What is Futures Contract?
Stock Futures are financial contracts where the underlying asset is an individual stock. Stock Future contract is an agreement to buy or sell a specified quantity of underlying equity share for a future date at a price agreed upon between the buyer and seller. The contracts have standardized specifications like market lot, expiry day, unit of price quotation, tick size and method of settlement. Futures are traded in contracts of 1 month, 2 months and 3 months. All F&O contracts will expire on the last Thursday of the month, if the last Thursday is a trading holiday, the contracts expire on the previous trading day. Futures will trade at a Futures price which is normally at a premium to the spot price due to the time value.
Calculation of Stock Futures priced
The theoretical price of a future contract is sum of the current spot price and cost of carry. However, the actual price of futures contract very much depends upon the demand and supply of the underlying stock. Generally, the futures prices are higher than the spot prices of the underlying stocks.
Futures Price = Spot Price + Cost of Carry
Cost of carry is the interest cost of a similar position in cash market and carried to maturity of the futures contract less any dividend expected till the expiry of the contract.
Spot Price of Reliance = 1600, Interest Rate = 7% p.a. Futures Price of 1 month contract=1600 + 1600*0.07*30/365 = 1600 + 11.51 = 1611.51
Opportunities offered by Stock Futures
Stock futures offer a variety of usages to the investors. Some of the key usages are mentioned below:
- Investors can take long term view on the underlying stock using stock futures.
- Stock futures offer high leverage. This means that one can take large position with less capital. For example, paying 20% initial margin one can take position for 100 i.e. 5 times the cash outflow and daily mark-to-market (MTM) loss, if any.
- Futures may look overpriced or underpriced compared to the spot and can offer opportunities to arbitrage or earn risk-less profit. Single stock futures offer arbitrage opportunity between stock futures and the underlying cash market. It also provides arbitrage opportunity between synthetic futures (created through options) and single stock futures.
- When used efficiently, single-stock futures can be an effective risk management tool. For instance, an investor with position in cash segment can minimize either market risk or price risk of the underlying stock by taking reverse position in an appropriate futures contract.
- Additionally, stocks that fall under the F&O segment are much more liquid compared with usual cash market stocks. So you can have easy entry and exit points on these counters. From brokerage or costing point of view as well, trading in futures has less charges compared with cash trades. As buying a future contract can be carried over with no additional cost, or you can say brokerage will not rise for carrying the position, you only need to pay the MTM, if any.
The sole purpose of futures trading is to benefit from price movement on either sides. High leverage can enable you to take large positions, but if the market does not go in your favour, the losses could be huge. F&O is all about betting on future price movements and to bet on high risk-high reward. Traders with high risk appetite may trade in the F&O segment with strict discipline and after doing the necessary homework on the market as well as price movement of the securities targeted.
What is Options Contract?
An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset on or before a stated date/day, at a stated price, for a price. The party taking a long position i.e. buying the option is called buyer/ holder of the option and the party taking a short position i.e. selling the option is called the seller/ writer of the option.
The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, option buyer/ holder will exercise his option only when the situation is favourable to him, but, when he decides to exercise, option writer would be legally bound to honour the contract. Stock options are traded in contracts of 1 month, 2 months and 3 months, while Nifty index options are traded in contracts of 1 month, 2 months, 3 months and maximum 5 Years. All 1-month Option contracts expire on the last Thursday of the month. Weekly Index option contracts expire on the last Thursday of the week. In case the last Thursday of the week is a trading holiday, the previous trading day is the expiry day.
Options may be categorized into two main types:-
• Call Options
• Put Options
Call Options: Give the buyer the right but not obligation to buy a given quantity of the underlying assets, at a given price on or before a particular date by paying the premium.
Put Options: Give the buyer the right but not obligation to sell a given quantity of the underlying assets, at a given price on or before a particular date by paying the premium.
Value of an option (premium)
There are two types of factors that affect the value of the option
- underlying stock price
- the strike price of the option
- the volatility of the underlying stock
- the time to expiration and
- the risk free interest rate
- Market participants” varying estimates of the underlying asset’s future volatility
- Individuals” varying estimates of future performance of the underlying asset, based on fundamental or technical analysis
- The effect of supply & demand- both in the options marketplace and in the market for the underlying asset
- The “depth” of the market for that option – the number of transactions and the contract’s trading volume on any given day.
Key of pricing
- Option pricing, the amount per share at which an option is traded, is affected by a number of factors including implied volatility.
- Implied volatility is the real-time estimation of an asset’s price as it trades.
- When options markets experience a downtrend, implied volatility generally increases.
- Implied volatility falls when the options market shows an upward trend.
- Higher implied volatility means a greater option price movement can be expected.
The significant differences in Futures and Options are as under:
- Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.
- In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset.
- Futures Contracts have symmetric risk profile for both the buyer as well as the seller, whereas options have asymmetric risk profile.In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.
- The Futures contracts prices are affected mainly by the prices of the underlying asset. The prices of options are however; affected by prices of the underlying asset, time remaining for expiry of the contract, interest rate & volatility of the underlying asset.
- Futures required higher margin required than buying any option.
- Unlimited Profit and loss in stock futures vs buying any option unlimited profit and limited loss potential.