Futures

A futures contract is an agreement to buy or sell an underlying asset at a set price on a specific date in the future.

Options

An options contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price on or before a specific date.

Derivatives Trading

Derivatives are used for various purposes, including:

• Hedging (risk management)

• Speculation (betting on price movements)

• Arbitrage (exploiting price differences)

Key Characteristics

• Derivatives have their price based on the underlying asset

• They can be traded on various markets (e.g., stock exchanges, commodity markets)

• They offer flexibility and leverage but also involve risk

By understanding futures and options, you can better navigate the world of derivatives and make informed investment decisions.

The underlying asset is the financial instrument that the derivative is based on, such as a stock, commodity, currency, or index. The derivative's value is derived from the underlying asset's value, and changes in the underlying asset's value affect the derivative's value. 

This means that derivatives offer a way to trade on the value of an underlying asset without actually buying or selling the asset itself. This can be useful for managing risk, speculating on price movements, or gaining exposure to a particular market or asset class without directly investing in it. 

Derivatives can be classified into two main categories:

1. Exchange-Traded Derivatives (ETD)

• Traded on organized exchanges (e.g., stock exchanges)

• Standardized contracts

• Settlement guaranteed by the exchange

• Examples: Futures, Options, Options on Futures

2. Over-the-counter (OTC) Derivatives

• Not traded on exchanges

• Non-standardized contracts

• Settlement negotiated between parties

• Examples: Forwards, Swaps, Swaptions, Credit Derivatives

Exchange-traded derivatives offer transparency, liquidity, and regulatory oversight, while OTC derivatives provide flexibility and customization but also carry higher counterparty risk.

Basis: Understanding the Price Difference

The basis represents the difference between the spot price of an underlying asset and its futures market price.

• Negative Basis (Contango): Futures price > Spot price

  • Due to costs like interest, storage, and insurance

  • Buying a futures contract may be more profitable than holding the physical asset

• Positive Basis (Backwardation): Spot price > Futures price

  • The benefits of holding the asset (e.g., dividends) exceed the costs

  • Expected fall in asset price

As the futures contract approaches maturity, the gap between futures and spot prices closes, and the basis tends toward zero.

Futures Contracts: Key Features

A futures contract is a binding agreement to buy or sell an underlying asset at a specified price on a predetermined date. The contract includes:

1. Buyer: The party that agrees to purchase the asset

2. Seller: The party that agrees to sell the asset

3. Price: The agreed-upon price for the asset

4. Expiry: The date on which the contract expires and the asset must be bought or sold

Futures contracts are available for various assets, including:

• Equity Stocks

• Indices (e.g., stock market indices like the S&P 500)

• Commodities (e.g., gold, oil, wheat)

• Currency (e.g., foreign exchange rates)

By trading futures contracts, investors can manage risk, speculate on price movements, or gain exposure to specific markets or assets without directly investing in them.

Options Contracts: Understanding the Basics

An options contract is a financial instrument that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a certain date (expiration date). The seller of the contract must buy or sell the asset if the buyer exercises their option.

Types of Options:

1. Call Option: Gives the buyer the right to buy the underlying asset at the strike price. The buyer of a call option hopes that the price of the underlying asset will rise, allowing them to buy the asset at the lower strike price and sell it at the higher market price.

2. Put Option: Gives the buyer the right to sell the underlying asset at the strike price. The buyer of a put option hopes that the price of the underlying asset will fall, allowing them to sell the asset at the higher strike price and buy it back at the lower market price.

Key Points:

• The buyer of an option has the right, but not the obligation, to exercise the option. This means they can choose not to exercise the option if it's not in their favor.

• The seller of an option must buy or sell the asset if the buyer exercises their option. This means they are bound by the contract and must fulfill their obligation if the buyer exercises their right.

• The buyer pays a premium to the seller for the options contract. This premium is the price of the option, and it's non-refundable even if the buyer doesn't exercise the option.

• If the spot price (market price) is unfavorably compared to the strike price, the buyer won't exercise their option. For example:

  • Call option: If the spot price is lower than the strike price, the buyer won't exercise their option to buy.

  • Put option: If the spot price is higher than the strike price, the buyer won't exercise their option to sell.

These examples illustrate this well:

• In a Call option, if the spot price is lower than the strike price (Rs 450 vs Rs 500), the buyer won't exercise their option to buy.

• In a Put option, if the spot price is higher than the strike price (Rs 619 vs Rs 600), the buyer won't exercise their option to sell.