Understanding Derivatives: Future and Option Contracts on NSE
What are derivatives?
Derivative, the noun is defined as something which is based on another source.
The term derivative in trading refers to a type of financial contract whose value or price is dependent on an underlying asset, group of assets, or benchmark.
By underlying asset, we mean the financial assets upon which a derivative’s price is based. ETFs, stocks, and bonds are some examples of what the contract can be based upon.
Future & Option contracts
Futures and options are the two most common derivatives in NSE.
What are Future Contracts?
A future contract is a legal agreement to buy or sell a particular commodity, asset, or security at a predetermined price at a specified time in the future.
We call them contracts since it’s an agreement. The time that is agreed upon on when the party will exercise the contract by buying/selling the said asset is what’s called the expiration date.
Let us take an example to be clear on what future contracts are.
Consider a Wheat future contract and also consider yourself as someone running a warehouse that distributes wheat to bakeries.
Wheat is measured in bushel. So say 1Bushel in the market right now is $100 for simplicity. Now you feel like the production of wheat is going to drop, decreasing the supply and since wheat is a staple, there is no way demand for bread is dropping. Thus you expect the future price to increase in the coming quarter. To protect yourself against price instability in future you approach a farmer and say that you wish to buy 5000 Bushels of Wheat in the future at a fixed price, this way you don’t have to worry about a price increase.
The farmer thinks about the proposition and he too feels the price of wheat is going to increase. So he tells you that he is willing if you buy for $105 per Bushel. Since you feel it’s a fair deal you decide to form a contract for $105 per Bushel and 5000 Bushel quantity with an agreement date of 1 quarter. By then the farmer will grow the necessary quantity of wheat.
The quantity 5000 Bushel is what we call a single LOT. Futures contracts are traded in lots. And each lot size varies depending on what the underlying is. In this case 1 Lot = 5000 Bushel.
Why would the farmer agree to this?
Farming has certain risks, which are price instability and demand for the stock he produces for the quarter. So to protect himself he agrees to a deal. Say there is a sudden trend of not having bread anymore. Then since demand has dropped, the price of wheat too will drop. But since you have already sold for a good future price. The farmer stays protected. But let’s say there is a shortage of wheat then future prices may go up to $110/$150 in which case the farmer doesn’t have many benefits but he is happy with this outcome since it reduces his risk.
Of course, the farmer isn’t going to start farming just because a contract was made. To make it binding he takes a good % of the amount he is due. This is what is called a Margin. It is usually a percentage of the entire contract value. A margin is simply to ensure security.
Future Contracts on NSE
On the stock exchange, we can trade futures for stocks and Indexes. In stock futures the underlying is a particular stock like RELIANCE or INFOSYS among many others. And for Index futures, the underlying is the Index like NIFTY50, NIFTY BANK. A future contract exists for commodities and currencies as well. But they are on a different exchange, MCX exchange is for commodities like gold, silver, nickel, copper, and natural gas. The good thing about an exchange is that there is no single buyer or seller. There are multiple participants, each having their own biases about various assets.
When we trade on the exchange most futures contracts are settled in cash. Meaning, if I buy a future contract of NIFTY50 then at expiry it will be settled with a seller. And the price difference will be debited or credited to my account.
Example: A single NIFTY future contract has a lot size of 50. And say the current market price for the contract is 18000. The underlying is usually priced lower than the future contract. But exceptions exist where future prices could be trading lower than the spot. It depends on the people who trading the contracts to decide the price. Since it’s a demand and supply game. So for this example, let’s assume the spot to be at 17950. Now I have a bias that NIFTY will move up within a few days. So I decide to buy a future contract. As expiry nears say the future contract market price changed from 18000 to 18500. Then at expiry it’ll be settled with another seller(it could be the same person who sold me the contract when I made a buy) and I will be credited (18500–18000)*50 = 25,000 into my account. But if the future price is lower say 17900 then (17900–1800)*50 = -10,000 will be deducted from my account.
On NSE all brokers settle the credit and debit at end of the day. Say I am carrying my future contract which I bought at 18000. And at day end the price went to 17900. Then at end of the day, -10,000 would be deducted. This is one of the downsides of holding a future contract.
Unlike the example, we took of a farmer and a baker. On the exchange, we don’t necessarily have to wait till expiry to get out of a contract. We can find another potential buyer who is looking to buy our contract and sell it to them.
Whenever a person sells a contract. It is said that he is opening a contract with another buyer. And this is what is called Open Interest.
The Margin varies for each future contract depending on the volatility of the underlying. But is usually a small percentage of the total value of the contract.
In our NIFTY future example where the lot size is 50. When we buy a contract we are supposed to give (18000*50) but since it’s a future contract only a certain portion of our funds is blocked as Margin which is usually a percentage of the contract and it will be returned to us when we close the contract. Blocking of margin means that we are not allowed to withdraw this amount from our broker.
Why do we use future contracts?
In summary future contracts are used to reduce risk on the underlying. In the case of the farmer, he is trying to reduce his risk w.r.t demand for his product.
Similarly, people who have large investments in stocks, say reliance. They would sell future contracts to hedge against potential downside risk due to recession etc.
Another advantage of a future contract is leverage. Since only a portion of the contract value is required to hold a contract. It is easy for people who trade for a shorter period to make profits from the movements of prices. The percentage returns are relatively large here because of the leverage. This also means that the risk is high as well for a trader.
Summary
In this article, we talked about
- What is a future contract?
- Expiry date
- Lot size
- Open interest
- Margin
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