Knowing Futures and Options-I
Futures and Options (F&O) is a relatively late entrant to the Indian market. Prior to that, speculative transactions used to be carried out under a system called ‘Badla’ – the Badla system was inefficient in as much as fraudsters could easily manipulate it to defraud and cheat investors. F&O is a refined, more efficient medium of speculation. Since the subject matter is complex, we intend to carry it over three parts. This is the first part.
The history of Futures is very interesting.
In the 19th century, grain shipped to the USA by producers in England took months. During this period if prices fell significantly, the grain was sold at a loss, ruining the producers. They sought to overcome this price risk by selling their grain forward (‘to arrive’ basis) at prefixed prices, sometimes even at lower than ruling or expected prices. This is the origin of the ‘Futures and Options’ extended to shares.
Futures
A Futures contract is an agreement between a seller and a buyer that calls for the seller (called ‘Short’) to deliver to the buyer (called ‘Long’) a specified quantity and grade of an identified commodity, at a fixed time in the future and at an agreed price. It is obligatory on both the parties. There is no premium payable by either party.
Options
A logical extrapolation of Futures is Options, which, unlike Futures, imposes an obligation on only the writer of the contract. Before the advent of the computers, the Option sellers wrote a contract. The nomenclature has continued to stay. The holder (purchaser) of Options has an option either to buy (call) or sell (put) a commodity at an agreed price within a prefixed future date. For this, the holder pays a one-time non-refundable fee (Option Premium) to the writer (seller). The Option premium is not adjusted against future payments, if any.
When an Option holder exercises it, he either pays the agreedupon price (strike price) if it is a call Option or receives payment in the case of a put Option. If the holder decides to waive his Option, which he can, his loss is only the premium, which, in effect is insurance and he loses it in any case.
In contrast, the writer has no authority or right to determine whether or at what point will the Option be exercised. The right rests only with the purchaser. The potential loss to the writer is unlimited. In contrast, if the holder chooses not to exercise his right and lets the Option expire, his loss is limited to the premium paid.
Options can also be used for speculative purposes. If one believes that price will rise in the future, he can buy a call. On the other hand, if he believes that it will fall, he can acquire a put. The premium or discount for reflects the market perception of the price at which the share is likely to be quoted.
Options trade takes place at the premium which is a small percentage of the underlying stock. In practice, most Options are allowed to expire. In other words, most Options are traded rather than exercised. If the Options are exercised, the clearing house chooses randomly the writer for doing the needful.
Options are standardised to expire in rolling one or two or threemonth cycles, typically at the end of the month. These are referred to as March calls or December puts or whatever month the expiry occurs. In India equity contracts expire on the last Thursday of each month and if it happens to be a holiday, on the preceding business day.
Transact in Lots
Understandably, it is ridiculous to transact options for one or two shares. Investors have to take an exposure of at least one lot, the size of which differs depending on the stock prices and index. Lot size refers to number of underlying securities in one contract and is same for an underlying traded across exchanges.
SEBI has standardised the lot size for derivatives vide SEBI/DNPD/Cir- 50/2010 dt 8.1.10 and the lot size depends upon the price band between which the stock is traded.
In case of Nifty it is 50 units. A mini Nifty Option contract started by BSE and NSE has a size of 20 units in a lot, especially for small investors.
Types of Options
European Option can be exercised only on the expiry of the specified period. Index Options, such as the Nifty and Sensex, are European. On the other hand, an American Option can be exercised at any time prior to or at its expiry. At the time of its exercise / maturity, an average of the prices during the life of the Option is taken into consideration for determining whether the Option is in-the-money (ITM), at-themoney (ATM) or out-of-money (OTM).
These terms refer to the intrinsic value of an Option, or how much money you would gain or lose on exercising the Option immediately. All these Options are traded worldwide and are not linked to any location like America
or Europe.
For ATM and OTM Options, the intrinsic value is zero though the Option has value because of the time left for expiry. Even if an Option is not ITM currently, the time left for maturity provides an opportunity for the stock price to change. An Option buyer pays for that opportunity.
For exercising an Option prior to its maturity, you have to give notice to the exchange through your broker before 4.15 p.m. The payout is on the basis of the weighted average price of the underlying security in the last half an hour of trading. Options that are ITM at expiry are automatically exercised by the exchange. Brokerage is paid on exercise as well as on squaring off based on the notional value of the contract.
Dividends during the life of the Option reduce the value of a call Option and increase the value of a put Option.
The significant difference between Futures and Options is strike price interval. In Futures there is only one price for any stock or index. Options have various strike prices, each with a premium attached to it, which reduces as the day of the expiry nears because of the time value. Moreover, Futures can be rolled over but not Options since these may or may not be exercised.
Next time, we shall deal with some more interesting aspects of this subject matter.