An introduction to Futures and Options

Futures and Options (F&O) is a famous phrase used by TV channels, web sites and in conversation nowadays but many of you many not familiar with the concept. Let me try and explain, in very simple terms.

Firstly, let me confirm what you already know: That you can buy and sell stocks on an exchange, and prices of stocks vary every day, and perhaps every minute. You buy a stock hoping for future appreciation, and sell when you want to exit or book profits.

This is called the “cash” or the “spot” market – that means, when you say “I will buy 100 shares of company X at Rs. 152” on a stock exchange, someone can sell it to you and you will get the shares “on the spot”. (Technically, you’ll get delivery after two days but that is really an administrative lag) You also pay money “on the spot” – that is, you will need to immediately pay the Rs. 15,200 in the example above.

Options Workshop

Futures
Now, let me talk about the futures markets. A future is a derivative contract in which two parties agree to buy or sell something to each other on a particular price at a FUTURE date.

That means delivery is not immediate, it is at a much later date. And payment is also not immediate, it is at a later date. This kind of contract is also called a “forward contract”.

Why do people do this? And how is this different from buying today?

No delivery right now
Futures are for different kinds of requirements. For instance you may not have the money right now to buy, but you believe the price will go up. You just buy a forward contract for a later date, and on that date you buy and IMMEDIATELY sell, so that you will simply pocket the difference (or lose the difference if the stock has lost money).

Short Selling
Secondly, futures can be used to “short sell”. If you want to sell something you should own it first, no? But futures are different – since they are for a later date, you can sell something without owning it, and then buy it later! So if you believe the price of an item is going down, you can SELL a forward contract. Since you don’t have to deliver it right now, the buyer does not care if you already have it or not. On the later date, just buy from the market and give it to the buyer, pocketing (or losing) the difference.

Hedging
Futures are also for “hedging”. Let’s say you are a rice farmer and have 1000 kilos of rice growing in your farm. You can harvest it only three months later but right now the price is very good, nearly Rs. 20 per kilo. But you know that this year, the rains have been kind, so every rice farmer is going to get a good crop. So there will be too much rice in the market, and prices will come down, even as low as Rs. 12 per kilo! What can you do?

You can’t sell the rice right now, because then the buyer will say “show me the rice” and you can’t show him because you can’t harvest it until three more months. But if you don’t sell right now you will lose Rs.8 per kg!

What you can do is SELL a futures contract for 1000 kilos at today’s price for three months later, Rs. 20 per kilo. Then three months later when you harvest if the price has gone down to Rs. 12 per kilo, you sell it in the market for Rs. 12 per kilo and make Rs. 12,000. Then you also have to sell 1000 kilos in your forward contract at Rs. 20, but for that you simply buy from the market at Rs. 12 and give it to the buyer at Rs. 20, making the extra Rs.8 per kilo, totally Rs.8000. Meaning you have made Rs. 20,000 for your 1000 kilos!

You may be thinking: Why doesn’t he simply give the 1000 kilos from his farm to the buyer? Well, the buyer may be in Brazil! Market traders for commodities like Rice can be anywhere in the world, therefore when you enter into a futures contract on an exchange, you need not terminate it with delivery. (in India, in most cases, you can’t even if you want to). You buy and sell on the very same exchange on the “SPOT” price on the date of delivery. Meaning, if you SOLD a futures contract, then on the future date the exchange will assume that you will buy at market price (spot price) and give you the difference between your future contract price (selling price) and the spot price (buying price).

The Underlying
In the example above, what was bought/sold in the future was “RICE”. This is the “underlying” commodity being traded in the futures contract. Rice is also traded in the “spot” market – which can be your local kirana store, or a wholesale APMC yard or a commodity exchange (meaning, you pay and you get your goods right now). The “underlying” can be anything – a commodity like rice, a set of company shares, an index value, foreign currency etc.

Exchanges
Okay what if I tell you that I will buy rice at Rs.20 and the price falls to Rs. 12? I can then run away and hide in a corner, and break my promise, because I stand to lose Rs. 8. This is where exchanges come in.

Exchanges ensure that your contract is executed. They “assure” your contract. So if I run away, the exchange will still make sure you get your profits. They will chase me for the losses. (In fact a futures contract must be traded on the exchange. If it’s not, then it’s just a “forward” contract)

Contract Values and Margin
In order to make sure that I don’t run away from them, exchanges ask for a “margin” – a certain portion of the contract value as a “deposit” until the contracted date. In India this is between 12 to 50% of the contract value for shares; so if you buy a future for buying 100 Infosys shares at Rs. 2200, the contract value is Rs. 220,000. The margin can be 20% (dictated by your broker or the exchange) so the margin will be Rs. 44,000. You are required to pay the margin on the day you buy or sell the futures contract. On the contracted date (in the future), you will get back your margin plus your profit (or minus your loss).

Mark to market
Let us assume I bought a forward contract (100 shares of INFY at current future price of Rs. 2200 per share, on January 27, 2007) paying a margin of Rs. 44,000. Now suddenly if there is a crash and the price of INFY in the spot market dipped to Rs. 1700? Essentially I have lost Rs. 500 per share – which, for 100 shares, is Rs. 50,000! This is greater than my margin of Rs. 44,000 so the broker or exchange may still think I can run away and they will be left to cover the loss. So they can make a “Marked to market” margin call, meaning that they will ask me to provide the extra Rs. 6,000 as an additional margin (and maybe another 20,000 to cover a FURTHER fall in prices, that they can do).

Usually mark-to-market means the difference between the spot price and the agreed future price – this can be positive (“Mark-to-market profit”) or negative (“MTM Loss”). Futures are actively traded in the market, and the price of the future is not decided by you – so once you have bought the future, you can SELL the contract to someone else. Let’s say the the contract I bought at Rs. 2,200 is now trading at Rs. 2,300 instead. I can sell the contract itself, and I make the Rs. 100 as profit per share – for 100 shares, it’s a Rs. 10,000 profit. The exchange will also give me my margin back, and take a margin from the new owner of the contract.

Square off
On the agreed date of the contract, the exchange will “square off” all contracts. Meaning, all buyers and sellers will be paid back their margin including any marked to market profits or minus any losses as of that date. To avoid arbitrary dates, stock exchanges in India have only three open (purchaseable) future contract dates – the last thursday of the current month, the last thursday of next month and the last thursday of the month after that. These are called near month, month+1, month+2. The square off happens at the end of that Thursday.

Options
Futures are pre-agreed contracts and the buyer MUST sell and the seller MUST purchase. They have no choice in the matter at all, once they sign the contract the contract has to be marked to market every day, they have to pay the margin and they have to square off. That means both the buyer and the seller has an OBLIGATION to square off the deal.

Now futures dealers are also quite smart – they want to make profits but they want to reduce their losses. So there is a concept of “options” – a kind of derivative contract which is slightly different.

The buyer of an Option has the RIGHT, but not the obligation to exercise the contract. What does this mean? Let’s say I think the Infosys share will go up next month, but I am not sure.

Instead of buying a future, I can buy a “CALL” option, which is a “right to buy” at a later date. If on that date the contract is favourable to me (meaning the spot price of INFY is higher) I will purchase it and square off, resulting in a profit to me.

If the spot price is lower than my call option price, I will “ditch” the contract, and not exercise it…meaning I have no losses.

But then the person selling it to me must be really stupid. Because if the price is higher, he has the OBLIGATION to sell it to me and make a loss, but if the price is lower I don’t exercise the option and he does not make a profit. So why would he do it? He charges me a “premium” which is the amount I pay to buy the option. It may be very cheap; about Rs. 20 per share, but that is the money for his trouble that he gets to keep in case I decide not to exercise the option. If I decide to exercise, he still keeps the margin, but pays the mark-to-market loss.

Calls and puts
The right to BUY an underlying stock at a certain price is known as a call option. The right to SELL an underlying stock at a certain prices is a PUT option.

It is quite confusing. You can buy a call option, and you can buy a put option. You have to associate the phrase “call” with “right to buy” and “put” with “right to sell”. (If you are really confused, repeat this mantra 108 times:

  CALL is the right to purchase
  PUT is the right to sell

)

Strike price

Now futures are traded like shares – so the price of the future is readily available in the market, and goes up and down every day. But an option is slightly different, because it is a right and not an obligation. You buy a future in the futures market, based on who is willing to pay how much for a future.

But an option is always at a pre-agreed price. In stock exchanges for stocks and indices, the exchange allows different strike prices, usually Rs. 10 between each other, and a new list of tradeable strike prices is released everyday. These will usually be a few priecs above the current market price, and a few prices below.

Example: If Infosys is trading at Rs. 2172 today, the exchange may allow strike prices of Rs. 2150, 2160, 2170, 2180, 2190 and 2200. If the price goes up to 2200 the exchange may open up NEW strike prices of 2210, 2220 and 2230 (the other ones are still available of course).

Writers
If you buy a CALL option then you buy the right to purchase something. But who sells it to you? This other person does not have the RIGHT to sell it to you, she has the OBLIGATION of selling it to you if you want it. This person is called a writer. You can buy an option, but you can also WRITE an option (meaning you are now obligated to sell it).

If you write an option you will receive the premium that the buyer will pay. (Minus any brokerage and taxes).

Writers have a problem: They have limited profits (the margin they receive, when the strike price is not profitable for the buyer) but unlimited risk of loss when the strike price is profitable. That means for a call option, if the spot price is below the strike price, the buyer will not exercise the option, therefore you only get the premium. If the spot price is above, buyer will exercise and you pay the difference (but keep the margin).

Let’s say you buy a CALL option of 100 INFY shares from me (Rs. 2200 strike price, Jan 07, Rs.20 premium per share). You pay me Rs. 2000 (Rs. 20 x 100 shares) as premium. If the price goes to Rs. 2,300 you will exercise the option and I will have to pay the Rs. 100 difference per share, totally Rs. 10,000. My loss is Rs. 8,000 because I got the 2,000 premium.

If the price goes down to Rs. 2,100, you will not exercise the option, and I will get only Rs. 2,000, which was the premium.

Why do I write options? Because most options go unexercised! Meaning, I can write an option today and it is quite likely that the market price will not be within the premium so I won’t have to lose money! And after all, I can write a CALL option and BUY a future at the same time, ensuring that I make profits in the difference. (This is also hedging)

In the money, out of the money
If a call option strike price is below the spot price, it is “in the money”. Meaning, if INFY price is Rs. 2200 and I have bought a call option for Rs. 2100, I am making profits, so the option is “in the money”.

The reverse is “out of the money” or “OTM”. Meaning, if I buy a call option for a strike price of 2100 but the current price is Rs. 2000, then I am not making profits right now, so the option is OTM. Writers usually like to make OTM contracts so that they are not immediately exposed to loss. (In the money options usually trade for a big premium, so big that when you consider the premium, you are making losses!)

Conclusion
This has been a long post and I am also tired, so I will stop here. Please post your questions and I will try and sort out any other things I may not have mentioned, or that are not very clear. Thanks for reading!

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