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        Future & Option Guide


Derivative trading is a type of investment that you can make at the stock exchange. In derivative trading or future trading stocks are bought in lot. In fact future trading is a contract that comes with a time frame that means you have to sell that stock within that stipulated time frame. The number of stocks in a lot varies from stock to stock and price of the lot is determined by the number of stocks in a lot multiplied by the current price of that stock. There are certain pros and cons of doing derivative trading.

Advantages Of Derivative Trading

The biggest advantage of derivative trading is that you can buy stocks in future trading by paying only 20% or 30% of the price. That means if you are buying a stock of Rs.10 each and the lot contains 1000 stocks you can pay only Rs.2000 to Rs.3000 to buy the lot. Whereas, the stock price in that cases would have been Rs.10000. So, you are gaining more profit at a time without investing more money.

In case of derivative trading you can short sell the stocks. That means you can first sell the lot of stock and then buy them back within the stipulated time to honor the contract. In case of an overvalued stock that are sure to fall in near future, you can gain from short selling. This is an option that you can not get in equity trading unless you are doing intraday trading.

In future trading the brokerage is usually lower than the equity trading. As you are buying the stocks in a lot the brokerage is calculated not on the unit of the stocks but on the unit of the lot.

Disadvantages Of Derivative Trading

The biggest disadvantage of the derivative trading is that you have a time frame to complete the selling of the stock. If the stock price does not rise up to the expected level, even then you have to sell off the stocks to honor the contract.

Another negative aspect is that the if the stock price fall then the investor loose huge money in derivative trading as the amount of stock involved in this trading is huge.

Another limitation of derivative trading is that not all the listed stocks are available for derivative trading. There are selected stocks in a stock exchangei.e Nse and Bse in which you can do derivative trading.

 

Beginners Guide to Futures Trading

Futures Trading - The Perfect Business?

Futures trading is a business that gives you everything you've ever wanted from a business of your own. It offers the potential for unlimited earnings and real wealth, and you can run it working your own hours while continuing to do whatever you're doing now.

You operate this business entirely on your own, and can start with very little capital. You won't have any employees, so you wouldn't need attorneys, accountants, or bookkeepers. In fact, although you'd be buying and selling the very necessities of life, you never even carry an inventory.

What's more, you'd never have collection problems because you won't have any "customers," and since there is no competition, you won't have to pay the high cost of advertising. You also won't need office space, warehousing, or a distribution system. All you need is a personal computer and you can conduct business from anywhere in the world.... Interested?... Please go ahead and read on!

What is a Futures Contract?

A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the delivery does not occur; instead, before the contract expires, the holder usually "squares their position" by paying or receiving the difference between the current market price of the underlying asset and the price stipulated in the contract.

Unlike options, futures contracts convey an obligation to buy. The risk to the holder is unlimited. Because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Dollars lost and gained by each party on a futures contract are equal and opposite. In other words, futures trading is a zero-sum proposition.

Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. Futures are distinguished from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. Also, in order to insure that payment will occur, futures have a margin requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed.

Trading in futures is regulated by the Securities & Exchange Board of India (SEBI). SEBI exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market.

Futures Trading

Futures contracts are purchased when the investor expects the price of the underlying security to rise. This is known as going long. Because he has purchased the obligation to buy goods at the current price, the holder will profit if the price goes up, allowing him to sell his futures contract for a profit or take delivery of the goods on the future date at the lower price.

The opposite of going long is going short. In this case, the holder acquires the obligation to sell the underlying commodity at the current price. He will profit if the price declines before the future date.

Hedgers trade futures for the purpose of keeping price risk in check. Because the price for a future transaction can be set in the present, the fluctuations in the interim can be avoided. If the price goes up, the holder will be buying at a discount. If the price goes down, he will miss out on the new lower price. Hedging with futures can even be used to protect against unfavorable interest rate adjustments.

While hedgers attempt to avoid risk, speculators seek it out in the hope of turning a profit when prices fluctuate. Speculators trade purely for the purpose of making a profit and never intend to take delivery on goods. Like options, futures contracts can also be used to create spreads that profit from price fluctuations.

Accounts used to trade futures must be settled with respect to the margin on a daily basis. Gains and losses are tallied on the day that they occur. Margin accounts that fall below a certain level must be credited with additional funds.

Settling Futures Contracts

Futures contracts are usually not settled with physical delivery. The purchase or sale of an offsetting position can be used to settle an existing position, allowing the speculator or hedger to realize profits or losses from the original contract. At this point the margin balance is returned to the holder along with any additional gains, or the margin balance plus profit as a credit toward the holder's loss. Cash settlement is used for contracts like stock index futures that obviously cannot result in delivery.

The purpose of the delivery option is to insure that the futures price and the cash price of good converge at the expiration date. If this were not true, the good would be available at two different prices at the same time. Traders could then make a risk-free profit by purchasing goods in the market with the lower price and selling in the market with the higher price. That strategy is called arbitrage. It allows some traders to profit from very small differences in price at the time of expiration.

Pricing Futures

Futures prices are presented in the same format as cash market prices. When these prices change, they must change by at least a certain minimum amount, called the tick. The tick is set by the exchange.

Prices are also subject to a maximum daily change. These limits are also determined by the exchange. Once a limit is reached, no trading is allowed on the other side of that limit for the duration of the session. Both lower and upper limits are in effect. Limits were instituted to guard against particularly drastic fluctuations in the market.

In addition to these limits, there is also a maximum number of contracts for a given commodity per person. This limit serves to prevent one investor from gaining such great influence over the price that he can begin to control it.

How Futures came into being - The History of the Markets

Along time ago, back in the days of Caesar, farmers and herdsmen needed a place to go to trade their commodities. Commodities, according to Websterís Dictionary, is any useful thing that is bought and sold as an article of commerce. So, the farmers set up a marketplace in which to trade the "commodities". That was all well and good except for the problem of timing. Unfortunately, corn and other grains only are harvested at certain times of the year while the need for these grains was consistent year-round.

The traders began making what is now called a forward contract. A forward contract in the commodities market is a contract made by two people setup for the purchase and sale of a certain amount of a certain commodity for delivery at a certain time. It is considered a forward contract because delivery of the good occurs in the future. These forward contracts allowed farmers and herdsmen to guarantee a buyer for their grains and herds at a certain price and in the time frame that they needed. This went well for a while; but, as time went on, they incurred some problems.

For example, letís say Antonious was a farmer of wheat back in the Caesarian times. And, he agreed to sell 5,000 bushels of wheat to Platius. Delivery was set for September. All is going great until a flash flood wiped out Antoniusí entire crop. September comes around and Platius approaches Antonius to collect his new wheat. Well, the price of wheat now has doubled and Antonius doesnít have any wheat. Oh, did I also tell you that Antonius skipped town. This poses a huge problem for Platius since he must now find someone else who has wheat, but also, he must pay double for it. Fortunately, this welching problem was corrected by the formation of "Guilds". The guilds were formed by the very traders using the markets. The guilds hold the entire group of users personally responsible. This allowed for confidence and insurance that the contracts made in the market would be backed by the full faith of the markets.

Upon the fall of the Roman Empire, the commodity markets followed in the same way. The "Dark Ages" brought a type of market, which had no centralized meeting place. A sort of nomadic group would travel around from village to village and buy or sell their supplies to those who needed them. Many times, traders would trick others upon the purchase of a pig. The buyer would choose the pig he or she wanted and the seller would reach under the table to grab a bag. Well, at the same time they were grabbing a bag, they would drop the pig and place a cat into the bag. What a surprise it must have been for the buyer to get home only to find out they would be the proud owner a cheap, useless cat instead of a pig. That is where the term, "Let the cat out-of-the-bag" comes from. After the dark ages, there wasnít a great deal of information recorded on the markets until the mid-1800ís.

The first futures contract (which is much like that of a forward contract) in our modern markets as we know of them today was for 2,000 bushels of corn traded in 1852. It was traded in a mid-sized town back then on the coast of Lake Michigan. Yes, that mid-sized town was Chicago, Illinois. A few years later, the Chicago Board of Trade was founded. Things havenít changed much since then. Except for the chalk boards where the prices were written upon are now digital and the telegraph has been upgraded to the telephone, everything else is pretty much the same. Today, there are many boards of trade, Chicago, Kansas City, Minneapolis, Montreal, QB; New York City, London, Hong Kong and many other cities around the world.

You may wonder why do we need the markets other than to have a place for producers and consumers of these commodities to trade. Well, the producers and consumers set up these markets to relieve themselves of the risk of losing excessive amounts of money from price fluctuation. You may ask where does the risk go? Well, the answer is the speculator. A speculator is an individual or a group of individuals that trade in the markets purely for the opportunity to make money. They are the traders that carry the risk in order to attempt to profit off it.

How do you fit in!

In your futures business, you buy or sell futures contracts because you expect to make a profit on the transaction.

In fact, most futures & commodities traders have no use for the actual commodities they are trading; they never even see them. They are just people like you and me; people with a certain amount of capital to invest getting started in their own business.

There are millions of them and they come from almost every profession: from clerks to executives, from janitors to doctors, from students to university presidents. It is the millions of traders controlling the millions and millions of contracts that allow the exchanges to exist.

But more than that, we make it possible for farmers, dealers, and manufacturers to reduce their own risks. For performing this service, we expect to make a profit.

The great thing about all of this is that you don't need a college degree or even a high school education to do well trading futures. However, you do need some training, you need an objective system, and you need a plan

 

Beginners Guide to Options

What is an option?
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date.

An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock (equity). In the case of an index option, its value is based on the underlying index (equity).

An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.

Options vs. Stocks
Similarities:
∑ Listed Options are securities, just like stocks.
∑ Options trade like stocks, with buyers making bids and sellers making offers.
∑ Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.

Differences:
∑ Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
∑ Options have expiration dates, while stocks do not.
∑ There is not a fixed number of options, as there are with stock shares available.
∑ Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.

Call Options and Put Options
Some people remain puzzled by options. The truth is that most people have been using options for some time, because option-ality is built into everything from mortgages to auto insurance. In the listed options world, however, their existence is much more clear.

To begin, there are only two kinds of options: Call Options and Put Options.

A Call option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.

If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned.

If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument increases.

When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price.

If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies.

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.

If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

With a Put option, you can "insure" a stock by fixing a selling price.

If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.

If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.

This is the primary function of listed options, to allow investors ways to manage risk.

Types Of Expiration
There are two different types of options with respect to expiration. There is a European style option and an American style option. The European style option cannot be exercised until the expiration date. Once an investor has purchased the option, it must be held until expiration. An American style option can be exercised at any time after it is purchased. Today, most stock options which are traded are American style options. And many index options are American style. However, there are many index options which are European style options. An investor should be aware of this when considering the purchase of an index option.

Options Premiums
An option Premium is the price of the option. It is the price you pay to purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ stock) may have an option premium of Rs.2.

This means that this option costs Rs. 200.00. Why? Because most listed options are for 100 shares of stock, and all equity option prices are quoted on a per share basis, so they need to be multiplied times 100. More in-depth pricing concepts will be covered in detail in other section.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract.

For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for Rs. 30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at Rs. 30 per share.

Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the month (except when it falls on a holiday, in which case it is on Thursday).

For example, the XYZ May 30 Call option will expire on the third Friday of May.

The strike price also helps to identify whether an option is in-the-money, at-the-money, or out-of-the-money when compared to the price of the underlying security. You will learn about these terms later.

Exercising Options
People who buy options have a Right, and that is the right to Exercise.

For a Call exercise, Call holders may buy stock at the strike price (from the Call seller).

For a Put exercise, Put holders may sell stock at the strike price (to the Put seller).

Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to Exercise or not to Exercise based upon their own logic.

Assignment of Options
When an option holder chooses to exercise an option, a process begins to find a writer who is short the same kind of option (i.e., class, strike price and option type). Once found, that writer may be Assigned.

This means that when buyers exercise, sellers may be chosen to make good on their obligations.

For a Call assignment, Call writers are required to sell stock at the strike price to the Call holder.

For a Put assignment, Put writers are required to buy stock at the strike price from the Put holder.

Types of options
There are two types of options - call and put. A call gives the buyer the right, but not the obligation, to buy the underlying instrument. A put gives the buyer the right, but not the obligation, to sell the underlying instrument.

Selling a call means that you have sold the right, but not the obligation, for someone to buy something from you. Selling a put means that you have sold the right, but not the obligation, for someone to sell something to you.

Strike price
The predetermined price upon which the buyer and the seller of an option have agreed is the strike price, also called the exercise price or the striking price. Each option on a underlying instrument shall have multiple strike prices.

In the money:
Call option - underlying instrument price is higher than the strike price.
Put option - underlying instrument price is lower than the strike price.

Out of the money:
Call option - underlying instrument price is lower than the strike price.
Put option - underlying instrument price is higher than the strike price.

At the money:
The underlying price is equivalent to the strike price.

Expiration day
Options have finite lives. The expiration day of the option is the last day that the option owner can exercise the option. American options can be exercised any time before the expiration date at the owner's discretion.

Thus, the expiration and exercise days can be different. European options can only be exercised on the expiration day.

Underlying Instrument
A class of options is all the puts and calls on a particular underlying instrument. The something that an option gives a person the right to buy or sell is the underlying instrument. In case of index options, the underlying shall be an index like the Sensitive index (Sensex) or S&P CNX NIFTY or individual stocks.

Liquidating an option
An option can be liquidated in three ways A closing buy or sell, abandonment and exercising. Buying and selling of options are the most common methods of liquidation. An option gives the right to buy or sell a underlying instrument at a set price.

Call option owners can exercise their right to buy the underlying instrument. The put option holders can exercise their right to sell the underlying instrument. Only options holders can exercise the option.

In general, exercising an option is considered the equivalent of buying or selling the underlying instrument for a consideration. Options that are in-the-money are almost certain to be exercised at expiration.

The only exceptions are those options that are less in-the-money than the transactions costs to exercise them at expiration.

Most option exercise occur within a few days of expiration because the time premium has dropped to a negligible or non-existent level.

An option can be abandoned if the premium left is less than the transaction costs of liquidating the same.

Option Pricing
Options prices are set by the negotiations between buyers and sellers. Prices of options are influenced mainly by the expectations of future prices of the buyers and sellers and the relationship of the option's price with the price of the instrument.

An option price or premium has two components : intrinsic value and time or extrinsic value.

The intrinsic value of an option is a function of its price and the strike price. The intrinsic value equals the in-the-money amount of the option.
The time value of an option is the amount that the premium exceeds the intrinsic value. Time value = Option premium - intrinsic value.

Beginner's Guide to Option Trading and Investing in Call and Put Options

 
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