Futures and Options : Futures and Options An Introduction
Deepak Shenoy
About this session : About this session Assumptions
Futures
How futures work in India – on the NSE
Futures margining
Lot sizes, “Instruments”
Transactions: Buying and selling futures
Options
Right/Obligation, Put/Call
Option Pricing (Black/Scholes)
Long options – no margin, only premium
Short options – margined, premium is yours
Margin set offs
How to trade them on the NSE
Liquidity
How we will do things : How we will do things First part of Session for 45 minutes
Q&A
Second part for 45 minutes
Q&A
Type in your questions during the Q&A
I can’t hear you, you can hear me
If I leave questions unanswered I will respond on the blog
Assumptions : Assumptions You have some idea about the stock market
You have bought/sold shares before
You have a brokerage account
What is not in this session : What is not in this session Option strategies
Nothing on covered calls, strangles, straddles etc.
No “tips”
Nothing advanced on Black Scholes, Implied Volatility, or Smiles
Futures : Futures Cash settlement
Future settlement
Eg. Shopping with cash versus credit card
Farmer example
Buy rice at Rs. 10 to be delivered in May
Buy 100 quintals (100,000 kg)
“Contract” size: 10 lakh
Pay only 1 lakh as “margin” till May
Some history : Some history Commodities
People knew that supply would come later, but wanted to lock prices today
Buyers wanted today’s prices to protect from demand spikes
Sellers wanted to lock today’s price to protect from oversupply/price destructions
On the “expiry” date, the buyer would be given the commodity = physical “delivery”
Seller was given full cash on expiry date
Exists for a VERY VERY long time
Settlement methods : Settlement methods “Delivery”
Buyer takes possession of the goods
Cash
difference between the cash market price and the future price
Futures in India : Futures in India Futures exists in various forms
Commodities (MCX, NCDEX)
Interest rate futures (NSE)
Stock and Index Futures (NSE)
NSE Stock/Index Futures
1 month, 2 month and 3 month contracts
Near, Mid and Far month
Settlement : Settlement Trading settlement on NSE
Cash: Rolling
Futures – settled once a month on NSE
Expiry Date in India
Last Thursday of month
If holiday, like Dec 25 is, then previous day
In unexpected circumstances, may be moved to next day
Cash settled, daily marked to market
you don’t have to provide “delivery” of stock if you sell a future
Differential of cash price and stock is charged to you (or paid to you) daily
Futures prices are DIFFERENT from underlying
Cost of carry
Lot Size : Lot Size Futures don’t trade in quantities of 1
A minimum lot size is used
Nifty futures = 50 Nifty
Reliance futures = 75 reliance shares
For each stock futures have different lot sizes
Listed on the NSE web site
Not all stocks have futures
And not all futures that exist are liquid!
Margin : Margin To buy or sell a future NSE requires a margin
A percentage of each contract size (lot size x price per share)
The actual margin per contract will change every day, calculated by NSE
Broker will take this margin money from you
Around 15-30% for index futures and 25-60% for stock futures
Eg. Two lots i.e. 100 Nifty at 3000 price, is a contract size of 3 lakhs. Margin will be between 40K to 1L (depending on broker, volatility)
Let us trade an example : Let us trade an example Buy two lots of Reliance Future (December) on December 1, 2008
Test order screen : Test order screen Underlying has a unique code
Choose “Futures” and Contract Expiry Date
Qty – multiples of 75
Limit order (buy at 1106 or lesser)
Marked to Market: Futures : Marked to Market: Futures At the end of each day, you are expected to pay or receive a mark to market price from/to your account
Difference of last price and current price
If price rose today and you are long a future
You receive money (credit)
If price fell today and you are long
You have to pay out the difference (debit)
Reverse if you are short
Online brokerages deduct this automatically
Offline route, you may have to pay a cheque
Marking to market: Example : Marking to market: Example Let’s assume a 50% margin
On day 1 you will have 1106x150 x 50% taken from you as margin
Rs. 82,950
Dec 1: RIL future closed at 1106
Dec 2: RIL future closed at 1075
So Rs. 31 loss is taken from you as Marked to market loss
For 150 RIL this is Rs. 4650 that you have to pay
Dec 3: RIL future closed at 1071
What happens?
Covering your future : Covering your future December 4: RIL reaches 1150
You “square off” your order.
you have already paid out mark-to-market margin upto 1071.
you will get back 1150-1071 = Rs. 79 as profit (along with your initial margin)
That’s a credit for Dec 4 of 11,850, plus the initial margin of 82,950
Your real profit is (1150 – 1106) per share, 150 shares
Rs. 6600
Investment = Rs. 90000 (approx)
RISK!
Shorting a future : Shorting a future If you believe RIL will go down in price, you can choose to “Sell” instead of buy
That will create an open “sell” position for you
Waiting for settlement : Waiting for settlement At the end of expiry day all futures are “automatically” settled
Price is assumed to be closing price of the underlying stock (in this case, RIL)
If RIL closes at
1200 –net profit, over all days added up will be (1200-1106)
1100 –net payout of Rs. 6
marked to market every day
Open Interest : Open Interest Each buy/sell pair is a contract
Someone buys, someone else sells
Total number of open contracts x lot size = Open interest
Open interest has limits
cannot exceed the number of shares that the company has
NSE announces if certain stocks reach close to this limit
Questions? : Questions?
Options : Options Instead of unlimited risk and unlimited reward, what if one limited the risk
I want to
buy RIL at 1100,
but not lose much if it is below that on expiry
my loss is limited, profit is unlimited
Options allow this – I can buy a reliance CALL option at “Strike Price” 1100.
Option types : Option types Call = right to buy
Put = right to sell
Options: (RIL 1100 call) : Options: (RIL 1100 call) Why will someone sell me this option?
I pay premium, per share. Eg. Rs. 40 per share
I don’t get back the premium even if Reliance goes to 2000
My break even point is Rs. 1140.
If you buy options you pay premium, but no margin
You can also Short-sell options
You have an obligation, not a right
Similar to a future, except you get premium that need not be returned
Margin requirements apply like futures, and are marked to market every day
Screenshot : Screenshot
Option Pricing : Option Pricing How do you know what premium is cheap or expensive?
Mathematical models that provide a reference price
“Black-Scholes” model commonly used
Based on (mostly)
Time To Expiry
Price of Underlying
Risk-Free Interest rate
“Volatility”
Not covered in this session
Options : Options Options have an effective price = the breakeven price
Nifty 2800 call with premium Rs. 150 has an effective price of 2950
Nifty 2700 put with premium Rs. 100 has an effective price of 2600
Payoff Diagram: 2700 put (100) : Payoff Diagram: 2700 put (100) Premium: 100, Lot size: 100
ITM/OTM : ITM/OTM “In The Money” (ITM) options
where the underlying’s value is GREATER than Strike price (for calls)
LESSER than Strike Price (for puts)
All other options are “Out of the money” (OTM)
Where strike price is close to current market price, option is “At the money”
Squaring off options : Squaring off options If you buy an option, I have to pay the full premium upfront
No margins apply, I can sell anytime on the exchange
“Exercise” – give me the option’s value
Current price – Strike Price for calls
Strike Price – Current Price for puts
Exercise only works if your option is In the Money
Exercise : Exercise Two types of options
European
Can only exercise at expiry (NIFTY)
American
Can exercise on any working day (stock options)
Only ITM options can be exercised
Brokerages have either online forms or can do it for you at their terminals
All options are
Auto exercised (for ITM options) by exchange
Cash settled
Liquidity : Liquidity Nifty options have maximum liquidity
European only
Apart from near months there are LEAPS
Available till 2011
Stock options are illiquid
Only few stocks have reasonably liquid options (Reliance etc.)
Where you are LONG an option you can choose to exercise if you cant find a buyer on the exchange
Risk and Leverage : Risk and Leverage Since you don’t pay 100% margin, F&O provide leverage
Eg. You pay 50K for a 100k contract,
If there is a 1% move, you make 1K,
which is, for you a 2% return on the margin of 50K
Leverage comes with risk
If there is a 1% move against you you lose 2%.
Don’t do F&O unless you have about 5 lakhs in your portfolio
Hedging : Hedging You can use F&O to reduce risk
Own stock, buy a put – you are covered on the downside (“Insurance”)
Own stock, Sell a call (“Covered call”) – earn some income and partial protection
Own stock, sell index future – hedge that locks in a profit/loss.
More advanced details in another session
Tell me if you are interested
Questions : Questions Links
http://delicious.com/shenoyatwork/BasicFOTutorial