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.

• Contract size : Just like stock futures, these contracts are also dealt in lots. But how is that possible when the index is simply a non-physical number. No, you do not purchase futures of the stocks belonging to the index. Instead, stock indices points – the value of the index – are converted into rupees.
• Expiry : Since indices are abstract market concepts, the transaction cannot be settled by actually buying or selling the underlying asset. Physical settlement is only possible in case of stock futures. Hence, an open position in index futures can be settled by conducting an opposing transaction on or before the day of expiry.
• Duration : As in the case of stock futures, index futures too have three contract series open for trading at any point in time – the near-month (1 month), middle-month (2 months) and far-month (3 months) index futures contracts.
• Illustration of an index futures contract : If the index stands at 3550 points in the cash market today and you decide to purchase one Nifty 50 July future, you would have to purchase it at the price prevailing in the futures market.This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh (i.e., 3550*100), depending on the prevailing market conditions. Investors and traders try to profit from the opportunity arising from this difference in prices.

The cost of carry model

• The Cost of Carry Model assumes that markets tend to be perfectly efficient. This means there are no differences in the cash and futures price. This, thereby, eliminates any opportunity for arbitrage – the phenomenon where traders take advantage of price differences in two or more markets. When there is no opportunity for arbitrage, investors are indifferent to the spot and futures market prices while they trade in the underlying asset. This is because their final earnings are eventually the same.
• The model also assumes, for simplicity sake, that the contract is held till maturity, so that a fair price can be arrived at.
• In short, the price of a futures contract (FP) will be equal to the spot price (SP) plus the net cost incurred in carrying the asset till the maturity date of the futures contract. FP = SP + (Carry Cost – Carry Return)
• Here Carry Cost refers to the cost of holding the asset till the futures contract matures. This could include storage cost, interest paid to acquire and hold the asset, financing costs etc. Carry Return refers to any income derived from the asset while holding it like dividends, bonuses etc. While calculating the futures price of an index, the Carry Return refers to the average returns given by the index during the holding period in the cash market. A net of these two is called the net cost of carry.
• The bottom line of this pricing model is that keeping a position open in the cash market can have benefits or costs. The price of a futures contract basically reflects these costs or benefits to charge or reward you accordingly.

How to buy & settle 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.

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:

• On Expiry : In this case, the futures contract (purchase or sale) is settled at the closing price of the underlying asset as on the expiry date of the contract. When closing a futures index contract on expiry, the closing value of the index on the expiry date is the price at which the contract is settled. If on the date of expiry, the index closes higher than when you bought your contracts, you make a profit and vice versa. The settlement is made by adjusting your gain or loss against the margin money you’ve already deposited.
• Before Expiry : It is not necessary to hold on to a futures contract till its expiry date. In practice, most traders exit their contracts before their expiry dates. Any gains or losses you’ve made are settled by adjusting them against the margins you have deposited till the date you decide to exit your contract. You can do so by either selling your contract, or purchasing an opposing contract that nullifies the agreement. Here again, your profits will be returned to you or losses will be collected from you, after adjusting them for the margins that you have deposited once you square off your position. Index futures contracts are settled in cash. This can again be done on expiry of the contract or before the expiry date.

Types of options

• Call option : The ‘Call Option’ gives the holder of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases. Call options are abbreviated as ‘C’ in online quotes.
• Put option: The Put Option gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls.Similarly, if the price of the stock rises during the contract period, the seller only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ‘P’ in online quotes.

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.

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:

• Buying options : When you buy an options contract, you pay only the premium for the option and not the full price of the contract. The exchange transfers this premium to the broker of the option seller, who in turn passes it on to his client.
• Selling options : Although the buyer of an option has a liability that is limited to the premium he must pay, the seller has a limited gain. However, his potential losses are unlimited. Therefore, the seller of an option has to deposit a margin with the exchange as security in case of a huge loss due to an adverse movement in the option’s price. The margins are levied on the contract value and the amount (in percentage terms) that the seller has to deposit is dictated by the exchange. It is largely dependent on the volatility in the price of the option. Higher the volatility, greater is the margin requirement.

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.

• For a buyer of a call option : There are two ways to settle – squaring off and physical settlement. If you decide to square off your position before the expiry of the contract, you will have to sell the same number of call options that you have purchased, of the same underlying stock and maturity date and strike price.
• For the seller of a call option : If you have sold call options and want to square off your position, you will have to buy back the same number of call options that you have written. These must be identical in terms of the underlying scrip and maturity date and strike price to the ones that you have sold.

Buying & settling 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.

• Kinds of put options : There are two kinds of put options – American and European – on the basis of when an option can be exercised. American options are more flexible; they allow you to settle the trade before the expiry date of the contract. European options can only be exercised on the day of the expiry. Thus, index options are European options, while stock options are a kind of American options.

• Squaring off : In the case of Stock options, you can buy an opposing contract. This means, if you hold a contract to sell stocks, you purchase a contract to buy the very same stocks. This is called squaring off. You make a profit from the difference in prices and premiums.
• Selling : If none of the above options seem profitable, you can simply sell the ‘put’ option you hold. This is also a kind of squaring off method.
• Physical Settlement : You can also exercise your option anytime on or before the expiry date of the contract. This means, you will actually sell the underlying stocks as specified in the options contract agreement.
  For put index options, you cannot physically settle, as the index is not tangible. So, to settle index options, you can either exit your position through an offsetting trade in the market. You can also hold your position open until the option expires. Subsequently, the clearing house settles the trade.
• For a buyer of a put option: If you decide to square off your position before the expiry of the contract, you will have to buy the same number of call options of the same underlying stock and maturity date. If you have purchased two XYZ put options with a lot size 500, a strike price of Rs 100, and expiry month of August, you will have to buy two XYZ call options contracts with an expiry month of August. Thus, these two cancel each other. Whatever is the difference in strike prices could be your profit or loss.
  You can also settle by selling the two put options contracts you hold in order to square off your position. This way, you will earn a premium on the contracts as the seller. The difference between the premium at which you bought the put option and the premium at which you sold them will be your profit or loss. Or, you can exercise your options on or before the expiration date. The stock exchange will calculate the profit/loss on your positions by measuring the difference between the closing market price of the share or index and the strike price. Your account will be then credited or debited for the amount. However, your maximum loss will be restricted to the premium paid.
• For the seller of a put option : If you have sold put options and want to square off your position, you will have to buy back the same number of put options that you have written. These must be identical in terms of the underlying asset (stock or index) and maturity date to the ones that you have sold.
  In case the options contract gets exercised on or before the expiration date, the stock exchange will calculate the profit/loss on your position. This will be based on the difference between the strike price and the closing market price of the stock or index on the day of exercise.
  You losses will be adjusted against the margin that you have provided to the exchange and the balance margin will be credited to your account with the broker.

Futures vs options contracts

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.

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.

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.