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Knowledge Corner

Futures & Options [F&O]-Basics

FUTURES & OPTIONS – THE BASICS
INTRODUCTION
Investment decision is a function of risk and return. Derivatives are amongst the most interesting financial tools in the recent times. It can be used for a variety of purposes but due to the presence of leveraging, an individual may be subjected to higher risk, if the instruments are not used wisely. Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basis underlying assets (simply known as underlying/spot). These contracts are legally binding agreements, made on the trading screen of the stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee/dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee etc. Here is a deeper understanding for traders/financial planners to help their clients navigate through derivatives by use of effective strategies.
How are Derivatives useful?
Leveraged positions, Lower margins than the margin funding, Index trading -- market directional trading, Hedging of portfolio, Through index, covered calls, options buying, Structured products for higher yields and Allow to take position in any market condition -- bullish, bearish, volatile or neutral.
History of Derivatives
Derivatives trading began in 1865 when the Chicago Board of Trade (CBOT) listed the first "Exchange traded" derivatives contract in the USA. These contracts were called “futures contracts". In 1919, the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on the Standard & Poor’s 500 Index traded on the CME. In April 1973, the Chicago Board of Options Exchange was set up specifically for the purpose of trading in options. The market for options developed so rapidly that by early 80s the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange.
Participants in the derivatives market
The participants in the derivatives market are broadly classified into three groups: Hedgers, Speculators & Arbitrageurs. Hedgers have a position in the underlying asset or are interested in buying the asset in the future. For example, a hedger could be an investor who has got funds to invest in stocks. Hedgers participate in the derivatives market to lock the prices at which they will be able to do the transaction in the future. Thus they are trying to avoid the price risk. Speculators participate in the futures market to take up the price risk, which is avoided by the hedgers. Arbitrageurs watch the spot and futures markets and whenever they spot a mismatch in the prices of the two markets they enter to get the extra profit in a risk-free transaction.
FUTURES
Futures are exchange -traded contracts to buy or sell an asset in future at a price agreed upon Today. The asset can be a share, index, interest, bond, rupee- dollar exchange rate, sugar, crude oil, soya bean, cotton, coffee etc.
Terms in Futures
Quantity of the underlying assets, Unit of price quotation (not the price), Expiration dates, Minimum fluctuation in price (tick size) & Settlement cycles
Features
Leveraged positions only margin required, trading in either direction--short/long, Index trading, Hedging/Arbitrage opportunity
Advantages of futures over cash trading
  • In futures the investor can short sell/buy without having the stock and carry the position for a long time, which is not possible in the cash segment.
  • An investor can buy and sell index components instead of individual securities when he has a general idea of the direction in which the market may move in the next few months.
  • The investor is required to pay a small fraction of the value of the total contract as margin. This means trading in stock index futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin. Example: suppose the investor expects a Rs.100 stock to go up by Rs10. One option is to buy the stock in the cash segment by paying Rs100. He will then make Rs10 on an investment of Rs100, giving about 10% returns. Alternatively he can take futures position in the stock by paying Rs.30 towards initial and mark-to- market margin. Here he makes Rs10 on an investment of Rs30, i.e. about 33% returns.
  • In the case of individual stocks, the positions, which remain outstanding on the expiration date, will have to be settled by physical delivery, which is not the case in futures.
  • Regulatory complexity is likely to be less in the case of stock index futures compared to the other kinds of equity derivatives, such as stock index options, individual stock options etc.
OPTIONS
Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying assets at a specified price on or before a specified date. On the other hand, the seller is under obligation to perform the contract (buy or sell). The underlying asset can be a share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soya bean, cotton, coffee etc.
Features
Limited risk, unlimited profit-call options, higher returns, higher risk- put options, and Positions in all market conditions/views.
Types of Options
CALL OPTIONS
A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.
PUT OPTIONS
A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.
IMPORTANT TERMINOLOGY
Underlying - The specific security / asset on which an options contract is based.
  • Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell
  • Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.
  • Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless.
  • Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options; the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option)
  • Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer.
  • Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited.
  • Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.
  • European and American Style of options - An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry. The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that.
  • In the money: Call option - underlying instrument price is higher than the strike price. Put option - underlying instrument price is lower than the strike price.
  • Out of the money: Call option - underlying instrument price is lower than the strike price.Put option - underlying instrument price is higher than the strike price.
  • At the money: The underlying price is equivalent to the strike price.
DERIVATIVE STRATEGIES
Strategies need to be arrived at based on one’s view of how the market will move. Strategies are generally combinations of various products –futures, calls and puts and enable an individual to realize unlimited profits, limited profits, unlimited losses or limited losses depending on his profit appetite and risk appetite.
Four simple views
  • Bullish view,
  • Volatile view,
  • Bearish view
  • Neutral view.
Bullish and bearish views are simple enough to comprehend.
Volatile view is where it is expected that the market or scrip could move rapidly. One might not be clear of direction (whether up or down), but the movement is expected to be significant in either direction. Volatile view is usually based on various situations which might warrant heavy movement. For example, during budget time, a favorable proposal might impact the price favorably; or the price could fall significantly. An expected foreign collaboration could see the price rise, and if it were not to happen, the price could fall. While a positive development might result in a price rise, a negative development might dampen the prices. Decision on huge lawsuits could significantly impact prices any which direction.
Neutral view is the reverse of the volatile view where one believes that the market or scrip in question will not move much in any direction.
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