Chapter 6: Trading Mechanism
NISM Series VIII — Equity Derivatives | 10% weightage | ~10 exam questions
What this chapter is about
This chapter is about the plumbing of the derivatives market — how orders are placed, how trades are executed, what the different order types are, and what it costs to trade. It's practical, operational knowledge. The exam tests terminology precisely — the difference between a limit order and a stop loss order, what tick size means, what impact cost is. Clean definitions, no numericals (except one stop loss calculation type). Good chapter to score full marks on.
Key concepts
Screen-based trading — all derivatives trading in India happens on electronic screens, not open outcry. This means:
- Full price transparency — every bid and offer is visible
- Anonymous — buyer and seller don't know each other
- Efficient — best price gets matched automatically
- SEBI mandated this for derivatives
Order types — heavily tested:
Market Order — execute immediately at whatever price is available. Speed over price.
Limit Order — execute only at your specified price or better. You set the price ceiling (for buy) or floor (for sell). May not execute if market doesn't reach your price.
Stop Loss Order — triggered when price reaches a specified level (trigger price), then releases as market order.
- Stop Loss Sell: protects against a falling position. Set trigger BELOW current price.
- Stop Loss Buy: protects against a rising short position. Set trigger ABOVE current price.
IOC (Immediate or Cancel) — execute whatever portion is available immediately, cancel the rest. No partial orders sitting in the book.
GTC (Good Till Cancelled) — order stays active until you cancel it. Valid up to 365 days.
Day Order — valid only for the trading day. Auto-cancelled at end of day if unexecuted.
Tick Size — minimum permitted price movement in a contract. For Nifty futures = ₹0.05 (5 paise). You can't quote ₹24,000.03 — the next valid quote after ₹24,000.00 is ₹24,000.05.
Circuit Filters / Price Limits — maximum permitted price movement in a day. All orders must be placed within these limits. Exchange sets them.
Market Maker — entity that continuously provides both buy AND sell quotes (two-way quotes) for a contract, ensuring liquidity. Earns the bid-ask spread.
Bid Price — highest price a buyer is willing to pay. ALWAYS lower than ask price. Ask Price — lowest price a seller is willing to accept. ALWAYS higher than bid price.
Impact Cost — the practical cost of executing a large order due to market illiquidity. High impact cost means the market is illiquid — large orders move the price adversely.
- High impact cost → BAD for both buyers and sellers (buyer pays more, seller receives less)
- NOT beneficial to anyone (a common trap: "beneficial to arbitrageurs" → FALSE)
- Nifty has very low impact cost → highly liquid market
Position Limits — maximum exposure any single participant (client, trading member, or market) can take in a contract. Set by SEBI. Clearing corporation monitors and enforces. Trading member can set sub-limits for their own clients.
Algo Trading — automated trading using pre-programmed strategies. Allowed on Indian exchanges with regulatory approval.
Real market example — Stop Loss calculation
You buy 100 shares of ABC at ₹980. You don't want to lose more than ₹1,000 on this position.
Maximum loss per share = ₹1,000 ÷ 100 shares = ₹10 per share
Stop loss trigger price = ₹980 − ₹10 = ₹970
Place a stop loss sell order at ₹970. If ABC falls to ₹970, the order triggers and you exit, limiting your loss to ₹1,000.
Common wrong answer: ₹990 (₹10 above instead of below). Always subtract for a long position stop loss.
Trap Alert
Trap 1: "High impact cost is beneficial to arbitrageurs" → FALSE High impact cost is beneficial to NOBODY — not buyers, not sellers, not arbitrageurs. It makes execution expensive for everyone. The correct answer is "neither buyers nor sellers."
Trap 2: "Tick size is the maximum permitted price movement" → FALSE Tick size is the MINIMUM permitted price movement. Maximum daily movement is the circuit filter/price limit.
Trap 3: "IOC order unmatched portion goes into the order book" → FALSE IOC = Immediate or Cancel. Whatever doesn't execute IMMEDIATELY is CANCELLED. Nothing sits in the book.
Trap 4: "Day orders are executed the next trading day if unexecuted today" → FALSE Day orders are CANCELLED automatically at the end of the trading day. They do not roll over.
Trap 5: "Screen-based trading reduces transparency" → FALSE Screen-based trading INCREASES transparency — every price is visible to all participants simultaneously. The big advantage over floor trading is transparency.
Trap 6: "More participants in a market = lower liquidity" → FALSE More participants = higher liquidity. More buyers and sellers = tighter spreads = easier execution.
Stop Loss numericals — the pattern
The exam always gives you:
- Entry price
- Maximum acceptable loss (in rupees)
- Number of shares/lots
Formula:
Loss per unit = Total acceptable loss ÷ Number of units
Stop loss price (long) = Entry price − Loss per unit
Stop loss price (short) = Entry price + Loss per unitMust-remember rules
- All derivatives trading in India = screen-based (mandated by SEBI)
- Market order = immediate execution, any price
- Limit order = your price or better, may not execute
- Stop loss = triggered when price hits trigger level
- IOC = execute now or cancel immediately (no partial orders in book)
- GTC = stays active up to 365 days
- Day order = cancelled at end of day automatically
- Tick size = MINIMUM price movement (not maximum)
- Circuit filter = MAXIMUM daily price movement
- Impact cost = high impact cost = illiquid = bad for everyone
- Bid < Ask always (bid = buyer's max, ask = seller's min)
- Market maker = provides two-way quotes, ensures liquidity
- Trading member can set position limits for clients independently
Weightage note
10% of exam = ~10 questions. Mostly definitions and one stop loss calculation. Order types and impact cost are the most frequently tested. Zero numericals beyond stop loss math which is simple arithmetic.
Quick revision — 60 second scan
- Screen based = transparent, anonymous, SEBI mandated
- Market order = now at any price | Limit order = at my price
- Stop loss = protect against adverse move (trigger = breach level)
- IOC = immediate or cancel | GTC = valid 365 days | Day = cancelled EOD
- Tick size = MINIMUM move | Circuit = MAXIMUM move
- Impact cost = cost of illiquidity = bad for everyone
- Bid always < Ask | Market maker = two-way quotes
- Stop loss (long) = entry − (max loss ÷ units)