Futures and Options – The basics.

Futures: Principles of pricing.

At any point of time, Futures price of a share differs from the spot price. As we have already learned, the spot price of a share is determined by lot of factors like demand and supply, performance of the company, broad economic conditions, media news, general market psychology etc.

Do the same factors decide futures prices? Or is there anything else we need to know?

The answer is – yes. We need to learn a concept called continuous compounding.

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Futures: Understanding ‘Open interest’.

OPEN INTEREST.

Open interest is one of the most confused terms in derivatives .  In simple terms, open interest is the number of unsettled contracts. This term should not be confused with  ‘volume’. A Common misconception amoung investors, especially beginners, is that open interest on any day represents the volume of future contracts traded.This needs to be corrected.

HERE’S AN EXAMPLE

With the help of an example, let’s try to understand the term open interest and why it is different from volume . Our friend Mr. X is a guy who would like to speculate in the futures market. Having made a killing from Nifty futures last month, he starts his game afresh. This week, this is what he has done in the first three days–

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Futures: Understanding the basic terms

UNDERLYING ASSET

  • The underlying asset that gives value to a futures contract could be shares, share market indices, commodities, currency, interest rates, weather etc.

LOT SIZE

  • The exchange specifies a particular lot size for each type of derivatives.
  • When you buy or sell futures, you do that in ‘lots’.
  • This lot size is not divisible. For example – the lot size of reliance futures is 250 shares. So, taking 1 lot of reliance futures would involve 250 shares. So if Reliance shares are trading at Rs 1000, then the value of 1 lot is Rs 250,000 (Rs 1000 x 250 Numbers)
  • The exchange specifies the lot size. Lot size would be different for different stocks/commodities.
  • Not all stocks traded in the exchange have equivalent futures contract. Stock are selected on the basis criteria specified by the SEBI

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Futures: Types of contracts

Depending on the type of underlying asset, there are different types of futures contract available for trading. They are –

  • Individual stock futures.
  • Stock index futures.
  • Commodity futures.
  • Currency futures.
  • Interest rate futures.

INDIVIDUAL STOCK FUTURES

Individual stock futures are the simplest of all derivative instruments.  Stock futures were officially introduced in India on 9th November 2001. Before that, the local version of stock futures called ‘badla’ were traded which was eventually banned by the Securities Exchange Board of India in July 2001.

The Badla system: the ‘badla system’ was almost similar to the futures contracts we discussed. In simple terms- A badla trader can delay the settlement of a trade by one week for payment of a small fee. So if you bought a particular share for Rs 100 and if you are bullish on that stock, you can delay the settlement by one week if you pay a fee. This carry over can be done for any number of times. Later on, unlimited carry over facility was restricted to 90 days at a time.

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