Demystifying Derivatives: Basics of Futures and Options Part 1

Over the past few weeks, we at Advisorkhoj have received several queries related to derivatives. Though derivative trading in India was introduced more than 15 years back, most retail investors perceive derivatives as something exotic, esoteric and risky. This perception is partly correct because most retail investors do not understand derivatives well. Derivatives trading can be risky, as we will explain later. If you want to increase your capital market knowledge, it is very useful to know what derivatives are and how they work, because derivatives are very important securities in capital markets. In this series of posts, we will try to demystify derivatives in fairly simple language.

What are derivatives?

In stock markets, you can buy or sell the shares of a company (also known as stock) or the derivatives of the stock. The textbook definition of derivatives is a “security whose price is derived from the underlying assets of the security”. In other words, when you are buying or selling a derivative, you are not buying or selling the underlying asset, but an instrument, whose value is derived from the underlying asset. In Indian stock exchanges (like NSE or BSE), there are two forms of derivatives, Futures and Options. You can trade in Futures and Options of individual stocks; you can also trade in Futures and Options of indices like Nifty, Bank Nifty etc.

Whether you buy or sell shares of a company for delivery or for intraday trading or for the purpose of a reverse trade tomorrow, these transactions take place in the cash (or spot) market segment of the stock exchanges. Derivatives trading take place in a separate market segment, known as the F&O segment. If you are investing directly in stock markets, it is important to understand the distinction between these two market segments (we will discuss the differences between these two segments in more details later in this post). Investors should know that the volume of F&O trading in our stock market is many times higher than stock (cash on delivery, intraday, buy today sell tomorrow etc.) trading. The chart below shows the volumes of cash trading versus derivatives trading in the National Stock Exchange last week:-

Source: Moneycontrol.com

You can see in the chart above that, daily derivatives volumes are 10 – 15 times larger than cash volumes. Though the cash and derivatives market segments of BSE and NSE are separate, there is a very close interrelationship between these two segments, because by definition, derivatives derive their price from the underlying price of the asset, i.e. price in the cash market. Even if you do not trade in derivatives, derivative market may give you important indicators about future short term price behaviour of individual stocks, sectors and markets. Therefore, as discussed earlier, if you are a short term investor or trader, it is very useful to know how derivatives work. In the first part of this series, let us understand what futures and options are and how they work, with practical examples. There are lot of jargons in the market, which we will try to avoid, as much as possible so that you can understand the concepts clearly.

What are Futures?

Futures contract, in very simple terms, is an agreement between the buyer and seller, to sell an asset at an agreed price, on a particular date near the end of the month (also known the F&O contract expiry date). You can be either a buyer or a seller and the stock exchange is the counterparty (seller or buyer, depending on what position you have taken). Let us explain with the help of an example. Let us assume you expect share price of Company A to rise by र 100 in the next few days or weeks. Suppose the current market price (CMP) of Company A is र 1,000. Let us suppose, the futures contract lot size is 1,000. It is important, at this point, to understand one important difference between cash market and futures market. In cash market you buy shares (you can buy 1 share of a company or as many shares as you want, depending on the availability in the market), but in futures market you can only buy or sell lots. One lot has a specified number of shares; in our example, 1000 shares.

You buy 1 futures contract (equivalent to 1,000 shares) of Company A. If by expiry (which is the last Thursday of the month), the share price of Company A increases by र 100, you will make a profit of र 100,000 (र 100 X 1,000 shares). You can ask, what is the difference between buying futures contract of Company A and buying 1,000 shares of Company A? The difference is in your capital outlay. To buy 1,000 shares of Company A at र 1,000 CMP, you will need a capital of र 10 lakhs, whereas to buy 1 futures contract of Company A (equivalent to 1,000 shares) you will need a capital of only र 1 lakh (assuming, the margin requirement of your stock broker is 10% of contract size).

In other words, when you are buying or selling futures, you are taking a leveraged position. In this case, by investing just र 1 lakh, you made a profit of र 1 lakh. Sounds very attractive, does it not? It is attractive, but very risky too. Suppose, instead of rising र 100, the share price of Company A, fell र 50. If you bought, one futures contract of Company A, your loss will be र 50,000.

Your investment was र 1 lakh and you will lose 50% of that, in just a month, if not earlier. The other major difference between futures and buying in cash market (delivery) is that, you can sell the futures of an underlying asset without owning the asset. On the other hand, in India, you are not allowed to sell shares in cash market, unless you own the shares. Therefore, if you expect share prices of a company to fall, you can make a profit by selling (shorting) futures contract.

Suppose you sold 1 futures contract (lot size of 1,000 shares) of Company A at a CMP of र 1,000 and the share price of Company A fell by र 50, you will make a profit of र 50,000 (र 50 X 1,000). Whether, you are buying or selling the futures contract, the risk remains. If you short (sell) a futures contract and the share price of the company increases, you will make a loss.

Investors should understand that, this is a very simplistic example. The futures price of a stock may be higher or lower than cash (spot) price of the stock. The difference between futures price and cash (spot) price is known as the premium or discount. The premium or discount is, usually, relatively quite small relative to the share price (usually less than 1% of the spot price); on August 12, 2016 the Nifty futures were trading at 8,678.4 versus Nifty spot of 8,672.15. The futures premium or discount goes down as we approach the expiry to the contract and on expiry there is no difference between futures and spot price.

Further, futures are marked to market, or in other words are re-priced constantly based on the value of the underlying asset (stock). Therefore, you do not need to wait till end of the month to book profits or losses. Let us understand this with the help of the example discussed above. You bought 1 futures contract of Company A (lot size 1000 shares). The CMP of the Company A, when you bought it was र 1,000. Let us assume that, the futures price of Company A was र 1,005 (futures premium of र 5), when you bought the futures. Let us suppose, the next day the share price of Company A rises to र 1,020. Since the futures price is a derivative of the share price, it will also rise by a similar (maybe not the exact) amount; let us assume, the futures price rises to र 1,024. Your book profit is now र 19,000 (increase in futures price by र 19 X lot size of 1,000 shares). Instead of waiting till expiry, if you want, you can book the र 19,000 next day itself, by squaring off the futures contract. You can square off your futures position at any time, based on the current value of the futures contract.

What are Options?

Options are slightly more complicated. An options contract, grants the buyer of the contract, the right to buy or sell the underlying asset at a certain price, but not an obligation to do the same. There are two kinds of options. Call option gives the buyer, the right (but not an obligation) to buy the asset at a certain price. Put option gives the buyer, the right (but not an obligation) to sell the asset at a certain price. An options contract has two important parameters, the strike price and the premium. We will discuss premium later. The strike price of an options contract is the price at which you will buy or sell the underlying asset on expiry of the contract.

Let us understand how call options work, by going back to the example discussed above. Let us assume you expect share price of Company A to rise by र 100 in the next few days or weeks. Suppose the current market price (CMP) of Company A is र 1,000. Let us suppose, the options contract lot size is 1,000. You buy 1 call option contract (equivalent to 1,000 shares) of Company A, with a strike price of र 1,000. Recall, call option gives the buyer, the right (but not an obligation) to buy the asset at a certain price. If by expiry (which is the last Thursday of the month), the share price of Company A increases by र 100, you will make a gross profit of र 100,000 (र 100 X 1,000 shares).

How do you make this profit? The call option gives you the right to buy shares of Company A at र 1,000, while the company is trading at र 1,100. You buy the shares of the Company A at र 1,000 and sell it at र 1,100, thereby making a profit of र 100 per share. In reality, you do not have to actually buy the shares of the company; the profit is built into the price of the option; all you have to do is to sell a call option of the same strike price at expiry and book the profits. What happens if the share price of Company A falls र 50 by expiry? In the futures example, you made a loss of र 50,000, but in the case of options, you will not make a loss (except the price of the option) because call option gives, you the right but not obligation to buy. In other words, after buying an option you will exercise it, only if it is profitable for you.

Put option is similar to call option, except that, put option is profitable when the share price of the asset falls. Therefore, you will be buy call or put option, depending on the price outlook of the underlying asset. In the above example, you bought a call option because you expected the share price to go up. If you are to expecting the share price to go down, you will buy a put option.

Let us understand how put options work, with the help of an example. Let us assume you expect share price of Company A to fall by र 50 in the next few days or weeks. Suppose the current market price (CMP) of Company A is र 1,000. Let us suppose, the options contract lot size is 1,000. You buy 1 put option contract (equivalent to 1,000 shares) of Company A, with a strike price of र 1,000. Recall that, put option gives the buyer, the right (but not an obligation) to sell the asset at a certain price. If by expiry the share price of Company A falls by र 50 then you will make a gross profit of र 50,000 (र 50 X 1,000 shares). How do you make this profit?

The put option gives you the right to sell shares of Company A at र 1,000, while the company is trading at र 950. You buy the shares of the Company A at र 950 and sell it at र 1,000, thereby making a profit of र 100 per share. In reality, you do not have to actually buy the shares of the company; the profit is built into the price of the option; all you have to do is to sell a call option of the same strike price at expiry and book the profits. What happens if the price of Company A rises instead of falling expiry? You will simply choose not to exercise the option, and therefore, not incur a loss.

In futures, both your profits and losses can be unlimited. In options, your profits are unlimited but your losses are limited, only to the premium you paid for the option. In the call option example, you bought 1 call option contract (lot size of 1,000 shares) with a strike price of र 1,000. Since, your profits are unlimited but your losses are limited, you have to pay the seller (also known as the writer) of the option a premium. Let us assume the premium of the option is र 50; therefore the total premium paid by you will be र 50,000. When the share price increased by र 100, your gross profit as discussed above was र 100,000 and your net profit would be र 50,000. If the share price went down by र 50 the net loss made your premium of र 50,000. If the share price increases by र 150, your gross profit will be र 150,000 and your net profit would be र 100,000. However, if the share price falls by र 150, your net less loss will still be र 50,000 only. When you are buying options your downside risk is protected.

Option premium is a complex topic and a comprehensive discussion of options pricing is beyond the scope of this post, but for the purposes of this post, it suffices to say that, the options premium depends on the strike price of the option, the current market price, the volatility in the market, time to expiry of the contract and interest rate. Like futures, option premiums are also marked to market or in other words, re-priced constantly based on a number of factors, primarily the CMP of the underlying asset. When the options contract becomes more and more profitable, based on price movement of the underlying asset, the option premium increases and when the options contract becomes less and less profitable, the option premium decreases. Therefore, if the share price of the underlying asset of a call option rises, the premium will also increase. If the share price of the underlying asset of a call option falls, the premium will also fall. If the share price of the underlying asset of a put option falls, the premium will increase. If the share price of the underlying asset of a put option rises, the premium will fall. Since premiums are marked to market, you do not need to wait till end of the month to book profits or losses. Like in futures contract, you can square off your options position at any time, based on the current value of the options contract.

One common feature between futures and options is the leverage. In other words, your capital outlay is much lower than what it would have been if you bought stocks in the cash market. We had discussed earlier that, if you bought 1 futures contract (lot size 1000 shares) of Company A (CMP र 1,000) and your broker requires a 10% margin on the position, then your total capital outlay is र 1 lakh versus र 10 lakhs, if you bought 1000 shares of Company A in the cash market for delivery. If you are buying options (whether call or put option) there is no margin requirement. All you have to do is to pay the premium of the options contract.

Readers should know that, you can either buy or sell options. Many new investors confuse between selling options (in derivatives lingo selling options is also known as writing options) and put options; they are completely different. In this post, we have limited our discussion to only buying call and put options. Selling or writing options is as risky as futures trading and requires a lot of experience and expertise; as such, writing options is out of the scope of this series on derivatives. Purely for the sake of completeness of our discussion on F&O margin requirements, suffices to say that, if you are writing options, then your broker will require a certain percentage of your position as margin. However, in Advisorkhoj, we will advise our readers, not to write options, unless they have the necessary expertise in options writing.

Summary

In this post, we discussed the basics of futures and options. You can make a lot of money by trading in derivatives, but you can also lose a lot of money. You should not trade in futures and options, unless you understand very clearly how these instruments work. At the beginning of this post, we said that, derivatives are complex and potentially risky instruments. However, knowledge of derivatives can be very useful, even if you are not trading in these instruments. As discussed, the derivatives market in India is much bigger than the cash (spot) market). The futures and options market can provide very useful clues to future short term asset price movements. While derivatives are risky, they can also be used for variety of portfolio management techniques to manage / reduce risks. In fact, mutual funds do use derivatives for reducing risks and generating income. More on that, in our upcoming posts; please stay tuned.