Meaning
• Spot price: The price at which an asset trades in the spot market.
• Futures price: The price at which the futures contract trades in the futures market.
• Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one month, two-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.
• Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.
• Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.
• Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
• Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
• Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.
• Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to–market.
• Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
Options terminology
• Index options: These options have the index as the underlying. Like index futures contracts, index options contracts are also cash settled.
• Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
• Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
• Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer wishes to exercise his option.
• Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
• Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the strike price or the exercise price.
• American options: : American options are options that can be exercised at any time upto the expiration date.
• European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart.
• In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current value of index stands at a level higher than the strike price (i.e. spot price > strike price). If the value of index is much higher than the strike price, the call is said to be deep ITM. On the other hand, a put option on index is said to be ITM if the value of index is below the strike price.
• At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the value of current index equals the strike price (i.e. spot price = strike price).
• Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately.
• A call option on the index is said to be out-of-the-money when the value of current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. On the other hand, a put option on index is OTM if the value of index is above the strike price.
• Intrinsic value of an option: The option premium can be broken down into two components–intrinsic value and time value. Intrinsic value of an option is the difference between the market value of the underlying security/index in a traded option and the strike price. The intrinsic value of a call is the amount when the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
• Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value. While intrinsic value is easy to calculate, time value is more difficult to calculate. Historically, this made it difficult to value options prior to their expiration. Various option pricing methodologies were proposed, but the problem wasn’t solved until the emergence of Black-Scholes theory in 1973.
Types of Traders
- Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
- The International Monetary Fund defines derivatives as “financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues”.
- the circulation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities.
- SEBI set up a 24-member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework
- submitted its report on March 17, 1998 prescribing necessary pre-conditions
- recommended that derivatives should be declared as ‘securities’
- SEBI also set up a group in June 1998 under the chairmanship of Prof. J. R. Varma, to recommend measures for risk containment in derivatives market
- The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements.
- The SCRA was amended in December 1999 to include derivatives within the ambit of ‘securities’
- Government also rescinded in March 2000, the three-decade old notification, which prohibited forward trading in securities
- Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000.
- SEBI permitted NSE and BSE
- SEBI approved trading in index futures contracts followed by approval for trading in options which commenced in June 2001
- Options on individual securities commenced in July 2001
- Futures contracts on individual stocks were launched in November 2001
- Futures and Options contracts on individual securities are available on more than 200 securities.
- Forwards: A forward contract is a customised contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.
- Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts.
- Options: Options are of two types – calls and puts.
- Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
- Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
- LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These are options having a maturity of upto three years.
- Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
- Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency
- Currency Swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
• Spot price: The price at which an asset trades in the spot market.
• Futures price: The price at which the futures contract trades in the futures market.
• Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one month, two-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.
• Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.
• Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.
• Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
• Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
• Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.
• Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to–market.
• Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
Options terminology
• Index options: These options have the index as the underlying. Like index futures contracts, index options contracts are also cash settled.
• Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
• Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
• Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer wishes to exercise his option.
• Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
• Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the strike price or the exercise price.
• American options: : American options are options that can be exercised at any time upto the expiration date.
• European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart.
• In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current value of index stands at a level higher than the strike price (i.e. spot price > strike price). If the value of index is much higher than the strike price, the call is said to be deep ITM. On the other hand, a put option on index is said to be ITM if the value of index is below the strike price.
• At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the value of current index equals the strike price (i.e. spot price = strike price).
• Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately.
• A call option on the index is said to be out-of-the-money when the value of current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. On the other hand, a put option on index is OTM if the value of index is above the strike price.
• Intrinsic value of an option: The option premium can be broken down into two components–intrinsic value and time value. Intrinsic value of an option is the difference between the market value of the underlying security/index in a traded option and the strike price. The intrinsic value of a call is the amount when the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
• Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value. While intrinsic value is easy to calculate, time value is more difficult to calculate. Historically, this made it difficult to value options prior to their expiration. Various option pricing methodologies were proposed, but the problem wasn’t solved until the emergence of Black-Scholes theory in 1973.
Types of Traders
- Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.
- Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.
- Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
Well it is a fragmented market consisting of multiple economies with independent regulatory and monetary regimes.
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