Excellent Trading School - 29 - Frequently Asked Questions about Options Contracts - Part 5 (Options Strategies)

Question: What are Strip and Strap strategies?

Answer: These strategies are quite similar to Straddle. The only difference is that unlike straddle, call and put options are not bought in equal numbers.

In Strip strategy, the number of puts bought or sold is double that of call options.

In Strap, the number of calls bought or sold is double that of put options.

You buy strip when you expect sharp movement in the prices of the underlying but are a little biased towards downward movement, so you buy more put than call options. 

Likewise while buying strap you are little biased towards upward movement, you buy more call than put options.

You sell strip when you expect the price to fluctuate in a narrow range but you also believe that in case the price moves beyond the range, it would move upward, so you sell more put than call options.

Likewise while selling strap you are a little biased toward downward movement of the underlying price in case it breaks the range.

Question: I believe that the underlying will fluctuate in a narrow range but am not very sure of it moving sharply in either direction. What should be my strategy? What is the upside potential and downside risk? What happens as time passes?

Answer: When you believe that the underlying will fluctuate in a narrow range but are not very sure of it moving sharply in either direction, Long Butterfly is the best strategy.

Strategy implementation: buy one in-the-money call, sell two at-the-money calls and buy one out-of-the-money call option. The same strategy can be implemented using put options also. It is difficult to execute four transactions simultaneously. As such there is execution risk involved.

Upside potential: the profit is limited to the extent of the difference between the lower and middle strike prices minus initial debit.

Downside risk: the loss is limited to the extent of initial debit.

Time decay characteristic: time works against.

Question: I am not sure of the direction and am fairly certain that the underlying is going to rise or fall sharply. What strategy should I follow? What is the upside potential and downside risk? What happens as time passes?

Answer: When you are not so sure that the underlying index or stock will rise or fall sharply and are not certain about the direction, Short Butterfly is the best strategy. Strategy implementation: sell one in-the-money call, buy two at-the-money calls and sell one out-of-the-money call option. The same strategy can be implemented using put options also. It is difficult to execute four transactions simultaneously. As such there is execution risk involved.

Upside potential: the profit is limited to the extent of initial credit received.

Downside risk: the loss is limited to the extent of the difference between the lower and middle strike prices minus initial credit received.

Excellent Trading School - 28 - Frequently Asked Questions about Options Contracts - Part 4

Question: How does the margin system work in option trading?

Answer: Since the risk of the buyer of an option is limited to the premium paid, there is no margin required from the buyer of the option. The buyer’s cost is limited to the premium paid. The risk of the option seller is unlimited and therefore he needs to pay the margin as prescribed by the exchange at the time of entering into an option contract. To reduce the default risk, the option position of the seller is marked to market every day.

Question: If I have two opposite positions in futures and options, then do I have to pay margin on both the positions?

Answer: You have to pay margin on your positions but the net margin required is lower than the margin on two separate positions. Suppose you have sold one futures contract on ACC at Rs152 and simultaneously bought an ACC call option with a strike price of Rs160 at Rs5. In this portfolio one position is bullish and the other bearish, so in case ACC’S price goes up, one position would gain and the other would lose. Similarly if ACC’S price goes down, one position would gain while the other would lose. These are hedging positions. Hence the margin is less.

Question: How are options different from futures?

Answer: In case of futures, both the buyer and the seller are under obligation to fulfill the contract. They have unlimited potential to gain if the price of the underlying moves in their favour. On the contrary, they are subject to unlimited risk of losing if the price of the underlying moves against their views.

In case of options, however, the buyer of the option has the right and not the obligation. Thus he enjoys an asymmetric risk profile. He has unlimited potential to profit if the price of the underlying moves in his favour. But a limited potential to lose, to the extent of the premium paid, in case the price of the underlying moves against the view taken.

Similarly the seller of the option is under obligation. He has limited potential to profit, to the extent of the premium received, in case the price of the underlying moves in his favour. But an unlimited risk of losing in case the price of the underlying moves against the view taken.

Question: How are options different from futures in terms of price behaviour?

Answer: Trading in futures is one-dimensional as the price of futures depends upon the price of the underlying only. Trading in option is two-dimensional as the price of an option depends upon both the price and the volatility of the underlying.

Question: I want to know all about the behaviour of the price of an option?

Answer: You need to understand and appreciate various option Greeks like delta, gamma, theta, vega and rho to completely comprehend the behaviour of option prices.

Question: What is delta of an option and what is its significance?

Answer: For a given price of underlying, risk-free interest rate, strike price, time to maturity and volatility, the delta of an option is a theoretical number. If any of the above factors changes, the value of delta also changes.

The delta of an option tells you by how much the premium of the option would increase or decrease for a unit change in the price of the underlying. For example, for an option with delta of 0.5, the premium of the option would change by 50 paise for a Rs1 change in the price of the underlying. Delta is about 0.5 for near/at the money options. As the option becomes in the money, the value of delta increases.

Conversely as the option becomes out of the money, the value of delta decreases. In other words, delta measures the sensitivity of options with respect to change in the price of the underlying. Deep out-of-the-money options are less sensitive in comparison to at-the-money and deep in-the-money options.

Delta is positive for a bullish position (long call and short put) as the value of the position increases with rise in the price of the underlying. Delta is negative for a bearish position (short call and long put) as the value of the position decreases with rise in the price of the underlying.

Delta varies from 0 to 1 for call options and from –1 to 0 for put options. Some people refer to delta as 0 to 100 numbers.

The Delta is an important piece of information for a option Buyer because it can tell him much of an option & buyer he can expect for short-term moves by the underlying stock. This can help the Buyer of an option which call / Put option should be bought. The factors which can change the Delta of an option are Stock Price, Volitility & No. of Days.

Question: What is theta of an option and its significance?

Answer: The theta of an option is an extremely significant theoretical number for an option trader. Like the other Greek terms you can calculate theta using option calculator.

Theta tells you how much value the option would lose after one day, with all the other parameters remaining the same.

Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. This means that if the price of Infosys and the other parameters like volatility remain the same and one day passes, the value of this option would reduce by Rs4.5.

Theta is always negative for the buyer of an option, as the value of the option goes down each day if his view is not realised. Conversely theta is always positive for the seller of an option, as the value of the position of the seller increases as the value of the option goes down with time.

Consider options as depreciating assets because of time decay and appreciating due to favourable price movements. If the rate of appreciation is more than that of depreciation hold the option, else sell it off. Further, time decay of option premium is very steep near expiry of the option. The following graph would make it clearer.

Question: What is vega of an option and its significance?

Answer: Vega is also a theoretical number that can be calculated using an option calculator for a given set of values of underlying price, time to expiry, strike price, volatility and interest rate etc. Vega indicates how much the option premium would change for a unit change in annual volatility of the underlying.

Suppose the vega of an option is 0.6 and its premium is Rs15 when volatility of the underlying is 35%. As the volatility increases to 36%, the premium of the option would change upward to Rs15.6.

Vega is positive for a long position (long call and long put) and negative for a short position (short call and short put).

Simply put, for the buyer it is advantageous if the volatility increases after he has bought the option. On the other hand, for the seller any increase in volatility is dangerous as the probability of his option getting in the money increases with any rise in volatility.

Sometimes you might have observed that though seven to ten days have passed after you bought an option, the underlying price is almost in the same range while the premium of the option has increased. This clearly indicates that volatility of the underlying might have increased.

Question: What is gamma of an option and its significance?

Answer: Gamma is a sophisticated concept. You need patience to understand it as it is important too. Like delta, the gamma of an option is a theoretical number. Feeding the price of underlying, risk-free interest rate, strike price, time to maturity and volatility, you can compute value of gamma using the option calculator. The gamma of an option tells you how much the delta of an option would increase or decrease for a unit change in the price of the underlying.

For example, assume the gamma of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying, the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option at changed underlying price is 0.54; so the rate of change in the premium has increased.

If I were to explain in very simple terms: if delta is velocity, then gamma is acceleration. Delta tells you how much the premium would change; gamma changes delta and tells you how much the next premium change would be for a unit price change in the price of the underlying.

Gamma is positive for long positions (long call and long put) and negative for short positions (short call and short put). Gamma does not matter much for options with long maturity. However for options with short maturity, gamma is high and the value of the options changes very fast with swings in the underlying prices.

Excellent Trading School - 27 - Frequently Asked Questions about Options Contracts - Part 3

Question: When is an option called in-the-money option?

Answer: Those options, which have certain intrinsic value, are called in the money, by virtue of the fact that they are holding some money right now.

For example, when SBI is quoting at Rs200, an SBI call option with Rs190 strike price is in the money because you have the right to buy at a price lower than the market price of the underlying. All those call options, which have their strike price lower than the spot price of the underlying are in the money.

Similarly when SBI is quoting at Rs200, an SBI put option with Rs210 strike price is in the money because you have the right to sell at a price higher than the spot price of the underlying. All those put options, which have their strike price higher than the spot price of the underlying are in the money.

Question: When is an option called out of the money?

Answer: Those options whose intrinsic value is zero are called out of the money, by virtue of the fact that they are not holding any money right now. For example, when SBI is quoting at Rs200, an SBI call option with Rs220 strike price is out of the money because you have the right to buy at higher price than the spot price of the underlying. All those call options which have their strike price higher than the spot price of the underlying are out of the money.

Similarly when SBI is quoting at Rs200, an SBI put option with Rs180 strike price is out of the money because you have the right to sell at a price lower than the spot price of the underlying. All those put options, which have their strike price lower than the spot price of the underlying are out of the money.

Question: When is an option called near or at the money?

Answer: Those options, which have their strike price closest to the spot price of the underlying are called near-the-money options because these options are due to get in or out of the money. The options whose strike price is the same as the spot price of the underlying are called at-the-money options.

Question: Are options permanently at, in or out of the money?

Answer: No. Options are not permanently in, at or out of the money. It is the movement of the spot price that makes the options in, at or out of the money. The same option which is in the money can become out of the money when the price moves adversely.

Question: How does settlement of the option take place on exercise/expiry?

Answer: Presently stock options are settled in cash. This means that when the buyer of the option exercises an option, he receives the difference between the spot price and the strike price in cash. The seller of the option pays this difference.

 It is expected that stock options would be settled by delivery of the underlying stock. This means that on exercise of a call option, a long position of the underlying stock effectively at the strike price would be transferred in the cash segment in the account of the buyer of the call option who has the right to buy. An opposite short position at effectively the strike price would be transferred in the cash segment in the account of the seller of the call option who has obligation to sell.

Similarly on exercise of a put option, a short position in the underlying stock effectively at the strike price would be transferred in the cash segment in the account of the buyer of the put option who has the right to sell. An opposite long position at effectively the strike price would be transferred in the cash segment in the account of the seller of the put option who has the obligation to buy.

Question: How is the seller chosen against whom the obligation is assigned?

Answer: When a buyer exercises his option, the exchange randomly selects a seller at client level and assigns the obligation against him. This process is called assignment. The seller of an option should be alert all the time as it is possible that an option could be assigned against him. Your broker would inform you about such an assignment.

Question: What can I do with the position so transferred in my account in the cash segment?

Answer: It totally depends upon you. You can square up your position or let it go for the settlement on T+2 days. You receive the shares on payment of money if you have long position. You receive money against delivery of shares if you have short position.

Question: What happens in case the buyer of an option forgets to exercise his option till expiry?

Answer: On the day of expiry if the option is in the money, the exchange automatically exercises it and pays the difference between the settlement/closing price and the strike price to the buyer. The seller of the option pays this difference.

Question: How does the time value vary for at-, in- and out-of-the-money

options?

Answer: The following graph shows how the premium of 30-day maturity, Rs260 strike price call option on Reliance varies with the movement of the spot price of Reliance. Study the price movement of the option carefully. You would find that the time value is the highest when the spot price is equal to the strike price, the option is at the money. As the spot price rises above the strike price, the option becomes in the money and its intrinsic value increases but its time value decreases. In the same way as the spot price falls below the strike price, the option becomes out of the money and its intrinsic value becomes zero while its time value decreases.

Question: How does option premium vary with maturity of the option?

Answer: The buyers of longer maturity options enjoy the right to longer duration and the sellers are subject to risk of price movement of the underlying during a longer term, since the price of both call and put options increases as the time to expiry increases.

Question: How does option premium vary with risk-free interest rate?

Answer: As the risk-free rate of interest increases, the price of call options increases and that of put options decreases and vice-versa.

Question: How does the price of an option vary with the movement of the spot price of the underlying?

Answer: As the spot price of the underlying rises, the value of the call option increases and that of put options decreases. As the spot price of the underlying falls, the price of the call option decreases and that of the put option increases.

Question: What happens to my position in the options contract when corporate announcements like dividend, bonus, stock split, rights etc are made?

Answer: Good question. In the event of such corporate announcements, the exchanges adjust the option positions such that the economical value of your position on the cum-benefit day and the ex-benefit day is the same.

Question: Please explain these adjustments with the help of some examples. What is the effect of dividend on options?

Answer: According to Sebi regulations, if the value of the declared dividend is more than 10% of the spot price of the underlying on the day of dividend announcement, on ex-dividend date the strike price of the options on a stock are reduced by the dividend amount. In case the declared dividend is lower than 10% of the spot price, then there is no adjustment for the dividend by the exchange and the market adjusts the price of options taking the dividend into consideration.

Suppose Reliance is trading at Rs260 and it announces a dividend of Rs30 per share. Since it is more than 10% of the prevailing market price, all the available strike price of Reliance options get reduced by Rs30 on ex-dividend date. The option with strike price of Rs260 stands at Rs230 and so on. If you are long on Reliance call 260. Your position on ex-dividend date would become long on Reliance call 230.

At the same time ACC is trading at Rs160 and it announces a dividend of Rs2 per share. Since it is lower than 10% of the underlying price, no change is made in the option contracts of ACC. The ACC option with a strike price of Rs160 on last cum-dividend date will remain as Rs160 strike price on ex-dividend date. The stock price reduces by the dividend amount on the ex-dividend date. This means the call option price decreases and the put option price increases on exdividend date. In reality the market adjusts the option price as soon as the dividend is announced.

Question: How does bonus affect my position in stock options?

Answer: The lot size and strike price of the stock option contract gets adjusted according to the bonus ratio. For example: if Infosys announces a bonus of 1:1, then the market lot of Infosys changes from 100 shares to 200 shares on ex- bonus day and the strike price of all the options on Infosys are reduced to half. Suppose you are short 100 Infosys put 4300, on ex-bonus day your position would become short 200 Infosys put 2150.

Excellent Trading School - 26 - Frequently Asked Questions about Options Contracts - Part 2

Question: What are the factors that affect the price of an option?

Answer: There are five fundamental factors that affect the price of an option.These are:

1. Price of the underlying stock or index

2. Strike price/exercise price of the option

3. Time to expiration of the option

4. Risk-free rate of interest

5. Volatility of the price of underlying stock or index

Adjust the price for dividend expected during the term of the option to arrive at prices.

Question: What is volatility?

Answer: Volatility is the measure of speed of the movement of underlying prices.In other words it is the probability of the movement of underlying prices. For example, when it is said that daily volatility of the closing price of a stock is 2%, it means that there is 50% probability that the stock price can go up or down 2% from its previous close.

Question: Can you explain how the probability of price movement of the underlying helps to find the price of an option?

Answer: Consider this: suppose a stock is trading at Rs70. There is 40% probability that the stock price would move to Rs80. Similarly the probabilities of the price being Rs90, Rs100, Rs110 and Rs120 are 25%, 15%, 10% and 5% respectively. What would be your expected return if you were the buyer of a call option with a strike price of Rs100? If the stock price were to finish at Rs80, Rs90 and Rs100, the call option would expire worthless. If the stock price were to finish at Rs110 or Rs120, you would gain Rs10 and Rs20 respectively. Your expected return from the call would be: (40%*0)+(25%*0)+(15%*0)+(10%*10)+(5%*20) = 11.

This means that you would like to pay anything less than Rs11 for this option to make a profit and the seller would always like to get anything more than Rs11 for giving you this option.

Question: What happens in the real world?

Answer: It is possible to take “n” number of prices and assign different probability

numbers to each of the price to compute the expected return and the value of an

option. But in real world there are infinite number of possibilities and this approach

of computing price is not feasible. Alternatively, the volatility figure, which is nothing

but indicated probability, is taken to find the price of an option.

Question: Is there an easier way to find the theoretical price of an option?

Answer: Yes, there are scientific formulae available to compute the theoretical value of an option. The most popular mathematical model for computing the price of European style options is known as Black & Scholes model. Binomial model is used to find the fair value of premium of American style options. These formulae are complex mathematical functions and need fair amount of understanding of differential calculus, a branch of mathematics. Instead of spending too much effort in understanding the formulae, it is prudent to use ready-made tools for computing option prices. There are Excel sheets and software available for computing option prices which apply these algorithms. Put in the value of the five factors of an option into the software to find the theoretical price of the option.

Question: Can you explain option pricing with an example?

Answer: What would be the value of a June 27, 2012 Reliance Industries call option with Rs.300 strike price when Reliance Industries is trading at Rs.320, there are 30 days remaining in expiry, the risk-free interest rate is 8% and annual volatility of Reliance Industries’ price is 48%. Put in the value of the five factors in the option calculator, Suppose this price is Rs.35...

Question: I understand the price can be Rs.20 as I am getting the right to buy Reliance Industries shares at Rs.300 when Reliance Industries is quoting at Rs.320. Can you explain why I should pay Rs.35 for this option?

Answer: The difference of Rs.20 between the strike price and the spot price is the value this option is holding right now. If you pay Rs.20 and immediately exercise the option, you would neither gain nor lose. But this option is giving you the right to buy Reliance Industries shares at Rs.300 till June 27, 2012, which is 30 days away. The seller would like to get something for the risk of price rise during this period. Hence Rs15 (premium minus intrinsic value) is the time value of the option.

Question: Can you explain the pricing of a put option with an example?

Answer: What would be the value of an August 29, 2012 RIL  put option with Rs800 strike price when RIL is trading at Rs750, there are 30 days remaining in expiry, the risk-free interest rate is 8% and the annual volatility of RIL price is  40% Put in the value of the five factors in the option calculator, you find the price is Rs75...

Question: I can understand the price can be Rs.50 as I am getting the right to sell RIL shares at Rs.800 when RIL is quoting at Rs750. Can you explain why I should pay Rs75 for this option?

Answer: The difference of Rs50 between the spot and the strike price is the value this option is holding right now. If you pay Rs50 and exercise the option immediately, you would neither gain nor lose. But this option is giving you the right to sell ITC shares at Rs800 till August 29, 2002, which is 30 days away. The seller would like to get some money for the risk of price falling during this period. The time value of the option is Rs25 (premium minus intrinsic value).

Question: Can I say that premium is the sum of intrinsic and time value of option?

Answer: Yes. You can divide the premium of an option into two components:

intrinsic value and time value.

Question: Would the intrinsic value of a Reliance Industries call option with Rs.340 strike price be negative when Reliance Industries is quoting at  Rs320?

Answer: No. The intrinsic value of an option is never negative, though it can be zero. The entire premium of such options consists of time value only.

Question: Can time value be negative?

Answer: No. Like intrinsic value, time value too is never negative, though it can be zero.

Question: What is extrinsic value?

Answer: Extrinsic value is nothing but another term used to describe time value.

Excellent Trading School - 25 - Frequently Asked Questions about Options Contracts - Part 1

Question: What is a strike price or exercise price in a option ?

Answer: The price at which you have the right to buy or sell is called the strike price. In the examples given above, the price of Rs250 per share in case of Hindustan Lever is  called strike price or exercise price.

Question: Who decides the strike price?

Answer: The exchanges decide the strike price at which call and put options are traded. Generally to simplify matters, the exchanges specify the strike price interval for different levels of underling prices, meaning the difference between one strike price and the next strike price over and below it.

For example, the strike price interval for Nifty is 100. This means that there would be strike prices available with an interval of Rs10. Typically you can see options on Nifty  with strike prices of 4700, 4800, 4900, 5000, 5100, 5200, 5300, 5400 etc.

Question: What happens when the underlying price moves up or down and I want to buy an option with a strike price that is not available on screen?

Answer: As the price of underlying moves up or down, the exchanges introduce more strike prices in keeping with the strike price interval rules. At any point in time, there are at least five strike prices (one near the stock price, two above the stock price and two below the stock price) available for trading in one-, two- and three-month contracts. Only incase of a very big move strike prices may not be available on an intra-day basis, as they are introduced at the end of the day for next day trading.

Question: How can I buy call and put options?

Answer: Call and put options are traded on-line on the trading screens of the National Stock Exchange and Bombay Stock Exchange like any other securities.

Question: Who fixes the price of call and put options?

Answer: The price of options is decided between the buyers and sellers on the trading screens of the exchanges in a transparent manner. You can see the best five orders by price and quantity. You can place market, limit and stop loss order etc. You can modify or delete your pending orders. The whole process is similar to that of trading in shares.

Question: Do I have to wait till expiry once I buy or sell an option or can I square up my position?

Answer: You are not compelled to wait till expiry of the option once you have bought or sold an option. Instead you can buy an option and square up the position by selling the identical option (same expiry and same strike) at any time before the contract expires. You can sell an option and square up the position by buying an identical option. You can buy first and sell later or you can initiate your position by selling and then buying—there is no restriction on direction. The difference between the selling and buying prices is your profit/loss. The process is similar to that of trading in shares.

Question: What are American style options? Is it possible for the buyer of such options to exercise his option before expiry?

Answer: Ideally the buyer should find a seller in the market to square up his long position, as he would get a better value for his option. However if a seller is not available, he can exercise his option at the end of the trading session. To exercise an option, call your broker before the exercise timings specified by the exchange. Option contracts which can be exercised on or before the expiry are called American options. All stock option contracts are American style.

Question: What are European style options? Is it possible for the buyer of an index option to exercise his option before expiry?

Answer: The options on Nifty and Sensex are European style options—meaning that buyer of these options can exercise his options only on the expiry day. He cannot exercise them before expiry of the contract as is the case with options on stocks. As such the buyer of index options needs to square up his position to get out of the market.

Excellent Trading School - 24 - Frequently Asked Questions about Futures Contracts - part 3

Question: What are the advantages of index futures?

Answer: After listening to the news and other happenings in the economy, you take a view that the market would go up. You substantiate your view after talking to your near and dear ones. When the market opens, you express your view by buying ABC stock. The whole market goes up as you expected but the price of ABC stock falls due to some bad news related to the company. This means that while your view was correct, its expression was wrong.

Using Nifty/Sensex futures you can express your view on the market as a whole. In this case you take only market risk without exposing yourself to any company specific risk. Though trading on Nifty or Sensex might not give you a very high return as trading in stock can, yet at the same time your risk is also limited as index movements are smooth, less volatile without unwarranted swings.

Question: How can I use volume and open interest figures to predict the market movement?

Answer: The total outstanding position in the market is called open interest. In case volumes are rising and the open interest is also increasing, it suggests that more and more market participants are keeping their positions outstanding. This implies that the market participants are expecting a big move in the price of the underlying. However to find in which direction this move would be, one needs to take help of charts.

In case the volumes are sluggish and the open interest is almost constant, it suggests that a lot of day trading is taking place. This implies sideways price movement in the underlying.

Question: What happens to my position in the futures contract when corporate announcements like dividend, bonus, stock split, rights etc are made?

Answer: In the event of such corporate announcements, the exchanges adjust the position such that value of your position on cum-benefit and on ex-benefit day itself.

Question: Please explain these adjustments with the help of some examples.What is the effect of dividend on futures?

Answer: While calculating the theoretical price of a futures contract, the interest rate should be taken as net of dividend yield. So on announcement of the dividend, the futures price should be discounted by the dividend amount.

However as per the policy of Sebi and stock exchanges, if the dividend is more than 10% of the market price of the stock on the day of dividend announcement, the futures price is adjusted. The exchanges roll over the positions from last-cum dividend day to the ex-dividend day by reducing the settlement price by dividend.

In such a case, the announcement of such does affect the price of futures with exceptional dividends. Suppose Reliance is trading at Rs300 and a two-month Reliance future, which has 45 days to maturity, is trading at Rs304. Reliance declares 50% dividend, ie Rs.5. The dividend amount is less than 10% of the market price of Reliance, so the exchange would not adjust the position. As such the market adjusts this dividend in the market price and the futures price goes down by Rs5 to Rs 299.

Question: How a bonus would affect my position?

Answer: The lot size of the stock that gives bonus gets adjusted according to the ratio of the bonus. The position is transferred from cum-bonus to ex-bonus day by adjusting the settlement price to neutralise the effect of bonus.

For example: the current lot size of Cipla is 200. Suppose Cipla announces a bonus of 1:1. You are long on 200 shares of Cipla and the settlement price of Cipla on cum-bonus day is Rs1,000. On ex-bonus day your position becomes long on 400 shares at Rs500. Thereafter the lot size of Cipla would be 400.

Question: How can I hedge my stock position using futures?

Answer: Suppose you are holding a stock that has futures on it and for two to three weeks the stock does not look good to you. You do not want to lose the stock but at the same time you want to hedge against the expected adverse price movement of the stock for two to three weeks.

One option is to sell the stock and buy it back after two to three weeks. This involves a heavy transaction cost and issue of capital gain taxes. Alternatively you can sell futures on the stock to hedge your position in the stock. In case the stock price falls, you make profit out of your short position in the futures. Using stock futures you would virtually sell your stock and buy it back without losing it. This transaction is much profitable, as it does not involve cost of transferring the stock to and from depository account.

You might say that if the stock had moved up, you would have made profit without hedging. However it is also true that in case of a fall, you might have lost the value too without hedging. Please remember that a hedge is not a device to maximize profits. It is a device to minimize losses.

Question: I am holding a stock that does not have futures on it; can I still hedge my position using futures?

Answer: You can hedge your cash market position in stocks that do not have stock futures by using index futures. Before we go any further, we need to understand the term called beta. Beta of a stock is nothing but the movement of the stock relative to the index. So suppose a stock X moves up by 2% when the Nifty moves up by 1% and it goes down by 2% when the Nifty falls by 1%, the beta of this stock is 2. Beta is crucial in deciding how much position should be taken in index futures to hedge the cash market position.

Suppose you have a long position in ABB worth Rs2 lakh. The beta of ABB is 1.1. To hedge this position in the cash market you need to take an opposite position in Nifty futures worth 1.1 x 2, ie worth Rs2.2 lakh. Suppose Nifty futures are trading at 1100 and the market lot for Nifty futures is 200. Then each market lot of Nifty is worth Rs2.2 lakh. Therefore to hedge your position in ABB you need to sell one contract of Nifty futures.

Question: Is this hedging with index futures perfect?

Answer: Hedging is like marriage and one should not expect it to be perfect (so always have Plan B ready when trading futures and get ready divorce papers with you in case). The beta taken in the calculation of the position of Nifty futures is historical and there is no guarantee that it will be the same in future. So any deviation of beta makes the hedge imperfect.

Suppose you want to hedge your position in ABB for 15 days and during those 15 days ABB becomes very volatile and the beta goes up as high as 1.5. In this case your hedging position of one contract is not sufficient and you will be under hedged. It is very difficult (in fact impossible) to get perfect hedge but one can improve the perfection by adjusting the position in Nifty futures from time to time.

Question: Can stock futures help me earn risk free interest money?

Answer: Yes, they can. Using stock futures you can deploy this money to earn risk-free interest. Suppose HUL is quoting at Rs300 in the cash segment and one-month future is quoting at 305, you can earn risk-free interest by following the steps mentioned below:

-Buy HUL in cash market at Rs300 and simultaneously sell HUL future at 305.

-Pay Rs300 to take delivery of HUL stock in cash market.

-On expiry of HUL future contract, the short position would be transferred to your account in the cash segment and a delivery order would be issued against you.

-Deliver the HUL stock.

-Whatever happens to the price of HUL, you earn Rs305-300=5 on Rs300 for one month.

-Need to have mark-to-mark margins in your account, incase HUL moves up. If required the future position can be rolled over to the next month position with a difference of Rs4-5. This roll-over process can continue till you want to get your money back.

Question: If futures are quoting below the cash market price, can I gain using futures?

Answer: Yes, of course. But you need to have that stock. Suppose one-month SBI future is quoting at 200 while SBI is quoting at Rs205 in the cash segment. Follow the steps mentioned below to make risk-free money.

-Sell SBI in the cash market at Rs205 and simultaneously buy SBI future at 200.

-Receive Rs205 and make delivery of SBI stock in the cash market.

-On expiry of the SBI future contract, the long position would be transferred to your account in the cash segment and a receive order would be issued to you.

-Get your SBI stock back.

-Whatever happens to the price of SBI, you earn Rs205–200=5 on your stock.

Question: Can I borrow against my shares using stock futures?

Answer: Yes, you can and that is the advantage of futures. Instead of going to the banker and complying with a whole lot of formalities, you can in fact just call me to help you raise money against your shares using futures.

Suppose ACC is quoting at Rs150 in the cash segment and one-month ACC futures are quoting at 152. Follow the steps mentioned below to raise money against your ACC shares.

-Sell ACC in the cash market at Rs150 and simultaneously buy ACC futures at 152.

-Receive Rs150 and make delivery of ACC stock in the cash market.

-On expiry of the ACC futures contract, the long position would be transferred to your account in the cash segment and a receive order would be issued to you.

-Get your ACC stock back.

-Whatever happens to the price of ACC, you lose Rs152-150=2 to raise money against your shares as cost.

Question: I have seen that the difference between the spot and futures prices varies intra-day, can you explain how to do arbitrage to make money in such situations?

Answer: When the futures are quoting at a premium to their theoretical price, one can buy cash and short futures. When the prices come in line, that is when the difference between the futures and cash prices comes down, reverse the positions. Conversely when the futures are quoting at a discount to the theoretical price, one can sell cash and buy futures. When the prices come in line, that is the difference between the futures and cash prices goes up, reverse the positions. Please note that there is the risk of execution of order, you need to decide the arbitration band depending on the transaction cost you bear.

Excellent Trading School - 23 - Frequently Asked Questions about Futures Contracts - part 2

Question: How can I use futures contracts?

Answer: You can do directional trading using futures. In case you are bullish on the underlying stock or index, you can simply buy futures on stock/index. Similarly if you are bearish on the underlying, you can sell futures on stock/index.

Question: Can I square up my position at any time before expiry?

Answer: Yes. It is not necessary to wait for the expiry day once you have entered into the position. You can square up your position at any time during the trading session, booking profit or cutting losses.

Question: What are the advantages and risks of trading in futures over cash?

Answer: The biggest advantage of futures is that you can short sell without having stock and you can carry your position for a long time, which is not possible in the cash segment because of rolling settlement.

Conversely you can buy futures and carry the position for a long time without taking delivery, unlike in the cash segment where you have to take delivery because of rolling settlement.

Further futures positions are leveraged positions, meaning you can take a Rs100 position by paying Rs25 margin and daily mark-to-market loss, if any. This can enhance the return on capital deployed.

For example, you expect a Rs100 stock to go up by Rs10. One way is to buy the stock in the cash segment by paying Rs100.  You make Rs10 on investment of Rs100, giving about 10% returns.

Alternatively you take futures position in the stock by paying about Rs30 toward initial and mark-to-market margin. You make Rs10 on investment of Rs30, ie about 33% returns. Please note that taking leveraged position is very risky, you can even lose your full capital in case the price moves against your position.

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.