These are great investment tools requiring thorough understanding, meant for those who are looking forward to multiply their investments in a short period of time by applying different strategies well suited to the market scenario.
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. The underlying asset may be equity, forex, commodities or any other asset.
In India, we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month.
HEDGING : Futures as risk management tools
Through the use of futures contracts, it is possible to partially or fully transfer the price risks. Also, the index futures can be used for hedging portfolios as they act as a barometer of market performance.
SPECULATION : Futures an attractive option for anticipators
Bullish security-buy futures : If your of the view that a particular security/ index is undervalued and expect the price to go up then, buy futures. Using LEVERAGE, a high exposure can be enjoyed with a low margin.
Bearish Security-Sell futures : In a similar way as above, if a speculator is of the view that a security/ market is overvalued and is likely to go down in the next few months, he can combine his view with the advantage of leverage and make profits despite the downward trend in the market.
ARBITRAGE : Opportunity to make risk free profit
Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise.
Overpriced Futures-Buy spot, sell futures : If the futures price is far greater than the spot price, then buy in the spot market and sell in the futures market.
Illustration : Suppose ABC Ltd trades at Rs.1000. One-month futures trade at Rs.1025 and seem overpriced. You can make risk free profits by taking the following positions :
- Buy security on the cash/spot market at Rs.1000.
- Simultaneously, sell the futures on the security at Rs.1025.
- Take delivery of the security and hold the security for a month.
- On the futures expiration date, the spot & the futures price converge. Now unwind the positions.
- Say the security closes at Rs.1015. Sell the security.
- Futures position expires with a profit of Rs.10.
- The result is a risk-less profit of Rs.15 on the spot position and Rs.10 on the futures position.
Under priced Futures-Buy futures, Sell spot : If the futures price is far smaller than the spot price, then sell in the spot market and buy in the futures market.
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.
The buyer of an option has a potentially unlimited upside and a limited downside(equal to the option premium if the option is not exercised)
Types of Options
CALL Option : is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.Call options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
PUT Option : are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies. With a Put Option, you can “insure” a stock by fixing a selling price, which is the pre-specified strike price.
HEDGING : Options as risk management tools
Have underlying-buy puts : To protect the value of your portfolio/security from falling below a particular level,buy the right number of put options with the right strike price. When the value of the portfolio/ stock falls, you lose money and the put options bought by you will gain in value.
SPECULATION : Options an effective tool for anticipators
Bullish security, buy calls and sell puts : There are times when investors believe that security prices are going to rise then they can benefit from their viewpoint by either buying call options or selling put options.
Bearish Security, buy puts and sell calls : One can implement a trading strategy to benefit from the falling market as well. In case of fall expected, buy put and sell calls.