 |
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
Webster’s 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, let’s 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
Antonius’ entire crop. September comes around and Platius approaches Antonius to
collect his new wheat. Well, the price of wheat now has doubled and Antonius
doesn’t 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 wasn’t a great deal
of information recorded on the markets until the mid-1800’s.
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 haven’t 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 |
