Investing in Futures and Options Essay

INTRODUCTIONOf late, investors who argon in the burgeon forth and trade good argon focusing their attention to cont finaleds military issue a chance prudence e special(a)ly due to spunky school excit suitableness nature.Since these excitability bowel movements argon uncertain, it has be vex fore closely cause of vagueness for such investors. Since the globalization of swap and free trade amid major countries has be f atomic number 18 the order of the day, any most all the investors halt to be below mercy of the substitute assess fluctuations which aftermaths in unpredictability .The nonion that commutation rank , meshingability and former(a) factors influence a firms quantify and therefore the hurt of its well-worn is widely held by fiscal analyst ,economists and corpo come in managers .The liberalization of economic policies and investing policies due to world trade constitutions (WTO) free flow of investments and trade among member countries and bilatera l free trade agreements between countries cause augmented internationalization of economic activity and exceptional era of world wide capital and pertain appreciates instability. To replication these monetary riskinesss, impertinently pi whizzering concept commodity and stock foodstuffplace hedgerow techniques submit nurtured at a rapid speed. The main feature of the using contraryials finished hedging is to have accountant oer the financial risk and minimizing the effect of uncertain cash flows.Financial institutions have come to rescue to these corporations who have exposure to financial risk with the be given of products to assist in risk management. By far the most signifi quite a littlet answer in finance during the past decade has been the extraordinary ontogeny and expansion of financial deriveds. These instruments enhance the ability to differentiate risk and allocate it to the investors most able and free to take it a a tho that has undoubtedly impro ved national productivity growth and standards of living . Allen unfledged Span, Chairman, Board of Governors of the US Federal Reserve System.The structural advantage of derivatives i.e. leverage or gearing becomes them capable for managing risk move also result in the generation of leveraged scratch or in the event of adverse commercialise movement , a significant losses. The main advantage of gearing is that the procureer or seller need only to cough up a shrimpy proportion of total worth at the time of deal is executed.It may be 1% and 8% depending upon the volatility of the chthonianlying commodity or instrument. In the case of ex channelize traded transactions, this deposit is recognized as initial margin and is evaluate to reflect the amount by which the hurt of a contract may vary in unity days trading. At the day end, all contracts pull up stakes be valued and if the harm has been represent to move against the position, the losing party will have to pay fur ther variation margin calls. In contrary, if the legal injury movement is positive, credit will be given to the party .It is this element of gearing that provides the opportunity to make super gains or losses.Prudent handling of this leverage will result in considerable profit maximization and if it accostd inexpertly, may gene roam losses .In some cases , these losses though high but they are few in number when measured against volume of clientele and number of participants in derivative business .The contributory factors for sustaining loss includes excessive position taking ( in relation to capital) , fraudulent activity , surprising foodstuff moves, ineffective risk management, insufficient product understanding and inadequacies in corpo regulate policy governing body their use. What is a derivative?Derivative is a mathematical word which refers to a variable, which has been derived from some other variable and they have no values of their own. Derivatives derive their value from the value of some other addition, which is referred as the underlying.For instance, a derivative of the shares of AT & T Corporation (underlying), will derive its value from the share price (value) of AT & T Corporation. Likewise, a derivative contract on wheat depends upon the price of wheat.An agreement or an pick to profane or sell the underlying summation of the derivative up to a certain time in the afterlife at a prede termined price i.e. the exercise price by way of special contract is k in a flashn as derivative contract.The contract also has a flat expiry limit mostly in the range of 3 to 12 schedule months from the date of origination of the contract. The price of the underlying asset and the expiry period of the contract determine the value of the contract.Financial derivatives comprises of underlying financial asset handle property, debt instruments, equity shares, share price power etc. interchange-traded derivatives are derivative contracts that ha s been standardized and traded on the stock exchanges. Over-the counter derivatives is wizard which has been customized as per the requirements of the user by negotiating with the other party bear on.Some of the common forms of derivatives are Futures, forward and Options. FuturesFutures are the derivative contracts that give the holder the chance to buy or sell the underlying asset at a pre-specified price some time in the near future and usually thy come with standardized form standardised contract size, determined expiry time and price.The future market is one where continues auction market and exchanges presenting the recent information or so the show and demand as regards to individual commodities or financial instruments like stocks . In other words, future market is one where buyers and sellers of variety of commodities, financial instruments shorten together to trade. The main aim of the future market is to manage price risk.The future price risk is averted by buying or exchange futures contract, with a price level arrived at now, for items to be exhibited in future. This is achieved by hedging which helps to shield against the risk of an adverse price change in the near future or use of futures to lock in an acceptable margin between their purchase and their selling price.In futures, vernacularers, farmers, traders, manufacturers will arrange for the purchase or sale of a futures contract. In future market, commodities are befuddled down into five categories namely agriculture, metallurgical, beguile bearingassets, jndexes and foreign currency.Agricultural futures market includes oats, corn , wheat , soy saucebeans , soy meal ,soyoil,sunflower oil ,cattles , live hogs and pork bellies, lumber , plywood ,cotton, coffee, cocoa, rice, orange juice and sugar. For every one of these commodities, different contract months are available and it depends upon the harvest cycle. More aggressively traded commodities usually have to a greater extent contract months available and a new type of contract is available almost every month to meet the growing institutional and corporate market.Futures on Metallurgical ProductsPetroleum products and metals is being taged under this group and it includes platinum, gold, silver, palladium, copper, gasoline, crude oil, propane and heating oil. Every month a new type of contract emerges to run the needs of ever increasing institutional and corporate market.Assets which bears elicit This has its origin during 1975 and products in these categories include treasury bonds, Treasury Bills, Municipal Bonds, Treasury Notes and Eurodollar deposits. It is also possible to trade contracts with the same maturity but different expected interest rate differentials.Futures on IndexesNow futures are available on most chief abilityes such as New York Stock exchange Composite, S&P 500, New York Stock Exchange Utility index, Russell 2000, Commodity Research Bureau (CRB), S&P 400 Midcap, FT-Se ascor bic acid Index (London) and order line. These stock index features are settled in cash and there is no delivery of goods is involved in this method. A trader has to settle his positions by buying or selling an offsetting position or in cash at expiration.Foreign money FuturesDuring the post war period, the exchange rates and interest rates were stable and the mechanism of fixed exchange rates of the Bretton Woods era enabled the corporations to know in advance their foreign exchange liabilities for their imports.But the collapse of Bretton Woodss system after the war resulted in the creative activity of general floating exchange rates replacing the earlier fixed system. The introduction of floating exchange rates have resulted in large unexpected movements in exchange rates that too in unforeseen directions and magnitudes which affected interest rate movements as the monetary establishment seek to influence the exchange rates by movements in interest rates. It is to be noted tha t the forward market in currencies is much bigger than the foreign exchange futures market. Further, there are cross currency futures that are being traded and these includes Deutsch mark / yen, Deutsch mark / French franc. Forwards & OptionsForward is another form of a derivative contract but tailored to the needs of the user in terms of expiry date, contract size, and price.These contracts chatter the holder the option to buy or sell the under lying at a pre-determined price some time in the future .Call option is one where the buyer has given his option to buy the underlying at the near future .Where as an option to sell the underlying at a specified price in the future is called as Put Option. As regards to the option contract, the buyer is not obliged to exercise the option contract. Generally, options can be traded on the stock exchange or on the OTC.In option, the participants may assume a position in an underlying futures contract at a certain price which is cognise as exe rcise or strike price within a particular period of time. The price or premium of the option is determined through action market trading. SwapsSwaps contract was introduced in 1981 and can be considered as one of the latest financial innovations to manage financial risks. The contracting parties are obliged to exchange specified cash flows at specified intervals under a swap contract. In a nutshell, a swap contract can be defined as a serial publication of forward contracts put together. If the exchange of interest rate payments in one currency for payments in another currency is devised, then it amounts to a currency swap.If the exchange between both parties of interest obligations or receipts in the same currency on an agreed amount of bad bargainer for an agreed period of time is devised, then it is known as interest rate swap. An interest rate swap is an agreement between two parties to exchange interest payments calculated on different bases over a period of time. Under inte rest rate swap, one party to the contract makes fixed rate payments while the other partys payments are based on a floating rate such as LIBOR.For instance, if a company which has borrowed from a bank at a floating rate (7 m LIBOR) may want to swap that for a fixed rate (7m LIBOR) so that they can cover the risk if the interest rates go up. On one side, they pay 7% (of the agreed notional principal) and receive 7m LIBOR and on the other side they pay 7m LIBOR straight out to repay their loan. Thus they have converted a floating rate loan into a fixed rate loan.The said bank may manages its own risk from the above swap transaction by backing it out with another swap , say by paying 6.95% for 7m LIBOR and so they earn a profit of 0.5% difference thus avoiding the risk in the interest rate changes .The other different types of interest rate swap areBasis swap For instance, swapping 2m LIBOR for 4m LIBOR. Basic swaps are mostly used by owe companies because the get the mortgage paymen ts on monthly basis.Both fixed Currency Swap Both fixed and say fixed $ for fixed Both floating currency swap 2m $ LIBOR for 4 m Yen LIBOR.Cross Currency Swap fixed for 2m CHF LIBOR.Companies derive to a greater extent flexibility to exploit their proportional advantage in their various(prenominal) borrowing markets under currency swaps. Under interest rate swap, corporations try to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long end of the maturity spectrum. USES OF DERIVATIVESDerivatives are mainly used for speculation or hedging. For speculation, derivatives turn us leverage.For instance, instead of buying 5Million bond in the anticipation that its price will rise up, one can buy an option on that bond, which might only cost 2000. The profit chances or opportunities are the same less the price of the option but the risk is much less as the most we can loose in this deal is the option price ( 2000 ).For hedging, derivatives let you to seal the price now for a trade in future or at least limits the rise or impress of that price. An UK company holding a US bond which is on the verge of its maturity could buy an interest rate option to guarantee the dollar / sterling rate did not diminish the value of its bond. volatility is regarded as the most precise measure of risk and its return. The greater the volatility, the greater the risk and the reward as it is evidenced in the transaction from bull to bear markets. It is to be observed in the bearish market, volatility and risk augment while returns disappear including short selling returns. HistoryThe very first exchange for trading derivatives started by Royal Exchange in London, which allowed forward contract. Likewise, the first future contract was introduced to Yodoya rice market in Osaka, Japan in 1650. Then in 1848, Chicago Board of Trade was started to handle futures market of US.Russell Sage, a famous New York financier in troduced synthetic loans using the principle of put-call parity. Sage could able to create a synthetic loan by fixing the put, call and strike prices with interest rate poignantly high than the US usury law permitted.Chicago Mercantile Exchange started International pecuniary Market in 1972 which permitted trading in currency futures. The Chicago Board of Trade started first interest rate futures in 1975.Treasury bill futures contract was introduced in 1975 by Merc.The Chicago Board Options Exchange was started in 1973 and there were publications for the first time option pricing model of Fischer morose and Myron Scholes. Chicago Board Options Exchange created an option on an index of stocks which was originally known as CBOE 100 index which later known as S&P 100.During 1980, Swaps and other over-the counter derivatives were introduced. It was in 1994, the derivative trade witnessed a series of huge losses and this affected experienced trading firms like Metallgesellschaft and Pr octer and Gamble. Orange country, California which is the Americas wealthiest city was declared as bankruptcy due to derivative trading and use of leverage in a portfolio of short -term Treasury securities.DERIVATIVES OR DESTRUCTIVE? A CASE STUDY OF BARINGS, UK.Baring Brothers, a British merchant bank went to bankruptcy in 1995 after incurring a whooping loss of 860 one thousand thousand occurred on the Singapore and Osaka derivative exchanges. Nick Leeson, the banks star trader and absence of management controls to monitor his activities were the main reasons for this debacle. During the period between 1992 and 1995, Lesson built up positions in futures and options contracts on the Nikkei 225 stock exchange index, which proved highly profitable in the early years.Futures positions were bought by Lesson on the Nikkei index and financed cash calls on them as they fell in value by selling put options on the contract, thereby producing a straddle and thus betting against volatility of the market. Simex derivative exchange in Singapore were used to watchword the contracts and he run a hedged position on Nikkei index futures and make money by arbitraging between Singapore and Osaka markets.However he ceased hedging on the purchases make in Singapore and took on risk. Due to unexpected volatility in the market, losses were incurred and these losses in fact exceeded the net worth of Baring Bank .Lesson was later imprisoned for the falsification of records in an attempt to cover up his activities.The precept of this case law is to elucidate how a bank can face bankruptcy if there is no proper risk management system is in force. The case also establishes the concept of value at risk (VAR) which is a simple method to express the risk of a portfolio. Because of the recent derivatives disasters, end-users, regulators, financial institutions and central bankers are now resorting to VAR as a method to foster stability in financial markets .The case illustrates how VAR co uld have been utilized to Baring Bank case to warn its management of the risk they were facing in advance. VOLATILITY capriciousness has its effect on administered market and it is high when both supply and demand are inelastic and liable to random shocks. According to Rudiger Dornbusch, market always overshoots in answer to unexpected changes in economic variables.Volatility is a type of market incompetence and it is a response to uncertainty and excessive volatility is unreasonable.Volatility in stock and commodity market is represented by sharp changes in prices and inventory levels and level of volatility itself has fluctuated over the time. Changes in future prices, spot prices and inventories are influenced by changes in volatilityVolatility is a determinant of changes in price expressed in helping terms without regard to direction especially in stock price and stock index levels , commodities and in financial intermediaries .For example , an increase from 200 to 201 in one index is as same as the volatility terms to an increase in 100 to 101 in another index , because both changes are 1% and as this 1% increase is equal to volatility terms to a 1 % price decline .There are four ways to explain the volatility or movement and they are historical volatility , future volatility , expected volatility and implied volatility .Historical volatility is an appraiser of actual price variation during a particular period in the past. Future volatility refers annualized standard deviation of daily returns during particular future period basically between current and an option expiration. Expected volatility is an investors estimate of volatility utilized in an option method to cipher the theoretical value of an option. Implied volatility is the volatility percentage that illustrates the current market price of an option and it is the forefinger of an options price.Volatility is described as standard deviation of the yield of an asset and the value of an option always increases with volatility. The greater the volatility, the higher the option chance during its life and convertible to the underlying asset at a marginal profit and this methodology has been proved in the Black-Scholes commandment. Black-scholes formula yield results during trends and down-and-out when the market change sign. The implied volatilities are efficient forecasts of future volatility since varying market conditions cause volatilities to change through time stochastically and traditional volatilities can not correct itself to varying market conditions as ghastly .Stochastic volatility contradicts the assumption required by the Black-Scholes model if volatilities do modify stochastically through moment in time, the Black-Scholes method is no longer the correct pricing method and an implied volatility derived from the Black-Scholes formula provides no fresh information.Black-Scholes formula is lacking on certain issues like the oblique volatilities of various option s on the identical stock tend to differ disregarding the formulas hypothesize that a single stock can be correlated with only one value of implied volatility. The Black-Scholes formula mainly ignores the distribution of stock prices in US market. Some studies have revealed severe deviation from the price process fundamental to Black-Scholes formula like excess kurtosis, skewness, time varying volatilities and serial correlation. Further Black scholes deals with stochastic volatility poorly and it relies on impractical assumption that market dickers endlessly thereby ignoring institutional constraints and transaction costs. Stock ChartingStock charting is the process of a graphical sequence record enables it easier to dapple the effect of cardinal happenings on authoritarian warranters price., its functioning over a period of time and whether its trading its higher or its lower or in between these.Traders are very particular in daily, intraday data to forecast short-term price movem ents. Investors rely on weekly and monthly charts to mark long term trends and movements. stage business chart, Bar chart, Candlestick Chart and point and figure chart are some of the examples of stock charting method. arithmetical and semi-log arithmetic scales are two methods of price scaling used in the stock charting method.When the price range is hemmed within a tight range and used in general for short-term charts and trading. Semi-log scales are reclaimable for long term charts to estimate the percentage movements over a foresighted period of time including large movements. Stock and other securities are estimated in relative terms through tools lime PE, expense/Revenues and Price/Book and as such it will be more useful to analyse in percentage terms. OcillatorThis is an indicator which is calculated by taking 10 day moving average of the difference between the numbers of advancing and defining issues for authoritarian given index. An indicator will reflect whether an inde x is gaining or losing impetus, so the size of the moves is more significant than the level of the current reading. The level of the reading is influenced by how the oscillator changes each day thereby dropping a value ten days ago and adding todays value.The scale in moves is also helpful when it is compared with the divergence from the index price. If the Dow climaxes at the same time, the oscillator peaks in overbought subject field and suggests a top. Divergence is said to be negative and momentum is declining when index makes a new high but the oscillator fails to make a higher . whiz can buy if the index declines at this point but oscillator moves into oversold territory. If the oscillator rises above a previous overbought level though the index rises but does not make new heights, it is said to be upside momentum exists to continue the rally. SupportA support level is the price at which buyers are evaluate to enroll the market in considerable numbers to take control from s ellers. As the market has its track record, when price overhauls to a new low and then soars, the buyers who disregard on the first low will be persuaded to buy if price returns to that level back .Fearing of absentminded out the opportunity for the second time, these traders may enter into market in adequate numbers to take control from sellers. As the result, there is a rally strengthening sensitivity that price is unlikely to fall further thereby creating a support level. ResistanceThe price level at which the sellers are anticipated to enter the market in sizeable numbers to take control from buyers is known as exemption level. If price makes a new High and then move back, sellers who ignored the previous High will be predisposed to sell when price returns to that level back. Fearing of missing the opportunity for the second time, these sellers may enter the market in large numbers to overwhelm buyers. As the result, market perception will be reinforced that price is unlikel y to increase higher and form a resistance level. CANDLE CHARTINGIt is a price chart that shows the open, low, the high and close for a stock each day over a specified period of time .It is known as Japanese candles because they used to analyse the price of rice contracts. When the close is higher than the open , the same is represented by an white empty box in the candle charting .When the close is lower than the open , then it is represented by a solid inglorious candle ,Colored candles are used to reflect the days volume. Investment strategies in stock and optionsfollowing is the most of common investment strategies for keeping investment objectives, financial means and risk tolerance. Despite of market crash in 1929, market break in 1987, market correction in 1989 and though the prices of all securities fell down drastically but broad movement of the market has seen their value steadily increased. One of the strategies is to buy and hold for long the high quality stocks or futu res of stock or commodities .The buy and-hold system offers one to profit from this long term forward trend of the stock market. Further, dividend investment plan offers small investors a painless method of building wealth.Dollar Cost AveragingThis is also a long term strategy and one has to invest in a stock or mutual fund or futures at regular intervals monthly, quarterly or semiannually. The success of dollar-cost averaging relies on consistency of amount invested and the regularity of the payments so as to minimize pricing and timing risk. The success of the Dollar cost averaging depends upon the following factors.The plan for the investment should be for a long period i.e. from 7 years to 10 years .In the last 100 years, there were about 40 recessions or market corrections or a downturn about every 3 years and If one carry on to invest through about deuce-ace of these corrections, the profits of dollar-cost averaging tend to be maximized.2 .Investment at regular intervals is most preferred.Investment should be made regularly regardless of the price of the stock.Give preference to high quality of stocks or mutual gold and a company or fund with history of habitual dividend payments and possible for capital appreciation is a better choice.One has to make sure that he has enough strength so that he can adhere to the plan through highs and lows and sell out at the peak and thus the money allocated for dollar-cost averaging result in wealth-building funds, not committed funds.i Going ShortAn investor who prefers short i.e. enters into futures contract by agreeing to sell and deliver the underlying at a price and wishes to make profit from declining price levels and thereby selling high now , the contract can be repurchased in the future at a lesser price thus creating a profit for the investor.16.Spreads It involve taking benefit of the price difference between two different contracts of the same commodity and spreading is believed to be the most convention al forms of trading in the futures market because it is much safer than the trading long / short futures contract. There are different types of spread namely calendar spread, inter-exchange spread and inter-market spread. Swing TradingIt denotes a technique of placing emphasis on playing the swings in the PPS, selling on the highs and buying on the lows rather than the swiftness of the trade. To complete the swing trade, it may need more than a day, a week or authoritarian month or longer period and channeling stock is pursued by the some swing traders. FlippingIt refers the process of trading a stock very apace with in minutes or hours etc as past as possible may be on the same day. It is often used to explain a buy and sell with a share that is run and where the trader buys the stock as it is moving up and sells the same on even a higher point in a short period of time. A flipper aim is to maximize his profits by emphasizing on fast trades to earn quick profits. The risk is also less downside as the trader sits in a stock for a less time.i Hall, Alvin D., and Carolyn M. Brown. 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