Futures and Options Part 2

The last post was all about the basics about the class of derivatives called Futures, in a way in which I understood it. I hope folks who read this also understood it to a great extent.


Taking a futures contract is like making an obligation. As the name suggests, Options gives you options.
There are 2 types of Options, Call Options and Put Options. I'll talk about them one by one. 

First lets talk about Call Options.

This is a derivative contract that's highly traded in bullish times.
Say on the first of April, I find that TCS has corrected a lot to Rs.1080, and I find this a good price to buy it. With Options you can choose to buy a stock at preset values known as Strike Prices. For TCS, the strikes are defined at every 50 rupee interval. So you have strike prices at Rs.1000,Rs.1050, Rs.1100 and so on.

The lot size for TCS is 250, as the notional value would then be Rs.1100 * 250 = Rs.275000, which is greater than the minimum Rs.2 lakh notional value required by NSE.

I check that the liquidity in 1050 Call Option is not that great. So I decide to buy a Call Option for 1100 Strike Price. For this I am required to pay a premium of Rs.30 per share(just an illustration). As a result, I pay a total of Rs.7500 as premium. I buy this call option from a trader working for Morgan FIT, through the NSE. In the real world, since this happens through the exchange, I don't know who has sold me the option.A person who sells an Option contract is known as a Options writer.
 
By buying this Call option, I now have the right, but not the obligation to buy 1 lot of TCS shares by the end of April.

So how's money made in this?
Say now, TCS starts to rally hard and touches Rs.1200 within a few days. Theoretically, for every rupee increase in TCS's share price above 1130(accounting for the premium that I paid initially), the value of the contract increases by 1 rupee. There's a time value also associated with it. A complex differential equation developed using Black Scholes method governs this, so we can conveniently ignore it, for we don't make money by solving it.

So the value of the contract now stands at Rs.110 or so. Rs.70 being contributed by TCS's share price and Rs.40 contributed by the time value.
Now, in order to realize the profits, I have three options.
1. I can now sell this contract to someone else at Rs.110 and make a decent profit of Rs.80 per share, which comes to Rs.20000.
2. At any time, I can also choose to exercise my Option. But this is a bit of a risk, as now all Stock Options are settled European style. Which means that even if I exercise my option on the 5th of the month, the contract will only be settled at the closing price on the day of F&O expiry.
So, if I exercise my option on 5th and on the day of F&O expiry TCS falls down to anything under Rs.1100, I lose the entire premium that I had initially paid.
3. I can also wait till F&O expiry day. I get to earn the difference between the closing price of TCS and the Strike Price. Say, if it closes at 1200, then I get to earn Rs.70 per share. Note that at the end of the month the contract has lost all its time value.
That's the reason why most traders choose to make money through option 1.


As of now, all Options are settled in cash, which means that on expiry day I don't get possession of 250 shares for which I would have to arrange Rs.275000. Instead, I get the difference between the Strike Price and the closing price. If TCS closes below Rs.1100 I lose just the premium that I initially paid. Buying Options is a limited loss unlimited gains strategy.

The buyer of a Call Option has the right but not the obligation to buy the underlying security. But on the other hand, the seller of a Call option(i.e. Call Writer) has the obligation to sell the underlying asset at the Strike Price.
So, now the question is, how does the Call Writer make money in this. Well, large institutions try to hedge a part of their large stock holdings by selling Call Options. For example, they would have bought some 200000 shares of TCS at Rs.1050 and they would want to have an insurance to sell some 20000 of them at Rs.1100.


There are many other traders, even large institutions who sell Calls with a slightly ulterior motive as well. They see that Rs.1100 is a key resistance for TCS. So, the moment TCS approaches Rs.1100 there is a good supply of stock and the price drastically falls below the strike price. At the end of the month, TCS is still below Rs.1100 and the seller of the Call smartly pockets the premium.

Its my sincere suggestion for all the followers of my blog to stick to buying calls and puts, and leave the selling of options to large traders, and institutional traders who have all the resources to make the market in the direction that they want.

Now coming to Put Options.

This is a derivative contract that's traded heavily in bearish times. And just like Call Options, they are used both for hedging as well as speculative trading.

Say, the market has rallied nicely for 6 months now, and ICICI bank has been one of the major contributors to it. And I happened to have 250 shares of it, which I bought at Rs.800 or so, at the beginning of the bull run. Currently, its trading at Rs.1060 and I have strange feeling that it might fall badly, maybe well below Rs.900. So I decide to hedge it, by buying a Put Option at Strike Price of 1000, paying a premium of Rs.20 per share, that comes to Rs.5000.
So theoretically, for every rupee fall of ICICI below Rs.980, the value of my contract increases by 1 rupee. My hunch was right and ICICI bank falls to Rs.890 in a few days' time. In the normal case, I would have panicked looking at such a fall. But now that I have the insurance by way of this Put Option, I don't  need to worry at all.
The value of my Put contract would have reached Rs.120 or so now. In this case too, I can choose 1 of the 3 options similar to what I had in the Call options scenario. I make a decent amount of Rs.100 per share, that comes to Rs.20000. Now,I can use this money to buy some more shares of ICICI and also keep the shares of ICICI for myself.

If ICICI didn't close below Rs.1000 this month, then all I lose is the premium amount, which is not much when compared to the initial investment that I made in ICICI.

I could use Put Options purely as a speculative instrument too. As I don't have to really own the shares of ICICI at any point of time, and still buy a Put Contract.

Till now I have spoken mostly about Stock Options. There is a class of options called Index Options, where you can speculate on the different indices. The mostly heavily traded amongst all options are the Nifty Call and Put Options.

In this case, the Strike Prices are defined at 100 point interval, and the lot size fixed at 50.Its like having an option to buy or sell 50 shares of Nifty itself. If you multiply the current price of Nifty with the lot size, you will see that notional value is also greater than Rs.2 lakhs.

Nifty call Options is mostly a speculative instrument. But on the other hand, Nifty Put Options are both speculative and a hedging instrument.

Say, you have a fairly well diversified portfolio of stocks with a greater allocation to index stocks. You figure that the situation is going to get bearish. All you need to do, is buy a number of lots of Nifty Put Options at an affordable price and a likely Strike Price below which Nifty might fall to.
Say if your portfolio is worth Rs.10 lakhs, roughly you need to buy 3 lots of Nifty Put Options. Say today Nifty closed at 5908, and you see that the nearest support is at 5600. So you can take Put Option for 5800 Strike Price at the prevailing market price.

By the end of the month, if Nifty tanks to below 5600, then the value of your contract would have increased to an extent that it nearly offsets the losses that you would have possibly seen due to the fall in your portfolio. On the other hand if Nifty rallies, then all you lose is the premium. Its just like taking a vehicle insurance, isn't it?
This is the reason that bigtime traders and institutions never lose much money, even in the worst of bearish times.


This was about my understanding of Options. There's a lot more to all this. In fact you can even predict in which direction the markets might move, the possible supports and resistances by just looking at the Options charts. Maybe, in some other post. And maybe only if there's public demand to it.

Happy Trading !

Futures and Options (Part 1)

   This post is for some of the followers of my blog, who may want to trade in Futures and Options, but don't have much idea about it. The big problem that I faced that there's a lot of information in the internet, but not all of it in one place.


So here are some of the basics about Futures and Options trading.



Both of them are derivatives. As in, they are instruments which can be used to negotiate the price or value of an underlying stock(say L&T,TCS) or index(say Nifty,Bank Nifty).

And this is primarily a trading and hedging tool. I shall tell more about hedging a bit later.

Futures trading :


Say on the 1st of March, I find that the share price of L&T is quoting at Rs.1600. I figure, that this is a good price to buy 1 lot of L&T. But I don't have all the money needed to buy 1 lot(125 shares of L&T).

Lot sizes are defined by the exchanges(NSE, BSE). As a standard, the value of a derivatives contract as stipulated by the exchanges is Rs.2 lakhs or thereabouts.
So if you calculate, I'd need Rs.2 lakhs to take 1 lot of L&T.

So I decide to take a Futures contract, by putting an upfront guarantee money. The guarantee money is defined for the stock by the broker(ICICIDirect, Kotak, HDFC Securities) based on its stock category and traded volumes (and many other factors which we will ignore for now).

My broker decides that I need to put 1/6th of the contract value as guarantee money for L&T. So I need to initially roughly set aside Rs. 33333 for this trade. This is known as initial margin.

On the other side, there might be a trader Chaman Patel who believes that Rs. 1600 is already a very high price for the L&T and he believes that by the end of the month it might fall further. So he decides to sell me the 1 lot of L&T at Rs.1600.

So a formal agreement is entered between me and Chaman Patel, all happening through the NSE, and facilitated by the broker. This is just an example, as in real life I don't know the true identity of the seller on the other side, as the NSE comes in between.

Bear in mind, a Futures contract is an obligation. I am obligated to buy 1 lot of L&T and Chaman Patel is obligated to sell that lot to me on the settlement date. In NSE, the settlement(also called F&O expiry day) date happens to be the last Thursday of the month, of course considering that its not an exchange holiday on that day.

So how is money made in this?
As told earlier, I enter a Futures contract to buy 1 lot of L&T at Rs. 1600 with March 31 as settlement date.Usually there is a slight difference between the Futures price and the stock price, a premium or discount based on the prevailing market conditions.

Say, on the 2nd, L&T rallies by 2% or 32 rupees. Due to this, the value of my contract also increases, because I already have Chaman Patel who has committed to selling me 1 lot Rs.1600 even though the market price is Rs.1632.
Theoretically, I can buy these shares at Rs.1600 from Chaman bhai and sell in the open market at Rs.1632.
So my broker credits Rs.32 * 125 = Rs 4000 into my  trading account.
On the other side, Chaman Patel's broker debits Rs. 4000 from his trading account.

Say, on the 3rd, L&T falls by 1% or 16 rupees. Due to this, the value of my contract decreases by 1%(roughly).
Now my broker debits Rs.2000 from my account, and similarly credits Rs. 2000 into Chaman bhai's account.

This whole thing keeps going in a while() loop as long as the contract is open, at most till the expiry day of the contract.

Say on the 7th, the price of L&T has reached Rs.1760, a nice rally of 10%. I figure that this is the maximum that L&T might go. I decide to close my contract with Chaman bhai by placing an offsetting sell order.

In other words, I exit this trade by selling my contract to some other trader through the NSE. Only now I sell this contract at a notional value of 125*Rs.1760.

So in effect,  I made a cool profit of 125*( 1760 - 1600) which comes to Rs.20000.

In the whole story till now  no shares were actually bought, or sold. And its not even necessary that Chaman bhai actually has these shares, should I choose to keep my contract open till final settlement day.

But, for some reason I keep this contract open till the end of the month. On expiry day, the futures price and the stock price converge. And on that day L&T closes at Rs.1650, and my contract is settled at this price.

My net profit in that case will be just 50*125 = Rs.6250. Even now, no shares are actually bought or sold.

How is money lost in this?
Look at the case of Chaman bhai. He entered into a contract to sell L&T at Rs.1600. On the day of final settlement, he ends up  losing 50*125 = Rs.6250. That's assuming that he has still not closed his contract till then.He could have also chosen to close his contract at any point of time before the expiry day, by taking an offset buy order on his contract.

Why is this risky?
A lot of traders go bankrupt in trying to make money quickly in futures. Due to the leveraging aspect coming in here, money is also lost pretty quickly in futures.

If my analysis of the market and the stock itself is wrong, and there is a major selloff and L&T falls by 10%, then  I make a loss of 160*125 = Rs.20000.  I could also be a subject of margin calls.

What is a margin call?
If you remember, I initially had blocked Rs.33333 as margin money with my broker . If L&T stock falls by  a lot very quickly, then my broker will want me to bring more money as margin, failing which he can choose to sell my contract.By this, he can limit any further losses and also initiate procedures to recover the losses from me.

Not all traders keep cash for margin(guarantee). They keep stocks as collateral with the broker. In case the trader is unable to meet the margin requirements, the broker starts to sell these shares kept as collateral and recover the losses. If this happens on a large scale with thousands of traders facing margin calls, something that's seen during times of major selloffs, then margin calls will add considerably to the selling pressure in the markets, and bring it down very quickly.

Futures hedging:
Say, in 2006 you bought some 125 shares of L&T at Rs.500 as long term investment, maybe with a 5 year perspective in mind. So far its been a good investment where you are seeing decent profit on the money that you put in.

But you figure that markets are entering into a short term correction, or maybe even a bear market, and you want to mitigate your risk.

So you decide to enter into a futures contract to sell 1 lot(125 shares) of L&T at the prevailing market price i.e. Rs.1600. In this case, you can choose to keep your L&T shares as margin.


Your guess is right and L&T falls by a 10% within a few days. You can choose to close your contract by taking an offsetting buy contract. By this you make a decent profit of Rs.20000.
By this, you achieve a few things. One,  your average price on each share reduces drastically. Two, you have additional money with you, which you can deploy in order to buy more shares of L&T (or any other stocks for that matter). Three, you still have valuable stock with you, which you can confidently keep with you for more years to come.

Large financial institutions, especially the FIIs employ hedging extensively in order to mitigate risks. But they use options more that futures to do this.

What are options?
Well , that's going to be another post, as this one has been a very long one. That shall be posted shortly.