Introduction to Futures and Options(F&O) Trading - Stock Market
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INTRODUCTION TO FUTURES AND OPTIONS
In recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter, we shall study in detail these three derivative contracts.
FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
- The salient features of forward contracts are:
- Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
- The contract price is generally not available in public domain.
- On the expiration date, the contract has to be settled by delivery of the asset.
- If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.
If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.
LIMITATIONS OF FORWARD MARKETS
Forward markets world-wide are afflicted by several problems:
- Lack of centralization of trading,
- Illiquidity, and
- Counterparty risk
Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.
INTRODUCTION TO FUTURES
The standardized items in a futures contract are:
- Quantity of the underlying
- Quality of the underlying
- The date and the month of delivery
- The units of price quotation and minimum price change
- Location of settlement
Merton Miller, the 1990 Nobel laureate had said that 'financial futures
represent the most significant financial innovation of the last twenty
years." The first exchange that traded financial derivatives was launched
in Chicago in the year 1972. A division of the Chicago Mercantile
Exchange, it was called the International Monetary Market (IMM) and
traded currency futures. The brain behind this was a man called Leo
Melamed, acknowledged as the 'father of financial futures" who was
then the Chairman of the Chicago Mercantile Exchange. Before IMM
opened in 1972, the Chicago Mercantile Exchange sold contracts whose
value was counted in millions. By 1990, the underlying value of all
contracts traded at the Chicago Mercantile Exchange totaled 50
trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board Options Exchange. By the 1990s, these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps, and their success transformed Chicago almost overnight into the risk-transfer capital of the world.
Distinction between futures and forwards
Futures |
Forwards |
Trade
on an organized exchange |
OTC
in nature |
Standardized
contract terms |
Customised
contract terms |
hence
more liquid |
hence
less liquid |
Requires
margin payments |
No
margin payment |
Follows
daily settlement |
Settlement
happens at end of period |
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS
FUTURES TERMINOLOGY
- Spot price: The price at which an asset trades in the spot market.
- Futures price: The price at which the futures contract trades in the futures market.
- Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and threemonths expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.
- Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.
- Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.
- Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
- Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
- Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.
- Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.
- Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
INTRODUCTION TO OPTIONS
OPTION TERMINOLOGY
- Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.
- Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
- Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
- Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
- Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.
- Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
- Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
- Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
- Strike price: The price specified in the options contract is known as the strike price or the exercise price.
- American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.
- European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.
- In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
- At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).
- Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
- Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.
- Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.
FUTURES AND OPTIONS
An interesting question to ask at this stage is - when would one use options instead of futures? Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating "guaranteed return products".
Options made their first major mark in financial history during the tulipbulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiralled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.
Distinction between futures and options
Futures |
Forwards |
Exchange traded, with novation |
Same as futures. |
Exchange defines the product |
Same as futures. |
Price is zero, strike price moves |
Strike price is fixed, price moves. |
Price is zero |
Price is always positive. |
Linear payoff |
Nonlinear payoff. |
Both long and short at risk |
Only short at risk. |
The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market.
More generally, options offer "nonlinear payoffs" whereas futures only have "linear payoffs". By combining futures and options, a wide variety of innovative and useful payoff structures can be created.
INDEX DERIVATIVES
Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives have become very popular worldwide. Index derivatives offer various advantages and hence have become very popular.
- Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes.
- Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.
- Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered.
- Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements.
- Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.
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