Futures Or Options ?

Dear Friends

1. Wanted to know whether Trading On Futures Or Options are the same . Both of them are same Lots and all.

2. And one more thing i wanted to know is that suppose i buy Nifty Futures @ 1900 And a Call(Option) Of 1900 @ 50 and at the end of the month Nifty is @ 1975. I want to know whether i would get the same Profit in the Call(Option) of 1900 as i am getting in Futures ? If Not Why ?

Sorry if theres any mistake in this question. -NewBie-

Regards.
-[NewBie]-

Hi Newbie,

1. Futures and options are not the same. The risk profiles of the two are very different.
On initiation of a futures contract you have to put up an Initial Margin (IM) which may range from 8 to 15%, based on the Index or stock. More volatile the stock, more the IM. Then you have a daily mark to market margin (MTM) which adjusts your profit/ loss on a day to day basis to reduce the default risk of market participants. This maintains market integrity. The procedure is the same, if you are short or long futures. The IM varies somewhat for long/ short positions, but thats not too important for now. For a futures buyer or seller, the potential for profit or loss is unlimited.
For options, the buyer only pays a premium and his maximum loss is limited to the premium paid. The profit potential however is unlimited. Once an option buyer pays the premium, there is no further cash flow implication until he squares off, exercises the contract, or the contract expires. If the option ends up out of the money (current price < strike price for calls, current price > strike price for puts), then there is no cash flow implication at all, and the premium paid is forfeited.
The option seller however, has a limited profit (to the amount of premium received) and unlimited loss profile. In addition, an option seller also has to post margins, to protect the option buyer from the seller defaulting.

2. No, the profit you would get under the two scenarios you have described would NOT be the same. By buying the Nifty 1900 call @ 50, you are implying that the Nifty index is around 1940 levels atleast, at the time you bought the call. That would be around Rs. 40 for the intrinsic value of the call, and around Rs. 10 for the time value (this breakup if just for an example. Could be Rs. 48 for intrinsic value and Rs. 2 for time value. The breakup would depend on the time to expiry of the call). On the other hand you are buying the futures at 1900. This would mean that the Nifty is around 1900 levels. The main reason for the difference between the profits achieved for futures and options is the fact that you have bought the future and the call at different levels of the Nifty. For the profit achieved to be same, the strike price + premium for the call should equal the futures price.

Hope this clears things somewhat.

ivanboesky, you explain the basics as well as traderji. Its always a pleasure to brush up the basics.

Why don't you take it a bit further. For instance for options, one has to first calculate the historical volatility, then calculate the current price through the options calculator. If the current price is greater than actual price, there is implied volatility which again is applied for future price projections at the time of settlement. I am aware of this but not too sure; I am sure an example will help.

Also, there is so much of other info flying around like daily F&o turnover, cost of carry, open interest, FII derivative exposure. How does all this really effect the individual trader in making decisions. Open interest is like volume but what about the rest? Also the discount(difference between futures and cash) has a bearing with increasing discount indicative of shorting; what is abnormal discount or it would be different for different scrips I suppose. Abnormal cost of carry(30+) during overbought conditions may point towards reversal but that apart how else is it helpful? I am sure if you help seperate the wheat from the chaff- irrelevant from relevant info, ppl will appreciate.

Thanks for the lucid writeup again, by the way

Hi sh50,

Lets take it one at a time. First, historical volatility and implied volatility. The historical volatility is what is used in the Black-Scholes model to calculate the call and put prices. When we compare this theoretical value with the actual prices in the market, we find that they frequently differ. This could be coz people use different risk free rates (their incremental cost of borrowing), or different historical volatilities (coz of using differing time periods). The volatility figure is mainly responsible for the difference. Higher volatility estimates result in higher option prices.

Implied volatility exists in all cases. When the market price of an option is greater than the theoretical price, the implied volatility is higher than the historical volatility, and vice versa.

People tend to sell options with high implied volatilities, and buy options with low implied volatilities.

The implied volatility is used in an Index called the Volatility Index (VIX). This Index is also called the Fear Index. When the implied vols are high, there is either fear or greed in the market (high implied vols on calls would imply greed, and high implied vols on puts would imply fear). These points generally signify turning points in the market. Low implied volatilities would imply complacency, and the market could break in any direction.

Am attaching an Excel sheet, where first the option prices are calculated, and then using goal seek, the implied vols are calculated give the market prices. Data used is for 3rd May. The reason here for calls having such a low implied volatility is that the market is currently pricing calls using the Nifty futures (and not the Nifty index), and puts using the Nifty index. Can anyone suggest a suitable arbitrage strategy to take advantage of this?

Attached Files

OptionPricing.zip (2.3 KB, 172 views)

From a buyer's perspective, let us assume that he decides to buy puts or calls. Depending upon the degree of bearishnes/bulishness we can follow the fancy option srategies but after buying do you really need any fancy software to monitor the increasing/decreasing profitability or you just apply good ol common sense and sqare off when the mkt turns against you before the settlement.

Thanks again. My knowledge of all this is in the midwife stage category and high time we gave birth to a new trend.

I agree with your one by one philosophy. Here too people should thank you one by one if you are able to clarify how all this fancy lingo and info that CNBC goes around spouting relevant from the Individual trader's perspective. Much of it is bound to be like heroines in some hindi films; style without substance and we maybe better off oggling at CNBC women(better option anyway) rather than listen to irrelvant stuff.

By the way all are derivatives of nifty so if a call is priced on basis of future instead of nifty, what are the implications/

From a speculators angle, assuming you bought a call or put, then the best time to unwind would be when you feel the market has peaked out or bottomed. The problem is in knowing when the market has peaked out or bottomed. Most people use technicals for this purpose.

Trading on volatility, as I described earlier, involves taking a position in an option and in the underlying stock/ future. If a call option is overpriced, that is, its implied volatility is higher than the historical volatility, buy the underlying and sell the call option. When the volatility comes back to its historical level, reverse the transaction. You make the difference... and time decay of options is very fast for short-term options!!

The Nifty futures are a proxy for the Index. Buying all the stocks in the index involves high brokerage, STT etc. apart from the impact cost of executing the trade. If you buy the Nifty futures, you do the same thing but with lower brokerage and impact cost. Take the current scenario. The futures are trading at a 20 pt discount to the Nifty. If the calls are priced using the Nifty as a reference, an arbitrageur can make a risk free profit by buying the futures and selling the calls. He gains in two ways... one, by expiry the discount disappears, and two, he makes money on the time decay of the call option.

As far as CNBC F&O analysis goes, the less said the better!! Maybe we can dedicate an entire thread to that discussion.

Great,man. You could be an asset to a trading school
What calls would you recommend in the current scenario. Since we are in a 1900-1970 range which could go either way, would you recommend calls around 1970 or as this is just the beginning of the month, maybe around 2000. Somebody was recommending selling a 1900 straddle today. Any comments?
I must specifically appreciate this. Very good tip. Supposing implied volatility is lower than historical volatility, is it vice-versa for arbitrage?

Nice of you to touch nifty futrures. There are lots of posts with wonderful graphs without explanation of some other points unless I have missed them?Let is focus on nifty futures alone. Help us weed out useless info briefly:-

1) I understand discount of 20 or more implies heavy shorting which implies mkt could reverse because of short covering. Any comments. Feel free to add whatever you want to if anything else to be kept in mind apart from selling calls which you have already recommended.
2) Is one supposed to monitor open interest- on the short or long side from nse website. Otherwise open interest would act as volume- increase with increase or decrease in price continuation of trend or reversal?
3) Cost of carry- This would apply more to individual stock futures.
4) Foreign mkts- ppl also monitor how asian mkts respond to foriegn mkts.
5) Total F&O turnover- is it worth monitoring? Isn't nifty volume and open interest enough.
6) Nifty put call ratio- god alone knows how relevant it is in India
Thanks a million once again. If there is anything grossly wrong, don't hesitate in point it out. Basically while trading nifty futures, what other things have to be kept in mind . This is a synopsis from moneycontrol website:-

Volumes low, turnover at Rs 7,989 crore (Rs 79.89 billion)
Nifty Futures shed 4.7 lakh shares in Open Interest
Nifty Futures trim discount to 9.5 points
Nifty Open Interest Put-Call ratio at 0.89
Activity seen in Nifty Put Options
Nifty Puts add 2.42 lakh shares in Open Interest
Nifty 1900 Put adds 1.12 lakh shares in Open Interest
Nifty 1880 Put also sees build-up
Top trades: Tata Steel, Tata Motors, RIL, Satyam, OBC, Arvind Mills
OBC adds 14.6 lakh shares in Open Interest
Satyam, Wipro, Infosys sheds Open Interest
Maruti adds 3 lakh shares in Open Interest
Tata Steel and SBI add 3 lakh shares in Open Interest
GAIL, NTPC, ONGC shed Open Interest
FII action: Net sell Rs 37.50 crore (Rs 375 million) on Friday
FII action: Net sellers in Nifty Futures, but buy Nifty Options
FII action: Open Interest at Rs 9,782.64 crore (Rs 97.82 billion)

It sounds very nice talking in parties like this and sounding knowledgeable in front of others but for individual trading, how much of all this is relevant? If you can just breifly enlighten us, we shall be deeply grateful. There is no end to information and analysis otherwise.Thanks

By the way I may have gone overboard a bit but you gotta hold on to a good trend.

Even if you just tell relevant/irrelevant with a brief explanation(otherwise confusion), that will suffice. You can take your own sweet time over the weekend. THanks

Hi,

Sorry for the late reply, but been caught up in too many things at the same time. Did not want to post anything that was only half-baked.

1. Yes, a discount of 20 points could mean heavy shorting. But then with many Nifty companies announcing dividends now, and the ex-dividend dates in May, a part of the discount could be attributed to that. The dividends have been impounded into the stock price and the price will drop on the ex-dividend date to adjust for it. This will lead to the Nifty falling, but the futures will not fall, thus reducing the discount. The remaining discount is shorting by speculators, or hedging by people with long positions in the cash market. In the event of some positive news, or toward expiry, short-covering will take the markets up. One way to take advantage is to long the futures and short the market. However, it is not possible to short the market, so we do this: long May futures and short June futures (This is assuming that the June futures are trading at a premium, or at the same level of the May futures). Toward expiry, the May futures will converge to the Nifty, and if there is still a bearish sentiment, the June futures will still be at a large discount. Made quite a lot of money doing that between the April and May futures last month!! Got into the position at a debit of 2 points and exited with a credit of 25 points. Not bad for a low risk trade.
2. Foreign markets - In todays world, where capital flows are almost free, something that happens in some part of the world or Asia could potentially affect us (Chaos theory). Gives us some idea of the sentiment around the world. If we look at other emerging markets too, we could have an inkling of whats coming, coz there will be a lot of common investors across these markets.

Okay, now I'll try and tell you how I look at all these indicators in sync. Forget about CNBC and theories expounded by so called "experts" appearing on these business networks. First, look at the price - up or down. Then look at the change in the Open Interest and cost of carry. If the price has fallen, open interest (OI) has increased, and the cost of carry (CoC) has reduced, then be sure that the downtrend will continue. If the price has risen, OI has increased, and the CoC has increased, then the uptrend should continue. The problem is that you will encounter such clear cut situations very rarely. If you see that a stock is falling, but there is an increase in OI, accompanied by an increase in the CoC, the stock may be approaching a support, and people are playing for the bounce. You have to develop you own rules and stick to them. I also use abnormal volume changes to add another dimension to this analysis.

F&o turnover and OI signifies the level of interest in the market. F&O volumes much larger than cash market volumes, and a high OI, signify froth in the market and a correction could be imminent. Also check out the FII activity in the F&O market. This gives a good idea of what they are doing in the F&O market, and what they could do in the cash market.

As for the Put call ratio (PCR), it could be used in conjunction with some other analysis. Dont know how much it can do on its own. Some use the PCR as a contrarian indicator, while some use it in a straighforward or intuitive way. I dont use it too often anyway.

Hope to address some other queries at some later point. Still busy!! Hope I have not goofed up anywhere in this post.

Will the GM and Ford downgrade trigger a "flight to safety"?

Great post......Keep 'em coming,ivan boesky(interesting name from the Wall Street of 80's)........and thanx!!