Futures and options represent two of the most common form
of "Derivatives". Derivatives are financial instruments
that derive their value from an 'underlying'. The underlying
can be a stock issued by a company, a currency, Gold etc.,
The derivative instrument can be traded independently of
the underlying asset.
value of the derivative instrument changes according to
the changes in the value of the underlying.
are of two types :
Exchange Traded : Exchange traded derivatives,
as the name signifies are traded through organized exchanges
around the world. These instruments can be bought and sold
through these exchanges, just like the stock market. Some
of the common exchange traded derivative instruments are
futures and options.
Over The Counter : Over the counter (popularly
known as OTC) derivatives are not traded through the exchanges.
They are not standardized and have varied features. Some
of the popular OTC instruments are forwards, swaps, swaptions
'Future' is a contract to buy or sell the underlying asset
for a specific price at a pre-determined time. If you buy
a futures contract, it means that you promise to pay the
price of the asset at a specified time. If you sell a future,
you effectively make a promise to transfer the asset to
the buyer of the future at a specified price at a particular
time. Every futures contract has the following features:
Some of the most popular assets on which futures contracts
are available are equity stocks, indices, commodities and
difference between the price of the underlying asset in
the spot market and the futures market is called 'Basis'.
(As 'spot market' is a market for immediate delivery) The
basis is usually negative, which means that the price of
the asset in the futures market is more than the price in
the spot market. This is because of the interest cost, storage
cost, insurance premium etc., That is, if you buy the asset
in the spot market, you will be incurring all these expenses,
which are not needed if you buy a futures contract. This
condition of basis being negative is called as 'Contango'.
it is more profitable to hold the asset in physical form
than in the form of futures. For eg: if you hold equity
shares in your account you will receive dividends, whereas
if you hold equity futures you will not be eligible for
these benefits overshadow the expenses associated with the
holding of the asset, the basis becomes positive (i.e.,
the price of the asset in the spot market is more than in
the futures market). This condition is called 'Backwardation'.
Backwardation generally happens if the price of the asset
is expected to fall.
is common that, as the futures contract approaches maturity,
the futures price and the spot price tend to close in the
gap between them ie., the basis slowly becomes zero.
contracts are instruments that give the holder of the instrument
the right to buy or sell the underlying asset at a predetermined
price. An option can be a 'call' option or a 'put' option.
call option gives the buyer, the right to buy the asset
at a given price. This 'given price' is called 'strike price'.
It should be noted that while the holder of the call option
has a right to demand sale of asset from the seller, the
seller has only the obligation and not the right. For eg:
if the buyer wants to buy the asset, the seller has to sell
it. He does not have a right.
a 'put' option gives the buyer a right to sell the asset
at the 'strike price' to the buyer. Here the buyer has the
right to sell and the seller has the obligation to buy.
in any options contract, the right to exercise the option
is vested with the buyer of the contract. The seller of
the contract has only the obligation and no right. As the
seller of the contract bears the obligation, he is paid
a price called as 'premium'. Therefore the price that is
paid for buying an option contract is called as premium.
buyer of a call option will not exercise his option (to
buy) if, on expiry, the price of the asset in the spot market
is less than the strike price of the call. For eg: A bought
a call at a strike price of Rs 500. On expiry the price
of the asset is Rs 450. A will not exercise his call. Because
he can buy the same asset from the market at Rs 450, rather
than paying Rs 500 to the seller of the option.
buyer of a put option will not exercise his option (to sell)
if, on expiry, the price of the asset in the spot market
is more than the strike price of the call. For eg: B bought
a put at a strike price of Rs 600. On expiry the price of
the asset is Rs 619. A will not exercise his put option.
Because he can sell the same asset in the market at Rs 619,
rather than giving it to the seller of the put option for