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Jan 24, 2013, 08.38 PM IST | Source: Moneycontrol.com

Basics of Futures and Options

We have understood Derivatives and their market landscape. We met the key players therein. Now let us introduce ourselves to the instruments that give Derivatives their flexibility and make them lucrative for traders.

Sahaj Agrawal

AVP- Derivatives, Kotak Securities

Expertise : F&O

More about the Expert...

By Sahaj Agrawal, AVP- Derivatives, Kotak Securities

What are my Futures?

We have understood Derivatives and their market landscape. We met the key players therein. Now let us introduce ourselves to the instruments that give Derivatives their flexibility and make them lucrative for traders.

As we already know, in a Derivative market, we can either deal with Futures or Options contracts. In this chapter, we focus on understanding what do Futures mean and how best to derive the most from trading in them.

A Futures Contract is a legally binding agreement to buy or sell any underlying security at a future date at a pre determined price. The Contract is standardised in terms of quantity, quality, delivery time and place for settlement at a future date (In case of equity/index futures, this would mean the lot size). Both parties entering into such an agreement are obligated to complete the contract at the end of the contract period with the delivery of cash/stock.

Each Futures Contract is traded on a Futures Exchange that acts as an intermediary to minimize the risk of default by either party. The Exchange is also a centralized marketplace for buyers and sellers to participate in Futures Contracts with ease and with access to all market information, price movements and trends. Bids and offers are usually matched electronically on time-price priority and participants remain anonymous to each other. Indian equity derivative exchanges settle contracts on a cash basis.

To avail the benefits and participate in such a contract, traders have to put up an initial deposit of cash in their accounts called as the margin. When the contract is closed, the initial margin is credited with any gains or losses that accrue over the contract period. In addition, should there be changes in the Futures price from the pre agreed price, the difference is also settled daily and the transfer of such differences is monitored by the Exchange which uses the margin money from either party to ensure appropriate daily profit or loss. If the minimum maintenance margin or the lowest amount required is insufficient, then a margin call is made and the concerned party must immediately replenish the shortfall. This process of ensuring daily profit or loss is known as mark to market. However, if and ever a margin call is made, funds have to be delivered immediately as not doing so could result in the liquidation of your position by the Exchange or Broker to recover any losses that may have been incurred.
When the delivery date is due, the amount finally exchanged would hence, be the spot differential in value and not the contract price as every gain and loss till the due date has been accounted for and appropriated accordingly.

For example, on one hand we have A, who holds equity of XYZ Company, currently trading at Rs 100. A expects the price go down to Rs 90. This ten-rupee differential could result in reduction of investment value.

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