Share Market

Futures and options are two of the common form of Derivatives – a financial instrument whose value depends on underlying variables. The underlying can be a stock issued by a company, a currency, gold or others accordingly. This article tries to explain futures and options with the help of a simple example:

Understanding Futures….

Let`s say X decides to buy 1,000 shares of co ABC at the rate of Rs 200 for each share. He finds Y who is interested in selling 1,000 shares, not now but at the end of this month, suppose last Thursday, the expiry date of the contract.

Considering Y has to undergo the trouble of maintaining the shares with him till the end of the month he places the cost of the shares as Rs 202, the strike price for the futures contract. Meanwhile, Rs 2 will be the cost of carry for these shares. The total size of the contract now equals Rs 101,000.

Now suppose, the price of the share falls to Rs 190, it will be much profitable for X to buy the share from the market. If instead, the price of the share rises to Rs 230, Y will honour X the difference (in case of cash settlement):

230 – 202 = Rs 28

If X decides not to honour the contract the agreement, it will be a loss for Y, similarly if X decides not to honour the agreement if the price rises; it will be a risk for X.

Buying Call Option

Options are a form of derivative instruments which provide the holder of the instrument the right to buy or sell the underlying asset at a predetermined price.

The buyer of the call option gets right to buy the asset at a given price, which is called the strike price of the underlying. The seller of the call option only has the option to sell the asset. The premium of the call option, which is paid while buying the call shows up as the debit in the trading account. One ends up in profit in a long call, when the price of the asset rises above the strike price of the asset. (profit = current price – strike price of the asset)

One can either exercise the call option or offset the option (profit is unlimited) by selling it at the same strike price and expiration date. If one chooses to offset the call option, the profit is unlimited. By exercising a long call, one ends up with denoted no of shares per option of the underlying stock. As the price of the underlying asset increases, the value of the long call increases as it gives the owner of the call option, the right to buy the underlying stock at the lower price of the call. This is no doubt the reason why one always wants to go long on a call option in a rising bull market.

Another point to note is that the buyer of the long call will exercise his option only if the spot price of the asset is higher than the strike price of the call. If otherwise, the spot price of the asset is below the strike price of the call, the option owner will not exercise the option, hence rendering the option as worthless.

If the current market price is greater than the strike price, the call option is in-the-money (ITM). If otherwise, the current market price is less than the strike price, the call option is out-of-the-money (OTM). Meanwhile, if the current market price is equal to or close to the strike price, the call option is at-the-money (ATM).

Let`s understand the concept of long call option with the help of an example:

Say suppose Mary has an understanding with the decent retailer to buy a mobile phone over next two months at a price of Rs 25,000 only. Mary has received an obligation to buy the mobile phone at the decided strike price of Rs 25000, two months from now.

Two months later, the price of the mobile phone has increased to Rs 28,000. If Mary executes this understanding with the retailer, she saves Rs 3,000. Her long call option was in the money.

If two months later, the price of the mobile phone reduces to Rs 23,000; her understanding (long call option) becomes worthless as she can buy the same option at a reduced price of Rs 23,000.