Futures Trading Simplified

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S P O T / C A S H M A R K E T

F U T U R E S O P T IO N S

D E R IV A T IV E S

F IN A N C IA L M A R K E TS

What is a Derivative?

It is a product whose value is derived from the value of one or more variables –bases \underlying asset which could be equity,commodity,forex,any other asset.

For e.g A farmer may wish to sell his harvest at a future date to eliminate risk of a change in price by that date.This is an example of a derivative transaction in which the price is driven by the spot price of wheat, which is the “underlying asset”.

Basics of Futures Trading A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in future at a certain price.

Index futures refer to futures contracts in which the underlying asset is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

In India, we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and nearly 3 months duration contracts are available at all times.

Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.

Basics of FuturesWhat are Index Futures? As Stated above, Futures are derivatives in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Index futures are futures contracts where the underlying is a stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

What is meant by Lot size? Lot size refers to the quantity in which you can trade in a derivative of a particular scrip. For Example-Nifty Futures have a lot size of 100 or multiples of 100. Hence if you buy 1 lot of Nifty Futures , the value would be 100*Nifty Index Value at that point of time.

Similarly many other scrips such as Infosys, Reliance etc can be bought and each may have a different lot size. NSE has fixed the minimum value as two lakhs for an Futures and Options contract. Lot sizes are fixed accordingly which will be the minimum shares on which a trader can hold positions.

Example of Future Contract

Let us assume, the Current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500 shares of Tata Steel. You find someone, say John, who has 500 shares. You tell John that you will buy 500 shares at Rs. 200, but not now, say on the last Thursday of this month.

This agreed date will be called the Expiry date of your agreement or contract. John more or less agrees but the following points come up in your agreement.

John will have to go through the trouble of keeping the shares with him until the end of this month. Moreover, the economy is doing well, so it is likely that the price of the stock at the end of the month will be not Rs. 200, but something more. So he says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed price of the deal will be called the Strike price of the futures contract.

Example of Future Contract (contd.)He says you can think of the Rs. 2 per share as his charge for keeping the shares for you until the expiry date. This difference between the strike price and the current price is also called as Cost of Carry.

The total contract size is now Rs. 202 for 500 shares, which means Rs 101000.However both you and John realize that each of you is taking a risk.

For Example:If the price of the stock falls from Rs. 200 to Rs. 190 tomorrow, in that case it is much more profitable for you to buy shares from the market than from John. What if you decide not to honors the contract or agreement? It will be a loss for John.

Similarly if the price rises you are at a risk if John doesn't honor the futures contract. So both of you decide that you will find a common friend and keep Rs.25000 each with this friend in order to take care of price fluctuations. This money paid by both of you is called Margin paid for the futures contract.

Example of Future Contract (contd.)Finally you decide that the futures contract will be cash settled. This implies instead of actually handing over 500 shares - John will pay you the money if the price rises, or if the price falls you will pay John the balance amount at the expiry date of the contract, .

At the end of the expiry date if you find out that the price of the share is Rs. 230, then the difference

Rs. 230 - Rs. 202 = Rs. 28

will be paid to you by John. You can then purchase the shares from the Stock Market at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he effectively sold each share at Rs.202, the agreed price.

Future Contract in NIFTY

Futures contracts in Nifty in July 2009

  

On 27th July 2009

Contract month Expiry/settlement

July 2009 July 30

August 2009 August 27

September 2009 September 24

Contract month Expiry/settlement

August 2009 August 27

September 2009 September 24

October 2009 October 29

Example of Future Contract in NIFTY - continued

The permitted minimum lot size is 100 or in multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be :

100*4500 (Nifty value)= Rs 4,50,000.

In case of BSE Sensex the market lot is 100. That is you buy one Sensex futures the total value will be

100*14600 (Sensex value)= Rs 14,60,000.

The index futures symbols are represented as follows:

BSE NSE

BSXJUN2009 (June contract) FUTDXNIFTY 28-JUN2009

BSXJUL2009 (July contract) FUTDXNIFTY 28-JUL2009

BSXAUG200 (Aug contract) FUTDXNIFTY 28-AUG2009

Daily marginingDaily margining is of two types:

1. Initial margins : The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days.

2. Mark-to-market profit/loss : 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 29JUN2009 at Rs 4500.

The initial margin payable as calculated by VaR is 15%. Total long position = Rs 9,00,000 (200*4500) Initial margin (15%) = Rs 1,35,000

Daily margining - ExampleAssuming that the contract will close on Day + 3 the mark-to-market position will look as follows:

Position on Day 1

New position on Day 2Value of new position = 4,400*200= 8,80,000 Margin = 1,32,000

 

Close Price Loss Margin released Net cash outflow

4400*200 =8,80,000

20,000 (9,00,000-8,80,000) 3,000 (1,35,000-1,32,000)

17,000 (20,000-3000)

Payment to be made

    (17,000)

Close Price Gain Addn Margin Net cash inflow

4510*200 =9,02,000

22,000 (9,02,000-8,80,000)

3,300 (1,35,300-1,32,000)

18,700 (22,000-3300)

Payment to be received

    18,700

Daily margining - Example

Position on Day 3

Value of new position = 4510*200 = Rs 9,02,000Margin = Rs 1,35,300

* Margin Account

 

Close Price Gain Net cash inflow

4600*200 =9,20,000 18,000 (9,20,000-9,02,000) 18,000 + 1,35,300 * = 153,300

Payment to be recd   153,300

Margin Account

Margin account*

Initial margin                =       Rs 135,000Margin released (Day 1) =  (-) Rs  3,000Position on Day 2                  Rs 132,000Addn margin                =  (+) Rs  3,300 Total margin in a/c                Rs 135,300*

Net gain/lossDay 1 (loss)                =     (Rs 17,000)Day 2 Gain                  =      Rs 18,700Day 3 Gain                  =      Rs 18,000Total 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.

Open interest (OI)

Open interest indicates the total gross outstanding open positions in the market for that particular series.

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.

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.

Open interest (OI) contd.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

Price Open interest Market Strong Warning signal Weak Warning signal

Common terms used in Futures Trading

Open Interest - Is the difference in the rate invested in the Futures market and the daily fluctuating rate of the stock.

Roll Over -If a stock invested in doesn't reach the Speculated rate in Futures market, then you can close the deal at the end of the series after which one can re-invest/rollover for the next series.

Cost Of Carrying-Relationship between futures prices and spot prices.

Initial Margin-Amount deposited in the margin account at the time you enter into a futures contract.

Marking to Market-In the futures market the margin account is adjusted at the end of each day to reflect your gain/loss depending on the futures closing price.

Common terms used in Futures Trading

In the money - Option leading to a positive cash flow to you. A call option is ITM if current index is higher than the strike price.

At the money - A call option at the index is ATM if the current index equals strike price. It would lead to a zero cash flow.

Out of the money options- A call option at the index is OTM if current index stands lesser than the then strike price.

Intrinsic value-Difference between spot price and strike price.

Time value-Is the difference between its premium and intrinsic value.

 

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