Here’s All you need to know about Futures and Options in Part-I of the series:
Futures and Options have always aroused the curiosity of the investors. Why wouldn’t these be exciting? For a nominal amount, they give such an enormous leverage. Investors have always been driven by the unlimited upside that derivatives offer. They are ready to leap even without looking. They simply ignore the other side of the story. Investors never take cognizance of the deadly unlimited downside of derivatives.
I advise that you need not fall in line with them.
Get your facts straight this season before getting hurt. Read on to get enlightened.
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Futures & Options -A Prologue
Futures & Options fall under the category of Derivative Instruments. They don’t have a value of their own. In fact, they get their value from the underlying asset. Their value keeps changing with the value of the asset. The asset could be securities, currencies, precious metals, stock indices or commodities. Primarily, these are used to hedge the risk of price fluctuations in the underlying asset.
Futures and Options have so much in common. While Futures pose an obligation, Options give the holder the right, but not an obligation, to buy/sell a specified quantity of an asset at a certain price on or before the expiration date. For enjoying this right, the option buyer pays a premium to the option seller; also known as Option Writer. The Call Option gives the right to buy the underlying asset whereas Put Option gives the right to sell the asset at a pre-determined price. The right needs to be exercised on or before the expiration date.
More on Options in the next article.
For now, read on to explore the intricacies of the Futures.
Futures – An Obligation
It is an obligation placed upon the parties to buy/sell a financial instrument or commodities at a certain future date at a certain price. The objective is to counter losses by locking in the future price of the underlying. Unlike forward contracts, these are standardised exchange-traded contracts which are highly liquid and have low counterparty risk. The contract outlines the quality and quantity of the underlying, the date and month of delivery, price quotes and minimum price change and the location of settlement. Money doesn’t change hands when the contract is entered into. All the contracts are settled in cash.
The Exchange acts as an intermediary between the buyer and the seller. It provides them with a trading platform, market information and price movements. For the buyer, the exchange assumes the seller’s role, and for the seller, it assumes the buyer’s role. Bids and offers are usually matched electronically on time-price priority and participants remain anonymous to each other. It ensures that both the parties perform their obligations and there’s no counterparty risk.
The seller usually takes a short position while the buyer takes a long position. Short position implies that the prices of the underlying may fall in future. On the contrary, a long position implies a likely price rise in future. It shows the expectation of both the parties from the futures contract.
Let’s understand with an example.
Michael is a wheat cultivator. He fears of loss due to fall in wheat prices in future. Larry owns a bakery wherein wheat is used as the primary input. He fears his profit margins would fall due to rising in the input costs. Both of them enter into a futures contract on the stock exchange. Michael takes a short position while Larry goes long on wheat prices. If the prices of wheat fall, Larry loses his margin amount. Michael, on the other hand, earns profits which he uses to offset the losses incurred in the spot market.
Terminologies used in Futures Contract
Some of the important terminologies found in Futures contracts are as follows:
Margin
The participants are required to submit an initial deposit called Margin. It is increased/decreased regularly to reflect the gains and losses incurred over the life of futures contract. It may cause the initial margin to fall below the minimum limit called the maintenance margin. At that time, the broker makes margin calls to the participant to replenish the amount. The participant needs to act quickly else the broker may close his position owing to insufficient balance.
Mark-to-Market
The price of futures contracts changes every day. Under mark-to-market mechanism, the positions of the parties to the contract are settled on a daily basis. As per the positions held by them, their respective accounts would be credited or debited daily based on the profits/losses made by them.
Suppose you purchase a single futures contract of XYZ Ltd., consisting of 200 shares. The contract expires in the month of August. In the beginning, the shares are valued at Rs 1,000. On the last Thursday of August, XYZ Ltd. closes at a price of Rs 1,030 in the cash market. The mark-to-market amount is adjusted with the margins you have maintained in your account. If you make gains, they will be added to the margins that you have deposited. If you suffer a loss, the amount will be deducted from the margins.
The following table shows the mark-to-market gains/losses, margin requirements and changes made in your account:
Spot Price & Future Price
The spot price is the current price at which a given asset such as security, commodity or currency can be bought or sold for immediate delivery.
Futures Price refers to the price agreed upon between the parties to the contract to buy/sell the underlying asset in future.
These prices are extensively used in commodity and derivatives trading.
Suppose the spot price of wheat is Rs 50per quintal and futures price is Rs 60. It shows that the prices of wheat are going to rise in future. So, a baker would buy futures to lock in his price of wheat. The futures contract enables him to hedge against any adverse changes in the price of wheat which could affect his profit margins.
Both the prices are driven by the demand and supply of the given commodity. If it’s assumed that there will be a huge demand for the product in future, the price will shoot up. Apart from that, future prices are a function of spot prices, the risk-free rate of return and expiration date of the contract. The longer the contract duration, the higher would be the futures price owing to additional storage cost.
Also read: Risk vs Volatility-Here’s the difference
Expiration Day
It refers to the last day on which the contracts expire. Futures contracts expire on the last Thursday of the expiry month. If the last Thursday happens to be a trading holiday, then the contracts expire on the previous trading day.
For e.g. February 2017 contracts mature on February 23, 2017.
Contract Cycle
Futures contracts have a maximum trading cycle of 3-months i.e. –
– the near month (1),
– the next month (2) and
– the far month (3).
On the expiry of the near month contracts, a new 3-month contract would be introduced on the next trading day. You may, hence, find 3 contracts available for trading in the market at any point in time
If you want to buy the futures contract on 9 January 2017, then there would be three contracts expiring on 25 January 2017, 23 February 2017 and 30 March 2017.
Risks involved in Futures
Futures are used by the Speculators to make profits out of the volatility.
Speculators, usually, lose on account of over-leveraged and uncovered positions. The basic interest in futures is due to the leverage that they provide. For a small margin of say 10% of contract value, you may get leverage of 90%. A small price change may result in substantial profits/losses. If your position is over-leveraged, then you may lose far more than the initial margin.
Additionally, short-selling can prove to be very dangerous on many counts. Historically, the incidences of price falls have been very few. Short-selling is done with an intent that prices would fall. But there’s no such guarantee. The prices can rise to any extent. So, if the market prices shoot up to unexpected levels, you are going to lose a lot more than your initial margin.
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Final Words
Undoubtedly, the futures contract is a robust risk management tool. For a nominal margin, you get a huge market exposure. The only catch here doesn’t jump into the pool uncovered and don’t take on huge leveraged positions. If at all you do, be smart enough to settle in time to save big on margins.
