The Securities and Exchange Board of India (SEBI) has recently taken a decision to expand trading in derivatives to options on stock market indices and on individual stocks. The risk containment and software related issues are being worked out. Index futures have recently made their entry into Indian markets and even though the volumes are still small, these are picking up.
When you buy or sell an index future, you take a view on what the index (say the Sensex) will be at some point in the future. Simply put, derivatives allow investors to trade in instruments derived from the cash market, where typically buyers take delivery on payment of cash. Such instruments – futures and options – allow investors to hedge their risk or even take speculative positions.
How can you hedge using these instruments?
This is how it works: if you feel the market is going to fall and the value of your portfolio is coined to diminish you take a position on the futures market. If it rises, then even though there is a loss on the futures position, the underlying cash portfolio rises, and this help risk minimization.
it is for this reason that indices, which mirror closely a very wide basket of stocks, prove successful in index futures trading.
What is a futures contract?
A futures contract is an agreement between a buyer and a seller for the purchase and sale of a particular asset at a specific future date. The asset in the case of index futures is an index – it could be the S&P CNX Nifty index or the BSE30 Sensex.
With the passage of time, several more indices are going to be allowed to be traded on the futures markets. In a futures contract, the price at which the asset would change hands in the future is agreed upon at the time of entering into the contract. A futures contract involves an obligation on both the parties to fulfill the terms of the contract.
What is the period for which a futures position could be taken?
Currently, both the stock exchanges have come out only with three
contracts: one month, two months and three months contracts each of which expires on the last Frida of the respective month. More flexibilities are expected to be introduced as index futures catch up.
What are the options?
Options are contracts which go a step further than futures contracts in the sense that they provide the buyer of the option the right, without the obligation, to buy or sell a specified asset at an agreed price on or up to a particular date. For acquiring this right, the buyer has to pay a premium to the seller.
The seller, on the other hand, has the obligation to buy or sell that specified asset at that agreed price. This makes options more of an insurance product where the downside risk is covered for the payment of a certain fixed premium. So the loss would be minimized to the extent of the premium paid, like in an insurance product.
An option is a contract, which gives the buyer the right, but not the obligation, to buy or sell a specified quantity of the underlying assets, at a specific price on or before a specified time. The underlying asset may be physical commodities like wheat, cotton, gold oil or financial instruments like equity stocks, stock index, bonds etc.
An investor buys a call option to purchase equity shares of BSES Ltd. at the end of 30 days at a price of Rs. 200 at a premium of Rs. 10. If the market price of the share on the day of expiry is paying Rs. 230, the investor will exercise the option and buy the share at Rs. 200 and earn Rs.20 per share (Rs.230- Rs.200-Rs.10). On the other hand, if the market price falls to say Rs.
170, then the investor will not exercise the option, and the maximum loss to him will be only Rs. 10 being the option premium paid. Thus, the losses are limited while the profits are unlimited. While the American style option can be exercised on or before the expiration date, the European style option can be exercised only on the expiration date.
What is a call or put option?
The right to buy is called a call option while the right to sell is called a put option. The buyer of the call option can call upon the seller of the option and buy from him, the underlying instrument, at any point in time on or before the expiry date by exercising his option at the agreed price. The seller of the option has to fulfill the obligation on the exercise of the option.
The right to sell is called the put option where the buyer of the option can exercise his right to sell the underlying instrument to the seller of the option, at the agreed price. The technical group of SERI has decided that stocks to be eligible for options trading should meet the following criteria key market capitalization during the preceding six months and average free-float market capitalization (non-promoter holding in the stock) should not be less than Rs. 750 crore.
The stock should appear in the list of top two hundred scrips based on the daily average volume during the preceding six months which should not be less than Rs. 5 crore faille underlying cash market.
The stocks should be traded at least ninety percentage of the trading days during the preceding six months. Non-promoter holding in the company should be at least 30%. The ratio of the daily volatility of the stock vis-a-vis daily volatility of index should not be more than 4, at any time during the preceding six months.