FUTURES AND OPTIONS:

MERITS AND DEMERITS

AN ASSIGNMENT BY:
PUROO SONI(15907)
 INTRODUCTION
A futures contract is a type of derivative instrument, or financial contract, in which two parties
agree to transact a set of financial instruments or physical commodities for future delivery at a
particular price. If you buy a futures contract, you are basically agreeing to buy something that a
seller has not yet produced for a set price. But participating in the futures market does not
necessarily mean that you will be responsible for receiving or delivering large inventories of
physical commodities - remember, buyers and sellers in the futures market primarily enter into
futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the
primary activity of the cash/spot market). That is why futures are used as financial instruments
by not only producers and consumers but also speculators.

The consensus in the investment world is that the futures market is a major financial hub,
providing an outlet for intense competition among buyers and sellers and, more importantly,
providing a center to manage price risks. The futures market is extremely liquid, risky and
complex by nature, but it can be understood if we break down how it functions.

While futures are not for the risk averse, they are useful for a wide range of people. In this
tutorial, you'll learn how the futures market works, who uses futures and which strategies will
make you a successful trader on the futures market.

Futures and options represent two of the most common form of "Derivatives". Derivatives are
financial instruments that derive their value from an 'underlying'. The underlying can be a stock
issued by a company, a currency, Gold etc., The derivative instrument can be traded
independently of the underlying asset.

The value of the derivative instrument changes according to the changes in the value of the
underlying.

Derivatives are of two types -- exchange traded and over the counter.

Exchange traded derivatives, as the name signifies are traded through organized exchanges
around the world. These instruments can be bought and sold through these exchanges, just like
the stock market. Some of the common exchange traded derivative instruments are futures and
options.

Over the counter (popularly known as OTC) derivatives are not traded through the exchanges.
They are not standardized and have varied features. Some of the popular OTC instruments are
forwards, swaps, swaptions etc.
Futures

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined
time. If you buy a futures contract, it means that you promise to pay the price of the asset at a
specified time. If you sell a future, you effectively make a promise to transfer the asset to the
buyer of the future at a specified price at a particular time. Every futures contract has the
following features:

 Buyer
 Seller
 Price
 Expiry

Some of the most popular assets on which futures contracts are available are equity stocks,
indices, commodities and currency.

The difference between the price of the underlying asset in the spot market and the futures
market is called 'Basis'. (As 'spot market' is a market for immediate delivery) The basis is usually
negative, which means that the price of the asset in the futures market is more than the price in
the spot market. This is because of the interest cost, storage cost, insurance premium etc., That is,
if you buy the asset in the spot market, you will be incurring all these expenses, which are not
needed if you buy a futures contract. This condition of basis being negative is called as
'Contango'.

Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For
eg: if you hold equity shares in your account you will receive dividends, whereas if you hold
equity futures you will not be eligible for any dividend.

When these benefits overshadow the expenses associated with the holding of the asset, the basis
becomes positive (i.e., the price of the asset in the spot market is more than in the futures
market). This condition is called 'Backwardation'. Backwardation generally happens if the price
of the asset is expected to fall.

It is common that, as the futures contract approaches maturity, the futures price and the spot
price tend to close in the gap between them ie., the basis slowly becomes zero.

Options

Options contracts are instruments that give the holder of the instrument the right to buy or sell
the underlying asset at a predetermined price. An option can be a 'call' option or a 'put' option.

A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is
called 'strike price'. It should be noted that while the holder of the call option has a right to
demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if
the buyer wants to buy the asset, the seller has to sell it. He does not have a right.
Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the buyer.
Here the buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the
contract. The seller of the contract has only the obligation and no right. As the seller of the
contract bears the obligation, he is paid a price called as 'premium'. Therefore the price that is
paid for buying an option contract is called as premium.

The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset
in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price
of Rs 500. On expiry the price of the asset is Rs 450. A will not exercise his call. Because he can
buy the same asset from the market at Rs 450, rather than paying Rs 500 to the seller of the
option.

The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset
in the spot market is more than the strike price of the call. For eg: B bought a put at a strike price
of Rs 600. On expiry the price of the asset is Rs 619. A will not exercise his put option. Because
he can sell the same asset in the market at Rs 619, rather than giving it to the seller of the put
option for Rs 600.
A BRIEF HISTORY
Aristotle described the story of Thales, a poor philosopher from Miletus who developed a
"financial device, which involves a principle of universal application". Thales used his skill in
forecasting and predicted that the olive harvest would be exceptionally good the next autumn.
Confident in his prediction, he made agreements with local olive press owners to deposit his
money with them to guarantee him exclusive use of their olive presses when the harvest was
ready. Thales successfully negotiated low prices because the harvest was in the future and no one
knew whether the harvest would be plentiful or poor and because the olive press owners were
willing to hedge against the possibility of a poor yield. When the harvest time came, and many
presses were wanted concurrently and suddenly, he let them out at any rate he pleased, and made
a large quantity of money.

The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet
the needs of samurai who—being paid in rice, and after a series of bad harvests—needed a stable
conversion to coin.

The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward
contracts in 1864, which were called futures contracts. This contract was based on grain trading
and started a trend that saw contracts created on a number of different commodities as well as a
number of futures exchanges set up in countries around the world. By 1875 cotton futures were
being traded in Mumbai in India and within a few years this had expanded to futures on edible
oilseeds complex, raw jute and jute goods and bullion.

Before the North American futures market originated some 150 years ago, farmers would grow
their crops and then bring them to market in the hope of selling their inventory. But without any
indication of demand, supply often exceeded what was needed and unpurchased crops were left
to rot in the streets! Conversely, when a given commodity - wheat, for instance - was out of
season, the goods made from it became very expensive because the crop was no longer available.

In the mid-nineteenth century, central grain markets were established and a central marketplace
was created for farmers to bring their commodities and sell them either for immediate delivery
(spot trading) or for forward delivery. The latter contracts - forward contracts - were the
forerunners to today's futures contracts. In fact, this concept saved many  a farmer the loss of
crops and profits and helped stabilize supply and prices in the off-season.

Today's futures market is a global marketplace for not only agricultural goods, but also for
currencies and financial instruments such as Treasury bonds and securities (securities futures).
It's a diverse meeting place of farmers, exporters, importers, manufacturers and speculators.
Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas
farmer can match a bid from a buyer in Europe.
STANDARDIZATION
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

 The underlying asset or instrument. This could be anything from a barrel of crude oil to a
short term interest rate.
 The type of settlement, either cash settlement or physical settlement.
 The amount and units of the underlying asset per contract. This can be the notional
amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional
amount of the deposit over which the short term interest rate is traded, etc.
 The currency in which the futures contract is quoted.
 The grade of the deliverable. In the case of bonds, this specifies which bonds can be
delivered. In the case of physical commodities, this specifies not only the quality of the
underlying goods but also the manner and location of delivery. For example, the
NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and
API specific gravity, as well as the pricing point -- the location where delivery must be
made.
 The delivery month.
 The last trading date.
 Other details such as the commodity tick, the minimum permissible price fluctuation.
MARGIN
To minimize credit risk to the exchange, traders must post a margin or a performance bond,
typically 5%-15% of the contract's value.

To minimize counterparty risk to traders, trades executed on regulated futures exchanges are
guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the
seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of
loss. This enables traders to transact without performing due diligence on their counterparty.

Margin requirements are waived or reduced in some cases for hedgers who have physical
ownership of the covered commodity or spread traders who have offsetting contracts balancing
the position.

Clearing margin are financial safeguards to ensure that companies or corporations perform on
their customers' open futures and options contracts. Clearing margins are distinct from customer
margins that individual buyers and sellers of futures and options contracts are required to deposit
with brokers.

Customer margin Within the futures industry, financial guarantees required of both buyers and
sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract
obligations. Futures Commission Merchants are responsible for overseeing customer margin
accounts. Margins are determined on the basis of market risk and contract value. Also referred to
as performance bond margin.

Initial margin is the equity required to initiate a futures position. This is a type of performance
bond. The maximum exposure is not limited to the amount of the initial margin, however the
initial margin requirement is calculated based on the maximum estimated change in contract
value within a trading day. Initial margin is set by the exchange.

If a position involves an exchange-traded product, the amount or percentage of initial margin is

set by the exchange concerned.

In case of loss or if the value of the initial margin is being eroded, the broker will make a margin
call in order to restore the amount of initial margin available. Often referred to as “variation
margin”, margin called for this reason is usually done on a daily basis, however, in times of high
volatility a broker can make a margin call or calls intra-day.

Calls for margin are usually expected to be paid and received on the same day. If not, the broker
has the right to close sufficient positions to meet the amount called by way of margin. After the
position is closed-out the client is liable for any resulting deficit in the client’s account.

Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how
much the value of the initial margin can reduce before a margin call is made. However, most
non-US brokers only use the term “initial margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other
securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets).

A futures account is marked to market daily. If the margin drops below the margin maintenance
requirement established by the exchange listing the futures, a margin call will be issued to bring
the account back up to the required level.

Maintenance margin A set minimum margin per outstanding futures contract that a customer
must maintain in his margin account.

Margin-equity ratio is a term used by speculators, representing the amount of their trading
capital that is being held as margin at any particular time. The low margin requirements of
futures results in substantial leverage of the investment. However, the exchanges require a
minimum amount that varies depending on the contract and the trader. The broker may set the
requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does
not want to be subject to margin calls.

Performance bond margin The amount of money deposited by both a buyer and seller of a
futures contract or an options seller to ensure performance of the term of the contract. Margin in
commodities is not a payment of equity or down payment on the commodity itself, but rather it is
a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or
loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be
calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)
(year/trade_duration)
-1. For example if a trader earns 10% on margin in two months, that would be about
77% annualized.
THE PARTIES
Hedgers
Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in
the futures market to secure the future price of a commodity intended to be sold at a later date in
the cash market. This helps protect against price risks.

The holders of the long position in futures contracts (the buyers of the commodity), are trying to
secure as low a price as possible. The short holders of the contract (the sellers of the commodity)
will want to secure as high a price as possible. The futures contract, however, provides a definite
price certainty for both parties, which reduces the risks associated with price volatility. Hedging
by means of futures contracts can also be used as a means to lock in an acceptable price margin
between the cost of the raw material and the retail cost of the final product sold.

  Example:
A silversmith must secure a certain amount of silver in
six months time for earrings and bracelets that have
already been advertised in an upcoming catalog with
specific prices. But what if the price of silver goes up
over the next six months? Because the prices of the
earrings and bracelets are already set, the extra cost of
the silver can't be passed on to the retail buyer,
meaning it would be passed on to the silversmith. The
silversmith needs to hedge, or minimize her risk
against a possible price increase in silver. How?

The silversmith would enter the futures market and

purchase a silver contract for settlement in six months
time (let's say June) at a price of $5 per ounce. At the
end of the six months, the price of silver in the cash
market is actually $6 per ounce, so the silversmith
benefits from the futures contract and escapes the
higher price. Had the price of silver declined in the
cash market, the silversmith would, in the end, have
been better off without the futures contract. At the
same time, however, because the silver market is very
volatile, the silver maker was still sheltering himself
from risk by entering into the futures contract.

So that's basically what hedging is: the attempt to

minimize risk as much as possible by locking in prices
for future purchases and sales. Someone going long in
a securities future contract now can hedge against
 rising equity prices in three months. If at the time of
the contract's expiration the equity price has risen, the
investor's contract can be closed out at the higher
price. The opposite could happen as well: a hedger
could go short in a contract today to hedge against
declining stock prices in the future.

A potato farmer would hedge against lower French fry

prices, while a fast food chain would hedge against
higher potato prices. A company in need of a loan in
six months could hedge against rising interest rates in
the future, while a coffee beanery could hedge against
rising coffee bean prices next year.

Speculators
Other market participants, however, do not aim to minimize risk but rather to benefit from the
inherently risky nature of the futures market. These are the speculators, and they aim to profit
from the very price change that hedgers are protecting themselves against. Hedgers want to
minimize their risk no matter what they're investing in, while speculators want to increase their
risk and therefore maximize their profits.

In the futures market, a speculator buying a contract low in order to sell high in the future would
most likely be buying that contract from a hedger selling a contract low in anticipation of
declining prices in the future.

Unlike the hedger, the speculator does not actually seek to own the commodity in question.
Rather, he or she will enter the market seeking profits by offsetting rising and declining prices
through the buying and selling of contracts.

Trader Short Long

Secure a price now to Secure a price now to
The Hedger protect against future protect against future
declining prices rising prices
Secure a price now in Secure a price now in
The
anticipation of declining anticipation of rising
Speculator
prices prices

In a fast-paced market into which information is continuously being fed, speculators and hedgers
bounce off of - and benefit from - each other. The closer it gets to the time of the contract's
expiration, the more solid the information entering the market will be regarding the commodity
in question. Thus, all can expect a more accurate reflection of supply and demand and the
corresponding price.
Regulatory Bodies
The U.S. futures market is regulated by the Commodity Futures Trading Commission (CFTC) an
independent agency of the U.S. government. The market is also subject to regulation by the
National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and
subject to CFTC supervision.

A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures
contracts. Futures brokers must also be registered with the NFA and the CFTC in order to
conduct business. The CFTC has the power to seek criminal prosecution through the Department
of Justice in cases of illegal activity, while violations against the NFA's business ethics and code
of conduct can permanently bar a company or a person from dealing on the futures exchange. It
is imperative for investors wanting to enter the futures market to understand these regulations
and make sure that the brokers, traders or companies acting on their behalf are licensed by the
CFTC.

In the unfortunate event of conflict or illegal loss, you can look to the NFA for arbitration and
appeal to the CFTC for reparations. Know your rights as an investor!
ADVANTAGES AND DISADVANTAGES
OF FUTURES
The ADVANTAGES of trading futures contracts:

1) The commission charges for futures trading are relatively small as compared to other
type of investments.

2) Futures contracts are highly leveraged financial instruments which permit achieving
greater gains using a limited amount of invested funds.

3) It is possible to open short as well as long positions. Position can be reversed easily.

4) Lead to high liquidity.

5) Standardization of contracts' parameters on a developed market leads to high

liquidity.

6) Daily settlement of gains and losses provides for regular realization of gains, which
the investors may utilize.

Disadvantages

The DISADVANTAGES of trading futures contracts:

1) Leverage can make trading in futures contracts highly risky for a particular strategy.

2) Futures contract is standardized product and written for fixed amounts and terms.

3) Lower commission costs can encourage a trader to take additional trades and lead to
over-trading.

4) It offers only a partial hedge.

5) Daily settlement of gains and losses provides for regular realization of losses, for
which reason an investor must have a sufficient reserve so that his or her position will not
be closed involuntarily.

6) It is subject to basis risk which is associated with imperfect hedging using futures.

7) Futures contracts involve the same risks as may be potentially involved in other
investment instruments, such as market and currency risks.
ADVANTAGES AND DISADVANTAGES
OF OPTIONS
The ADVANTAGES of Trading Options are:

1) Options trading offers flexibility to the buyers as well as to the sellers. It can be used
in a wide variety of strategies in order to make a profit from the ever changing market.

2) Financial leverage is another advantage of trading options. Investors can employ

considerable leverage without committing to a trade.

3) They are less risky as compared to other types of trading instruments. Huge losses can
be avoided as risk is limited to the option premium, so the maximum loss is the price you
paid to purchase it (known as premium).

4) Hedging using options enables investors to manage risk and reduce potential risk.

The Disadvantages of Options Trading:

Lower liquidity. Many individual stock options don't have much volume at all. The fact
that eacg optionable stock will have options trading at different strike prices and
expirations means that the particular option you are teading will be very low volume
unless it is one of the most popular stocks or stock indexes. This lower liquidity won't
matter much to a small trader that is trading just 10 contracts though.

Higher spreads. Options tend to have higher spreads because of the lack of liquidity.
This means it will cost you more in indirect costs when doing an option trade because
you will be giving up the spread when you trade.

Higher commissions. Options trades will cost you more in commission per dollar
invested. These commissions may be even higher for spreads where you have to pay
commissions for both sides of the spread.

Complicated. Options are very complicated to beginners. Most beginners, and even
some advanced investors, think they understand them when they don't.

Time Decay. When buying options you lose the time value of the options as you hold
them. There are no exceptions to this rule.
 Less information. Options can be a pain when it is harder to get quotes or other standard
analystical information like the implied volatility.

Options not available for all stocks. Although options are available on a good number
of stocks, this still limits the number of possibilities available to you.