BASIC TERMINOLOGIES OF DERIVATIVE MARKET
Spot Price - The price at which an asset trades in the cash market.
Futures Price - The price of the futures contract in the futures market.
Contract Cycle - It is a period over which a contract trades. Every futures contract expires on last Thursday of respective month. And, a new contract is introduced on the trading day following the expiry day of the near month contract.
Expiration Day - The day on which a derivative contract ceases to exist. It is last trading day of the contract. It is the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. On expiry date, all the contracts are compulsorily settled. If a contract is to be continued then it must be rolled to the near future contract. For a long position, this means selling the expiring contract and buying the next contract. Both the sides of a roll over should be executed at the same time. Currently, all equity derivatives contracts (both on indices and individual stocks) are cash settled.
Tick Size - It is minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts as part of contract specification. Bid price is the price buyer is willing to pay and ask price is the price seller is willing to sell.
Contract Size and contract value - Futures contracts are traded in lots and to arrive at the contract value we have to multiply the price with contract multiplier or lot size or contract size.
Basis - The difference between the spot price and the futures price is called basis. If the futures price is greater than spot price, basis for the asset is negative. Similarly, if the spot price is greater than futures price, basis for the asset is positive.
During the life of the contract, the basis may become negative or positive, as there is a movement in the futures price and spot price. Further, whatever the basis is, positive or negative, it turns to zero at maturity of the futures contract i.e. there should not be any difference between futures price and spot price at the time of maturity/expiry of contract. This happens because final settlement of futures contracts on last trading day takes place at the closing price of the underlying asset.
Cost of Carry - Cost of Carry is the relationship between futures prices and spot prices. It measures the storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on the asset during the holding period. For equity derivatives, carrying cost is the interest paid to finance the purchase less (minus) dividend earned.
For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A person wishes to buy the share, but does not have money. In that case he would have to borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this share for one year and in that year he expects the company to give 200% dividend on its face value of Rs. 1 i.e. dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend received = 6 – 2 = Rs. 4. Therefore, break even futures price for him should be Rs.104. It is important to note that cost of carry will be different for different participants.
Margin Account
As exchange guarantees the settlement of all the trades, to protect itself against default by either counterparty, it charges various margins from brokers. Brokers in turn charge margins from their customers.
Brief about margins is as follows:
Initial Margin
The amount one needs to deposit in the margin account at the time entering a futures contract is known as the initial margin. Let us take an example - On November 3, 2015 a person decided to enter into a futures contract. He expects the market to go up so he takes a long Nifty Futures position for November expiry. Assume that, on November 3, 2010 Nifty November month futures closes at 8000. The contract value = Nifty futures price * lot size = 8000 * 75 = Rs 6,00,000. Therefore, Rs 6,00,000 is the contract value of one Nifty Future contract expiring on November 26, 2010.
Assuming that the broker charges 10% of the contract value as initial margin, the person has to pay him Rs. 60,000 as initial margin. Both buyers and sellers of futures contract pay initial margin, as there is an obligation on both the parties to honour the contract. The initial margin is dependent on price movement of the underlying asset. As high volatility assets carry more risk, exchange would charge higher initial margin on them .
Marking to Market (MTM)
In futures market, while contracts have maturity of several months, profits and losses are settled on day-to-day basis – called mark to market (MTM) settlement. The exchange collects these margins (MTM margins) from the loss making participants and pays to the gainers on day-to-day basis.
Let us understand MTM with the help of the example. Suppose a person bought a futures contract on November 3, 2015, when Nifty was at 8000. He paid an initial margin of Rs. 60,000 as calculated above. On the next trading day i.e., on November 4, 2015 Nifty futures contract closes at 8100. This means that he/she benefits due to the 100 points gain on Nifty futures contract. Thus, his/her net gain is Rs 100 x 75 = Rs 7,500. This money will be credited to his account and next day the position will start from 8100.
Open Interest and Volumes Traded
An open interest is the total number of contracts outstanding (yet to be settled) for an underlying asset. It is important to understand that number of long futures as well as number of short futures is equal to the Open Interest. This is because total number of long futures will always be equal to total number of short futures. Only one side of contracts is considered while calculating / mentioning open interest. The level of open interest indicates depth in the market. Volumes traded give us an idea about the market activity with regards to specific contract over a given period – volume over a day, over a week or month or over entire life of the contract.
Price band
Price Band is essentially the price range within which a contract is permitted to trade during a day. The band is calculated with regard to previous day closing price of a specific contract. For example, previous day closing price of a contract is Rs.100 and price band for the contract is 10% then the contract can trade between Rs.90 and Rs.110 for next trading day. On the first trading day of the contract, the price band is decided based on the closing price of the underlying asset in cash market.
For example,
Today is first trading day of a futures contract for an underlying asset i.e. company A. The price band for the contract is decided on the previous day’s closing price of company ‘A’ stock in cash market. Price band is clearly defined in the contract specifications so that all market participants are aware of the same in advance. Sometimes, bands are allowed to be expanded at the discretion of the exchanges with specific trading halts.
Positions in derivatives market
As a market participant, you will always deal with certain terms like long, short and open positions in the market. Let us understand the meanings of commonly used terms:
Long position - Outstanding/ unsettled buy position in a contract is called “Long Position”. For instance, if Mr. X buys 5 contracts on Sensex futures then he would be long on 5 contracts on Sensex futures. If Mr. Y buys 4 contracts on Pepper futures then he would be long on 4 contracts on pepper.
Short Position - Outstanding/ unsettled sell position in a contract is called “Short Position”. For instance, if Mr. X sells 5 contracts on Sensex futures then he would be short on 5 contracts on Sensex futures. If Mr. Y sells 4 contracts on Pepper futures then he would be short on 4 contracts on pepper.
Open position - Outstanding/ unsettled either long (buy) or short (sell) position in various derivative contracts is called “Open Position”. For instance, if Mr. X shorts say 5 contracts on Infosys futures and longs say 3 contracts on Reliance futures, he is said to be having open position, which is equal to short on 5 contracts on Infosys and long on 3 contracts of Reliance. If next day, he buys 2 Infosys contracts of same maturity, his open position would be – short on 3 Infosys contracts and long on 3 Reliance contracts.
Naked and calendar spread positions
Naked position in futures market simply means a long or short position in any futures contract without having any position in the underlying asset.
Calendar spread position is a combination of two positions in futures on the same underlying - long on one maturity contract and short on a different maturity contract. For instance, a short position in near month contract coupled with a long position in far month contract is a calendar spread position. Calendar spread position is computed with respect to the near month series and becomes an open position once the near month contract expires or either of the offsetting positions is closed.
A calendar spread is always defined with regard to the relevant months i.e. spread between August contract and September contract, August contract and October contract and September contract and October contract etc.
Opening a position - Opening a position means either buying or selling a contract, which increases client’s open position (long or short).
Closing a position - Closing a position means either buying or selling a contract, which essentially results in reduction of client’s open position (long or short). A client is said to be closed a position if he sells a contract which he had bought before or he buys a contract which he had sold earlier.
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