FUTURES AND OPTIONS

FUTURES

Introduction to Derivatives Derivative is a product/contract which does not have any value on its own i.e. it derives its value from some underlying asset.

• What are Forward contracts?

A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place. However forward contracts suffer from poor liquidity and default risk.

• What are Future contracts?

Future contracts are organized contracts, which are traded on the exchanges and are very liquid in nature. In the futures market a clearing corporation provides the settlement guarantee.

• What are Index Futures?

Index futures are the future contracts for which the underlying asset is the cash market index. For example: BSE may launch a future contract on "BSE Sensitive Index".

Frequently used terms in Index Futures market

Contract Size The value of the contract at a specific level of the Index.
It is Index level * Multiplier.

Multiplier It is a pre-determined value, used to arrive at the contract size. It is the price per index point.

Tick Size It is the minimum price difference between two quotes of similar nature.

Expiry Day The last day on which the contract is available for trading.

Open interest Total outstanding long or short positions in the market at any specific point in time.

Volume Number of contracts traded during a specific period of time.

Long position Outstanding/unsettled purchase position at any point of time.

Short position Outstanding/ unsettled sales position at any point of time.

Open position Outstanding/unsettled long or short position at any point of time.

Cash settlement Open position at the expiry of the contract is settled in cash. These contracts are designated as cash settled contracts. Index Futures fall in this category.

Operators in the derivatives market

Hedgers People who want to reduce the risk component of their portfolio.

Speculators People who intentionally take the risk from hedgers in pursuit of profit.

Arbitrageurs People who operate in the different exchanges simultaneously and benefit from the difference in the price of the same stock in different exchanges.

Hedge terminology

Long hedge When you hedge by going long(buying) in the futures market.

Short hedge When you hedge by going short(selling) in the futures market.

Cross hedge When a futures contract is not available on an asset, you hedge your position in the cash market on this asset by going long or short on the futures for another asset whose prices are closely associated with that of your underlying asset.

Hedge Contract Month Maturity month of the contract through which hedge is accomplished.

Hedge Ratio Number of future contracts required to hedge the position.

Some specific uses of Index Futures

Portfolio Restructuring An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of Index Futures.

Index Funds These are the funds which imitate/replicate an index with the objective to generate a return equivalent to that of the Index. This is called Passive Investment Strategy.

Speculators in the Futures market

Speculation is all about taking position in the futures market without actually having the underlying asset. Speculators operate in the market with a motive to make money. They take:

Naked positions - Position in any future contract.

Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

Arbitrageurs in Futures market Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

• What are the advantages of the derivatives market when compared to the cash market?

- Higher liquidity
- Availability of risk management products attracts more investors to the cash market
- Arbitrage between cash and futures markets fetches additional business to cash market
- Improvement in delivery based business
- Lesser volatility
- Improved price discovery

OPTIONS

• What are Options?

Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

A call option gives the holder the right to buy an underlying asset at a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a certain price which is called "the call option premium or call option price".

A put option, on the other hand gives the holder the right to sell an underlying asset at a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a certain price, which is called "the put option premium or put option price".

The price at which the underlying asset would be bought in the future at a particular date is the "Strike Price" or the "Exercise Price". The date on the options contract is called the "Exercise date", "Expiration Date" or the "Date of Maturity".

There are two kinds of options based on the date. The first is the European Option(CE) which can be exercised only on the maturity date. The second is the American Option(CA) which can be exercised before or on the maturity date.

Cash settled optionsare those where, on exercise the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put).

Delivery settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of the undertaking (puts).

• Who are the Market players in options?

Hedgers The objective of these kind of traders is to reduce the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets, where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or in the commodities market, where spiraling oil prices have to be tamed using the security in derivative instruments.

Speculators They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down.

Arbitrageurs Riskless profit making is the prime goal of Arbitrageurs. Buying in one market and selling in another or buying two products in the same market are common. They could be making money even without putting there own money in and such opportunities often come up in the market but last for very short timeframes. This is because as soon as such a situation arises arbitrageurs take advantage and demand-supply forces drive the markets back to normal.

Options Pricing

Prices of options commonly depend upon six factors. Unlike futures which derive their prices primarily from prices of the undertaking, option prices are far more complex.

Spot prices: In case of a call option the payoff for the buyer is maximum therefore greater the Spot Price greater the payoff and it is favorable for the buyer. It is the other way round for the seller, more the Spot Price higher are the chances of his going into a loss.

In case of a put Option, the payoff for the buyer is maximum therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing.

Strike price: A higher strike price would reduce the profits for the holder of the call option.

Time to expiration: More the time to Expiration more favorable is the option. This can only exist in case of American option as in case of European Options the Options Contract matures only on the Date of Maturity.

Volatility: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer.

Risk free rate of interest: In reality the risk and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect
- Increase in expected growth rate of stock prices
- Discounting factor increases making the price fall

In case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the buyer to the position of loss in the payoff chart. The discounting factor increases and the future value becomes lesser.

In case of a call option these effects work in the opposite ion. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favorable on the call option.

Dividends: When dividends are announced then the stock prices on ex-dividend are reduced. This is favorable for the put option and unfavorable for the call option.