Trading Mechanism — how an F&O order actually reaches the market

Two ways a trade gets booked, and India uses only one

Markets around the world are classified into two types based on the method of booking a trade.

Open outcry is communication between professionals on an exchange by shouting or using hand signals to transfer information about buy and sell orders. Trading happens in a large hall called a pit, where members are physically present and contracts trade through continuous bids and offers.

Electronic trading replaces the pit with screen-based broker dealing terminals.

Futures and options trading in India is electronic, with bids, offers and acceptances displayed on the terminal continuously. Every derivatives exchange in India provides a fully automated screen-based trading platform for index futures, index options, stock futures and stock options. These systems support an order driven market and simultaneously provide complete transparency of trading operations.

The workbook adds a sensible instruction: the best way to develop an understanding of the trading mechanism is to watch the screen and observe trading. Derivatives trading is similar to trading equities in the cash market segment.

Who is who — the entities

This is a list examiners love, because four of the names sound alike and differ on exactly one privilege each.

Read the table twice. The Self Clearing Member and the Trading cum Clearing Member are both trading members — the difference is that the SCM cannot clear and settle trades of other Trading Members. The PCM is the odd one out: it is not a trading member of the exchange at all. Typically banks or custodians become a PCM, clearing and settling for Trading Members as well as for Custodial Participants.

Trading Member details. The exchange assigns a trading member ID to each trading member. A trading member can have more than one user, and the number of users allowed is decided by the exchange from time to time. Each user must be registered with the exchange, where he is assigned a unique user ID. The trading member ID is common for all users of that trading member and functions as a reference for them. The trading member is responsible for maintaining adequate control over persons having access to the firm's User IDs.

Participants. A participant is a client of a trading member. The rule to remember: clients may trade through various trading members but settle through a single clearing member.

Authorised Persons (APs). SEBI had earlier allowed sub-brokership and the Authorised Person's network to expand brokers' reach. But the SEBI Board, in its meeting held on 21 June 2018, decided that sub-brokers as an intermediary shall cease to exist with effect from 1 April 2019. All existing sub-brokers migrate to become Authorised Persons or Trading Members if they meet the eligibility criteria under exchange bye-laws and SEBI Regulations.

Market timing

Trading on the derivatives segment takes place on all working days of the week between 9:15 am and 3:30 pm.

There is a second, wider permission that candidates forget. SEBI has permitted Stock Exchanges to set their trading hours in the Equity Derivatives Segment between 9:00 AM and 11:55 PM, to enable integration of trading across segments — provided that the Stock Exchange and its Clearing Corporation have in place a risk management system and infrastructure commensurate to the trading hours. It is a permission with a condition attached, not a change to the current session.

The corporate hierarchy inside a broking firm

The F&O trading software lets a trading member define a hierarchy among users. There are exactly three levels.

Corporate Manager — the highest level in a trading firm. He can perform all functions: order and trade related activities, and receiving reports for all branches of the firm and all dealers of the firm. He can also define exposure limits for the branches — and the workbook is explicit that this facility is available only to the Corporate Manager.

Branch Manager — placed under the Corporate Manager. He can perform and view order and trade related activities for all dealers under that branch.

Dealer — the lowest level. He can only view his own orders and trades and has no access to information on other dealers, whether in the same branch or another branch.

What the trading member owes the client

A trading member is responsible for a long compliance list: the Know Your Client (KYC) form, execution of the Client Broker agreement, timely execution of orders given by clients, collection of adequate margins, maintaining a separate client bank account for segregation of client money, ensuring timely pay-in and pay-out of funds, timely issue of contract notes, resolving clients' complaints, sending periodical statements of account, and maintaining a unique client code.

Order types — two families

Conditions attached to orders fall into time conditions and price conditions, and combinations of the two are allowed.

Time conditions

Day order — valid for the single day on which it is entered. If not executed during the day, the trading system cancels it automatically at the end of the day.

Immediate or Cancel (IOC) order — the user buys or sells as soon as the order is released into the system. Any unmatched order is immediately cancelled. Partial matching is possible, and the unmatched portion is cancelled immediately.

Price conditions

Limit order — an order to buy or sell at a specified price. The user must specify the limit price, and the order executes only at that limit price or at a better price — lower for a buy order, higher for a sell order.

Market order — an order to buy or sell at the best bid or offer price currently available. The price is not specified at the time of placing the order. A buy market order executes at the best price at which a seller is ready to sell; a sell market order executes at the best price at which a buyer is ready to buy.

Stop-loss order — an order to buy once the price climbs above, or sell once the price drops below, a trigger price. It gets activated when the trigger price is reached or crossed, and then enters the market as a market order or as a limit order, as defined at the time of placing it.

The workbook's illustration is worth memorising because the exam re-uses its shape. A trader buys ABC Ltd shares at ₹100 expecting a rise. Prices start falling and he wants to limit his loss. He places a limit sell order with a trigger price of ₹95 and a limit price of ₹92. The rule: the trigger price must be between the last traded price and the limit price while placing a sell limit order. Once the market price of ABC breaches the trigger price of ₹95, the order converts to a limit sell order at ₹92.

Trigger price is the price at which the order gets triggered from the stop loss book.

How orders match

India's F&O platforms are an order driven market, and orders match automatically on a price-time priority basis.

As orders arrive they are first time stamped, then immediately processed for a potential match. If no match is found, they are stored in different books, in this sequence:

1. Best Price
2. Within price, by time priority

The best buy order matches with the best sell order. And here is the definition that trips people up:

• The best buy order is the one with the HIGHEST price.
• The best sell order is the one with the LOWEST price.

Why? Because the computer views all buy orders from the point of view of a seller, and all sell orders from the point of view of the buyer. A seller wants the highest bid; a buyer wants the lowest offer. An order may match partially with another order, resulting in multiple trades.

Price bands — and the surprise

Here is a statement that catches almost everybody: there are no price bands applicable in the derivatives segment.

What exists instead, purely to prevent erroneous order entry, are operating ranges and day minimum/maximum ranges:

Orders placed at prices beyond the operating ranges reach the Exchange as a price freeze.

SEBI enhanced the criteria for Dynamic Price Bands for scrips in the derivatives segment via a circular dated 24 May 2024. Five changes:

1. Tighter rules for flexing a price band. Previously the band could be increased if 25 trades happened at a certain price with 5 unique traders on both sides. Now it requires 50 trades, 10 unique traders and 3 brokerage firms on each side.

2. Price bands move together across markets. If a stock's band is adjusted in the cash market or the futures market, the bands for all futures contracts of that stock change at the same time.

3. More cooling-off time before further changes. If a stock keeps hitting the limit, the wait grows:

4. Sliding price bands — no more one-sided adjustments. If a price band moves upward, the lower price limit also moves up. The workbook's example: a stock with a range of ₹90 – ₹110 whose upper band moves to ₹115 will see its lower band shift up to ₹95.

5. Temporary price limits for options. When a stock hits a price limit and enters cooling-off, options traders get temporary limits based on the latest price or a calculated value. Once the cooling-off period ends, options trade freely again.

The stated purposes: reduce sudden price jumps caused by big orders or mistakes, prevent manipulation by a small group of traders, give traders more time to react, and make price movements smoother and more predictable.

The trader workstation

Nine windows are displayed on the screen: Title bar, Ticker window of futures and options market, Ticker window of underlying (capital) market, Toolbar, Market watch window, Inquiry window, Snap quote, Order/trade window, and System message window.

When entering orders, trading members are required to identify orders as proprietary or client. "Pro" identifies proprietary orders; "Cli" identifies client orders, and the client account number must be provided for client orders.

The F&O segment provides trading in four instruments: index based futures, index based options, individual stock options and individual stock futures.

Which stocks qualify for derivatives at all

The selection criteria exist to ensure a stock is large in market capitalisation and turnover, has sufficient liquidity in the underlying market, and has no adverse issues related to market manipulation.

A stock on which stock options and single stock futures are proposed shall conform to the following criteria for a continuous period of six months:

And a cross-exchange rule: stocks which meet the eligibility criteria in the underlying cash market of any stock exchange are permitted to trade in the equity derivatives segment of all stock exchanges.

What happens on failure. If an existing security fails the continued eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that security. Existing unexpired contracts may trade till expiry, and new strikes may also be introduced in the existing contract months. Once a stock is excluded, it shall not be considered for re-inclusion for a period of one year from its last trading day in the derivatives segment.

Getting back in. A stock excluded from derivatives trading must fulfil the eligibility criteria for six consecutive months to be re-introduced.

The Product Success Framework for stock derivatives

On similar lines to the existing PSF for index derivatives, SEBI introduced additional exit criteria for stocks:

These exit criteria apply only to stocks which have completed at least 6 months from the date of introduction. After that gestation period, stocks failing the PSF exit from the derivatives segment in the upcoming review cycle. Again: no fresh month contract, but existing unexpired contracts may trade till expiry and new strikes may be introduced.

The cross-exchange rule cuts both ways here too: a stock exits only if it fails the eligibility criteria across all exchanges. If it meets the criteria on any exchange, it continues to be eligible on all exchanges.

Which indices qualify

An exchange may consider introducing derivative contracts on an index if:

• The weightage of constituent stocks that are individually eligible for derivatives trading is at least 80%, and
• No single ineligible stock in the index has a weightage of more than 5%.

Compliance must be continuous, and the Exchange checks monthly. If the index fails for three consecutive months, no fresh contract shall be issued — existing unexpired contracts trade till expiry and new strikes may be introduced.

PSF for index derivatives applies to all index derivatives except the flagship indices of the exchanges, at the underlying level:

Once an index is excluded, it shall not be considered for re-inclusion for a period of at least six months. Exchanges may re-launch contracts on the same index after suitable modifications to contract specifications based on market feedback, after a cooling-off period of at least six months, and subject to SEBI approval.

Note carefully how the numbers differ between the two frameworks: 200 trading members for stocks versus 20 for indices; ₹75 crore turnover versus ₹10 crore; ₹500 crore open interest versus ₹4 crore. The 15% and the 75% of trading days are the two figures that are the same.

The surrogate or pseudo index

A surrogate or pseudo index is an alternative index used when the primary index under review does not meet all the criteria for derivatives trading, but a similar index in another exchange does. If an index fails a review, the exchange may still allow derivatives on it if such a surrogate exists.

Three conditions:

• The number of constituents in the smaller index (the surrogate) should be at least 80% of the larger index
• At least 50% of the constituent stocks in the larger index should also be part of the smaller index
• The correlation between the two indices should be at least 0.90 for the previous 6 months on a rolling basis

And a limit: an index in an exchange shall have only one pseudo or surrogate index per exchange.

Adjusting for corporate actions

The governing principle, stated first because everything else follows from it:

The basis for any adjustment shall be such that the value of the position of the market participants on the cum and ex-date for the corporate action shall continue to remain the same as far as possible. This retains the relative status of positions — in-the-money, at-the-money and out-of-the-money — and also addresses issues related to exercise and assignment.

Adjustments mean modifications to three things: (a) Strike Price, (b) Position, (c) Market Lot / Multiplier. Which of them is changed depends on the nature of the corporate action, and adjustments are carried out on all open positions.

When. Any adjustment is carried out on the last day on which a security is traded on a "cum" basis in the underlying cash market, after the close of trading hours.

Corporate actions are broadly classified into stock benefits and cash benefits, and the list is: Bonus, Rights, Merger/De-merger, Amalgamation, Splits, Consolidations, Hive-off, Warrants, Secured Premium Notes (SPNs) and Extraordinary dividends.

Bonus, stock splits and consolidations

Three mechanical rules:

• New strike price = old strike price ÷ adjustment factor
• New market lot / multiplier = old market lot × adjustment factor
• New position = old position × adjustment factor

And the adjustment factors:

Notice the design: the strike is divided while the lot and position are multiplied, so the product — the value of the position — is preserved. That is the principle in action, not a coincidence.

Rights

The workbook sets out the notation precisely:

• A = number of existing shares
• B = rights entitlement (rights to subscribe)
• Total entitlement = A + B
• P = underlying close price on the last cum date
• S = issue price of the rights
• E = benefits per share

Then:

• Benefit per Right Entitlement = (P − S)
• Benefit per share, E = (P − S) / (A + B)
• Adjustment Factor = (P − E) / P

Any dividend declared by the company along with the rights is adjusted as per the prevailing dividend adjustment policy in the F&O segment.

Handling fractions

A ratio like a bonus of 3:7 produces fractions. To minimise fractional settlements the methodology is:

1. Compute the value of the position before adjustment
2. Compute the value of the position using the exact adjustment factor
3. Round off the Strike Price and Market Lot
4. Compute the value of the position based on the revised strike price and market lot

The difference between step 1 and step 4, if any, is settled by adjusting the Strike Price or the Market Lot, so that no forced closure of an open position is mandated.

Dividends — the 2% line

Dividends below 2% of the market value of the underlying stock are deemed ordinary dividends, and no adjustment in the strike price is made.

For extraordinary dividends — above 2% of the market value — the Strike Price is adjusted.

The mechanics for an extraordinary dividend:

• All positions in existing strike prices continue to exist in the corresponding new adjusted strike prices
• All open positions are carried forward at the daily settlement price less the dividend amount for the respective futures contract
• The total dividend amount (special and/or ordinary) is reduced from all the strike prices of the option contracts on that stock
• The revised strike prices apply from the ex-dividend date specified by the exchange

And the detail that decides borderline cases — which market price do you compare 2% against?

• Normally, the closing price of the stock on the day previous to the date on which the announcement of the dividend is made by the Company after the Board meeting
• But if the announcement is made after the close of market hours, the same day's closing price is taken
• And if the shareholders at the AGM change the rate of dividend declared by the Board, the test uses the rate communicated to the exchange after the AGM and the closing price of the stock on the day previous to the date of the AGM

Merger and demerger

On announcement of the record date, the last cum-date is determined by the Exchange or Clearing Corporation. The date of expiration of all contracts in the underlying which will cease to exist is the last cum date, and this is informed to members. Then:

• No fresh month contracts on futures and options are introduced in the underlying which will cease to exist
• Unexpired contracts outstanding as on the last cum-date are compulsorily settled at the settlement price
• The settlement price is the last available closing price of that underlying in the Capital Market segment of the Exchanges, on the last cum-date

What a trade actually costs

Trading costs fall into three groups: user charges, statutory charges, and impact cost.

User charges. Brokerage is the commission charged by brokers who place orders for clients. It is usually lower for intra-day trades, and rates differ widely according to the additional services offered by the broker. Separately, stock exchanges collect transaction charges from brokers who are their members.

Statutory charges are Securities Transaction Tax (STT), Goods and Services Tax (GST), Stamp Duty, and SEBI Turnover fees plus applicable GST on it.

STT rates currently applicable to the equity derivatives segment, as mandated by Union Budget 2026-27 and effective from 1 April 2026:

Read the third column. STT on a futures sale and on an option sale falls on the seller. STT on an exercised option falls on the purchaser — and it is charged on the settlement price, not the premium.

Transaction charges are fees levied on trades conducted through stock exchanges. They are levied on both the buy and sell sides, and for options they are charged on the premium.

IPFT charges. The Investor Protection Fund Trust is created by the stock exchanges to make up for investors' claims when a defaulting trading member's assets are not enough to cover them. The fund also promotes investor education, awareness and research. The NSE rates:

GST is charged at 18% on brokerage plus the transaction charges. Both STT and GST are collected by the Central government.

Stamp duty is charged at 0.002% (₹200 per crore) for buyers of equity futures and at 0.003% (₹300 per crore) for buyers of equity options — buyers only.

SEBI turnover fees are ₹10 per crore plus applicable GST.

Bid-ask spread and impact cost are the odd ones out: these are not actually paid by market participants. They arise because of market imperfections or lack of liquidity. The result is that buyers who place market orders instead of limit orders end up paying higher prices, and sellers who place market orders instead of limit orders receive lower prices.

The workbook's order book:

The best buy price is ₹16.60 and the best sell price is ₹16.80. An investor in a hurry to buy pays the ask of 16.80; one who wants to sell immediately receives the bid of 16.60. Buy at 16.80 and immediately square up at 16.60 and you have lost ₹0.20 per lot.

This gap is the bid-ask spread. It tends to be larger for illiquid stocks with lesser participation by traders. Impact cost is a measure of the cost incurred due to the bid-ask spread — the larger the spread, the larger the impact cost.

The full cost of one trade

A trader takes a short position of 1 lot of index futures at 17,500 with a lot size of 50. Contract value = 1 × 50 × 17,500 = ₹8,75,000.

Two notes the workbook attaches, both examinable. The brokerage of 0.03% is only illustrative — most brokers today charge brokerage at a flat rate per order. And stamp duty is not considered in this example, as it is only charged on the buy side of the transaction — this trader is short, so he sold.

Look at line 7 carefully: GST is computed on items 2, 4, 5 and 6 — brokerage, exchange fees, SEBI charges and IPFT charges. STT is not in that bracket. There is no GST on STT.

Algorithmic trading

Algorithmic trading is the process of executing orders utilising automated and pre-programmed trading instructions to account for variables such as price, timing and volume. An algorithm is a set of directions for solving a problem — a mathematical model developed by programmers and fed into a computer. The model considers changing market conditions such as security prices, traded volumes and time of day, and dynamically places buy and sell orders.

Two advantages named in the workbook:

• The biggest advantage is that because order placement is automatic and computer-driven, the individual trader's emotions are not allowed to affect trading decisions.
• Another huge advantage is that it reduces the overall time taken for order execution, because computers place orders at far higher speeds than human operators.

High-frequency trading is an offshoot of algo trading which allows a trader to make tens of thousands of trades per second. Algo trading is mainly used by institutional investors and large brokers to cut down their trading costs.

The mis-selling problem. Many unregulated platforms have started offering algo trading services and strategies, aggressively marketing them with promises of high returns. SEBI has cautioned investors against dealing with such platforms, and has directed brokers offering algo trading services (a) not to refer to the past or expected returns from such algo strategy, and (b) not to associate with any algo platform that refers to the past or expected return from any algo strategy.

The regulatory framework, proposed with effect from 1 October 2025, introduces these terms:

And the operating rules:

White box versus black box. The categorisation is a table worth learning line by line:

Tracking futures and options data

Before internet trading, daily newspapers were the chief source of spot and derivatives prices. Now both can be tracked on a real-time basis on exchange websites and broker platforms.

The fields available include Date, Symbol (the underlying index or stock, e.g. NIFTY, ACC), Instrument (the contract descriptor, e.g. FUTSTK, OPTIDX), Expiry date, Option Type, Corporate Action level, Strike Price, Opening price, High price, Low price, Closing price and Last traded price.

Option Type codes: CE = Call European, PE = Put European, CA = Call American, PA = Put American.

Corporate Action level is the Corporate Action Flag, which changes when there is a corporate action on a contract — either a symbol change or a dividend announced by the company.

Open Interest is computed differently for futures and options:

• Futures: open positions in that futures contract × its last available closing price
• Options: open positions × the notional value, where notional value = the open position in that option contract × the last available closing price of the underlying

Note the difference: the futures figure uses the futures contract's closing price; the option notional uses the underlying's closing price.

Also tracked: Total Traded Quantity (total number of contracts on which business took place during the day), Total Traded Value (the total money value of that business) and Number of Trades.

Trend information available on exchange sites:

• Positive trend — the top gainers in the futures market
• Negative trend — the top losers in the futures market
• Futures OI gainers — futures whose percentage increase in Open Interest is among the highest that day
• Futures OI losers — futures whose percentage decrease in Open Interest is among the highest
• Active Calls and Active Puts — calls and puts with high trading volumes that day
• Put/Call ratio (PCR) — the ratio of trading volume of put options to call options, calculated either on the basis of options trading volumes or on the basis of their open interest

The IRRA platform — a safety net when your broker's systems fail

The Investor Risk Reduction Access (IRRA) platform is designed to protect investors from technical glitches and unforeseen outages that can make a trading member's site inaccessible. It is intended as an alternative when both the primary trading platform and the disaster recovery sites are experiencing challenges.

• It is a joint platform developed by the exchanges giving investors the opportunity to square off or close open positions and/or cancel pending orders when a trading member's services are disrupted
• It supports multiple segments across multiple exchanges
• Trading members facing technical glitches request enablement, and IRRA is enabled on receipt of such requests
• Once enabled, all investors of that TM are informed by the exchange through email or SMS and a public notice on the exchange website; TMs must also display it on their own website
• IRRA shall not permit any action that increases the risk of the investor
• It also gives the TM an Admin Terminal to monitor investors' actions and carry them out on investors' instructions
• IRRA is exclusively for individual investors. It does not cater to algorithmic trading or institutional clients. Its primary function is closure of positions and cancellation of pending orders — not the initiation of new positions

The technical glitch framework

Three deadlines, and the exam asks for them by number:

The Preliminary Incident Report includes the date and time of the incident, details, effect, and the immediate action taken to rectify it. The RCA Report — in a format specified by SEBI — includes time of incident, cause of the glitch (including root cause from vendors if applicable), duration, chronology of events, impact analysis, corrective and preventive measures, and restoration of operations.

Because a growing number of investors puts additional burden on a broker's trading system, adequate capacity planning is a prerequisite for continuity of service.

Two systems support this:

• iSPOT — the Integrated SEBI Portal for Technical Glitches — a web-based portal for submission of preliminary and final RCA reports of technical glitches by the MIIs, streamlining reporting and creating a centralised repository
• LAMA — an API based Logging and Monitoring Mechanism — operated between stock exchanges and specified stock brokers' trading systems, under which specified stock brokers monitor key systems and functional parameters to ensure their trading systems function smoothly

Business continuity across exchanges

For the interoperable segments — Cash Market, Equity Derivatives, Currency Derivatives, Interest Rate Derivatives:

• Common scrips, single stock derivatives, correlated indices, currency and interest rate derivatives: if identical or correlated products exist on another venue, participants hedge open positions by taking offsetting positions there. Because these segments are interoperable, offsetting positions on the other venue net off the open positions for end clients and release the margin, so no separate treatment is required
• Scrips exclusively listed on one exchange: exchanges may create reserve contracts for such scrips and single stock derivatives not traded on their own exchange, to be invoked at the time of an outage on the other exchange
• Index derivatives without a correlated product elsewhere: an exchange may consider creating such an index and introducing contracts on it, giving an avenue to hedge during an outage
• Intimation: the affected exchange must intimate the alternative trading venue and SEBI within 75 minutes of the occurrence of impact, and the alternative trading venue invokes its business continuity plan as per the SOP within 15 minutes from such intimation
• NSE acts as the alternative trading venue for BSE and vice versa, and both prepare a joint SOP