What are options?

Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance.
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.
‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or if he chooses not to walk away from the contract.
To begin, there are two kinds of options: Call Options and Put Options.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.
Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.

Derivatives Glossary

Backwardation: A market where future prices of distant contract months are lower than the near months.
Basis: The difference between the Index and the respective contract is the basis i.e. cash netted  for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is the  strengthening and weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means increasing short positions.
Basis Point: It is equal to one hundredth of a percentage point
Contango market: This is a market where futures prices are higher for distant contracts than for nearby delivery months.
Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically means the annualized interest cost players decide to pay (receive) for buying (selling) a respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is more interpretable being an annualized figure, as compared to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and Open Interest in highlighting the market trend.
Delivery month: Is the month in which delivery of futures contracts need to be made.
Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price.
Derivative: A financial instrument designed to replicate an underlying security for the purpose of transferring risk.
Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation.
Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the

• Value of a Futures contract;
• Value of the portfolio to be Hedged; and
• Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.
Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.
Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day.
Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.
Futures contract: A futures contract is similar to a forward contract in terms of its working. The difference is that contracts are standardized and trading is centralized. Futures markets are highly liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes the counterparty to both sides of each transaction and guarantees the trade.
Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.
Speculation: Trading on anticipated price changes, where the trader does not hold another position which will offset any such price movements.
Spread ratio: The number of futures contracts bought, divided by the number of futures contracts sold.
VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence.
Strike Price: The price at which an option holder may buy or sell the underlying asset, which is specified in an option contract

Selecting the right index Futures

In selecting the index and contract month one should consider the following points.

Expiration date: If the investor has a month or two’s view about the market then he should choose that index futures which has a similar time left for expiry.
Liquidity: The index and the contract month, which is the most liquid must be used. This will save cost because of the low bid-ask spread. This also saves hedging costs.
Stock should be correlated to the index: The stock to be hedged should have a correlation with the index selected.
Potential mispricing: One should sell index futures contract which is overpriced. In such an event one can not only hedge but also earn some profit in selling high.
In a nutshell, one should hedge by using the most popular and fairly priced index and delivery month should not be very far since liquidity and predictability of very few contracts are low.

How to read the futures data...

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for anyone planning to venture in futures trading. Economic dailies and exchange websites www.nseindia.com and www.bseindia.com are some of the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries end of day derivatives summary alongwith the quotes.
The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices.
The following table shows how futures data will be generally displayed in the business papers daily.

Series	First Trade	High	Low	Close	Volume (No of contracts)	Value                (Rs in lakh)	No of trades	Open interest (No of contracts)
BSXJUN2000	4755	4820	4740	4783.1	146	348.70	104	51
BSXJUL2000	4900	4900	4800	4830.8	12	28.98	10	2
BSXAUG2000	4800	4870	4800	4835	2	4.84	2	1
Total					160	38252	116	54

Source: BSE

·         The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract.

·         The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades.

·         One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs. 2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts.
The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract.
A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of outstanding long or short positions – not both.
Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts.

Action	Resulting open interest
New buyer (long) and new seller (short) Trade to form a new contract.	Rise
Existing buyer sells and existing seller buys –The old contract is closed.	Fall
New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer.	No change – there is no increase in long contracts being held
Existing seller buys from new seller. The Existing seller closes his position by buying from new seller.	No change – there is no increase in short contracts being held

Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge market signals. The following chart may help with these signals.

Price	Open interest	Market
UP	UP	Strong
UP	DOWN	Warning signal
DOWN	UP	Weak
DOWN	DOWN	Warning signal

The warning sign indicates that the Open interest is not supporting the price direction.

Margins In Futures Market

Margins

The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis.
Daily margining is of two types:
1. Initial margins
2. Mark-to-market profit/loss
The computation of initial margin on the futures market is done using the concept of Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front.
The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.
Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.

• A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.
• The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)
Initial margin (15%) = Rs 45,000
Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:
Position on Day 1

Close Price	Loss	Margin released	Net cash outflow
1400*200 =2,80,000	20,000 (3,00,000-2,80,000)	3,000 (45,000-42,000)	17,000 (20,000-3000)
Payment to be made			(17,000)

New position on Day 2
Value of new position = 1,400*200= 2,80,000
Margin = 42,000

Close Price	Gain	Addn Margin	Net cash inflow
1510*200 =3,02,000	22,000 (3,02,000-2,80,000)	3,300 (45,300-42,000)	18,700 (22,000-3300)
Payment to be recd			18,700

Position on Day 3
Value of new position = 1510*200 = Rs 3,02,000
Margin = Rs 3,300

Close Price	Gain	Net cash inflow
1600*200 =3,20,000	18,000 (3,20,000-3,02,000)	18,000 + 45,300* = 63,300
Payment to be recd		63,300

Margin account*
Initial margin                =       Rs 45,000
Margin released (Day 1) =  (-) Rs  3,000
Position on Day 2                  Rs 42,000
Addn margin                =  (+) Rs  3,300
Total margin in a/c                Rs 45,300*
Net gain/loss
Day 1 (loss)                =     (Rs 17,000)
Day 2 Gain                  =      Rs 18,700
Day 3 Gain                  =       Rs 18,000
Total Gain                   =       Rs 19,700
The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.

Settlements

All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement price.
The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference between the contract value and closing index value is paid.

Trading Strategies using Hedging

Hedging
Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stock’s Beta. The Beta of stocks are available on the www.nseindia.com.
While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.
Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks?
Have you ever been a ‘stockpicker’ and carefully purchased a stock based on a sense that it was worth more than the market price?
A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the market price or
2. The entire market moves against him and generates losses even though the underlying idea was correct.
Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.
Let us see how one can hedge positions using index futures:
‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is ruling at 1527?
To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.
On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90).
Therefore, the net gain is 59940-46551 = Rs 13,389.
Let us take another example when one has a portfolio of stocks:
Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk
If the index is at 1200 * 200 (market lot) = Rs 2,40,000
The number of contracts to be sold is:

1. 1.19*10 crore / 2,40,000 = 496 contracts

If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged.
Thus, we have seen how one can hedge their portfolio against market risk