Futures and options, part of the D-family of Financial instruments. The D here is Derivatives but these instruments are often adjudged as the destroyers of wealth. As dangerous as they are said to be, they can be equally powerful and when used effectively, they can lead to astronomical returns and efficient risk management.
What are derivatives?
Derivatives are contracts that have no independent value, but derive their value from the value of an underlying security. Like any other contract, derivatives have certain rights and obligations attached and they hold good until the trade is closed. Derivatives are a large group of instruments, each having a specific purpose, 100 different ways to trade and multiple objectives to achieve.
The Outset
History has countless instances of the use of variants of present day derivates. For example, in ancient Greece, Thales, forecasted a bumper Olive crop and instead of speculating on the price of the crops, he bought the right to buy some olive presses by paying a deposit with the limited amount of money that he had. Even in the 16th Century, the King of Portugal used the port of Antwerp to sell spices that the ships bought back from the Indies. The merchants paid in advance and fixed the price at which they would purchase the spices when the fleet arrived. These contracts were, like modern-day futures, speculative and volatile
In India, derivatives are traded on shares, commodities, currencies and interest rates. They are traded majorly on the National Stock Exchange (‘NSE’) and the Multi Commodity Exchange (‘MCX’). The Bombay Stock (‘BSE’) is also in the process on introducing derivatives on its platform. NSE was the first exchange in India to launch trading in Futures and Options in the Year 2001
In this article we have discussed the fundamentals of stock futures and options.
Futures
Futures are standardised contracts where the parties to the contract agree to buy or sell a specified quantity of shares at specified price on a specified date. A futures contract is essentially a promise, which means that the buyer must purchase and the seller must sell the shares at the specified price on a specified date, irrespective of the current market price of the underlying share. Futures are not over the counter instruments and trading in futures is facilitated by an exchange. There is no risk of counter party default since the exchange ensures that these contracts are honoured. Futures are traded on stocks as well as indexes. As of the September series, Futures are traded on 139 stocks and 2 indexes, namely Nifty and Bank Nifty. The selection criteria is explained later
The fair value of a futures contract is calculated as follows:
Futures Price = S * ( 1 + rf * (t/365)) – D
where,
S = Spot price, i.e. price of the underlying share
rf = the risk free rate. For this you can take rate of RBIs 91 day treasury bill
t = days to settlement
D = Dividend
The price of the futures contract can be slightly higher or lower than the price of the underlying depending upon the interplay between these factors. At the date of settlement, the price of the futures contract will be equal to spot price. When the price of the futures is higher than the underlying, they are said to be trading at a “premium” and when the price is lower than the underlying, they are said to be trading at a “discount”.
The specified date
The specified date is the date on which all the contracts are settled, i.e. the date on which the obligation is supposed to be fulfilled. Also called as the “settlement date” or the “Expiry date”. This is one of the major differences between the underlying security and the derivates, derivatives have a limited life i.e. the contract holds good only for a certain period whereas trading in the underlying shares can go on.
In India, for futures, settlement date is the last Thursday of the month and if the markets are closed on the last Thursday then the contracts are settled a day prior. Usually, the contracts are for 1,2 and 3 months.
How are they settled?
There are two ways in which stock derivative contracts can be settled:
1. Cash Settlement: The contract is settled by paying the difference between the buying price and the selling price
2. Physical Delivery: The stock is purchased from the market by the seller and delivered to the buyer
The exchange determines the price at which these contracts will be settled. October, 2019 onwards all the stock derivatives are settled as per the physical delivery mechanism to curb volatility and speculative trading. Prior to October, 2019 stock futures were settled as per the cash settlement mechanism
Index derivatives are always cash settled since it is impractical to have physical delivery of the underlying index. Imagine having to assemble the 50 shares in the Nifty 50 in the exact proportion at the exact price. It just wouldn’t work.
The specified number
The specified number of shares is called Lot size. It is the minimum number of shares in one contract. You can trade in contracts of Futures and not in any number. This helps in standardization of derivative contracts. SEBI requires the value of the contract to be in the range of INR 5 Lakhs to INR 10 Lakhs. The stock exchanges review the lot size once every six months and make necessary changes to the lot size
For example, price of one share of HDFC Ltd is ~INR 1,900. The lot size of the futures contract for the September series is 300. Therefore, the value of contract is INR 5,70,000
The lot size also changes depending on corporate actions such as Bonus, Rights, Split, etc.
For example, recently we saw a split of 10:1 in the shares of Eicher motors. Before the split, the lot size was 35 and after the 10:1 split the new lot size was 350.
So, how does a futures contract come into existence?
For a futures contract to come into existence, there has to be a seller of the contract, also known as ‘writer’ and a buyer. The buyer is said to be long and the writer is said to be short on the share.
What is Open Interest (‘OI’)?
OI is the number of contracts outstanding in the market. Lets understand with the help of an example
On Friday, A sells 2,000 contracts of shares of XYZ Ltd. and B & C purchase 1,000 contracts each. The total number of outstanding contracts is 2,000
On Monday, A & B purchase 1,000 contracts and 500 contracts respectively while C and D sell 1,250 contracts and 250 contracts respectively thereby reducing the open interest to 1,500 contracts.
So on and so forth, you get the idea, right?
How to interpret OI?
Margin
Margin is the upfront payment made by the trader via the broker to the exchange. It is required by the exchange to guarantee that the trader can meet the obligations of the contract
Initial margin = Span Margin + Exposure Margin
Both, Span Margin and Exposure margin are a % of the contract value and are specified by the exchange.
Mark-to-Market (M2M)
M2M is the process marking daily profits. In simple terms, it is the process of adjusting daily profit and loss of your position. As you know, the price of the futures contract keeps on changing. At the end of the day you will either receive or pay the difference depending upon the changes in the price of your contract
For example,
Day 1
10:00 AM you purchase 1 lot of HDFC Ltd Futures @ 1,900
3:30 PM the price of futures is 1,920
M2M: You will receive 20 (i.e. 1,920-1,900) *300 (the lot size) = 6,000
Day 2
3:30 PM the price of the futures is 1,905
M2m: You will pay 15 (i.e. 1,920-1,905) *300 = 4,500
Day 3
1:00 PM you square off your position @ 1,910
You will receive 5 (i.e. 1,910-1,905) * 300 = 1,500
To summarise,
Essentially, because of the system of Margin, you can trade in a contract by using a fraction of the amount and because of which your return on capital in terms of % increases.
Continuing the above example, if you had to buy 300 shares of HDFC @ 1,900, you would require INR 5,70,000. However, the margin requirement for HDFC September series futures is ~INR 1,50,000
Remember one thing, margin works both ways. The profit that you saw above, it was a result of someone else’s loss. Just because you can get that exposure that doesn’t mean you have to take it.
Options
Options are instruments that give you the right to buy or sell the underlying security at a fixed price. It is not an obligation. An options contract is essentially a choice, unlike futures contract which is a promise
The right to buy is known as “Call” and the right to sell is known as “Put”. For you to have the right to buy or sell the underlying security, you have to pay a small price, it is called “premium”. If you are an option buyer and choose not to exercise the option, your loss is limited to the premium amount that you pay. The amount of premium depends upon various factors and have multiple models to calculate it, which are discussed later
Lets understand options with the help of an example
Say, as per your analysis the price of HDFC is going to increase and you have a limited amount of capital. You purchased the right to buy 300 shares of HDFC at the price of 1,900 by paying INR 18,000 (i.e. INR 60 per share). At the end of the expiry there could be 3 scenarios:
1. The price of HDFC is 1,800: In this scenario, you will choose to buy the shares from the market for 1,800 instead of exercising your right to buy the shares for 1,900. Your loss it capped to the premium that you paid i.e. INR 18,000
2. The price of HDFC is 1,900: In this scenario, you are indifferent. You can either exercise the option or buy the shares from the market, the price is the same. You still lose the premium that you paid
3. The price of HDFC is 2,200: In this scenario, you will exercise your option to buy the shares for 1,900. Your profit in this transaction is 240 per share i.e. 2,200 – 1,900 – 60
The seller of the call made a profit of INR 18,000 (the premium you paid) in scenario 1 and 2 whereas you made a profit of INR 72,000 (240 * 300) in scenario 3. The downside for an option seller is unlimited with a limited profit but the seller tends to have a higher chance of making profit. For the buyer the upside is unlimited with a limited capital at risk but the chance of making profit is low
It is not necessary for you to hold the options until expiry. From the time of your purchase to the time expiry, if the stock moves in the favourable direction the price of the option will increase. You can sell the option at a higher price and profit from the difference
Options can be used to hedge Futures position and to speculate on the price of the underlying
You can buy / sell only calls or puts or a combination of buying and selling them in order to optimize returns and reduce risk
To buy an options contract, you only have to pay the premium. Whereas, to sell an options contract, you have to deposit a margin with the exchange just like the futures contract.
The Fixed Price
This fixed price is known as the strike price. It is the price at which the underlying share can be purchased. There are multiple strikes at which option contracts are ‘written’. A set of all the strike prices is called the ‘Option chain’ and it looks like this.
This is an option chain for HDFC Ltd. for the September series
Option chain can be accessed here: www.nseindia.com/option-chain
The lot size, settlement date and settlement mechanism of stock options is same as that of the Futures contract. The only difference for index options is that they expire every Thursday and are always cash settled. Further, the concept of Open Interest and its interpretation for each options contract also remains the same as futures
There are two types of options based on its settlement date, American Options and European options. American Options can be exercised at any date on or before the expiry date whereas, European options can be exercised only on the date of expiry. In India, European style of options is followed.
Moneyness of Options
Moneyness is a classification of options into 3 categories based on strike price and the current market price (‘CMP’) of the share:
1. In the Money (‘ITM’);
2. At the Money (‘ATM’) and
3. Out of the Money (‘OTM’)
Option Premium / Option price
It is the price you pay to purchase the right to buy or sell the underlying shares. It is the sum of intrinsic value and time value.
Intrinsic value is the difference between the strike price and the CMP of the share.
Time Value/ Extrinsic Value is the difference between the option price and the intrinsic value.
Even OTM options have some value. This is because there is still time before they expire. This means that there is a chance that there would be a favourable movement in the underlying shares and as a result of which the buyer will either exercise the option or sell the option at a profit.
The time value of an options contract tends towards zero as we near the expiry date. This happens because the chance reduces as expiry approaches.
Option Pricing
There are four models to calculate the fair price of options contract:
1. Binomial riskless model;
2. Binomial risk neutral model;
3. Black – Scholes – Merton model (‘BSM’);
4. Monte Carl0 Simulation
BSM model is the most widely used. The calculation is as follows
C = St * N(d1) − Ke−rt N(d2)
where: d1= ln (St/K) + (r+(σ2v / 2)) * t
and
d2=d1−σs * sqrt(t)
where:
C=Call option price
S=Current stock price
K=Strike price
r=Risk-free interest rate
t=Time to maturity
σ=standard deviation of log returns (volatility)
N=Area under a normal distribution curve
Don’t worry there are various online calculators where you can easily calculate the fair value of options using this model
This model makes certain assumptions:
1. The option is European and can only be exercised at expiration
2. No dividends are paid out during the life of the option
3. Markets are efficient
4. There are no transaction costs in buying the option
5. The risk-free rate and volatility of the underlying are known and constant
The returns on the underlying asset are normally distributed
Option Greeks
A set of factors that affect the price of an options contract
1. Delta – Measures the rate of change of options premium based on the directional movement of the underlying
2. Gamma – Rate of change of delta itself
3. Vega – Rate of change of premium based on change in volatility
4. Theta – Measures the impact on premium based on time left for expiry
Options are far more complicated than the futures given the factors that affect its pricing and the ways to use them
The Selection Criteria
The eligibility of a stock or Index for trading in the Derivates segment is based on the criteria laid down by the Securities and Exchange Board of India (‘SEBI’). Some of these criteria for stocks are as follows:
1. The stock should be among the top 500 stocks in terms of market capitalisation and average daily traded value in the last six months;
2. The market wide position limit shall not be less than INR 500 Cr;
3. The average daily delivery value in the cash market shall not be less than INR 10 Cr in the last six months
If the existing stocks fail to meet these criteria for three consecutive months, no fresh contracts shall be issued on that security. A stock which is excluded from the derivatives trading may become eligible once again, provided it fulfils an enhanced eligibility criteria for six consecutive months.
I have been trading futures and options for sometime now and all I have to say is that they are not as scary as they sound but they are not easy either. Trading them requires a lot of practice, patience and discipline. These instruments are like two edged swords, they cuts both ways. Your money can vanish to become thin air or you could earn ample, it depends on how you handle your armoury.
Thank you for reading.
Sources: www.sebi.gov.in , www.nseindia.com, Zerodha varsity, The investors tool box by Peter Temple
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Superb Parth..Well explained!!👍