Monday, March 11, 2013

What are Futures and Options and how to gain from it? - Part 1

Introduction

So you are an avid Business channel buff, dabble in the stock market buying shares and mutual funds but haven't probably not ventured deeper into the stock market ocean. If so, you must have always ignored  terms such as "Open Interest", "Long unwinding", "Put-Call-Ratio", "Expiry"  and others so eloquently put forth by your favorite TV anchors. You even think that since you don't dabble in F&O you don't need to know these terms. Wrong. Markets are highly correlated and what happens in spot/cash has a bearing in F&O and vice-versa and you must definitely know what's going on in F&O (even if you don't actually trade there), and understand these terms. In this article, we will examine some F&O terminology explain what they are with examples and then see how we can use them in understanding the trends in the market or a particular share better.

Futures

Let's deal with the Futures market first. A futures contract is something that you enter into to sell or buy something at a fixed date at a fixed price in the future. In the NSE, you can enter into futures contract in stocks as well as some indices. Futures and Options contracts are called Derivatives because their price is derived from the price of another security, in this case the price of a share in the spot market or the spot market index value. People who primarily engage in futures trading are speculators/traders who bet on the price of a stock or the index to go up/down and hedgers who have an opposite position in the spot market (e.g. they will sell futures if they are long in the spot market) and wish to safeguard against massive losses in case the market turns in the opposite direction of their spot bet.

In Margin trading, we saw how we could leverage the money we have in our trading account to buy or sell larger quantities of shares than we actually have the capability for in the spot market. The problem with margin trading though is that eventually you have ulcers trading this way because you are trading on what the future may look like in the next few minutes or hours - basically you need to square off your trade within the same day (with a few exceptions for margin buys which can be dragged to 5 days with some brokers).  But what if you wanted to take longer duration bets say for a month, or two months or three months even? i.e. you expect the price of a stock to go down or up but within the next one/two/three months.

Differences with spot market margin trading

Well the futures market is for you then where you take bets on the future price of a share or the index and the future date could be in hours, days or months. Apart from the time factor, there are a few other important differences from spot market margin trading:

1. No delivery and Expiry Dates. There is no actual delivery of shares that will take place between buyer and seller. Instead, what you are entering into are contracts to buy or sell a particular share (called the "underlying" because the contract is priced based on the price of the underlying share's spot market price) within a specified date. This date is called "Expiry Date".

Typically, there are three contracts that are running in the same share at the same time. If you visit NSE Futures quote for REC, you will see there are three expiry dates. One for the "near month" (the first quote which is for the immediate upcoming date), one for the "middle month" (the second quote which is for the date that comes after the immediate upcoming date) and one for the "far month" (the third quote). Each one is also called a "series" e.g. Feb series, Mar series and Apr series.

So, if you bought or sold a REC contract with an expiry date in the near month, then you must square-off before the expiry date or else it would be "settled" in cash on the day of expiry based on the price of the underlying in the spot market.  i.e. say you bought REC futures with an expiry date of 28-MAR-2013 at a price of 235 and you didn't square it off by selling REC futures with the same expiry date (before 28-MAR-2013), then on the 28-MAR-2013 based on the (usually closing) price of REC in the spot market the difference is either required to be paid by you OR any profit is paid to you. So if the closing price on 28-MAR-2013 is above 235 you are in profit and if it is below 235 you are in loss. Brokerage and Statutory charges of course are extra to be paid by you, so you need to subtract that from your profit or add it to your loss.

No delivery also means that you cannot convert your futures trade into delivery. i.e. you cannot Sell a futures contract and then say you will deliver physical shares or Buy a futures contract and take delivery of physical shares(not in NSE atleast so far).

2. Market Lots: You cannot buy or sell an arbitrary number of shares, but only deal in the market lot prescribed by the exchange. So for REC one market lot is defined as 1000 shares. So you can only trade in market lots prescribed by the exchange which is in multiples of 1000 shares (1 lot) for REC.

3 Longer square-off time: While all spot market trades have to be settled within the day, in the futures market you have upto the expiry date of the contract to square off.

4 Index trading. You can also trade in Nifty futures (NSE) , Sensex futures (BSE) which has the respective index as the underlying. Each index point is treated usually as equivalent to Re.1.

5 Tax treatment. F&O trading for most people will be treated as .Business income. Recall that spot margin trading was treated as speculative income. The problem with speculative income is that only speculative losses can be set-off against speculative profits. With business income, you can set-off any losses against any income other than income under head Salary.

6. Margins. Similar to spot market margin trading, you are required to maintain margins here too. Because the length of the trade is much longer, it is typical to pay higher initial margins in Futures. Further, minimum margin percentages may be changed during the course of the contract. Additional margin (mark-to-market) may need to be deposited on a daily basis based on whether the trade is going in your favor or not.

Terminology

Let's deal with some terminology now. 

1. Open Interest: This is by far the most often used term in business channels, so this must have some significance. So what is open interest? Open interest is basically the total number of open positions in a particular contract . What does this open interest mean in the futures context? 

So let us say today is 29-MAR-2013 and the 28-MAR-2013 series expired yesterday. So a new series is going to start on 29-MAR-2013, the far month series which is the June series with an expiry date of 27-JUN-2013 (the last thursday of the month). Now because the June series has just started on 29-MAR-2013 let us assume that no trades have happened yet for this series. 

So let us say the first contract for the June series is traded for REC and 2 lots were traded (i.e. one person Ram bought 2 lots and another Shyam sold 2 lots to this buyer). So open interest now rises by 2000 and total open interest for the Jun series of REC is currently 2000 because this was the first trade (market lot for NSE is 1000 so 2 contracts * 1000 = 2000). 

Now let us say  Supreet decides to buy 1 lot and Ram ( who has already bought 2 lots) decides to square off one of his lots and sells it to Supreet. Now open interest is unchanged because the 1 open lot simply got transferred from one person (old buyer) to another (new seller). 

Now let us say John (new buyer) decides to buy 1 lot from Jane (new seller), open interest again increases by 1*1000 so the total open interest now is 3000. 

Now later in the day, let us say Supreet (old buyer now turned seller) decides to sell his 1 lot to Jane (old seller now turned buyer). Now Jane is buying to cover her position of 1 sell from earlier and Supreet is selling to cover his position of 1 buy from earlier. Both are closing off their old trades, so open interest will now reduce by 1000 (1*1000) and now total open interest in the Jun series REC is back to 2000. 

This goes on throughout the day and open interest increases and decreases this way. Open Interest gets carried over to the next day and basically becomes zero on the day of expiry which in this case is 27-JUN-2013. 

2. Cost of Carry and Futures prices: Because futures contracts are contracts for buying or selling the underlying (in our case the index or shares) at a future date, the buyer must give some sort of compensation to the seller for waiting for the number of days or months till expiry. For instance, if we promised a second hand car seller to buy  a car worth 1 lakh today from him 30 days later, the second hand car seller won't sell it to us for the same 1 lakh 30 days later. This is because he has lost interest on that money for 30 days had he sold it to someone else today. So you need to pay some interest money to the car seller. The car seller is also incurring other expenses such as storage cost and maybe insurance for this 30 day period. He will add all these expenses and then enter into a contract with you for 1 lakh + those expenses to be paid by you on that future date. 

Stock and index futures too follow a similar pricing model. The additional expenses incurred by the seller will be priced into the future contract. The expenses in the case of stocks and index futures usually is only interest income. However, in the case of stocks and the index, sometimes the seller may receive some dividends while holding the asset to be sold at a later date. So these inflows will be deducted from the interest income lost to arrive at the final price of the future contract. 

E.g. Let us say Tata Steel is priced in the spot market at 358.9 (the underlying price). The futures contract is for the 28-MAR-2013 expiry and today's date is 11-MAR-2013 so there are 18 days left. Let us assume the interest the seller would have earned on the money realized had he sold the stock in the spot market and kept it for 18 days is 9% p.a. So what would be the futures price of Tata Steel?
It would simply be Spot Price + Spot Price*Interest for days left (18). 

How to calculate fair futures price
Spot price358.9
Interest Rate assumed9.00%For 365 days
Days left18
Interest Rate 0.44%pro-rated for days left
Futures price360.49

So what's cost of carry? Cost of carry is the cost of carrying this position which we have now seen to be as 9% if we entered into a contract at the price of 360.49 in the futures market for the 28-MAR-2013 expiry in Tata Steel. This is what the NSE website shows you as well in the Cost of Carry section. Tata Steel futures quote and cost of carry on NSE (simply as 9 without the percentage symbol).

3. Rollover: So we just said that all futures contracts need to be squared-off or they will get settled on the day of expiry. But what if you wanted to continue your position into the next series? Well you can. Rollover is when you carry your existing position into the next series or the far series. You need to first square-off your position in the current series that is expiring and then take a fresh position in the new series. Any difference in rates between the current series and the new series has to be borne by you (including any brokerage, statutory fees for the two transactions). Rollovers percentages (the percentage of new positions in the current series that were carried from the previous series) are usually not disclosed by the exchange instead they are calculated by brokerages and other financial institutions.

The rollover calculations are a best guess because it is not possible to know for sure if the same people who closed their positions in the previous series were the same people who took the new positions in the following series.It may be that some people closed their positions int he current series and a different set of people took a similar position in the new series.

4. Volatility:  Volatility in the financial world indicates the range of outcomes you can expect. For instances, the throw of a dice has the expected outcomes of 1 to 6. Similarly, when you buy a stock or an index its price volatility indicates the range of returns. Higher the volatility number, the higher is perceived its risk. Higher volatility also means potential for higher returns and higher losses. For instance, on 11-MAR-2013 DLF has a daily volatility as reported on NSE as 2.99 (annualized as 57.09) whereas ITC has a daily volatility of 1.12, HUL is 1.67 and Tata Steel is 2.02.

There are two kinds of volatility numbers reported. The first is Daily Volatility which we saw above for futures. The second is Implied Volatility which we will see in Options later.

5. Arbitrage: Let us say you have a buyer for a particular model new car in one city for 5 lakh and a willing dealer for the same new car in another city for 10,000 less in the same state. The transportation costs for this car is 4000 to the other buyer's city. So if you made both deals at the same time - buying the car in one city and simultaneously selling the same car in the other you stand to make a risk free profit of 6000 = 10,000 - 4000. This is basically the idea of arbitrage. Arbitrage in our context is the difference in pricing between the futures and spot market for the same underlying share taking into account the dividends that are due in that series and the interest rate.

So lets say DLF is quoting in the spot market at 300 and the futures price for the March series is 320. Let's assume  there are 18 days left to expiry. Let us say you took advantage of this large difference and bought DLF in the spot market at 300 and sold the futures contract at 320 in the futures market. On settlement day, the price of futures and spot converge (say at 305), so on the day of settlement you execute the reverse trade to square things off, sell in the cash market at 305 and buy the futures at 305. You have now ended up where you started except that you pocketed the difference of 20 rupees minus all the (brokerage + statutory charges + income tax). Say you dealt in one lot (1000 shares) of DLF, the money you would have needed to execute such a trade was 300*1000 = 300,000. Assuming you had the money handy with you what would you have earned as a risk-free return on this money..perhaps around 8% being the Govt. of India 10-year bond yields currently. If you calculate that interest for 18 days that would come to about 1183. Here you have earned before expenses and taxes 20*1000 = 20000 in 18 days. Even if 50% of that was expenses and taxes, you have earned nearly 10 times the risk-free return.

Realistically though such arbitrage opportunities are rare. The truth would be closer to around single digit higher percentages than the risk-free return when such opportunities arise.

There are other types of arbitrages available such as a difference in BSE and NSE prices, reverse arbitrage opportunities where the futures price (interest adjusted or not) is less than the spot price. There are entire mutual funds that are dedicated to finding and making money from such arbitrage opportunities.                                                    

How do we determine trends based on open interest?

Let us study a few more terms that you hear often on TV.

6. Long buildup: As we all know longs are taken when someone is bullish about the market or a particular share. So let's say the market in general is bullish about REC. We see new contracts being created (open interest is increasing) at higher and higher prices each day. This is called long buildup when an increase in open interest is accompanied by increase in prices. A long buildup confirms an upward trend in prices and the trend is likely to continue.

7. Long unwinding: So the bulls have been at it for a few days and now the price of REC has reached slightly astronomical levels, so what is that the bulls do now? They start squaring off their positions. When this happens open interest starts to fall accompanied by a fall in prices because there will be a lot of sellers in the market so the buyers will demand lower prices. This is called long unwinding when open interest is falling along with a fall in prices. A long unwinding tells us that the upward trend in prices has started to end.

8. Short buildup: Short buildup happens when the market is in general bearish about the stock. So new contracts are being entered into (open interest increasing) at lower and lower prices. This trend when there is an increase in open interest accompanied by a fall in prices is called short buildup. A short buildup confirms a downward trend in prices and that the trend is likely to continue.

9. Short covering: So after a while, the bears decide to take some profits so they start covering their short positions. When this happens open interest starts reducing accompanied by an increase in prices because there will a lot of buyers in the market so the sellers will now demand higher prices. This is called short covering when open interest is decreasing along with an increase in prices. Short covering tells us that the price fall trend has started to end.

10. Settle price: Each day the exchange arrives at something called as a settle price which is the closing price (doesn't mean the last traded price) as determined by a formula of the exchange. This settle price is used to calculate the mark-to-market losses for all positions to determine additional margin to be paid by people under a loss and credit margin to people under a profit. This price is deterrmined each day till expiry.

On the NSE you can see historical data for any futures security. I have taken the Settle Price and Open
Interest (OI) from the NSE website for certain days for Tata Steel and Wipro for illustrating trends. OI trend is calculated simply as (current day's OI - previous day's OI/previous day's OI) and similarly for the Price trend. The analysis section states what we have just discussed earlier.


TATA STEEL
DateSettle PriceOIOI trendPrice trendAnalysis
08-Mar-2013360.7515921000-3.26%2.37%Short covering
07-Mar-2013352.4164580002.29%-0.62%
06-Mar-2013354.616090000-4.49%2.34%Short covering
05-Mar-2013346.5168470000.08%2.88%
04-Mar-2013336.8168340002.58%-1.94%Short buildup
01-Mar-2013343.45164100001.83%-0.19%
28-Feb-2013344.116115000




WIPRO
DateSettle PriceOIOI trendPrice trend Analysis
08-Mar-2013446.153364000-4.21%-1.17%long unwinding
07-Mar-2013451.45351200010.16%1.70%long buildup
06-Mar-2013443.931880005.25%2.10%long buildup
05-Mar-2013434.75302900010.51%3.34%long buildup
04-Mar-2013420.727410004.26%-0.52%
01-Mar-2013422.926290001.27%0.91%
28-Feb-2013419.12596000

Usually, you cannot look at just Open Interest only for gauging trends. It is better to see other indicators as well because sometimes the traded volumes may not be very high.


How do we determine trends based on daily volatility, rollovers and cost of carry?

Daily volatility: Generally an increase in daily volatility is considered bearish whereas a lower volatility is considered bullish.

Rollovers: A higher percentage of rollovers usually compared to the 3-month average for the underlying scrip or index means that the current trend (bullishness or bearishness) is strong and likely to continue. A high percentage of rollovers means people who believe the current trend will continue are high and so they stay in their respective positions longer. A lower percentage of rollovers compared to the average means that there aren't sufficient people willing to bet on the current trend continuing. 

Cost of Carry: Increasing positive cost of carry usually indicates a bullish trend and an increasing negative cost of carry usually indicates a bearish trend. Usually cost of carry is also read with rollover numbers during the beginning of a new series to gauge trends. High rollover coupled with increasing positive cost of carry indicates a bullish trend and a high rollover with decreasing cost of carry would indicate a bearish trend.

Conclusion

We have seen some of the terminology explained in this article with respect to Futures and how to use the data that is presented to understand trends. In the second part of this article we will understand terminology specific to Options such as puts, calls, put-call-ratio etc. and how to gauge trends using them.