Derivatives Trading in India (Contd) (Page: 2 of 2)

Index Futures and Index Option Contracts

Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index. Similarly, the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.

An index, in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy (Sectoral Index). By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry.

A futures contract is an obligation to buy or sell a specific quantity of a commodity, financial instrument or stock index at a fixed price at a specific date in the future. An option is an instrument that gives the owner the right -- but not the obligation -- either to buy or sell the underlying stock, index or futures contract at a set price for a particular period of time, usually a few months. Like futures, options are also speculative, but they have one advantage over futures: The amount of money you can lose is limited to the amount of money you paid for the option premium.

The spot market is the cash market, i.e., current cash prices. The futures market is predetermined future prices. The futures price may or may not end up being the spot price when that future date arrives.

A long futures position results from buying futures contracts and a short futures position results from selling futures contracts. Generally, you take a long futures position if you anticipate a rise in the price of the underlying commodity and a short futures position if you anticipate a decline in the price of the underlying commodity.

Hedging is risk management. Futures can be used to hedge against interest rate and price risks. The position you take determines the type of hedge. A short hedge is created by selling futures contracts and a long hedge is created by buying futures contracts. For example, if the investor expects a decline in the stock market and he has a stock portfolio, he might sell stock index futures, thus taking a short hedge. What this means is that he has locked in a price to sell the index now for delivery sometime in the future. Should the market decline, he would realize a loss in the value of his stock portfolio but also a gain in your futures position, since the futures contracts are valued at the higher price stated in the futures contract. One position offsets (or partially offsets) the other, reducing the risk of loss.

An option is a contract, which gives the option buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.

SEBI has permitted option trading in Indian Capital Market Securities in the year 2001, both by way of trading in stock options and also Index Options. Options are currently traded on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Like trading in stocks, options trading is regulated by SEBI. These exchanges seek to provide competitive, liquid, and orderly markets for the purchase and sale of standardized options.

Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one's portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading.

Investors belonging to the following categories, depending on their financial goals and investment objectives generally consider trading in options.

• Investors who want to participate in the market without trading or holding a large stock portfolio.

• Investors who have strong views on the market and its future movement and want to take advantage of the same

• Investors who are following the equities market very closely, and

• Investors who want to protect the value of their diversified equities portfolio.

An option gives you the right to buy or sell an asset at a future date. This can be done at the price specified in the option contract. But you need to use it only if the option contract price is favourable to you. If the price trend is unfavourable, you need not exercise the option. Instead you can go and buy or sell the asset in the market at a price better than the option contract price. This means an option holder has a right but not the obligation to exercise the contract. But this facility comes with a price; options help you benefit from the contract price if there are unfavourable movements asset prices in the market.

On March 1, 2003, 'A' sells a call option (right to buy) on "INFOSYS." to 'B' for a price of say Rs.300. Now 'B' has the right to approach 'A' on March 31, 2003 and buy 1 share of "INFOSYS" at Rs.5000. Here 'B' does not have to necessarily buy 1 share of "INFOSYS." on March 31,2004 at Rs.5000 from 'A'. 'B' may find it worthwhile to exercise his right to buy only if "INFOSYS Ltd." trades above Rs.5000. If "B" exercises his option, A has to necessarily sell "B" one share of "INFOSYS." at Rs.5000 on March 31, 2003. So if the price of "INFOSYS" goes above Rs.5000 'B' may exercise his option, or else the option may lapse. Then 'B' loses the original option price of Rs.300 and 'A' has gained it.

The similarities between them are :- both are traded through exchanges as a standardized contracts in terms of size, maturity and the nature of the underlying assets under stringent financial safeguards. Executions of the contracts are guaranteed by the concerned exchanges in both cases. However, the downside risks in futures are unlimited which is limited to the option premium in options. The futures contracts are supported by the initial margin an amount payable by the client as a percentage of contract value. Apart from this, if there are any changes in the futures prices on daily basis - adverse fluctuations below this initial margin - are collected from the party (mark to market). The favorable prices are credited to parry's account. In options either the underlying assets are taken as security (covered options) alternatively sufficient cash margins are kept as a measure of security.

Commodities Futures for Coffee, Oil Seeds, Oil (Castor, Palmolein), Pepper, Cotton, Jute and Jute Goods are traded in the Commodities Futures. Forward Markets Commission regulates the trading of commodities futures. Index futures based on Sensex and Nifty Index are also traded under the supervision of SEBI. RBI has permitted Banks, FIs and PDs to enter into forward rate agreement (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risks and ensuring orderly development of the derivatives market. NSE became the first exchange to launch trading in options on individual securities. Trading in options on individual securities commenced from July 2, 2001. Option contracts are American style and cash settled and are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI). NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI).BSE also has started trading in individual stock options & futures (both Index & Stocks) around the same time as NSE

The measures specified by SEBI include:

• Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor.

• The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.

• Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member.

• In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/ Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.