Options and futures

1. Futures
A future isa derivative contractinwhichtwopartiesagree tobuyor sell somethingtoeachotheron
a particularprice at a FUTURE date.
That meansdeliveryisnotimmediate,itisata much laterdate.Andpaymentisalsonot immediate;
it isat a laterdate.Thiskindof contract is alsocalleda "forwardcontract".
Why dopeople dothis?Andhowisthisdifferentfrombuyingtoday?
No deliveryrightnow
Futuresare for differentkindsof requirements.Forinstance youmaynothave the moneyrightnow
to buy,but youbelievethe price will goup.Youjustbuya forwardcontract for a laterdate,and on
that date you buyand IMMEDIATELY sell,sothatyou will simplypocketthe difference (orlose the
difference if the stockhaslostmoney).
Short Selling
Secondly,futurescanbe usedto"shortsell".If youwantto sell somethingyoushouldownitfirst,
no? Butfuturesare different - since theyare fora laterdate,you can sell somethingwithoutowning
it,and thenbuyit later!So if youbelievethe price of anitemisgoingdown,youcan SELL a forward
contract. Since youdon't have todeliveritrightnow,the buyerdoesnotcare if you alreadyhave it
or not. Onthe laterdate,justbuyfromthe marketand give itto the buyer,pocketing(orlosing)the
difference.
Hedging
Futuresare also for"hedging".Let'ssayyouare a rice farmerand have 1000 kilosof rice growingin
your farm.You can harvestitonlythree monthslaterbutright now the price is verygood,nearlyRs.
20 per kilo.Butyouknowthat thisyear,the rains have beenkind,soeveryrice farmerisgoingtoget
a good crop. Sothere will be toomuch rice inthe market,andpriceswill come down,evenaslow as
Rs. 12 perkilo!What can youdo?
You can't sell the rice rightnow,because thenthe buyerwill say"show me the rice"and youcan't
showhimbecause youcan't harvestit until three more months.Butif youdon't sell rightnow you
will lose Rs.8perkg!
What youcan dois SELL a futurescontractfor 1000 kilosattoday's price forthree monthslater,Rs.
20 per kilo.Thenthree monthslaterwhenyouharvestif the price hasgone downtoRs. 12 per kilo,
yousell itinthe marketforRs. 12 per kiloandmake Rs. 12,000. Thenyoualsohave to sell 1000 kilos
inyour forwardcontract at Rs. 20, but forthat yousimplybuyfromthe marketat Rs.12 andgive it
to the buyerat Rs. 20, makingthe extraRs.8 perkilo,totallyRs.8000. Meaningyouhave made Rs.
20,000 for your1000 kilos!
You may be thinking:Whydoesn't he simplygive the 1000 kilosfromhisfarmto the buyer?Well,
the buyermay be inBrazil!Market tradersfor commoditieslike Rice canbe anywhere inthe world,
therefore whenyouenterintoafuturescontract onan exchange,youneednotterminateitwith
delivery.(inIndia,inmostcases,youcan'tevenif youwant to).You buyand sell onthe verysame

2. exchange onthe "SPOT"price on the date of delivery.Meaning,if youSOLDa futurescontract,then
on the future date the exchange will assumethatyouwill buyatmarketprice (spotprice) andgive
youthe difference betweenyourfuture contractprice (sellingprice) andthe spotprice (buying
price).
The Underlying
In the example above,whatwasbought/soldinthe future was"RICE".Thisisthe "underlying"
commoditybeingtradedinthe futurescontract.Rice isalsotradedin the "spot"market - whichcan
be your local kiranastore,or a wholesale APMCyardor a commodityexchange (meaning,youpay
and youget yourgoodsright now).The "underlying"canbe anything- a commoditylike rice,asetof
companyshares,an index value,foreigncurrencyetc.
Exchanges
Okaywhat if I tell youthat I will buyrice atRs.20 and the price fallstoRs. 12? I can thenrun away
and hide ina corner,and breakmy promise,because Istandtolose Rs.8. Thisiswhere exchanges
come in.
Exchangesensure thatyourcontract is executed.They"assure"yourcontract.Soif I runaway, the
exchange will still make sure yougetyourprofits.Theywill chase me forthe losses. (Infactafutures
contract must be tradedon the exchange.If it'snot,thenit'sjust a "forward"contract)
Contract ValuesandMarginIn orderto make sure thatI don't run awayfrom them, exchangesask
for a "margin"- a certainportionof the contract value asa "deposit"until the contracteddate.In
Indiathisisbetween12 to 50% of the contract value forshares;so if youbuy a future forbuying100
InfosyssharesatRs. 2200, the contract value isRs. 220,000. The margin can be 20% (dictatedby
your brokeror the exchange) sothe marginwill be Rs.44,000. You are requiredtopaythe margin on
the day youbuy or sell the futurescontract.Onthe contracted date (inthe future),youwill getback
your marginplusyourprofit(orminusyourloss).
Mark to market
Let usassume I boughta forwardcontract (100 sharesof INFYat currentfuture price of Rs. 2200 per
share,on January27, 2007) payinga marginof Rs. 44,000. Now suddenlyif there isacrashand the
price of INFYinthe spotmarketdipped toRs. 1700? EssentiallyIhave lostRs.500 pershare - which,
for 100 shares,isRs. 50,000! Thisis greaterthanmy marginof Rs.44,000 sothe brokeror exchange
may still thinkIcan run awayand theywill be lefttocoverthe loss.Sotheycan make a "Markedto
market"margincall,meaningthattheywill askme to provide the extraRs.6,000 as an additional
margin(andmaybe another20,000 to covera FURTHER fall inprices,thattheycan do).
Usuallymark-to-marketmeansthe difference betweenthe spotprice andthe agreedfuture price -
thiscan be positive ("Mark-to-marketprofit") ornegative ("MTMLoss").Futuresare activelytraded
inthe market,andthe price of the future isnot decidedbyyou - so once you have boughtthe
future,youcan SELL the contract to someone else.Let'ssaythe the contract I boughtat Rs. 2,200 is
nowtradingat Rs.2,300 instead.Ican sell the contract itself,andImake the Rs. 100 as profitper
share - for 100 shares,it'sa Rs. 10,000 profit.The exchange willalsogive me mymarginback,and
take a marginfromthe newownerof the contract.

3. Square off
On the agreeddate of the contract, the exchange will "squareoff"all contracts.Meaning,all buyers
and sellerswill be paidbacktheirmarginincludinganymarkedtomarketprofitsor minusanylosses
as of that date.To avoidarbitrarydates,stockexchangesinIndiahave onlythree open
(purchaseable) future contractdates - the lastthursdayof the currentmonth,the last thursdayof
nextmonthandthe lastthursdayof the monthafterthat. These are callednearmonth,month+1,
month+2. The square off happensatthe endof that Thursday.
Options
Futuresare pre-agreedcontractsandthe buyerMUST sell andthe sellerMUSTpurchase.Theyhave
no choice inthe matter at all,once theysignthe contract the contract hasto be markedtomarket
everyday,theyhave to paythe margin andtheyhave to square off.That meansboththe buyerand
the sellerhasan OBLIGATION tosquare off the deal.
The buyerof an Optionhasthe RIGHT, butnot the obligationtoexercisethe contract.Whatdoes
thismean?Let's sayI thinkthe Infosysshare will goupnextmonth,butI am not sure.
Insteadof buyinga future,Ican buy a "CALL" option,whichisa"right to buy"at a later date.If on
that date the contract isfavourable tome (meaningthe spotprice of INFYishigher) Iwill purchase it
and square off,resultinginaprofittome.
If the spotprice is lowerthanmycall optionprice,Iwill "ditch"the contract,andnot exercise
it...meaningIhave nolosses.
But thenthe personsellingittome mustbe reallystupid.Because if the price ishigher,he hasthe
OBLIGATION to sell ittome andmake a loss,butif the price is lowerIdon't exercise the optionand
he doesnot make a profit.Sowhy wouldhe doit?He chargesme a "premium"whichisthe amount
I pay to buythe option.Itmay be verycheap; aboutRs. 20 pershare,but that isthe moneyforhis
trouble thathe gets to keepincase I decide nottoexercise the option.If Idecide toexercise,he still
keepsthe margin,butpaysthe mark-to-marketloss.
Callsand puts
The right to BUY an underlyingstockata certainprice isknownas a call option.The righttoSELL an
underlyingstockata certainpricesisa PUT option.
It isquite confusing.Youcanbuy a call option,andyou can buya putoption.You have toassociate
the phrase "call"with"rightto buy"and "put" with"rightto sell".
CALL is the right to purchase
PUT isthe right to sell

4. Strike price
Now futuresare tradedlike shares - so the price of the future isreadilyavailable inthe market,and
goesup and downeveryday.Butan optionisslightlydifferent,because itisaright and notan
obligation.Youbuya future inthe futuresmarket,based onwhoiswillingtopayhow muchfor a
future.
But an optionisalwaysat a pre-agreedprice.Instockexchangesforstocksandindices,the exchange
allowsdifferentstrikeprices,usuallyRs.10 betweeneachother,anda new listof tradeable strike
pricesisreleasedeveryday.Thesewill usuallybe afew priecsabove the currentmarketprice,anda
fewpricesbelow.
Example:If InfosysistradingatRs. 2172 today,the exchange mayallow strike pricesof Rs.2150,
2160, 2170, 2180, 2190 and 2200. If the price goesupto 2200 the exchange mayopenupNEW
strike pricesof 2210, 2220 and2230 (the otheronesare still available of course).
Writers
If you buya CALL optionthenyoubuythe rightto purchase something.Butwhosellsittoyou?This
otherpersondoesnothave the RIGHT to sell itto you,she has the OBLIGATION of sellingittoyouif
youwant it.Thispersonis calledawriter.Youcan buyan option,butyoucan alsoWRITE an option
(meaningyouare nowobligatedtosell it).
If you write anoptionyouwill receive the premiumthatthe buyerwill pay.(Minusanybrokerage
and taxes).
Writershave a problem:Theyhave limitedprofits(themargintheyreceive,whenthe strike price is
not profitable forthe buyer) butunlimitedriskof losswhen the strike price isprofitable.Thatmeans
for a call option,if the spotprice is below the strike price,the buyerwill notexercise the option,
therefore youonlygetthe premium.If the spotprice isabove,buyerwill exercise andyoupaythe
difference (butkeepthe margin).
Let's sayyou buya CALL optionof 100 INFY sharesfromme (Rs.2200 strike price,Jan07, Rs.20
premiumpershare).Youpayme Rs.2000 (Rs.20 x 100 shares) as premium.If the price goestoRs.
2,300 youwill exercise the option andIwill have topaythe Rs. 100 difference pershare,totallyRs.
10,000. My lossis Rs.8,000 because Igot the 2,000 premium.
If the price goesdownto Rs.2,100, youwill notexercise the option,andIwill getonlyRs.2,000,
whichwasthe premium.
Why doI write options?Because mostoptionsgounexercised!Meaning,Icanwrite an optiontoday
and itis quite likelythatthe marketprice will notbe withinthe premiumsoIwon't have to lose
money!Andafterall,Ican write aCALL optionand BUY a future at the same time,ensuringthatI
make profitsinthe difference.(Thisisalsohedging)

5. In the money,out of the money
If a call optionstrike price isbelowthe spotprice,itis"inthe money".Meaning,if INFYprice isRs.
2200 and I have boughta call optionfor Rs.2100, I am makingprofits,sothe optionis"inthe
money".
The reverse is"outof the money"or "OTM". Meaning,if Ibuy a call optionfor a strike price of 2100
but the currentprice is Rs.2000, thenI am not makingprofitsrightnow,sothe optionisOTM.
Writersusuallylike tomake OTMcontractsso that theyare notimmediatelyexposedtoloss.(Inthe
moneyoptionsusuallytrade forabigpremium, sobigthat whenyouconsiderthe premium, youare
makinglosses!)