All About Futures

All About Futures

What are futures? Futures are derivatives. These are securities whose value depends on the value of an underlying asset, which could be a commodity or a financial instrument. A future or a forward contract is an agreement between two parties to buy or sell an underlying asset at a certain time in the future for a certain price, which is fixed now. One party buys the asset and the other party sells the asset.

What are some commonly used derivatives? Some commonly used derivatives are forward contracts, futures, options, swaps and warrants

What is meant by a contingent claim? A contingent claim is another word for a derivative security. It is so called because they are claims whose values are contingent (i.e., depend on) on the value of the underlying asset.

What is the nature of the underlying asset? Underlying assets can be of several types, such as : Commodities. Agricultural commodities such as wheat, corn, or rice. Animal products such as pork. Metals such as iron or gold. Shares, currencies and bonds. Share indices. The first two asset types have a physical existence in some form. The last are merely are numbers calculated on the basis of a basket of share prices and have no physical existence.

Are futures and forward contracts the same? No. Forward contracts are contracts entered into privately between two parties as above. Futures contracts are contracts that are traded on an exchange.

What are the differences between futures contracts and forward contracts? In quite a few ways, futures contracts are superior to forward contracts. Some of them are : No counter-party risk : Since the exchange takes the responsibility of settling every trade, each party to the contract will have his portion settled, irrespective of whether the other party settles or not. But in forward contracts, the failure of one party to the contract can lead to non-settlement of the contract itself. Liquidity : Since futures are traded on an exchange, they are very liquid. It is possible to get in and out of futures positions pretty fast. This feature does not exist in forward contracts since they are not traded on any exchange. Uniformity : Futures contracts are standardised in terms of the size of the contract, the delivery date and the quality of the commodity itself. Such standardisation does not exist in the case of forward contracts. Still, forward contracts are popular because they can be structured in a manner to suit both parties to the contract in terms of size of contract or maturity date or quality / nature of commodity or financial asset. In fact, the forward market for foreign currencies dominated by banks is the largest financial market in the world. Another difference is that in the case of futures, the exchange marks to market the contract on a daily basis. So each of the parties to a contract either receives or pays out the difference. But with forwards, there is no such mark to market arrangement and all differences are settled at the maturity of the contract. Let us illustrate this with an example : Mr. Sharma buys a futures contract on the exchange which entitles him to receive 100 shares of ABC Industries three months hence paying a price of Rs 350 per share. Simultaneously, the counter-party to the contract, Mr. Tripathi has an obligation to deliver 100 shares of ABC three months hence and receive Rs 350 per share. Given the current market price of ABC is Rs. 350, we could have three situations tomorrow: The price moves up to Rs 360 : Then Mr. Sharma will receive Rs 1,000 (100 shares multiplied by difference of Rs 10 per share) from the exchange and Mr. Tripathi will have to pay Rs 1,000 to the exchange. The price falls to Rs 340 : Then Mr. Sharma will have to pay Rs 1,000 (100 shares multiplied by difference of Rs. 10 per share) to the exchange and Mr. Tripathi will receive Rs 1,000 from the exchange. The price remains unchanged at Rs 350 : Then neither Mr. Sharma nor Mr. Tripathi will have to pay or receive anything. Such marking of the contract to changes in market price does not happen with forward contracts.

What are financial futures? Financial futures are futures where the underlying asset is a financial instrument such as a share, currency or an index.

Is there a difference between financial futures and commodity futures, other than the nature of the underlying asset? Commodity futures are settled partly by cash and partly by delivery of the concerned commodity. Financial futures are mostly settled in cash, by paying out or receiving differences and rarely by delivery.

What is meant by standardisation of futures? The exchange standardises futures contracts in terms of the following features : Value or size : All futures contracts based on a particular underlying instrument, say the S&P CNX Nifty, would be of the same size. Month of delivery : Usually 90-day contracts expire in March, June, September and December. Together with the month of delivery, the days on which delivery can be made are also fixed, if possible. Range of fluctuation : It is the tick or amount by which price of futures contract can move up or down. For example, in a futures contract, the tick could be Rs 0.25 or 25 paise. In the case of commodity futures, the exchange also specifies the product quality and the delivery location.

What is meant by ‘going long’ or ‘going short’ in a futures contract? The buyer of a future contract is said to ‘go long’ the future, whereas the seller is said to ‘go short’ that future.

What do price changes of a futures contract reflect? The price changes of the future will reflect the price changes of the underlying instrument (share or index). With a long position, the value of the position rises as the price of the underlying instrument rises and it falls as this price falls. With a short position, a loss ensues if the price of the underlying instrument rises, while profits are generated if this price falls.

How is the performance of the parties to a futures contract guaranteed? Clearing houses at futures exchanges guarantee the performance of the parties to a futures contract. This is accomplished by a process called novation, wherein the clearing house functions as a seller to every buyer and a buyer to every seller. As a result, after a trade is concluded, the two parties to the trade need not interact with each other at all. The clearing house settles each leg of the trade independently. In the case of commodity futures, clearing houses also facilitate settlement by delivery.

How do clearing houses guarantee trades? Each clearing house will have a mix of strategies to ensure that, even in the most volatile of markets, each party to a contract fulfils its obligation. These are accomplished by a strict system of initial and mark to market margins imposed on the members of the clearing house, who settle the trades with the clearing house. In addition to this, most clearing houses also get themselves insured against failure of their members and build up contingency funds from contributions by their members to safeguard against large scale failures.

Is futures trading meant for someone like me? Futures trading is very useful to three categories of people. If your investing style matches any of the three following categories, you would find futures trading useful : Speculators : A speculator is a person who takes a view on the value of the futures contract and takes a position in the instrument. For example, a speculator might think that ABC prices would go up from their existing level. Hence he will go long (or buy) ABC futures. Or a speculator might think that XYZ shares would go down from their current price levels. Hence he will go short (or sell) XYZ futures. A speculator would use futures instead of taking a position in the underlying asset because futures give cash flow efficiency. Instead of paying the value of the underlying asset up front, only the initial margin is paid, with daily profits and losses being settled on a day to day basis. Thus futures are a highly geared alternatives to cash market positions. You could speculate, too. But remember; speculate only to the extent that you can afford to lose. Never over extend yourself. Arbitrageurs : An arbitrageur is a person who takes advantage of price differentials between two markets and makes profit in the process. For example say ABC shares are available on the BSE for Rs 300 and a one-month futures is quoting at Rs 320. The arbitrageur will buy ABC shares on the BSE and sell the one-month futures contract. On maturity of the futures contract, he will deliver the ABC shares and receive Rs 320, thus booking a profit of Rs 20 per share. An arbitrageur takes a covered position, in that he is not exposed to price risks in either market. You too could arbitrage between the two markets. However, such opportunities are available for very short periods of time and should be taken advantage of quickly. Hedgers : A hedger is a person who has a position in an underlying asset and takes an opposite position in the futures market to protect his price. Say you have a portfolio of shares. Current market valuations are pretty good, but you do not want to sell say because of tax reasons. You are, however, afraid that the market may crash and your portfolio value would come down. You can do hedging of the portfolio by selling index futures of equivalent value. If the market falls down, the profit on the index futures contract will offset the loss on your portfolio. If the market goes up, the loss on the futures contract will be offset by the profit on your portfolio.

What is a spot price in a futures market? The spot price is the price of the underlying commodity in the spot or cash market. In this market, settlement takes place in 48 hours.

What is a delivery price in a futures contract? The specified price in a futures contract is called the delivery price.

What is a forward price in a futures contract? This is defined as the delivery price that would make the contract value zero. At the time of entering into the futures contract, the forward price and the delivery price are equal. As time passes, the forward price and delivery prices tend to diverge. The delivery price remains the same, while the forward price varies with the maturity of the contract.

What is the maturity date of a futures contract? The maturity date of a futures contract is the date on which the buyer and seller have to settle their obligations to the exchange.

What is the maturity value or terminal value of a long position in a futures contract? The value at maturity or terminal value of a long position is defined as the difference between the spot price on the day of maturity and the delivery price. That is, ST – D, where D is the delivery price and ST is the spot price at maturity. If the terminal value is negative, it indicates that the buyer of the contract has incurred a loss.

What is the maturity value of a short position in a futures contract? The value at maturity of terminal value of a short position is the difference between the delivery price and the spot price at maturity. That is, D - ST, where D is the delivery price and ST is the spot price at maturity. If the terminal value is negative, it indicates that the seller of the contract has incurred a loss.

What is an index future? Futures contracts whose value depends on the value of an underlying share index are known as index futures. Each share trades at a specific price at any point of time. But there is a need to represent the price of the market as a whole. This is done by identifying a basket of shares that s representative of this market, and tracking their consolidated value in terms of their base value. The value of this basket of shares is the value of the share index comprising these shares.

How do investors benefit from index futures? As investors are always affected by fluctuations in the market index, hedging using index futures is more effective for an investor rather than hedging with a (single) share future.

Where can I trade in futures in India? You can trade index and stock futures in Indian markets. Both the Bombay Stock Exchange and the National Stock Exchange offer trading in futures linked to the value of their underlying. Besides, the BSE Sensex and the S&P CNX Nifty, you can also trade in NSE Bankex and NSE IT indices.

What is a futures contract cycle? Contract cycles are trading periods for which futures contracts remain active. For example, a 3-month futures contract would come into existence on 1st January and would expire on 31st March. On 1st April, this contract would cease to exist, and the next contract with expiration on 30th June would start trading.

What is a calendar spread? A calendar spread is a position where one contract cycle of a future is hedged by an offsetting future position of different contract cycle in the same underlying asset. For example, a short position in three month index futures contracts may be hedged by a long position in six month index futures contracts.

What is a daily price movement limit? Daily price movement limits are the limits on the extent to which futures prices are allowed to vary from day to day. These limits are prescribed by the exchanges to prevent large price movements due to excessive speculation.

All About Options

All About Options

Options are contracts, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.

How are options different from futures? The significant differences in Futures and Options are as under : Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the right but not the obligation, to buy or sell the underlying asset. All Futures contracts have to be settled on the contract date. Options contracts can be settled on or before the settlement date depending on whether they are "American" style or "European" style contracts Futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset. It costs nothing to enter into a futures contract whereas there is a cost of buying an options contract, termed as Premium.

What are European and American Style of options? Options come in two varieties - European vs. American. In a European option, the holder of the option can only exercise his right (if he should so desire) on the expiration date. In an American option, he can exercise this right anytime between purchase date and the expiration date.

What are Call Options? A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller, however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example : An investor buys One European call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose the stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 { (Spot price - Strike price) - Premium}. In another scenario, if at the time of expiry, the stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the buyer loses the premium (Rs 100), paid which shall be the profit earned by the seller of the call option.

What are Put Options? A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before the expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Example : An investor buys one European Put option on Reliance at the strike price of Rs. 300/-, at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ - , the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option.

What is meant by the term Underlying The Underlying is the specific security / asset on which an options contract is based. In case of an Index option, the index (Sensex / Nifty) is the Underlying. In case of an option on Infosys, the Infosys scrip becomes the underlying.

What does Option Premium mean? It is the price paid by the buyer to acquire the right. This is the amount, which the buyer of the option (whether it is a call or put option) has to pay to the option writer to induce him to accept the risk associated with the contract. In other words it is the price paid to buy the option.

What is the Strike Price or Exercise Price? The strike price is the price at which the call / put option is written. This price is fixed by the Exchange currently.

Explain what is meant by Expiration date? An option contract has a finite life. The date on which the option expires is known as Expiration Date.

Who is an Option Holder? An Option Holder is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time.

Who is an Option seller/ writer? An Option Writer is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option.

What is meant by the term Assignment? When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment. What is meant by In the Money, At the Money and Out of the money Options. An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price in the spot market. This is true for both puts and calls. A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Nifty call option with strike of 1100 is 'in-the-money', when the spot Nifty is at 1200 as the call option has value. The call holder has the right to buy a Nifty at 1100, no matter how much the spot market price has risen. And with the current price at 1200, a profit can be made by selling the Nifty at this higher price. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of the Nifty call option, if the Nifty falls to 1000, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Nifty at 1100 when the current price is at 1000. A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.

Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.

What are Covered and Naked Calls? An option contract is said to be a Covered Call Option, when the option is covered or protected by the writer by depositing the shares of the company on which the option is written in an escrow account with the brokerage firm. Therefore the writer of the call option does not have to deposit any cash as such and whenever and exercise notice is received from the clearing corporation, the shares are delivered. In case, the option expires or if the writer enters into an offsetting transaction, he can withdraw the stocks deposited. E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock. If a call option is written without owning the underlying stock, it is called as Naked Call writing. When the writer does not own the underlying stock, he has to deposit the necessary amount of margin with the brokerage firm who in turn deposits it with the exchange. However in such a case the cash margin to be deposited to be 100% covered cannot be estimated as the upside movement is unlimited. Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value. When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.

What is the Intrinsic Value of an option? The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market. For a call option : Intrinsic Value = Spot Price - Strike Price For a put option : Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

What is Time Value with reference to Options? Time value is the amount option buyers are willing to pay for the possibility that the option may become profitable prior to expiration due to favorable change in the price of the underlying. An option loses its time value as its expiration date nears. At expiration, an option is worth only its intrinsic value. Time value cannot be negative.

What are the factors that affect the value of an option (premium)? There are two types of factors that affect the value of the option premium : Quantifiable Factors : Price of the underlying instrument. Strike price. Time remaining till expiration. Risk-free interest rate. Expected volatility. Corporate action like dividend or interest payments, if any. Non-Quantifiable Factors : Market participants' varying estimates of the underlying asset's future volatility Individuals' varying estimates of future performance of the underlying asset Supply & demand- both in the options marketplace and in the market for the underlying asset "Depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

Who decides on the premium paid on options & how is it calculated? Options Premium is not fixed by the Exchange. The fair value/ theoretical price of an option can be known with the help of pricing models and then depending on market conditions the price is determined by competitive bids and offers in the trading environment. An option's premium / price is the sum of Intrinsic value and time value (explained above). If the price of the underlying stock is held constant, the intrinsic value portion of an option premium will remain constant as well. Therefore, any change in the price of the option will be entirely due to a change in the option's time value. The time value component of the option premium can change in response to a change in the volatility of the underlying, the time to expiry, interest rate fluctuations, dividend payments and to the immediate effect of supply and demand for both the underlying and its option.

How do options trade get settled? An option is a contract which has a market value like any other tradable commodity. Once an option is bought there are following alternatives that an option holder has : You can sell an option of the same series as the one you had bought and close out /square off your position in that option at any time on or before the expiration. You can exercise the option on the expiration day in case of European Option or; on or before the expiration day in case of an American option. In case the option is 'Out of Money' at the time of expiry, it will expire worthless.

What are the risks involved for an options buyer? The risk/ loss of an option buyer is limited to the premium that he has paid.

What are the risks for an Option writer? The risk of an Options Writer is unlimited where his gains are limited to the Premiums earned. When a physical delivery uncovered call is exercised upon, the writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call. The writer of a put option bears a risk of loss if the value of the underlying asset declines below the exercise price. The writer of a put bears the risk of a decline in the price of the underlying asset potentially to zero.

How can an option writer mitigate his risk? The risk of being an option writer may be reduced by the purchase of other options on the same underlying asset thereby assuming a spread position or by acquiring other types of hedging positions in the options/ futures and other correlated markets.

Who can write options in Indian derivatives market? In the Indian Derivatives market, any market participant can write options. Sebi has not created any particular category of options writers.

What are Index Options? The Index Options are options where the underlying asset is a Stock Index for e.g. Options on NSE Nifty/ Options on BSE Sensex etc. As opposed to options on Individual stocks, index options give an investor the right to buy or sell the value of an index which represents group of stocks.

What are the uses of Index Options? Index options enable investors to gain exposure to a broad market, with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stocks or individual equity options, numerous decisions and trades would be necessary.

Who would use index options? Index Options are effective enough to appeal to a broad spectrum of users, from conservative individual investors to more aggressive stock market traders. Individual investors might wish to capitalize on market opinions (bullish, bearish or neutral) by acting on their views of the broad market or one of its many sectors. To a market professional, managing risks associated with large equity positions may mean using index options to either reduce risk or increase market exposure.

What are Options on individual stocks? Options contracts where the underlying asset is an equity stock, are termed as Options on stocks.

Strategies used in derivatives

Strategies used in derivatives

As explained earlier any position on a stock involves the inherent position on the market, so when you have bought Infosys betting on its superior price performance you also bet on the upward movement of the index. The degree of index that you have bought into Infosys (or any other stock for that matter) is measured in terms of "beta" of the stock. Following are the basic modes of trading on the index futures market Hedging Strategies Long stock, short index futures Short stock, long index futures Have portfolio, short index futures Have funds, long index futures Speculative Strategies Bullish view on index, long index futures Bearish view on index, short index futures Arbitrage Strategies Have funds , lend them to the market Have securities, lend them to the market Operators in the Futures markets There are three classes of operators who use derivative markets : Hedgers - operators who want to transfer a risk component of their portfolio Speculators - operators who intentionally trade in index futures in pursuit of profit Arbitrageurs - operators who operate in different markets simultaneously, in pursuit of profit and efficient pricing.

Hedgers use Index Futures to mitigate the risk of market downturn Suppose a Fund manager of an FII perceives that his carefully selected portfolio of stocks will be depreciated due to an upcoming political crisis. In absence of Index futures he would have only two solutions to counter the problem Sell the entire holding and sit on cash, waiting for the crisis to have its play, and reconstruct the original portfolio at lower levels. Hold on to the original portfolio throughout the ensuing crisis, watch its value shrink, and hope for better days to recoup the lost values However, armed with Index futures, he sells the entire value of the market risk on his portfolio by selling Index Futures of equivalent amount i.e. going short on Index. Suppose the Index is 5000 points when he executes his sell. During the crisis, the Index loses 800 points to rule at 4200, the Fund manager feels that the crisis is over, and should recover. The Fund manager hence covers his short position by reversing the original transaction, i.e. buying back equal number of Index futures at 4200 which he had sold at 5000.The gains made on 800 point difference would cover the erosion in the value of his portfolio of stocks. Thus effectively he has a hedge on the value of his portfolio. Suppose that his original assumption is wrong and market moves up instead of capsizing, in such a scenario the losses made on index futures would be roughly neutralised by the gains made on the portfolio. Hedge between two markets The FIIs operating in India face risks of Rupee depreciation in addition to risks of stock markets. Their clients would need to be repatriated profits in foreign currency of their home country(or US dollars). Under such circumstances it would be prudent for them to manage the risk of rupee depreciation by hedging the portfolio value in Forex futures. Currently derivative-based currency hedging mechanism is not available in India. The FIIs, it is reported hedge their risks on Indian currency by taking positions on the informal derivatives market in Singapore. Thus risks are hedged across markets. Delayed funds, don’t miss that rally At times you may want to enter markets expecting a bullish phase but the funds flowing to you may take time in coming into your hands. You can take exposure to the equity markets by buying long futures equivalent to the amount you want invested in the market ultimately. You would have to pay approximately 8-12 percent of the entire investment corpus to take an exposure of say Rs 5 million. You had say Rs 500,000 upfront, which you invested, as margin for buying futures worth Rs 5 million. Example You made a list of 14 stocks to buy, at 17th Feb prices, totaling approximately Rs. 5 million and decided to take delivery of stocks as and when your funds came in. Say the S&P CNX Nifty was at 991.70. You entered into a LONG S&P CNX NIFTY MARCH FUTURES position for 5000 nifties, i.e. your long position was worth 5,053,600. From 18th Feb to 9th Mar you gradually acquired the stocks each day, purchased one stock and sold off a corresponding amount of futures. On each day, the stocks purchased were at a changed price (as compared with the price prevalent on 17th Feb). On each day, you obtained or paid the ‘mark-to-market margin on your outstanding futures position, thus capturing the gains on the index. By 9th Mar you had fully invested in all the shares that you wanted (as of 17th Feb) and had no futures position left. The same sequencing of purchases, without the umbrella of protection of the LONG S&P CNX NIFTY MARCH FUTURES position, would have cost more had you to wait for all the funds to arrive in your hands a month later as by that time stocks you had listed would have appreciated. You were able to gain the appreciation by way of long position on the index, which was used to partially neutralise the rise in cost of your purchases. Bearish on Index, but shares not at hand Reverse strategy may be employed in case you feel that market is going to fall, however, your shares are not available immediately. In such a scenario you could just short the futures equivalent to the amount of your entire portfolio and then cover your short position on futures when you actually sell shares as and when they are available. The depreciation in the sale price of your shares will be covered to an extent by the profit you make on short-selling the index.

Speculative Strategies Speculators in stock markets take advantage of the high leverage offered (approximately 10 times to 12 times the funds available) by margin system in the index futures to punt on index movements and profit from the index movement. You can either buy selected liquid securities, which move with the index, and sell them at a later date, or buy the entire index portfolio and then sell it at a later date. The first alternative is widely used – a lot of the trading volume on stocks like HINDLEVER is based on using HINDLEVER as an index proxy. However, these positions run the risk of making losses owing to HINDLEVER-specific news; they are not purely focused upon the index. The second alternative is hard to implement. An investor needs to buy all the stocks in S&P CNX Nifty in their correct proportions. Most retail investors do not have such large portfolios. This strategy is also cumbersome and expensive in terms of transaction costs. Using index futures, an investor can "buy" or "sell" the entire index by trading on one single security. Once a person buys S&P CNX NIFTY using the futures market, he gains if the index rises and loses if the index falls. Example 5th Jan. - You feel the market will rise Buy 100 S&P CNX NIFTY January futures contract at 1450 costing Rs.145000 (100*1450) expiration date – 5th Jan. 14th Jan. Nifty January futures have risen to 1470 You sell off your position at 1470 Make a profit of Rs. 2000 (100* 20) After a bad budget, or bad corporate results, or the onset of a coalition government, many people feel that the index would go down. Once a person sells S&P CNX NIFTY using the futures market, he gains if the index falls and loses if the index rises. Example 8th Feb - You feel the market will fall Sell 100 S&P CNX NIFTY February expiry contract Expiration date 25th Feb Nifty February contract is trading at 1560 Your position is worth Rs. 156,000 15th Jan. - Nifty February futures have fallen to 1520 You square off your position at 1520 Make a profit of Rs.4000 (100*40)

Arbitrageurs lend securities to market to earn return on long term holdings The index futures market offers a risk less mechanism for (effectively) loaning out shares and earning a positive return for them. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counter party on both legs of the transaction is the National Securities Clearing Corporation). You would sell all 50 stocks in S&P CNX Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money as you like until futures expiration. On this date, you would buy back your shares, and pay for them. How do we actually do this? Suppose you have Rs. 4 million of the S&P CNX Nifty portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalisation). Sell off all 50 shares on the stock market. Buy index futures of an equal value. A few days later (on NSE payout day), you will receive money and have to make delivery of the 50 shares. Invest this money at the risk less interest rate. On the date that the futures expire, put in order to buy the entire S&P CNX Nifty portfolio. A few days later (on the NSE pay-in date), you will need to pay in the money and get back your shares. Example You put in sell orders for Rs. 4 million of S&P CNX Nifty using the feature in NEAT to rapidly place 50 market orders, in quick succession. The seller always suffers impact cost; suppose he contains an actual execution at 1098. A moment later, you put in a market order to buy Rs. 4 million of the S&P CNX Nifty futures. The order executes at 1110. At this point, you are completely hedged. A few days later (approximately 15 days, at the end of NSE settlement in which you sold your shares), you make delivery of shares and receive Rs. 3.99 million (assuming an impact cost of 2/1100) Suppose you lend this out at 1% per month for two months. At the end of two months, the money comes back to you as Rs. 4,072,981. Translated in terms of S&P CNX Nifty, this is1098 * 1.012 or 1120. On the expiration date of the futures, you put in market orders to buy back your S&P CNX Nifty portfolio. Suppose S&P CNX Nifty has moved up to 1150 by this time. This makes shares costlier in buying back, but the difference is exactly offset by profits on the futures contract. When the market order is placed, suppose you end up paying 1153 and not 1150, owing to impact cost. You have funds in hand of 1120 and the futures contract pays 40 (1150-1110) so you end up with a clean profit, on the entire transaction, of 1120+40-1153 = 7. On a base of Rs. 4 million, this is Rs. 25,400. Arbitrageurs lend funds in the stock market to earn superior return Traditional methods of loaning money into the stock market suffer from Price risk of shares and Credit risk, of default of the counterparty. Index futures market supplies a technology to lend money into the market without suffering any exposure to S&P CNX Nifty and without bearing any credit risk. The lender buys all 50 stocks of S&P CNX Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counter party on both legs is the National Securities Clearing Corporation (NSCC) which supplies clearing services on NSE. How do we actually do this? To buy all 50 stocks in S&P CNX Nifty on the cash market requires a significant amount of money because of the minimum market lot Calculate a portfolio, which buys all the 50 stocks in S&P CNX Nifty in correct proportion, i.e., where the money invested in each stock is proportional to its market capitalisation. Round off the number of shares in each stock to the nearest market lot. Buy all 50 shares in rapid succession into the NSE trading system. This gives you the buy position. A moment later, sell S&P CNX Nifty futures of equal value. Now you are completely hedged, so fluctuations in S&P CNX Nifty do not affect you. A few days later, you will have to take delivery of the 50 stocks and pay for them. This is the point at which you are "loaning money to the market". Some days later, at your discretion you will unwind the entire transaction. Sell in rapid succession all the 50 shares you had bought at market price A moment later, reverse the future position. Now your position is down to 0. A few days later, you will have to make delivery of the 50 stocks and receive money for them. This is the point at which "your money is repaid to you". Example On 1 August, S&P CNX Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. You want to earn this return (30/1200 for 27 days). You buy Rs. 3 million of S&P CNX Nifty on the spot market. In doing this, you place 50 market orders and end up paying slightly more. Your average cost of purchase is 0.3% higher, i.e. you have obtained the S&P CNX Nifty spot for 1204. You sell Rs. 3 million of the futures at 1230. The futures market is extremely liquid so the market order for Rs. 3million goes through at near-zero impact cost. You take delivery of the shares and wait. While waiting; a few dividends come into your hands. The dividends work out to Rs. 7,000. On 27 August, at 3:15, you put in market orders to sell off your S&P CNX Nifty portfolio, putting 50 market orders to sell off all the shares. S&P CNX Nifty happens to have closed at 1210 and your sell orders (which suffer impact cost) goes through at 1207. The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is always equal to the S&P CNX Nifty spot). You have gained Rs. 3 (0.255) on the spot S&P CNX Nifty and Rs. 20 (1.63%) on the futures for a return of near 1.88%. In addition, he has gained Rs. 7,000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free.

Financial Market Terms Explained

Financial Market Terms Explained

Stock Market Index Definition : A Stock Market Index is a basket of representative scrips which accurately reflects the trends of the market movement faithfully and is an approximation to returns obtained in owning "the overall economy". The BSE 30 Sensex, first compiled in 1986 is a market capitalisation weighted index that represents thirty large well-established and financially sound companies .The Sensex also has the largest social recall attached with it –it was the first index to be launched by any Stock Exchange in India. The Nifty S&P CNX Nifty is a more recent index based on market capitalisation of fifty large companies listed on the National Stock Exchange .

Derivatives Definition : A derivative is a product whose value is derived from the value of underlying asset, index, or reference rate. The underlying asset may be equity, forex, commodity, or any other asset.

Beta value of a stock Definition : The beta of a stock is the average impact of a 1 per cent move in the index that is reflected upon the stock. The National Stock Exchange tracks and updates betas of stocks and this data are readily available on the internet site http//www.nseindia.com or NSE newsletter. Betas of stocks are calculated by using advanced financial formulae which in essence follow the afore-mentioned principle. In absence of a beta value of a stock it is generally safe to assume the beta of a stock equivalent to 1,which denotes the same volatility as that of the entire market.

Basis Definition : The difference between the spot price and the futures price is called the basis. In a normal market, the basis is negative. The basis reduces as the date of expiration of the contract comes closer, since there is a convergence of the futures price towards the spot price. On the date of expiration, the basis equals zero.

Daily settlement price Definition : Daily Settlement price is the closing price of the futures contracts for the trading day. The closing price is calculated as the last half an hour weighted average price or such other price as may be decided by the relevant authority from time to time.

Final Settlement Price Definition : Final settlement price is the closing price of the Underlying Securities on the last trading day of the futures contracts or such other price, as may be decided by the relevant authority from time to time.

The Concept Of Risk

The Concept Of Risk

All investments in market carry two types of risks : Instrument-specific risks Market-specific risks This principle is true of any type of commodity, debt, or equity-exposure. Albeit, the intensity of underlying risks varies in each investment significantly. Market-specific risks are all events that may affect the market, such as political uncertainty, direction of economy, war-like conditions, droughts etc. In the case of Stock markets, when such events occur all securities are summarily marked down irrespective of individual merit. For example, when aggression on Kargil front was announced in 1999, participants marked down the value of all stocks summarily in initial stages of panic that gripped the nation.