Derivatives (Futures and Options)

Other day my roomy Mr. Amit Chauhan asked me post something about F&O. And yesterday Anurag also asked me about it. And people like Adi and Tenzin are asking me to keep it as simple as possible. But when I want to write about Derivatives, I don’t think it is going to be simple, since derivatives are the most complex and riskier financial instruments. And more importantly I don’t trade in derivative segment, so I am also little untouched in this. But whatever little I know and whatever I got in the net I am posting that. So bear with me in this…

Derivative instrument

A derivative, as the name suggests, is a financial instrument whose value is derived from another asset (known as the underlying). The underlying can be a stock, a commodity, and a market index among other things. The value of the derivative instrument changes according to the changes in the value of the underlying. Futures and Options represent two of the most common form of "Derivatives".

Derivatives are of two types -- Exchange traded and Over The Counter (OTC).

Exchange traded derivatives are traded through organized exchanges around the world. These instruments can be bought and sold through these exchanges, just like the stock market. Some of the common exchange traded derivative instruments are futures and options.

Over the counter (OTC) derivatives are not traded through the exchanges. Some of the popular OTC instruments are forwards, swaps, swaptions etc.

Now I am posting only about F&Os not any other derivative instrument and let me start with option first…

Options

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

Confused!!! Let me give an example. Once you decide to purchase a plot for Rs 400000. But don’t have that much amount right now with you so talk to the owner and negotiate a deal that give you an option to buy the plot in three months for a price of 400000. The owner agrees, but for this option, you pay a price of 4000.

Now there are two possibilities…

1. For some reason, value of the plot doubled in 3 months then at that time actual value will be 800000. But owner entered a contract with you for 400000 he has to sell you for 400000 only. Then you make a profit of 396000 (800000-40000-4000)

2. For some reason value of the plot reduced by 50% in 3 months

then its value will be 20000. Since you entered in Option

you need not buy that after 3 months. So you will loose only

Rs. 4000 what you paid for option contract.

Options are classified into American, which can be exercised at any time prior to the expiry date and European which can only be exercised at the expiry date.

In India options on individual stocks are American-style while options on indices like the Nifty are European.

Call and Put Options

The two types of options are calls and puts

A call gives the holder the right to buy an asset at a certain price (strike price) within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

There are four types of participants in options markets depending on the position they take:

1. Buyers (holders) of calls
2. Sellers (writers) of calls
3. Buyers (holders) of puts
4. Sellers (writers) of puts

Buyers (holders) of the option contract (call or put) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.

Sellers (writers) of the option contract (call or put) however, are obligated to buy or sell. This means that if the buyer/seller wants to buy/sell the asset, the seller of the contract has to buy/sell it. He does not have a right.

Terminology

To know option well you need understand certain terminologies

Strike price: The price at which an underlying stock can be purchased or sold.

In the money: For call options if the share price is above the strike price and put option is in-the-money when the share price is below the strike price. Its nothing but profit. Whether your contract is in profit or not!!!

Intrinsic value: The amount by which an option is in-the-money is referred to as intrinsic value. Means how much profit you are making.

Premium: The total cost of an option contract is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. And calculation of premium is complicated and I also don’t know about it.

How options work

Let's say that on May 1, the stock price of Mutnal & Mutnal Co. is Rs 67 and the premium is Rs 3.15 for a July 70 Call, which indicates that the expiration is the last Thursday of July and the strike price is Rs 70. The total price of the contract is Rs 3.15 x 100 = Rs 315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of Rs 70 means that the stock price must rise above Rs 70 before the call option is worth anything; furthermore, because the contract is Rs 3.15 per share, the break-even price would be Rs 73.15.

Three weeks later the stock price is Rs 78. The options contract has increased along with the stock price and is now worth Rs 8.25 x 100 = Rs 825. Subtract what you paid for the contract, and your profit is (8.25 - 3.15) x 100 = Rs 510. You almost doubled our money in just three weeks! You could sell your option, which is called "closing your position," and take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride.

By the expiration date, the price drops to Rs 62. Because this is less than our Rs 70 strike price and there is no time left, the option contract is worthless (I mean you don’t exercise your contract). You are now down to the original investment of Rs 315.

Futures

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time.

Unlike options, buying a futures contract gives you the obligation to buy the underlying and thus involves greater risk. Another difference is that commodities like gold, cotton, crude oil etc are especially prominent in futures markets.

In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future.

Futures transactions can be settled in three ways: squaring off, delivery and cash settlement.

Squaring off means taking a position opposite your initial one. For example, you square off the purchase of a gold futures contract by selling the identical contract.

Delivery means physically delivering the underlying asset on the agreed date. If you sell a gold futures contract of say 1 kilogram then you will have to give real gold to the buyer on the mutually agreed date.

Cash settlement involves paying the difference between the futures price and the spot price of the underlying asset.

For example, if you sell a gold futures contract worth one kilogram for say Rs 1.2 lakh and the price of the contract on expiry day is Rs 1.3 lakh then you will have to pay the buyer the difference of Rs 10,000.

How Futures work

Buy a contract

In Futures, you buy a contract which will have a specific lot size depending on the stock.

Let's say you want to buy an Infosys Futures contract. This will comprise 100 shares. Or, you want to buy a HPCL Futures contract. This will be a lot of 650 shares. In Futures, you buy a lot. The lot size is set for each futures contract and it differs from stock to stock.

Margin payment

When you buy a Futures contract, you don't pay the entire value of the contract but just the margin. This margin amount too is prescribed by the exchange.

Let's say you buy a HPCL Futures contract. And the price of each HPCL share is Rs 311. This will amount to Rs 202150 (Rs 311 x 650 shares).

You don't pay the entire amount of Rs 202150. You only pay 15% to 20% of that amount and this is called the margin amount.

The margin depends on what the exchange sets for the day. Based on certain parameters, it declares the margin for each stock.

So the margin for Infosys will vary from, say, HPCL.

Let's say the margin for the HPCL Futures is 15%. So you end up just paying just Rs 30322 (not Rs 202150).

How you make or lose money

You purchased a HPCL Futures contract and the underlying price is Rs 311 per share. Let's say, the next day it moves to Rs 312. The difference is Rs 1 per share (312 - 311). You get a credit Rs 650 (Rs 1 per share x 650 shares). The following day, it dips to Rs 310. The difference is Rs 2 per share (312 - 310). Since the price has dipped, Rs 1,300 (Rs 2 per share x 650 shares) is debited from your account.

This will go on till you sell the Futures contract or it expires (last Thursday of the month). So, on a daily basis you make and lose money.

Sources…

Rediffmail.com

Investopedia.com