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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.

January 24, 2013 / 08:38 PM IST

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.



On the other hand, we have B, who has been tracking the performance of XYZ Company and given his intuition and expertise, feels that the stock price could increase to Rs 130 in the next three months. He wishes to buy the stock at a lower price now to sell later when the price increases in the future, thereby making a quick profit in the bargain. However, he can only pay a nominal sum now and arrange for the necessary funds to buy the stock in three months.

Now, A and B submit their orders to the Exchange to enter into a futures contract with a maturity period of three months (this is the maximum available time limit on the Exchange for the Futures segment). Once the orders are matched and traded, both traders hold their desired Futures positions as decided, so now A would hold a short position against his holdings. Thus if the stock price fell below Rs 100, A would not lose the value of his holdings as he remains hedged against the lowering of price.

In the above example A would be the seller of the contract while B would be the buyer. A’s market position hence would be short (sell) while B would go long (buy). This thus reflects the expectations that each party has from the Futures Contract they have participated in - B hopes that the asset price is going to increase, while A expects that it will decrease.

Futures are used to both hedge and speculate possible price movements of stock. Participants in a Futures market can profit from such contracts because they can enjoy benefits without actually having to hold on the stock until expiry. In the above example, B is holding his buy position with the expectation of a possible increase in the price until the contract expires and can also hedge his position by entering into a another Futures Contract with C as a seller, with the same Contract specifications – ie – quantity, quality, price, time period and location. B would thus, be able to deflect or offset any loss he may incur in his agreement with A.

To sum up, Futures are leveraged standardised contracts with linear returns in reference to the underlying asset and are traded on a secure and monitored Exchange platform, thereby reducing credit risk.

With this article outlining the basics, we hope that you are ready for the Futures!

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