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Sunday, March 16, 2008

What are Futures & Options (Derivatives)?

What are Derivatives?
A derivative is a financial instrument whose value depends on the values of other underlying variables. As the name suggests it derives its value from an underlying asset. For Ex-a derivative, may be created for a share, or any material object. The most common underlying assets include stocks, bonds, commodities etc.
Let us try and understand a Derivatives contract with an example:
Anil buys a futures contract in the scrip "Satyam Computers". He will make a profit of Rs.500 if the price of Satyam Computers rises by Rs 500. If the price remains unchanged Anil will receive nothing. If the stock price of Satyam Computers falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Satyam Computers scrip, which is the underlying security. Similarly, futures trading can be done on the indices also. Nifty futures is a very commonly traded derivatives contract in the stock markets. The underlying security in the case of a Nifty Futures contract would be the Index-Nifty.

What are the different types of Derivatives?
Derivatives are basically classified into the following:
Futures /Forwards
What are Futures?
A futures contract is a type of derivative instrument, or financial contract where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.
The example stated below will simplify the concept:
Ravi wants to buy a Laptop, which costs Rs 50,000 but owing to cash shortage at the moment, he decides to buy it at a later period say 2 months from today.However,he feels that after 2 months the prices of Lap tops may increase due to increase in input/Manufacturing costs .To be on the safer side, Ravi enters into a contract with the Laptop Manufacturer stating that 2 months from now he will buy the Laptop for Rs 50,000. In other words he is being cautious and agrees to buy the Laptop at today's price 2 months from now.The forward contract thus entered into will be settled at maturity. The manufacturer will deliver the asset to Ravi at the end of two months and Ravi in turn will pay cash delivery.
Thus a forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell a specific quantity of an asset at a certain future time for a specified price. No cash is exchanged when the contract is entered into.

What are Index Futures?
As Stated above, Futures are derivatives where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Index futures are futures contracts where the underlying is a stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

What is meant by Lot size?
Lot size refers to the quantity in which an investor in the markets can trade in a derivative of a particular scrip.For Ex-Nifty Futures have a lot size of 100 or multiples of 100.Hence if a person were to buy 1 lot of Nifty Futures , the value would be 100*Nifty Index Value at that point of time.
Similarly lots of other scrips such as Infosys, reliance etc can be bought and each may have a different lot size. NSE has fixed the minimum value as two lakhs for an Futures and Options contract. Lot sizes are fixed accordingly which will be the minimum shares on which a trader can hold positions.

What is meant by expiry period in Futures?
Each contract entered into has an expiry period. This refers to the period within which the futures contract must be fulfilled. Futures contracts may have durations of 1 month,2 months or at the most 3 months. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.

What are options?
Before you begin options trading it is critical to have a clear idea of what you hope to accomplish. Only then will you be able to narrow down on an options trading strategy. Let us first understand the concept of options.
An option is part of a class of securities called derivatives.
The concept of options can be explained with this example. For instance, when you are planning to buy some property you might have placed a nonrefundable deposit to hold it for a short time while you evaluate other options. That is an example of a type of option.

Similarly, you have probably heard about Bollywood buying an option on a novel. In 'optioning the novel,' the director has bought the right to make the novel into a movie before a specified date. In both cases, with the house and the script, somebody put down some money for the right to buy a product at a specific price before a specific date.

Buying a stock option is quite similar. Options are contracts that give the holder the right to buy or sell a fixed amount of a certain stock at a specified price within a specified time. A put option gives the holder the right to sell the security, a call option gives the right to buy the security. However, this type of contract gives the holder the right, but not the obligation to trade stock at a specific price before a specific date.

Several individual investors find options useful tools because they can be used either as:
A) A type of leverage or
B) A type of insurance.
Trading in options lets you benefit from a change in the price of the share without having to pay the full price of the share. They provide you with limited control over the shares of a stock with substantially less capital than would be required to buy the shares outright.

When used as insurance, options can partially protect you from the specific security's price fluctuations by granting you the right to buy or sell shares at a fixed price for a limited amount of time.

Options are inherently risky investment vehicles and are suitable only for experienced and knowledgeable investors who are prepared to closely monitor market conditions and are financially prepared to assume potentially substantial losses.

What are the different types of Options? How can Options be used as a strategic measure to make profits/reduce losses?
Options may be classified into the following types:
a) Call Option
b) Put Option

As mentioned before, there are two types of options, calls and puts. A call option gives the holder the right to buy the underlying stock at the strike price anytime before the expiration date. Generally Call options increase in value as the value of the underlying instrument increases.

By contrast, the put option gives the holder the right to sell shares of the underlying stock at the strike price on or before the expiry date. The put option gains in value as the value of the underlying instrument decreases. A put option is one where one can insure a stock against subsequent price fall. If the value of your stocks goes down, you can exercise your put option and sell it at the price level decided upon earlier. If in case the stock price moves higher, all you lose is just the premium amount that was paid.
Note that in newspaper and online quotes you will see calls abbreviated as C and puts abbreviated as P.

The examples stated below will explain the use of Put options clearly:

Case 1:
Rajesh purchases 1 lot of Infosys Technologies MAY 3000 Put and pays a premium of 250 This contract allows Rajesh to sell 100 shares of Infosys at Rs 3000 per share at any time between the current date and the end of May.Inorder to avail this privilege, all Rajesh has to do is pay a premium of Rs 25,000 (Rs 250 a share for 100 shares).
The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Case 2:
If you are of the opinion that a particular stock say "Ray Technologies" is currently overpriced in the month of February and hence expect that there will be price corrections in the future. However you don't want to take a chance , just in case the prices rise. So here your best option would be to take a Put option on the stock.

Lets assume the quotes for the stock are as under:
Spot Rs 1040
May Put at 1050 Rs 10
May Put at 1070 Rs 30
So you purchase 1000 "Ray Technologies" Put at strike price 1070 and Put price of Rs 30/-. You pay Rs 30,000/- as Put premium.

Your position in two different scenarios have been discussed below:
1. May Spot price of Ray Technologies = 1020
2. May Spot price of Ray Technologies = 1080

In the first situation you have the right to sell 1000 "Ray Technologies" shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option you earn Rs (1070-1020) = Rs 50 per Put, which amounts to Rs 50,000/-. Your net income in this case is Rs (50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so you will not sell at a lower price by exercising the Put. You will have to allow the Put option to expire unexercised. In the process you only lose the premium paid which is Rs 30,000.

what is open interest?
The total number of option contracts and/or futures contracts that are not closed or delivered on a particular day and hence remain to be exercised, expired or fulfilled through delivery is called open interest.

What are Index Futures?
As Stated above, Futures are derivatives where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Index futures are futures contracts where the underlying is a stock Index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

What is meant by the terms Option Premium, strike price and spot price?
The price that a person pays for a call option/Put Option is called the Option Premium. It secures the right to buy/sell that particular stock at a specified price called the strike price. In other words the strike price is the specified price at which the holder of a stock option may purchase the stock. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Premium of an option = Option's intrinsic value + Options time value The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by the option holder upon exercise of the option contract is called the Strike price. Spot Price is the current price at which a particular commodity can be bought or sold at a specified time and place.

What is meant by settlement price?
The last price paid for a contract on any trading day. Settlement prices are used to determine open trade equity, margin calls and invoice prices for deliveries.

How does one determine the price of an option?
A variety of factors determine the price of an option.

The behavior of the underlying stock considerably affects the value of an option. Investors have different opinions about how a particular stock will behave in the future and hence may disagree about the value of any given option.

In addition, the value of an option decreases as its expiration date approaches. Thus, its value is also highly dependent on the amount of time left before the option expires.

Intrinsic & Time Value
An options price is composed of its intrinsic value and time value.

What a particular option contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be, in the money or out-of-the-money at expiration. Intrinsic value is how far an option is 'in-the-money.' Thus, the phrase is an adjective used to describe an option with an intrinsic value. A call option is in- the-money if the spot price is above the strike price. A put option is in the money if the spot price is below the strike price.

It is calculated by subtracting the options strike price from the spot price. An out-of-the-money option has an intrinsic value of zero.

For example if XYZ is trading at Rs 58 and the June 55 call is trading at Rs 4, to calculate the intrinsic value subtract Rs 55 from 58, leaving you with Rs 3 of intrinsic value. The remaining Rs 1 is known as extrinsic or time value.

Time value is the amount over intrinsic value that a buyer pays for the option. While buying time value, an options purchaser assumes that the option will increase in value before it expires. As the option nears expiration, its time value starts decreasing toward zero.
Theoretical Value
Theoretical value is the objective value of an option. It shows how much time-value is left in an option. The most commonly used formula to calculate the theoretical value of an option is known as the Black-Scholes model.
This model considers the price of the stock, the options strike price, the time remaining before expiration, the volatility of the underlying stock, the stock's dividends and the current interest rate while arriving at the theoretical value of the option.
Although an option may trade for more or less than its theoretical value, the market views the theoretical value as the objective standard of an option's value. This makes the price of all options tilt toward their theoretical value over time.

The Components of Theoretical Value
The volatility of the underlying stock is one of the key factors in determining the value of an option. Often, the options price increases as the volatility of the stock increases. The difficulty in predicting the behavior of a volatile stock permits the option seller to command a higher price for the additional risk.
There are two types of volatility, historical and implied. As the term suggests, historical volatility is a measurement of the stocks movement based on its past behavior.
By contrast, implied volatility is calculated using option prices. It is a measurement of the stocks movement as implied by how the market is currently valuing options.
As an owner of a call option you can always exercise your right to the stock and receive any dividend it might pay.
Interest Rate
If you buy an option rather than a stock, you invest less money upfront.
Days Until Expiration
An option, being a wasted asset; wastes a little as each day lapses. Thus its value is calculated in accordance to the amount of days left in its life.

What are swaptions?
A swaption is an option on an interest rate swap. Swaptions are options contracts, which give you the right to enter into a swap agreement at the option expiration, in return for a one-off premium payment.
What is meant by Covered Call, Covered Put, In the Money, Out Of the Money, At the Money?Ø In-the-money
A call option is in the money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.
Ø Out of the money
A call option is out-of-the-money if the price of the underlying instrument is lower than the exercise/strike price. A put option is out-of-the-money if the price of the underlying instrument is above the exercise/strike price.
Ø At-the-money
At the money is a condition in which the strike price of an option is equal to (or nearly equal to) the market price of the underlying security.
Ø Covered Call
You can take a covered call if you take a long position in an asset combined with a short position in a call option on the same underlying asset.
Ø Covered Put
The selling of a put option while being short for an equivalent amount in the underlying security.
What are the uses of Derivatives? What are the various derivative strategies that I can use?Derivatives have a multitude of uses namely:
a) Hedging
b) Speculation &
c) Arbitrage

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