experiment and figure out what works for you. Of course, I will discuss few posit ion sizing
techniques soon.
Now, irrespective of which position sizing technique you will follow, at some point the
technique will require you to estimate your equity capital. For this reason, we will address
the technique of estimating equity capital first and then proceed to learn position sizing
techniques.
What do I mean by equity capital?
Equity capital is the basically the amount of money you have in your trading account based
on which you decide how much capital to deploy in a trade. This may seem very trivial to you
at this point. But allow me to illustrate why this is a tricky task.
Assume you have Rs.500,000 capital and you work with a simple position sizing principle of
exposing not more than 10% capital to a single trade. Given this, assume you t ake a position
worth Rs.50,000/-.
Now for the next trade, how much is your equity capital?
1. Is it Rs.450,000?
2. Is it still Rs.500,000 considering the fact 50K is deployed in a trade?
3. Should it be 450,000 plus 50K ± the P&L from the trade that exists in the m arket?
Given that there are numerous outcomes and possibilities, estimating equity for the trade is
not really a straightforward task. Hence, getting our act right in estimating the equity capital
is very important before we proceed to learn position sizing concepts.
12.2 – Estimating Equity Capital

At this point, I’d like to go back to good old Van Tharp and talk to you some of the techniques
he uses to estimate equity capital. These are some of the better techniques compared to the
many out there. Essentially there are three techniques or models as he calls them –
1. Core Equity model
2. Total Equity model
3. Reduced total equity model
The core equity model requires you to deduct the capital allocated to a trade from the
existing capital. This way, the exposure to a trade goes on reducing as you ladder up more
and more positions. Let me give you an example – assume your equity capital is Rs.50,000/-
and you follow a simple 10% position sizing formula. The 10% rule implies that you do not
expose or risk more than 10% of your capital to a trade. So the first trade gets an exposure
of Rs.5000. The core equity is now reduced to Rs.45000. Have a look at the following table –
Download the excel sheet here.
So, the first trade assumes the equity available is Rs.50,000, hence 10% of the available equity
is exposed first trade i.e Rs.5000/-. The core equity model requires you to deduct the capital
deployed to a trade and re work on the core equity model. So, the core equity is now
Rs.45000/-, which is also the available equity for the 2 nd trade.
For the 2nd trade, we again deploy 10% of the equity available i.e 10% * 45000 = Rs.4500/-. We
deduct this amount to calculate the new core equity, which is now Rs.40,500/-. This also is
now the newly available equity for the 3 rd trade.
So for the 3 rd trade, the capital exposure for the trade is Rs.4050 and the new core equity is
Rs.36,450/-. So on and so forth, I’m assuming you get the drift.
I consider this as a slightly conservative equity estimation model as you tend to reduce the
capital allocation as the number of opportunities increases. For all you know, your 5 th trade
(for which the equity exposure is far lesser) may be a great winner. The other side of the
argument is that the 5 th trade could be the worst loser compared to the rest.
Having said that, I like this model for the sake of its simplicity. Once you commit the capital
to a trade, you kind of forget about that and move on with what is available.
The Total equity model aggregates all the positions in the market along with its respective
P&L and cash balance to estimate the equity. Let me straight away take an example to explain
this –
Free cash available – Rs.50,000
Margin blocked for Trade 1 = Rs.75,000
P&L on Trade 1 = + Rs.2,000
P&L on Trade 2 = + Rs.7000
P&L on Trade 1 = – Rs.4,000
Total Equity = 50000 + 7000 + 2000 +115000+7500+55000-4000
= Rs.300,000/-
So, as you can see, in the total equity model, free cash along with margins blocked and the
P&L per position is taken into consideration. Now, if my position sizing strategy suggests a
10% exposure to a new position, then I’d expose Rs.30,000/- on a new trade. If the free
balance in my account does not permit me to take this position, then I’d not really initiate a
new position. I’d wait to close one of the existing positions to take a new position.
The fact that this model considers a live position along with its P&L into account for
estimating equity makes it a little risky. I’m personally not a big fan of this equity estimation
model. This is somewhat like counting the chicken before they hatch.
I do like the 3 rd model to estimate the equity, this one is called the ‘Reduced Total Equity
Model’.
This model kind of combines the best of both the core equity model and the total equity
model. It basically reduces the capital allocation to a particular trade (similar to core equity
model) and at the same time includes the P&L of the trade which is already in place (similar
to total equity model). However, the P&L is only on the locked in profits.
Let me work with an example to help you understand this better. Assume I have a capital of
Rs.500,000/-. Further, assume my position sizing strategy allows me to invest not more than
20% on a single trade, which is Rs.100,000/- per trade.
I’m looking at the chart of ACC and I decide to go long on ACC futures at 1800 by blocking a
margin of approximately Rs.90,000/-, which is well within my position sizing limit of
Rs.100,000/-.
I’ve now entered a position and waiting for the market to move. Meanwhile, as per the
reduced total equity model, my the capital available for the 2 nd trade is –
20%*( 500,000 – 90,000)
= Or about 20% of Rs.410,000/-
= Rs. 82,000/-
Note, because of the existing position, the exposure capital has reduced from Rs.100,000 to
Rs.82,000/-. Up to this point, it works exactly like the core equity capital model.
Now, assume the stock moves, and ACC jumps by 25 points to 1850. Considering the lot size
of 400, I’m now sitting on a paper profit of –
400*50
= Rs.20,000/-
I would now put in a trailing stop loss and lock in at least about 25 points out of 50 point move
or in Rupee terms, I want to lock in Rs.10,000 as profits.
This means, for the long ACC position at 1800, I have to now place a stop loss at 1825 and
locked in Rs.10,000/- as profits.
I will now add this locked in profits back to the total equity. Hence my total equity now stands
at –
410,000 +10,000
=420,000/-
This means, my new exposure capital will be 20% of the total equity –
=20% * 420000
= Rs.84,000/-
As you notice, the exposure capital has now increased by an additional 2000/ -.
I kind of like the reduced total equity model to estimate the total capital available to position
size. If one follows tends to follow this technique, then it kind of forces you to practice basic
stop loss principles, which according to me is very good.
Anyway, I’d like to close this chapter at this point. In the next chapter, we will consider one
of the above-stated methods to estimate equity and look into few position sizing techniques.
1. Estimating equity capital is crucial for position sizing

2. Core equity model deducts the capital allocated to a trade and recalculate the capital
available
3. Total Equity model requires you to add the free cash, margins blocked, and the P&L of
the positions to estimate the equity capital
4. Reduced Total Equity model requires you to add the free cash to the locked in profits
of an existing position
CHAPTER 13
Position Sizing for active traders (Part 3)
13.1 – Choose your path

We addressed a very crucial concept in the previous chapter. We looked at how one can
determine equity based on 3 different models. Each of these three models on its own merit
imposes some sort of position sizing discipline, but clearly that’s not enough. We still need a
standalone method to position size. Given this, we will move forward to discuss some of Van
Tharp’s techniques on position sizing.
I’d like to talk about three core position sizing techniques at this point, they are –
1. Unit per fixed amount

2. Percentage margin
3. Percentage of volatility
Do note, these models are asset independent and time frame independent. What d o I mean
by this? This means that you can apply these position sizing techniques to any asset you
want. It could be stocks, stock futures, commodity futures, or currency futures. Further you
can apply them across any time frame – intraday, few trading session, or even trades
extending for over few months.
To understand this really well, I’d suggest you pick a trading system, it could be as basic as a
moving average crossover system. Identify entry and exit rules and evaluate the returns you
would generated for the given time period. Now for the same set of data, apply one of the
position sizing technique (which we will shortly discuss) and evaluate the performance. I’m
sure, you will observe a huge improvement not just in terms of P&L but also the stability of
the system.
Just to throw some light into how complex this can get –
 Assume you have a trading system – a simple moving average cross over system
 You intend to deploy cash on this and start trading every signal that the system generates
 There are 3 models to define equity and there are at least 3 basic models to define position
sizing techniques
 This means you can position size in 3 x 3 = 6 different ways to deploy cash for the same
opportunity (signal)
 The P&L for each will be different
However, from my experience, I would suggest you stick one method to estimate equity and
maybe 1 or at the most 2 (meaningful) techniques to position size. Anything more may not be
a great, in the sense, it would induce complexity, and complex does not necessarily mean
better.
So you as a trader need to assess which path to follow based on your temperament. Anyway,
let’s get started on the core position sizing techniques.
13.2 – Unit per fixed amount

Let’s discuss the ‘Unit per fixed amount’ model first. This is a fairly simple model. Any trader
who has a slight inkling towards position sizing would have explored this model in the initial
days. I like and dislike this model for the same reason – its simplicity.
The model requires you to simply state how many shares or lots (in case of futures) you will
trade for a given amount. For example, assume you have Rs.200,000 in your trading account
and you have the following 5 assets (futures) as your opportunity universe –
1. Nifty
2. SBI
3. HDFC
4. Tata Motors
5. Infosys
You could simply state that you would not want to trade more than 1 lot of futures per 100,000
of any asset at any given point. Given this, assume you get a signal to buy Nifty, now since
there is 2L in the account, you can choose to buy one or 2 lots.
The best part about this model is that it does not complicate the decision-making process.
However, there are few problems with this model.
Consider this – the trading system that you follow generates a signal to buy Nifty Futures and
at the same time the system signals you to buy Tata Motors. Since you have 2L in your
account, you decide to buy 1 lot each. Do note at the point of writing this article, Nifty Futures
requires a margin of about 60K and Tata Motors around 72K.
Irrespective of the margin, the rule simply states, 1 lot per 1L. This means, position sizing rule
is assigning an equal weight to both the contracts, ignoring the implicit ‘riskiness’ of the
asset. To give you a perspective, Nifty Futures has an annualized volatility of around 14% and
Tata Motors has an annualized volatility of over 40%. So essentially, you are exposing yourself
to a higher risk at the portfolio level.
This in fact, is both good and bad at the same time. Good in the sense that it does not reject
a trade based on the riskiness and bad in the sense it does not really factor in risk.
There is another angle here – think about this, consider you are following a trading system to
which you apply the 1 lot per 100,000 position size rule. Assume you have a 2 lac capital. Now,
further assume that the system performs really well and you are bestowed with multiple
winning trades. Now, for each signal, the maximum number of lots you can buy is restricted
to just 2. For you to increase another lot or 2, you really need to double your capital or wait
for your profits to double up you capital. So in a sense this particular position sizing
technique limits the scalability of a system. The only antidote to this is to bring in a much
larger account size.
For these reasons, I kind of don’t prefer the ‘unit per fixed amount’ position sizing technique.
However, please don’t take my word, I’d suggest you work around and figure out your
comfort level with this technique before deciding to adopt or not adopt this as your core
position sizing technique.
13.3 – Percentage Margin
The percentage margin is an interesting position sizing technique. I personally think this
technique is far more structured than the ‘unit per fixed amount’, technique especially for
intraday traders. The percentage margin technique requires you to position size based on the
margins.
Here you essentially fix a ‘X’ percentage of your capital as margin amount to any particular
trade. Let’s work with an example to understand this better.
Assume you have a capital of Rs.500,000/-, with this you decide that you will not expose more
than 20% as margin amount to a particular trade. This translates to a capital of Rs.100,000/ -
per trade.
Assume you spot an opportunity to trade Nifty Futures, you can easily take this position as
the margins for this is roughly around 60K. However, let’s say you spot an opportunity in
ICICI, you will be forced to let go of this as the margin for this is close to Rs.105,000/ -. This
means, ICICI will be out of your trading universe until and unless you increase your capital.
Obviously, one should not randomly increase the capital just to accommodate opportunities.
Capital should increase as an outcome on profits accumulating in your account.
Anyway, after you initiate the position in Nifty, assume you spot an opportunity in ACC, the
margin for this is 90K.
Will you take this position?
The answer to this really depends on the way you estimate equity.
If you consider the total equity model, then you will still consider your capital to be 5L, 20%
of which is 1L, hence you can safely take the position in ACC.
However, if you consider the reduced total equity model, then this is how it would work
(assuming 20% position sizing rule) –
Starting Capital = 5L
Margin blocked = 60K
New capital = 4.4L
Margin @ 20% = 88K
Given this, you’d fall short by (just) 2K for a 90K position, hence you would have to let go…and
as you realize, equity estimation plays very crucial role here.
Lastly, assume, you spot an opportunity which requires a margin of 40K, since you have 88K,
you can comfortably take up 2 lots of this position.
So on and so forth.
The percentage margin rule ensures you pay roughly the same margin to all positions.
However, the volatility from each position could vary. You could end up with risky bets and
therefore altering the entire risk profile of your account.
This exposure to risk is overcome by next position sizing model.
13.4 – Percentage Volatility

The percentage volatility rule accounts for volatility of the underlying asset. The volatility as
per this technique is not really the ‘standard deviation’, but rather the daily expected
movement in the underlying.
For example, if SBI’s OHLC is 276, 279, 274, and 278, then the volatility for the day is simply
the difference between low and high i.e
279 – 274
=5
To get a sense of the generic volatility measured this way, I can look at the difference between
low and high for last ‘n’ days and take an average. However, the only problem here would be
that I would be ignoring the gap up and gap down openings. For this reason, Van Tharp
suggest the use of ‘Average True Range’ to measure the stock’s volatility.
The ‘Percentage Volatility’ method of position sizing requires us to define the maximum
amount of volatility exposure one can assume for the given equity capital.
For example, if the equity capital is Rs.500,000/- then I could make a rule saying that I do not
want to expose more than 2% of the capital to volatility.
Let’s work with an example. Here is the chart of Piramal Enterprises Limited (PEL) –
The 14-day ATR is 76. This means each share of PEL contributes to a fluctuation (volatility) of
Rs.76/- to my equity capital.
Now assume I spot an opportunity to trade PEL, the question is how many share should I buy
considering my equity is 5L and I’ve capped volatility exposure as not more than 2% .
2% of 5L is 10,000/-. This means I should only so many number of shares of PEL, such that the
overall volatility caused by PEL is not more than 10k.
Given this, I simply have to divide 10,000 by 76 to find out the number of shares that I can buy
–
10,000/76
= 131.57 or about 131 shares.
PEL is currently trading around 2700, which means to say, your overall exposure would be –
131 * 2700
=Rs.353,700/-
I’d suggest you stick to the reduced total equity model for estimating equity here. This
means, the capital available for the next trade would be –
500,000 – 353,700
=146,300
Now @ 2% volatility, the capital exposure reduced to Rs.2929/-. Clearly the capital exposure
to the next trade would reduce, but the exposure to volatility would remain the same.
Here is an advice (from Van Tharp, of course) if you are inclined to follow percentage volatility
technique – the do estimate the total amount of volatility you want to expose your portfolio
too. If the number is say 15% then on a 5L capital this works out to Rs.7 5,000/-.
Think about it, if every position goes against you, then you stand to lose 75k on a capital of
5L on a single day. How does that feel? If your stomach churns, then 15% portfolio volatility
maybe a bit high for you.
In the next chapter, we will explore few more concepts before we proceed to understanding
‘Trading biases’.
1. Estimating equity plays an important part in position sizing

2. Suppose you have 3 ways to estimate equity and 4 ways to position size, then
essentially you have a 4 x 3 = 12 position sizing technique
3. Unit fixed model requires you to ascertain how many shares or lots you will trade for
every ‘x’ amount of capital in your account
4. Unit fixed model does not consider risk
5. Percentage margin method requires you to define the maximum margin amount you
will expose your capital to. You ideally should club this with total reduced equity
model
6. Percentage volatility measures volatility in term or ATR.
7. Percentage volatility equal weights ‘volatility’ exposure to each position
CHAPTER 14
Kelly’s Criterion
14.1 – Percentage Risk

Last chapter we looked at three important position sizing techniques, all of them were unique
in their own merit. The three techniques were –
 Unit per fixed amount

 Percentage Margin
 Percentage Volatility
All three methods work differently and when combined with a certain equity estimation
technique, they produce totally different results. Given this, it is really up to you to figure out
the marriage of which position sizing technique with which equity estimation technique
works best for you.
Before I proceed, I thought it is important to discuss another practical position sizing

technique, called the ‘Percentage Risk’, method. I do know quite a few traders who use this
and I myself find this quite simple and intuitive technique to use.
The percentage risk method, relies upon your own assessment of ‘loss’ that you are willing
to bear for a given trade. This, as you may know is also called the ‘Stop loss’ for the trade.
The stop loss for a trade is the price at which you decide to close the trade and take a hit. The
percentage risk technique controls the position size as a function of risk defined by stop loss.
Let me take the example of a stock futures and explain how this works, in fact, I th ink this is
a good trade setup –
Here is an intraday chart of Tata Motors, the frequency is 15 mins (14 th Sept 2017, around
11:30 AM).
Let me explain why this is a trade worth considering –
Tata Motors is at 393.65, which happens to be a price action zone, considering it tested the
same level, twice in the past. So this makes 393.65, a support price for Tata Motors (on an
intraday basis). Both the times in the past, the price declined of Tata Motors declined when
the stock tested 393.65. Given this, there is a possibility that the price could again test 393.65
and react to bounce back to the price from which it started to decline i.e 400.
Also, do notice the low volume retracement between 400 to 393.65 – I’ve discussed why I like
trades like these in the Technical Analysis module. If you’ve not read that module, maybe you
should
Considering these factors, a trader could be inclined to go long on Tata Motors Futures at
393.65.
What if the trade heads the other direction? What is the stop loss?
I notice some sort of support at 390/-, hence I’d be happy to set this as stop loss for the trade.
Nothing complicated, as you can see this is a very straightforward setup.
So the trade would be –
Stock: Tata Motors Limited
Trade: Long
Trade Price: 393.65
Target Price: At least 400
Target value 6.35
Stop loss Price: 390
Stop loss value: 3.65
Reward to Risk: 1.7 (which is great for an intraday trade)
Lot size: 1500
Margin Required: 73.5K
Now assume I have a capital of Rs.500,000/-, how many lots of Tata Motors can I buy
considering the margin per lot is Rs.73,500/-?
Technically speaking one can buy up to 6.8 or 6 lots –
500000/73500
=6.8
However the question is – would you expose your entire capital to this one trade alone? Not
a smart thing to do, if you were to ask me, because if the trade goes wrong, you would be
losing Rs.32,850/- (3.65 * 1500 * 6) on this trade.
In other words, you would lose –
32850/500000
=6.57% of your capital on one trade.
However great a trade set up is, it is not a smart thing to expose so muc h capital to risk. As a
thumb rule, professional traders do not risk more than 1 to 3% of their capital on any single
trade, and this rule forms the core of the ‘Percentage risk’ position sizing technique.
Given this, let us define the maximum risk per trade as a percentage of overall capital –
maybe 1.5% for now. This means on this trade, the maximum loss I’m willing to bear is
1.5% * 500000
Rs.7,500/-
In other words, I don’t intend to lose more than Rs.7,500/- on any single trade. This is the
maximum loss threshold.
We know the stop loss for this trade is 390, from an entry price of 393.65, the stop loss in
absolute Rupee terms is –
393.65 – 390
= 3.65
The loss per lot is –
3.65 * 1500
= 5475
In the event the stop loss is triggered I would be taking a hit of Rs.5475 per lot.
Now to identify the number of lots I could take for the risk I’m willing to bear, I simply have
to divide the maximum threshold by the loss per trade.
= 7500/5475
= 1.36
Therefore, on this trade I can go ahead and buy up to 1 lot, which will cost me Rs.73,500/- as
margin deposits.
For the next trade, it is prudent (or rather conservative in a positive way) to reduce the money
blocked from the overall capital and re-work the maximum loss threshold. Let’s do that and
identify the new max loss threshold –
500000 – 73500
= 426,500
1.5% * 426500
= 6397.5
Given this, for the next trade, I will work out the stop loss, multiply that with the lot size and
divide the max risk i.e 6397.5 by loss threshold to identify how many lots I can transact in.
So on and so forth!
By the way, curious to know how the trade panned out? Here you go –
I like trades like these, when the price does not even approach close to the stop loss J. As I
had pointed out earlier, I did have a great amount of conviction on this trade. This leads me
to the next topic – how do I position size when my conviction on a particular trade is high?
What in such situations I want to expose a slightly higher capital?
Well, say hello to Kelly’s Criterion!
14.2 – Kelly’s Criterion

Kelly’ Criterion has an interesting background. It was proposed by John Kelly in the 50’s who
at that point was working for AT&T’s Bell Laboratories. He in fact, suggested the Kelly’s
Criterion to help the telecom company with long distance telephone noise issues. However,
the same theory was adopted by professional gamblers to identify the optimal bet size. This
soon found its way to the stock markets as well, and there are many professional traders and
investors who use Kelly’s Criterion for bet sizing. Perhaps, this is one of those very few tools
that both traders and investors commonly use.
I still don’t know how the transition from Telecom to stock markets happened – I’m a Telecom
Engineer by qualification (although I know nothing about Telecommunications now) and I’ve
been involved in Stock markets for over 13+ years….but I just can’t wrap my head around
how Kelly’s Criterion made its transition across these two different worlds J
Anyway, the Kelly’s Criterion essentially helps us estimate the optimal bet size (or the fraction
of our trading capital) considering –
 We have a certain information on the bet we are about to take

 We have an edge taking that particular bet
Let’s jump straight to Kelly’s Criterion with an example. The Kelly’s Criterion is an equation,
the output of which is a percentage, also known as a the Kelly’s percent. The equation is as
below –
Kelly % = W – [(1-W)/R]
Where,
W = Winning probability
R = Win/Loss ratio.
o The winning probability is defined as the total number of winning trades divided over the
total number of trades
o The win/loss ratio is the average gain of winning trades divided over average loss of the
negative trades.
To understand this better, let’s take up an example. Assume I have a trading system which
has produced the following results, for sake of simplicity, let’s assume this is a trading system
to trade just one stock, Tata Motors.
Given the above data –
W = Total Number of winners / Total number of trades
= 6/10
=0.6
R = Average Gain / Average Loss
Average gain = Average of [5325, 2312, 4891, 1763, 8675, 4231]
= 4,532
Average loss = Average of [6897, 231, 989, 1980]
=3,274
R = 4532 / 3274
= 1.384
Do note, a number greater than 1 is always desirable as it indicates that your average gains
are higher than your average loss.
Lets plug these numbers back to the Kelly’s Criterion equation –
Kelly % = W – [(1-W)/R]
= 0.6 – [(1-0.6)/1.384]
=0.6 – [0.4/1.384]
= 0.31 or 31%.
As per the original school of thought – Kelly’s percentage is a direct representation of how
much capital one should expose for a trade. For example, for the 11 th trade on Tata Motors,
Kelly’s Criterion suggests a capital exposure of 31%.
But I think this can be a little tricky, imagine a trading system with great accuracy – the Kelly;s
Percentage can turn out to be 70%, suggesting a capital exposure of 70% to the next trade.
Not a very smart thing to do if you ask me. However, you may ask why not? After all a system
with 70% accuracy is a great, so why not maximize the bet?
This is because, there is still a 30% chance to lose 70% of your capital!
Given this, here is a simple modification to Kelly’s criterion. Let us go back to the percentage
risk position sizing technique we discussed earlier in the chapter.
We defined the percentage risk as a technique wherein the exposure to a trade is defined as
1.5% (or any percentage) of the capital. Given Kelly’s criterion, we can modify the exposure
as ‘up to 5%’ (or any percentage you deem suitable).
What does this mean? This means for a given trade, I would not expose more than 5% of the
capital. This also means that capital exposed could range from as low as 0.1% to all the way
up to 5%. So how do I decide?
We can use Kelly’s percentage here. For example, if the Kelly’s percentage is 30%, then I’d
expose, 30% of 5% or in other words, I’d expose 1.5%. If the Kelly’s percentage is 70%, then
I’d expose 70% of 5% or say 3.5% of the capital on the trade.
So higher the Kelly’s percentage, higher is the capital exposed and vice versa.
For a more Mathematical explanation on Kelly’s Criterion, I’d suggest you watch this video,
if not for anything, watch from the 10 th minute onward.
With this, I’d like to close the discussion on position sizing, hopefully the last 4 chapters has
given you a fair understanding of the importance of position sizing and techniques to position
size your bets.
Onwards to ‘Trading and Investing Biases’.
1. Percentage Risk is an easy and intuitive position sizing technique

2. One has to define the maximum amount of risk one as a percentage of capital, dividing
this over the stop-loss gives us a sense of how much capital one should expose to a
trade
3. Kelly’s Criterion suggests how much capital one can expose for a given trade
4. One can combine Kelly’s Criterion with percentage risk for optimal results
CHAPTER 15
Trading Biases
15.1 – Mind games

If you are a part of any WhatsApp group related to stock markets, then chances are that you
may have watched this video –
If you are in no mood to watch it, then let me give you a quick summary – This is a show where
people call in during the show and ask the show host questions related to stock markets. This
is a video clip of one such caller asking the host of the show, the procedure to convert 20,000
shares of MRF LTD from paper to digital form. The shares were bought by his grandfather back
in the 90’s and were kept in the paper form – ‘physical certificates’, as they are called.
After informing the caller the procedure to convert the shares from the physical form to
DEMAT form, the show host casually informs him the value of his shares in today’s terms.
The price of MRF on a per share basis was roughly Rs.64,000/-. Considering the fact that he
has 20,000 shares, the overall value works out to –
20,000 * 64,000= 1,280,000,000
Or about Rs.128 Crores.
Can you imagine that – ONE TWENTY-EIGHT Crore!
I was flabbergasted when I first saw this video.
The first thought that occurred to my mind was – how can someone have the vision to buy
MRF 25 years ago? How is he motivating himself to still stay invested? How could he resist the
temptation to not sell the stock? Especially after watching the stock grow multiple times over
his initial investment?
A common investor according to me would probably sell his investment if he saw his
investment return say – 50%, maybe 100%…or at most 200%. But this guy has held his stock
across years, watching it grow at least 20 times or 2000%.
How did this happen?
Think about this – if we can understand what exactly is happening here, maybe it will throw
out a bunch of insights which will help us create similar wealth right?
When I thought through this again (and watched the video again) – I kind of figured what was
going on here. Here are my observations –
 His grandfather had bought the shares of MRF back in days, has not paid much attention
to it since the purchase
 One fine day he realized that he has few shares of MRF lying in the attic
 He must have mentioned this to his grandson (the caller)
 The grandson has now decided to convert them to DEMAT
 I’m assuming that he would probably sell the shares as soon as it gets them converted
I find this situation extremely interesting, there is a lot happening here and one can draw few
conclusions here –
1. It is likely that the grandfather has forgotten about his investment, and spent his time
somewhere else
 This is a valid conclusion as otherwise; he would have taken efforts to convert shares
to DEMAT long ago
2. Because he had forgotten, he has not paid much attention to the price appreciation
over the years
What can we infer from this?
One straightforward inference that you would agree I suppose – granddad had made a ton of
money by simply forgetting the fact that he owns shares of MRF.
Now for a moment imagine – what if he had not forgotten about his investments? What if he
had access to a broker or a friend who would call him every day to tell him the stock price of
MRF?
Do you think he would have held on to his shares for these many years? Don’t you think there
is a high probability of him selling out his investment – at say a return of 100%, 200% or even
500%?
In other words – because he forgot and did not pay attention to his investment, he held on to
his investment over the years and reaped its benefit.
Now, had he deiced to track the stock price and update himself with the latest developments
– what do you think would have happened? He would analyze the data – when people analyze
data – they don’t just analyze the facts, they try and be smart about it by adding their own
imagination. These imaginations originate from our own interpretation of an ideal world. We
often refer to this as ‘biases’.
Biases, in the trading and investing world, is the only thing standing between you and a
profitable P&L.
This objective of this chapter and the next is to discuss some of these common biases and
help you overcome these biases.
15.2 – Illusion of Control

Let us start with one of the most common biases traders and investors tend to have. Have a
look at the chart below, a typical chart you’d find on any technical analyst’s desk. There are
quite a few things happening here in this chart –
1. Candlestick chart for price action

2. Bollinger band to track volatility
3. Fibonacci retracement to identify retracements
4. Pivot points for support and resistance
5. Volume chart
6. ATR
7. Stochastic indicator
I’m certain, at least 8 out of every 10 technical traders would have a similar setup while
analysing charts. Clearly, for someone not familiar with charts or technical analysis this chart
would look quite intimidating. After all, there are so many things happening here.
Each element on this chart gives out a unique insight to the trader. Along with these so-called
insights, the chart does something else to the trader at the subconscious level.
Because of the complexity of the chart, and the fact that not many people can relate to it – it
somehow makes the trader believe that he is dealing with a complex subject – and he is in
total control over the stock by virtue of all the ‘important insights’ he seems to have derived.
This is often called the ‘illusion of control’ – one of the biggest trading biases for a technical
trader. Traders who are heavily influenced by the illusion of control often make stat ements
like ‘This stock is not going to go above 500’ or sometimes they make super confident
statements like ‘Go ahead and buy puts’, you question them why, and they will be quick to
say ‘Boss, I’m telling you just buy Puts’.
Why do they do this?
Well, traders have this tendency to get attracted to complex things, it just feels very nice to
be looking at complex charts and making sense out of it. This is like fighting fire with fire –
markets are so complex, the default notion is to fight this complex beast with complex
analysis. Further, the fact that only you can make sense of it and others cannot give you that
additional kick.
This physiological behavior can be attributed to the ‘Illusion of control’.
Remember, no matter how many indicators you load or how many numbers you crunch, there
is no way you can control all the outcomes. End of the day, there are several different
outcomes possible for every possible situation in the market. You cannot control them all.
The only way to overcome this behavior is to stay focused on results and statistics. If you are
dealing with a trading strategy, then you got to know the odds of the next trade being
profitable. When you start looking at market opportunities this way, you will start being
truthful to yourself (and others around you) and will always remain humble. If not for
anything, you not get carried away by noise.
From all my market experience I can tell you one thing with conviction – the best analysis is
done when things are kept simple. Complex does not necessarily mean ‘better’. Hence, you
as a trader need to be completely aware of this and work towards building a data -driven
approach and not get swayed by inputs that don’t really matter.
15.3 – Recency Bias

Here is another bias that plagues traders. I find this quite interesting – no matter how many
years of experience you have, at some point, you will fall prey to it. Let me illustrate with a
recent example.
If you have been tracking ‘Café Coffee Day Enterprises’ (CCD), then you’d know what is really
happening with the company and stock price. For the uninitiated – the company has been
under the radar of ‘Income Tax Department’ for tax evasion and hoarding large amounts of
income. Couple of days ago, Economic Times carried out the story in great detail, here is what
the headlines said –
I’ve always maintained one stance when it comes to making long-term investments – if the
company’s corporate governance is questionable, then no matter how attractive the
investment appears, one has to avoid. History has taught us many times that such
investments will eventually go down the drain. Given this investment stance and the recent
events in CCD, I’d be hesitant in making a long-term investment in CCD.
But what if you already have an investment and this news rolls out? Well, assuming there is
truth in the news, the first thing I’d do would be to get out, no matter how much money I’d
be making or losing at that point.
A good family friend had made an investment in CCD, he called me a couple of days after the
news rolled out asking me for my advice. Do note, the news by the time he called me was
already 2-3 days old. Things had calmed down (but the fact that the income was concealed,
still remains). When he asked me for my advice – I asked him to get out. He quickly pulled the
chart of CCD and asked me to take a look –
As you can see, after the steep fall, the latest green candle suggests that there was some
buying in the stock. Maybe, there were few traders/investors trying to bottom fish.
Now, if the idea is to get out because of corporate governance issue – you have to. There are
no two ways about it. However, this friend of mine suggested, ‘Maybe I’ll hold for few days
before selling, I could get a better price’.
I just left it at that and didn’t really try convincing him to get rid of the sock.
But why do you think this friend of mine wanted to hang on to the stock? Does the latest
green candle override the fact that there was concealed income at CCD? Or does it give a
clean chit to the company’s corporate governance?
I don’t think so.
Instead, what it does is – it induces a bias called the ‘Recency bias’.
‘Recency bias’, gets you carried away with the latest information/event by making you turn a
blind eye to the past events or facts. This is exactly what is happening to my friend – the latest
green candle is making him turn bullish and he is convincing himself that there is more up
move left. Well, there could be an up move – but that still does not override corporate
governance and turns the stock to an investable grade stock.
Recency bias distorts your sense of judgment. It makes you weigh the recent event far higher
than what you probably should.
The only way to overcome recency bias is by taking cognizance of the wider picture. You
should be in a position to see things from an overall perspective and not really a microscopic
view.
1. Markets are complex, but the means to analyze markets need not be complex
2. Traders often complicate their charts, subconsciously it makes them think they are
invincible, gives them a sense of control
3. Illusion of control makes you spend many hours trying to derive data, which is otherwise
pointless
4. More data does not necessarily mean quality of information
5. Recency bias makes you turn a blind eye to the past events (which could have more impact
on markets)
6. Having a sense of the overall picture helps you prevent yourself from falling prey to recency
bias
CHAPTER 16
Trading Biases (Part 2)
16.1 – Anchoring Bias

I’ve spent close to about 13 years participating in the stock markets. I’ve spent these years in
various capacities – as a trader, investor, broker, money manager, analyst etc. I’ve had my
fair share of happiness and regrets in the markets and I’ve learned a lot (still continue to
learn) during these years. I’ve realized that happiness and regret may not always be a linked
to the outcome of a trade that you’ve taken up – you feel happy when you make a profit and
regret when the trade results in a loss. These feelings can also manifest out of trades that
you’ve not taken up. Let me tell you one of my biggest regrets in the stock markets till date.
I the recent years, August / Sept 2013 was one of the greatest times to build a long -term
portfolio from scratch. Stocks of great business were available at throwaway valuations. I
was fortunate enough to be aware of this situation in the market and I was really busy
structuring my equity portfolio. I had a tough time selecting stocks to include in my portfolio.
Tough time in the sense that there were too many opportunities to choose from. In fact, this
is what a bear market does to you – it spoils you for choices.
I included few stocks in the portfolio (which I still continue to hold) and I let go of many stoc ks
including MRF, Bajaj Finserv, etc. The decision to let go of these stocks was based on the fact
that I perceived investing in other stocks more attractive. Stocks like MRF and Bajaj Finserve
have performed phenomenally well, but then I don’t regret my decision.
However, the decision to not invest in Sundaram Clayton Limited pains my heart – I consider
this as one of the biggest regrets.
Take a look at this chart –
I did my usual stock research and was convinced that the stock was a great buy. I’ve circled
the area around which I wanted to buy – roughly around 270 per stock. Given that it was a
bear market, I was kind of rigid on the price to buy – 270 or lower.
The stock price moved slightly higher to about 280, but I did not budge. I waited. The stock
price moved to 290, I waited. A couple of days later, the stock shot to 310 and I remember
convincing myself – the stock will retrace back to 270 considering that it was a bear market.
After all, I was in no mood to pay a 15% ‘premium’ on a price that I perceived as ‘the best
price’.
As you may have guessed, 270 never occurred and I never got to buy this stock, and here is
what really happened to the stock later on –
I’ve circled the 270 price mark again for your reference, which is where my so -called ‘price
conflict’ occurred – all in my mind!
I probably missed out one of the greatest investment opportunity in my life, and all thanks to
the games my mind played with me. More formally, what really prevented me from buying
Sundaram Clayton can be attributable to a notorious trading bias called ‘The Anchoring Bias’.
I was looking up on Wikipedia for ‘Anchoring Bias’, and I discovered a new term for the same
– it is also called ‘Focalism’. Anchoring bias belongs to a group of biases grouped under
‘Cognitive Biases’. Cognitive bias is a systematic error in our thinking that affects the way
human beings make their decisions or judgments. Anchoring Bias leads the list of cognitive
biases.
Under the influence of Anchoring Bias, we tend to get fixated to the first level of information
we get. For example, in my very own case, the first price I saw on the terminal was 270 (for
Sundaram Clayton), and I was fixed to that price. Here 270, formed a price anchor.
Think about your own trading situations – how many times you may have missed placing that
buy order or a stop loss order because the price that you perceived as ‘right’ never occurred,
only to later see the stock perform exactly the way you thought it would. After all, in most of
these situations, the price difference between what we perceived as right and the one
available in the markets would be marginal – few Rupees probably, but then our minds just
do not permit us to go ahead.
Like any other biases, there is no real cure for anchoring bias. The only real cure is to be aware
of it and adopt critical thinking in your approach to markets.
16.2 – Functional Fixedness
This is yet another cognitive biases – although you will not read much about this particular
bias in the trading world. However, I think it kind of has its impact on traders, especially the
ones who trade derivatives.
Let me give you a generic explanation of ‘functional fixedness’ bias and then relate this to the
trading world.
There is juice shop near my office which I frequent for a glass of fresh juice. On one of those
visits, I asked for my regular orange juice, but the guy at the juice shop was busy fixing the
mixer jar. The handle of the jar was loose and had to be fixed. The guy was busy trying to find
a screwdriver to tighten the mixer’s handle. Unable to find one, he was kind of clueless on
how to proceed.
At the same time, his colleague walked in and learned about the issue. He simply picked up
a spoon which was lying around, used the other end of the spoon (which basically has a flat
side) as a makeshift screwdriver and tightened the jar. Problem solved, juice was served.
This is functional fixedness at its best. Functional Fixedness is a cognitive bias that limits a
person to using an object only in the way it is traditionally used. We assign tasks to objects
and we live with that rigidity all our lives. For example – we have all grown up with the notion
that we only need to look for a screwdriver to tighten screws, without which one cannot.
However, a simple spoon can do the same job! One has to start thinking out of the box to
solve problems in unconventional ways.
There are few ways in which Functional Fixedness limits our way of thinking when it comes
trading. Let me start with a classic example.
Assume you have Rs.100,000/- in your trading account. You have identified a great trading
opportunity in Nifty and you expect to hold onto the trade for the next 2 or 3 days. Since you
intend to hold this trade overnight, you have to opt for a ‘NRML’, product type. The typical
margin blocked for this trade would be about Rs.65,000/-.
So you take the trade around 3:20 PM and carry the position forward. End of the day 65K
would be blocked as margin and 45K would be your available balance, which can be utilized
toward another trade the next day.
The next day market opens, Nifty starts moving in the direction that you expect it to move.
You are happy with the way things are going.
Now, assume that you spot a great intraday opportunity, TCS stock futures, which requires
you to pay an MIS margin of 60K. What will you do? The available margin is 45K, you’d fall
short of 15K right? Therefore, you cannot take the TCS intraday trade.
Now, this is where the functional fixedness is playing the culprit. We consider the NRML
(margins blocked for overnight positions) as ‘margins blocked’, and we invariably forget
about this capital until we square off the position.
With a little bit of ‘out of the box’, thinking (and some efforts) we can, in fact, continue to hold
the overnight position plus take up the intraday opportunity.
Here is how it would work –
1. At the start of the day, you have available margin of 45K, short of 15K to take up the
intraday trade
2. Convert the NRML Nifty position to MIS. When you do this, from the 65k that was
blocked, nearly 39K would be freed up – as MIS for Nifty is about 26K
3. You now have 45K + 39K or 84K free cash for the day
4. With 84K, you can easily place an MIS order, blocking 60K. You will still have 14k as
available margin
5. End of the day, square off the MIS stock futures trade – remember this was an intraday
trade
6. Your available margin goes up to 84K
7. Convert back the MIS Nifty trade to NRML and carry forward the position
The snapshot below shows you how you can do this on Kite –
16.3 – Confirmation Bias
Have a look at the Tata Motor’s below
I’ve marked few important points on this chart –
1. The stock is around 430 today

2. 430 seems to be a price action zone considering the past price reactions
3. Sometime in early August, the price cracked through 430 and declined to 370
4. The stock price stabilized around 370, quite evident with the double/triple bottom
formation
5. Since 370, the price has consistently trended up, all the way back to 430, which is
where the current stock price is
Considering the above, guess the stock is all primed up for an up move – don’t you think so?
Also, keeping that analysis in the back of our mind how would you view this piece of news
which made the headlines earlier today –
Chances are that you will views this news piece as a trigger for Tata Motors to edge higher
and therefore support your logic of buying the stock. However, in reality, the fundamental
news may not really be a great trigger to drive the stock price higher. B ut then, at a
subconscious level, you start looking for pieces of information that support your view. In
other words, when you form a trading opinion, no matter what happens, you only look and
assimilate information that supports your view. Your brain somehow does not allow you to
pay attention to information that does not support your original contention.
This is called the ‘Confirmation Bias’.
Critical reasoning is the key to overcome the confirmation bias. You got to ask yourself – so
what?
16.4 – Attribution Bias

This one is funny.
How many times have you had a winning trade and ended up feeling proud of your analysis?
Perhaps you bought an option and it gained 100% on the premium or maybe you bought a
stock and saw it appreciate multifold.
Every time you make a profit – it is somehow because of your smart trading logic, and
therefore you give yourself a pat on your back. But what about the times you’ve made a loss?
How do you deal with it?
Coming from a stockbroking industry, let me tell you one thing – when people make a loss,
they invariably attribute this as broker’s fault and not really their own. Traders find all sorts
of reasons to blame the broker – broker’s system failed, charts not loading, orders are slow,
and what not.
Everything thing is attributable to someone else’s mistake (mainly the broker) and not really
the subpar analysis in the first place!
This is called the ‘Attribution Bias’ and people succumb to it owing to acknowledge the fact
that they are wrong. One way to overcome the attribution bias is to maintain a trading journal
and make entries which reason outs why you’ve entered into a trade and why you decided to
close the trade. These journal entries over time give you a great insight into your own trading
behavior.
16.5 – And it’s a wrap!
The list of these biases gets endless. Naturally, covering all of them would be hard. However,
here is what I’ll do – I’ll keep this chapter open and I will continue to add more biases as and
when I discover them myself
With this chapter, I’d like to close this module on Risk and Trading Psychology. As usual, I
hope you enjoyed reading this module, as much as I enjoyed writing it for you all.
Keep those comments coming!
Key takeaway from this chapter
1. Anchoring Bias can be quite notorious – tricks the trader/investor to anchor them to
the first piece of information
2. Anchoring Bias may lead you to miss great opportunities
3. Functional Fixedness fixes your opinion on the utility of the tools, restricts your
imagination
4. One can overcome functional fixedness by practicing ‘out of the box’ thinking
approach
5. Confirmation bias makes you seek information (or tricks you to assimilate
information) which can support your original hypothesis
6. In a typical trading world, traders attribute losses to problems in the outside works
and not really because of subpar analysis
7. Attribution Bias can be overcome by maintaining a trading journal
Table of Contents
1 What to expect? 1
2 Pair Trading logic 6
Pair Trading, Method 1, Chapter 1 (PTM1, C1) -Tracking

3 13
Pairs
4 PTM1, C2 – Pair stats 21
5 PTM1, C3 – Pre trade setup 30
6 PTM1, C4 – The Density Curve 39
7 PTM1, C5 – The Pair Trade 48
Pair trade Method 2, Chapter 1 (PTM2, C1) – Straight line

8 59
Equation
9 PTM2, C2 – Linear Regression 66
10 PTM2, C3 – The Error Ratio 77
11 PTM2, C4 – The ADF test 86
12 Trade Identification 98
13 Live Example – 1 104
14 Live Example – 2 117
15 Calendar Spreads 121
16 Momentum Portfolios 130

CHAPTER 1
What to expect?
1.1 – What is a trading system?
Such a glorious day to start this module! Here is the headline that rocked the stock
markets today –
Yesterday i.e. 24th Oct 2017, the Finance Minister announced that the Government would
infuse Rs. 210,000 Crore into the Public Sector banking system, which is basically an effort
to save the PSU banks from the deteriorating NPAs (Non-performing assets).
How did PSU Banks react to this announcement? After all, this is a lease of life to the PSUs.
Well, they were jubilant, as expected –
As you can see, the PSU Bank index shot up 27.75% at opening.
Some of the PUS stock options were on steroids, here is the hero of the day –
zerodha.com/varsity 1
Punjab National Bank’s 160 Call option expiring on 26 th Oct 2017, shot up 20,600%
overnight! If you had bought 1Lac worth of option on 24th Oct, it would have translated to
2.02 Cr on 25th Oct morning. So clearly, there is a lot of action in the market today.
Earlier in the day, my colleague and I were looking at the way markets were behaving and
trying spot an opportunity, and here is something that looked interesting –
Bank Nifty Index too joined the party, with the index going up nearly 3% (look at the image
of the sectoral indices above). However, a 3% move on Bank Nifty was quite questionable
considering the fact that PSU banks contribute just around 10% to the Bank Nifty index,
look at the index constituents and its weights below –
Considering this, my colleague and I decided to write a short strangle on Bank Nifty and
collect a premium of close 253 points per lot, obviously hoping that the volatility would
die and premiums would reduce.
I don’t want to debate about the reasoning of this trade – whether it’s going to make
money or not is not really the concern, although I hope it does
However, I want you to think about the thought process behind this trade. The trade idea
originated through what I consider as ‘systematic deduction’. To make such systematic
deduction and find opportunities, you need to question what is happening in the market
and sometimes be willing to take contrarian positions, which is exactly what we did.
‘Systematic deduction’ is one of the most popular methods market participants adapt to
trade the market. However, not all systematic deductions are right, you could, of course,
succumb to biases and make systematic errors while making these deductions.
Nevertheless, systematic deduction is one of the other popular techniques to trade. Other
popular trading techniques being –
o Trade because your gut says so
o Trade because my friend says so
o Trade because the guy on TV says so
o Trade because my broker says so
None of the above mentioned ‘approach’ to trade the market, including the ‘systematic
deduction’ can really be defined as a process. These are ad-hoc methods, which cannot
really be quantified or backtested.
Any approach to trade where you cannot really define ‘the approach’ as a process is not
considered as a trading system.
On the contrary, if you can define the approach and can quantify the process to trade the
market, then you are essentially talking about a ‘Trading System’, which is exactly the
focus of this module.
1.2 – Trading system – the Holy Grail?
The moment you talk about a trading system, people generally tend to think of these
systems as a sure shot technique to make money, or in other words, they approach these
systems as a money-making machine. They expect profits to roll from the first trade itself.
Unfortunately, it does not really work that way.
Remember, a trading system receives a bunch of inputs from your end, performs a set of
task, and gives you an output. Based on the output, you then decide (or the system itself
decides) if this is a trade worth taking or not.
Here is how you can visualize this –
If you realize, for the trading system –
1. You give the system the inputs
2. You design the system
3. You decide to trade or not to
So the onus of making money really depends on you. The advantage of a trading system,
however, is that – you only have to decide the logic once and then just follow the system
that you’ve designed.
Of course, as you may have sensed, I’ve dumbed down the journey of a trading system to a
large extent, and this is just to give you a perspective at this stage.
1.3 – What to expect from this module?
The trading systems that we will discuss in this module will be complete, in the sense, it
will have –
1. The logic, which is the core of the trading system
2. Input parameters
3. Interpreting the output
4. The decision to trade or not
At this point, I’ve planned to write about the following 4 trading systems –
1. Pair trading
2. Volatility based Delta hedging
3. Calendar spreads
4. Momentum strategy (Portfolio approach)
There two techniques to pair trade – a simple approach based on correlations and a
slightly complex approach using statistical concepts – both of which we will explore. Of
course, as we proceed, I may try and add other trading systems as well.
However, this module will not include the ‘backtest’ bit. The onus is on you to backtest the
system and figure out if the system works for you or not. You will have to take the rules of
the system and figure out how many times in the past it has worked and if it has worked,
what kind of profitability pattern the system is showcased.
Remember, no trading system is complete without having the backtesting results. The
only reason why I’m not including the backtesting part is that I lack programming skills.
Some of these systems can be efficiently backtested if you can manage to write a piece of
code. When these systems were developed, I was fortunate enough to have a fellow trader
with programming skills, hence I was in a position to get greater insights into these
systems. I must also tell you that these were fairly competent systems to trade – and I
presume they still are.
Of course, the market conditions have changed, hence a fresh set of backtesting is
justified.
However, the broader objective of this module is to showcase different systems and give
you insights into how systems are developed. Hopefully, this will inspire you to develop
your own system and perhaps works out to be your own money making machine!
With this hope let us proceed – onwards to Pair trading!
PS: The short strangle on Bank Nifty worked out quite well
CHAPTER 2
Pair Trading logic
2.1 – The idea
If you have ever been on an interstate highway, then you would have noticed that the
highway usually includes the main highway, on which the vehicles zoom by at full speed.
On either side of the highway, it is common to find a single road, which is often called the
service road. The service road is used to give access to private driveways, shops, houses,
industries or farms. These service roads are also known as the local-express lanes. The
service road and the highway usually run parallel to each other for the entire length.
Now imagine this – assume a new highway and service road is being commissioned. The
road contractor has stated the work of laying down the highway and service road. At one
point, on this new service road, the contractor encounters a small little tree. Now, for
whatever reason, the road contractor decides not chop off the tree but instead circumvent
it by taking a small deviation from the tree and get back on track to run parallel to the
highway.
The road gets built this way, and people start using it. What do you make of it?
If you think about it – the two roads run parallel to each other, for the entire stretch. At any
part, if the highway is inclined, so would the service road. If the highway goes down, so
would the service road. If the highway crosses a river, so would the service road. So on and
so forth. So for all practical purposes, the two roads ‘behave’ somewhat identically,
except at that point where the tree briefly obstructed the path on the service road.
Let’s take this a step further and break it down into variables –
1. Entities – Highway and the service road
2. Relationship – The two entities are defined by their parallelity. What happens to
one entity (highway) is likely to happen to the other (service road)
3. Relationship anomaly – In an otherwise perfect world, the tree on the service road
causes a brief break in the parallelity of the two roads
4. Effect of the anomaly – The anomaly is short-lived; the roads are quick to regain
their relationship
I know this is a weird analogy, but if you can somehow imagine this highway, service road,
and that tree, and the parallel relationship between them, then you will (hopefully)
understand the underlying philosophy of pair trading.
So let me attempt to do that.
Now, just like the two roads (or entities as we defined them) i.e. the highway and service
road – think about two companies which are similar, let’s say – HDFC Bank and ICICI Bank.
By the way, if you pick up any classic book on Pair Trading, you will come across the
example of Coca-Cola and Pepsi. Since they are not listed in India, let’s go ahead with ICICI
and HDFC.
1. Both these banks are very similar in every respect
2. Both are private sector banks
3. Both have similar banking products
4. Both cater to similar client base
5. Both have similar presence in the country
6. Both banks have similar regulatory constraints
7. Both banks have similar challenges in terms of running the business
So on and so forth.
Given the striking similarities between the two banks, whatever change in the business
environment affects one bank, the 2nd bank should be affected in the same way. For
example, if RBI increases the interest rates, then both the banks would be affected the
same way and likewise when the rates are lowered.
Up to this point, we can define –
1. The entities – HDFC and ICICI
2. The relationship – similar business landscape
Given the above inference, we can make the following conclusion –
1. Because both the businesses are so alike, their stock price movement should be
similar
2. On any given day, if HDFC Bank’s stock price goes up, then ICICI Bank’s stock price
is also expected go up as well
3. If HDFC stock price comes down, then ICICI’s stock price is also expected to come
down
We can generalize this –
Given there is a well-established relationship between the two companies, considering all
else equal, if the stock price of entity 1 moves in a certain direction, then the stock price of
entity 2 is also expected to make a similar move. If not, then there could be a trading
opportunity.
For example, all else equal, on a given day, ICICI stock price moves up by X% then given
the relationship, HDFC is also expected to move up at least y%, but for whatever reason,
assume HDFC stayed flat. Then we can go ahead and claim that ICICI stock price has
moved higher than expected when compared to HDFC’s stock price.
In the arbitrage world – this translates to buying the cheaper stock i.e. HDFC and selling
expensive one i.e. ICICI.
In a nutshell, this is the essence of ‘Pair Trading’.
Hang on a second – what about the tree on the service road and its relevance to the whole
narration? Well, remember the tree caused the anomaly in an otherwise perfect ‘parallel’
relationship between the two roads?
Likewise, in an otherwise perfect relationship between the stock prices of two companies
– an event can trigger a price anomaly – where the price of stock 1 can deviate from the
price of stock 2.
An anomaly in stock prices gives us an opportunity to trade. The anomaly can happen
because of anything –
1. HDFC Bank announcing quarterly results – on an immediate basis this impacts

HDFC more than ICICI, hence the price relationship between the two changes, only
to be realigned later
2. Likewise, with ICICI announcing its results
3. A top executive at one of these banks resigns, causing a minor dent in its stock
price, while the other continues to trade regularly
4. Excessive speculation in stock 1 compared to stocks 2
Generally speaking, a price anomaly is a local event, which causes the stock price of one
company reacts (or overreacts) compared to the other. I prefer to call it a local event
because it affects only 1 company in our universe of two stocks J
So the relationship essentially sets the rules on how the two stock prices are related.
Therefore, the bulk of the work in pair trading revolves around –
1. Identifying the relationship between two stocks
2. Quantifying their relationship
3. Tracking the behaviour of this relationship on a daily basis
4. Looking for anomalies in the price behaviour.
There are multiple ways to define these relationships between two stocks. However, the
two popular techniques are based on–
1. Price spreads and ratios
2. Linear Regression
Both these techniques are different and sort of elaborate. I intend to discuss both these
techniques in Varsity.
Before we close this chapter – a quick note on the history of Pair trading.
The first pair trade was executed by Morgan Stanley in the early 80’s by a trader named
Gerry Bamberger. Apparently, Gerry discovered the technique and kept it ‘proprietary’ for
the longest time, until another trader called Nunzio Tartaglia, again from Morgan Stanley,
popularized it.
Nunzio, at that time, had a huge following, considering he was one of the pioneers in
‘Quant trading’ on Wall Street. In fact, he led Morgan Stanley’s prop trading desk in the
80’s.
DE Shaw, the famed Hedge Fund, adopted this strategy in its initial days.
2.2 – Few closing thoughts
As you may have guessed, pair trading requires you to buy and sell two
stock/assets/indices simultaneously. Many familiar with this believe that pair trading is a
market neutral strategy. Market neutral, because you are both long and short at the same
time. This is grossly wrong, simply because you are essentially long and short on two
different stocks.
To be market neutral, you need to be – long and short, on the same underlying, at the
same time. A good example here is the calendar spread. In a calendar spread, you are long
and short on the same underlying expiring on two different dates.
Hence, please do not be under the impression that pair trading in market neutral. This is a
trading strategy that seeks to take advantage of price differentials between two, related
assets.
By simultaneously buying and selling the two assets, we are trying to profit from the
“relative value” of the two securities. For this reason, I’d like to refer to Pair trading as
‘Relative Value trading’.
If you think about this, in its pure sense, this is an arbitrage opportunity – we buy the
undervalued security and sell the overvalued security. For this reason, some even call this
the Statistical Arbitrage.
The measurement of ‘undervalued’ and ‘overvalued’ is always with respect to the one
another – and the measurement technique is what we will start learning next chapter
onwards.
1. The stock prices of two companies with similar business landscape tends to make
similar price moves
2. The prices move can be quantified by
3. A local event (particular to 1 company) can create an anomaly in the price

movement
4. When an anomaly occurs an opportunity to trade arises
5. In pair trading, you buy the undervalued security and sell the overvalued one
6. Pair trading is also called – Relative value trading or statistical arbitrage
CHAPTER 3
Pair Trading, Method 1, Chapter 1 (PTM1,

C1) -Tracking Pairs
3.1 – Getting you familiar with Jargons
Like I had mentioned in the previous chapter, there are two techniques based on which
you can pair trade. The first technique that we will discuss starting now, is usually referred
to as the correlation based technique. I consider this as a fairly standard approach as
many traders get their pair trading handholding of sorts using this approach.
We need to learn few jargons before we get started on the actual technique, so let’s get to
that straight. The jargons we will talk about in this chapter are related to tracking pairs. At
this stage, I just want you to know what is what. We will connect the dots as we proceed.
Spreads – The spread, is perhaps the most versatile jargon used in the trading world. For
example, if you are scalping the market then the word spread refers to the Rupee
differential between the bid price and the ask price. Now, if you are doing an arbitrage
trade, then the word spread refers to the difference between the prices of the same asset
across two different markets. In the pair trading world (actually, just correlation-based
technique), the word spread refers to the difference between the closing prices of two
stocks.
The spread is calculated as –
Spread = Closing value of stock 1 – closing value of stock 2
Take a look at this –
If I assume GICRE as a stock 1 and ICICIGI as stock 2, then the spread is calculated as –
Spread = 6.1 – 3.85
= 2.25
Please note, both 6.1 and 3.85 represents a change in stock price with respect to the
previous close. Also, both the numbers are positive here. Now, for a moment assume, the
closing price of ICICIGI was negative 3.85, in this case, the spread would turn out to be –
6.1- (-3.85)
= 9.95
I’ve calculated the spread for the last couple of trading days, this should give you an idea
of how the spread ‘runs’. Also, since I’ve calculated the spread on a daily basis, traders
refer to this as the ‘historical spread’.
As you can see, the spread varies on a daily basis. Also, here is an interesting (general)
observation –
1. The spread expands if the closing value of S1 is positive and S2 is negative
2. The spread contracts if the closing value of S1 is positive and S2 is also positive
Of course, there are other possible combinations which lead to the expansion of
contraction of the spreads. More on this later.
Differential – Unlike spreads, the differential measures the difference in the stock prices.
The differential measures the absolute difference in the closing stock prices of two stock.
The formula is as below –
Differential = Closing Price of Stock 1 – Closing Price of Stock 2
So if a stock 1 has closed at Rs.175 and stock 2 has closed at 232, the differential is –
175 – 232
= – 57
As you may have guessed, you can run this as a time series and calculate this on a daily
basis, I’ve done this for GICRE and ICICIGI –
Here is something you need to know about differentials – if you are using spreads to track
pairs, then you can use it on an intraday basis. But unlike spreads, the ‘differentials’ is not
a great technique to track pairs on an intraday basis, its best used at an end of day basis.
Of course, more on these things later. For now, let’s just focus on busting some jargons.
Ratio – I find the ratio bit quite interesting. The ratio is essentially dividing the stock price
of stock 1 over the price of stock 2. Or it can be the other way round as well.
Ratio = Stock Price of stock 1 / stock price of stock 2
I’ve calculated the ratio of the same two stocks, here is how it looks –
The Ratio as you can see is a bit more consistent (or at least appears) when calculated as a
time series. I’ve represented all the three variables on graph –
So what are these things that we just looked at – spread, differential, and ratios and how
are they related to pair trading?
Well, as you can imagine, these are the different variable which helps us measure or
quantify the relationship between two stocks, which we consider as pairs. The graph tells
us how the two stocks move with respect to each other. For instance, if we consider the
spread, we know it expands if the closing value of S1 is positive and S2 is negative and the
spread contracts if the closing value of S1 is positive and S2 is also positive.
Likewise, in the ratio – the ratio between two stocks decrease if the stock prices of both
the stock decline and the ratio increases if the stock prices of both the stocks increases. Of
course, there are other variations possible – for example, the ratio can increase if stock 1
declines heavily and stock 2 stays flat or the other way round. Alternatively, stock 2 can
increase a lot more compared to stock 1 or the other way round J
Confusing isn’t it?
Hence, for this reason, we need to look at the chart of the variable we are following, the
variable could be spread, differential, or the ratio. We need to track the movement of the
variable and figure out if the spread is expanding or contracting. This leads us to the next
two jargons.
Divergence – If the ratio or the spread between the two stocks is expected to move apart
or alternatively, you expect the graph to move up, then this translates to something called
a divergence. When you expect your variable to diverge, you can make money (or at least
attempt to make) by setting up a divergence trade.
Convergence – If the ratio or the spread between the two stocks is expected to move
closer or alternatively, you expect the graph to move down, then this translates to
something called as a convergence. When you expect your variable to converge, you can
make money (or at least attempt to make) by setting up a convergence trade.
Now here is the big question – what makes you believe the variable can either converge or
diverge? When do you decide to set up a trade? What are the triggers? How do you set up a
trade? What if the trade does not work out? What is the stop-loss for such trades?
Well, even before we answer these questions, how do we qualify two stocks as a pair? Just
because two stocks belong to the same sector, does that mean they qualify as a pair? For
instance, does ICICI Bank and HDFC Bank qualify as a pair because they both belong to
private sector banking?
To qualify two stocks as a pair we need to rely upon the good old statistical measure,
called the ‘Correlation’. I guess, we have discussed correlation multiple times on varsity.
Here is a quick explanation –
Correlation between two variables gives us a sense of how two variables move with
respect to each other. Correlation is measured as a number which varies between -1 to +1.
For example, if the correlation between two stocks is +0.75, then it tells us two things –
1. The plus preceding the number tells us that they both are positively correlated i.e.
when they move in the same direction
2. The actual number gives us a sense of the strength of this movement. In a loose
sense, the closer it is to +1 (or -1) the higher is the tendency for the two variable to
move in tandem.
3. A correlation of 0 suggests that the two variables are not related to each other.
From the above, we know a correlation of +0.75 suggests that the two variables move not
only in the same direction but also tend to move together closely. Note, the correlation
does not suggest the extent of the move, all it suggests is that the move in the same
direction is likely to happen. For example, if Stock A moves 3%, and the correlation
between stock A and stock B is +0.75, then it does not mean that Stock B will also move by
3%, all that the correlation suggests is that Stock B will move up positively, just like Stock
A.
But, there is another twist here – suppose stock A and Stock B are correlated at 0.75, and
the daily average return on Stock A and Stock B is 0.9% a 1.2%, then it can be said that on
any given day, if Stock A moves above its daily average return of 0.9%, then stock B is also
likely to move higher than its daily average return of 1.2%.
Likewise, a correlation of -0.75 indicates that the two variables move in opposite direction
(-ve sign) but they both tend to move in opposite direction. Suppose stock A moves up by
+2.5%, then by virtue of correlation we know that Stock B is likely to come down, but by
what degree will it come down will not be known.
While we are at it, one more point on correlation. This bit is only for those interested in the
math part of correlation. The correlation data makes sense only if the data series is
‘stationary around the mean’. What does this mean? – Well, it simply means that the data
set should be sticking close the average values.
Keep this line ‘stationary around the mean’ in the back of your mind, don’t forget it. This
will come back to again, when we discuss the 2nd technique to pair trade, much later in
this module.
We will proceed with correlation as a measure to understand how tightly two stocks are
coupled. In the next chapter, we will figure out how to calculate two different varieties of
correlations.
For now, I want you to be clear on Spread, Differentials, Ratios, Divergence Trading,
Convergence Trading, and Correlations!
Download the Excel sheet used in this chapter here.
1. Spread measures the difference between the closing values of two stocks
2. Differentials measures the difference between the closing prices of two stock
3. Ratio between the two stocks essentially requires you to divide stock 1 over stock 2
4. Divergence is when you expect the two stocks to move apart
5. Convergence is when you expect the two stocks closer to each other
6. Correlation is like a glue which tells how tightly two stocks move together.
CHAPTER 4
PTM1, C2 – Pair stats
4.1 – Correlation and its types
I have to mention this at this point. The pair trading technique we are discussing now is
discussed in a book called, ‘Trading Pairs’, by Mark Whistler. I like this book for the fact
that it got me hooked to Pair trading and over time as my interest grew, I explored the
strategy beyond Mark Whistler’s techniques. Needless to say, I will discuss those
techniques later in this module. At this point, my intention is to take you through the
exact learning path I underwent learning pair trading.
Towards the end of the previous chapter, we introduced the concept of correlation and
the way one can analyse the correlation values. We will take that discussion forward now
and understand how to calculate the correlation between two stocks, on excel. As you
may have guessed by now, the calculation of Correlation between two stocks is the key in
pair trading.
For the sake of this example, I’ve considered Axis Bank and ICICI Bank. Both are Private
sector banks and have similar business backgrounds, hence intuition says that the two
stocks should be highly correlated.
At this point, I have downloaded the closing price of Axis Bank and ICICI Bank from 4 th Dec
2015 to 4th Dec 2017, roughly 2 years of trading data or about 496 data points.
Before we proceed, a quick note on data –
1. Make sure you are dealing with the same number of data points. For example, if
you have 400 data point for Stock A, then you need to ensure you have the same
number of data points for Stock B, corresponding to same dates.
2. Make sure the data is cleaned for corporate actions such as bonus/splits etc.
As you can see from the above image, besides ICICI and Axis, I have also downloaded the
data for BPCL, HPCL, and HDFC Bank. You can use this data to build and test other
correlations.
Anyway, at this stage, the only data we have is the date and the closing price of the stock.
We will go ahead and calculate the daily returns. I guess you are familiar with the daily
return calculation; we have discussed this several time in the previous module.
The daily return can be calculated as
= [today’s closing price / previous day’s closing price] – 1
I’ve calculated this for both ICICI and Axis Bank –
Now, correlation can be calculated on the basis of two parameters –
1. The daily closing price
2. The daily return series
The daily closing price correlation requires you to calculate the correlation based on the
closing prices of two stock. I’m not a big fan of calculating correlation on closing prices,
but then let’s just go ahead and do this for time being.
To do this in excel, simply use the ‘=Correl()’, function on the daily closing prices. I’m
running this calculation on a new sheet, which is labelled it as ‘Pair Data’.
The correlation between the closing prices of ICICI Bank and Axis bank is 0.51. Not
particularly a great correlation, but we can live with this for now. Do recollect, our gut said
the two banks could be highly correlated as they have similar business backgrounds, but
the number is painting a slightly different picture
We will now run the correlation on the daily % return series for the two stock. I’ve already
calculated this % return, I’ll just have to run the correl function now.
Again, not a very encouraging number, but that is ok for now.
Some traders, run the correlation on the absolute per day change calculated as ‘Today’s
stock price – yesterday’s stock price’. Again, I’m not a big fan of this. But let me just go
ahead and introduce the same to you –
In all the above calculations, I’ve run the correlation of Axis Bank versus ICICI Bank, the
results obtained will be same if I had opted to calculate the correlation of ICIC Bank versus
Axis. Generally speaking, the correlation between A and B is the same as Correlation
between B and A.
In this method of trading pairs, the correlation number is considered sacred. Ideally
speaking, the number should be above 0.75. Clearly, that is not the case with ICICI and
Axis, but then as I mentioned earlier, we can live with it.
4.2 – Setting up the datasheet
In the previous chapter, we discussed three variables concerning the pairs namely the
spread, differential, and the ratios. Let us go ahead and calculate these variables on the
two stocks we are studying. We will do this on a separate sheet within the same workbook
and name the sheet as the ‘Data Sheet’. Here is the snapshot –
The calculation of these variables is quite straightforward, I’ve explained this in the
previous chapter.
Different types of Pair Trading works at different complexities levels. We will deal with
basic stats for this version of pair trading. Given this, we will now define 3 most commonly
used statistic variables.
4.3 – Basic stats
I’ll discuss 3 basic statistical terms at this stage. These are basic terms which play a very
crucial role in pair trading. I’m fairly certain that you’d have learned these in your high
school math, even otherwise this is quite basic and you can pick it up anytime.
To help you understand these jargons better, I’ve come up with a set of arbitrary runs
scored by batsmen across 10 cricket matches –
Match Runs scored
1 72
2 65
3 44
4 100
5 82
6 55
7 100
8 23
9 51
10 34
Mean – Also called the arithmetic average, represents the average of a set of numbers. You
can calculate the average by taking the sum of all the observations by the total number of
observations.
So if I were to find the average in the above example, I’d total up all the scores and divide
it by 10 (10 being the total number of observations).
Mean (Average) = 626/10
=62.6
On excel, you can simply use the ‘=Average ()’ function to calculate the average of any set
of numbers.
Median – The median number represents the middle number of the data series when the
data series is arranged in its numerical order. If there are even set of numbers (which is the
case here), then we have to take the average of the middle two numbers to calculate the
mean. However, if there are an odd number of data points, then we simply take the middle
data point as the median.
So let me rearrange the data points in its numerical order –
23, 34, 44, 51, 55, 65, 72, 82, 100, 100
Since there are even numbers of observation, I’ll take the middle two numbers i.e. 55 and
65, their average represents the median.
Median = (55 + 65)/2
=60
The excel function to calculate median is ‘=Median()’.
The mean and median when viewed together gives a sense of the trend. More on this later.
Mode – The mode of a data series is simply that data point which occurs the most number
of times in the series. Clearly, 100 is repeating twice, with no other number appearing
more than once, and that makes it the mode of the data series.
The excel function to calculate Mode is ‘=Mode()’.
In the next chapter, we will use these function in excel and understand its relevance to
pair trading.
Download the excel sheet used in this chapter here.
Stay tuned.
1. Care has to be taken to ensure the data is clean and adjusted for corporate actions
2. Close correlation is the correlation when calculated on the closing prices of stocks
3. The % return correlation is the correlation when calculated on the daily returns of
the stock
4. Mean is the arithmetic average of the data series
5. Median is the middle observation of a data series.
6. If the data series has even number of observations, then the median is the average
of the middle two observations
7. If the data series has odd number of observations, then the median is the middle
observation
8. The mode of a data series is that value which repeats the highest number of times
9. The mean and median, when viewed together to each other, offers great insight
into the data trend.
CHAPTER 5
PTM1, C3 – Pre trade setup
5.1 – Revisiting the Normal Distribution
If you have been a regular reader on Varsity, then chances are you’d have come across the
discussion on Normal Distribution in the Options Module. If you’re not, then I’d strongly
suggest you read up this chapter on Normal distribution.
This is a very important topic, I’d suggest you spend some time reading about it before
you proceed. We will use the concept of Normal Distribution in both the techniques of Pair
Trading, i.e. the Mark Whistler’s Pair Trading technique, and the other technique we will
discuss later on in this module. Given the central role it plays, you should spend time
reading about it.
I’m reproducing the central theme around Normal distribution, this should serve as a
quick refresher for people who are familiar with Normal Distribution, but for those who
are not, I hope this does not demotivate you from reading the chapter on Normal
distribution –
The general theory around the normal distribution which you should know –
o Within the 1st standard deviation, one can observe 68% of the data
o Within the 2nd standard deviation, one can observe 95% of the data
o Within the 3rd standard deviation, one can observe 99.7% of the data
The following image should help you visualize the above –
Of course, there are other forms in which the data gets distributed – distribution such as
uniform, binomial, exponential distribution etc. This is just for your information.
5.2 – Descriptive Statistics
In the previous chapter, we discussed three basic statistical metrics namely the Mean,
Median, and Mode. We will now calculate these metrics on the pair data i.e. the
differential, spread, and ratio which we computed in the previous chapter. We will do
these calculations using the excel functions.
Please note, I’m continuing on the excel that we were working on in the previous chapter,
needless to say, you can download the updated excel from the link provided towards the
end of the chapter.
The sheet is set up as below –
The Excel functions are as follows –
1. Mean – ‘=average()’
2. Median – ‘=median()’
3. Mode – ‘=mode.mult()’
And the numbers are as below –
As you may notice, the correlation numbers were calculated in the previous chapter.
We now have the data setup. We need to add one key variable here and that would be the
standard deviation. Again, standard deviation as a concept has been explained in Varsity
earlier. I’d suggest you read this chapter to understand Standard Deviation better. Here is
the summary though –
Standard Deviation simply generalizes and represents the deviation from the average.
Here is the textbook definition of SD “In statistics, the standard deviation (SD, also
represented by the Greek letter sigma, σ) is a measure that is used to quantify the amount of
variation or dispersion of a set of data values”.
So in a sense, Standard Deviation gives us a sense of variability of the data or in other

words, help us understand how widely the data set is spread out. Let me try and put this in
the context of the Pair data we are dealing with.
The differential data which we computed a while ago is something like this –
Together there are 496 differential data points and earlier in this chapter, we have even
calculated the average value across these data points i.e. 228.52.
Now, what if I were to ask you to help me understand the variability of these data points
from its average value? Or a better question to ask – why would I need to know the
variability of the data points from its average value?
Well, if we don’t know the variability of the data, then there is no way we can make an
intelligent assessment of the behaviour of the data set. For example, when the 498th data
is generated, we will know if this value is around the mean or within the range it varies.
This, in fact, forms the crux of pair trading.
Standard Deviation helps us measure this variation.
While I personally think standard deviation is good enough, there are traders who would
also like to calculate another variable called the ‘Absolute Deviation’. Both standard
deviation and absolute deviation help us understand the variability of the data. But they
differ in terms of the way do they data is treated.
I was looking at the explanation to help you understand the difference between standard
deviation and absolute deviation, and I found the following on Investopedia, which I think
is quite nice. I’m taking the liberty of reproducing the content here –
“While there are many different ways to measure variability within a set of data, two of the
most popular are standard deviation and average deviation. Though very similar, the
calculation and interpretation of these two differ in some key ways. Determining range
and volatility is especially important in the finance industry, so professionals in areas such
as accounting, investing and economics should be very familiar with both concepts.
Standard deviation is the most common measure of variability and is frequently used to
determine the volatility of stock markets or other investments. To calculate the standard
deviation, you must first determine the variance. This is done by subtracting the mean
from each data point and then squaring, summing and averaging the differences. Variance
in itself is an excellent measure of variability and range, as a larger variance reflects a
greater spread in the underlying data. The standard deviation is simply the square root of
the variance. Squaring the differences between each point and the mean avoids the issue
of negative differences for values below the mean, but it means the variance is no longer
in the same unit of measure as the original data. Taking the root of the variance means the
standard deviation returns to the original unit of measure and is easier to interpret and
utilize in further calculations.
The average deviation, also called the mean absolute deviation, is another measure of
variability. However, average deviation utilizes absolute values instead of squares to
circumvent the issue of negative differences between data and the mean. To calculate the
average deviation, simply subtract the mean from each value, then sum and average the
absolute values of the differences. The mean absolute value is used less frequently
because the use of absolute values makes further calculations more complicated and
unwieldy than using the simple standard deviation.”
We will go ahead and compute both “Standard Deviation”, and “Absolute Deviation” for
all the three pair data variables.
By the way, I’m interchanging the Y-axis to Mean, Median, and Mode. The X-axis to
Differential, Ratio, and Spread. Given this, the snapshots posted above will be slightly
different from the one posted below, hope you won’t mind my clumsy data handling skills
J
The excel function to calculate these variables are –
Standard Deviation – ‘=Stdev.p()’
Absolute Deviation – ‘=avedev()’
The Mean, Median, Mode, Standard Deviation, and Absolute Deviation is also known as the
basic descriptive statistics.
5.3 – The Standard deviation table
The standard deviation as you know helps us get a sense of the variation in the data. We
will now take this a step further and try and quantify the variation. Why do we need to do
this, you may ask? Well, this will help us understand the extent of the variation from the
mean value. For example, the 498th differential data could be 275, we will exactly know if
275 is way above the mean or way too below the mean.
With this information, we can choose to either buy the pair or short the pair. Of course, we
will get into these details later on. For now, let us focus on quantifying the extent of the
variation. In order to quantify the data point, we need to build something called as a
standard deviation table.
The structure of the table is as below –
As you may have guessed, we are now going to calculate the values of 1, 2, and 3 standard
deviations above the mean and below the mean, across spread, differential, and the ratio.
For example, let us just focus on the Spread data for now. The mean of the spread is 0.06.
We also know the standard deviation (SD) is 8.075.
Therefore, the 1st SD above the mean would be –
0.064 + 8.075 = 8.139
2nd SD –
0.064 + (2*8.075) = 16.123
3rd SD –
0.064 + (3*8.075) = 24.288
These are all values above the mean. We can do the same to identify the values below the
mean –
-1 SD –
0.064 – 8.075 = -8.011
-2 SD –
0.064 – (2*8.075) = -16.086
-3 SD –
0.064 – (3*8.075) = -24.160
I’ve done the same math across Differential and Ratio. Here is how the table looks –
So if the 498th differential data read 315, then we can quickly understand that the value is
around the +2 standard deviations and with 95% confidence you could conclude that
there is only 5% chance for the next set of data points to go higher than 315.
Anyway, at this stage, we have almost all the data that we need to make the assessment of
the pair and probably identify if there is an opportunity to trade. In the next chapter, we
will go ahead and do this. In fact, I’ll start the next chapter with a quick recap of everything
we have discussed so far, this is just to ensure we are all on the same page.
You can download the excel sheet used in this chapter here.
Signing of this chapter by wishing you all a very happy Xmas and a happy new year! Hope
2018 brings in wisdom, wealth, and peace your way.
1. Normal distribution plays a pivotal role in pair trading
2. Within the 1st standard deviation, one can observe 68% of the data
3. Within the 2nd standard deviation, one can observe 95% of the data
4. Within the 3rd standard deviation, one can observe 99.7% of the data
5. Standard deviation and absolute deviation measures the variability of the data
6. The standard deviation table gives us a sense of how the current data stands with
respect to its expected variation
7. The cues to trade the pair either long or short comes from the standard deviation
table.
CHAPTER 6
PTM1, C4 – The Density Curve
I think a quick recap is justified at this stage, this is to ensure we are all on the same page.
I’d strongly recommend you read through the recap, to ensure we are on track. I’ll keep
this as a pointwise recap to ensure we don’t digress.
o Two companies are comparable if they have similar business background
o Business background includes factors which influence the day to day running of
the business
o If two companies have similar business backgrounds, then it is reasonably safe to

assume that their share prices move somewhat similarly on a day to day basis
o If the daily stock price of two comparable companies move together (and therefore
their daily returns), then they do tend to have a tight correlation
o There are times when a local event can change the course of the movement in the
stock price of one of the two companies, creating a pair trading opportunity
o The relationship between the stock prices of the two companies can be estimated
by any of the three variables – spread, differential, or ratio
o The variables are expected to be normally distributed, hence we calculate the

standard deviation of these variables, along with the basic descriptive statistics
such as the mean, median, and mode.
o As a ready reckoner, we also have the standard deviation (SD) table, extending up
to the 3rd SD, either sides
o Lastly, do remember we are in the process of discussing two variants of pair

trading, starting with Paul Whistler’s technique of Pair Trading. After this, I will
discuss a slightly more complicated version of Pair Trading
So this brings us to where we are at this stage. In this chapter, we will go ahead and
discuss the density curve and the eventual trigger to pair trade.
6.2 – Selecting the variable
We have come to a stage where we need to stick to one of the variables amongst Spread,
Differential, and Ratio. Why just and why not all, you may ask?
Well, this is to ensure that we are sticking to a regime and not really getting confused with
conflicting signals. The reason I’ve introduced all three variables is to showcase that there
are three different possibilities. It is up to you as a trader to choose the variable that you
are most comfortable with. For example, I personally prefer the ratio over the differential
or spread. This is because the ratio kind of captures the market valuation of the stocks
since it considers the latest stock price. Besides the ratio also gives us a quick sense of
how much of Stock 1 should be bought or sold with respect to stock 2.
For example, if the price of Stock 1 is 190 and Stock 2 is 80, then the ratio of stock 1 over 2
is –
190/80
= 2.375
This implies for every 1 share of Stock 1, 2.375 shares of Stock 2 have to be transacted. We
will get to the finer details later, but for now, hope you get the drift.
You are of course, free to choose any of the variable – spread, differential, or ratio.
However, for the sake of this discussion, I will go ahead with the ratio.
6.3 – The trade trigger
As the name suggests, the pair consists of two stock. Until now, we have not defined how
to buy or sell a pair, we will do that later in this chapter. For now, assume that you can buy
or sell a pair just like the way you can buy or sell a single stock.
As you may have guessed, the decision to buy or sell a pair is dependent on the variable
that you track and the variable itself could be the spread, differential, or ratio. For the
purpose of this discussion, we are going ahead with the Ratio.
Think about it this way – the stock prices change every day, therefore the ratio of the pair
itself changes every day. On most of the days, the daily change in the ratio falls within the
expected range. However, there could be days when the daily change goes beyond the
expected range. These are the days when a pair trading opportunity arises.
Have a look at the chart below –
Casual eyeballing reveals two obvious information –
1. The ratio chart hovers around 1.8 and 2 – probably the ratio’s mean is around this
price. I’ve highlighted this with a green line. I’d suggest you check the mean value
of the ratio we calculated in the earlier chapters.
2. On most of the days, the ratio hovers above or below the mean value
I want you to pause here and think about this. This is the tipping point in Pair trading, if
you can understand everything we have discussed up to now, then the rest is a cakewalk.
The ratio itself is a variable which is derived by dividing stock 1 over stock 2. The ratio
changes every day since the stock prices change every day. If you plot the chart of the
daily change in the ratio you will notice that the ratio has an average (mean) value and the
ratio trades above and below the mean value. Irrespective of where the ratio is today (i.e.
either above or below the mean) – there is a great chance that ratio will come back to
mean over the next few days. Notice, I use the word ‘great chance’, here. This means, that
we should be able to quantify the probability of the ratio reverting to mean.
In fact, this phenomenon is referred to as ‘Mean reversion’ or reversion to mean.
I’ve circled (in red) two points in the chart where the ratio has deviated away from the
mean. The first circle from the left indicates a point where the ratio has deviated higher
than the mean value. The 2nd circle from the left indicates a point where the ratio has
deviated below the mean value. In both these cases, eventually, the ratio reverted to
mean.
Now, if you look at it in another way – we now seem to have an opinion on the direction in
which the ratio is likely will move. For example, the first circle where the ratio has moved
above the average indicates that the ratio is likely to retrace back to mean. Or in other
words, you can short the ratio at the high point and buy it back around the mean.
Likewise, the second circle points to an opportunity where one can buy the ratio, with an
expectation that the ratio will move back to the average value.
Think about the ratio as a stock or futures. Since the directional movement of the ratio is
predictable, we can as well place bets on the directional movement of the ratio itself.
I hope you are getting the point here.
The ratio’s value with respect to the mean acts as a key trigger to initiate the trade. If the
ratio is –
o Above the mean, the expectation is that the ratio will revert to mean, hence short
the ratio
o Below the mean, the expectation is that the ratio will scale back to the mean and
hence go long on the ratio
Alright – so far so good. Here are few questions though –
1. The ratio is always above or below the mean value – does this imply there is always
a trading opportunity?
2. There are multiple points where the ratio seemed to have bottomed out or peaked,
how do we know the exact point at which the trade has to be initiated?
The answers to these questions lie in something called as the ‘Density Curve’. Let’s figure
that out.
6.3 – The Density Curve
Have a look at the chart below –
I’ve highlighted 4 points on the chart, at all these points, the ratio has traded above the
mean. Assume, you were looking at this chart around the time the first circle is marked.
Now, just because the ratio has shot up above the mean, would you take the trade? In fact,
the same question can be asked every time the ratio has traded above (or below) the
mean.
I’m sure you’d agree that this would be a great idea. We need to observe the ratio closely
and initiate a trade only when the chance of mean reversion is very high. Or in other
words, we need to initiate a trade only when we are reasonably certain that the ratio will
slide down to the mean value, as quickly as possible.
To put the point across – this is pretty much like a tiger waiting in the ambush to hunt
down a prey. Just because the prey is in the open, the tiger will not jump and ruin its
chances of a kill. It will attack only when it is convinced that the effort will lead to a kill.
So how do we stay in the ambush and wait for our chance for the kill?
Well, we seek refuge in the good old Normal distribution and its properties. I’m hoping you
are aware of normal distribution and its properties by now. Here is a quick recap, I’d
suggest you read the complete theory, I’ve discussed this across various chapters in
Varsity –
o Within the 1st standard deviation (SD) one can observe 68% of the data
o Within the 2nd standard deviation one can observe 95% of the data
o Within the 3rd standard deviation one can observe 99.7% of the data
So here is what this means with respect to the ratio –
o The ratio, irrespective of where it stands with reference to the mean, has a
standard deviation value. For example – it could be just a few points away from the
mean and this could translate to say, 0.5 standard deviations from mean
o If the ratio deviates to the 2nd standard deviation, then according to the normal
distribution properties, there is only 5% chance of it going higher or in a very loose
sense, it poses a 95% chance of reverting to mean.
o Likewise, if the ratio deviates to the 3rd standard deviation, then it only has a 0.3%
chance of drifting higher or in a very loose sense, it poses a 99.7% chance of
reverting to mean
So at every SD, we can estimate the likelihood of the ratio reverting to mean. This means
we can filter out opportunities and initiate a trade only at points where the likelihood of
success is high.
This further leads to an interesting take – the key trigger to initiate a trade is not just
based on where the ratio is, but also depended on its standard deviation. Given this, it
makes sense to directly track the daily standard deviation of the ratio as opposed to the
ratio itself.
This can be achieved by tracking the ‘Density Curve’ of the ratio. The density curve is a
non-negative value which lies anywhere between 0 and 1. I’d suggest you watch this
video on Khan Academy to learn more about Density Curve.
Calculating the density curve on excel is quite straightforward. Here is how you can do
this, have a look at the image below –
You can use the inbuilt excel function called Norm.dist for this. The function requires 4
inputs –
o X – this is the daily ratio value
o Mean – this is the mean or average value of the ratio
o Standard Deviation – this is the standard deviation of the ratio
o Cumulative – You have to select true or false, select the default value as true.
I’ve calculated the density curve value for all variables, here is how the table looks –
I guess we could break this chapter at this point. In the next chapter, we will look into
details on how we can use the density curve to trigger long and short pair trade.
Download the excel sheet used in this chapter.
o Ratio as a variable is more versatile as it captures the valuation elements of the

stock
o The ratio tends to trade above or below its mean value
o The idea is the ratio, when it deviates away from the mean, will also tend to revert
to mean
o At every point at which the ratio deviates, we can measure the probability of its
reversion to mean
o The above point can be measured by normal distribution
o The density curve is a non-negative value which varies between 0 and 1. This can
be easily calculated on MS Excel by using an in build function.
CHAPTER 7
PTM1, C5 – The Pair Trade
7.1 – Quick Reminder
We closed the previous chapter with a note on Density curve and how the value of the
density curve helps us spot pair trading opportunity. In this chapter, we will work towards
identifying and initiating an actual trade and learning other dynamics associated with a
pair trade.
Just as a reminder – the techniques we have discussed so far in pair trading (i.e. from
chapter 1 through 7) is from the book called ‘Trading Pair’, by Mark Whistler. The good
part about this technique is the simplicity and the part that I’m not too conformable with
this technique is also its simplicity. Over time I’ve improved technique to pair trade, which
I will discuss from the next chapter onwards.
Why not discuss the 2nd method directly, you may ask – well, this is because I think Mark
Whistler method to pair trade lays an excellent foundation and it helps understand the
slightly more complex pair trading technique better. So let me attempt to finish the Mark
Whistler’s method in this chapter and move to the next method to pair trade.
Now, because I’ll discuss this other technique to pair trade, I’ll take the liberty to not really
get into the nuances of the trade set up. I’ll instead focus on the broad trade set up.
So let’s get started on it.
7.2 – Digging into Density curve
The density curve acts as a key trigger for us to identify an opportunity to trade. I want you
to pay attention to the following two things –
1. The density curve is calculated based on the time series data, and the time series
data in our context is the ‘ratio’ – as you may recall from the previous chapter, the
main inputs to calculate the density curve is the ratio’s time series, the ratio’s
mean, and the ratio’s standard deviation
2. The density curve is a value – varying between 1 and 0. The value of the density
curve helps us understand the probability of the ratio, falling back to the mean.
I understand the 2nd statement may confuse some of the readers, but at this point, I’d
suggest you keep this statement in mind. You will understand what I mean by this as we
proceed.
Let us spend a little time on the normal distribution, I know we have discussed this
multiple times in the past, but bear with me one more time.
The time series data (like the ratio) typically have an average (or mean) value. For
example, the average value for the ratio time series is 1.87 (we calculated this in the earlier
chapter). More often than not, the value of the ratio tends to lie around the mean value. If
the value of the ratio drifts away from the mean, then one can expect the value of the ratio
to gravitate back to the mean.
For example, if the latest value of the ratio shoots up to 2.5, then over time, one can
expect the value of the ratio to fall to 1.87 and likewise if the value of the ratio plummets.
Now here is a question – If the ratio drifts away from the mean (which is bound to happen
on a daily basis), is there a way wherein we can quantify the probability of the ratio to
move back to the mean, again?
For example, if the latest ratio value is at 2.5, we all know it will fall to a mean of 1.87, but
what is the probability of this occurring? Is it 10%, 20% or 90%?
This is where the density curve comes in handy. The value of the density curve tells us how
far, in terms of standard deviation, the ratio has deviated away from its mean. Now, if the
value is in terms of standard deviation, then naturally there is a probability assigned to it,
and eventually, this probability helps us set up a trade.
Let me give you a quick example.
Consider the following data –
Latest ratio – 2.87
Ratio Mean – 1.87
Density curve – 0.92
Here is how you will interpret this data – the 0.92 value of the density curve indicates that
the latest ratio of 2.87 has approximately deviated to the 2nd standard deviation and there
is approximately 95% chance that the ratio of 2.87 will fall back to its average value of
1.87.
How did we arrive at this? I mean what tells us that the ratio of 2.87 is approximately near
the 2nd standard deviation? Well, we infer this by looking at the corresponding density
curve value i.e. 0.92.
The density curve value from 0 to 1 represents the standard deviation values. For example
–
1. The density curve of 0.16 implies that the corresponding value is at the -1 standard
deviation below the mean
2. The density curve value of 0.84 implies that the corresponding value is at the +1
standard deviation above the mean
3. The density curve value of 0.997 implies that the corresponding value is at the 3
standard deviations above the mean
Once I know the standard deviation, I’ll also know the probability.
But How did I arrive at 0.16, 0.84, 0.997 etc. in the first place? Well, these are standard
deviation values, I will skip dwelling further into standard deviation, instead give you a
table which you can use as a ready reckoner –
Density Curve How many Standard deviation Probability of reverting to
value away mean
0.16 – 1 SD 65%
0.025 – 2 SD 95%
0.003 – 3 SD 99.7%
0.84 + 1 SD 65%
0.974 + 2 SD 95%
0.997 + 3 SD 99.7%
Given the above, if I see the density curve value of around 0.19, I know the ratio is around
the – 1ststandard deviation, hence the probability of the ratio to move back to mean is
around 65%. Or if the density curve value is around 0.999, I know the value is around the –
3SD, hence the probability of the ratio to move back to mean is around 99.7%
So on and so forth.
7.3 – The first pair trade
So, finally, here we are, very close to showcasing our first Pair trade. Few points to
remember –
1. The ratio is calculated by dividing Stock A over Stock B. In our example, Stock A is
Axis Bank and Stock B is ICICI Bank. So Ratio = Axis Bank / ICICI Bank
2. The ratio value changes daily, based on the stock prices of Axis Bank and ICICI
Bank
3. The ratio and its corresponding density curve value has to be calculated daily
The trading philosophy is as below –
1. If two business are alike and operate in the same landscape – like Axis Bank and
ICICI Bank, then their stock prices tend to move together
2. Any change in the business landscape will affect the stock prices of both the
companies
3. A stray incident can cause the stock price of one company to deviate away from the
stock price of the other. On such days, the ratio to deviates
4. We look for such deviations to identify good trading opportunities
So essentially, a pair trader tracks the ratio and its corresponding density curve value. A
pair trade is set up when the ratio (and the density curve) has deviated convincingly
enough from the mean value.
This leads us to the next obvious question – what is convincingly enough? Or in other
words, at what value of the density curve, should we initiate the trade?
Here is a general guideline to set up a pair trade –
Trade Trigger (density Standard

Target Stoploss
Type curve) Deviation
Long Between 0.025 & 0.003 Between 2nd & 3rd 0.25 or lower 0.003 or higher
0.975 or
Short Between 0.975& 0.997 Between 2nd & 3rd 0.997 or higher
lower
The idea is to initiate a trade (either long or short) when the ratio is between 2nd and
3rd standard deviation and square off the position as it goes below the 2 nd standard
deviation. Obviously, the closer it goes toward the mean, the higher is your profit.
Let’s set up a trade based on the above table, for this, I’d suggest you download the excel
sheet available towards the end of the previous chapter.
On 25th Oct 2017, the density curve value was 0.05234 and the corresponding ratio value
was 1.54. This is a decent long pair trade set up. Although this does not fall within the
preview of a long trade (we need the density curve to be between 0.025 and 0.003), I guess
this is the best value in the time series we are considering.
If the ratio is defined as Stock A / Stock B, then –
1. A long trade requires you to buy Stock A and Sell Stock B
2. A short trade requires you to sell Stock A and Buy Stock B
We have defined the ratio as Axis / ICIC, hence, on 25th closing, one would –
1. Buy Axis Bank @ Rs.473
2. Sell ICICI Bank @ 305.7
The lot size for Axis is 1200, hence the contract value is 1200 * 473 = Rs. 567,600/-. The lot
size of ICICI Bank is 2750, hence the contract value is Rs. 840,675/-.
Ideally, we need to stay long and short of the same Rupee value. This is also called ‘Rupee
Neutrality’, but I’ll skip this part for now. We will take the concept of Rupee neutrality to a
different dimension when we take up the next pair trading technique.
So, once the trade is set up, we now have to wait for the pair to move towards the mean.
Ideally, the best pair trade is when you initiate a trade near the 3 rd SD and wait for the ratio
to move to the mean, but then this could happen over a long period, and the mark to
market could be quite painful. In the absence of deep pockets to accommodate for mark
to market, one has to be quick in closing a pair trade.
On 31st Oct 2017, the ratio moved up to 1.743 and the corresponding density curve value
was 0.26103, which is roughly the target density curve value. Hence once can consider
closing the trade.
We Sell Axis Bank @ 523 and buy back ICIC at 300.1. The P&L and other details are as
follows –
Lot
Date Stock Trade Sq off date Sq off Price P&L
Size
25th Oct Axis Bank Buy @ 473 1200 31st Oct Sell @ 523 50*1200 = 60K
ICICI Sell @ 5.6*2750
25th Oct 2750 31st Oct Buy @300.1
Bank 305.7 =15.4K
Total P&L Rs.75,400/-
If you notice, the bulk of the profits comes from Axis Bank, this indicates that Axis Bank
had deviated away from the regular trading pattern.
Not bad eh?
Let’s look at a short trade now.
On 9th August 2016, the density curve printed a value of 0.99063156, close enough to
initiate a short pair trade. Remember in a short trade, we sell Axis and buy ICICI.
If you find it confusing to remember which one to buy and sell, think of it this way – the
numerator is the dominating stock, so if the pair trade demands you to go long, then buy
the numerator. Likewise, if the pair trade is to short, the short the numerator. Whatever
you do with the numerator, the opposite trade happens with the denominator.
Hence we sell Axis Bank (numerator) and sell ICICI Bank (denominator).
Trade details are as follows –
o Short Axis @ 574.1
o Buy ICICI @ 245.35
o Ratio – 2.34
o Corresponding Density Curve value – 0.99063156
Once initiated, the opportunity close this trade occurred on 8 th Sept, (yes, the trade was
held open for almost a month). The trade details were –
o Buy Axis @ 571
o Sell ICICI @ 276.33
o Ratio – 2.27
o Corresponding Density Curve value – 0.979182
Agreed, once could have waited a bit longer to for the density curve to fall further, but
then like I said before, the pair trader has to strike a balance between the time and mark
to markets.
The P&L for the trade is as below –
Lot Sq off
Date Stock Trade Sq off Price P&L
Size date
Axis Sell @
9th Aug 1200 8th Sept Buy @ 571 3.1*1200 = 3.72K
Bank 574.1
ICICI Buy @ Sell 31.03*2750 =

9th Aug 2750 8th Sept
Bank 245.3 @276.33 85.3K
Total P&L Rs.89,052/-
Again, the bulk of the profit comes from one of the stocks i.e. ICICI, indicating that ICICI
had probably deviated away from its course.
I must confess, both the trades did not really fall under the prescribed table giving you the
guideline to enter and exit the pair trade. But like I said before, use the table as a reference
and build your expertise around it.
I’d encourage you to look for any other opportunities in the Axis & ICICI Bank example.
I hope the P&L of pair trade is incentivizing you enough to learn more about pair trading.
I’ll deliberately stop here, to ensure you soak in everything that we have discussed. I’ll
leave you with few final points.
1. Everything we have learned so far accounts to about 25% of what I intend to

discuss going ahead
2. These first 7 chapter discusses a very basic pair trading technique, mainly to help
lay a foundation
3. We have not adhered to strict trade definitions – stop loss, targets etc. If you
notice, I’ve kept things quite generic
4. Neutrality of both the positions is a key angle, we have not discussed that yet
5. We are yet to discuss the risk associated with Pair trading
6. Pair trading is a margin money guzzler, so one needs to have sufficient funds to
pair trade, but the P&L is worth it
7. For a given pair, at the most 2-3 signals is what you can expect in a year. So one has
to track multiple pairs to find continuous opportunities in the market
Anyway, I hope I’ve managed to ignite your curiosity to learn more on Pair Trading. I’m
eager to move forward, I hope you are too!
Download the excel sheet.
1. The density curve acts as a key trigger to initiate a pair trade
2. A pair trade is initiated when the ratio drifts to a value between 2 and 3 standard
deviation
3. A pair trade is closed when the ratio approaches the mean
4. Long pair trade requires you to buy the numerator and sell the denominator
5. Short pair trade requires you to sell the numerator and buy the denominator
6. Typically, the bulk of P&L comes from one of the stocks which have deviated away
from the regular pair trade
7. Pair trade can be live for an extended period, but the P&L makes the wait worth it
8. Pair trade is a margin money guzzler.
CHAPTER 8
Pair trade Method 2, Chapter 1 (PTM2, C1)

– Straight line Equation
8.1 – A straight relationship
Today happens to be 14th of Feb, people around me are excited about Valentine’s Day,
they are busy celebrating love and relationships. I think Valentine’s Day is a packaged
affair, meant to boost the revenues of restaurants, jewellers, and gift shops, but then it’s
just me and my random thoughts.
Anyway, given its valentine’s day, I thought it would be a perfect idea to discuss
relationships. Don’t worry, I’m not going to bore with a clichéd love story or give you any
unsolicited advice on maintaining a great relationship, rather I’ll talk to you about two
sets of numbers and how you can measure the relationship between them if at all there
exists one.
In the process, I’ll attempt to take you back to your school days, well, at least back to your
high school math class
A quick recap here – Chapter 1 to 7 of this module, we discussed a rather simple technique
of pair trading. This was as taught by Mark Whistler. Moving forward from this chapter, we
will discuss a slightly more advanced technique of pair trade. This is also called
‘Statistical Arbitrage’ or ‘Relative value trading’ or RVT in short.
So here we go.
Do you remember the time your math teacher discussed the equation of a straight line in
the class? If you were like me, you’d have promptly ignored the lecture and looked outside
of the window, quietly rebelling against the mainstream education.
But then, if only the teacher had said ‘learn this, you’ll make money off it someday’, the
interest level would have been totally different!
Anyway, life always gives you a second chance, so this time around, pay attention, and
hopefully, you will make some money off it
The equation of a straight line reads something like this –
Y = mx + ε
Click here for a detailed explanation, or continue reading for a bare bone explanation.
Before we discuss the equation, a quick note on the notations used –
y = Dependent variable
M = Slope
X = Independent variable
E = Intercept
The equations states, the value of a dependent variable ‘y’ can be derived from an
independent variable ‘x’, by multiplying x by its slope with y’ and adding the intercept ‘e’
to this product.
Sounds confusing? I guess so
Let me elaborate on this and by the way before you start thinking why we are discussing
the straight line equation instead of relative value trading (RVT), then please be rest
assured, this concept has deep relevance to RVT!
Consider two fitness freaks, let’s call them FF1 and FF2, between the two, FF2 is the kind
of guy who wants to go that step extra and something more than what FF1 does. So if FF1
does 5 pushups, FF2 does 10. If FF1 does 20 pull-ups, then FF2 does 40. So on and so
forth. Here is a table on how many pushups they did Monday to Saturday –
Day FF1 FF2
Monday 30 60
Tuesday 15 30
Wednesday 40 80
Thursday 20 40
Friday 10 20
Saturday 15 ???
Now, if you were to guess the number of push-ups FF2 would do on Saturday, what would
it be? I guess it’s a no-brainer, it would be 30.
This also means – the number of pushups FF2 does, is kind of dependent on the number of
pushups FF1 does. FF1 does not really bother about FF2, he will go ahead and do as many
pushups his body permits, but FF2, on the other hand, does twice the number of pushup
as FF1.
So this makes FF2 a dependent variable and FF1 an independent variable. Or in the
straight line equation, FF2 = y and FF1 = x.
FF2 = FF1*M + ɛ
In simple English, the equation reads like this –
The number of pushups FF2 does is equal to the number of pushups FF1 does, multiplied
by a certain number, plus a constant.
That certain number is called the slope (M), which happens to be 2, and the constant or ɛ
happens to be 0. So the equation is –
FF2 = FF1*2 + 0
I hope this is fairly clear now. Let me copy paste the definition I had posted earlier –
The straight line equations states, the value of a dependent variable ‘y’ can be derived from
an independent variable ‘x’, by multiplying x by its slope with y’ and adding the intercept ‘e’
to this product.
Now, think about another case –
There are two hungry men, let’s call them H1 and H2. Just like FF1 and FF2, H2 eats twice
the number of paratha as H1 plus 1.5 more. For example, if H1 eats 2 parathas, then H2
will eat 4 plus eat another 1.5. H2 will always ensure he eats that extra 1.5 parathas, no
matter how full he is.
So here is the table which gives you count of how many parathas these two hungry men
ate over the last 6 days –
Day H1 H2
Monday 2 5.5
Tuesday 1.5 4.5
Wednesday 1 3.5
Thursday 3 7.5
Friday 3.5 8.5
Saturday 4 ???
If you notice, H2 (who is really hungry, all the time), eats twice as much as H1 plus 1.5
paratha extra. So on Saturday, he will eat –
4*2 + 1.5 = 9.5 paratha!
Remember, the number of parathas H2 eats is dependent on how many parathas H1 eats.
H1, on the other hand, eats till he is satisfied. Given this, let us a construct a straight line
equation for these two hungry men, just like the way we did for the two fitness freaks.
H2 = H1*2 + 1.5
Here, H2 is the dependent variable, whose value is dependent on H1. 2 is the slope, and
1.5 is the constant.
Before we proceed, let’s make a small change in the paratha example, think of ‘Y’ as a diet
conscious person. Every day, irrespective of how hungry or full Y is, he eats just 1.5
parathas. Not a morsel more or not morsel less.
So, X eats 3 parathas, Y eats 1.5, X eats 5, Y eats 1.5, X eats 2.5, Y eats 1.5. So on and so
forth. So what do you think the equation states?
y = x*0 + 1.5
The slope here is 0, hence, y is not really dependent on x, in fact, the value of y is a
constant of 1.5, which is quite obvious. Hopefully, you get the point by now on how you
can relate two sets of numbers.
Now forget the fitness, forget the parathas, I’ll give you two sets of random numbers –
X Y
10 3
12 6
8 4
9 17
20 36
18 22
X is the independent variable and Y is the dependent variable. Given this, do you see a
relationship between these two sets of numbers here? Eyeballing the numbers suggest
that there is no relationship between X and Y, definitely not like the one which existed in
the above two examples. But this does not mean that there is no relationship between the
two at all. It’s just the relationship is not obvious to the naked eye.
So how do we establish the relationship between the two? To be more precise, how do we
figure out the values of the slope’ and the constant ‘ɛ’?
Well, say hello to linear regression!
I’ll introduce the same to you in the next chapter.
1. A straight line equation can define the relationship between two variables
2. Of the two variables, one of it is dependent and the other one is independent
3. The slope of a straight-line equation, represented by ‘m’ helps you identify the
extent by which the independent variable has to be scaled
4. The term ɛ represents a constant term
5. If the slope is zero, the Y = ɛ
6. Sometimes, the relationship between two variables is not obvious
7. When the relationship is not obvious, one can identify the relationship by
employing a statistical technique called ‘Linear regression’.
CHAPTER 9
PTM2, C2 – Linear Regression
9.1 – Introduction to Linear Regression
The previous chapter laid down a basic understanding of a straight line equation. To keep
things simple, we took a very basic example to explain how two variables can be related to
each other. Needless to say, the examples were selected in a way that casual eyeballing
could reveal the relationship. Towards the end of the chapter we posted a table
containing two arrays of numbers – the task was to figure out if there was a relationship
between the two sets of numbers, if yes, what how could one express the relationship in
the form of a straight line equation. More precisely, what was the intercept and constant?
We will figure how to establish a relationship in this chapter and move closer towards the
relative value trading technique. For convenience, let me post the table with the two
number arrays once again –
X Y
10 3
12 6
8 4
9 17
20 36
18 22
Clearly, casual eyeballing does not reveal any information about the relationship between
the two sets of numbers. Maybe it does, if you are a mutant, but for a mere mortal like me,
it does not work.
Under such circumstances, we rely upon a technique called the ‘Linear Regression’. Linear
regression is a statistical operation wherein the input is an array of two sets of numbers
and the output contains many different parameters, including the intercept and constant
needed for constructing the straight line equation.
To perform the linear regression operation, we will depend on the good old Excel. Here is
the step by step guide to perform a simple linear regression on two arrays of numbers. Be
prepared to see a lot of screenshots and instructions
Step 1 – Install the Plugin
Open a fresh excel sheet and insert the values of X & Y as seen in the above table. I’ve done
the same as shown below –
This is our data set. Do remember, Y is the ‘Dependent’ variable whose value depends on
the independent variable X. Both X and Y will be the input variables for the linear
regression operation.
On the excel sheet, click on the Data ribbon as highlighted in red, shown below –
The data ribbon will now show you the ‘Data Analysis’, option. This is highlighted in blue.
Now, some of you may not see this option, if yes, don’t panic. I’ll tell you what needs to be
done.
Click on ‘File’ –
This will open up a new window, and on your left-hand side panel, you will see an option
to select ‘option’ –
Click on the Options, and you will see a bunch of general options to work with. On the left-
hand panel, select ‘Add-Ins’, click on it and then click on the ‘Analysis Tool pack’. Then
click on ‘Go’, and finally on ‘Ok’. With this, you’d essentially added the ‘Data Analysis’
option to the data ribbon.
Close the excel sheet and restart your system and you are good to roll.
Step 2 – Enter the values
So we proceed further based on the assumption that your excel sheet has the data
analysis pack. The next step is to invoke the linear regression function within the data
analysis pack. To do this, click on the ‘Data’ ribbon, and select the Data Analysis. This will
open up a pop-up, which will have a list of statistical operations which you can perform on
data sets. Select the one which says ‘Regression’.
Select regression and click ok, you will see the following pop up –
As you can see, there are a bunch of fields here. I’d suggest you pay attention to the first
section, which is the input section. There are two fields here – ‘Input Y Range’ and ‘Input X
Range’. As you may have imagined, Y is for the dependent variable and X is for the
dependent variable.
This is where we feed in the X and Y series data. To do that, click on the input channel and
select Y and X range –
Also, please notice that I’ve checked the label box, this indicates that the first cell value i.e.
A2 and B2 contain the series label i.e. X & Y respectively.
I’d suggest you ignore the other input values for now.
On the output side, ensure you’ve clicked the following –
Selecting ‘New worksheet’, ensures that the output data is printed on a new worksheet.
I’ve also clicked on two other variables called – Residuals and Standardized Residuals. I
will talk about these two variables at a later point. For now, just ensure they are selected.
With this, you are good to perform the linear regression operation. Click on the ‘Ok’ button
which is available in the right-hand top corner.
Excel will now take these inputs and perform the linear regression operation, the results
will be posted in a new sheet within the same workbook.
9.2 – Linear Regression Output
So here is how the linear regression output looks and as expected, the summary of the
output is presented in a new sheet.
Agreed, the summary output is quite scary at the first glance. It has lots and lots of
information. We will unravel this output in bits and pieces as we proceed.
For now, let’s concentrate on finding our slope and intercept. I’ve highlighted this for you
in the below snapshot –
The data points highlighted in red contains the coefficients we are looking for i.e. the
intercept (or constant) and the slope (denoted by x).
Some of you may be confused with the slope being represented by x, I understand its
misleading, it would have been best if it was M instead of x as it would match the straight-
line equation, but then I guess we will have to live with x for slope.
So,
o Slope of the equation = 1.885
o Intercept (or constant) = -7.859813.
Given this, the straight-line equation for the arbitrary set of data is –
y = 1.885*x + (-7.859813) or
y = 1.885*x – 7.859813
So what does this really mean?
Well, if you recollect from the previous chapter, this equation essentially helps us predict
the value of y or the dependent variable for a certain x. Let me repost the table here for the
sake of convenience –
X Y
10 3
12 6
8 4
9 17
20 36
18 22
15 ??
I’ve added a new data point for x here i.e. 15, now using the slope and intercept, we can
predict the value of y. Let’s do that –
y = 1.885 * 15 – 7.859813
= 28.275 – 7.859813
= 20.415
So, if x is 15, then most likely, the predicted value of y is 20.415.
How accurate is this prediction, you may ask?
Well, it’s not accurate. It is only an estimation. For example, consider the value of x is 18
(refer to the last but one data point), then according to the straight line equation, the
value of y should be –
y = 1.885*18 – 7.859813
= 33.93 – 7.859813
= 26.07019
However, the actual value of y is 22.
This leads us two values of y –
1. Predicted value of y via the straight line equation
2. Actual value of y
The difference between the two values of y is called the residuals. For example, the
residual for y (difference between actual and predicted y), when x = 18 is
26.07019 – 22
= 4.070187
The summary output when you perform linear regression also contains the residuals, I’ve
highlighted the same in the snapshot below –
I’ve also highlighted the residual when x = 18, which is what we calculated above.
To give you a heads up – the bulk of the focus for carrying out the relative value trade
depends on the residuals. Stay tuned!
Download the excel sheet here.
1. Linear regression is a statistical operation which helps you construct a straight line
equation
2. Linear regression can be performed on excel. One needs to install the excel plugin
to perform linear regression
3. Amongst many other output variables, linear regression gives out the values of the
slope and intercept
4. With the help of the slope and intercept, one can predict the value of y
5. The difference between actual y and predicted y is called the residual
6. The residual is also a part of the output summary
CHAPTER 10
PTM2, C3 – The Error Ratio
10.1 – Who is X and who is Y?
I hope the previous chapter gave you a basic understanding of linear regression and how
one can conduct the linear regression operation on two sets of data, on MS Excel.
Remember, we are talking about two variables here – X and Y.
X is defined as the independent variable and Y is the dependent variable. If you’ve spent
time thinking about this, then I’m certain you’d have guessed X and Y will eventually be
two different stocks.
In fact, let us just go ahead and run a linear regression on two stocks – maybe HDFC Bank
and ICICI Bank and see what results we get.
I’m setting ICICI Bank as X and HDFC Bank as Y. A quick note on data before we proceed –
1. Make sure your data is clean – adjusted for splits, bonuses, and any other
corporate actions
2. Make sure the data matches the exact dates – for instance, the data I have for both
the stocks here runs from 4th of Dec 2015 to 4th Dec 2017.
Here is how the data looks –
I’ll run the linear regression on these two stocks (I’ve explained how to do this in the
previous chapter), also do note, I’m running this on the stock prices and not really on
stock returns –
The result of the linear regression is as follows –
Since ICICI is independent and HDFC is dependent, the equation is –
HDFC = Price of ICICI * 7.613 – 663.677
I’m assuming, you are familiar with the above equation. For those who are not familiar, I’d
suggest you to read the previous two chapters. However here is the quick summary – the
equation is trying to predict the price of HDFC using the price of ICICI.
Or in other words, we are trying to ‘express’ the price of HDFC in terms of ICICI.
Now, let us reverse this – I will set ICICI as dependent and HDFC as the independent.
Here is how the results look –
The equation is –
ICICI = HDFC * 0.09 + 142.4677
So for the given two stocks, you can regress two ways by reordering which stock is
dependent and which one is the independent variable.
However, the question is – how do you decide which one should be marked dependent
and which one as independent. Or in other words, which order makes the most sense.
The answer to this depends on three things –
1. Standard Error
2. Standard Error of intercept
3. The ratio of the above two variables.
Remember, the linear equation above, essentially expresses the variation of price of ICICI
in terms of HDFC (refer to the equation above). This expression or explanation of the price
variation of one stock by keeping the price of the other stock as a reference can never be
100%. If it was 100%, then there is no play here at all.
Having said so, the equation should be strong enough to explain the variation in price of
the dependent variable as much as possible, keeping the independent variable in
perspective. The stronger this is, the better it is.
This leads us to the next obvious question – how do we figure out how strong the linear
regression equation is? This is where the ratio –
Standard Error of Intercept / Standard Error comes into play. To understand this ratio,
we need to understand both the numerator and the denominator before talking about the
ratio itself.
10.2 – Back to residuals
Here is the linear regression equation of ICICI as independent and HDFC as the dependent
–
HDFC = Price of ICICI * 7.613 – 663.677
This essentially means, if I know the price of ICICI, I should be able to predict the price of
HDFC. However, in reality, there is a difference between the predicted price of HDFC and
the actual price. This difference is called the ‘Residuals’.
Here is the snapshot of the residuals when we try and explain the price of HDFC keeping
ICICI as the independent variable –
When I talk about the regression equation and the residuals, usually, I get one common
question – what is the use of regression if there is a residual each and every time? Or in
other words, how can we rely on an equation, which fails to predict accurately, even once.
This is a fair question. If you look at the residuals above, they vary from a low of -288 to a
high of 548, so using this equation to make any sort of prediction one price is futile.
But then, this was never about predicting the price of the dependent stock, given the price
of an independent stock. It was always about the residuals!
Let me give you a heads-up here – the residuals display a certain behaviour. If we can
understand this behaviour and figure a pattern within it, then we can rework backwards to
construct a trade. This trade obviously involves buying and selling the two stocks
simultaneously, hence this qualifies as a pair trade.
Over the next few chapter, we will dwell deeper into this. However, for now, let’s talk
about the ‘Standard Error’, the denominator in the Standard Error of Intercept /
Standard Error equation.
The standard error is one of the variables which gets reported when you run a linear
regression operation. Here is the snapshot showing the same –
The standard error is defined as the standard deviation of the residuals. Remember, the
residuals itself is a time series array. So if you were to calculate the standard deviation of
the residuals, then you get the standard error.
In fact, let me manually calculate the standard error of the residuals, I’m doing this for X =
ICICI and y = HDFC
And excel tells me the standard deviation is 152.665. The standard error as reported in the
summary output is 152.819. The minor difference can be ignored.
The ‘Standard Error of the Intercept’, is a little tricky. It does get reported in the regression
report, and here is the standard error of the intercept with x = ICICI and y = HDFC
Recall, the regression equation –
y=M*x+ C
Where,
M = Slope
C = Intercept
If you realize, here both M and C are estimates. And how are they estimated? They are
estimated based on the historical data provided to the regression algorithm. The data can
obviously contain noise components and few outliers. This implies that there is a scope
for the estimates can go wrong.
The Standard Error of the Intercept is the measure of the variance of estimated intercept.
It helps up understand by what degree the intercept itself can vary. So in a sense, this is
somewhat similar to the ‘Standard Error’ itself. To summarize –
o Standard Error of Intercept – The variance of the intercept
o Standard Error – The variance of the residuals.
Now that we have defined both these variables, let’s bring back the ‘Error Ratio’. Please
note, the term ‘Error Ratio’ is not a standard term, I’ve come up with it for ease of
understanding.
Anyway, the error ratio, as we know –
Error Ratio = Standard Error of Intercept / Standard Error
I’m calculated the same for –
1. ICICI as X and HDFC as y = 0.401
2. HDFC as X and ICICI as y = 0.227
The decision to designate X and Y to stocks depends on the value of the error ratio. The
lower the better. Since HDFC as X and ICICI as y offers the lowest error ratio, we will
designate HDFC as the independent variable (X) and ICICI as the dependent variable (Y).
I’d love to explain the reason as to why we are using the error ratio as the key input for
designating X and Y, but I guess I will hold back. I’ll revisit this again when I take up pair
trade example. For now, remember to calculate the error ratio and estimate which stock
should be dependent and which one will be the independent.
You can download the excel sheet used in this chapter here.
1. X is the independent stock and Y is the dependent stock
2. The decision to figure out which stock is X and which one should be Y depends on
‘Error Ratio’
3. Both the slope and the intercept from the linear regression equation are estimates
4. Error Ratio = Standard Error of the Intercept / Standard Error
5. Standard error is the standard deviation of the residuals
6. Standard error of intercept gives you a sense of the variance of the intercept
7. Regress Stock 1 with Stock 2 and also Stock 2 with Stock 1, whichever offers the
lowest error ratio defines which stock is dependent and which one is independent
8. Residuals display certain properties, studying which can help identify pair trading
pattern
CHAPTER 11
PTM2, C4 – The ADF test
11.1 – Co-Integration of two-time series
I guess this chapter will get a little complex. We would be skimming the surface of some
higher order statistical theory. I will try my best and stick to practical stuff and avoid all
the fluff. I’ll try and explain these things from a trading point of view, but I’m afraid, some
amount of theory will be necessary for you to know.
Given the path ahead I think it is necessary to re-rack our learnings so far and put some
order to it. Hence let me just summarize our journey so far –
1. Starting from Chapter 1 to 7, we discussed a very basic version of a pair trade. We

discussed this simply to lay out a strong foundation for the higher order pair
trading technique, which is generally known as the relative value trade
2. The relative value trade requires the use of linear regression
3. In linear regression, we regress an independent variable, X against a dependent

variable Y.
4. When we regress – some of the outputs that are of interest are the intercept, slope,
residuals, standard error, and the standard error of the intercept
5. The decision to classify a stock as dependent and independent really depends on

the error ratio.
6. We calculate the error ratio by interchanging both X and Y. The one which offers
the lowest error ratio will define which stock is X and which on as Y.
I hope you have read and understood everything that we have discussed up to this point.
If not, I’d suggest you read the chapters again, get clarity, and then proceed.
Recollect, in the previous chapter, we discussed the residuals. In fact, I also mentioned
that the bulk of the focus going forward will be on the residuals. It is time we study the
residuals in more detail and try and establish the kind of behaviour the residuals exhibit.
In our attempt to do this, we will be introduced to two new jargons – Cointegration and
Stationarity.
Generally speaking, if two-time series are ‘co integrated’ (stock X and stock Y in our case),
then it means, that the two stocks move together and if at all there is a deviation from this
movement, it is either temporary or can be attributed to a stray event, and one can expect
the two-time series to revert to its regular orbit i.e. converge and move together again.
Which is exactly what we want while pair trading. This means to say, the pair that we
choose to pair trade on, should be cointegrated.
So the question is – how do we evaluate if the two stocks are cointegrated?
Well, to check if the two stock is cointegrated, we first need to run a linear regression on
the two stocks, then take up the residuals obtained from the linear regression algorithm,
and check if the residual is ‘stationary’.
If the residuals are stationary, then it implies that the two stocks are cointegrated, if the
two stocks are cointegrated, then the two stocks move together, and therefore the ‘pair’ is
ripe for tracking pair trading opportunity.
Here is an interesting way to look at this – one can take any two-time series and apply
regression, the regression algorithm will always throw out an output. How would one
know if the output is reliable? This is where stationarity comes into play. The regression
equation is valid if and only if residuals are stationary. If the residuals are not stationary,
regression relation shouldn’t be used.
Speculating and setting up trades on a co-integrated time series is a lot more meaningful
and is independent of market direction.
So, essentially, this boils down to figuring out if the residuals are stationary or not.
At this point, I can straight away show you how to check if the residuals are stationary or
not, there is a simple test called the ‘ADF test’ to do this – frankly, this is all you need to
know. However, I think you are better off if you spend few minutes to understand what
‘Stationarity’ really means (without actually deep diving into the quants).
So, read the following section only if you are curious to know more, else go to the section
which talks about ADF test.
11.2 Stationary and non-stationary series
A time series is considered ‘Stationary’ if it follows three 3 simple statistical conditions. If

the time series partially satisfies these conditions, like 2 out of 3 or 1 out of 3, then the
stationarity is considered weak. If none of the three conditions are satisfied, then the time
series is ‘non-stationary’.
The three simple statistical conditions are –
o The mean of the series should be same or within a tight range
o The standard deviation of the series should be within a range
o There should be no autocorrelation within the series – this means any particular
value in the time series – say value ‘n’, should not be dependent on any other value
before ‘n’. Will talk more about this at a later stage.
While pair trading, we only look for pairs which exhibit complete stationarity. Non-
stationary series or weak stationary series will not work for us.
I guess it is best to take up an example (like a sample time series) and figure out what the
above three conditions really mean and hopefully, that will help you understand
‘stationarity’ better.
For the sake of this example, I have two-time series data, with 9000 data points in each.
I’ve named them Series A and Series B, and on this time series data, I will evaluate the
above three stationarity conditions.
Condition 1 – The mean of the series should be same or within a tight range
To evaluate this, I will split each of the time series data into 3 parts and calculate the
respective mean for each part. The mean for all three different parts should be around the
same value. If this is true, then I can conclude that the mean will more or less be the same
even when new data points flow in the future.
So let us go ahead and do this. To begin with, I’m splitting the Series A data into three
parts and calculating its respective means, here is how it looks –
Like I mentioned, I have 9000 data points in Series A and Series B. I have split Series A data
points into 3 parts and as you can see, I’ve even highlighted the starting and ending cells
for these parts.
The mean for all the three parts are similar, clearly satisfying the first condition.
I’ve done the same thing for Series B, here is how the mean looks –
Now as you can see, the mean for Series B swings quite wildly and thereby not satisfying
the first condition for stationarity.
Condition 2 -The standard deviation should be within a range.
I’m following the same approach here – I will go ahead and calculate the standard
deviation for all the three parts for both the series and observe the values.
Here is the result obtained for Series A –
The standard deviation oscillates between 14-19%, which is quite ‘tight’ and therefore
qualifies the 2ndstationarity condition.
Here is how the standard deviation works out for Series B –
Notice the difference? The range of standard deviation for Series B is quite random. Series
B is clearly not a stationary series. However, Series A looks stationary at this point.
However, we still need to evaluate the last condition i.e. the autocorrelation bit, let us go
ahead and do that.
Condition 3 – There should be no autocorrelation within the series
In layman words, autocorrelation is a phenomenon where any value in the time series is
not really dependent on any other value before it.
For example, have a look at the snapshot below –
The 9th value in Series A is 29, and if there is no autocorrelation in this series, the value 29
is not really dependent on any values before it i.e. the values from cell 2 to cell 8.
But the question is how do we establish this?
Well, there is a technique for this.
Assume there are 10 data points, I take the data from Cell 1 to Cell 9, call this series X, now
take the data from Cell 2 to Cell 10, call this Series Y. Now, calculate the correlation
between Series X and Y. This is called 1-lag correlation. The correlation should be near to
0.
I can do this for 2 lag as well – i.e. between Cell 1 to Cell 8, and then between Cell 3 to Cell
10, again, the correlation should be close to 0. If this is true, then it is safe to assume
assumed that the series is not auto correlated, and hence the 3rd condition for stationarity
is proved.
I’ve calculated 2 lag correlation for Series A, and here is how it looks –
Remember, I’m subdividing Series A into two parts and creating two subseries i.e. series X
and series Y. The correlation is calculated on these two subseries. Clearly, the correlation
is close to zero and with this, we can safely conclude that Time Series A is stationary.
Let’s do this for Series B as well.
I’ve taken a similar approach, and the correlation as you can see is quite close to 1.
So, as you can see all the conditions for stationarity is met for Series A – which means the
time series is stationary. While Series B is not.
I know that I’ve taken a rather unconventional approach to explaining stationarity and co-
integration. After all, no statistical explanation is complete without those scary looking
formulas. But this is a deliberate approach and I thought this would be the best possible
way to discuss these topics, as eventually, our goal is to learn how to pair trade efficiently
and not really deep dive into statistics.
Anyway, you could be thinking if it is really required for you to do all of the above to figure
out if the time series (residuals) are indeed stationary. Well, like I said before, this is not
required.
We only need to look at the results of something called as the ‘The ADF Test’, to establish
if the time series is stationary or not.
11.3 – The ADF test
The augmented Dickey-Fuller or the ADF test is perhaps one of the best techniques to test
for the stationarity of a time series. Remember, in our case, the time series in
consideration is the residuals series.
Basically, the ADF test does everything that we discussed above, including a multiple lag
process to check the autocorrelation within the series. Here is something you need to
know – the output of the ADF test is not a definitive ‘Yes – this is a stationary series’ or ‘No
– this is not a stationary series’. Rather, the output of the ADF test is a probability. It tells
us the probability of the series, not being stationary.
For example, if the output of the ADF test a time series is 0.25, then this means the series
has a 25% chance of not being stationary or in other words, there is a 75% chance of the
series being stationary. This probability number is also called ‘The P value’.
To consider a time series stationary, the P value should be as low as 0.05 (5%) or lower.
This essentially means the probability of the time series is stationary is as high as 95% (or
higher).
Alright, so how do you run an ADF test?
Frankly, this is a highly complex process and unfortunately, I could not find a single source
online which will help you run an ADF test for free. I do have an excel sheet (which has a
paid plugin) to run an ADF test, but unfortunately, I cannot share it here. If I could, I would
have.
If you are a programmer, I’ve been told that there are Python plugins easily available to
run an ADF test, so you could try that.
But if you are a non-programmer like me, then you will be stuck at this stage. So here is
what I will do, once in a weak or 15 days, I will try and upload a ‘Pair Data’ sheet, which
will contain the following information of the best possible combination of pairs, this
includes –
1. You will know which stock is X and which stock is Y
2. You will know the intercept and Beta of this combination
3. You will also know the p-value of the combination
The look back period for generating this is 200 trading days. I’ve restricted this just to
banking stocks, but hopefully, I can include more sectors going forward. To help you
understand this better, here is the snapshot of the latest Pair Datasheet for banking stocks
–
The first line suggests that Federal Bank as Y and PNB as X is a viable pair. This also means,
that the regression of Federal as Y and PNB as X and Federal as X and PNB as Y was
conducted and the error ratio for both the combination was calculated, and it was found
that Federal as Y and PNB as X had the least error ratio.
Once the order has been figured out (as in which one is Y and which one is X), the intercept
and Beta for the combination has also been calculated. Finally, the ADF was conducted
and the P value was calculated. If you see, the P value for Federal Bank as Y and PNB as X
is 0.365.
In other words, this is not a combination you should be dealing with as the probability of
the residuals being stationary is only 63.5%.
In fact, if you look at the snapshot above, you will find only 2 pairs which have the desired
p-value i.e. Kotak and PNB with a P value of 0.01 and HDFC and PNB with a P value of
0.037.
The p values don’t usually change overnight. Hence, for this reason, I check for p-value
once in 15 or 20 days and try and update them here.
I think we have learned quite a bit in this chapter. A lot of information discussed here
could be new for most of the readers. For this reason, I will summarize all the things you
should know about Pair trading at this point –
1. The basic premise of pair trading
2. Basic overview of linear regression and how to perform one
3. In linear regression, we regress an independent variable, X against a dependent

variable Y.
4. When we regress – some of the outputs that are of interest are the intercept, slope,
residuals, standard error, and the standard error of the intercept
5. The decision to classify a stock as dependent and independent really depends on

the error ratio.
6. We calculate the error ratio by interchanging both X and Y. The one which offers
the lowest error ratio will define which stock is X and which on as Y
7. The residuals obtained from the regression should be stationary. If they are
stationary, then we can conclude that the two stocks are co-integrated
8. If the stocks are cointegrated, then they move together
9. Stationarity of a series can be evaluated by running an ADF test.
If you are not clear on any of the points above, then I’d suggest you give this another shot
and start reading from Chapter 7.
In the next chapter, we will try and take up an example of a pair trade and understand its
dynamics.
You can download the Pair Data sheet, updated on 11th April 2018.
Lastly, this module (and this chapter, in particular) could not have been possible without
the inputs from my good friend and an old partner, Prakash Lekkala. So I guess, we all
need to thank him
1. If two stocks move together, then they are also cointegrated
2. You can pair trade on stocks which are cointegrated
3. If the residuals obtained from linear regression is stationary, then it implies the two
stocks are co-integrated
4. A time series is considered stationary if the series has a constant mean, constant
standard deviation, and no autocorrelation
5. The check for stationarity can be done by an ADF test
6. The p-value of the ADF test should be 0.05% or lower for the series to be
considered stationary.
CHAPTER 12
Trade Identification
12.1 – Trading the equation
At this stage, we have discussed pretty much all the background information we need to
know about Pair trading. We now have to patch things together and understand how all
these concepts make sense while taking up a pair trade.
Let’s start with the basic equation again. I understand we have gone through this equation
earlier in this module, but I want you to relook at this equation from a trader’s
perspective. I want you to think about ways in which you can trade this equation. I want
you to see opportunities here. This is where everything starts to culminate.
y = M*x + c
What is this equation essentially trying to tell you? Well, frankly, it depends on how your
perspective of this equation. You can look at it from two different perspectives –
1. As a statistician
2. As a trader
Since we are dealing with two stocks here, the statistician would look at this as an
equation where the stock price of a dependent stock ‘y’ is being explained with respect to
an independent stock price ‘x’. This process of ‘price explanation’ generates two other
variables i.e. the slope (or beta) ‘M’ and the intercept ‘c’.
So in an ideal world, the stock price of y should be exactly equal to the Beta times X plus
the intercept.
But we know that this is not true, there is always a variation in this equation which leads
to the difference between the actual stock price of Y and the predicted stock price of Y.
This difference is also termed as the ‘residual’ or the error term.
In fact, we can extend the above equation to include the residuals and with that, the
equation would look like this –
y = M*x + c + ε
Where, ε represents the error or the residual of the equation. Of course, by now we are
even familiar with the stationarity of the residuals which adds more sanctity to the above
equation.
Fair enough, now for the interesting bit – how would a trader look at this equation? Let
me repost the equation again –
y = M*x + c + ε
Let us break this equation into smaller pieces –
y = M*x, this essentially means, the price of the dependent stock ‘y’ is equal to the
independent stock price ‘x’, multiplied by the slope M. Well, the slope is essentially the
beta and it tells us how many stocks of x would equal the price of y.
For example, here is the linear regression output of HDFC Bank (y) vs ICICI Bank (x) –
And here is the snapshot of the prices of ICICI and HDFC –
Now, this means, the price of HDFC Bank is roughly equal to the price of ICICI times the
Beta. So, 1914 = 291 *7.61.
Don’t jump in to do the math, I know that does not add up
But for a moment, assume if this equation were to be true, then, in other words, this
essentially means 7.61 shares of ICICI equals 1 share of HDFC. This is an important
conclusion.
This also means, if I were to go long on one share of HDFC and short on 7.61 shares of ICIC,
then I’m essentially long and short at the same time, hence I’ve hedged away a large
amount of directional risk. Don’t forget the basic premise here, we are considering these
two stocks because they are co-integrated in the first place.
So here is the equation again –
y = M*x + c + ε
If this equation were to be true, then by going long and short on y and x, we are hedging
away the directional risk associated with this pair.
This leaves us with the 2nd part of the equation i.e. c + ε
As you know, C is the intercept. Now, at this point, I want you to recollect the ‘Error Ratio’
which we discussed in chapter 10.
Error Ratio = Standard Error of Intercept / Standard Error.
As you may recollect, we discussed the lower the error ratio, the better it is.
Mathematically, this also implies that we are looking at pairs which have a low intercept.
Again this is a very crucial point for you to note, we are selecting the pairs, such that the
standard error of the intercept is low.
Remember, in this equation y = M*x + c + ε we are trying to establish a trade (or hedge)
every element. We are hedging y with Mx. We are trying to minimize c or the intercept
because we are not trading or hedging it. Therefore, the lower it is, the better for us.
This leaves us with just the residual or the ε.
Remember, the residual is a time series. We have even validated the stationarity of this
series. Now, because the residual is a stationary time series, the properties of normal
distribution can be quite beautifully applied. This means, I only need to track the residuals
and trigger a trade when it hits the upper or lower standard deviation!
Generally speaking, a trade is initiated when –
1. Long on the pair (buy y, sell x) when the residuals hit -2 standard deviation (-2SD)
2. Short on the pair (sell y, buy x) when the residuals hit +2 standard deviations
(+2SD)
Like in the first method, the idea here is to initiate a trade at the 2 nd standard deviation
and hold the trade till the residual reverts to mean. The SL can be kept at 3SD for both the
trades. More on this in the next chapter.
I know this is a short chapter, but I will conclude it here, as I don’t want to clutter your
mind with other information.
It is important for you to understand this equation from a trader’s perspective and figure
out what exactly you are trading. Remember, we are only trading the residuals here. We
are hedging away the stock price of y with x. The intercept is kept low, and the residual is
traded.
Why is the residual tradable? Because its stationary and therefore, its behaviour is kind of
predictable. In the next chapter, I’ll try and take up a live trade and deal with the practical
aspects of pair trading.
1. The pair trading equation is actually the main equation which we trade
2. Every element of the equation is looked into
3. We hedge the stock price of y with the stock price of x. The beta of x tells us the
number stocks required to hedge 1 stock of y
4. By looking into the error ratio, we are ensuring the intercept is kept low. Please
remember we are not hedging the intercept, hence this needs to be kept low
5. The residual is what we trade as it is stationary and follows the normal distribution
quite well
6. A long trade is initiated when residuals hit -2SD. Likewise, a short trade is initiated
when the residuals hit +2SD
7. Long on a pair requires us to go long on Y and short on X
8. Short on a pair requires us to go short on Y and long on X
9. When we initiate a pair trade, we expect the residual to hit the mean, so we hold
until then
10. The SL can be kept at 3SD for both long and short trades
CHAPTER 13
Live Example -1
13.1 – Tracking the pair data
We have finally reached a point where we are through with all the background theory
knowledge required for Pair Trading. I know most of you have been waiting for this
moment
In this last and final chapter of pair trading, we will take up an example of a live trade and
discuss factors that influence the trade.
Here is a quick recap of pre-trade theory –
1. Basic overview of linear regression and how to perform one
2. Linear regression requires you to regress an independent variable X against a

dependent variable Y
3. The output of linear regression includes the intercept, slope, residuals, standard
error, and the standard error of the intercept
4. The decision to classify a stock as dependent (Y) and independent (X) depends the
error ratio
5. Error ratio is defined as the ratio of standard error of intercept/standard error
6. We calculate the error ratio by interchanging both X and Y. The combination which
offers the lowest error ratio will define which stock is assigned X and which on as Y
7. The residuals obtained from the regression should be stationary. If they are
stationary, then we can conclude that the two stocks are co-integrated
8. If the stocks are cointegrated, then they move together
9. Stationarity of a series can be evaluated by running an ADF test
10. The ADF value of an ideal pair should be less than 0.05
Over the last few chapters, we have discussed each point in great details. These points
help us understand which pairs are worth considering for pair trading. In a nutshell, we
take any two stocks (from the same sector), run a linear regression on it, check the error
ratio and identify which stock is X and which is Y. We now run an ADF test on the residual
of the pair. A pair is considered worth tracking (and trading) only if the ADF is 0.05 or
lower. If the pair qualifies this, we then track the residuals on a daily basis and try to spot
A pair trade opportunity arises when –
1. The residuals hit -2 standard deviations (-2SD). This is a long signal on the pair, so
we buy Y and sell X
2. The residuals hit +2 standard deviations (+2SD). This is a short signal on the pair, so
we sell Y and buy X
Having said so, I generally prefer to initiate the trade when the residuals hit 2.5 SD or
thereabouts. Once the trade is initiated, the stop loss is -3 SD for long trades and +3SD for
short trades and the target is -1 SD and +1 SD for long and short trades respectively. This
also means, once you initiate a pair trade, you will have to track the residual value to
know where it lies and plan your trades. Of course, we will discuss more on this later in
this chapter.
13.2 – Note for the programmers
In Chapter 11, I introduced the ‘Pair Data’ sheet. This sheet is an output of the Pair
Trading Algo. The pair trading algo basically does the following –
1. Downloads the last 200-day closing prices of the underlying. You can do this from
NSE’s bhavcopy, in fact, automate the same by running a script.
2. The list of stock and its sector classification is already done. Hence the download is
more organized
3. Runs a series of regressions and calculates the ‘error ratio’ for each regression. For
example, if we are talking about RBL Bank and Kotak Bank, then the regression
module would regress RBL (X) and Kotak (Y) and Kotak (X) and RBL (Y). The
combination which has the lowest error ratio is considered and the other
combination is ignored
4. The ADF test is applied on the residuals, for the combination which has the lowest
error ratio.
5. A report (pair data) is generated with all the viable X-Y combination and its
respective intercepts, beta, ADF value, standard error, and sigma are noted. I know
we have not discussed sigma yet, I will shortly.
If you are a programmer, I would suggest you use this as a guideline to develop your own
pair trading algo.
Anyway, in Chapter 11, I had briefly explained how to read the data from the Pair data, but
I guess it’s time to dig into the details of this output sheet. Here is the snapshot of the Pair
data excel sheet –
Look at the highlighted data. The Y stock is Bajaj Auto and X stock is TVS. Now because
this combination is present in the report, it implies – Bajaj as Y and TVS as X has a lower
standard error ratio, which further implies that Bajaj as X and TVS as Y is not a viable pair
owing to higher error ratio, hence you will not find this combination (Bajaj as X and TVS as
Y) in this report.
Along with identifying which one is X and Y, the report also gives you the following
information –
1. Intercept – 1172.72
2. Beta – 2.804
3. ADF value – 0.012
4. Std_err – -0.77
5. Sigma – 103.94
I’m assuming (and hopeful) you are aware of the first three variables i.e. intercept, Beta,
and ADF value so I won’t get into explaining this all over again. I’d like to quickly talk about
the last two variables.
Standard Error (or Std_err) as mentioned in the report is essentially a ratio of Today’s
residual over the standard error of the residual. Please note, this can get a little confusing
here because there are two standard errors’ we are talking about. The 2nd standard error is
the standard error of the residual, which is reported in the regression output. Let me
explain this with an example.
This is the regression output summary of Yes Bank versus South Indian Bank. I’ve
highlighted standard error (22.776). This is the standard error of the residuals. Do
recollect, we have discussed this earlier in this module.
The second highlight is 20.914, which is the residual.
The std_err in the report is simply a ratio of –
Today’s residual / Standard Error of the residual
= 20.92404/22.776
= 0.91822
Yes, I agree calling this number std_err is not the best choice, but please bear with it for
now
This number gives me information of how today’s residual is position in the context of the
standard distribution. This is the number which is the key trigger for the trade. A long
position is hit if this number is -2.5 or higher with -3.0 as stop loss. A short position is
initiated if this number reads +2.5 or higher with a stop loss at +3.0. In case of long, target
is at -1 or lower and in case of short, the target is +1 or lower.
This also means, the std_err number has to be calculated on a daily basis and tracked to
identify trading opportunities. More on this in a bit.
The sigma value in the pair data report is simply the standard error of the residual, which
in the above case is 22.776.
So now if you read through the pair data sheet, you should be able to understand the
details completely.
Alright, let us jump to the trade now
13.3 – Live example
I have been running the pair trading algo to look for opportunities, and I found one on
10th May 2018. Here is the snapshot of the pair data, you can download the same towards
the end of this chapter. Do recollect, this pair trading algo was generated using the closing
prices of 10th May.
Look at the data highlighted in red. This is Tata Motors Ltd as Y (dependent) and Tata
Motors DVR as X (independent).
The ADF value reads, 0.0179 (less than the threshold of 0.05), and I think this is an
excellent ADF value. Do recollect, ADF value of less than 0.05 indicates that the residual is
stationary, which is exactly what we are looking for.
The std_err reads -2.54, which means the residuals is close has diverged (sufficiently
enough) away from the mean and therefore one can look at setting up a long trade. Since
this is a long trade, one is required to buy the dependent stock (Tata Motors) and short the
independent stock (Tata Motors DVR). This trade was supposed to be taken on 11 th May
Morning (Friday), but for some reason, I was unable to place the trade. However, I did take
the trade on 14th May (Monday) morning at a slightly bad rate, nevertheless, the intention
was to showcase the trade and not really chase the P&L.
Here are the trade execution details –
You may have two questions at this point. Let me list them for you –
Question – Did I actually execute the trade without checking for prices? As in I didn’t even
look at what price the stocks, I didn’t look at support, resistance, RSI etc. Is it not
required?
Answer – No, none of that is required. The only thing that matters is where the residual is
trading, which is exactly what I looked for.
Question – On what basis did I choose to trade 1 lot each? Why can’t I trade 2 lots of TM
and 3 lots of TMD?
Answer – Well this depends on the beta of the stock. We will use the beta and identify the
number of stocks of X &Y to ensure we are beta neutral in this position. The beta
neutrality states that for every 1 stock of Y, we need to have beta*X stock of X. For
example, in the Tata Motors (Y) and Tata Motors DVR (X) for example, the beta is 1.59. This
means, for every 1 stock of Tata Motors (Y), I need to have 1.59 stocks of Tata Motors DVR
(X).
Going by this proportion, the lot size of Tata Motors (Y) is 1500, so we need 1500*1.59 or
2385 shares of Tata Motors DVR (X). The lot size is 2400, quite close to 2385, hence I
decided to go with 1 lot each. But I’m aware this trade is slightly more skewed towards the
long side since I’m buying additional 115.
Also, please note, because of this constraint, we cannot really trade pairs if the beta is –ve,
at least, not always.
Remember, I initiated this trade when the residual value was -2.54. The idea was to keep
the position open and wait for the target (-1 on residual) or stop loss (-3 on residual) was
hit. Until then, it was just a waiting game.
To track the position live, I’ve developed a basic excel tracker. Of course, if you are a
programmer, you can do much better with these accessories, but given my limited
abilities, I put up a basic position tracker in excel. Here is the snapshot, of course, you can
download this sheet from the link posted below.
The position tracker has all the basic information about the pair. I’m guessing this is a
fairly easy sheet to understand. I’ve designed it in such a way that upon entering the
current values of X & Y, the latest Z score is calculated and also the P&L. I’d encourage you
to play around this sheet, even better if you can build one yourself
Once the position is taken, all one has to do is track the z-score of the residual. This means
you have to keep tracking the values and the respective z-scores. This is exactly what I did.
In fact, for the sake of this chapter, my colleague, Faisal, logged all the values (except for
the 14th and 15th). Here are the logs –
As you can see, the current values were tracked and the latest z-score was calculated
several times a day. The position was open for nearly 7 trading session and this is quite
common with pair trading. I’ve experienced positions where they were open for nearly 22 -
25 trading sessions. But here is the thing – as long as your math is right, you just have to
wait for the target or SL to trigger.
Finally, on 23rd May morning, the z-score dropped to the target level and there was a
window of opportunity to close this trade. Here is the snapshot –
Notice, the gains in Tata Motors DVR is much larger than the loss in Tata Motors. In fact,
when we take the trade, we will never know which of the two positions will make us the
money. The idea, however, is that one of them will move in our favour and the other won’t
(or may). It’s however, just not possible to identify which one will be the breadwinner.
The position tracker for the final day (23rd May) looked like this –
The P&L was roughly Rs.14,000/-, not bad I’d say for a relatively low-risk trade.
13.4 – Final words on Pair Trading
Alright guys, over the last 13 chapter, we have discussed everything I know about pair
trading. I personally thing this is a very exciting way of trading rather than blind
speculative trading. Although less risky, pair trade has its own share of risk and you need
to be aware of the risk. One of the common ways to lose money is when the pair can
continue to diverge after you initiate the position, leaving you with a deep loss. Further,
the margin requirements are slightly higher since there are two contracts you are dealing
with. This also means you need to have some buffer money in your account to
accommodate daily M2M.
There could be situations where you will need to take a position in the spot market as
well. For example, on 23rd May, there was a signal to go short on Allahabad Bank (Y) and
long on Union Bank (X). The z-score was 2.64 and the beta for this pair is 0.437.
Going by beta neutrality, for every 1 share of Allahabad Bank (Y), I need 0.437 shares of
Union Bank (X). The Lot size of Allahabad Bank is 10,000, this implies I need to buy 4378
shares of Union Bank. However, the lot size of Union Bank is 4000, hence I had to buy 370
shares in the spot market.
Well, I hope I trade is successful
I know most of you would want the pair data sheet made available. We are working on
making this sheet available to you on a daily basis so that you can track the pairs.
Meanwhile, I would suggest you try and build this algo yourself. If you have concerns,
please post it below and I will be happy to assist.
If you don’t know how to program then you have no option but to find someone who
knows programming and convince him or her that there is money to be made, this is
exactly what I did
Lastly, I would like to leave you with a thought –
1. We run a linear regression of Stock A with Stock B to figure out if the two stocks are
cointegrated with their residuals being stationary
2. What if Stock A with Stock B is not stationary, but instead Stock A is stationary with
stock B & C as a combined entity?
Beyond Pair, trading lies something called as multivariate regression. By no stretch of the
imagination is this easy to understand, but let me tell you if you can graduate to this
arena, the game is different.
Download the Position Tracker and Pair Datasheet below:
DOWNLOAD POSITION TRACKER
DOWNLOAD PAIR DATASHEET
1. The trigger to trade a pair comes from the residual’s current value
2. Check for beta neutrality of the pair to identify the number of stock required in X
and Y
3. If the beta of the pair is negative, then it may not be possible to set up the trade
4. Once the trade is initiated, check the z-score movement to trade its current
position
5. The price of the futures does not really matter, the emphasis is only on the z-score
CHAPTER 14
Live Example – 2
14.1 – Position Sizing
I know, the discussion on pair trading was to end with the previous chapter, but I thought I
had to discuss a special case before we finally wrap up. I’ll also try and keep this chapter
really short
So here you go.
I ran through the pair trading algo y’day evening (28th May) and found a very interesting
trade. Here are the regression parameters –
o Stock X = ICICI Bank
o Stock Y = HDFC Bank
o ADF = 0.048
o Beta = 0.79
o Intercept = 1626
o Std_err = 2.67
What do you think of it? Perfect isn’t it? Its ICICI and HDFC, two of the largest private sector
banks, both have similar business landscape, both have a similar revenue stream, both
regulated by RBI. Perhaps the perfect candidate for a pair trade, right?
The ADF value is 0.048, which means there is only 4.8% chance that the residual is non-
stationary or about 95.2% chance of the residuals being stationary, which is fantastic.
The std_err is +2.67, which is a perfect residual value to initiate a short pair trade. The
trade here is short HDFC and go long on ICIC.
So, how do we position size this? Here are the price and lot size details –
o HDFC Fut Price = 2024.8
o HDFC Lot size = 500
o ICICI Fut price = 298.8
o ICICI Lot size = 2750
Remember we discussed position size in the previous chapter. We look at the beta and
estimate the number of shares required for this trade.
The beta is 0.79, this means, every 1 share of Y needs to be offset with 0.79 shares of X. The
lot size of HDFC (Y) is 500, this means to offset the beta, we need 395 shares of ICICI (X).
Do you see the problem here? The lot sizes simply do not match.
We cannot simply trade 1 lot each here like we did in the TATA Motors and Tata Motors
DVR example, discussed in the previous chapter. If we do, then this won’t be a beta neutral
trade.
Hence to position size this, we need to work around with the lot sizes –
The lot size of ICIC is 2750, beta is 0.79, lot size of HDFC is 500. Given this, that the lot size is
higher than HDFC, what should be the minimum number of HDFC shares which will beta
neutral 2750 shares of ICICI.
To figure this out, we simply divide –
2750/0.79
= 3481.01
Since the lot size of HDFC is 500, we can round this off to 3500. Considering the lot size of
HDFC is 500, this will be 7 lots of HDFC against 1 lot of ICICI.
14.2 – Intercept
Alright, now that we know the position size as well, here is the big question – will you take
this trade?
Everything seems perfect, right? ADF has a desirable value, residual is at 2.67 SD, the two
stocks are highly correlated, the business is similar. So what can go wrong?
Yes, I agree, everything looks good, but on a closer look, the intercept reveals a slightly
different story.
To understand this, we need to quickly revisit the regression equation –
y = Beta * x + Intercept + Residual
If you think about this equation, we are trying to explain the stock price of Y in terms of the
stock price of X multiplied by its beta. The intercept is essentially that portion of the y’s
stock price which the model cannot explain, and the residual is the difference between
predicted y and actual y.
Going by this, a large intercept implies that a large portion of Y’s stock price cannot be
explained by the regression model.
In this case, the intercept is 1626. The stock price of HDFC is 2024 per share, this means,
1626 out of 2024 cannot be explained by the regression equation. This means, the
regression equation cannot explain nearly 80% (1626/2024) of Y’s stock price or in other
words the equation can explain only 20% of the equation, which according to me is quite
tricky.
This further implies, that if we are trading this pair, then we are essentially trading a very
small probability here. I’d rather avoid this and look for another opportunity than trade
this. Of course, I know traders who would love to jump in and take this trade, but for
someone like me, I’d look at risk first and then the reward
Good luck!
DOWNLOAD PAIR DATASHEET
CHAPTER 15
Calendar Spreads
15.1 – The classic approach
I had briefly introduced the concept of calendar spreads in Chapter 10 of the Futures
Trading module. Traditionally calendar spreads are dealt with a price based approach.
Here is a quick recap on how this is done –
1. Calculate the fair value of current month contract
2. Calculate the fair value of the mid-month contract
3. Look for relative mispricing between the two contracts
Based on the mispricing, you either buy the current month contract and sell the mid-
month contract or sell the current month contract and buy the mid-month contract. Here
is an example of a Calendar Spread –
1. Buy TCS Futures expiring 28th June 2018 @ 1846
2. Sell TCS Futures expiring 28th July 2018 @ 1851
Here you buy and sell the futures of the same stock, but of contracts belonging to different
expiries like showcased above. The difference between prices of the two contracts is what
is expected to made here. The risk is extremely low in calendar spreads so therefore the
money you make on calendar spreads is also small. If you are trader like me, who is averse
to risk, then this is something you may like.
This approach to performing a calendar spread is a decent one.
By the way, if you are not familiar with what I’m discussing, then I’d suggest you read
Chapter 10 in the Futures Trading module to get a quick perspective on the classic
calendar spreads approach. I think it forms a crucial foundation on top of which you can
build other variant/styles of calendar spreads.
So let’s get started straight away.
15.2 – Calendar spread logic
If you have read the chapters on pair trading, then understanding the calendar spread
logic is quite straightforward. This simplified approach assumes that the current price of
futures is a reflection of everything known in the market. The known set of information
can extend from news on the stock, corporate action, discount/premium, fair value, and
literally everything out there which is relevant to the stock.
Now, if the above assumption is valid, then probably we can use the price itself as a trigger
to identify opportunities to set up a calendar spread trade. This kind of simplifies the
whole approach. Calendar spreads are a low-risk strategy so therefore do not expect big
bucks from this strategy. However, since you simultaneously buy-sell the same asset, you
take out the directional risk involved in the trade, hence it does make sense to top up the
leverage. Also, unlike pair trade, the calendar spread trades can be ultra-short term in
nature, with most of the trades closing within the same day. Before I take up an example
to explain this, I’ll quickly give you an overview of this is done.
Start with downloading the continuous futures closing prices of the stock for both near
month and next month contracts.
Calculate the daily historic difference between the two contracts and generate a time
series. Calculate the mean and standard deviation of the time series. Using the mean and
standard deviation data we can estimate the range for the difference. A trading signal is
triggered when the difference between the two contracts move to mean plus or minus 1
standard deviation and the trade is closed when the difference collapses to mean.
You get the point, don’t you
15.3 – Calendar spread example
I’ve taken the example of SBIN to illustrate calendar spreads. I have download the
continuous futures data from Zerodha Pi (Zerodha’s desktop trading application) for last
200 trading days. I have got the closing prices on excel sheet, and this is how it looks –
The next step is to calculate the difference between the two contracts. It is advisable to
subtract the price of near month contract from the current month contract. This is
because, all else equal, the futures price of Near month contract is always higher than the
previous month contract owing to the ‘cost of carry’. Chapter 10 of futures module
explains this in more detail. The difference is calculated and the time series data is
generated, as shown below –
I will now calculate the mean and standard deviation on this time series. The mean will
give me an estimate on how much of the difference is acceptable on a ‘day to day’ basis
and at the same time, the standard deviation will give me a sense of variation in this
difference. Here is the snapshot.
You can calculate the mean and standard deviation on excel using the ‘=Average ()’ and
‘=stdev()’ functions respectively.
The mean of 1.227 tells me that, all else equal, the difference between the two contracts
should be 1.227 or in that vicinity. This essentially means, there is no trade opportunity if
the spread (or the difference) between the two contracts hovers around this value.
We now use the standard deviation value and the mean value to calculate the range of the
spread –
o Upper range = 1.227 + 0.4935 = 1.7205
o Lower Range = 1.227 – 0.4935 = 0.7335
I had mentioned that the spread can hover around 1.227, but I had not quantified
‘vicinity’, which is quite important. The range calculation does just that, it helps us
quantify the range within which (vicinity) the spread can vary on a daily basis. Any value of
the spread outside this range gives us an opportunity to set up a calendar spread.
If the spread has increased beyond the upper range of 1.7205, it means either the near
month contract has increased in value or the current month contract has reduced in
value.
The rule of thumb in any arbitrage is to always buy the asset in the cheaper market and
sell the same asset in the expensive market, hence the trade here would be to buy the
current month contract and sell the near month contract.
Likewise, if the spread has fallen below the lower range value i.e. 0.7335, this means the
current month has become expensive and near month has become cheaper. Hence, the
trade here is to sell the current month and buy the near month contract.
With this logic in perspective, let’s evaluate the if SBIN has given us any opportunities over
the last 200 trading days.
15.4 – Spotting opportunities
Keeping the above pointers in perspective, we can conclude the following –
1. Sell the spread when the spread increases beyond 1.7205. Sell spread means, sell
the near month contract and buy the current month contract
2. Buy the spread when the spread shrinks below 0.7335. Buy spread means, buy the
near month contract and sell the current month contract.
If you find it hard to figure out which contract to buy and which one to sell when a signal
originates, then simply think in terms of the near month contract. Sell spread means sell
the near month (therefore buy current month) and buy spread means buy the near-month
(therefore sell the current month contract).
In the excel sheet, I now look for the historical opportunities. I will identify the sell spread
opportunities first. To do this, I simply have to apply a filter, to filter out all values above
1.7205. I’ve done the same, here are the results –
As you can see, on 6 occasions, the spread increases beyond 1.7205 or the first standard
deviation levels. On all these occasions, there was a trigger to sell, implying the spread
would fall back to mean.
In fact, here is how the spread behaved –
Sell spread Trade closing Buy spread

Signal Date P&L
value date value
31-08-2017 2.45 1-09-2017 1.35 1.1
28-092017 2.6 29-09-2017 1.15 1.45
30-11-2017 2.35 01-12-2017 1.55 0.8
28-12-2012 3.8 29-12-2017 1.45 2.35
22-02-2018 2.5 23-03-2018 1.3 1.2
26-04-2018 1.85 27-04-2018 0.6 1.25
As you can notice, signals originate around month ends, probably due to expiry dynamics.
Also, every trade has resulted in a profit (although small) and closed the very next day.
Let us see how the buy spread trades have performed. I have filtered for all values below
0.7335, and here are the results –
There are close to 28 trade here and not all of them are successful. Of course, the losses
are as small as the profits, if not smaller. I’ll let you do the exact calculation; like the way
I’ve shown for the short trades.
I hope this example gives you a general sense of how to carry out calendar spread. I’m
sure you’d agree that this is far simpler and intuitive compared to the classic approach to
calendar spreads.
I have summarized my thoughts on Calendar spreads here and this will also double up as
the key takeaways for this chapter –
1. The expected profits and losses are small in calendar spreads
2. Directional risk is eliminated; hence you go can go full throttle on leverage
3. All the short trades in SBIN were successful but longs were not – this implies that I
would only look for short opportunities in SBI. In other words, you need to backtest
the P&L profile of each futures contract and figure out which contract you can go
long on and which contract you can go short on
4. Since the P&L is small, ensure your trading costs are minimum, a discount broker
like Zerodha is most suited for such trades J
5. Trades usually close within a day or two
6. Trades usually originate around expiry due to expiry dynamics
Think about this, if you can backtest this across the entire universe of equity and
commodities futures contract, you will essentially have at least a signal or 2 every day!
I’d love to hear your thoughts, so please do post your queries.
DOWNLOAD THE EXCEL SHEET
PS: I won’t be posting any new chapters for a while, but that does not mean I’m not
working on new content, it is just that the delivery format will be different and way more
exciting!
Stay tuned
CHAPTER 16
Momentum Portfolios
16.1 – Defining Momentum
If you have spent some time in the market, then I’m quite certain that you’ve been
bombarded with market jargons of all sorts. Most of us get used to these jargons and in
fact, start using these jargons without actually understanding what they really mean. I’m
guilty of using few jargons without understanding the true meaning of it and I get a feeling
that some of you reading this may have experienced the same.
One such jargon is – momentum. I’m sure we have used momentum is our daily
conversations related to the markets, but what exactly is momentum and how is it
measured?
When asked, traders loosely define momentum as the speed at which the markets move.
This is correct to some extent, but that’s not all and we should certainly not limit our
understanding to just that.
‘Momentum’ is a physics term, it refers to the quantity of motion that an object has. If you
look at this definition in the context of stocks markets, then everything remains the same,
except that you will have to replace ‘object’ by stocks or the index.
Simply put, momentum is the rate of change of returns of the stock or the index. If the rate
of change of returns is high, then the momentum is considered high and if the rate of
change of returns is low, the momentum is considered low.
This leads us to the next obvious question i.e. is what is the rate of change of returns?
The rate of change of return, as it states the return generated (or eroded) between two
reference time period. For the sake of this discussion, let’s stick to the rate of change of
return on an end of day basis. So in this context, the rate of change of returns simply
means the speed at which the daily return of the stock varies.
To understand this better, consider this example –
The table above shows the daily stock closing price of an arbitrary stock for 6 days. Two
things to note here –
o The prices are moving up on day to day basis
o The percentage change is 0.5% or higher on a daily basis
Consider another example –
Two things need to note –
o The prices are moving up on day to day basis
o The percentage change is 1.5% or higher on a daily basis
Given the behaviour of these two stocks, I have two questions for you –
o Which stock has a higher rate of change in daily returns?
o Which sock has a higher momentum?
To answer these above questions, you can look at either the absolute change in Rupee
value or the percentage change from a close to close perspective.
If you look at the absolute Rupee change, then obviously the change in Stock A is higher
than Stock B. However, this is not the right way to look at the change in daily return. For
instance, in absolute Rupee terms, stock in the range of say 2000 or 3000 will always have
a higher change compared to Stock A.
Hence, evaluating absolute Rupee change will not suffice and therefore we need to look at
the percentage change. In terms of percentage change, clearly Stock B’s daily change is
higher and therefore we can conclude that Stock B has a higher momentum.
Here is another situation, consider this –
Stock A, has trended up consistently on a day to day basis, while stock B has been quite a
dud all along except for the last two days. On an overall basis if you check the percentage
change over the 7-day period then both have delivered similar results. Given this, which of
these two stock is considered to have good momentum?
Well, clearly Stock A is consistent in terms of daily returns, exhibits a good uptrend, and
therefore can be considered to have continuity in showcasing momentum.
Now, what if I decide to measure momentum slightly differently? Instead of daily returns,
what if we were to look at the return on a 7 days’ basis? If we were to do that, then both
Stock A and B would qualify as momentum stocks.
The point that I’m trying to make here is that traders generally tend to look at momentum
in terms of daily returns, which is perfectly valid, but this is not necessarily the only way to
look at momentum. In fact, the momentum strategy we will discuss later in this chapter
looks at momentum on a larger time frame and not no daily basis. More on this later.
I hope by now, you do have a sense of what exactly momentum means and understood
the fact that momentum can be measured not just in terms of daily returns but also in
terms of larger time frames. In fact, high-frequency traders measure momentum on a
minute to minute or hourly basis.
16.2 – Momentum Strategy
Amongst the many trading strategies that the traders use, one of the most popular
strategies is the momentum strategy. Traders measure momentum in many different
ways to identify opportunity pockets. The core idea across all these strategies remains the
same i.e. to identify momentum and ride the wave.
Momentum strategies can be developed on a single stock basis wherein the idea is to
measure momentum across all the stocks in the tracking universe and trade the ones
which showcase the highest momentum. Do note, momentum can be either way – long or
short, so a trader following single stock momentum strategy will get both long and short
Traders also develop momentum strategies on a sector-specific basis and set up sector-
specific trades. The idea here is to identify sector which exhibits strong momentum, this
can be done by checking momentum in sector-specific indices. Once the sector is
identified, further look for the stocks within the sector which display maximum strength in
terms of momentum.
Momentum can also be applied on a portfolio basis. This involves the concept of portfolio
creation with say ‘n’ number of stock, with each stock in the portfolio showcasing
momentum. In my opinion, this is a great strategy as it is not just plain vanilla momentum
strategy but also offers safety in terms of diversification.
We will discuss one such strategy wherein the idea is to create a basket of stock aka a
portfolio consisting of 10 momentum stocks. Once created, the portfolio is held until the
momentum lasts and then re-balanced.
16.3 – Momentum Portfolio
Before we discuss this strategy, I want you to note a few things –
o The agenda here is to highlight how a momentum portfolio can be set up.
However, this is not the only way to build a momentum portfolio
o You will need programming skills to implement this strategy or to build any other
momentum strategy. If you are not a coder like me, then do find a friend who can
help
o Like any other strategy, this too has to be backtested
Given the above, here is a systematic guide to building a ‘Momentum Portfolio’.
Step 1 – Define your stock universe
As you may know, there are close to 4000 listed stocks on BSE and about 1800 on NSE.
This includes highly valuable companies like TCS and absolute thuds such as pretty much
all the Z category stocks on BSE. Companies such as these form the two extreme ends of
the spectrum. The question is, do have to track all these stocks to build a momentum
portfolio?
Not really, doing so would be a waste of time.
One has to filter out the stocks and create something called as the ‘tracking universe’. The
tracking universe will consist of a large basket of stocks within which we will pick stocks to
constitute the momentum portfolio. This means the momentum portfolio will always be a
subset of the tracking universe.
Think of the tracking universe as a collection of your favourite shopping malls. Maybe out
of the 100s of malls in your city, you may end up going to 2-3 shopping malls repeatedly.
Clothes bought from these 2-3 malls make up for your entire wardrobe (read portfolio).
Hence, these 2-3 malls end up forming your tracking universe out of the 100s available in
your city.
The tracking universe can be quite straightforward – it can be the Nifty 50 stocks or the
BSE 500 stocks. Therefore, the momentum portfolio will always be a subset of either the
Nifty 50 or BSE 500 stocks. Keeping the BSE 500 stocks as your tracking universe is a good
way to start, however, if you feel a little adventurous, you can custom create your tracking
universe.
Custom creation can be on any parameter – for example, out of the entire 1800 stocks on
NSE, I could use a filter to weed out stocks, which has a market cap of at least 1000Crs.
This filter alone will shrink the list to a much smaller, manageable set. Further, I may add
other criteria such as the price of the stock should be less than 2000. So on and so forth.
I am just randomly sharing few filter ideas, but you get the point. Using the custom
creation techniques helps you filter out and build a tracking universe that exactly matches
your requirement.
Lastly, from my personal experience, I would suggest you have at least 150-200 stocks in
your tracking universe if you wish to build a momentum portfolio of 12-15 stock.
Step 2 – Set up the data
Assuming your tracking universe is set up, you are now good to proceed to the 2nd step. In
this step, you need to ensure you get the closing prices of all the stocks in your tracking
universe. Ensure the data set that you have is clean and adjusted for corporate actions like
the bonus issue, splits, special dividends, and other corporate actions. Clean data is the
key building block to any trading strategy. There are plenty of data sources from where
you can download the data free, including the NSE/BSE websites.
The question is – what is the lookback period? How many historical data points are
required? To run this strategy, you only need 1-year data point. For example, today is
2nd March 2019, then I’d need data point from 1st March 2018 to 2nd March 2019.
Please note, once you have the data points for last one-year set, you can update this on a
daily basis, which means the daily closing prices are recorded.
Step 3 – Calculate returns
This is a crucial part of the strategy; in this step, we calculate the returns of all the stocks
in the tracking universe. As you may have already guessed, we calculate the return to get a
sense of the momentum in each of the stocks.
As we discussed earlier in this chapter, one can calculate the returns on any time
frequency, be it daily/weekly/monthly or even yearly returns. We will stick to yearly
returns for the sake of this discussion, however, please note; you can add your own twist
to the entire strategy and calculate the returns on any time frequency you wish. Instead of
yearly, you could calculate the half-yearly, monthly, or even fortnightly returns.
So, at this stage, you should have a tracking universe consisting of about 150-200 stocks.
All these stocks should have historical data for at least 1 year. Further, you need to
calculate the yearly return for each of these stocks in your tracking universe.
To help you understand this better, I’ve created a sample tracking universe with just about
10 stocks in it.
The tracking universe contains the data for the last 365 days. The 1-year returns are
calculated as well –
If you are wondering how the returns are calculated, then this is quite straight forward, let
us take the example of ABB –
Return = [ending value/starting value]-1
= [1244.55/1435.55]-1
= -13.31%
Quite straightforward, I guess.
Step 4 – Rank the returns
Once the returns are calculated, you need to rank the returns from the highest to the
lowest returns. For example, Asian paints have generated a return of 25.87%, which is the
highest in the list. Hence, the rank of Asian paints is 1. The second highest is HDFC Bank,
so that will get the 2nd rank. Infosys’s return, on the other hand, is -35.98%, the lowest in
the list, hence the rank is 10. So on and so forth.
Here is the ‘return ranking’ for this portfolio –
If you are wondering why the returns are negative for most of the stocks, well then, that’s
how stocks behave when deep corrections hit the market. I wish, I had opted to discuss
this strategy at a better point
So what does this ranking tell us?
If you think about it, the ranking reorders our tracking universe to give us a list of stocks
from the highest return stock to the lowest. For example, from this list, I know that Asian
Paints has been the best performer (in terms of returns) over the last 12 months. Likewise,
Infy has been the worst.
Step 5 – Create the portfolio
A typical tracking universe will have about 150-200 stocks, and with the help of the
previous step, we would have reordered the tracking universe. Now, with the reordered
tracking universe, we are good to create a momentum portfolio.
Remember, momentum is the rate of change of return and the return itself is measured on
a yearly basis.
A good momentum portfolio contains about 10-12 stocks. I’m personally comfortable with
up to 15 stocks in the portfolio, not more than that. For the sake of this discussion, let us
assume that we are building a 12 stocks momentum portfolio.
The momentum portfolio is now simply the top 12 stocks in the reordered tracking
universe. In other words, we buy all the stocks starting from rank 1 to rank 12. In the
example we were dealing with, if I were to build a 5 stock momentum portfolio, then it
would contain –
o Asian Paints
o HDFC Bank
o Biocon
o ACC
o Ultratech
The rest of the stocks would not constitute the portfolio but will continue to remain in the
tracking universe.
What is the logic of selecting this subset of stocks within the tracking universe, you may
ask?
Well, read this carefully – if the stock has done well (in terms of returns generated) for the
last 12 months, then it implies that the stock has good momentum for the defined time
frame. The expectation is that this momentum will continue onto the 13 th month as well,
and therefore the stock will continue to generate higher returns. So if you were to buy
such stocks, then you are to benefit from the expected momentum in the stock.
Clearly, this is a claim. I do not have data to back this, but I have personally used this exact
technique for a couple of years with decent success. It is easy to back-test this strategy,
and I encourage you to do so.
Back in the days, my trading partner and I were encouraged to build this momentum
portfolio after reading this ‘Economist’ article. You need to read this article before
implementing this strategy.
Once the momentum portfolio stocks are identified, the idea is to buy all the momentum
stocks in equal proportion. So if the capital available is Rs. 200,000/- and there are 12
stocks, then the idea is to buy Rs. 16,666/- worth of each stock (200,000/12).
By doing so, you create an equally weighted momentum portfolio. Of course, you can
tweak the weights to create a skewed portfolio, there is no problem with it, but then you
need to have a solid reason for doing so. This reason should come from backtested
results.
If you like to experiment with skewed portfolios, here are few ideas –
o 50% of capital allocation across the top 5 momentum stocks (rank 1 to 5), and 50%
across the remaining 7 stocks
o Top 3 stocks get 40% and the balance 60% across 9 stocks
o If you are a contrarian and expect the lower rank stocks to perform better than the
higher rank stocks, then allocate more to last 5 stocks
So on and so forth. Ideally, the approach to capital allocation should come from your
backtesting process, this also means you will have to backtest various capital allocation
techniques to figure out which works well for you.
Step 6 – Rebalance the portfolio
So far, we have created a tracking universe, calculated the 12-month returns, ranked the
stocks in terms of the 12-month returns, and created a momentum portfolio by buying the
top 12 stocks. The momentum portfolio was built based on the 12-month performance,
with a hope that it will continue to showcase the same performance for the 13 th month.
There are few assumptions here –
o The portfolio is created and bought on the 1st trading day of the month
o The above implies that all the number crunching happens on the last day of the
month, post-market close
o Once the portfolio is created and bought, you hold on to the stocks till the last day
of the month
Now the question is, what really happens at the end of the month?
At the end of the month, you re-run the ranking engine and figure out the top 10 or 12
stocks which have performed well over the last 12 months. Do note, at any point we
consider the latest 12 months of data.
So, we now buy the stocks from rank 1 to 12, just like the way we did in the previous
month. From my experience, chances are that out of the initial portfolio, only a hand full
of stocks would have changed positions. So based on the list, you sell the stocks which no
longer belongs in the portfolio and buy the new stocks which have featured in the latest
momentum portfolio. In essence, you rebalance the portfolio and you do this at the end of
every month.
So on and so forth.
16.4 – Momentum Portfolio variations
Before we close this chapter (and this module), I’d like to touch upon a few variations to
this strategy.
The returns have been calculated on a 12-month portfolio and the stocks are held for a
month. However, you don’t have to stick to this. You can try out various options, like –
o Calculate return and rank the stocks based on their monthly performance and hold
the portfolio for the month
o Calculate return and rank the stocks based on fortnightly performance and hold
the portfolio for 15 days
o Rank on a weekly basis and hold for a week
o Calculate on a daily basis and even do an intraday momentum portfolio
As you can see, the options are plenty and it’s only restricted by your imagination. If you
think about what we have discussed so far, the momentum portfolio is price based.
However, you can build a fundamental based momentum strategy as well. Here are a few
ideas –
o Build a tracking universe of fundamentally good stocks
o Note the difference in quarterly sales number (% wise)
o Rank the stocks based on quarterly sales. Company with the highest jump in sales
gets rank one and so on
o Buy the top 10 – 12 stocks
o Rebalance at the end of the quarter
You can do this on any fundamental parameter – EPS growth, profit margin, EBITDA
margin etc. The beauty of these strategies is that the data is available, hence backtesting
gets a lot easier.
16.5 – Word of caution
As good as it may seem, the price based momentum strategy works well only when the
market is trending up. When the markets turn choppy, the momentum strategy performs
poorly, and when the markets go down, the momentum portfolio bleeds heavier than the
markets itself.
Understanding the strategy’s behaviour with respect to market cycle is quite crucial to the
eventual success of this portfolio. I learned it the hard way. I had a great run with this
strategy in 2009 and ’10 but took a bad hit in 2011. So before you execute this strategy, do
your homework (backtesting) right.
Having said all of that let me reassure you – a price based momentum strategy, if
implemented in the right market cycle can give you great returns, in fact, better more
often than not, better than the market returns.
Good luck and happy trading.
o Momentum is the rate of change of return and can be measured across any time
frame
o A price based momentum portfolio consists of stocks which have exhibited highest
momentum over the desired time frame
o Tracking universe should be carefully populated. BSE 500 is a good tracking

universe
o Calculate the returns for the tracking universe
o Rank the stocks based on highest to lowest return
o The momentum portfolio is simply the top 12 or 15 stocks
o The expectation is that the momentum will continue during the holding period
o The asset allocation technique can vary based on backtesting Equally weighted
portfolio is a good asset allocation technique
o Momentum can be measured on fundamental data as well – growth in sales,

EBITDA margins, EPS growth, net profit margin etc.
o Price based momentum works best in an upward trending market and not really in
a sideways or a down trending market.

Varsity

Uploaded by

Copyright:

Available Formats

Varsity

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Varsity

Uploaded by

Copyright:

Available Formats

ZERODHA

1 The Need to Invest 1

4 The IPO Markets - Part 1 21

5 The IPO Markets - Part 2 32

6 The Stock Markets 40

7 The Stock Markets Index 50

8 Commonly used Jargons 59

9 The Trading Terminal 65

10 Clearing and Settlement process 79

11 Five corporate actions and its impact on stock prices 84

12 Key Events and Their Impact on Markets 91

The Need to Invest

1.1 - Why should one Invest?

1. To drive the point across, let us make few simple assumptions.

Years Yearly income Yearly expense Cash retained

1 600,000 360,000 240,000

2 6,60,000 3,88,800 2,71,200

3 7,26,000 4,19,904 3,06,096

4 7,98,600 4,53,496 3,45,104

5 8,78,460 4,89,776 3,88,684

6 9,66,306 5,28,958 4,37,348

7 10,62,937 5,71,275 4,91,662

8 11,69,230 6,16,977 5,52,254

9 12,86,153 6,66,335 6,19,818

10 14,14,769 7,19,642 6,95,127

11 15,56,245 7,77,213 7,79,032

12 17,11,870 8,39,390 8,72,480

13 18,83,057 9,06,541 9,76,516

14 20,71,363 9,79,065 10,92,298

15 22,78,499 10,57,390 12,21,109

16 25,06,349 11,41,981 13,64,368

17 27,56,984 12,33,339 15,23,644

18 30,32,682 13,32,006 17,00,676

19 33,35,950 14,38,567 18,97,383

20 36,69,545 15,53,652 21,15,893

Total Income 17,890,693

1. After 20 years of hard work you have accumulated Rs.1.7 Crs.

1.2 - Where to invest?

1 600,000 360,000 240,000 20,67,063

2 6,60,000 3,88,800 2,71,200 20,85,519

3 7,26,000 4,19,904 3,06,096 21,01,668

4 7,98,600 4,53,496 3,45,104 21,15,621

5 8,78,460 4,89,776 3,88,684 21,27,487

6 9,66,306 5,28,958 4,37,348 21,37,368

7 10,62,937 5,71,275 4,91,662 21,45,363

8 11,69,230 6,16,977 5,52,254 21,51,566

9 12,86,153 6,66,335 6,19,818 21,56,069

10 14,14,769 7,19,642 6,95,127 21,58,959

11 15,56,245 7,77,213 7,79,032 21,60,318

12 17,11,870 8,39,390 8,72,480 21,60,228

13 18,83,057 9,06,541 9,76,516 21,58,765

14 20,71,363 9,79,065 10,92,298 21,56,003

15 22,78,499 10,57,390 12,21,109 21,52,012

16 25,06,349 11,41,981 13,64,368 21,46,859

17 27,56,984 12,33,339 15,23,644 21,40,611

18 30,32,682 13,32,006 17,00,676 21,33,328

19 33,35,950 14,38,567 18,97,383 21,25,069

20 36,69,545 15,53,652 21,15,893 21,15,893

TOTAL CASH AFTER 20 YEARS 4,26,95,771

1. Fixed income instruments