Stock Options and Futures

Futures Contract:

A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded in organized exchanges. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values.

An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled/completed.

Characteristics of Futures contract:

1. They are traded in organized exchanges

2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house.

3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.

How it works:

Lets say you are the holder of 200 shares of AT&T. You enjoy the dividend that it pays and believe it is a good investment to hold onto long term even though you may not expect a large move in the share price in the immediate future. A covered call option strategy may be a great way to increase your return on this position.

For this example lets say that AT&T is trading at $35 and a December call contract with a strike price of $39 is trading for $1.00 per share.

As the owner of the underlying security you could write/sell 2 contracts (100 shares a piece) for the December calls that are trading at $1.00 per share. As the contract writer you would immediately receive the $1.00 a share x 200 shares or $200.

Now, lets look at what you are obligated to do for this $100 premium. The person that bought this contract from you now owns the right to exercise that contract and buy your shares for $39 dollars anytime between now and the December options expiration date.

So, there are 2 scenarios that could take place:

1. You pocket the premium and the option is never exercised.
2. You pocket the premium and the contract is exercised and your shares are sold at $39 dollars regardless of what the market price is at the time. In effect, limiting the upside potential on your shares between contract origination and December options expiration.

There is a tutorial on covered calls here: http://www.borntosell.com/covered-call-tutorial

* * VaR Margin : As mandated by SEBI, the Value at Risk (VaR) margining system, which is internationally accepted as the best margining system, is applicable on the outstanding positions of the members in all scrips. a) The VaR Margin is a margin intended to cover the largest loss that can be encountered on 99% of the days (99% Value at Risk). For liquid stocks, the margin covers one-day losses while for illiquid stocks, it covers three-day losses so as to allow the Exchange to liquidate the position over three days. This leads to a scaling factor of square root of three for illiquid stocks. For liquid stocks, the VaR margins are based only on the volatility of the stock while for other stocks, the volatility of the market index is also used in the computation. Computation of the VaR margin requires the following definitions:

* * Scrip sigma means the volatility of the security computed as at the end of the previous trading day. The computation uses the exponentially weighted moving average method applied to daily returns in the same manner as in the derivatives market. * * Scrip VaR means the higher of 7.5% or 3.5 scrip sigmas. * * Index sigma means the daily volatility of the market index (S&P CNX Nifty or BSE Sensex) computed as at the end of the previous trading day. The computation uses the exponentially weighted moving average method applied to daily returns in the same manner as in the derivatives market. * * Index VaR means the higher of 5% or 3 index sigmas. The higher of the Sensex VaR or Nifty VaR would be used for this purpose. The VaR Margins are specified as follows for different groups of stocks: Liquidity Categorization One-Day VaR Scaling factor for illiquidity VaR MarginLiquid Securities (Group I) Scrip VaR 1.00 Scrip VaR Less Liquid Securities (Group II) Higher of Scrip VaR and three times Index VaR 1.73 (square root of 3.00) Higher of 1.73 times Scrip VaR and 5.20 times Index VaR Illiquid Securities (Group III) Five times Index VaR 1.73 (square root of 3.00) 8.66 times Index VaR b) The VaR margin is collected on an upfront basis by adjusting against the total liquid assets of the member at the time of trade. c) The VaR margin is collected on the gross open position of the member. The gross open position for this purpose is the gross of all net positions across all the clients of a member including his proprietary position. d) For this purpose, there would be no netting of positions across different settlements. e) Dissemination of Information : The VaR amount applicable in respect of the scrips would be disseminated on the website of the Exchange on a daily basis.

**DM

The buyer of a put is either believes the price of the underlying equity will fall below the strike price before the excersise date and hopes to profit or the buyer is simply protecting a long position.

The writer of the put believes the underlying security will trade flat to higher over the lifetime of the contract and has the goal of simply collecting the premium.

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A put writer can also have the goal of buying securities at a discounted price.

Say I believe Joe's Windows is going to sell for $50.50 per share on February 1. Right now (we'll say right now is September) it's selling for $54. I also know Joe's is a cyclical industry--Joe doesn't sell very many windows in February because no one wants to replace windows when it's cold outside, but he sells a lot of them in May. I think Joe's is going to sell for $65 per share in May. So I sell a put for a thousand shares of Joe's with a $51 strike price and a February 1 expiration date, and a premium of $1 per share. In automated options trading, if the stock price is five cents or more lower than the strike price the option is automatically exercised. I put the $1000 premium in my brokerage account. On February 1, the stock price was $50.90; the option exercised. My brokerage account balance went down by $51,000, my portfolio went up by 1000 shares of stock, and there are three happy campers: the person who sold me the stock because he's $51,000 richer; the broker, who gets a commission from the trade; and me because after the $1000 premium is subtracted I really only had to pay $50,000 for that stock. And I'll be even happier on April 14, because after Joe's new warehouse opens and the stock price shoots up to $70 per share I'll have even more of a profit than I was planning!