Tuesday, February 26, 2013

Excellent Trading School - 22 - Frequently Asked Questions about Futures Contracts - part 1


Question: How many stocks are trading in Futures & Option? What is the minimum quantity we need to trade?
Answer: The minimum quantity you can trade in is one market lot. The market lot is different for different stocks/index. Regarding Stocks trading in Futures and Options Segment, from Time to time list will keep changing.

Question: what is Open Interest (OI) and Contract in the enclosed charts?
Answer:Open interest is the total number of options and/or futures contracts that are not closed out on a particular day, that is contracts that have been purchased and are still outstanding and not been sold and vice versa.

A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct since there could be huge volumes but if the volumes are just because of participants squaring off their positions then the open interest would not be large. On the other hand, if the volumes are large because of fresh positions being created then the open interest would also be large.

The Contract column tells us about the strike price of the call or put and the date of their
settlement. For example, the first entry in the Active Calls section (4500.00-August) means it is a Nifty call with Rs 4500 strike price, that would expire in August. It is interesting to note from the newspaper extract given above is that it is possible to have a number of options at different 46 strike prices but all of them have the same expiry date. For example, there are a number of call options on Nifty with different strike prices, but all of them expiring on the same expiry date in August.

There are different tables explaining different sections of the F&O markets.
1. Positive trend: It gives information about the top gainers in the futures market.
2. Negative trend: It gives information about the top losers in the futures market.
3. Future OI gainers: It lists those futures whose % increases in open interest are among the highest on that day.
4. Future OI losers: It lists those futures whose % decreases in open interest are among the highest on that day.
5. Active Calls: Calls with high trading volumes on that particular day.
6. Active Puts: Puts with high trading volumes on that particular day.

Question: Is there a theoretical way of pricing futures?
Answer: The theoretical price of a futures contract is spot price of the underlying plus the cost of carry. Please note that futures are not about predicting future prices of the underlying assets.
In general, Futures Price = Spot Price + Cost of Carry
The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity futures). Revenue may be in the form of dividend. Though one can calculate the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset.

Question: Can you explain with a few examples how futures are priced?
Answer: Suppose Reliance shares are quoting at Rs300 in the cash market. The interest rate is about 12% per annum. The cost of carry for one month would be about Rs3. As such a Reliance future contract with one-month maturity should quote at nearly Rs303. Similarly Nifty level in the cash market is about 1100. One month Nifty future should quote at about 1111. However it has been observed on several occasions that futures quote at a discount or premium to their theoretical price, meaning below or above the theoretical price. This is due to demand-supply pressures. Everytime a Stock Future trades over and above its cost of carry i.e. above Rs. The arbitragers would step in and reduce the extra premium commanded by the future due to demand. eg: woud buy in the cash market and sell the equal amount in the future. Hence creating a risk free arbitrage, vice-versa for the discount.

Question: What happens to the futures price as a contract approaches expiry?
Answer: As the futures contract approaches expiry, the cost of carry reduces as time to expiry reduces; thus futures and cash prices start converging. On expiry day, the futures price should equal cash market price.

Question: How does settlement take place?
Answer: Presently both stock and index futures are settled in cash. The closing price in the cash segment is considered as the settlement price. The difference between the trade price and the settlement price is ultimately your profit/loss.

Question: What would happen in case of delivery-based settlement?
Answer: Stock-based derivatives are expected to be settled in delivery. On expiry of the futures contract, the buyer/seller of the future would receive a long/short position at the closing price in the cash segment on the next trading day. This position in the cash segment would merge with any other position the buyer/seller has. In case the buyer /seller wants he can square up this position by selling/buying the shares. Or else he would be required to deliver/receive the underlying shares on the settlement day (eg T+2) in the cash segment.
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