Destimoney New to Derivatives

New to Derivatives

Futures and Options together make up the derivatives segment.

While a futures contract makes it obligatory for participants to honour the contract between them, options confers on them the right, but not the obligation, to trade in the specified asset.

A futures contract is a standardized instrument where the buyer and seller agree to settle the trade on or before a specified date known as the expiry date. Typically, futures contracts have one-month, two-month and three-month expiry cycles, which expire on the last Thursday of the corresponding (first, second or third) month following the contract date. New cycles are created on the Friday immediately following the expiry.

Futures contracts may be settled any time up to the expiry date. If they haven’t, then they are automatically settled on the expiry date. That is, after the expiry date, the contract ceases to exist.

Futures and options are traded in lots where the lot size varies from instrument to instrument. For example, currently, the single lot size of a Nifty contract is 50, while that of a Reliance contract is 300. Plans are afoot to periodically review and vary the lot size, so that contract values hover around a standard mean, and do not become exorbitant and unaffordable when spot prices rise during bull runs.

Know more about Futures

In the case of Futures, consummation of the trade between buyer and seller is compulsory. In the case of Options, as the term suggests, the buyer literally has an option whether or not to go through with the deal.

Options also involve a buyer and a seller (also known as a writer). The seller possesses the asset, and the buyer is granted a right, but not the obligation, to buy or sell the asset at an agreed price (known as the Strike Price or Exercise Price) on the specified expiry date. If the buyer exercises this right to buy or sell the asset, then the seller is under compulsion to trade the asset. As mentioned, the buyer has the option to let the contract expire.

The buyer’s options are to Call (assume a long position or buy the asset) or Put (assume a short position or sell the asset) at the Strike Price, which is the net of the spot price (prevailing price) and the Premium payable.

While upfront, the buyer of a futures contract needs to commit only a negligible amount by way of margin, the buyer of an options contract has to pay the entire premium. However, in futures, at expiry, if the buyer incurs a loss, he will now have to pay the entire amount, while in the case of options his loss is limited to the amount of premium already paid upfront. Given this reality, options are perceived to be more attractive than futures.

Know more about Options

Once again, trading in options is best understood by a basic example

A buyer who is bullish on a particular stock (or index, but let us presume the same stock from our futures example), would scan the options written by various sellers. If he then buys a Call option of one lot (lot size 2000 shares) at a premium of Rs. 5 over the prevailing price of Rs. 100 (ie Strike Price of Rs. 100 + 5 = 105), he would, upfront, have to pay the premium of Rs.10000 (Rs.5*2000).

Now, at expiry, if the price of the stock is above Rs. 105 (the Strike Price) he could choose to exercise the Call option. If at that point, the stock is trading at, say, Rs. 110, he would receive a total of Rs. 20,000 [Rs.(110-100)*2,000], although his actual profit would be the value above the Strike Price, ie Rs. 10,000 [Rs.(110-105)*2,000], as he would have already paid the premium of Rs. 10,000 upfront. The higher current price of the stock at expiry, the greater would be his profit.

If however, at expiry, the price was below the Strike Price (in the example Rs. 105), he would then have the option to let the ‘contract’ expire unexercised, and his loss would be limited to the amount of premium paid (in the above example, Rs 10,000).

Again, if the price at expiry is below the Strike Price (Rs. 105) but above the price prevailing when the contract was taken (ie Rs. 100), say Rs. 102, he would then prudently exercise his option and thus limit his loss to Rs. 6,000 [ie (105-102)*2,000], rather than let the option lapse and incur a loss of Rs. 10,000, which was the premium paid.

It unfolds in reverse with a Put option. If, as in the above example, the investor was bearish and expects the market to fall, he might buy a Put option for a Strike Price of, say, Rs 95, which would be below the prevailing price of, say, Rs. 100. He would upfront need to pay the premium of Rs.10,000 [(100-95)*2,000].

Now, on expiry, if the prevailing price was below the Strike Price, then the buyer could choose to exercise his Put option (ie sell the seller’s stock) and make a profit to the extent of the price below the Strike Price. E.g., if the prevailing price was Rs 90, he would make a profit of Rs 10,000 [Rs.(95-90)*2,000]. Of course, he would receive a total consideration of Rs. 20,000 [Rs.(100-90)*1,000], which would include the Rs 10,000 premium paid upfront.

If however, at expiry, the stock’s price was above the Strike Price of Rs. 95, he would have the option to let the ‘contract’ expire unexercised and his loss would be limited to the amount of premium paid (in the above example, Rs 10,000).

Again, if the price at expiry hovered between the Strike price (Rs. 95, here) and the price prevailing on the day of entering into the contract (Rs. 100), say, expiry date price at Rs. 98, then it would be more prudent to exercise the Put option, and limit losses to Rs. 6,000 [(95-98)*2,000] rather than let the contract lapse and lose the entire premium of Rs. 10,000.

In case of a Put option, the lower the current price in relation to the Strike Price, the greater would be the profit.

Thus, in options, for the buyer, while the loss is capped, the upside profit is theoretically unlimited. The seller’s (or writer’s) fortunes are inversely proportional to the buyer’s. His gain is limited to the extent of the premium forfeited when the buyer does not exercise his option, but his loss (even if notionally) is theoretically unlimited if the stock moves beyond the Exercise Price in a direction favouring the buyer.

Buying options are more lucrative than buying the actual stock, because for the same amount of money, the buyer can leverage a far greater number of shares.

Many investors use derivatives to hedge the risks associated with investing in the spot markets. By using various strategies, someone holding or buying a stock in the regular spot market, can insure himself against the risk of price volatility by taking positions in the derivatives market. Almost like an equity trader’s insurance policy!

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Besides hedgers, derivatives also find favour with speculators, who seek to make profits by taking exposure to an asset, without intending to take delivery of, or own, it.

Finally, there are the arbitrageurs, who seek to take advantage of the price differential of the same asset in two different markets (spot and derivatives). Again, by using a combination of strategies in both markets, the arbitrageur can actually make a profit without committing any – or at least sizable – funds.

As explained earlier, you can trade in Financial Derivatives (stocks etc) as well as in Commodities Derivates. In the former, while the underlying assets are stocks, currencies etc, in the latter they may be food grain, sugar, rapeseed, paper, precious metals, etc… etc.

Of course, you can easily and seamlessly trade in both kinds of Derivatives right here on Destimoney. Simply click the following link to get yourself directly to the DERIVATIVES trading pages.

New to Derivatives

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