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Taking a Call on Futures

Pritam P Hans        Print Edition: May 2011

Are you quite positive about the future returns of a particular scrip that you have been tracking? It may be the case that you have money to buy just 250 shares of this company, when you actually want to buy 1,000. Don't settle for less-invest in equity derivatives instead. You will need to invest just a fraction of the value of the stocks upfront.

Derivatives are instruments whose value is based on the future prospects of the underlying stocks or indices. For instance, in the case of stock-based derivatives- futures and options (F&O)-you promise to buy or sell a number of shares of a company at a set price by a given date.

For trading in F&O you need to have a demat and a trading account. "The margin amount (upfront payment) varies from stock to stock. You have to deposit a margin to buy or sell futures or to sell an option. To buy an option, you only deposit a premium," says Shomesh Kumar, head (derivatives), Karvy Stock Broking.

STOCK FUTURES Vs OPTIONS

In the case of equity futures you are obliged to honour your exchange-traded contract for buying or selling a specified quantity of a stock at a future date. You can, however, close the deal before maturity by entering into an equal and opposite transaction called 'squaring off'. In contrast, an options contract is more flexible as it grants the holder the right to buy or sell shares on or before a specific date but does not make it mandatory.

The buyer enters into a contract with the options writer or the seller, a deal is done at a strike price or the price at which the two parties agree to buy or sell the asset in the future. The contract-holder can choose to exercise the 'call' option for buying or the 'put' option for selling the shares. But the options writer is obliged to sell or buy the stock if the option is exercised.

Futures and options contracts are traded through clearing corporations such as National Securities Clearing Corporation (NSCCL), which provide a guarantee in case there is a breach of contract.

Options can also be traded directly on the over-the-counter (OTC) exchange, but this is seen as risky. F&O contracts can be bought for one, two or three months.

INDEX DERIVATIVES

While trading in index derivatives, you take a stand on the movement of an index such as the Nifty or the Sensex. So, you do not get delivery of any stocks, and the deal is settled through cash on the expiry date.

Here's how index futures operate. Assume that you are bullish on the market, while the Nifty is trading at 5,450 points, and you buy 50 units of Nifty futures at a strike rate of Rs 5,550. This means you are betting that the Nifty will cross 5,550 by the expiry date of your contract.

If on that date, the Nifty is trading at 5,650 points, you have made a profit of Rs 100 on each unit or Rs 5,000 on your investment. If, however, the Nifty falls to 5,500, you lose Rs 2,500 (Rs 50 x 50 units).

For index options, let's assume the Nifty is at 5,650 and you expect it to decline. You buy 50 units of Nifty put option (to sell) and pay a premium of, say, Rs 500 at the strike rate of Rs 5,550. On the day of settlement, if the Nifty is trading at 5,500 points, you gain Rs 50 per unit or Rs 2,500. If you deduct the premium paid, it comes to Rs 2,000. In case, the index rises to 5,700 points, you can choose not to exercise the option. You lose just Rs 500.

BIG REWARDS

Let's assume that you are gung-ho on a stock and expect it to rise from Rs 90 per share to Rs 125 in about three months. In the futures market, it is trading at Rs 100. If the contract size is 1,000 and margin requirement is 20%, you have to keep Rs 20,000 as security (which is later returned) for buying the contract.

If your prediction comes true, you make a profit of Rs 25 on each share or Rs 25,000. If you had operated in the spot market, you may have been able to buy just 222 shares of the scrip for Rs 20,000 and earned just Rs 7,750 (See Profit Potential). An alternative would be to buy a call option for the stock and exercise it when the share crosses your target.

Let's now assume that you expect a particular share trading at Rs 120 per share and expect it to decline to Rs 80. You place a put option or buy the right to sell 100 shares of this stock after a month.

At a strike rate of Rs 100 for a premium of Rs 5 per share, your investment comes to Rs 500. If the share price actually declines to Rs 80, you buy the share from the cash market and sell it to the option writer for Rs 100. As you have paid a premium of Rs 5 per share, your profit per share will be Rs 15. For 100 shares, your profit will be Rs 1,500 (Rs 2000 less Rs 500). You lose just Rs 500 if the shares do not decline It is this profit potential that has made the average daily turnover in the derivatives market grow from Rs 11 crore in 2000-01, when it came into existence, to around Rs 1.15 lakh crore at the beginning of March 2011.

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