The term “futures and options” (also known as derivatives) refers to contracts which are traded in financial markets. A futures contract requires delivery of a commodity, bond, currency, stock or index, at a specified price, on a specified future date. The physical delivery of underlying asset may or may not happen. Instead, it may be squared off before its expiry date. For example, if a person is “long” on index future i.e. who bought the contract at the beginning of the month may sell it just two days prior to its expiry. The difference in the value of contract will be paid to him as profit (or deducted from his account as loss) as the case may be. Similar to trading stocks, a certain percentage of the traded value will be levied as commission (brokerage), a service tax (to the brokerage amount) and a securities transaction tax (STT). The brokerage may vary for different brokers. Some may charge a fixed brokerage; some may charge based on traded value.
There are 1 month, 2 month and 3 month futures contracts available in India. The contracts are settled on the last Thursday of every month. If this happens to be a trading holiday, the previous day would be the expiry date.
The risk involved in trading a futures contract is equal for both buyer and seller or “symmetrical”. Futures trading also comes under the purview of Securities and Exchange Board of India (SEBI).
In case of short selling equity shares (selling a share one doesn’t possess) the trade needs to be squared off on the same day; otherwise the short sold equity shares will be sold in auction. The short seller will be penalized by the exchange for not squaring it off. But in case of futures no such thing happens; a person can carry a “short” position overnight. He can continue to do so till the expiry date. However, the minimum margin requirements need to be maintained. Margin money is defined as the amount, based on which the broker may allow purchase or sale of a stock or future; this margin also varies from broker to broker. In case of equity share purchases using margin trading, the buyer needs to pay the outstanding amount to the broker before a fixed date i.e. before he receives delivery of shares. In case of futures, stocks in possession can be used as margin for trading in futures; however, market to market obligations (such as losses) need to be met in cash.
Futures contract prices also have the same structure like the cash market prices. But there is no price band for futures or options; To avoid errors in entering orders the exchange may fix the price range. Prices in excess of the range will need to be reviewed by the exchange. In addition, if the “open interest” or the maximum number of outstanding contracts exceeds a certain value, no fresh positions will be allowed for the particular scrip.
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a specified date. In the case of a stock option, its value is based on the underlying stock (equity). For an index option, its value is based on the underlying index.
Options are traded in the same way like stocks. They can be bought and sold just like any other security. In case of options, the buyer pays the premium amount only; not the value of the entire contract. The commission for the Options, however, will be based on the value (strike price) of the underlying assets.
There are two option types; Call and Put.
A Call option is an option to buy a stock or index at a specific price on or before an expiry date. Call options usually increases in value as the value of the underlying asset increases. The premium amount is paid by the buyer to secure the right to buy the underlying asset. In case, if one does not want to buy the underlying asset, he will lose the option premium paid; no other obligation exists between him and the option seller.
Put option is an option to sell a stock or index at a specific price on or before a expiry date. Similar to the call option, a premium amount is paid by the buyer of the put option. In case if he does not want to sell the underlying asset, as in the case of call option, he will lose the option premium.
There are two types of expiration; European style in which options cannot be exercised until expiry date; American style in which options can be exercised anytime before expiry. In India all stock options are American style and index options are European style.
Option contracts should never be short sold. If the market turns the other way around, the buyer or seller may want to exercise the option. In this case loss resulting from shorting the option will be huge; so short selling options is very risky.
“Strike Price” is defined as the the price at which the underlying security can be bought or sold as specified in the option contract. “Spot price” refers to the market price of the underlying security. An option writer is defined as the one who sells the option to the option holder.
Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile.
In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited, depending upon the spot price and whether he wants to exercise the option or not.
Futures and Options trading at NSE:
In India, at the NSE, index futures trading was introduced in the year 2000. Index Options trading was also made available in 2001. Stock futures were introduced a little later. F & O index contracts are available in Nifty, Junior Nifty, Bank Nifty, CNX – IT (IT sector index) and CNX 100 (diversified 100 stock index accounting for 35 sectors of the economy). For individual securities, F & O contracts are available in 187 scrips, starting from Aban Offshore to Zee Entertainment Enterprises Limited.
The contracts are traded as “lots” meaning a contract will have certain fixed number of instruments. For example, the nifty shall have 50 instruments and it is called lot size. When a buyer places an order for a contract he has to bid for 50 or multiples of 50. Stock futures are available for most of the Nifty and Junior Nifty stocks. The stocks are chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. The market wide position limit in the stock shall not be less than Rs. 50 crores. The market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free-float holding.
Daily turnover:
The daily turnover in F & O segment on the NSE for 22-Jun-07 is shown below:
| Product | No. of | Turnover |
|
| contracts | Rs. Crores |
| Index Futures | 439509 | 9398.68 |
| Stock Futures | 737522 | 23255.47 |
| Index Options | 193118 | 4110.95 |
| Stock Options | 37754 | 1176.21 |
| F&O Total | 1407903 | 37941.31 |
The details for cash segment are given below:
| Number of | Quantity | Value |
| shares | lakh shares | Rs. Crores |
| 3517321 | 3406.03 | 9251.2 |
As it can be seen from the tables, turnover in F & O segment is 4 times higher than cash segment.
Risks and rewards associated with F & O trading:
Since F & O positions involve a certain time frame, if the trade is not squared off, it will be settled at the end of the month. So, open positions with losses in market to market carry a risk. In case of options, the investor faces the risk of losing the entire premium amount, if the market turns against his position.
Since contracts are traded in lots, the profits could be higher. Commissions are also less compared to cash segment. It is possible to remain short on the index or stocks whereas it is not possible in cash segment.
Usually the FII’s are very active in F & O segment. If the options have to be profitable, spot prices should move according to the positions of the holders i.e. increase in case of call options and decrease in case of put options. There is usually a hedging strategy (combination of long and short positions at any given time) to minimize risk. One may buy put options in the market; if he has to make money, he may sell stocks in the cash segment. So it will also depend on Put Call ratio, i.e. number of puts to calls at any given time.
It will be a good strategy to trade in F & O for active traders. They have access to all the price charts, open interest positions, FII activity etc.