Introduction to Derivatives - Futures & Options

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Introduction to Derivatives - Futures & Options

A derivative is a financial product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset.

Derivatives have been in use for centuries in various commodities markets. Across the world and in India, the turnover of the derivatives segment is several times that of the equity/ cash segment.

In the context of the Indian stock market, there are two types of derivatives:

-Futures
-Options

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Introduction to Futures

A futures contract is a derivative product whose value depends on the underlying stock or index. Futures transactions are traded on a payment of a margin.

EXAMPLE: Anuj buys a futures contract of Infosys. If the price of Infosys rises by Rs 1000, Anuj makes a profit of Rs.1,000/- on the futures. But if the price of Infosys falls by Rs 1000, Ram makes a loss of Rs.1,000/- on the futures.

Dealing in futures is exactly like dealing in stocks except for some key differences:

-Futures contracts have an expiry period of 1,2 or 3 months (stocks can be held forever)
-Futures contracts require payment of a margin (stocks require 100% payment)
-Futures contracts are cash settled (stocks involve transfer to/ from demat accounts)
-You can take long and short positions in futures (in stocks you cannot go short)

Nifty / Index futures
Index futures are futures contracts where the underlying is the stock index (Nifty). By trading in Nifty futures, you are basically taking a bet on the direction of the market.

You can earn money whether the markets are bullish or bearish. If you expect the NSE index to rise, you should buy Nifty futures. If you expect the NSE index to fall, you should sell Nifty futures.

Duration: In India, futures contracts (stock/ index) are available for 1, 2 and 3 months duration. 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.

Margins: Nifty futures are traded on a margin basis (10%-12%) which means your initial investment is vastly reduced. The market lot is 200 which means if you go long on nifty futures @ 2000, your investment is Rs.40,000/- only (10% margin).

Daily mark-to-market: irrespective of whether you close your current position, the NSE will credit the profit/ loss on the futures contract to your account on a daily basis.

Cash settlement: Since futures is a contract and there is no concept of delivery (as in stocks), settlement is always on cash basis. One does not need to have a demat account at all!

Trading in nifty futures: If you expect the nifty to rise, you should buy nifty futures (and vice-versa). A 10 point change in nifty gets you Rs.2,000/- as profits on a base of Rs.40,000/- (assuming purchase price 2000, margins @ 10% and market lot 200).

As futures contracts are leveraged transactions, return on investment is high compared to stocks. Though you can make excellent profits, you can easily lose money as well if you trade against the market.

Day trading in nifty futures: Since nifty futures have excellent liquidity, you can do day trading in these contracts. There are many daytraders who trade only on the nifty and enter and exit positions several times a day.

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Introduction to Options

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.

Options are popular as the buyer has limited investment and potentially unlimited profits.

�Option�, as the word suggests, is a choice given to the investor to either honour the contract; or walk away from the contract.

An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock (equity). In the case of an index option, its value is based on the underlying index (equity).

Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.

To begin, there are two kinds of options: Call Options and Put Options.

Call Option: is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.

When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. 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.

Put Options: are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies.

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.

Example of stock options
Bullish view: Sam is bullish on ABC and purchases a December CALL option at Rs 40 for a premium of Rs 15. That is he has purchased the right to BUY that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Bearish view: Sam is bearish on ABC and purchases a December PUT option at Rs 40 for a premium of Rs 15. That is he has purchased the right to SELL that share for Rs 40 in December. If the stock falls below Rs 35 (40-15) he will break even and he will start making a profit. Suppose the stock does not fall and instead rises he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Other issues
Premium: is tradeable and can increase or decrease depending upon the price of the underlying. This is described in detail subsequently.

Duration: In India, option contracts (stock, index) are available for 1, 2 and 3 months duration. 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.

Margins: Option buyers do NOT have to pay any margin except for the premium paid to initiate a contract.

Options sellers, however must pay a margin (as the liability is unlimited). The margin here is the futures margin less the premium collected from the buyer of the option.

Cash settlement: Since options is a type of derivatives contract, there is no concept of delivery (as in stocks). Settlement is always on cash basis and one does not need to have a demat account at all!

Trading in options: is extremely profitable provided you know the trend of the market. It is very easy to get returns of 100-200% within 4-5 days. Veteran option players get returns well in excess of 400%.

Options are popular with retail investors as the buyer has limited investment and potentially unlimited profits. For nifty options, the investment amount varies from Rs.2,000/- to Rs.10,000/-. You can also invest Rs.500/- but chances of earning anything here are very slim unless the market is poised to make a major move.

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Option Terminology

Strike or exercise price: denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 10 (nifty). If the index is currently at 1,400, the strike prices available will be 1,380, 1,390, 1,400, 1,410, 1,420. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.

For stocks, strike price intervals vary from Rs.5/- to Rs.20/- depending on the base value of the stock.

In-the-money: A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.

Out-of-the-Money: A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.

At-the-Money: The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money.

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Option Pricing

Recall that options consist of a strike price and premium. The premium is determined by several factors like the price of underlying (security or index), time to expiry, volatility and risk-free interest rate.

Intrinsic value of an option: is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Price of underlying: The premium is affected by the price movements in the underlying instrument.

For Call options � the right to buy the underlying at a fixed strike price � as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium.

For Put options � the right to sell the underlying at a fixed strike price � as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.

Time Value of an Option: Generally, the longer the time remaining until an option�s expiration, the higher its premium will be. This is because the longer an option�s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option�s price remaining the same, the time value portion of an option�s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option�s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Volatility: is the tendency of the underlying security�s market price to fluctuate either up or down. It reflects a price change�s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option�s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Risk-free interest rate: this is not very important and can be ignored.

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Buying options for a living

Options present a good opportunity to earn excellent profits with low investments.

I strongly recommend nifty options as the volatility is the lowest (compared to stock options). This means you pay less premiums as well.

An advantage with nifty (futures or options) is that nifty is either up or down...it rarely spends time consolidating except during corrections. Stocks on the other hand, tend to consolidate for weeks with the result that nothing really happen for a rather long time.

The catch with buying options
While retail interest is extremely high in nifty options, not many people actually make money.

The reason is simple...many retail investors fail to understand the trend. This means they buy call options when they should actually be buying put options (and vice versa).

Also, retail investors have a poor understanding of option pricing. Coupled with the fact that you must have a long term view of max 30 days, it is easy to see why making money in options is not easy.

Importantly, fear and greed play an interesting role. Most retail investors buy options out of greed (in a strong rally, when premiums shoot up) and sell in panic (when premiums drop faster than they should).

Liquidity too plays an important role. Stock options are generally illiquid so it is very difficult to book profits (or even losses) due to lack of buyers. Nifty options have very good liquidity (compared to stock options).

Of course, professional traders are experts at this game and so rarely ever lose money.

So should you buy options at all?
Only if you are good at technical analysis or have a good idea about trends, corrections and trend reversals. If you have no idea about this, then you should not deal in options...you are certain to lose money.

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Writing options for a living

Option writers are the only people who consistently make money (in bullish or bearish markets) and rarely ever lose!

Option writing is a profitable and interesting concept. It is interesting because the profits are limited but investments are high (margin against possible losses).

So why would anyone in his senses write options?

Recall that for option buyers, if the targeted price is not achieved within a certain number of days, he has lost money. So the option buyer needs to be sure of the trend so that he can make money. Also recall that towards expiry, the premium will progressively reduce to zero if there is no change in the value of the underlying...this is because of the time-decay factor in option premiums.

It is the premium component (time decay factor) which excites option writers. The income is fixed but certain if you are smart enough to do some clever hedging.

In reality, option writers rarely ever lose money.

Investment required
The investment is the same as that payable on the futures less the premium component.

Example - for writing a Nifty (call or put) option strike price 2000 with premium say Rs.50/-, the amount required is 2000*200*10% - 50*200 = Rs.30,000/-.

Here, 10% is the margin rate fixed by NSE for nifty derivatives and 200 is the market lot.

In addition, you must reserve the futures sum for hedging purposes.

Slow and steady wins the race
Always. And this is true of the stock markets as well.

While most investors are driven by greed and high profit targets, option writers are satisfied with relatively low returns. They are not interested in 50% gain in a month...in fact they are very happy even if they earn 8% per month. Eventually the option writer wins as this money is assured even if the markets are bullish or bearish.

Should you write options?
Yes. If you are looking at fixed returns irrespective of market direction, then option writing could be for you.

Note that while option buyers are small investors, option writers are extremely clever and smart traders who rarely lose money.

In fact, all over the world including India, option writers are the only people to consistently make money. And this whether the markets are bullish or bearish!

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Open Interest and Derivatives

Open interest is the total number of options and/or futures contracts that are not closed or delivered on a particular day. Open interest is NOT the same thing as volume of options and futures trades.

-On Jan 1, A buys an option, which leaves an open interest and also creates trading volume of 1
-On Jan 2, C and D create trading volume of 5 and there are also 5 more options left open
-On Jan 3, A takes an offsetting position and therefore open interest is reduced by 1, and trading volume is 1
-On Jan 4, E simply replaces C and therefore open interest does not change, trading volume increases by 5.

Open interest, the total number of open contracts on a security, applies primarily to the futures market. It is often used to confirm trends and trend reversals for futures and options contracts.

What Open Interest Tells Us
A contract has both a buyer and a seller, so the two market players combine to make one contract. The open-interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.

Rules of Open Interest

-If prices are rising and open interest is increasing at a rate faster than its average, this is a bullish sign. More participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature
-If the open-interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top
-High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral
-An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway
-A breakout from a trading range will be much stronger if open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move
-Rising prices and a decline in open interest at a rate greater than the seasonal norm is bearish. This market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course, prices will decline
-If prices are declining and the open interest rises more than the seasonal average, this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish
-A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.
-If prices are rising and the volume and open interest are both up, the market is decidedly strong. If the prices are rising and the volume and open interest are both down, the market is weakening. Now, if prices are declining and the volume and open interest are up, the market is weak, but when prices are declining and the volume and open interest are down, the market is gaining strength.

Volume and Open Interest
Used in conjunction with open interest, volume represents the total number of shares or contracts that have changed hands in a one-day trading session in the commodities or options market. The greater the amount of trading during a market session, the higher the trading volume. A new student to technical analysis can easily see that the volume represents a measure of intensity or pressure behind a price trend. The greater the volume the more we can expect the existing trend to continue rather than reverse.

Volume precedes price, which means that the loss of either upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart. The rules that have been set in stone for both volume and open interest are combined because of their similarity; however, having said that, there are always exceptions to the rule, and we should look at them.



So, price action increasing in an uptrend and open interest on the rise are interpreted as new money coming into the market (reflecting new buyers) and is considered bullish. Now, if the price action is rising and the open interest is on the decline, short sellers covering their positions are causing the rally. Money is therefore leaving the marketplace and is considered bearish.

If prices are in a downtrend and open interest is on the rise, chartists know that new money is coming into the market, showing aggressive new short selling. This scenario will prove out a continuation of a downtrend and a bearish condition. Lastly, if the total open interest is falling off and prices are declining, the price decline is being caused by disgruntled long position holders being forced to liquidate their positions. Technicians view this scenario as a strong position technically because the downtrend will end as all the sellers have sold their positions. The following chart therefore emerges: