What are Contracts?
A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. In case of a forward contract the price which is paid/ received by the parties is decided at the time of entering into contract. It is simplest form of derivative contract mostly entered by individual in day to day life.
The holder of a long (short) forward contract has an agreement to buy (sell) an asset at a certain time in the future for a certain price, which is agreed upon today. The buyer (or seller) in a forward contract:
Acquires a legal obligation to buy (or sell) an asset (known as the underlying asset)
At some specific future date (the expiration date)
At a price (the forward price) which is fixed today.
Basic Features of a Contract
The basic features of a contract are given in brief here as under:
Forward contracts are bilateral contracts, and hence, they are exposed to the counter party risk. There is risk of non-performance of obligation either of the parties, so these are riskier than to futures contracts.
Each contract is custom designed, and hence, is unique in terms of contract size, expiration date, the asset type, quality etc.
In forward contract, one of the parties takes a long position by agreeing to buy the asset at a certain specified future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contract is said to have an open position. A party with a close position is, sometimes, called a hedger.
The specified price in a forward contract is referred to as the delivery price. The forward price for a particular forward contract at a particular time is the delivery price that would apply if the contract were entered into at that time. It is important to differentiate between the forward price and the delivery price. Both are equal at the time the contact is entered into. However, as time passes, the forward price is likely to change whereas the delivery price remains the same
In the forward contract, derivative asset can often be contracted from the combination of underlying assets; such assets are often known as synthetic assets in the forward market
In the forward market, the contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsory go to the same counter party, which may dominate and command the price it wants as being in a monopoly situation
In a forward contract, covered party or cost of carry relations are relation between the prices of forward and underlying assets.
Forward contract are very popular in foreign exchange market as well as interest rate bearing instruments. Most of the large and international banks quote the forward rate through their forward desk lying within their foreign exchange trading room. Forward foreign exchange quotes by these banks are displayed with the spot rates
Basic Futures of a Contract
Futures contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place. Future contracts are normally traded on an exchange which sets the certain standardized norms for trading in futures contracts. The features of a futures contract may be specified as follows:
Futures are traded only in organized exchanges.
Futures contract required to have standard contract terms
Futures exchange has associated with clearing house
Futures trading required margin payment and daily settlement
Futures positions can be closed easily
Futures markets are regulated by regulatory authorities like SEBI
The futures contracts are executed on expiry date
The futures prices are expressed in currency units, with a minimum price movement called a tick size.
The quality of positive economic theory explains about its ability with precision clarity and simplicity.
The main characteristics of futures explained by a good economic theory are as follows:
There are a limited number of actively traded products with futures contracts. .
The trading unit is large and indivisible
It has no more than maturity of 3 months
The success ratio of new contract is about 25% in the world financial markets
Futures are seldom used by farmers
There are both commercial and non-commercial users of futures contract in interest rates and foreign exchange.
The main use of the future by the commercial users is to hedge corresponding cash and forward positions.
The positions of the non-commercial users take almost entirely speculative positions. In foreign exchange futures, the positions of the commercials users are unbalanced
There are different types of contracts in financial futures which are traded in the various futures market of the world. The followings are the important types of financial futures contract
Stock future or equity futures . .
Stock index futures
Interest rate futures
Options are derivative contract that give the right, but not the obligation to either buy or sell a specific underlying security for a specified price on or before a specific date. In theory, option can be written on almost any type of underlying security. Equity (stock) is the most common, but there are also several types of non-equity options, based on securities such as bonds, foreign currency, indices or commodities such as gold or oil.
The person who buys an option is normally called the buyer or holder. Conversely, the seller is known as the seller or writer. Again we can say “An option is a particular type of a contract between two parties where one person gives the other person the right to buy or sell a specific asset at a specified price within a specified time period.” Today, options are traded on a variety of instruments like commodities, financial assets as diverse as foreign exchange, bank times deposits, treasury securities, stock, stock indexes, petroleum products, food grains, metals etc. The main characteristics of options are following
Options holders do not receive any dividend or interest
Option yield only capital gains.
Options holder can enjoy a tax advantages
Options are traded on OTC and in all recognized stock exchanges
Options holders can control their rights on the underlying assets
Options create the possibility of gaining a windfall profit. .
Options holder can enjoy a much wider risk- return combinations
Options can reduce the total portfolio transaction costs.
Options enable with the investors to gain a better returns with a limited amount of investment. .
A call which is the right to buy shares under a negotiable contract and which do not carry any obligation. The buyers have the right to receive the delivery of assets are known as call option.
In this option the owner has the right to sell the underlying asset under the negotiable contract. Put option holder has the right to receive the payment by surrendering the asset.
The writer of an option is a stock broker, member or a security dealer. The buyer of an option pays a price depending on the risk of underlying security and he as an investor or a dealer or trader.
The basic features of options or followings:
The option is exercisable only by the owner namely the buyer of the option.
Option yield only capital gains.
The owner has limited liability
Owners of options have no voting rights and dividend right
Options have high degree of risk to the option writers
Options involving buying counter positions by the option sellers
Flexibility in investors needs.
No certificates are issued by the company
Options are popular because they allow the buyer profits from favorable movement in exchange rate
Options can be classified into different categories like:
(i) Call options
(ii) Put options
(iii) Exchange traded options
(iv) OTC traded options
(v) American options
(vi) European options
(vii) Commodity options
(viii) Currency options
(ix) Stock options
(x) Stock Index options
Key Terms in options
A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called "the call option premium or call option price".
A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price".
KEY TERMS IN OPTIONS
Before diving deep in the option market lets understand the key term in option trading, which are repeatedly used and also the factors that influence the option price
Strike Price: - The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by option holder upon exercise of the option contract. (Ex Reliance capital call at 350)
Expiration Date: - The date on which option expires is expiration date, the Exercised date, the strike date or the maturity date. It is the last day on which option can be exercised. Option normally has a month and/or quarterly expiration cycle.
Option Price: - Option price is the price, which the option buyer pays to the option seller. It is also referred to as option premium. The Premium depends on various factors like strike price, Stock price, Expiration date, Volatility, Interest rate. The buyer pays premium to seller. On receiving the premium seller has the obligation to exercised the option when assigned to him
American option: - American options are option that can be exercised any time upon the expiration date. Most exchange-traded option is American. Options on individual stocks are American. Ex. Reliance. CA, Tisco .PA, SBI. CA
European option: - European options are option that can be exercised only on the expiration date itself. Index based option are European option. Ex. NIFTY CE
CA: Call American
PA: Put American
CE: Call European
PE: Put European
In the money: An in the money (ITM) option is an option that would lead to positive cash flows to the holder if it was exercised immediately. A call option is ITM when spot price is greater than strike price. If the difference is huge it is called deep in the money
At-the-money: An at the money (ATM) option will lead to zero cash flow if exercised immediately. Option is at the money if strike price is equal to spot price
Out-of-the-money: An out of money (OTM) option will lead negative cash flow if exercised immediately. In case of call option if strike price is greater than spot price than it is OTM. Whereas in case of put option if strike price is less than spot price it is OTM
Intrinsic Value of an option: Option premium has two parts in it, i.e. Intrinsic value and Time value. Intrinsic value means how much is option ITM. Deeper is the option in the money more is the intrinsic value of an option. If the option is Out of the money or at the money its intrinsic value is zero.
Time Value of an option: Time value of option is difference between Premium and Intrinsic value. Both call and put have time value. ATM and OTM option only have time value and no Intrinsic value.
A swap is an agreement between two or more people or parties to exchange sets of cash flows over a period in future. Swaps are agreements between two parties to exchange assets at predetermined intervals. Swaps are generally customized transactions. The swaps are innovative financing which reduces borrowing costs, and to increase control over interest rate risk and FOREX exposure. The swap includes both spot and forward transactions in a single agreement.
Swaps are at the centre of the global financial revolution.
Swaps are useful in avoiding the problems of unfavorable fluctuation in FOREX market. The parties that agree to the swap are known as counter parties. The two commonly used swaps are interest rate swaps and currency swaps.
Interest rate swaps which entail swapping only the interest related cash flows between the parties in the same currency.
Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than the cash flows in the opposite direction
Fundamental Understanding of Derivatives
Derivatives provide platform to investor to make huge profit by leveraging their position. However it is double edge sword if not handled properly may result in huge losses too. So as a prudent and smart investor one must look at the signal that markets continuously provide to make a right decision by taking calculative risk.
The most important parameter to judge the performance of stock in Future and Option market is
Open interest and volumes are very close to each other. However Volumes considered total trade carried out whereas open interest is number of outstanding contracts at a particular time. It is more relevant as it considers number of contract which are outstanding and not squared off by the investor. Further Open interest increases only when new contract is traded i.e when existing parties (Buyer or seller) enters in fresh position and not square of or when new parties enter into a contract whereas
Open interest decreases when existing parties i.e. Buyer as well as seller square off their position
Buyer of the contract sells it
Seller of the contract buys it
While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. Yet one of the most reliable indicators of future market direction is a contrarian sentiment measure known as the Put/Call options volume ratio.
Put option gives the right to sell the option at a predetermined price whereas call option gives right to sell. While too many put buyer usually signals that market bottom is nearby while too many call buyer indicates market top is making.
Put call ratio is simply number of put contracts divided by number of call contracts traded during the particular day. Higher put call ratio signifies market player are bearish and feel stock may fall whereas lower put call ratio tells the opposite story.
However signals thrown by market player contradict the real outcome. Higher PCR portrays that the stock is oversold and reversal is on the way .Its right time to get in. whereas Lower PCR portrays that the stock is overbought and downward trend is soon expected
The Put/call ratio is yet another solid weapon within a speculator's arsenal to trade and give clear picture many times that when to exit or when to enter the market but then also one cannot rely only on Put/call ratio to survive in the market and earn money. This fact also cannot be ignored that it is a very powerful tool, which help speculator up to a great extent to prejudge the market movement and invest accordingly