Futures & Options -Basics

Futures Contracts- What is a futures contract?·Agreement between buyer and seller. Buyer has an obligation to buy and seller has obligation to sell by a specified date at specific price.

• Futures are standardized products traded on exchanges.• Futures are daily settled.• Most contracts are closed out before maturity.

- By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)

- Major Characteristics

• Contract: Agreement between buyer and seller to provide delivery of commodity or a financial instrument e.g.. E-mini S&P 500 Futures.

• First Notice Date: date after which the buyer of the contract will be required to take possession of the underlying commodity. The majority of market participants will close their contracts before the first notice date and certainly before the actual expiration

• Delivery/Settlement Date: the final date by which the underlying commodity must be delivered as defined in the contract.

• Expiration Date :This is the day after which the futures contract is no longer valid and is replaced by a contract with another expiration Egg. Gold-March, Gold-April.

• Premium: The cost of owning a contract is referred to as the premium. While the buyer pays the premium for owning the contract, the seller receives the premium. Premium of a contract is slightly above the spot price of the underlying instrument.

• Long & Short: Owning a contract is long, selling a contract without owning is short. Traders make short position when they are bearish on contract and long in case of bullish.

• Offset

-If futures positions are not closed before the relevant date, Saxo Bank will close the position on your behalf at the first available opportunity at the prevailing market rate.- Nominal value of future contact is Number of Lots * Lot size * Price

Futures Contracts

Futures Contracts – Profit from Long and Short Positions

Profit

Price of Underlying at Maturity

Short

Profit

Price of Underlying at Maturity

Long

Futures Contract: Margin and Settlement

- Settlement Process : settling or completing the futures contract at the expiry date or after a contract has been closed.

- Settlement are of two types:- Physical Delivery: it is rare that some market participant choose physical delivery of

underlying assets as per exchange guidelines.- Cash Settled: after contract is settled, investor will be able to realize P&L from

underlying contract.

- Margin: - Initial Margin: All traders must post initial margin with their broker in order to be able

to open a futures contract. Margin requirement can vary for contracts and its volatility.- Maintenance Margin: it is minimum level of margin balance that has to be maintained

till future position open. If balance goes below maintenance margin then trader has to deposit difference equivalent to Initial Margin – Current Balance.

- Margin Call: Deposit calls to trader when margin balance goes below maintenance margin.

Future Contract – Example Trade

Contract Value (Exposure) = Price * Number of Underlying Shares (Lot Size) * Lot (Number of Future Contracts)

Lot size a 1000Nbr of Contract 3

Buying Price 49 Qty 3000

Margin Requirement % 15% Costs 0.10%

Minimum Margin 200000

Action Trade Date Future Price Costs Contact Value Unr P/L Margin Balance Margin Call

Closing Balance

Buy 0 50 150 150000 200000 1 48 144000 -6000 194000 6000 200000 2 58 174000 30000 230000 0 230000 3 45.44 136320 -37680 192320 7680 200000 5 55 165000 28680 228680 0 228680 8 44 132000 -33000 195680 4320 200000 Sell 10 60 180 180000 200000 0 248000 Gross P/L 30000 Net P/L 30000-150-180 =29670

Forwards Contracts

– Forward contracts are similar to futures except that they trade in the over-the-counter market.

– Forward contracts are popular on currencies and interest rates.– There is no daily settlement (but collateral may have to be posted). At the end

of the life of the contract one party buys the asset for the agreed price from the other party.

– The forward price may be different for contracts of different maturities.– Forwards have credit risk, but futures do not because a clearing house

guarantees against default risk by taking both sides of the trade and marking to market their positions every night.

– Forwards are basically unregulated, while futures are regulated at regulatory authorities.

Options• An option is a contract which carries The buyer has the right to buy or sell

the asset. The seller (writer) of an option is, in turn, obligated to sell (in the case a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request.

• A European option can be exercised only at the end of its life.• An American option can be exercised at any time.• Equity option holders do not have the rights due stockholders – e.g.,

voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.

• Characteristics: – Strike Price is the fixed price at which the holder of the call or put can buy or sell the

underlying asset– The expiration date is the final date that the option holder has to exercise her right to

buy or sell the underlying asset.– Call Options provide the holder the right (but not the obligation) to purchase an

underlying asset at a specified price (the strike price), for a certain period of time.– Put Options give the holder the right to sell an underlying asset at a specified price (the

strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price.

Options• Characteristics

– Premium (Option Price) : To acquire the right of an option, the buyer of the option must pay a price to the seller. This is called the option price or the premium.

Premium = Intrinsic Value (value if exercised) + Extrinsic value (Time Value)• Intrinsic Value of Call Option: Underlying Price – Call Strike Price• Intrinsic Value of Put Option: Put Strike Price - Underlying Price • Time Value : extrinsic value is the part which goes down over time all the way to expiration

• Exercise: As a buyer you can exercise buy or sell rights of call/put options if option is in-the-money.

• Assignment: when buyer exercise buy/sell rights, option writer (seller) will have to sell/buy the obligated to deliver the terms of option contract.

• Volatility Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects the magnitude of price fluctuation.

• Benefits :options can provide investors with a great degree of flexibility. Traders can quickly adapt to the movements in the market, whether these are up, down or sideways and deploy option strategies according to the market outlook.

Profit & Loss (Payoff) From Long Positions

• Long call : bought right to buy underlying on or before Expiry.• Long put: bought right to sell underlying on or before Expiry.• Buyer has the right to exercise option at any time prior to its expiration.• Buyer’s potential loss is limited to the amount (premium) paid for the option

contract.

30

20

10

0

-5

70 80 90 100

110 120 130

Profit ($)

stock price ($)

Profit from Long Call

30

20

10

0

-770605040 80 90 100

Profit ($)

stock price ($)

Profit from Long Put

Profit & Loss From Short Position

• Short describes a position in option in which seller writes a contract i.e. sell which seller does not own. In return, seller gets obligation to buy or sell if buyer (holder) exercise contracts.

• Short call: Sold the right to buy underlying to buyer.• Short put: Sold the right to sell underlying to buyer.• When you are short..

– You can be assigned an exercise notice at any time during the life of the option contract. – Your potential loss can be theoretically unlimited (the risk of loss is limited by the fact that the

stock cannot fall below zero in price).

Profit from Short Put-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)

stock price ($)

Profit from Short Call

-30

-20

-10

7

070

605040

80 90 100

Profit ($)

stock price ($)

In-the-money, At-the-money, Out-of-the-money• Call option:

• In-the-money = strike price less than stock price• At-the-money = strike price same as stock price• Out-of-the-money = strike price greater than stock price

• Put option:• In-the-money = strike price greater than stock price• At-the-money = strike price same as stock price• Out-of-the-money = strike price less than stock price

Options: Trade Example

Lot size 1000 Nbr of Contract 1

Qty 1000

Symbol Microsoft Jan2015 36.00 Call

Action Trade DateStrike Price

Underlying Price

Option Price Costs

Contact Value

Amount Paid/Received

Buy 0 36 40 4.75 -150 4750 -4900 1 36 38 4.50 4500 Sell 2 36 41 5.75 -150 5750 5600

P/L 700