Futures and Options The basics.

The world of high finance is all about risk; infact, its all
about taking calculated risks. So far all what we
discussed was about buying shares with the money you
intend to invest-on the spot. Since the whole deal is
done with pure cash, Its also called cash segment. But
thats one part of stock markets. If you have the heart to
take calculated risks, then section is for you ..

Introduction to Derivatives.
Derivatives have become very popular during the past
two decades. The real purpose of derivatives is to allow
traders to maximise returns and simultaneously limit
their risk exposure. However, common investors have
developed speculative interest with derivatives. Its a
complex subject and here, I am trying to crack down this
subject in a step by step approach. May be you are not
used with the term derivatives but if I say Futures and
options or F & Os or calls and puts Im sure all of you
would understand what Im talking about.
GOING FOR THE A.R. RAHMAN CONCERT.
The objective of this story is to introduce you the term
derivatives. After finishing the story, I will break up the
explanation into maximum pieces as possible! Lets begin
our story
You want to watch the A R Rahman concert scheduled
next month. You find from the advertisements that entry
ticket costs Rs 1,000. You call up the booking counter
only to find that tickets are fully sold out! You approach a
friend who is part of the concert team for a ticket and he
gives you a reference letter under which if you show the
letter you can buy a ticket by paying Rs 1,000. As the
concert date draws closer, tickets are being sold in grey
market at Rs 1,500. Now, the reference letter you have
attains value because of the simple reason that you can
buy a ticket, now available in the market at Rs 1,500, for
Rs 1,000. That means your letter is worth Rs 500. Two
days before the concert, the price in the grey market
shoots up to Rs 2,000, the value of your letter increases
to Rs 1,000.
But, on the concert day, you get a call from your office.
Theres an important assignment to be done. So you
decide to sell this letter to someone who is wiling to pay
 Rs. 1,000 to you. You cant afford to postpone the sale
because, once the concert starts, your letter becomes
worthless.
Forget about what happened after that. Instead, we will
discuss more about that letter you had with you. Lets try
to understand the features of that letter.
That letter gave you a right to buy a ticket at Rs 1,000.
When? Anytime before the Concert starts.
The Letter gained value. How? Grey market rate of the
tickets shot up.
The value of the letter kept changing. Why? Because the
price in the grey market kept increasing. So, the value of
the letter is derived from the value of the ticket it
represents.
 In pure financial language, this letter will be called a
derivative instrument.
A derivative instrument is nothing but a contract (in this
case the letter) whose value is derived from the value
of the underlying asset (in this case The concert ticket)

FINANCIAL DERIVATIVES
Now I hope you are clear about the term. The concert
ticket was an imaginary derivative instrument. We
generally dont find such ticket derivatives in real
life. The real ones are derivatives in financial markets.
These derivatives are widely traded to guard against
price fluctuations. We will discuss the uses of derivatives
against price fluctuation in a different chapter. For the
 time being, lets wind up this article by discussing what a
financial derivative is -
Derivative is a general term.
Derivative literally means derived from.
These are nothing but financial instruments that can be
bought and sold.
Futures and options are types of derivatives.
What it carries is a right. When you buy derivative, you
buy a Right. In normal stock market trading, we buy
and sell shares. But in this case, the stock is not traded
instead; the right to buy or sell a share is traded.
Note that, the right may be The right to buy or the
right to sell.
But, this right, to buy or sell, cannot be held on forever.
The exchange sets a cut off date before which you have
 to either exercise your right or sell off the right to
another person.
The cost of buying a right is very less compared to the
actual stock price.
For example you hold the right to buy Infosys at Rs.
2000 per share today. You bought the right for Rs 200.
Now, after a few days, Infosyss shares are trading at
Rs.2500. But you can buy it at Rs 2000 since you have
purchased the right to buy Infosys at that
price.Naturally, since the price in cash market is Rs
2500, you can exercise the right to buy at Rs.2000 and
sell it at Rs.2500. So, your investment of Rs 200 gave
you return of Rs 300 ( Total cost = 2000 + 200) because
the underlying asset (shares of Infosys) went up in
value.
 So, buying a derivative does not result in acquiring a
share, but it results in buying the right to buy a share
or to sell a share.
In other words, the buyer of a derivative gets a right
over an asset (shares) which after a certain period of
time might result in the buyer buying or selling the
asset.
Not only shares, the base asset can be anything like
commodities, foreign currency, treasury bills, bonds or
share indices.
In fact, any transaction that results in a right without
actually transacting the asset becomes a derivative
instrument.
 All derivative instruments are not the same. They differ
when it comes to the kind of obligation it creates on the
holder.
Forwards, Futures , Options and Swaps are the types of
instruments that are clubbed under this general term.

Types of derivatives 1 Forward contract.

Lets catch up with the oldest and the simplest of
derivatives.
FORWARD CONTRACTS
In forward contracts, two persons enter into an
agreement for purchase and sale of a commodity /
financial asset at a specified price at a specified future
 date. These contracts are generally used by traders to
guard against price volatility.
For example- You are a trader of fruits. You enter into a
contract with a farmer to deliver 1000 kilograms of
apples at 100 per kilo, 3 months from now. Thats a
forward contract. Here, apples are the specified asset,
100 per kilo is the specified price and 3 months is the
specified future date.
So, in short, it is a contract between a buyer and a
seller-
To deliver some goods / asset at a particular price at a
future date, the price being fixed right now. On the
delivery date, the buyer pays the price and receives the
asset/goods
 These are tailor made contracts and one can choose the
quantity, mode of delivery and time of contract maturity.
What if one party to the contract does not oblige?

That risk is always present. There is no performance

guarantee in a forward contract. Its up to the buyer and
the seller to fight it out!
FORWARDS IN OUR DAILY LIVES..
Forwards are part of our daily lives unknowingly.
Imagine this Gold prices are rising every year and you
want to invest in Gold coins. You go to a jeweler but
since gold coins are out of stock, they say that it would
take 5 days to deliver. But you want it at todays rate.
The jeweler , not wanting to lose a customer agrees to
 deliver gold coins at todays rate, 5 days later.
Technically speaking, this is a forward contract.
You and the jeweller has entered into a forward contract
The jeweler is obligated to give you gold coins 5 days
later when you bring the agreed amount of money.
The price , size , delivery date and any other terms
and conditions are already locked in through this contact.
Payment is made only on delivery-not before that. Lets
also assume that this was a written contract.
Technically this contract can be called as a Gold forward
contract.
Four important points to note here is that
The seller sold the forward contract. Seller has agreed to
sell the coin in the future at a price agreed
mutually ON the date of contract. So the seller must
 deliver the Gold coin in the future at the agreed upon
price.
You bought a forward contract. You buy the coin in the
future at a set price. You are supposed to contact the
seller after 5 days from today and must deliver the
promised money.
The contract is not Exchange traded. Its a private
contract. Hence, counter party risk is present.
Margin money (advance payment) is generally not made
at the time of entering into agreement. However, there is
no hard and fst rule that no payment should be made. If
both the parties are ok with making an advance
payment, they can.
WHAT WOULD HAPPEN IF THE GOLD PRICE FALL?
Then, the seller would be happy since he sold Gold coin
to you for a higher price! Conversely, you would stand to
gain should the Gold prices go up. The price of Gold after
5 days is irrelevant. The purchase price was locked and
the deal has to be executed at the rate agreed
previously.
Since forward contracts are not properly regulated,
either the buyer or the seller can default in performing
his part, should circumstances be unfavorable to him.
To continue the above example You may not turn up
after 5 days to buy the gold coin at the agreed rate if the
price drops. Or, if the price went up, its not necessary
that the dealer would settle for the previously agreed
price.
The jargon for this is counter party risk. Its always
present in forward contracts.
SETTLEMENT
So, finally, one of the parties to the contract stands to
gain depending on the price movement. Now the next
question is how is a forward contract settled?
Forward contracts are usually settled OTC (Over the
counter). Hence these are also called OTC contracts. The
phrase over-the-counter refers to any settlement
process via a dealer network and not through a
centralized exchange.
The settlement of the contract occurs at the end of the
contract. The contract can be settled in two ways-
One, actual delivery of the goods upon payment. Second,
cash settlement- The buyer and the seller would simply
exchange the difference in the associated cash positions.
AT THE ORCHARDS.
Heres a realistic scenario where forward contracts are
used.

Oranges sell at Rs 2500 a ton right now. An orchard is

expected to yield 10,000 tons of oranges 3 months from
now. The orchard owner however fears that the price of
oranges would come down by then, because he expects
excess supply of oranges from different orchards to the
market. The only way for him to eliminate this risk is to
find a buyer who is ready to buy these oranges at 2500
per ton.
At the same time, an orange juice company fears that its
competitors may buy in bulk and as a result the oranges
may be in short supply and so the prices may go up.
They cant change the price of orange juice because they
fear if thats done the sales may drop. They need to
maintain the cost and profit at the present rate.
So, these two parties agree today on a forward price of
Rs 50 per Kg, for delivery 3 months from now when the
crop is harvested. It just an agreement. No payment is
made. In 3 months, 10,000 tons of oranges should be
delivered to the juice company.When they do it, they can
take the price agreed 3 months back.
The price of oranges 3 months hence could be Rs 3000
per ton or Rs 2000 per ton but, that price is irrelevant.
Both the parties have already predetermined their profits
and have eliminated the risk of price volatility and can
plan ahead.
I Hope you are clear with forwards. We will discuss
futures in our next article
Till then

Types of derivatives 2 Futures contract

We continue with our discussion on derivatives
 As said in my last article, forward contracts have some
de-merits.
First, The quantity, the mode of payment, the delivery
date, the price, everything varies from one contract to
another and performance of the contract is not
guaranteed.
Second, to continue the orange juice example, suppose
after some days the orange juice company decides to
back off since they feel that they dont need oranges at
that price. This would give rise to problems between the
buyer and the seller.
In short, nothing is regulated in forwards. Its tailor-
made according to circumstances and can be written for
any amount and terms.
Quite easy to understand, I guess.

How about a contract thats regulated in all these

aspects? That is, you get a fixed quantity contract, at a
fixed rate, for a fixed expiry date. You can buy and sell
the contract anytime. Liquidity is ensured and somebody
stands in between to regulate and guarantee the
performance- Thats futures.
So, there is no much difference between forwards and
futures, except that futures are well regulated in all
aspects.
A future is an agreement between the seller and the
buyer to deliver a specified quantity of a
share/commodity/forex at a fixed time in the future at a
price fixed between the parties NOW. An organization
called clearing house stands in between to ensure that
both the parties fulfill their obligations.
How does the clearing house ensure that?
Both the parties are required to pay a percentage of the
total value of shares/ commodity / forex to the clearing
house. This amount is called Initial Margin money. Since
the contract is marked to market or linked to market on
real time basis, the value changes every now and then.
Accordingly, the amount to be maintained by the buyer
and the seller with the clearing house also fluctuates on
daily basis.
The stock exchange (for stocks futures) or commodity
exchange (in case of commodity futures) will take
responsibility for collecting the payments and making the
settlements. There is no chance of default.
To achieve this, each trade is split into two parts- Buyer
with the clearing house and Clearing house with
the seller. So each party has to fulfill their obligation to
the clearing house. Even if one party to the trade
defaults, the clearing house fulfills performance.
In other words, by virtue of a futures contract, when you
have the right to buy the clearing house takes a sell
position against it and when you have the right to sell
the clearing house takes a buy position against it so
that the performance is always guaranteed.
So in short, future contracts issued by the exchange can
be traded just like shares. For example, Reliance
October Futures may be issued by the exchange. This
contract would have the following features:
 Specific quantity: Each futures contract has a specified
quantity. In this case, lets assume its 100.
Specified share: if you have entered into a futures
contract to buy 100 reliance shares, you will have to
deliver 100 reliance shares and not 100 Infosys shares.
Specified date: the date and month of delivery is
determined by the exchange. As of now, the exchange
has fixed the last Thursday of every month for
settlement of contracts.
The clearing house plays an important part in trading of
futures contracts. It does all the back office operations.
It guarantees performance from either side. Hence there
is no risk of default. Thus Reliance October futures
contract becomes a standard asset like any other asset
that can be traded in the market.
MARGIN MONEY
To enter into these futures contract you need not put in
the entire money. For example, reliance shares trades at
Rs 1000 in the share market. If you want to enter into
one lot of Reliance October futures contract which
consists of 100 reliance shares, you need not put 100 x
1000. Instead, you would be required to maintain a small
deposit (called margin) with the broker. Margin is
decided by the exchange. This margin amount will keep
varying with changes in daily prices. If the price goes up
the buyers margin is reduced and the sellers margin is
increased by an equal amount. If the price comes down,
the buyers margin is increased and the sellers margin is
reduced by an equal amount.
Heres the link to know the margin money requirements
of future contracts
Heres an example-
Let us assume you bought a Future contract of Infosys
October (i .e, 100 shares of INFY at current future price
of Rs. 2200 per share, settlement date being last
Thursday of October) .Lets further assume that the
margin money required by the exchange is 20%. So, you
pay Rs. 44,000.
Now suddenly there is a crash and the price of INFY in
the spot market dips to Rs. 1700. So you have lost Rs.
500 per share which, for 100 shares, is Rs. 50,000!
This is greater than your margin of Rs. 44,000 so the
broker will ask you to provide the extra Rs. 6,000 as an
additional margin to keep your contract afloat.
 Futures are actively traded in the market, and the price
of the future is not decided by you so once you have
bought the future, you can SELL the contract to someone
else. Lets say the contract you bought at Rs. 2,200 is
now trading at Rs. 2,700 instead. You can sell the
contract itself, and make the Rs. 500 as profit per share
for 100 shares; thats Rs. 50,000 profit. The exchange
will also give your margin back, and take a margin from
the new owner of the contract.
Before I end this article, heres a point wise
differentiation between forwards and futures:-
1. Size of the contract In the case of forwards, its
decided by the parties. In futures, its decided by the
exchange. In the case of share futures, a lot is generally
100 shares.
 2. Price of the contract In the case of forwards, its
decided by the parties. It remains fixed till the end of the
contract. In futures, the price keeps floating according to
daily price movements. This is called Marked to market
in technical terms.
3. Margin money In the case of forwards, it may or
may not be required, depends upon how the party
negotiates. In futures, margin money is fixed by the
exchange. It is usually a percentage of the value of the
contract and it has to be paid by the buyer and the seller
to the exchange. Since its marked to market; the
margin requirements will have to be settled on a daily
basis.
 4. Number of contracts In the case of forwards, there
can be any number of contracts. In futures, the number
is decided by the exchange
5. Settlement In the case of forwards, the settlement
is through OTC. In the case of futures, the settlement is
through exchange.
6. Mode of delivery In case of forwards cash
settlement or delivery. In the case of futures most of
them are cash settled.
I hope youve got some understanding about futures and
the difference between forwards and futures. Its
important to understand these two instruments clearly.
Till my next article on options
Types of derivatives 3 Options contract
We discussed forwards and futures. The next derivative
instrument is options.
Before we move on, here are two stock market games
for you to play.
TWO GAMES AT YOUR OPTION !
Game 1.
Share price of a company, say Wipro, is at Rs 300
now. For a small fee of Rs 3 per share, you will be given
the right to buy 1000 shares. The condition is that if
price moves up and strikes Rs 390, you keep the gain on
1000 shares. If price falls, you need not suffer the loss
on 1000 shares. You lose only that small amount you
paid for participating in the game.
 So, if you win, you make a lot of money. For example
If the price moves up to Rs 390, you gain Rs 90,000
(1000 x 90) less Rs 3,000(3 x 1000). If price falls, youll
let go a small amount of Rs 3,000 for playing that game.
The benefit is- Unlimited gains. Limited loss.

Game 2
Share price of a company, say Wipro, is at Rs 300 now.
The price of the share is expected to fall to Rs 250 per
share. For a small fee of Rs 3 per share, you will be
given the right to 1000 shares. If price falls as expected,
you keep the difference on 1000 shares. If price moves
up, you lose that small amount you paid for participating
in the game.
 So if the stock strikes 250, you gain Rs 50,000 (1000 x
50) less Rs 3000 (1000 x 3). If the price went up
contrary to expectations, you lose the small amount paid
as fee.
Limited gains. Limited loss.
In reality, Do we have such games ?
The answer is , yes. The game is called options.

CRACKING THE GAME CODE.

Game 1 is called a call option. What you did is, buying a
call option.
Game 2 is called a put option. What you did is, buying a
put option.
 As a buyer of calls or puts, youre henceforth called the
holder.
Where is this game played?
In the stock market, of course. Options are bought and
sold at the stock markets.
Who starts the game?
The stock exchange. The exchange would introduce the
game and set the ball rolling.
Which game should you play?
If you expect the stock price to rise, you play game 1,
that is, you buy a call option. If you expect the price to
fall you play game 2, that is, you buy a put option.
Who sells?
Thats right. The game is played in the stock exchange
and all I am taking about is buying call options and put
options. But how can you buy unless there someone to
sell the same?
There are sellers. They are also called writers. Those are
game participants who think contrary to your views.
They expect the price to fall, so they sell a call
option (Recall game 2 Alternatively, they could have
bought a put option).
If they expect the price to rise, they sell a put
option. (Alternatively, they could have bought a call
option)
A logical doubt
As implied from the above paragraph, if someone
expects the price to rise, they sell a Put option.
Alternatively, they could have played game 1- buy a call
option. Both have the same effect, I am right?
 No.
Why? Both actions are based on the calculation that a
stock price will rise. The buyer of a call and the seller of
a put share the same opinion about the price direction of
the stock. But thats where the similarity ends
A person chooses to buy a call when he reasonably
thinks that the prices are moving up. If he was 100%
certain that the price would move up, he would have
bought the shares itself, and not options! Similarly, a
person chooses to buy a put when he reasonably thinks
that the prices are moving down.
But sellers of calls and puts basically do it for some other
reason. They are actual shareholders who want to
protect themselves from price volatility and at the same
time make some money out of it. Since they sell the
 right , Sellers are obligated to perform their part.
Theres no option.
Option strategies will be discussed in later articles. For
the time being, it important to keep things simple.
Before I finish this introductory article, heres the
summary of what weve discussed. Its cut into 3 parts.
Make sure you understand part by part.
Section 1
Option contracts are introduced by the stock exchanges.
There are two types of options call option and Put
option. Call = right to buy, put = right to sell.
You can buy or sell any of these options.
If you are a buyer, youre called the holder of an option.
Buy= hold
 If you are a seller, youre called the writer of an option.
Sell = write
Section 2
You can hold a call or hold a put. As a holder of option,
you have the option to buy or sell and not an obligation.
o Depending on the price movement, a call holder may get
unlimited gains or limited loss. A put holder has only
limited Loss and limited profits.
o You can write a call or write a put. As a writer of option,
you are obligated to perform. You have an obligation to
sell if youve written a call and you have an obligation to
buy if youve written a put.
o Depending on the price movement, a call writer may
suffer unlimited loss or limited profit. A put writer has
only limited loss and limited profits
o Writing, since it carries obligation, is risky.
Section 3
When youre bullish on a stock, you BUY CALL OPTIONS
which gives you the right to buy that share at the
present price at a future date. So, in future, when the
price moves up, you stand to gain. Contrary to your
expectations, In future, if the price of the stock falls, you
will not exercise your right to buy at present price. The
only loss is the commission paid for buying call options.
When youre bearish on a stock, you BUY PUT OPTIONS
which give you the right to sell that share at the present
price at a future date. So, in future, when the price
moves down, you stand to gain. Contrary to your
expectations, in future, if the price of the stock shoots
up, you will not exercise your right to sell at the present
 price. The only loss is the commission paid for buying put
options.
You WRITE options to control risk of shares you hold or
to lock in profits or to gain from writing.

Who plays in this market?

There are at least 5 categories of players in derivatives
market. Irrespective of what you intend to do in the
market, you would fall in any one of the 5 categories
mentioned here.
CATEGORIES OF PARTICIPANTS.
As mentioned above, there are 5 categories:
1. Hedgers
2. Arbitrageurs
3. Speculators
4. Spreaders
5. Amateurs
HEDGERS
They are the real users of derivatives. In fact, derivative
instruments were invented solely for the purpose of
hedging or risk management. Hedgers are investors who
want to reduce the risk of price fluctuation on their
investments. The meaning of hedging, its uses and the
way its done would be discussed in another post.
Hedgers are basically risk averse investors.

ARBITRAGEURS
Arbitrageurs are participants who are always on the look
out for spot price anomalities between futures contracts
and their underlying assets or between spot price of an
asset in two different markets in order to reap a risk free
return. Arbitrage is a source of risk free income. For
example lets assume that you have invested in 600
shares of Reliance. On one trading day, you notice that
Reliance is trading at Rs 2000 on the BSE and Rs 2010
on the NSE. You sell your 600 shares on the NSE at Rs
2010 and simultaneously buy back the 600 shares on the
BSE at Rs 2000. You profit in this case is 600*10 = 6000
less brokerages if any. This is one form of arbitrage.
Arbitrage too, is discussed in a subsequent post in detail.
SPECULATORS.
As in the case of any markets or business, there are
speculators in derivatives market too. These are risk
seekers, willing to risk their capital to make that extra
buck, quickly! They dont do this blindly. In fact,
experienced speculators know when to hold or to walk
away from a trade. These guys engage in trades that
involves substantial risk but at the same time has the
potential to return huge profits if things work out to their
advantage.
SPREADERS
This is a category of very professional people who
specialises in trading derivative contracts in combination
with other derivatives or spot assets with the objective of
reducing risk and making money in the process.
Spreaders are experts in derivatives who would create
complex transactions by smartly combining futures,
options and spot markets. This is a very professional and
specialised field.
AMATEURS
People who enter the derivatives segment just to know
whats going around, to get a first hand feel of the
derivatives market. There could be students, aspiring
derivatives traders etc..Everyday in the market, there is
a small segment of people who are lured in by
advertisements or by brokers and advisors. So, thats the
last of 5 classes of players in this segment.
Whichever way you enter derivatives market, youre sure
to be included in any one of the 5 categories mentioned
above.
Why do derivatives market exist?
As we saw in the introductory articles, derivatives are
complex financial instruments and dealing with
derivatives is often riskier than dealing with the
underlying asset themselves. If they are so complex to
deal with, then why do they exist? Why are so many
interested in it? What purpose do they serve? Well try to
find answer all this in this post.
Before that let me clarify a point. There is a common
misconception that derivatives would bring financial
ruin. Thats not true. Derivatives by them selves do not
bring in any additional risk to the economy. Improper
handling of derivatives can cause damage now, isnt
that true with anything we handle in life? So the root
cause of any loss through derivatives is not the problem
of derivatives.

Of course, the financial ruin of America started with the

complex transactions on derivatives.. President Barack
Obama recently said that he will veto legislation that
does not bring the derivatives market under control so
that he can assure that America does not have the same
kind of crisis that they have seen in the past.
However, the problem was not with derivatives. The
problem was with the people who used it in an
uninformed and reckless manner.
DO WE REQUIRE DERIVATIVES?
Do we require derivatives? The answer is yes. Its
required because of its advantages to the economy.
Derivatives in any economy serve three basic functions:
 1. Price discovery
2. Risk management
3. Speculative activity
All the three functions are required for any economy to
function properly.
PRICE DISCOVERY
Derivatives play a crucial role in discovering the present
and future price of any commodity or financial asset. This
is an essential part of an efficient economic system.
Prices of stocks and commodities tend to move in the
same direction as the expectations of market
participants. Hence, the price in the futures market
reveals the demand supply expectation in the future
and thus undertakes the process of price discovery in the
spot market.
For example take the case of a sugar manufacturer. He
doesnt know what could be the price of sugar two
months down the lane. By closely following the futures
market rates of sugar he would be in a position to figure
out the future demand-supply relation of sugar and plan
his production accordingly.
Or, take the case of jewelers in Mumbai and Delhi.
Assets like gold may be sold for marginally different
rates in Mumbai and Delhi.Gold Derivative contracts on
the NSE would have only one value and so traders in
Mumbai and Delhi can validate the prices of spot markets
in their respective location to see if it is cheap or
expensive and trade accordingly.
RISK MANAGEMENT.
Organizations or individuals financial uncertainties
expose them to unexpected losses in many ways.
Derivatives are instruments meant to cover risks.
Corporates, traders and individuals use derivatives as a
tool of risk management to cover the vagaries of price
fluctuations.
For example:
Lets assume that today is May 1st and you hold shares of
reliance now trading at Rs 500. You expect the price of
shares to come down in future. Reliance futures are
available at Rs 525 right now. You can sell shares at Rs
525 and lock your profits. Should the spot price of
reliance fall to Rs 375 as expected, you gain Rs 150 per
share. In the normal case, you would have been sitting
with a loss of Rs 125 per share.
The above process is technically called Hedging.
ie,making an investment to offset the potential loss of
another investment.
Lets take another scenario. June 30 Reliance call options
are available on the NSE at 500 strike. That means,
buying that call will give you the right to buy reliance
shares at 550. Now, at the end of June, if the share price
remains at 550 or less than that, you will not exercise
your right and will consider the amount paid to buy the
option ( called premium) as loss.
That amount of premium is the maximum loss he would
suffer. Hence, loss is always limited. On the other hand,
if the share price of Reliance goes above Rs 550, ( say
current market price is 600) the call will be exercised.
You will buy the shares at 550 and sell it at 600 and
make profit. You profit will be 50 (minus) premium paid.
The possibility of gain can be unlimited. Imagine the
profit if the share price increased to 950 by the end of
June. it would be 400 (950-550) less the premium paid.
Assuming that the premium paid is 30, your profit would
be
*400-30 = 370 per share x number of shares in one lot.
So, derivatives help informed investors take advantage
of favorable price movements.
SPECULATIVE ACTIVITY.
Speculators, due to their volume of activity, drives prices
in one direction and then, in the other causing upward
and downward movements in prices. What drives them is
not fundamentals but mass sentiments. Irrational
speculators may get lost in the process of speculation.
But, rational speculators would jump in on any
mispricings in the market and this results in the price
being brought back to equilibrium. For example, if a
speculator thinks that the price of a certain stock is over
priced and hence may fall, he would immediately jump in
and sell the stock. The masses follow the trend and that
results in a huge sell off and thereby it brings the stock
back to its actual worth. They also add liquidity to the
markets. So speculative activity is required to maintain
that balance.

Futures: Types of contracts

 Depending on the type of underlying asset, there are
different types of futures contract available for trading.
They are
Individual stock futures.
Stock index futures.
Commodity futures.
Currency futures.
Interest rate futures.
INDIVIDUAL STOCK FUTURES
Individual stock futures are the simplest of all derivative
instruments. Stock futures were officially introduced in
India on 9th November 2001. Before that, the local
version of stock futures called badla were traded which
was eventually banned by the Securities Exchange Board
of India in July 2001.
The Badla system: the badla system was almost similar
to the futures contracts we discussed. In simple terms- A
badla trader can delay the settlement of a trade by one
week for payment of a small fee. So if you bought a
particular share for Rs 100 and if you are bullish on that
stock, you can delay the settlement by one week if you
pay a fee. This carry over can be done for any number of
times. Later on, unlimited carry over facility was
restricted to 90 days at a time.
Badla system had its downsides lack of transparency,
data regarding volume, rates of badla charges, open
positions etc were not available. There was no margin
requirement and badla charges varied from seller to
seller. So, chances of manipulation were more. Badla
was pure Indian version of futures but did not provide
the advantages of price discovery or risk management
that organized futures market provide.
STOCK INDEX FUTURES.
Understanding stock index futures is quite simple if you
have understood individual stock futures. Here the
underlying asset is the stock index. For example the
S&P CNX Nifty popularly called the nifty futures. Stock
index futures are more useful when speculating on the
general direction of the market rather than the direction
of a particular stock. It can also be used to hedge and
protect a portfolio of shares. So here, the price
movement of an index is tracked and speculated. One
more point to note here is that, although stock index is
traded as an asset, it cannot be delivered to a buyer.
Hence, it is always cash settled.
 Both individual stock futures and index futures are
traded in the NSE.
COMMODITY FUTURES
Its the same as individual stock futures. The underlying
asset however would be a commodity like gold or silver.
In India, Commodity futures are mainly traded in two
exchanges 1. MCX (Multi commodity exchange) and
NCDEX (National commodities and derivatives
exchange). Unlike stock market futures where a lot of
parameters are measured, the commodity market is
predominantly driven by demand and supply.
The term commodity is a very broad term and it
includes
Bullion gold and silver
 Metals Aluminum , copper, lead, iron, steel, nickel, tin,
zinc
Energy-crude oil, gasoline, heating oil, electricity, natural
gas
Weather- carbon
Oil and oil seeds crude palm oil, kapsica khali,refined
Soya oil, Soya bean
Cereals- barley, wheat, maize
Fiber- cotton, kapas
Species-cardamom, coriander, termuric etc
Pluses chana
Others- like potatoes, sugar, almonds, gaur
CURRENCY FUTURES.
The MCX-SX exchange trades the following currency
futures:
 Euro-Indian Rupee (EURINR),
Us dollar-Indian rupee (USDINR),
Pound Sterling-Indian Rupee (GBPINR) and
Japanese Yen-Indian Rupee (JPYINR).
INTEREST RATE FUTURES.
Interest rate futures are traded on the NSC. These are
futures based on interest rates. In India, interest rates
futures were introduced on August 31, 2009.The logic of
underlying asset is the same as we saw in commodity or
stock futures in this case , the underlying asset would
be a debt obligation debts that move in value
according to changes in interest rates
(generally government bonds). Companies,
banks, foreign institutional investors, non-resident
Indian and retail investors can trade in interest rate
futures. Buying an interest rate futures contract will
allow the buyer to lock in a future investment rate.
FROM WEATHER TO TERROR..!!
Weather influences everyones lives. Right from daily
lives to agriculture to corporate earnings everything
gets affected if the weather is not favorable. For
example lets assume that this year cold winter is
expected in most parts of the United States. What
happens is that the price of heating oil goes up. Heating
oil futures are traded in commodity markets depending
on weather forecasts.
The fear of terrorist strikes had even made Pentagon
think of creating a futures market to help predict
terrorist strikes. Their theory was that possibility of
terror strikes in a particular area for example
possibility of a terror strike in New York would be traded
as if it was a commodity. Higher the price, higher the
possibilities of a terror strike. This way they thought,
would help them in finding potential threats.
Or take another example the assassination of Israel
prime minister futures which would be available for
trade as a commodity. Higher the price, the more likely
the event.
However the attempt was scrapped by pentagon in the
initial stages itself.

Futures: Understanding the basic terms

UNDERLYING ASSET
 The underlying asset that gives value to a futures
contract could be shares, share market indices,
commodities, currency, interest rates, weather etc.
LOT SIZE
The exchange specifies a particular lot size for each type
of derivatives.
When you buy or sell futures, you do that in lots.
This lot size is not divisible. For example the lot size of
reliance futures is 250 shares. So, taking 1 lot of reliance
futures would involve 250 shares. So if Reliance shares
are trading at Rs 1000, then the value of 1 lot is Rs
250,000 (Rs 1000 x 250 Numbers)
The exchange specifies the lot size. Lot size would be
different for different stocks/commodities.
 Not all stocks traded in the exchange have equivalent
futures contract. Stock are selected on the basis criteria
specified by the SEBI

VALUE OF A LOT
The value of one lot would be the price of the share x lot
size.
In most cases, it is approximately Rs 2-3 lakhs.
MARGIN MONEY
When a person enters into a futures contract, he need
not pay the full value of the contract upfront-only a small
percentage needs to be paid. That payment is called
margin money. Usually margin money would be a
percentage ranging from 10% to as high as 35 or 40% in
times of heavy volatility.
 For example the margin required for buying 1 lot of
reliance futures now is 15.70%. I.e., approximately Rs
29,000.00
The actual margin money required to be maintained
changes every day, specified by the NSE.
LIFE OF A CONTRACT
The life of one contract is 3 months.
At any point of time, 3 futures contract will be available
for trading with different time limit to expiry 1month, 2
month and 3 month contract. ( Also called near month,
mid month and far month contracts)
DIFFERENT TYPES OF FUTURES
Stock futures and stock index futures traded on the
NSE
Commodity futures traded on MCX / NCDEX
 Interest rate futures traded on NSE
OPEN INTEREST
Open means yet to be settled. Open interest is the
number of yet to be settled contracts.
The term used to describe a pair of buy and sell.
In live futures market, for each seller of a futures
contract there must be a buyer of that contract. Ie, there
must be a pair. Thus, a seller and a buyer combine to
create only one contract.
For example if Mr. x buys 5 futures contract from Mr. Y
(seller of the contract), then open interest rises by 5.
The total number of open contracts x lot size is called
open interest. The open interest cannot exceed the
number of shares a company has.
 An increase in open interest may mean that more money
is flowing in.
MARKED TO MARKET
Futures contracts are monitored regularly by the
authorities. Hence, Futures prices are marked to market.
It means that every change in value to the investor is
shown in the investors account at the end of each
trading day.
The implication is that, if your futures position is in
profits on a particular day, your account is credited with
that much of profits (which would be taken away, if the
prices fall on the next day). This process would keep
going until you settle the contract.
At the same time, if your position is in loss, the loss will
be shown in your account on the end of the trading day
 and if such loss is beyond your initial margin youve
given, you will have to pay the difference.
DISPLAY ON THE TRADING SCREEN
Futures are displayed on the trading screen just like
equities. Each future contract will be in a coded form just
like equities.
Future contracts are displayed in alphabetical order.
For a particular share / index / commodity, 3 contracts
will be displayed. The near month contracts are listed
first.
The trading screen would also show the open price, high,
low, traded quantity etc.
LONG AND SHORT POSITIONS
 Unsettled or open purchase position at any point of time
is called a long position and unsettled sales position at
any time point of time is called a short position.
SPOT AND SPREAD.
The cash market price is called the spot price and the
prices of futures contracts are called the futures price.
The term spread used to describe the difference between
two prices. For example reliance October futures may
be trading at Rs 750 per share and reliance December
futures may be trading at say, Rs 765. The difference is
called spread.
In fact, spread is a general term. It should be understood
in the context in which it is used. The difference between
the bid price and ask price is also called spread.
 Futures price will be greater than the spot price in a
normal market.
EXPIRY DATE OF A CONTRACT
Any futures contract would expire on the last Thursday of
a month. On that date the contract ceases to exist and
all the obligations must be fulfilled and the rights, if any,
become invalid thereafter.
Near month contract expire on the last Thursday of that
month. For example Infosys July contract (1 month)
would expire on the last Thursday of July while Infosys
September contract which is available for trading in July
(3months contract) would expire on the last Thursday of
September.
If the last Thursday happens to be a holiday (like
Christmas), the expiry will be fixed for the next day.
 In case of unforeseen circumstances the maturity date
may be shifted to another day by the SEBI through a
notification.
At the expiry day, all contracts are automatically
settled.
One the next day after the maturity, a new 3 month
contract will be introduced.
SETTLEMENT
In most futures markets, actual delivery never takes
place. Futures are cash settled.
Futures are used by traders for hedging price risks or by
speculators for betting against price movements.
Generally nobody is interested in taking delivery of the
underlying asset.
 For example lets take the case of a person who has
taken two futures long positions of reliance at Rs 750. At
the expiry of a futures contract, if the price of an
underlying asset (reliance shares) is more than Rs 750,
the exchange will pay the difference plus the initial
margin as settlement value. If the price of reliance has
dropped below Rs 750, the trader will have to pay the
difference to the exchange.
So, settlement takes place by taking an opposite position
to the one you have. When your contract is settled or
liquidated, the initial margin you paid plus or minus any
gains or losses will be credited back to your account.

Futures: Understanding Open interest.

OPEN INTEREST.
Open interest is one of the most confused terms in
derivatives . In simple terms, open interest is the
number of unsettled contracts. This term should not be
confused with volume. A Common misconception
amoung investors, especially beginners, is that open
interest on any day represents the volume of future
contracts traded.This needs to be corrected.
HERES AN EXAMPLE
With the help of an example, lets try to understand the
term open interest and why it is different from volume .
Our friend Mr. X is a guy who would like to speculate in
the futures market. Having made a killing from Nifty
futures last month, he starts his game afresh. This week,
this is what he has done in the first three days
 Monday bought 500 nifty futures.
So, volume is 500, number of open contracts 500.He
could buy 500 contracts because there was someone on
the other side (say, Mr. Y) to sell the same. In futures
market, every long position (buy position) has to have
an equivalent short position (sell position).
Tuesday bought 500 nifty futures.
Volume for that day is 500, the number of open
contracts rises to 1000. Note that we are counting
volume from 0 everyday but open positions are counted
as a running total. Secondly, when 500 contracts were
bought by our friend, 500 contracts were sold by
someone (Lets assume Mr. Y is the seller ).To count the
volume, we did not add up 500 buy +500 sell. We
 counted a pair of BUY and SELL as 1. Same logic
follows for open interest as well.
Wednesday sold 600 Nifty futures.
The volume for that day is 600.
However, the number of open position or unsettled
contracts may fall to 400 (1000 long -600 short) or
remain the same depending upon who purchased the
futures from Mr.X.If what Mr. X sold was purchased by
Mr. Y, then the open interest would get reduced to 400.
But, if it was purchased by a new entrant (say Mr. C),
then the open interest remains at 1000. Why? Thats
because, when Y purchased, it has the effect of squaring
up open positions. So, open interest gets reduced to 400.
But when C purchased it, X still has 400 contracts (buy)
to settle, Y has 1000 (sell) to settle and new entrant C
has 600 (Buy) to settle. The net effect is open
positions remain at 1000.
The rate of purchase or sale of futures or the amount of
profit made or loss suffered on the deal is of no
importance. What matters is the number of unsettled
contracts.
LONG OR SHORT-IT DOESNT MAKE ANY
DIFFERENCE.
Open interest on the long side or short side? Open
interest thats reported daily on the newspapers and
websites is the net open positions on the long side.
Equivalently, its also the number of short positions in
the market. So it doesnt make any difference.
For example- if the media reports that open interest of
Wipro futures is 2 lakhs, it means that future contracts
equivalent to 2 lakh shares were unsettled. There are 2
lakh shares on the long side and equal number of shares
on the short side.
Now I hope, you are clear about the difference between
open interest and volume. Open interest is the total of
active positions in the market. So, when traders buy /
sell and settle positions in the market, the open interest
will keep changing. Its basically a running total. Volume
is a totally different figure. Each day, volume is counted
afresh from 0.
THE USE OF OPEN INTEREST.
As a single stand alone figure, open interest is of no use.
It doesnt tell you much. The only fact you can guess is
that towards the end of the contract cycle, if open
 interest remains very high, volatility can be expected in
the market.
However, if you read open interest data with the price
changes and volume in the market, you may get
meaningful information.
Here are the thumb rules-
Prices will continue to rise when volume, prices and
open interest are rising
If prices are rising, but volume and open interest keeps
falling- It means that an uptrend would gradually halt.
Its a weak market if the prices are falling, but volume
and open interest are rising. New money is entering the
market in the form of short sellers.
 And finally, when prices, volume and open interest are all
declining, then we can assume that the market has
almost bottomed out.

Futures: Principles of pricing

At any point of time, Futures price of a share differs from
the spot price. As we have already learned, the spot
price of a share is determined by lot of factors like
demand and supply, performance of the company, broad
economic conditions, media news, general market
psychology etc.
Do the same factors decide futures prices? Or is there
anything else we need to know?
 The answer is yes. We need to learn a concept called
continuous compounding.

THE PRICE OF FUTURE.

Of course, economic conditions, demand and supply of
the underlying asset and countless other factors like
hedging and short selling influence futures pricing. But
theoretically, the futures price of stocks at any point of
time is determined by two factors-
Short term risk free interest rates and
Dividends.
HOW TO FIND THE VALUE OF FUTURES
Theoretical futures price when no dividend is expected.
Value of futures = Spot price x E (R x T)
Where E is the exponential value
 R= risk free interest rate
T= time to maturity
For example The share of X ltd is Rs 200 in spot
market. The risk free interest rate is 8%. What would be
the theoretical price of X Ltds 3 months futures?
Value of futures = Spot price x E (R x T)
Spot price = Rs 200
Risk free rate = 8% or 0.08
Time to maturity = 3 months or 3/12 or 0.25
So, R x T = .08 x .25 = .02
E (.02) = 1.0202 ( from natural logs table)
Value of futures = 200 x E (.02) = Rs 204.04
Note: To get the value of E(.02) refer to the E +X table of
natural logarithms. Log tables are nothing new. We all
have used log tables in our school days. Its also
available online in many math sites.
Whats mentioned above is the price of futures,
theoretically. The method we used is called continuous
compounding. This is one of the vital principles in
futures pricing. In some cases, the security in which a
futures position is taken may generate income. For
example- dividend on shares. In such cases the above
formula has to be modified to include the expected
dividend.
Theoretical futures price when specific dividend is
expected.
In this case, we have to consider the dividend expected
from the stock. The logic is that if dividend is paid by the
 company, then the amount required for investment
would be lower.
Value of futures = (Spot price- expected
dividend) x E (R x T)
If the dividend expected is expressed as a percentage,
then the above formula may be modified a little bit as
follows
Value of futures = spot price x E (R-Y) T
Where Y is the expected rate of dividend or dividend
yield.
To sum it up, if the expected dividend is expressed in
terms of money, we deduct the same from the spot
price. Whereas, if a specific dividend yield is expected,
then adjustment is made on the rate of return.
There are two crucial aspects here
1. The accuracy of dividend forecasts.Depending on the
accuracy , the value computed may vary.
2. Future dividends, expressed in rates or absolute
values, have to discounted to the present value. The
discounting process of dividends is the exact reverse of
continuous compounding discussed earlier. Examples are
given in the next post.
RISK FREE INTEREST RATE.
The topic was discussed elsewhere in our earlier posts.
Risk free rate is the rate of return that any individual can
achieve by investing in risk free assets. Generally,
government bonds are considered to be risk free and the
rate of return on such bonds are considered as the risk
free rate of return.
COST OF CARRY
Its a jargon used in futures. Cost of carry is theoretically
the risk-free interest rate that could be earned by
investing your money in a safe investment such as
government bonds. So, it represents the cost of
carrying or holding an investment.In the above
example the cost of carry would be Rs 4.04
ARBITRAGE OPPURTUNITIES
Mispricings in the theoretical vale of Single stock futures
unearths arbitrage opportunities. Such mispricings can
be used effectively to earn risk free profits.
More on that in our next post.

Futures: Compounding and discounting techniques.

We discussed continuous compounding in the last post.
Derivatives pricing are done using this method of
compounding. The justification is that returns on assets
like shares change continuously-on a minute by minute
basis. However, in real life, since interest rates are
expressed as an annual percentage, conversion to
continuous rate is necessary to make accurate
calculations.
We also saw in the last article that interest rates and
dividends are the two factors that determine the
theoretical pricing of futures. The correctness of
calculations therefore depends on how accurately youve
assumed these two figures.
HOW TO FACTOR IN EXPECTED DIVIDENDS
 In the case of dividends, you can only make a best guess
by studying the past dividend history and the present
financial strength of the company. Thats where it ends.
Dividends have to be discounted at appropriate rate to
find the present value. The technique used for this is
continuous discounting the reverse process of
continuous compounding.

The formula is:

Present Value of future dividends = Future dividends
x E - (R x T)
For example
The dividend expected on the X Ltds stock 3 months
from now is Rs 10,000. What would be the present value
 of dividends if the risk free continuous compounding
interest rate is 16% Per annum?
Present value = 10,000 x E (0.16 x .25)
= 10,000 x E (0.4)
10,000 x 0.96079 = Rs 9607.90
Note: Just like E (+x), E (x) values are available from the
natural log tables.
INTEREST RATES
Risk free interest rates would be expressed as a
percentage on an annual basis. The question is- How do
we convert interest rates expressed on annual or semi
annual basis to continuous basis?
The mathematical formula that helps to achieve this task
is as follows:
M x NL (1+ Normal rate/ M)
 Where, M = frequency of compounding and
NL = Natural logarithm
Here are two examples:
1. The risk free interest rate is quoted as 18 % P.a. What
is the equivalent continuous compounding rate?
M x NL (1+ Normal rate/ M)
Where , M= 1( annual compounding), normal rate =
18%
1 x NL (1+ 0.18/1) = 1 x 0. 16551 = 0.16551 or
16.551%
2. The risk free interest rate is quoted as 18 % P.a. with
half yearly compounding. What is the equivalent
continuous compounding rate?
M x NL (1+ Normal rate/ M)
 Where , M= 2( half yearly compounding), normal rate =
18%
2 x NL ( 1+ 0.18/2) = 2 x 0.08618 = 0.1724 or 17.24%

Futures: Arbitrage & its meaning

ARBITRAGE
Buying in one market (say, spot market) and
simultaneously selling in another market (say, futures
market) to make risk free profits when there is
substantial mismatch between two prices is called
arbitrage. Arbitrage is described as risk free because
participants are not speculating on market movements.
Instead, they bet on the mis-pricing of a share/asset that
has happened between to related markets.
In short, when you earn by selling and buying same
security at different rates in different markets, it is called
Arbitrage. It is a highly technical field. Markets mis-
pricing is taken advantage by traders to make risk free
gains.
Mispricing? How?
The futures price has a definite relationship with the spot
price. In normal market conditions, futures price would
be greater than the spot price because of the effect of
cost of carry and it moves in tandem with the price of
the underlying asset. So, broadly we can say that if the
spot price of the share moves up by Rs 5, the futures
position would also have made a profit of Rs 5. The
correlation is not very accurate but, almost so.
Thus, based on the cost of carry principle, if the spot
price of a share on a given day is x then, the futures
price on that day would be x + the interest for holding
the spot to the duration of futures contract ( minus) any
dividend accrued on the spot.
So, to compute the cost of carry accurately a participant
needs accurate information on interest rates and
expected dividends. However, futures market is not so
perfect where all the requisite information is readily
available to all. Imperfections are common and that
results in a mismatch between spot and futures price
based on the cost of carry principle.
When the relationship between spot and futures does not
hold, the futures are incorrectly priced and that results in
arbitrage opportunities.
Example-1
AT THE GOLD SOUK.
Gold coins sell at Rs 2500 for a gram right now. 1 year
gold futures are available at Rs 3750 for a gram. (I.e.
Gold coins deliverable after one year from now). Lets
also assume that personal loan interest rates are 15%.
Given the above situation, is there a way to make some
guaranteed profits? The answer is yes. Lets see how.
You borrow Rs 2500 at 15% interest for a year and buy
in the spot market. At the same time, youd also sell
futures at Rs 3750. A year later, to fulfill the futures
contract ( remember, you were the seller of futures
contract) you deliver the gold for Rs 3750 and out of the
proceeds, you pay back your loan of Rs 2500 with
interest which works out to Rs 2875. Net of Rs 875
(3750-2875) is your guaranteed profit, whatever may
come. What youve done is technically called arbitrage.
You made money because; the futures were priced
illogically higher than the spot price. The actual fair price
of the futures should have been Rs 2875 (spot + cost of
carry). But since futures were priced higher, you got the
opportunity to make money.
Example 2.
The risk free interest rate is 6% right now. Shares of
Toobler Ltd are available in the cash market for Rs 2000
whereas the futures contract of Toobler due for expiry in
3 months from now is available at Rs 2030 which is a
1.50% premium over cash market. This 1.50% works
out to an annual risk free cost of 6% based on cost of
carry principle. There is no arbitrage opportunity right
now as the relationship is theoretically correct.
Opportunities arise when the market over reacts to some
news or events disturbing this equilibrium.
For instance, lets assume that the government raises
the interest rates to 8% and Toobler Ltds share price in
cash market slumps to Rs 1970. The futures of Toobler
Ltd, which is traded by speculators, may fall 3% to Rs
1969. You might get an arbitrage opportunity here since
the theoretical spread between spot and futures has to
be maintained by the market. Either the spot market has
to fall or the futures price has to rise thereby maintaining
the spread between the two. Here, if you buy futures and
sell spot, you may make some risk free profits when the
market comes back to normalcy.
THE TWO RULES OF ARBITRAGE.
We sum up the two rules of arbitrage.
Rule 1. Buy spot and sell futures if the actual futures
price is greater than the theoretical futures price.
Rule 2. Buy futures and sell spot- If the actual futures
price is lower than the theoretical futures price.
Example 3
The shares of Toobler Ltd are quoted at Rs 2000 in the
spot market. The risk free interest rate 12% per annum
continuously compounded. Toobler is certain to pay a
dividend of Rs 125 per share 3 months from now. 3
month Toobler future contracts are available. What
would be the value of futures? If Tooblers futures are
available at Rs 2100, what would be your strategy to
make risk free profits?
Fair futures price:
 The present value of divided to be declared 3 months
from now would be
Rs 125 x E -(0.12 x .25)
Rs 125 x E (0.03) = Rs 125 x 0.97045 = Rs 121.30
Therefore, adjusted spot market price would be Rs 2000
121.30 = Rs 1,878.70.
Fair value of futures would be
Rs 1878.70 x E ( R x T)
Rs 1878.70 x 1.30345 = Rs 1935.
Since the futures are over valued at Rs 2100, you should
sell futures and buy spot. (Rule 1)
Example 4.
If we assume that Toobler Ltds futures are available for
Rs 1800. What would be the strategy to make risk free
gains?
Since futures are undervalued at Rs 1800, we apply Rule
2. You should buy futures and sell spot.

Futures: Risk levels of participants.

Future contracts, as we have already seen, are
instruments used for transferring risk. In other words,
future contracts are basically used for Financial risk
management.
That brings us to one basic question. When and for
whom is risk management necessary? Risk management
is necessary only for those who have a risky asset
position. I.e., when you have assets (shares / gold /
currency / commodity etc) which fluctuates heavily in
value. The uncertainty of price movements that
surrounds such investments necessitates the use of
derivatives. Many examples were discussed in our early
posts on how derivatives help investors in reducing the
risk they face.
The point i would like to bring here is that you should be
very clear about why you are using derivatives.

Many investors, Ive seen, use derivatives purely in

pursuit of windfall gains. This is where the danger
is.Many individuals and corporates have gone bankrupt
because of reckless speculation in derivatives market.
Way back in 1936, the dangers of speculation was
explained by economist J M Keynes. The excerpt is given
below-
JOHN MAYNARD KEYNES ON SPECULATION
Professional investment may be likened to those
newspaper competitions in which the competitors have
to pick out the six prettiest faces from a hundred
photographs, the prize being awarded to the competitor
whose choice most nearly corresponds to the average
preferences of the competitors as a whole; so that each
competitor has to pick, not the faces which he himself
finds the prettiest, but those which he thinks likeliest to
catch the fancy of the other competitors, all of whom are
looking at the problem from the same point of view.
It is not a case of choosing those which, to the best of
ones judgment, are really the prettiest, nor even those
which average opinion genuinely thinks the prettiest. We
have reached the third degree when we devote our
intelligences to anticipating what average opinion
expects the average opinion to be. And there are some, I
believe, who practice the fourth, fifth and higher
degrees.J.M Keynes- From his book The general theory
of employment, interest and money.
The above situation holds true for all those uninformed
traders who take positions in derivatives market
expecting to make huge money.
World over, the misuse of derivatives is on the
rise. Misuse of these financial instruments contributed
significantly to the global financial crisis in 2008.
Newspapers and internet carry advertisements of
advisory firms which provide futures and options calls
with 90% or more success rate. Nave investors are
lured to trade in derivatives by these firms. When many
participants unnecessarily bet in different directions, the
volatility in the market increases. Add to that those
events like scams that occur across the finance
world. All put together, sudden upward surges and
downfalls occur which wipes off the wealth of many
families and corporates.
Speculation is part and parcel of every market. No
system can control or curb speculation. In fact,there is
no need to control them. Speculators of the first and
second degree are required for the smooth functioning of
the markets. They provide the much required volume
and liquidity. But, when you put your money anticipating
what average opinion expects the average opinion to be,
youve gone too far. Opt for derivatives only if you have
a genuine purpose of doing so. If you have a cash
position or a heavy portfolio, youll have to protect it
from the vagaries of price fluctuations. In such cases,
you can use the derivatives route to reduce your risk so
that when you lose on one, you gain on the other and
thus neutralize the effect. You may also gain from
favorable price movements.
If you are using derivatives as a quick route to huge
wealth, you are totally caught on the wrong side. In this
case, your risk is substantial.Derivatives have the
potential to evaporate all your money in seconds.
In short, amateurs and speculators are the participants
who would lose/ earn money depending on their stars or
destiny. For them, the risk level is high. Other
participants like arbitrageurs, spreaders and hedgers are
in with a purpose.
Futures: Hedging & its importance
HEDGING.
Imagine this situation- you just bought a fundamentally
good stock at a bargain. You know that youve done your
home work and have bought the share at the right price
and time. But still, in a surprise move, the market may
think other wise and would send the stock price crashing.
You may not even understand why the stock price
tumbled. Such pitfalls are common in stock
markets.What a weird place to be. isnt it?
Now, is there a way to protect your money in such
cases?
Yes ! There are many methods. One such method is to
use futures to hedge your position. Before we explain
that, lets understand the meaning of hedging. Hedging
is any act that trys to protect an investment from price
risk to the maximum extend possible.So, its just like
insurance. We insure our life - against death
, against serious health problems, dont we? But, we
dont take insurance for cold & cough. Similarly, hedging
is not a strategy to employ for small investors because of
the cost and effort involved. Hedging is effective when
your investment involves a substantial amount.

HEDGING WITH FUTURES.

To hedge with futures, just take the opposite of the
position taken in the spot market. i.e. if you are long in
the spot market, short futures. If you are short in the
spot market, go long in futures.
 If the price in spot market falls, you lose in spot and gain
in futures. If the price in spot market is up, you gain in
spot and lose in futures. Either way, you would gain in
one market and lose in the other. This never guarantees
a huge return but it helps you to offset the loss incurred
in a position and eliminates the price risk.
EXAMPLE.
1. You bought 2000 shares of ICICI currently trading at
Rs 700. Since the market is turbulent you fear that the
stock price would fall and hence want to protect your
investment from price risk. Futures of ICICI can be
bought or sold at Rs 710. What would you do to hedge
your position?
SHORT HEDGE Sell 2000 shares of ICICI futures. Lets
assume that the stock price falls to Rs 670 and
 consequently, the futures too, falls to Rs 673. You lose
Rs 30 per share in the spot market and would gain Rs 37
(Rs 710-673) per share in the futures market.
Contrary to whats said above if the stock price in the
spot market rise to Rs 730, with futures trading at Rs
733, you would gain Rs 30 per share in the spot and lose
Rs 23 per share in futures. Either way, you stand to gain
Rs 7 per share. Your gain from the deal is Rs 14,000
(2000 x Rs 7) minus brokerage.
2. Youve shorted 1000 shares of HDFC currently trading
at Rs 500. But soon after, some good news hits the
market and the sentiments seem to be in favor of HDFC.
You fear that the price in the spot market may go up and
hence, want to protect your money to the maximum
extent possible. Futures of HDFC are available at Rs 505.
What would you do to hedge your position?
LONG HEDGE Buy 1000 shares of HDFC futures. Lets
assume that the stock price is at Rs 525 and
consequently, the futures trade at Rs 530. You lose Rs
25 per share in spot market and gain Rs 25 per share in
futures. You nullify the effect of price that went against
your calculations.
Now, suppose, there was no such good news and the
stock price comes down as expected. HDFC now trades
at Rs 475 and futures are trading at Rs 480. You gain Rs
25 in the spot market and lose Rs 25 in the futures
market. So again, you nullify the effect of price
fluctuations.
PERFECT HEDGE AND CROSS HEDGE
If a position taken would eliminate the risk of an existing
position, or if a position can eliminate all the market risk
from a portfolio of investments, it is called a perfect
hedge. In order to be a perfect hedge, a position would
require a 100% inverse correlation to the initial position.
Such positions are a rarity. Any hedge thats not perfect
is called an imperfect hedge.
In real life, it may so happen that the asset which is
being hedged may not have a corresponding contract in
futures segment. For example, futures are not available
for A ltd, in which you hold 5000 shares. After a lot of
observation and research, you find that A ltds shares
moves in tandem with another company in the same line
of business, B ltd. B ltds futures are available for trade.
So, in order to hedge your position in Altd, you can go
short on B ltd. Such a hedge is called Cross hedge.
FULL HEDGE AND PARTIAL HEDGE.
We dont think theres much to explain here. Full hedge
is when you take exactly equivalent opposite position in
order to protect 100% of your portfolio. Partial hedge is
when you decide to hedge only a part of your holdings
against risk. For example, an investor may be confident
in 25% of his investments in blue chips, but may fear
about the price risk of the other 75% invested in
midcaps and small caps. Hence he may decide to hedge
only 75% of his holdings.What he has done is called
partial hedge.
Thats the basics for you. The purpose of this post was to
explain hedging. In real life, however, it may not be
possible to create a perfect hedge due to various
reasons. Hedging decisions are not simple as it is
explained in this post. Its also not totally risk free as we
saw in the examples. The reason lies in a concept
called basis risk coming up in our next article.

Futures : Understanding basis risk

BASIS.
By creating a long or short hedge using futures, if you
thought your cash position is safe, you are wrong. As we
saw in the previous posts examples, hedging eliminates
price risk. But it opens up a second risk called Basis
risk. To understand that, first you should understand the
term Basis.
The difference between spot price and futures price at
any point of time is called Basis.
BACK TO EXAMPLES.
Lets go back to the HDFCs example from our previous
post. The basis at the beginning was Rs 5 per
share. (Hows that? Cash price- futures price, Rs 500
Rs 505).
In situation 1, the stock price moves up to Rs 525 and
the futures were at Rs 530. Hence, the basis works out
to Rs 5. In situation2, the stock price crashed to Rs 475
and the futures were at Rs 480. Again, the basis remains
unchanged at Rs 5. The effect in either situation, the
loss was offset by the profit made.

Take note:
 Basis at the beginning and at the end were same, i.e. Rs
5.
When the basis doesnt change theres no risk. The
hedger neither makes a profit no incurs a loss.
The end result is, either way the loss/profit in cash
market is exactly offset by profits/loss in futures.
Now, our second example in the case of ICICI, the
basis at the beginning was Rs 10 per share.
In situation 1, When the stock fell to Rs 670, the futures
were at Rs 673. So, the basis works out Rs 3 ( cash price
Rs 670- futures price Rs 673) In situation 2, when stock
price went up to Rs 730, the futures were at Rs 733;
hence, the basis at that time is also Rs 3.The effect was
that you made a profit of Rs 7 at the end in either
situation.
 In contrast to the first example, note that:
Basis at the beginning and at the end were not the same.
(at the beginning it was Rs 10, at the end it was Rs 3)
When the basis changed (favorably this time), the
hedger made a profit.
The end result is that since the basis changed favorably,
in either situation, the hedger makes money.
Hope you understood what basis is. Basis is a crucial
factor in futures. Its a source of risk for hedgers who
use futures to safeguard their position. From the above
examples we also come to the conclusion that when the
basis doesnt change, the hedge is perfect (as in the case
of HDFC); but when the basis changes over time, it could
turn favorable or unfavorable to the hedger (as in the
case of ICICI).
BASIS RISK
Basis risk is described by many as the mother of all
risks. It occurs when futures and cash prices fail to
move in tandem. Depending on this relation between
basis at the beginning and basis at the end, certain
unavoidable risk scenarios may arise as explained below.
IF YOURE A SHORT HEDGER
Senario1. Cash Price Decreases Faster than the Futures
Price.
When cash prices drop faster than the futures price, you
incur a loss which is equal to the difference between cash
price at beginning (C0) cash price at the end (C1)
and futures price at the beginning (F0) futures price
at the end (F1).
 Weak basis ; unavoidable loss = {( C0-C1) (F0-F1)} +
brokerage
Scenario 2. Cash Price Increases Faster than the Futures
Price
When cash price increases faster than the futures price,
you get a windfall gain which is equal to the difference
between cash price at beginning (C0) cash price at the
end (C1) and futures price at the beginning (F0) -
futures price at the end (F1).
Weak basis ; windfall gain = {( C0-C1) (F0-F1)}
less brokerage
Scenario 3. Futures Price Decreases Faster than the Cash
Price.
When futures prices drop faster than the cash price, you
get a windfall gain.
 Strong basis ; windfall gain = { (F0-F1) (C0-C1)} less
brokerage
Scenario 4 Futures Price Increases Faster than the Cash
Price.
When futures prices increases faster than the cash price,
you incur a loss
Weak basis ; unavoidable loss = { (F0-F1) (C0-C1)} +
brokerage
Scenario 5. Futures Price Decreases /Increases in
tandem with the Cash Price.
No change in basis; perfect hedge.
Your expense for protection = brokerage paid.
Scenario 6. Cash price and futures price stays the same.
No change in basis; no hedge.
Your profit is C1-F1 less brokerage.
 IF YOURE A LONG HEDGER
Scenario 7. Cash Price Increases Faster than the Futures
Price
When cash price increases faster than the futures price,
you incur a loss which is equal to the difference between
cash price at beginning (C0) cash price at the end (C1)
and futures price at the beginning (F0) - futures price
at the end (F1).
Strong basis ; unavoidable loss = {( C0-C1) (F0-F1)}
+ brokerage
Scenario 8. Futures Price Increases Faster than the Cash
Price
When futures price increases faster than cash price, you
get a windfall gain which is equal to the difference
between futures price at the beginning (F0) - futures
 price at the end (F1) and cash price at beginning (C0)
cash price at the end (C1) and
Weak basis; windfall gain = { (F0-F1) (C0-C1)}
less brokerage
Scenario 9 Cash Price Decreases Faster than the Futures
Price
When cash price decreases faster than the futures price,
you gain which is equal to the difference between cash
price at beginning (C0) cash price at the end (C1)
and futures price at the beginning (F0) - futures price
at the end (F1).
Weak basis ; windfall gain = {( C0-C1) (F0-F1)}
less brokerage
Scenario 10. Futures Price Decreases Faster than the
Cash Price.
 When futures price decreases faster than the cash
price, you incur a loss which is equal to the difference
between cash price at beginning (C0) cash price at the
end (C1) and futures price at the beginning (F0) -
futures price at the end (F1).
Strong basis; unavoidable loss = {( F0-F1) (C0-C1)}
+ brokerage
Scenario 11. Futures Price Increases / decreases in
tandem with the Cash Price
No change in basis; perfect hedge.
Your expense for protection = brokerage paid.
Scenario 12. Cash price and futures price stays the
same.
No change in basis; no hedge.
Your profit is F1-C1 less brokerage.
CONCLUSION: If youve hedged your position at any
time, youre definite to face any of the 12 scenarios
mentioned above. Theres nothing you could do about it.
The only way that you can reduce basis risk is to improve
your hedging skills and make right moves to the
maximum extent possible. You cannot eliminate this risk
altogether.

Futures: Contango and backwardation

CONTANGO & BACKWARDATION.

Contango and backwardation are two technical jargons
used in the futures market. These terms are used to
describe the position of futures price in comparison with
the spot price.
In a normal market, futures price would be greater than
the spot price due to the effect of cost of carry. This
situation is generally referred to as a Contango market.
In our last article, we understood that the basis is
difference between spot price and futures price at any
point of time. In the case of a contango market, since
futures price is more than the spot price , the basis
would be a negative figure.

Backwardation is just the opposite of Contango. In some

special situations, the futures prices may be decided by
factors other than cost of carry. For example- When a
stock market scam breaks out, its possible that the
stock market would be driven by negative sentiments
rather than fundamentals or technicals. In such cases,
futures may trade below the underlying assets value.
Such situations, where the spot price minus futures price
(basis) is a positive figure, is generally termed as
backwardation market.
CONVERGENCE OF FUTURES AND SPOT PRICES
At this juncture, one more point worth noting is that the
futures price and spot price would tend to converge as
the contract period draws closer. The basis would be
more at the time of introducing the contract. As the
maturity time approaches, the basis would gradually
diminish and finally reach zero. So, the basis risk also
will also fall to zero by that time.
REASON?
The reason for this can be traced back to the theory on
cost of carry and arbitrage discussed earlier in this
series.
In short, the relation between spot and futures market
would be backwardation or Contango before expiry. As
the maturity draws closer, this difference would be
gradually wiped away and the prices would tend to
converge. Finally, at the delivery point, the spot price
and futures price would be the same.
What if the price doesnt converge?
Such a scenario will not happen. The reason is simple. If,
on the day of maturity, the futures price is more than the
spot price, arbitrageurs would immediately step in and
sell futures and buy spot and pocket a risk free return on
the same day. If its the other way round, they would sell
spot and buy futures and pocket the difference. This
would again result in price convergence in no time.
We also tried the track the history of the term Contango
& backwardation. We got some information from
wikipedia and were reproducing that here:
The term contango originated in mid-19th century
England and is believed to be a corruption of
continuation, continue or contingent. In the past on
the London Stock Exchange, Contango was a fee paid by
a buyer to a seller when the buyer wished to defer
settlement of the trade they had agreed. The charge was
based on the interest forgone by the seller not being
paid. The purpose of the buyer was to speculate in the
market.
Like Contango, the term backwardation originated in
mid-19th century England, originating from backward.
In that era on the London Stock Exchange,
backwardation was a fee paid by a seller wishing to defer
delivering stock they had sold. This fee was paid either
to the buyer, or to a third party who lent stock to the
seller. The purpose of the seller was to speculate in the
market.
(Source: wikipedia)
Both these deals have similarity with our own badla
system in the Bombay stock exchange. Thats contango
and backwardation for you.

Futures: End note

 CONNECTING THE LOOSE ENDS.
As we come to the end of basic theory on futures , there
are some loose ends to be connected. These were
collected from the questions that readers have asked us.
Not all stocks have corresponding futures. In India,
Stock futures are introduced by the exchange and its
decided based on criteria specified by the Securities
Exchange Board of India. If an existing security fails to
meet the eligibility criteria for 3 months consecutively,
then no fresh future contracts will be issued in that
stock. In the case of existing contracts, if the exchange
is of the view that continuing derivatives contracts on a
particular stock is detrimental to the interest of the
market, it may compulsorily close all derivatives contract
positions in that particular stock.
 The price of futures contract now is not the expected
price of the underlying stock on the maturity date.
Futures price is determined by the cost of carry principle.
However, empirical evidence on cost of carry is not
consistent. Studies have shown that the cost of carry
principle does not perfectly hold over a period of time
and it keeps changing from week to week or even day to
day.
There will be three futures contracts available for trade
at any given point of time. Theoretically, these contracts
would be priced applying the cost of carry principle and
hence, the far month futures would be priced higher than
the near month futures.
Backwardation is not just a theoretical concept. Such
scenarios are real. Backwardation conflicts with the cost
 of carry principle. When other economic factors pre-
dominate the markets, such imperfections are possible.
The most important use of futures is hedging. Hedging
protects investors from adverse price movements. At the
same time, it also prevents the hedger from participating
in extreme favorable price movements. So, taking
decisions on hedging calls for a lot of experience and
expertise.
You have to pay margin money to enter into a futures
contract. Margins are of two types 1. Initial margin and
2. Daily margin. The initial Margin is collected to cover
the potential losses for one day. The initial margin
percentage may differ from stock to stock based on the
risk involved in the stock, which depends upon the
liquidity and volatility of the respective stock besides the
 general market conditions. Apart from initial margin, the
difference between the cost of the position held and the
current market value of that position, if loss, has to be
remitted by the party on a daily basis.
There are limits for entering into futures contracts at all
levels at the client level, trading member level and at
the market level as a whole. One person cannot enter
into as many future contracts he likes. There is a limit to
the gross open position, specified by the exchanges
every month. Position limits are introduced for
controlling excessive speculation.
A trader cannot enter any rate for trade. In the case of
stock futures, there is a price range which is +/- 20% of
the base price. The base price is nothing but the daily
settlement price. However, on the first day of trading,
 since there is no previous settlement price, the base
price would be the theoretical futures price. Orders below
or above this operating range of + / 20% from the
base price would be freezed by the exchange.
A trader cannot enter any quantity for a trade. In case of
stock futures, there is a maximum quantity specified by
the SEBI. In case of Stock Futures the quantity for each
stock is specified by exchange from time to time and
single order notional value should not normally be
beyond Rs. 5 Crores approximately. Notional value is the
futures prices multiplied by the lot size.
Corporate actions like bonus, rights, dividends, merger,
amalgamations and splits would have an impact on the
futures contracts and such actions have to be adjusted
 accordingly. The effect of corporate actions and how it is
adjusted would be explained later.
NRIs can participate in derivative Contracts (except
currency derivatives) out of INR funds held in India on
non-repatriable basis (NRO) subject to the limits
prescribed by SEBI. An NRI, who wishes to trade on the
F&O segment of the exchange, is required to apply for a
custodial participant (CP) code. Thereafter he can open a
trading account and start trading in derivatives. Position
limits for NRIs shall be same as the client level position
limits specified by SEBI from time to time.
Futures contracts are always cash settled. On settlement,
the settlement price would be the underlying assets
closing price.
Options: Kick off
OPTIONS
Options are slightly complex than futures. Weve already
discussed the meaning of option contracts. From this
article onwards, well proceed to break up various
aspects of options just like we did with futures.
Options are traded in the exchanges just like futures. At
any given point of time , there would be three
outstanding contracts near month contract, mid month
contract and far month contract. Option Contracts expire
on the last Thursday of the expiry month. So, all those
features are common between futures and options.

BUYERS AND SELLERS.

In any market, there would be both buyers and sellers.
The option market is no different. There would be buyers
and sellers for option contracts. You can buy/sell two
categories of options calls and puts. As already
mentioned in our introductory article on options, buyers
are called holders and sellers are called
writers.Straight and simple.
Now, we would like to discuss just two points in this
article.
EVERYTHING IS AT YOUR OPTION... ( If you are the
buyer !! )
Thats the first point.
As a buyer, you are the king it doesnt matter if you
bought a call or a put if youre the holder, what you
hold is a right. The peculiarity of this right is that, it is
not at all necessary that you should exercise this
right!! You would proceed to exercise the right only if
its favorable for you.
So, as a buyer you have two choices you can buy a
call or buy a put.
If youre buying a call That gives you the right to buy
the underlying asset (i.e., stocks) within a certain period
at a specified price, called the strike price. Its just a
right. At the end of the contract, it is not necessary to
exercise the right. Its your option.
If youre buying a put That gives you the right to sell
the underlying asset within a certain period at a specified
price (strike price). Again, its just a right. At the end of
the contract, its not at all necessary to exercise the
right. Its your option.
 So, if markets move according to your calculations, youd
jump in and exercise the right and make money. Or else,
youll leave the right to lapse.
For example
The shares of reliance are trading at Rs 650 and
according to your calculations, the stock would move up
to Rs 750 in 25-30 days. But since there is nothing called
100% surety in stock markets, you also fear that if some
negative news breaks out, the stock would plummet to
Rs 590 or below. Reliances near month options are
available at a strike price of Rs 670. Now, how do you
take advantage of this situation and at the same time
protect yourself?
Buy reliance call option That gives you the right to
buy Reliance shares at Rs 670 anytime within 30 days.
Its just a right. At the end of the contract, it is not
necessary to exercise the right. Its your option. If
everything works out according to your calculations, then
30 days later, the stock would be trading at Rs 750 and
youd immediately exercise the right to buy at Rs 670
and sell at Rs 750. The difference is your profit.
Now suppose the price of reliance drops to Rs 590. You
being the call holder at Rs 670 (strike price) would not
be interested in buying at Rs 670 anymore. So youll not
exercise the option and the option lapses.
NOTHING IS AT YOUR OPTION ( If youre the
seller..!!)
Thats the second important point.
As a seller, youre the slave it doesnt matter if youve
sold a call or a put if youre the seller, what you sold is
a right. Since rights are sold, if the guy who bought the
right from you opts to exercise his option, you are bound
to obey. Theres no option.
Here also, as a seller of options you can sell a call or
sell a put.
If youre selling a call That gives the buyer the right to
buy the underlying asset from you within a certain period
at a specified price, called the strike price. At the end of
the contract, he may or may not exercise the right. Its
his option. You as a seller have a definite obligation to
sell.
If youre selling a put youre selling the right to sell
the underlying asset within a certain period at a specified
price (strike price). At the end of the contract, if the
buyer of the put option wants to sell it to you, youre
obligated to buy the stock at a predetermined price.
So if youre the seller of a put or call, you are always
obligated. Your performance is compulsory. As a seller of
options, your gain is always limited but your possibility
for losses is unlimited. So, selling options is very risky.
Its perfectly all right for beginners to get confused
towards the end. In that case, go back to the options
definition, and the then come back and read once again.
Youll get the clear picture.