A futures contract is an agreement to buy or sell an asset on a particular date in the future. Futures are exchange traded, highly regulated, and usually liquid. They offer individuals an easy way to invest in currencies, commodities, stock indices, and individual stocks. First, we’ll discuss some of the mechanics of futures contracts. Then we’ll follow with a discussion on how futures are priced.
Futures contracts are not actually bought and sold. Instead, they are entered into. An investor enters into a contract to buy Gold at a certain price, rather than buying the contract itself. Later on, the investor can enter into an opposing position, i.e. a contract to sell Gold and this will close out his position. Because contracts are not bought and sold, no cash is exchanged between parties up front. In fact, an investor won’t even be aware of the counterparty to his trade. Instead, he settles his position with the exchange.
The mechanics of trading futures
Let’s use a crude oil future as an example to illustrate the mechanics of trading futures. Assume that on 1st July the investor goes long one July crude oil contract at a price of Rs 3,500 on the MCX. Contract specifications are as follows:
Expiry: 19th July
Quotation: Rs. per Barrel
Trading Unit: 100 Barrels
Initial Margin: 5% When I enter into the contract, the total value of the position is Rs. 3,50,000 (This is the price multiplied by number of barrels multiplied by number of contracts). I have to put up the initial margin which is 5% of the total contract value, i.e. Rs. 17,500. This money is held by the exchange as collateral in case the position loses money. At the end of the trading day, the exchange will mark to market the position. This means that they will pay me if the contract has increased in the value, or I will pay them if it has decreased in the value. The next day, I will again keep a margin deposited with the exchange to cover potential future losses. The profit/loss from this position will be the difference between Rs. 3,500 and the final spot price on 19th July multiplied by 100 barrels. Because I have gone long, if the spot price is higher (lower) than Rs. 3,500, I will make a profit (loss).
Pricing relative to underlying assets
Let’s take a look at how futures are priced relative to their underlying assets. Futures (and all derivatives) are priced on the assumption that there is no arbitrage, or risk free profit. This means that whether you purchase the underlying asset, or a long a futures contract, your return should be the same. For the purposes of trading to speculate on currency, commodity, or stock movements, this is all one needs to know. I will not go into the mathematical relationships that define futures pricing, those who are interested should consult a textbook. In general, futures prices track spot prices very closely. The prices become equal at maturity of the futures contract. The no arbitrage conditions assure the investor that the return from holding the underlying asset or the future will be the same.
Futures contracts can also be understood as an expected value of the spot price. Depending on the market condition, future prices can be either higher or lower than spot prices. This is known as the term structure of prices. If futures prices are higher (lower), the market is said to be in contango (backwardation). This can be used as an indication of where the market expects prices to move in the future. The term structure reflects current supply and demand versus expected future supply and demand.
One of the primary advantages of futures is leverage. Going back to our crude oil future example, we can see that to control a position that was worth Rs 3,50,000, we needed only an initial deposit of Rs. 17,500 (which is 5% of the value of the contract). Leverage can magnify your returns as well as your losses, so risk management becomes increasingly important in trading futures. If crude oil rises 5%, I will make a 100% return on equity, and if crude oil falls 5%, I will have lost everything! For this reason, futures are extremely useful for short term trading, when one is looking for a small change in the underlying asset to make a profit. If I wanted to invest in oil longer term, I’d probably keep aside more than the minimum 5% required to fund the position simply because oil is volatile and can certainly move more than 5% over a longer timeframe. Alternatively, I could buy an oil ETF but then I would not get the leverage that futures provide.
If I wanted to invest in company XYZ, what would be the difference between buying the stock versus going long a futures contract? Buying the stock would mean I have to pay the full amount, I would receive dividends, and my position would be perpetual until I sold the stock. Going long a futures contract would mean I put up only a small percentage of the total position value, I would not receive any dividends (as only actual stockholders receive them), and my position has an expiry date. For the shorter term, futures are advantageous due to the leverage allowed. In the longer term, futures are disadvantageous due to higher transaction costs (needed to enter into new contracts when existing ones expire) and lack of dividends. For commodities and currencies, trading futures is much better than trading the underlying as it is very difficult for retail investors to physically hold and trade commodities and currencies. Trading the future allows an investor the benefit from price movements without dealing with the underlying product.
Now that we’ve had a look at how futures work, the next step is to actually start trading them! Next week, I will explain some basics of trading futures and some specific strategies that can be applied.
This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!
~
equitymaster
Showing posts with label Derivatives. Show all posts
Showing posts with label Derivatives. Show all posts
Friday, July 23, 2010
Introduction to Derivatives
A derivative is a financial instrument that derives its value from another financial asset.
For example, the value of a crude oil futures contract depends on the value of the underlying asset, which is crude oil itself. Derivatives come in all shapes and sizes, so let's discuss some of the most common ones. These are futures, forwards, options, and swaps.
The most common type of derivatives
Futures are perhaps the most common type of derivatives. When an investor enters into a futures contract, he agrees to buy or sell an asset at a predetermined price on a particular date in the future. For example, today is 1st July and the spot (current) price of gold is US$ 1,000. A three month gold future (expiring 1st October) is trading at US$ 1,010. As an investor, I believe the price of gold is going to rise over the next three months, so I enter into a long futures contract at the current futures price of US$ 1,010/oz. Fast forward to 1st October, and the gold spot price is US$ 1,100. I earlier agreed to purchase gold in three months at US$1,010 and now the market price is US $ 1,100, so I have made a profit of US$90. Similarly, if the gold price had fallen below US$ 1,010 on 1st October, I would have incurred a loss equal to the difference between the initial futures price and the final spot price.
A close cousin of the futures
Forwards work in a very similar way to futures. A forward contract is also an agreement to buy or sell an asset at a predetermined price in the future. The profit or loss from the contract will depend on the spot price at the time of contract expiry. Let’s examine some of the key differences between futures and forwards: First, futures contracts are traded on an exchange, whereas forwards are traded OTC (over the counter - meaning two willing parties enter into a contract without going through an exchange). As a result, futures contracts are standardized and more regulated, whereas forward contracts are customizable and less regulated. Forward contracts are generally not available to trade for retail investors (contracts tend to trade between banks and large companies), whereas futures can be traded by almost anyone. Futures also have the added advantage that they can be bought and sold prior to expiry, whereas forwards are more difficult to terminate.
The most fashionable type of derivatives
Options, which are usually exchange traded, are a whole new category of derivatives, and are extremely fashionable among investors. An option contract gives you the right (but not the obligation) to buy or sell a particular asset on a particular date. Call options give you the right to buy, and put options give you the right to sell. For example, today is 1st July, and like before, the spot price of gold is US$1000. A call option that gives the holder the right to purchase gold for US$1000 on 1st October is trading at US$30. As an investor, I believe the price of gold is going to rise over the next three months, so I spend US$30 and purchase this call option. Fast forward to 1st October, and the price of gold is now US$ 1,100. I exercise (use) the option, purchase gold for US$ 1,000, and have made US$ 100 profit (as the current market price is US$ 1,100). My net profit (after subtracting the cost of the option) is US$ 70. If the market price at expiry was below US$ 1000, I would not have exercised the option (as the market price is cheaper than the option strike price) and my profit would be US$ 0. Once we factor in the cost of the option, we have a net loss of US$ 30. The beauty of an option is that if in the example above, gold were to fall, no matter how much it fell, my maximum loss is always US$ 30, the price I paid for the option, whereas my maximum gain is infinite. You can see why options are so popular!
Another over the counter derivatives
Finally, we have swaps. I won’t go into too much detail on swaps because like forwards, they are traded only over the counter, and not available to retail investors. Swaps take all forms such as interest rate swaps, currency swaps, equity swaps and many others. Let’s discuss a basic interest rate swap. Two parties enter into an agreement to swap cash flows based on an agreed notional principal. At regular intervals, one party will pay a fixed amount to another party, while the other party will pay the initial party a floating amount (which varies as interest rates vary). Essentially, interest rate swaps are used by banks and companies to convert fixed liabilities to floating ones and vice versa.
Who bears the risk for derivatives?
There are three types of players in the derivatives markets. These are market makers, hedgers, and investors. Market makers include large banks which buy and sell derivatives to earn spreads and commissions. An example of a hedger would be a commodity producer that uses derivatives to hedge the price for which they can sell their product. Finally, investors use derivatives to profit from market movements and earn return.
A question that people often throw: what is the purpose of investors and speculators in the derivative market? Clearly, market makers are necessary or the market wouldn’t exist. Derivatives are obviously beneficial to hedgers who can better manage their business risks by hedging their exposures. But why do we need speculators? Let’s say a farmer produces corn and has a harvest due in 3 months. If he wants to get rid of the risk he can sell corn futures and lock in a price in 3 months. He has gotten rid of his risk. So where does that risk go? Someone has to take the other side of that contract, and this is where the investor comes in. Investors take on the risks that hedgers want to get rid of. Hedgers pass on the risks to investors, and investors as a result expect to earn a profit for taking on the risk. This why the more investors take part in derivatives markets, the more efficiently they can function and serve the needs of hedgers.
Over the course of this derivatives tutorial, I will focus primarily on futures and options (as this is what is available to retail investors), looking at how they are priced and various trading strategies for each. Next week, we will take a closer look at futures markets; understand how they are priced, how to use them, and how they differ from traditional investments in stocks.
This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!
Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader.
~
Equitymaster
For example, the value of a crude oil futures contract depends on the value of the underlying asset, which is crude oil itself. Derivatives come in all shapes and sizes, so let's discuss some of the most common ones. These are futures, forwards, options, and swaps.
The most common type of derivatives
Futures are perhaps the most common type of derivatives. When an investor enters into a futures contract, he agrees to buy or sell an asset at a predetermined price on a particular date in the future. For example, today is 1st July and the spot (current) price of gold is US$ 1,000. A three month gold future (expiring 1st October) is trading at US$ 1,010. As an investor, I believe the price of gold is going to rise over the next three months, so I enter into a long futures contract at the current futures price of US$ 1,010/oz. Fast forward to 1st October, and the gold spot price is US$ 1,100. I earlier agreed to purchase gold in three months at US$1,010 and now the market price is US $ 1,100, so I have made a profit of US$90. Similarly, if the gold price had fallen below US$ 1,010 on 1st October, I would have incurred a loss equal to the difference between the initial futures price and the final spot price.
A close cousin of the futures
Forwards work in a very similar way to futures. A forward contract is also an agreement to buy or sell an asset at a predetermined price in the future. The profit or loss from the contract will depend on the spot price at the time of contract expiry. Let’s examine some of the key differences between futures and forwards: First, futures contracts are traded on an exchange, whereas forwards are traded OTC (over the counter - meaning two willing parties enter into a contract without going through an exchange). As a result, futures contracts are standardized and more regulated, whereas forward contracts are customizable and less regulated. Forward contracts are generally not available to trade for retail investors (contracts tend to trade between banks and large companies), whereas futures can be traded by almost anyone. Futures also have the added advantage that they can be bought and sold prior to expiry, whereas forwards are more difficult to terminate.
The most fashionable type of derivatives
Options, which are usually exchange traded, are a whole new category of derivatives, and are extremely fashionable among investors. An option contract gives you the right (but not the obligation) to buy or sell a particular asset on a particular date. Call options give you the right to buy, and put options give you the right to sell. For example, today is 1st July, and like before, the spot price of gold is US$1000. A call option that gives the holder the right to purchase gold for US$1000 on 1st October is trading at US$30. As an investor, I believe the price of gold is going to rise over the next three months, so I spend US$30 and purchase this call option. Fast forward to 1st October, and the price of gold is now US$ 1,100. I exercise (use) the option, purchase gold for US$ 1,000, and have made US$ 100 profit (as the current market price is US$ 1,100). My net profit (after subtracting the cost of the option) is US$ 70. If the market price at expiry was below US$ 1000, I would not have exercised the option (as the market price is cheaper than the option strike price) and my profit would be US$ 0. Once we factor in the cost of the option, we have a net loss of US$ 30. The beauty of an option is that if in the example above, gold were to fall, no matter how much it fell, my maximum loss is always US$ 30, the price I paid for the option, whereas my maximum gain is infinite. You can see why options are so popular!
Another over the counter derivatives
Finally, we have swaps. I won’t go into too much detail on swaps because like forwards, they are traded only over the counter, and not available to retail investors. Swaps take all forms such as interest rate swaps, currency swaps, equity swaps and many others. Let’s discuss a basic interest rate swap. Two parties enter into an agreement to swap cash flows based on an agreed notional principal. At regular intervals, one party will pay a fixed amount to another party, while the other party will pay the initial party a floating amount (which varies as interest rates vary). Essentially, interest rate swaps are used by banks and companies to convert fixed liabilities to floating ones and vice versa.
Who bears the risk for derivatives?
There are three types of players in the derivatives markets. These are market makers, hedgers, and investors. Market makers include large banks which buy and sell derivatives to earn spreads and commissions. An example of a hedger would be a commodity producer that uses derivatives to hedge the price for which they can sell their product. Finally, investors use derivatives to profit from market movements and earn return.
A question that people often throw: what is the purpose of investors and speculators in the derivative market? Clearly, market makers are necessary or the market wouldn’t exist. Derivatives are obviously beneficial to hedgers who can better manage their business risks by hedging their exposures. But why do we need speculators? Let’s say a farmer produces corn and has a harvest due in 3 months. If he wants to get rid of the risk he can sell corn futures and lock in a price in 3 months. He has gotten rid of his risk. So where does that risk go? Someone has to take the other side of that contract, and this is where the investor comes in. Investors take on the risks that hedgers want to get rid of. Hedgers pass on the risks to investors, and investors as a result expect to earn a profit for taking on the risk. This why the more investors take part in derivatives markets, the more efficiently they can function and serve the needs of hedgers.
Over the course of this derivatives tutorial, I will focus primarily on futures and options (as this is what is available to retail investors), looking at how they are priced and various trading strategies for each. Next week, we will take a closer look at futures markets; understand how they are priced, how to use them, and how they differ from traditional investments in stocks.
This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!
Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader.
~
Equitymaster
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