Note: This example is for illustrative purposes only. In reality, the spot prices of shares and their value in the futures market may not rise and fall by the same amount.
By entering a futures contract, the investor benefits from the fact that the current valuation will remain more or less the same, even if there is a fall in the price of the shares. He can also reap some gain on this hedge position if he books profits on the future position if he sees signs of recovery in the share price, i.e. to settle future position in February 2010 and continue with the cash position.
In a nutshell, you can buy 5 times the amount of shares with the same amount of money simply because you have to pay up only 20% (1/5th) of the value of the shares.
Futures are exchange-traded standardized derivative products. It is a contract between two parties to buy or sell an asset at a particular price on a particular date.
Stock futures are contracts with a particular stock being the underlying asset; whereas index futures are contracts which have the index value as the underlying asset.
The future price of any asset should normally be higher than its spot price due to the time value of money, i.e. you need to be compensated for parting with your capital. In theory, the future price is derived by using the formula, F = SerT
F = Future Price
S = Spot Price,
r = rate of interest
e = 2.71828 (continuous daily compounding)
T = Time till expiry (in years)
In reality, however, the price of futures are determined by the market as players take into account various factors such as the price of the underlying, the expected price of the futures as time goes by and so on.
The difference between the future price and spot price of an asset is termed as 'basis'. In normal market conditions, the basis should be positive. A high positive basis is considered as a bullish signal and whereas a negative basis indicates bearish market conditions.
Normally, the futures price is expected to be in line with the future spot price of the underlying asset. However, due to market forces, the futures price may be higher than the expected future spot price. This situation is termed as 'Contango'. The price will gradually decline to the spot price before the maturity date of the contract.
On the other hand, when the futures price is lower than the expected future spot price of the asset, it is referred to as 'Backwardation'. As we approach the maturity date, the price will gradually rise to the spot price. This is explained below.
We have assumed that the expected futures price is ` 100/- at all times. The graph below shows how the prices gradually decline or rise to the spot price in contango and backwardation respectively.
Futures can be bought or sold by merely paying a margin amount, which is specified by the exchange. At any point of time there are futures contracts with three expiry dates being simultaneously traded. Although all three have a duration of 3 months, some are due to mature at the end of the current month, others at the end of the next month and the last lot will mature two months from now (again, at the end of the month). All the open future contracts for the current month are to be settled on the last Thursday of the month. Buyers and sellers in the futures segment are required to comply with the various margin requirements.
Futures transactions on stock exchanges in India are settled in cash on their maturity date. Although the underlying is shares, these are not exchanged on the maturity date, the parties are under obligation to settle the transaction in cash, at the closing price of the share on the expiry date.
When you enter into a futures contract, you need to deposit an initial margin with your broker. Your trading account is then debited or credited on a daily basis. The debit or credit is based on the daily closing price of the underlying till the final settlement of the future contract is made. On settlement date the trade gets settled at the closing price of the futures contract. This value is the closing price of the shares in the cash market multiplied by the lot size.
For instance, you wish to take a long position in Nifty futures for December 2009 at a future price of 5100 with the lot size of 50 on December 24, 2009. Let us assume that the futures contract is closing on December 31st and the initial margin is 20% of the contract size.
You have gained ` 1,000 since you had taken a long position at 5100 whereas the final settlement price was 20 points higher.
When you expect the price of a particular stock to rise, you may buy stock futures. Further, if the overall market is likely to remain bullish in the coming days, one can go for index futures.
Similarly, when the price of a particular stock is expected to fall, futures of such a stock can be sold (short position). Similarly, index futures can be sold (short) when the overall market outlook is bearish.
An option is a contract written between a buyer and a seller, which gives the buyer a right but not an obligation to buy or sell a particular asset at a particular price on or before a specified date.
Put option gives the buyer the right to sell a certain quantity of a particular asset at a specified price (strike price) on or before the expiry date of the contract.
Buyer of a call option can enter into an options contract by paying a premium (at a price determined by market forces) and take a long (bullish) position on a particular asset. If the price of the underlying rises, the buyer can exercise his option to record gains. If the price falls, the loss borne by the buyer is limited to premium paid for entering into an options contract.
Let us consider a situation where you and your friend are bullish on the price of a particular stock since you expect the company to announce its third quarter result on Jan 27, 2010 with a huge upside in profits. On Jan 21, 2010, you decide to invest ` 2 lakh and buy 200 shares at ` 1,000 per share. Your friend on other hand buys a call option of the same strike price, which is quoted at Rs 40 for a lot size of 200 shares and pays ` 8,000 towards premium.
While you will start gaining immediately on increase in share price of the company beyond purchase price of ` 1,000, your friend will profit only once the price crosses ` 1,040 since he has paid premium of ` 40 per share. Now let us look at two scenarios where the company's result is as per expectation and against expectation, assuming both of you close / sell shares on Jan 27, 2010 after results are announced.
To exemplify, suppose you are holding 100 shares of a telecom company ABC Ltd. which are currently trading at ` 400 a share. The company is going to announce its third quarter result which you feel will be disastrous due to overall industry scenario. Since you have invested with a long term view, you don't want to sell your shares and are also not ready to see the value of your portfolio going down due to bad results. You decide to buy a put option with a strike price of ` 400 (same as the current spot price). This is available at a premium of ` 10 per share.
By taking a put option, you have restricted the fall in your portfolio value in both the scenarios by paying small premium amount of ` 1,000.
If you feel that the price of a particular asset will rise in the near future, buy a call option. Put options can be bought, if you hold a bearish view on the asset’s price.
If an investor owns a particular stock and is moderately bearish on the stock price, but does not wish to sell it, he can sell a call option. If there is a sudden, huge rise in stock price, as against his expectations, though he will be losing on the options contract, he can still make money on his cash position. Hence, he is covered against the losses. Entering an option contract, having a cash position simultaneously is therefore a 'covered option'.
When the investor sells an option contract (call or put) without having a corresponding long or short position on the underlying stock, the position is termed as ‘naked option’. For example, an investor selling a call option for a stock without owning the shares of that stock. Under naked option, there is a huge amount of risk involved since this is an unlimited loss and limited gain situation.
Trading in the option segment of the market requires the buyer of the contract to pay a premium to the seller. The buyer then acquires the right to exercise an option to buy or sell within the specified contract tenure. Options are available for the current month, next month and for duration of 3 months. Buyers of the current month options can exercise their right by the last Thursday of the month.
Since options are settled at a future date, in theory the valuation of an option includes the time value of money, volatility impact and general bullish/bearish view on the asset price. Suppose a stock is currently trading at Rs 100 and the call option of stock with strike price of Rs 90 is traded at Rs 14, the the value of the call option is ` 4(Strike price + premium price – current stock price).
The Black-Scholes equation is widely used for the pricing of options. The equation considers various aspects of pricing an option such as continuous compounding, delta (a measure of change in the option price on a change in the price of the underlying) and a measure of volatility.
Call option price = C = SN (d1) – (Xe)-rt N(d2)
Put option price = P = (Xe)-rt N(-d2) – SN(-d1),
S = the price of the underlying stock
X = Strike price
r = continuously compounded risk-free interest rate
t = Time until expiry of the option (in years)
N = Standard normal cumulative distribution function
As per Section 43(5) of the Income Tax Act, 1956, income or losses on derivative transactions, carried out on recognized stock exchanges, can be set off against any other income during the year (except under the head 'salaries'. The income is treated as a business income and is taxable under the prevalent tax rates. In case of losses, if the set-off is not possible, then such losses can be carried forward up to next 8 years and set-off only against income from business and profession.
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