Forwards, Futures & Options Introduction - Chapter 2

Preface to forwards and futures 

Structurally, forwards and futures are largely similar. They both entail an agreement between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. The only difference is that forwards are over the counter (OTC) contracts while futures are exchange traded contracts and hence standardized and also more secure. Here are some of the key differences between forwards and futures.

Key shortcomings of forward contracts

Having understood the concept of forwards, let us look at some of the limitations of forward contracts and how they are overcome by futures contracts.

• Forwards can be low on liquidity since it is hard to get secondary market participants for customized contracts. Forwards contracts are not standardized and that makes them less liquid.
• Since forwards are not listed or traded on exchanges, pricing is quite opaque and also arbitrary at most times. Here the larger participant has an undue advantage compared to the futures contracts which are more democratic.
• Forwards are vulnerable to counterparty risk. This risk arises if one of the party defaults. The only way out is the legal option, which can be lengthy and cumbersome. On the other hand, futures are guaranteed by the clearing corporation and hence defaults are avoided since the clearing corporation takes over the defaulter’s liability.
• Forward contracts are also subject to settlement and clearing complications since these are directly done by the contracting parties and there is no central and objective referee in this case. The centralized trading platform of futures takes care of this.

However, forwards continue to exist in areas like commodities and banks where the participants are large institutions and hence chances of default are much less. However, for the traders and hedgers and large, futures remains a more transparent option.

Key characteristics of a futures contract

Some of the key attributes of a futures contract can be captured as under:

• Like in case of forwards, futures are also an agreement to buy or sell an underlying. For every futures contract, there a buyer and a seller
• Futures is a contract between two consenting parties through the exchange platform where the exchange acts as the centralized platform
• The price of the futures is based on transparent price discovery mechanism and like stock prices, these futures prices are also discovered by demand and supply.
• Futures are leveraged products and hence margins are payable by both the buyer and the seller of the contract. In addition MTM margins are also payable if the price movement is unfavourable.
• Quality and quantity of the contract are standardized. Quantity standardization happens in the form of lot sizes but quality standardization is more relevant to commodity futures since commodities are a lot more heterogeneous

Key concepts you need to know about futures contracts

Futures contracts are much simpler than options but still there are some unique features to be understood. The best way to understand this is with a live snapshot of a futures screen of the Nifty Futures as under.

Chart source: NSE

Futures contracts expire on the last Thursday of every month and at any point of time there are 3 contracts trading viz. near month, mid month and far month. As of 13^th August, the near month will expire in August, mid month in September and far month in October. In the live illustration above, we have considered Nifty September Futures contract. Now let us look at the concepts.

Futures Price: is the price of the Nifty futures contract. In the above case, the September 2019 Nifty futures closed at 10,965.30. Futures normally trade at a premium to spot.

Spot Price: is the price at which the spot value of the Nifty trades. In the above case, the spot Nifty has closed at 10,925.85.

Expiration Day: The day on which a derivative contract ceases to exist. Trades can either square off the contract or exercise the contract or just leave it to expire. In the above case, the expiration day is 26^th September 2019.

Tick Size:  Tick Size is the minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts as part of contract specification. Tick size for Nifty futures is 5 paisa.

Bid and Ask Price: Bid price is the price that buyer is willing to pay and ask price is the price the seller is willing to sell at. Your buy orders get executed at the best ask price and your sell orders get executed at the best bid price. The order book above captures bid and ask prices.

Contract Size and Contract Value: Contract size is the lot size which is 75 for Nifty in the above case. When the futures price is multiplied by the lot size or the contract size you get the actual contract value. Contract lots help to standardize the futures contracts.

Basis:  The difference between the spot price and the futures price is called basis. If the futures price is greater than spot price, basis for the asset is negative. Similarly, if the spot price is greater than futures price, basis for the asset is positive. In the above case, the futures price of 10,965 is greater than the spot price of 10,925 and hence basis is negative.

Cost of Carry:  It is the relationship between futures prices and spot prices. In commodities the futures includes storage cost, insurance plus the interest cost. In case of equity and index futures, the cost of carry only factors interest cost and the dividends earned. This is how it works. If the futures are trading at a premium of Rs.7 and Rs. 3 is to be received as dividend per share then the net cost of carry would be Rs.4. The above NSE snapshot screen captures the cost of carry on a real time basis for the best buy price, best sell price and the closing price.

Open Interest and Volumes Traded: Open interest is the total number of contracts outstanding (not settled) for any underlying asset. Total number of long futures will always be equal to total number of short futures and so only one side of contracts is considered while calculating open interest. Shifts in open interest give an idea of where accumulation is happening. Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market.

 Volumes are the actual trades executed and can be looked at in terms of number of contracts or in terms of the value of contracts executed.

Types of margins in futures contracts

Since futures are leveraged contracts, the exchange needs to collect margins since the trades are guaranteed by the clearing corporation of the stock exchange. To compensate for this risk, the exchange charges margins on open futures contracts. Here are some of the margins that you will have to pay to the exchange on futures contracts.

Initial Margin

When you buy or sell a futures contract on the exchange, the initial margin has to be deposited upfront. This initial margin is based on the concept of Value at Risk (VAR), which calculates the maximum possible loss on a single day in over 99% of the cases.

Volatility or Extreme Loss Margins (ELM)

In addition to the VAR margin, there is also a fixed percentage volatility margin that is charged on the contract. In the past, collecting ELM was optional. From 2018, SEBI has made it mandatory to collect ELM also at the time of the contract.

Marking to Market (MTM) Margins

This is collected on a daily basis in the futures market, even through the contract may have a maturity of several months. To avoid price risk, the profits and losses are settled on day-to-day basis – called mark to market (MTM) settlement. The exchange collects these margins (MTM margins) from the loss making participants and pays to the gainers on day-to-day basis.

Contract specifications for futures and options

The NSE chart below captures the contract specifications for stock futures, index futures, stock options and index options.

Chart Source: NSE

Contract specifications include the salient features of a derivative contract like contract maturity, contract multiplier also referred to as lot size, contract size, tick size etc. They basically help to standardize the contracts. Here are some samplers above.

• Index futures and index options are only available on 3 indices
• Stock futures and stock options are available only on 196 stocks
• All call options and put options are European in nature
• Other than Nifty which has long term options, all other contracts only have 3 contracts
• All contracts expire on the last Thursday of the month, except the weekly options contract which expire every Thursday
• Strike price intervals for options are determined based on the market price

Having understood futures in elaborate detail, let us move on to options and understanding the nuances of options.

What exactly is meant by an Options Contract?

An Option is a contract that gives the buyer of the option the right, but not an obligation, to buy or sell the underlying asset on a stated date, at a stated price by paying a premium. The trader taking a long position i.e. buying the option is called buyer/ holder of the option and the party taking a short position i.e. selling the option is called the seller/ writer of the option. The option buyer has the right but no obligation with regards to buying or selling the stock or the index, while the option writer has the obligation in the contract.

Since the option buyer gets a right without an obligation he needs to pay a price for this right. This price of the right is called the option premium and it is this right that actually gets traded in the options exchange. Broadly options are of two types viz. Call Option (right to buy) and put option (right to sell). Options can either be American (exercised at any time on or before expiry) or European (exercised only on expiry date. Initially, index options were European and stock options were American. However, post 2010 all options traded in the stock market are necessarily European only.

Breaking up an Options Contract

Why do people buy or sell call and put options. The table below captures the gist of the view that each of these parties have.

The above table captures the payoffs for the key players in any option contract. In short, profits are unlimited but losses are limited for the buyer of options. On the other hand, losses are unlimited but inflow is limited for the seller of the option.

ITM, ATM and OTM options

When it comes to options trading, this is one of the most important concepts. It is the gap between the spot price of the stock and the strike price. Broadly there are 3 types of options in terms of moneyness.

In the money (ITM) option: ITM option gives the holder a positive cash flow, if it were exercised immediately. A call option is said to be ITM, when spot price is higher than strike price. The put option is said to be ITM when spot price is lower than strike price.

FOR CALL OPTION ITM = SPOT PRICE > STRIKE PRICE

FOR PUT OPTION ITM = SPOT < STRIKE PRICE

At the money (ATM) option: ATM option would lead to zero cash flow if it were exercised immediately. Therefore, for both call and put ATM options, strike price is equal to spot price. Since ATM options are not practical in most cases, the options traders also use NTM (Near to money) options which are the contiguous strikes.

FOR CALL AND PUT OPTION ATM: SPOT PRICE = STRIKE PRICE

Out of the money (OTM) option: OTM option is one with strike price worse than the spot price for the holder of option. A call option is said to be OTM, when spot price is lower than strike price. A put option is said to be OTM when spot price is higher than strike price.

FOR CALL OPTION OTM = SPOT PRICE < STRIKE PRICE

FOR PUT OPTION OTM = SPOT > STRIKE PRICE

Let us look at a practical screenshot to understand these points with the option chain analysis of Reliance Industries.

Chart source: NSE

In the above option chain analysis, the strike prices of Reliance Options contract are in the centre. On the left are the calls and on the right side are the puts for each strike. The contracts shaded in yellow represent in-the-money (ITM) options while the ones in white background are the out-of-the-money (OTM) options.

Intrinsic Value and Time Value

No discussion on options pricing and option valuation is complete without understanding the concepts of intrinsic value and time value. The option premium can be broken up into intrinsic value and time value. Let us understand these two concepts in greater depth.

• Intrinsic value of an option refers to the amount by which option is in the money i.e. amount an option buyer will realize, without adjusting for premium paid, if exercised instantly. Only ITM options have intrinsic value whereas ATM options and OTM options have zero intrinsic value. Remember, the intrinsic value of an option can never be negative. In case of call option, intrinsic value is the excess of spot price (S) over the strike price (X), i.e. intrinsic value = (S - X). For put options the intrinsic value is (X – S)
• Time value is the residual option premium left after intrinsic value is removed. Obviously, ATM and OTM options will have only time value because the intrinsic value of such options is zero. ITM options will have intrinsic value and time value and when we talk of time decay in options; it is this time value component that actually decays.

How are options priced?

When we value options, we value the right to buy or sell an asset. Valuation of an option is important for the same reason as you value stocks. It helps you identify options that are underpriced and options that are overpriced. The most popular method for valuing options is the Black & Scholes Model, which helps calculate the intrinsic value of an option based on a number of parameters. The calculation of the Black & Scholes Model is based on a very complex formula but this is available on derivatives websites and also on your trading terminal. But it would be instructive to understand the factors that impact the value of an option.

Understanding Option Greeks

Option Greeks measure the sensitivity of option price to various factors. Option Greeks are very useful for options traders. There are five broad option Greeks to understand.

1. Delta: measures the sensitivity of the option value to a given change in the spot price of the underlying asset. It may also be seen as the speed with which an option moves with respect to price of the underlying asset. Call options have positive delta while put options have negative delta.
2. Gamma: measures change in Delta with respect to change in price of the underlying asset. This is a second derivative option. Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an option will go either in-the-money or out-of-the-money due to a change in price of the underlying asset.
3. Theta: is a measure of an option’s sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay and is very useful for option sellers who basically play on time decay.
4. Vega: is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change (typically 1%) in the underlying volatility.
5. Rho: is the change in option price given a one percentage point change in the risk-free interest rate. Rho measures the change in an option’s price per unit increase in the cost of funding the underlying.

In a nutshell, options can used to trade on price movements, trade on volatility shifts and also to hedge the portfolio by taking positions contrary to your underlying cash market positions. Options are asymmetric and that makes them more flexible.