Knowing Futures & Options-III

This week we present the third and the last part of our series on Futures & Options. After having examined the basics in the previous two parts, this time we shall discuss some numerical examples to try and understand the practical use of these derivative products.

Example 1: Selling/Writing a Call

Take the case of Narayan selling to you 100 contracts of September at Rs 270 call in Company XYZ. This means that you (taker) can call for 100 shares at Rs 270 each, any time before the September call expires. In that case, Narayan must deliver, whether he owns the shares or not, at the exercise or strike price. Thus, a September 270 XYZ call means the strike price is Rs 270, the expiry date is at the end of September, and the underlying shares are XYZ. In return for granting this privilege of being able to call the share away from him, Narayan demands a premium of Rs 15. By the established convention, Option prices are always expressed on per share basis, not on the market lot. If the price of underlying does not go up before the date of expiry, the buyer will not exercise his Option and Narayan’s profit will be Rs 1,500 less brokerage.

Now suppose on August 11 the stock has closed at Rs 280. If you were to exercise the Option on that day, you would receive Rs 10, which is the difference between the stock price and the exercise price. Your Option is ‘in-the-money’ by Rs 10, or that the intrinsic value of the Option is Rs 10. Since there are 20 days left for expiry, the price of this Option would actually be around Rs 15. The difference between the price of the Option and its intrinsic value, Rs 15 in this case, is the time value.

If you are long on the XYZ 270Option and want to close your position, you may exercise the Option to receive Rs 10, or sell the Option to receive Rs 15. The second alternative gives you a higher profit, or a smaller loss.

Example 2: Buying a Put

If fund manager wants to hedge a stock quoting at Rs 120, without loosing out on the upward gains that the stock may offer, he may opt for buying a put Option, say for Rs 20 at a strike of Rs 120 instead of selling the stock in the market. In such a case the fund manager avoids a fall in the value of the fund due to any possible fall in that stock. On the negative side if the market moves up the fund looses on the premium of Rs 20, but continues to be benefited by the appreciation in the price of the stock.

Example 3: Trading in Futures

Consider a portfolio with an asset composition of (i) Equity Rs 90 crore, (ii) Cash Rs 10 crore and (iii) Beta of Portfolio 1.1.

If at any time, the fund manager expects the market to decline, he may, with a view to immunising the portfolio from such a decline, decide to sell index Futures. In this case, the ideal value of Futures contracts to be sold so as to achieve a perfect hedge would be Rs 99 crore (= 90*1.1).

Let us suppose the index Futures at that time are selling at 4,300. Assuming a lot size of 50 per contract, the number of contracts to be sold is 4,600 = 99 crore / 4,300 × 50 (rounded off). At a later date, the market declines by 10 per cent and the index Future price falls to Rs 3,900 and the fund manager decides to close out the position. While due to a 10 per cent fall in the market the stock portfolio would have declined by 11 per cent, thanks to beta, i.e. Rs 9.9 crore, the net gain arising from the Futures position works out at Rs 9.2 crore arrived at as under:

Purchase price per contract Covered price per contract Profit per contract Total profit

This will reduce the net loss on the hedged portfolio to just Rs 0.7 crore (= 9.9 – 9.2) as against a loss of Rs 9.9 crore, had the portfolio remained unhedged.

The cost which the scheme will have to bear will be the opportunity cost which is the interest on the margin money amount of Rs 9.9 crore (assuming the margin specified by the exchange is 10 per cent of the value of the Futures contract) and the brokerage.

Tax Treatment — A Dilemma Solved Partially

There was a lot of confusion related with whether the income from transaction in derivatives should be treated as speculative or business.

FA05 has clarified that derivative transactions will no longer be classified as speculative in nature and income therefrom is not speculative income. FA12 has passed on similar protection to derivative transactions in commodities.

However, it has not been clarified whether an investor can

= Rs 50 × 4,300 = Rs 2,15,000

= Rs 50 × 3,900

= Rs 50 × (4,300-3,900) = Rs 20,000 = Rs 4,600 × 20,000 = Rs 9.2 crore

treat derivatives as a capital asset and claim benefit of concessional rate of 15 per cent on short-term gains. Instead of merely stating that it is not speculative, the authorities should have stated the nature of the transaction positively.

Cash v Physical Settlement

Sebi’s board meeting of 6.3.10 decided in principle to allow the Stock Exchanges to introduce —

Equity derivatives contracts with tenures up to 5 years,

Derivative contracts on volatility indexes which have suitable track record, and

Physical settlement of equity derivatives. At present, trades are settled in cash in the form of contracts for differences. Now that the necessary systems are in place, the settlement of derivative contracts can be allowed through physical settlement through delivery of securities.

With this, we have completed our coverage of the subject matter.

Hope you have found the series useful and it will help you navigate the twists and turns of the capital market. If you have any questions or require any clarifications on the subject, please feel free to write in.

The authors may be contacted at wonderlandconsultants@yahoo.com