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FUTURE MARKETS,PUT AND OPTION CONTRACTS,DERIVATIVE

MARKETS AND MECHANISM


FUTURE MARKETS
What is FuturesContract?
So lets say theres a farmer who cultivates wheat
And a bread manufacturer who needs wheat as an input for making bread
The farmer thinks that the price of wheat which is currently trading at Rs. 100
could fall to Rs. 90 in 3 months
The bread manufacturer on the other hand feels that the price of wheat on the
other hand might become Rs. 120 in 3 months
In such a case both of them get together and sign a contract which says that at the
end of 3 months the farmer would sell wheat to the bread manufacturer at Rs. 110
Thus the farmer is protected against possible fall in prices
And the bread manufacturer is protected against the price of wheat, a key
ingredient in bread manufacturing to go up beyond Rs. 110
Such a contract is called a Futures contract
In a Futures contract both parties are obliged to honor the contract and there is
no escape route for either party
OPTIONS CONTRACT
But what if the contract gives the farmer the option of either
Selling his produce to the bread manufacturer at the pre-agreed price of Rs 110 or
Choosing to exit the contract and selling the produce in the open market or
wherever he deems fit.
Thus, he would not be obliged to honor the contract made with the bread
manufacturer on the date of settlement
Such a contract which gives the farmer the option of either executing the
contract or exiting it is known as an Options contract
But the farmer obviously cannot get this privilege just like that. He obviously has
to pay a premium for exercising this facility
Now, lets say that after 3 months the price of wheat reaches Rs. 120
In this case the farmer quite obviously will want to exit the contract so that he is
free to sell his produce in the open market for Rs. 120. Thus while the farmer gets
away the bread manufacturer is left high and dry and has no other option but to
buy from the open market at Rs 120
But it is not such a bad situation for the bread manufacturer as it appears as he gets
compensated by the farmer for having been a party to the Options contract.
This compensation * in the form of price is called the Option premium that the
farmer has to pay for the Options contract and quite evidently it would be a small
amount.
Lets say in our case the amount is Rs 2.
So the farmer is obliged to pay the bread manufacturer Rs 2 as he has chosen to
opt out of the contract
Thus although the bread manufacturer has no other option left but to go to the
open market and purchase wheat at Rs. 120, he does get the benefit of Rs 2 as
compensation for being a party to the Options contract.
So even if the price is Rs. 120 in the open market, for him the effective price turns
out to be Rs. (120 -2) = Rs 118.
So by simply participating in the contract he too stands to gain something
As far as the farmer is concerned it is a win win scenario for him by
participating in the contract.
Had the prices fallen to Rs 90 as he had anticipated he would have executed the
Options contract. But since prices rose to Rs 120 he chose to exit the contract.
Thus he is blessed with the Option by signing such a contract.
It is important to understand that in an Options contract only one party gets the
privilege to exercise the option while the other party is obliged to honor the option
chosen.
Thus in our case the farmer has the option to either execute or exit the contract
whereas the bread manufacturer is obliged to honor the decision of the farmer.
A contract such as this where only the seller of the commodity gets the option to
either exercise or exit the contract is known as Put option
There is another option which is called a Call option
Even in an Options contract both parties land up achieving their goals and their
interest is protected
The farmer stands to gain the most by getting to exercise a choice that benefits
him the most
The bread manufacturer too benefits by being a party to the contract due to the
compensation he receives from the farmer for not honoring the contract.
The bread manufacturer due to the compensation receives wheat from the open
market at an effective price of Rs 118
And hence is better off than the ordinary or spot buyer who would have to pay Rs
120.
Thus in a sense both parties landed up getting some gains by being parties to the
options contract.
However unlike in a Futures contract, in the Options contract one party gains
more than the other party.
CALL OPTION
In a Futures contract both parties are obliged to honor the contract and there is no
escape route for either party.
But what if the contract gives the bread manufacturer the option of (either)
Buying the wheat from the farmer at the pre-agreed price of Rs 110 (or)
Choosing to exit the contract and buy wheat from the open market at the
prevailing market price?
In other words, the bread manufacturer is given the option of not honoring the
contract made with the farmer on the date of settlement.
Such a contract that gives the bread manufacturer the option of either executing
the contract or exiting it is known as an Options Contract.
But the bread manufacturer cannot get this privilege just like that. He obviously
has to pay a premium for exercising this facility
Now, lets say that after 3 months the price of wheat falls to Rs. 90.
In this case the bread manufacturer quite clearly would want to exit the contract so
that he is free to buy wheat from the open market for Rs. 90.
If so, while the bread manufacturer gets away, the farmer is left high and dry and
has no other option but to sell his produce in the open market at Rs 90.
But it is that bad a situation for the farmer as it appears as he gets compensated by
the bread manufacturer for having been a party to the Options contract.
This compensation * in the form of price is called the Option Premium that the
bread manufacturer has to pay for the Options contract and is usually a small
amount.
Lets assume in our case the amount is Rs 5.
So the bread manufacturer is obliged to pay the farmer Rs 5 as he has chosen to
opt out of the contract.
Thus although the farmer has no other option left but to go to the open market and
sell wheat at Rs. 90, he does get the benefit of Rs 5 as compensation for being a
party to the Options contract.
So even if the price is Rs. 90 in the open market, for him the effective price turns
out to be
Rs. (90+5) = Rs 95
So by simply participating in the contract he too stands to gain something.
For the bread manufacturer, it is a winwin scenario by participating in the
contract.
Had the prices risen to Rs 120 as he had anticipated, he would have executed the
Options contract at Rs 110 and would have got protected.
But since prices fell to Rs 90 he chose to exit the contract. Thus he is blessed with
the Option of either executing or not executing the contract based upon the price
in the open market at the time of contract settlement.
It is important to understand that in an Options contract, only one party gets the
privilege to exercise the option while the other party is obliged to honor the option
if it is chosen.
Thus, in our case, the bread manufacturer has the option to either execute or exit
the contract whereas the farmer is obliged to honour the decision of the bread
manufacturer.
A contract such as this where only the purchaser of the commodity gets the option
to either exercise or exit the contract is known as Call option.
Basically in the Put option the choice of honoring the contract was with the
farmer or seller while in the Call option this option was with the bread
manufacturer or purchaser.
Even in an Options contract both parties land up achieving their goals and their
interests are protected.
The bread manufacturer stands to gain the most by getting to exercise a choice
that benefits him the most.
The farmer on the other hand too benefits by being a party to the contract due to
the compensation he receives from the bread manufacturer for not executing the
contract.
The farmer due to the compensation sells the wheat in the open market at an
effective price of Rs. 95
And hence is better off than the ordinary or spot seller who would have to sell at
Rs 90.
Thus in a sense both parties landed up getting some gains by being parties to the
options contract.
However unlike in a Futures contract, in the Options contract one party gains
more than the other party.

DERIVATIVES MARKETS

However in all our explanations we had a simplistic example of a farmer and a
bread manufacturer which does not represent the manner in which we deal with
derivative products in the stock markets.
Imagine there were several farmers in market. Perhaps a few thousands with a
view that price of the Wheat is going to fall in near future (bearish participants)
And several thousand bread manufacturers with a view that price of the wheat is
going to rise in the near future (bullish participants)
And a market place where there is free flow of information. It provides a platform
to both bullish & bearish participants to execute their trades without even knowing
each other or hunting for the counterparties
So the expected future stock price (price of wheat for the sake of comparison with
our previous examples) is known to every farmer and bread manufacturer.
Any farmer trying to extract a higher price will not be able to do so because for
the bread manufacturer there are several other farmers to buy from and vice versa.
Since the price is universally known and there are several farmers and bread
manufacturers, there is no need to get into individual contracts.
There is no need to know who the options/futures buyer is and who the
options/futures seller is for it does not make any difference for either party
The markets also make it possible for either party to deal with several counter
parties at the same time.
The market thus makes it possible to keep identities of parties to remain
confidential with respect to the respective counter parties.
If one were to replace the farmer and bread manufacturer by normal people who
have opposite views about the future prices of stocks, what we have is a typical
Derivatives Market.
IN REAL STOCK MARKET
Now in the stock market we do not have farmers and bread manufacturers, but
instead have investors who are both buyers and sellers of stocks.
Now lets say there is a stock A listed on the stock exchange and its futures is
quoted at Rs. 120.
Also, lets assume there are participants in the market to buy and sell the
futures to each other based on their contrarian view about the stock.
And lets say the expiry date for settlement of the futures contract is after 5
days.
Now, for the sake of understanding, suppose you were to buy a futures of
stock A for Rs 120. In this context, it is important for you to understand that in
a derivative product what you actually do is take a view on future price
movements and at the end of the settlement period, you reconcile based on
whether your view was right or wrong.
Since at no point in time the investor has to take delivery of the stock, he does
not have to pay the entire price of the stock at the time of the deal. All he has
to pay hence is the margin money which is a fraction of the price, say, 15% of
the price which is Rs 18 in the above example.
Now to understand this better, lets look at how the prices move in these 5
days.
DAY 1
Closing Price on day One 122
Your buying price day One 120
Your profit Rs 2
So at the end of the day your account with your broker would get credited by
Rs 2.
Debit Credit
Day 1 Rs. 2

DAY 2
Closing Price on day two 125
Your profit as compared to the previous day is Rs 3
So at the end of day 2, your account with your broker would get credited by
Rs 3.
CREDIT DEBIT
DAY 1 0 2
DAY 2 0 3
DAY 3
Closing Price on day Three 124
Your loss as compared to the previous day is Rs.1
So at the end of day 3, your account with your broker would get debited by Rs 1.



Debit Credit
Day 1 Rs. 2
Day 2 Rs 3
Day 3 Rs.1


DAY 4
Closing Price on day Four 123
Your loss as compared to the previous day is Rs.1
So at the end of day 4, your account with your broker would get debited by Rs 1
Debit Credit
Day 1 Rs. 2
Day 2 Rs 3
Day 3 Rs.1
Day 4 Rs. 1
DAY 5 SETTLEMENT DATE
Closing Price on day Five 125
Your profit as compared to the previous day is Rs.2
So at the end of day 5, your account with your broker would get credited by Rs 2.
Debit Credit
Day
1
Rs. 2
Day
2
Rs 3
Day
3
Rs.1
Day
4
Rs. 1
Day
5
Rs 2
Thus the effect of the 5 days leading to the settlement would be like this
Debit Credit
Day 1 Rs. 2
Day 2 Rs 3
Day 3 Rs.1
Day 4 Rs. 1
Day 5 Rs 2
Total Rs 2 Rs 7
So in this case the investor gained Rs 5 on settlement date.
However since your investment was only Rs. 18 (15% margin money), you need to
calculate Rs. 5 as a percentage of Rs. 18.
Thus, the returns earned would be equal to 5/18 x 100 = 27% (approx.)

GEORGE SINHA

List of references
http://www.investopedia.com/terms/p/putoption.asp
http://www.theoptionsguide.com/call-option.aspx
moneycontrol
investopedia