Understanding Futures & Options

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The Basics of Futures Options

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Futures options can be a low-risk way to approach the futures markets. Many new traders start by trading futures options instead of straight futures contracts. There is less risk and volatility when buying options compared with futures contracts. Many professional traders only trade options. Before you can trade futures options, it is important to understand the basics.

Futures Options

An option is the right, not the obligation, to buy or sell a futures contract at a designated strike price for a particular time. Buying options allow one to take a long or short position and speculate on if the price of a futures contract will go higher or lower. There are two main types of options: calls and puts.

The purchase of a call option is a long position, a bet that the underlying futures price will move higher. For example, if one expects corn futures to move higher, they might buy a corn call option. The purchase of a put option is a short position, a bet that the underlying futures price will move lower. For example, if one expects soybean futures to move lower, they might buy a soybean put option.

Types of Options

There are three types of options: in-the-money (an option that has intrinsic value), out-of-the-money (an option with no intrinsic value), and at-the-money (an option with no intrinsic value where the price of the underlying asset is exactly equal to the strike price of the option).

Key Terms

Premium: The price the buyer pays and seller receives for an option is the premium. Options are price insurance. The lower the odds of an option moving to the strike price, the less expensive on an absolute basis and the higher the odds of an option moving to the strike price, the more expensive these derivative instruments become.

Contract Months (Time): All options have an expiration date; they only are valid for a particular time. Options are wasting assets; they do not last forever. For example, a December corn call expires in late November. As assets with a limited time horizon, attention must be accorded to option positions. The longer the duration of an option, the more expensive it will be. The term portion of an option’s premium is its time value.

Strike Price: This is the price at which you could buy or sell the underlying futures contract. The strike price is the insurance price. Think of it this way: The difference between a current market price and the strike price is similar to the deductible in other forms of insurance. As an example, a December $3.50 corn call allows you to buy a December futures contract at $3.50 anytime before the option expires. Most traders do not convert options to futures positions; they close the option position before expiration.

Buying an Option

If one expects the price of gold futures to move higher over the next 3 to 6 months, they would likely purchase a call option.

Purchase, 1 December $1,400 gold call at $15:

  • 1: number of option contracts bought (represents 1 gold futures contract of 100 ounces)
  • December: Month of option contract
  • $1,400:strike price
  • Gold: underlying futures contract
  • Call: type of option
  • $15: premium ($1,500 is the price to buy this option or, 100 ounces of gold x $15 = $1,500)

Buying an option is the equivalent of buying insurance that the price of an asset will appreciate. Buying a put option is the equivalent of buying insurance that the price of an asset will depreciate. Buyers of options are purchasers of insurance.

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When you buy an option, the risk is limited to the premium that you pay. Selling an option is the equivalent of acting as the insurance company. When you sell an option, all you can earn is the premium that you initially receive. The potential for losses is unlimited. The best hedge for an option is another option on the same asset as options act similarly over time.

The Importance of Volatility

The chief determinate of option premiums is “implied volatility,” or the market’s perception of the future variance of the underlying asset. Historical volatility, on the other hand, is the actual historical variance of the underlying asset in the past.

Understanding futures and options

Derivatives are products that are linked to the value of an underlying share or index.

Today, some 30 lakh contracts worth almost Rs 50,000 crore are traded on the NSE in a day. The derivatives of 267 shares and six indices are traded on the NSE. The BSE has 126 scrips and seven indices.

FUTURES

• A futures contract gives you the right to buy or sell shares at a specific price in the future. The future price is usually higher than the prevailing market price of the security.

• Futures and options are sold in lots. Highpriced shares are offered in small lots of 50-60, while low-priced shares are available in big lots of 7,000-8,000.

• Futures and options expire on the last Thursday of a month. It’s possible to roll over a future by buying the next month’s contract, but it is not possible to roll over an option.

• Stock derivatives are available for up to three months in the future. So, in November, you can buy stock futures and options for November, December and January. But index derivatives can be bought up to three years in advance. Right now, Nifty options of 2020 can be bought.

• Futures contracts are leveraged instruments. The investor pays just 20-25% of the value of the transaction as margin money. A 1% change in the share’s value means a 4-5% change in the value of the contract. The loss incurred is deducted from the margin and the investor is asked to pay the additional margin. If he can’t pay, the shares are sold.

Unlimited profit, limited risk
If you are bullish >> Buy Calls >> The profit can be unlimited, but the loss is limited to the premium.
If you are bearish >> Buy Puts >>

OPTIONS

Like futures contracts, options also give you the right to buy (through a Call option) or sell (through a Put option) a share at a future date. But you are not under any obligation to do so.

Calls: When you buy a Call, you are buying shares of the underlying scrip at a specified price. If the share price goes up, the value of the Call also rises.
Puts: Buying a Put option means you are selling the shares at a specified price. If the price of the underlying security falls, the value of the Put rises.

Index options: If it is an index option, the option can only be exercised on the expiry date. These are European types of options and are denoted as CE (Calls) and PE (Puts).
Stock options: If it is a stock option, it can be exercised at the end of any trading day. These are American types of options and are denoted as CA (Calls) and PA (Puts).

Options are available for stocks and indices at price intervals called the strike price. For instance, if the price of the underlying share is Rs 100, options will be available in intervals of Rs 5. For an index, the strike price may be in intervals of Rs 50. The price paid for an option is called the premium. At the beginning of the contract month, the probability of a share moving in either direction is higher, so the premium is usually high. As the expiry date nears, the premium goes down progressively.

EXERCISING THE OPTION

A buyer can sell the option for a profit (or loss) on any trading day based on his reading of the market. He can also exercise a stock option if the transaction is profitable.

On the exercise and the expiry dates, the value of a Call option is calculated as follows:
Value of Call = Market price of share — Strike price

For a Put option, the calculation is the reverse:
Value of Put = Strike price — Market price of share

Understanding a Futures Contract

Futures do not trade in shares as stocks do, rather they trade in standardized contracts. Each futures contract has a standard size that has been set by the futures exchange on which it trades. As an example, the contract size for gold futures is 100 troy ounces. That means when you buy one contract of gold futures, you have control of 100 troy ounces of gold. If the price of gold were to move $1 higher, it would result in a profit of $100 ($1 x 100 ounces). A new trader needs to become familiar with each commodity and futures contract since the quantity of different futures varies.

Delivery Months

Futures exchanges often call delivery months, contract months. If you are familiar with stock options, you already are aware that option contracts expire months designated by the exchange. The same system exists for options on futures. Options on futures must relate to a futures contract because of the delivery mechanism that is designated by the exchange.

As an example, in a November soybean futures contract, a seller has the right to deliver 5,000 bushels of soybeans in November and a buyer has the right to stand for delivery of the soybeans. Some futures only have a few delivery months and others have a delivery mechanism in all 12 months. ​A futures contract expires after the designated date in the delivery month.

Ticker Symbols

Futures tickers differ slightly from stocks. Each futures market has a specific ticker symbol that is followed by symbols for the contract month and the year. For example, crude oil futures has a ticker symbol – CL. The complete ticker symbol for December 2020 Crude Oil Futures would be – CLZ7. Gold has a ticker symbol -GC and the complete ticker symbol for June 2020 Gold would be GCM7.

In the case of oil the “CL” stands for the underlying futures contract.
The “Z” stands for a December delivery month. (F=Jan, G=Feb, H=Mar, J=Apr, K=May, M=June, N=July, Q=Aug, U=Sep, V=Oct, X=Nov, Z=Dec) The “7” stands for the year – 2020.

This is the standard formula for futures ticker symbols. Some quote services may differ slightly so always make sure to check with your provider you will provide you with a list of ticker symbols for all futures markets

Minimum Fluctuation or Tick Size

The minimum fluctuation or tick size describes the smallest increment a given futures market can move – also called a tick. For example, a tick in crude oil would be .01 or 1 cent. The contract size of Crude Oil is 1,000 barrels.

To calculate the value of a tick, you would multiply 1,000 x .01 = $10. So, every time you see the price of Crude Oil move up or down .01, you know that means it’s a $10 move. A 5-cent move in the price of Crude Oil would mean it is worth $50 if you are trading one contract.

In gold, the minimum tick size is 10 cents, since the total contract value is 100 troy ounces, one tick also equals $10 per contract. While gold and oil have the same per tick value, other futures contracts vary so make sure you familiarize yourself with the minimum tick values for each of the contracts you intend to trade.

Contract Specifications are something you need to memorize before you begin trading commodities and futures. Costly errors can occur by not understanding these numbers.

It is not uncommon for a novice trader to make a costly mistake by buying or selling contracts that are far too large and volatile for their accounts. It is always better to be prepared with knowledge before you start trading, learning the hard way can be very expensive.

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