FUTURE
MARKETS
What is
FuturesContract?
·
So let’s say
there’s a farmer who cultivates wheat
·
And a bread
manufacturer who needs wheat as an input for making bread
·
The farmer
thinks that the price of wheat which is currently trading at Rs. 100 could fall
to Rs. 90 in 3 months
·
The bread
manufacturer on the other hand feels that the price of wheat on the other hand
might become Rs. 120 in 3 months
·
In such a case
both of them get together and sign a contract which says that at the end of 3
months the farmer would sell wheat to the bread manufacturer at Rs. 110
·
Thus the farmer
is protected against possible fall in prices
·
And the bread
manufacturer is protected against the price of wheat, a key ingredient in bread
manufacturing to go up beyond Rs. 110
·
Such a contract is called a Futures contract
·
In a Futures contract both parties are
obliged to honor the contract and there is no escape route for either party
·
OPTIONS CONTRACT
·
But what if the
contract gives the farmer the “option” of either
·
Selling his
produce to the bread manufacturer at the pre-agreed price of Rs 110 or
·
Choosing to exit
the contract and selling the produce in the open market or wherever he deems
fit.
·
Thus, he would
not be obliged to honor the contract made with the bread manufacturer on the
date of settlement
·
Such
a contract which gives the farmer the option of either executing the contract
or exiting it is known as an “Options”
contract
·
But the farmer
obviously cannot get this privilege just like that. He obviously has to pay a
premium for exercising this facility
·
Now, let’s say
that after 3 months the price of wheat reaches Rs. 120
·
In this case the farmer quite obviously will
want to exit the contract so that he is free to sell his produce in the open
market for Rs. 120. Thus while the farmer gets away the bread manufacturer is
left high and dry and has no other option but to buy from the open market at Rs
120
·
But it is not
such a bad situation for the bread manufacturer as it appears as he gets
compensated by the farmer for having been a party to the “Options” contract.
·
This
compensation * in the form of price is called the “Option premium” that
the farmer has to pay for the Options contract and quite evidently it would be
a small amount.
·
Let’s say in our
case the amount is Rs 2.
·
So the farmer is
obliged to pay the bread manufacturer Rs 2 as he has chosen to opt out of the
contract
·
Thus although the bread manufacturer has no
other option left but to go to the open market and purchase wheat at Rs. 120,
he does get the benefit of Rs 2 as
compensation for being a party to the “Options” contract.
·
So even if the
price is Rs. 120 in the open market, for him the effective price turns out to
be Rs. (120 -2) = Rs 118.
·
So by simply
participating in the contract he too stands to gain something
·
As far as the
farmer is concerned it is a win – win scenario for him by participating in the
contract.
·
Had the prices
fallen to Rs 90 as he had anticipated he would have executed the Options
contract. But since prices rose to Rs 120 he chose to exit the contract. Thus
he is blessed with the “Option” by signing such a contract.
·
It is important to understand that in an
“Options” contract only one party gets the privilege to exercise the option
while the other party is obliged to honor the option chosen.
·
Thus in our case
the farmer has the option to either execute or exit the contract whereas the
bread manufacturer is obliged to honor the decision of the farmer.
·
A contract such as this where only the seller
of the commodity gets the option to either exercise or exit the contract is
known as “Put” option
·
There is another
option which is called a “Call” option
·
Even in an
Options contract both parties land up achieving their goals and their interest
is protected
·
The farmer
stands to gain the most by getting to exercise a choice that benefits him the
most
·
The bread
manufacturer too benefits by being a party to the contract due to the
compensation he receives from the farmer for not honoring the contract.
·
The bread
manufacturer due to the compensation receives wheat from the open market at an
effective price of Rs 118
·
And hence is
better off than the ordinary or spot buyer who would have to pay Rs 120.
·
Thus in a sense
both parties landed up getting some gains by being parties to the “options
contract”.
·
However unlike
in a “Futures” contract, in the “Options” contract one party gains more than
the other party.
CALL OPTION
·
In a Futures
contract both parties are obliged to honor the contract and there is no escape
route for either party.
·
But what if the
contract gives the bread manufacturer the “option” of (either)
·
Buying the wheat
from the farmer at the pre-agreed price of
Rs 110 (or)
·
Choosing to exit
the contract and buy wheat from the open market at the prevailing market price?
·
In other words,
the bread manufacturer is given the option of not honoring the contract made
with the farmer on the date of settlement.
·
Such a
contract that gives the bread manufacturer the option of either executing the
contract or exiting it is known as an ‘Options’ Contract.
·
But the bread
manufacturer cannot get this privilege just like that. He obviously has to pay
a premium for exercising this facility…
·
Now, let’s say
that after 3 months the price of wheat falls to Rs. 90.
·
In this case the
bread manufacturer quite clearly would want to exit the contract so that he is
free to buy wheat from the open market for Rs. 90.
·
If so, while the
bread manufacturer gets away, the farmer is left high and dry and has no other
option but to sell his produce in the open market at Rs 90.
·
But it is that
bad a situation for the farmer as it appears as he gets compensated by the
bread manufacturer for having been a party to the ‘Options’ contract.
·
This
compensation * in the form of price is called the “Option Premium” that the
bread manufacturer has to pay for the Options contract and is usually a small
amount.
·
Let’s assume in
our case the amount is Rs 5.
·
So the bread
manufacturer is obliged to pay the farmer Rs 5 as he has chosen to opt out of
the contract.
·
Thus although
the farmer has no other option left but to go to the open market and sell wheat
at Rs. 90, he does get the benefit of Rs
5 as compensation for being a party to the ‘Options’ contract.
·
So even if the
price is Rs. 90 in the open market, for him the effective price turns out to be
Rs. (90+5) = Rs 95
Rs. (90+5) = Rs 95
·
So by simply
participating in the contract he too stands to gain something.
·
For the bread
manufacturer, it is a win–win scenario by participating in the contract.
·
Had the prices
risen to Rs 120 as he had anticipated, he would have executed the Options
contract at Rs 110 and would have got protected.
·
But since prices
fell to Rs 90 he chose to exit the contract. Thus he is blessed with the
‘Option’ of either executing or not executing the contract based upon the price
in the open market at the time of contract settlement.
·
It is important
to understand that in an ‘Options’ contract, only one party gets the privilege
to exercise the option while the other party is obliged to honor the option if
it is chosen.
·
Thus, in our
case, the bread manufacturer has the option to either execute or exit the
contract whereas the farmer is obliged to honour the decision of the bread
manufacturer.
·
A contract such as this where only the
purchaser of the commodity gets the option to either exercise or exit the
contract is known as ‘Call’ option.
·
Basically in the ‘Put’ option the choice of
honoring the contract was with the farmer or seller while in the ‘Call’ option
this option was with the bread manufacturer or purchaser.
·
Even in an
Options contract both parties land up achieving their goals and their interests
are protected.
·
The bread
manufacturer stands to gain the most by getting to exercise a choice that
benefits him the most.
·
The farmer on
the other hand too benefits by being a party to the contract due to the
compensation he receives from the bread manufacturer for not executing the
contract.
·
The farmer due
to the compensation sells the wheat in the open market at an effective price of
Rs. 95
·
And hence is
better off than the ordinary or spot seller who would have to sell at Rs 90.
·
Thus in a sense
both parties landed up getting some gains by being parties to the ‘options
contract’.
·
However unlike
in a ‘Futures’ contract, in the ‘Options’ contract one party gains more than
the other party.
DERIVATIVES MARKETS
·
However in all our explanations we had a simplistic
example of a farmer and a bread manufacturer which does not represent the
manner in which we deal with derivative products in the stock markets.
·
Imagine there were several
farmers in market. Perhaps a few thousands with a view that price of the Wheat
is going to fall in near future (bearish participants)
·
And several thousand bread
manufacturers with a view that price of the wheat is going to rise in the near
future (bullish participants)
·
And a market place where
there is free flow of information. It provides a platform to both bullish &
bearish participants to execute their trades without even knowing each other or
hunting for the counterparties
·
So the expected future
stock price (price of wheat for the sake of comparison with our previous
examples) is known to every farmer and bread manufacturer.
·
Any farmer trying to
extract a higher price will not be able to do so because for the bread manufacturer
there are several other farmers to buy from and vice versa.
·
Since the price is
universally known and there are several farmers and bread manufacturers, there
is no need to get into individual contracts.
·
There is no need to know
who the options/futures buyer is and who the options/futures seller is for it
does not make any difference for either party
·
The markets also make it
possible for either party to deal with several counter parties at the same
time.
·
The market thus makes it
possible to keep identities of parties to remain confidential with respect to
the respective counter parties.
·
If one were to replace the
farmer and bread manufacturer by normal people who have opposite views about
the future prices of stocks, what we have is a typical Derivatives Market.
IN REAL STOCK MARKET
·
Now in the stock market we
do not have farmers and bread manufacturers, but instead have investors who are
both buyers and sellers of stocks.
·
Now lets say there is a
stock A listed on the stock exchange and its “futures” is quoted at Rs. 120.
·
Also, let’s assume there
are participants in the market to buy and sell the futures to each other based
on their contrarian view about the stock.
·
And let’s say the expiry
date for settlement of the futures contract is after 5 days.
·
Now,
for the sake of understanding, suppose you were to buy a ‘futures’ of stock A
for Rs 120. In this context, it is important for you to understand that in a
derivative product what you actually do is take a view on future price
movements and at the end of the settlement period, you reconcile based on
whether your view was right or wrong.
·
Since
at no point in time the investor has to take delivery of the stock, he does not
have to pay the entire price of the stock at the time of the deal. All he has
to pay hence is the margin money which is a fraction of the price, say, 15% of
the price which is Rs 18 in the above example.
·
Now to understand this better, let’s look at
how the prices move in these 5 days.
DAY 1
·
Closing Price on day “One”
– 122
·
Your buying price day “One” – 120
·
Your profit – Rs 2
·
So at the end of the day
your account with your broker would get credited by Rs 2.
|
·
Debit
|
·
Credit
|
|
|
·
Day 1
|
·
Rs. 2
|
DAY 2
Closing Price on day “two” – 125
Your profit as compared to the
previous day is Rs 3
So at the end of day 2, your account with your broker would get credited
by Rs 3.
CREDIT DEBIT
DAY 1 0 2
DAY 2 0 3
DAY 3
Closing Price on day
“Three” – 124
Your loss as compared to
the previous day is Rs.1
So at the end of day 3,
your account with your broker would get debited by Rs 1.
|
Debit
|
Credit
|
|
|
Day 1
|
Rs. 2
|
|
|
Day 2
|
Rs 3
|
|
|
Day 3
|
Rs.1
|
DAY 4
Closing
Price on day “Four” – 123
Your loss
as compared to the previous day is Rs.1
So at the
end of day 4, your account with your broker would get debited by Rs 1
|
Debit
|
Credit
|
|
|
Day 1
|
Rs. 2
|
|
|
Day 2
|
Rs 3
|
|
|
Day 3
|
Rs.1
|
|
|
Day 4
|
Rs. 1
|
DAY 5 SETTLEMENT DATE
Closing Price
on day “Five” – 125
Your profit as
compared to the previous day is Rs.2
So at the end
of day 5, your account with your broker would get credited by Rs 2.
|
Debit
|
Credit
|
|
|
Day 1
|
Rs. 2
|
|
|
Day 2
|
Rs 3
|
|
|
Day 3
|
Rs.1
|
|
|
Day 4
|
Rs. 1
|
|
|
Day 5
|
Rs 2
|
Thus the effect
of the 5 days leading to the settlement would be like this…
|
Debit
|
Credit
|
|
|
Day 1
|
Rs. 2
|
|
|
Day 2
|
Rs 3
|
|
|
Day 3
|
Rs.1
|
|
|
Day 4
|
Rs. 1
|
|
|
Day 5
|
Rs 2
|
|
|
Total
|
Rs 2
|
Rs 7
|
So in this case
the investor gained Rs 5 on settlement date.
However since
your investment was only Rs. 18 (15% margin money), you need to calculate Rs. 5
as a percentage of Rs. 18.
Thus, the
returns earned would be equal to 5/18 x 100 = 27% (approx.)
GEORGE
SINHA
List of references
moneycontrol
investopedia
