Futures and Options – The basics.

Options: Kick off

OPTIONS

Options are slightly complex than futures. We’ve already discussed the meaning of option contracts. From this article onwards, we’ll proceed to break up various aspects of options just like we did with futures.

Options are traded in the exchanges just like futures. At any given point of time , there would be three outstanding contracts – near month contract, mid month contract and far month contract. Option Contracts expire on the last Thursday of the expiry month. So, all those features are common between futures and options.

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Futures: End note


CONNECTING THE LOOSE ENDS.

As we come to the end of basic theory on futures , there are some loose ends to be connected. These were collected from the questions that readers have asked us.

  • Not all stocks have corresponding futures. In India, Stock futures are introduced by the exchange and it’s decided based on criteria specified by the Securities Exchange Board of India.  If an existing security fails to meet the eligibility criteria for 3 months consecutively, then no fresh future contracts will be issued in that stock. In the case of existing contracts, if the exchange is of the view that continuing derivatives contracts on a particular stock is detrimental to the interest of the market, it may compulsorily close all derivatives contract positions in that particular stock.

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Futures: Contango and backwardation

CONTANGO & BACKWARDATION.

Contango and backwardation are two technical jargons used in the futures market. These terms are used to describe the position of futures price in comparison with the spot price.

In a normal market, futures price would be greater than the spot price due to the effect of cost of carry. This situation is generally referred to as a ‘Contango’ market.

In our last article, we understood that the ‘basis’ is difference between spot price and futures price at any point of time. In the case of a contango market, since futures price is more than the spot price , the basis would be a negative figure.

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Futures : Understanding basis risk


BASIS.

By creating a long or short hedge using futures, if you thought your cash position is safe, you are wrong. As we saw in the previous post’s examples, hedging eliminates price risk. But it opens up a second risk called ‘Basis risk’. To understand that, first you should understand the term ‘Basis’.

The difference between spot price and futures price at any point of time is called ‘Basis’.

BACK TO EXAMPLES.

Let’s go back to the HDFC’s example from our previous post. The basis at the beginning was Rs 5 per share. (How’s that? Cash price- futures price, Rs 500 – Rs 505).

In situation 1, the stock price moves up to Rs 525 and the futures were at Rs 530. Hence, the basis works out to Rs 5. In situation2, the stock price crashed to Rs 475 and the futures were at Rs 480. Again, the basis remains unchanged at Rs 5. The effect – in either situation, the loss was offset by the profit made.

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