What are Futures Contracts

A futures contract is an agreement between two parties – a buyer and a seller – wherein the former agrees to purchase from the latter, a fixed number of shares or an index at a specific time in the future for a pre-determined price. These details are agreed upon when the transaction takes place. As futures contracts are standardized in terms of expiry dates and contract sizes, they can be freely traded on exchanges. A buyer may not know the identity of the seller and vice versa. Further, every contract is guaranteed and honoured by the stock exchange, or more precisely, the clearing house or the clearing corporation of the stock exchange, which is an agency designated to settle trades of investors on the stock exchanges. Futures contracts are available on different kinds of assets – stocks, indices, commodities, currency pairs and so on.

Stock Futures

Index Futures

A stock index is used to measure changes in the prices of a group stocks over a period of time. It is constructed by selecting stocks of similar companies in terms of an industry or size. Some indices represent a certain segment or the overall market, thus helping track price movements. For instance, the BSE Sensex is comprised of 30 liquid and fundamentally strong companies. Since these stocks are market leaders, any change in the fundamentals of the economy or industries will be reflected in this index through movements in the prices of these stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500, etc, which represent price movements on different exchanges or in different segments. Futures contracts are also available on these indices. This helps traders make money on the performance of the index.

Features

Advantages and risks of future contracts

Advantages

Risks Involved

The main risk stems from the temptation to speculate excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits. Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge among market participants could lead to losses.

The cost of carry model

Expectancy model of future pricing

The Expectancy Model of futures pricing states that the futures price of an asset is basically what the spot price of the asset is expected to be in the future.

This means, if the overall market sentiment leans towards a higher price for an asset in the future, the futures price of the asset will be positive.

In the exact same way, a rise in bearish sentiments in the market would lead to a fall in the futures price of the asset.

Unlike the Cost of Carry model, this model believes that there is no relationship between the present spot price of the asset and its futures price. What matters is only what the future spot price of the asset is expected to be.

This is also why many stock market participants look to the trends in futures prices to anticipate the price fluctuation in the cash segment.

How to buy & settle futures

Buying Futures

One of the prerequisites of stock market trading – be it in the derivative segment – is a trading account. Money is the obvious other requirement. However, this requirement is slightly different for the derivatives market.

When you buy in the cash segment, you have to pay the entire value of the shares purchased – this is unless you are a day trader utilizing margin trading. You have to pay this amount upfront to the exchange or the clearing house. This upfront payment is called ‘Margin Money’. It helps reduce the risk that the exchange undertakes and helps in maintaining the integrity of the market.

Once you have these requisites, you can buy a futures contract. Simply place an order with your broker, specifying the details of the contract like the Scrip , expiry month, contract size, and so on. Once you do this, hand over the margin money to the broker, who will then get in touch with the exchange.

Settle Futures

When you trade in futures contracts, you do not give or take immediate delivery of the assets concerned. This is called settling of the contract. This usually happens on the date of the contract’s expiry. However, many traders also choose to settle before the expiry of the contract.

For stock futures, contracts can be settled in two ways:

What are options?

An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.

The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.

They can be used as:

Strike price intervals for nifty index

The number of contracts provided in options on index is based on the range in previous day’s closing value of the underlying index and applicable as per the following table:

Index Level Strike Interval Scheme of Strike to be introduced
upto 2000 50 4-1-4
> 2001 upto 4000 100 6-1-6
>4001 upto 6000 100 6-1-6
>6000 100 7-1-7

Expiration Date

American and European options

The terms ‘American’ and ‘European’ refer to the type of underlying asset in an options contract and when it can be executed. American options’ are Options that can be executed at any time on or before their expiration date. ‘European options’ are Options that can only be executed on the expiration date.

Types of options

How is premium pricing arrived at

The price of an Option Premium is controlled by two factors – intrinsic value and time value of the option.

What are call options

As a trader, you would choose to purchase an index call option if you expect the price movement of the index to rise in the near future, rather than that of a particular share. Indices on which you can trade include the CNX Nifty 50, CNX IT and Bank Nifty on the NSE and the 30-share Sensex on the BSE.

Buying & selling call options

As we read earlier, the buyer of an option has to pay the seller a small amount as premium. Seller of call option has to pay margin money to create position. In addition to this, you have to maintain a minimum amount in your account to meet exchange requirements. Margin requirements are often measured as a percentage of the total value of your open positions.

Let us look at the margin payments when you are buyer and a seller:

Settle call option

When you sell or purchase an option, you can either exit your position before the expiry date, through an offsetting trade in the market, or hold your position open until the option expires. Subsequently, the clearing house settles the trade. Such options are called European style options.

What are put options

In any market, there cannot be a buyer without there being a seller. Similarly, in the Options market, you cannot have call options without having put options. Puts are options contracts that give you the right to sell the underlying stock or index at a pre-determined price on or before a specified expiry date in the future. In this way, a put option is exactly opposite of a call option. However, they still share some similar traits.

Key features of the put option

Buying & settling put option

Buying put option

There is a major difference between a call and a put option – when you buy the two options. The simple rule to maximize profits is that you buy at lows and sell at highs. A put option helps you fix the selling price. This indicates you are expecting a possible decline in the price of the underlying assets. So, you would rather protect yourself by paying a small premium than make losses.

This is exactly the opposite for call options – which are bought in anticipation of a rise in stock markets. Thus, put options are used when market conditions are bearish. They thus protect you against the decline of the price of a stock below a specified price.

Settle a put option

what are covered & naked options?

Simply put, covered options are contracts sold by traders who actually own the underlying shares. In contrast, naked options are those where the writer does not own the underlying assets. Writers of naked options are thus unprotected or naked from an unlimited loss In Covered options, the buyers are not actually obligated to exercise the agreement. So, they have limited scope for losses, as they are only subject to lose the amount they paid as premium. Sellers, on the other hand, are obligated to uphold the contract if and when the buyer chooses. This increases his potential liability. Also, the sellers profit is largely limited to the premium he/she receives

When you sell a naked call or put option, you have no underlying assets or open position in the futures market to protect you from an unlimited loss, if the market goes against you. However, this does not necessarily mean that a naked option does not have its perks. It allows traders to participate in the derivatives market even if they have relatively small holdings in the cash segment.

Naked options are usually sold by speculators, who feel very strongly about the direction of an index or the price of a stock. And, if the market does go against them, they may try to salvage the situation by offsetting their options by purchasing identical but opposing options. They could also consider taking up a position in the futures market that will nullify the losses made through selling a naked call or put.

Futures vs options contracts

Obligation

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Here, the buyer is obliged to buy the asset on the specified future date.

An options contract gives the buyer the right to buy the asset at a fixed price. However, there is no obligation on the part of the buyer to go through with the purchase. Nevertheless, should the buyer choose to buy the asset, the seller is obliged to sell it.

Risk

The futures contract holder is bound to buy on the future date even if the security moves against them. Suppose the market value of the asset falls below the price specified in the contract. The buyer will still have to buy it at the price agreed upon earlier and incur losses. The buyer in an options contract has an advantage here. If the asset value falls below the agreed-upon price, the buyer can opt out of buying it. This limits the loss incurred by the buyer.

In other words, a futures contract could bring unlimited profit or loss. Meanwhile, an options contract can bring unlimited profit, but it reduces the potential loss.

Advance payment

There is no upfront cost when entering into a futures contract. But the buyer is bound to pay the agreed-upon price for the asset eventually. The buyer in an options contract has to pay a premium. The payment of this premium grants the options buyer the privilege to not buy the asset on a future date if it becomes less attractive. Should the options contract holder choose not to buy the asset, the premium paid is the amount he stands to lose.

In both cases, you may have to pay certain commissions.

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