How dose Future trading work?
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Futures and options represent two of the most common form of “Derivatives”.
Derivatives are financial instruments that derive their value from an ‘underlying’. The underlying can be a stock issued by a company, a currency, Gold etc., The derivative instrument can be traded independently of the underlying asset.
The value of the derivative instrument changes according to the changes in the value of the underlying.
Derivatives are of two types : exchange traded and over the counter.
Exchange-traded derivatives, as the name signifies are traded through organized exchanges around the world. These instruments can be bought and sold through these exchanges, just like the stock market. Some of the common exchange-traded derivative instruments are futures and options.
Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not standardized and have varied features. Some of the popular OTC instruments are forwards, swaps, swaptions etc.
A ‘Future’ is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features:
Buyer Seller Price Expiry
Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities, and currency.
The difference between the price of the underlying asset in the spot market and the futures market is called ‘Basis’. (As ‘spot market’ is a market for immediate delivery) The basis is usually negative, which means that the price of the asset in the futures market is more than the price in the spot market. This is because of the interest cost, storage cost, insurance premium etc., That is, if you buy the asset in the spot market, you will be incurring all these expenses, which are not needed if you buy a futures contract. This condition of basis being negative is called as ‘Contango’.
Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For eg: if you hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not be eligible for any dividend.
When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes positive (i.e., the price of the asset in the spot market is more than in the futures market). This condition is called ‘Backwardation’. Backwardation generally happens if the price of the asset is expected to fall.
It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to close the gap between them ie., the basis slowly becomes zero.
Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a ‘call’ option or a ‘put’ option.
A call option gives the buyer, the right to buy the asset at a given price. This ‘given price’ is called ‘strike price’. It should be noted that while the holder of the call option has a right to demand the sale of the asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right.
Similarly, a ‘put’ option gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy.
So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as ‘premium’. Therefore the price that is paid for buying an option contract is called a premium.
The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price of Rs 500. On expiry, the price of the asset is Rs 450. A will not exercise his call. Because he can buy the same asset from the market at Rs 450, rather than paying Rs 500 to the seller of the option.
The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot market is more than the strike price of the call. For eg: B bought a put at a strike price of Rs 600. On expiry, the price of the asset is Rs 619. A will not exercise his put option. Because he can sell the same asset in the market at Rs 619, rather than giving it to the seller of the put option for Rs 600.