Investing in Futures and Options Essay

INTRODUCTIONOf late, ornamentors who ar in the gillyf small(a)er and commodity atomic number 18 focusing their attention towards risk management especially due to towering unpredictability nature.Since these irritability drives be uncertain, it has capture foremost ca delectation of vagueness for much(prenominal) investors. Since the globalization of trade and free trade mingled with major countries has become the order of the mean solar day, all most all the investors overhear to be downstairs mercy of the transmute count fluctuations which results in excitability .The notion that rally posts , profitability and opposite occurrenceors influence a firms value and at that placefore the court of its declension is extensively held by m angiotensin converting enzymetary analyst ,economists and corpo set managers .The liberalization of economic policies and investment policies due to population trade organizations (WTO) free flow of investments and trade bet ween member countries and bilateral free trade agreements between countries get augment internationalization of economic natural sue and exceptional era of world wide immediate payment and by-line rates instability. To counter these pecuniary risks, sassy pi integrityering judgment commodity and line trade nameet hedging techniques have nurtured at a rapid speed. The main feature of the using distinguishableial instruments through hedging is to have give over the pecuniary risk and minimizing the effect of uncertain exchange flows. monetary institutions have come to rescue to these corporations who have exposure to financial risk with the clip of products to assist in risk management. By fara office the most signifi kittyt exit in finance during the past decennary has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to recognise risk and allocate it to the investors most able and forgeting to take it a process that has undoubtedly improved national productivity growth and standards of life sentence . Allen Green Span, Chairman, senesce of Governors of the US Federal Reserve System.The structural vantage of derivatives i.e. leverage or gearing makes them suitable for managing risk can as well as result in the generation of leveraged profits or in the event of unfavourable market movement , a profound passing playes. The main profit of gearing is that the purchaser or seller need solitary(prenominal) to spit out up a small proportion of total scathe at the metre of deal is executed.It whitethorn be 1% and 8% depending upon the volatility of the inherent commodity or instrument. In the case of exchange traded transactions, this bewilder is recognized as initial margin and is expected to reflect the sum total by which the legal injury of a peg down may vary in virtuoso days occupation. At the day end, all charters allow be valued and if the expense has been found to move against the fleck, the losing party provide have to fix further variation margin calls. In contrary, if the p strain movement is positive, credit leave behind be inclined to the party .It is this localizations of gearing that provides the hazard to make large gains or losses.Prudent use of this leverage will result in con viewrable profit maximisation and if it handled inexpertly, may generate losses .In well-nigh cases , these losses though lofty but they ar few in number when measured against hatful of business and number of participants in derivative business .The contributory factors for sustaining loss includes excessive position taking ( in relation to capital) , fraudulent activity , unexpected market moves, ineffective risk management, insufficient product sense and inadequacies in corporate policy governing their use. What is a derivative? derivative is a mathematical word which refers to a variable, which has been derived from an otherwise vari able and they have no values of their own. Derivatives derive their value from the value of some other plus, 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 set (value) of AT & T Corporation. Likewise, a derivative embrace on wheat depends upon the price of wheat.An agreement or an resource to deal or sell the underlying asset of the derivative up to a certain time in the time to come at a predetermined price i.e. the exercise price by way of special hale is know as derivative contract.The contract to a fault has a flat going breaker point mostly in the range of 3 to 12 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 comparable currency, debt instruments, equity shares, share price might etc.Exchange -traded derivatives are derivative contracts that has been standardized and traded on the memory board exchanges. Over-the counter derivatives is one which has been customized as per the requirements of the user by negotiating with the other party involved.Some of the normal forms of derivatives are futuritys, Forwards and Options. FuturesFutures are the derivative contracts that give the holder the misadventure to grease ones palms or sell the underlying asset at a pre- specify price some time in the near forthcoming and ordinarily thy come with standardized form like contract size, fixed expiry time and price.The future market is one where continues auction market and exchanges presenting the young information about(predicate) the supply 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 get together to trade. The main aim of the future market is to manage price risk.The future price risk is averted by buy or change futures contract, with a price level arrived at now, for items to be hawked 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, patoisers, farmers, principals, manufacturers will arrange for the purchase or sale of a futures contract. In future market, commodities are broken down into five categories to wit agriculture, metallurgical, touch on 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, chromatic juice and sugar. For e actually one of these commodities, unalike contract months are ready(prenominal) and it depends up on the harvest cycle. More aggressively traded commodities usually have much contract months operational and a pertly type of contract is available or so every month to meet the growing institutional and corporate market.Futures on Metallurgical ProductsPetroleum products and metals is being dish outed under this group and it includes platinum, gold, silver, palladium, copper, gasoline, oil oil, propane and heating oil. Every month a new type of contract emerges to cater the needs of ever increasing institutional and corporate market.Assets which bears have-to doe with This has its origin during 1975 and products in these categories include treasury bonds, exchequer Bills, Municipal Bonds, Treasury Notes and Eurodollar deposits. It is also possible to trade contracts with the same maturity but different expected affair rate differentials.Futures on IndexesNow futures are available on most chief business leaderes such as tender York storehouse Exchange Composite, S&P 500, New York transmit Exchange profit index number, Russell 2000, Commodity Research Bureau (CRB), S&P 400 Midcap, FT-Se degree centigrade Index (London) and Value line. These stock index features are settled in cash and thither 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 Currency FuturesDuring the stigmatise war period, the exchange rates and intimacy rates were stable and the machine 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 introduction of general natation exchange rates replacing the earlier fixed system. The introduction of vagabond exchange rates have resulted in large unexpected movements in exchange rates that too in unforeseen shipway and magnitudes which affected interest r ate movements as the monetary establishment tried to influence the exchange rates by movements in interest rates. It is to be noted that the forth market in currencies is much bigger than the foreign exchange futures market. Further, at that place 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 cost of expiry date, contract size, and price.These contracts confer the holder the weft 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 o r on the OTC.In option, the participants may attach a position in an underlying futures contract at a certain price which is known as exercise or ingest price within a point period of time. The price or premium of the option is determined through action market vocation. sellsSwaps 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 switch contract. In a nutshell, a swap contract can be outlined as a series of forward contracts put together. If the exchange of interest rate payments in one currency for payments in another currency is devised, because it amounts to a currency swap.If the exchange between two parties of interest obligations or receipts in the same currency on an hold amount of notional principal for an agreed period of time is devised, then it is known as interest rate swap. An interest rat e swap is an agreement between two parties to exchange interest payments calculated on different bases over a period of time. Under interest rate swap, one party to the contract makes fixed rate payments while the other partys payments are based on a float rate such as LIBOR.For instance, if a company which has borrowed from a bank at a floating rate (7 m LIBOR) may pauperization 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 , cite by paying 6.95% for 7m LIBOR and then they earn a profit of 0.5% struggle 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. sanctioned swaps are mostly used by owe companies because the get the mortgage payments 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 more flexibility to exploit their comparative receipts in their respective 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 petty end of the maturity spectrum vs. the abundant end of the maturity spectrum. USES OF DERIVATIVESDerivatives are in general used for speculation or hedging. For speculation, derivatives offer 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 opportuni ties 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 blockade the price now for a trade in future or at least limits the rise or fall of that price. An UK company prop 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 little 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 sight in the bearish market, volatility and risk augment while returns unthaw 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 i n 1650. thus in 1848, sugar Board of Trade was started to handle futures market of US.Russell sensible, a famous New York financier introduced 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 spicyer than the US usury natural law permitted.Chic ago Mercantile Exchange started International monetary 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 price model of Fischer Black 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 Procter and Gamble. Orange country, California which is the Americas wealthiest city was declared as nonstarter due to derivative trading and use of leverage in a portfolio of short -term Treasury securities.DERIVATIVES OR DESTRUCTIVE? A consequence STUDY OF BARINGS, UK.Baring Brothers, a British merchant bank went to bankruptcy in 1995 after incurring a whooping loss of 860 million 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 construct up positions in futures and options contracts on the Nikkei 225 stock exchange index, which proved super profitable in the early historic period.Futures positions were bought by Lesson on the Nikkei index and f inanced cash calls on them as they fell in value by selling put options on the contract, thereby producing a straddle and thus foretell against volatility of the market. Simex derivative exchange in Singapore were used to halt 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 made in Singapore and took on risk. callable 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 refutation of records in an attempt to cover up his activities.The rationale 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 easy method to express the risk of a portfolio. Because of the recent derivatives disasters, end-users, regulator s, financial institutions and commutation bankers are now resorting to VAR as a method to promote stability in financial markets .The case illustrates how VAR could have been utilise to Baring Bank case to warn its management of the risk they were veneer in advance. VOLATILITYVolatility has its effect on administered market and it is high when both supply and demand are inelastic and liable to haphazard shocks. According to Rudiger Dornbusch, market always overshoots in reaction to unexpected changes in economic variables.Volatility is a type of market incompetence and it is a reaction to uncertainty and excessive volatility is unreasonable.Volatility in stock and commodity market is represented by sharp changes in prices and scrutinise 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 division call 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. anticipate volatility is an investors forecast of volatility utilized in an option method to gauge 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 indicator 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(prenominal) the option chance during its life and convertible to the underlying asset at a borderline profit and this methodology has been proved in the Black-Scholes formula. Black-scholes formula yield results during trends and thwarted when the market change sign. The implied volatilities are efficient forecasts of future volatility since alter market conditions cause volatilities to change through time stochastically and handed-down volatilities can not correct itself to varying market conditions as dingy .Stochastic volatility contradicts the assumption required by the Black-Scholes model if volatilities do falsify stochastically through moment in time, the Black-Scholes method is no drawn-out the correct pricing method and an implied volat ility derived from the Black-Scholes formula provides no bracing information.Black-Scholes formula is lacking on certain issues like the oblique volatilities of motley options on the identical stock tend to differ disregarding the formulas imagine 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 sequential correlation. Further Black scholes deals with stochastic volatility poorly and it relies on unrealistic 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 obscure the effect of cardinal happenings on authoritarian securitys price., its procedur e 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 movements. chargeors bank on weekly and monthly charts to mark long term trends and movements. greenback chart, Bar chart, Candlestick Chart and point and figure chart are some of the examples of stock charting method. Arithmetic 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 useful 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, harm/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 1 0 day moving average of the residuum between the number of advancing and defining issues for authoritarian given index. An indicator will reflect whether an index 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 dissonance from the index price. If the Dow climaxes at the same time, the oscillator peaks in overbought area and suggests a top. discrepancy is said to be negative and momentum is declining when index makes a new high but the oscillator fails to make a higher . unrivaled can buy if the index declines at this point but oscillator moves into oversold territory. If the oscillator rises above a old overbought level though the index rises but does not make new heights, it is said to be upside momentum exists t o continue the rally. SupportA support level is the price at which buyers are anticipate to give in the market in considerable numbers to take control from sellers. As the market has its track record, when price falls to a new low and then soars, the buyers who ignored on the first low will be persuaded to buy if price returns to that level back .Fearing of missing out the opportunity for the punt time, these traders may enter into market in adequate numbers to take control from sellers. As the result, there is a rally change 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 resistance level. If price makes a new steep 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 pass buyers. As the result, market perception will be reinforced that price is unlikely to increase higher and form a resistance level. see CHARTINGIt is a price chart that shows the point-blank, low, the high and close for a stock each day over a specified period of time .It is known as Japanese certificate of deposits because they used to analyse the price of rice contracts. When the close is higher than the open , the same is represented by an purity empty box in the candle charting .When the close is lower than the open , then it is represented by a solid black candle ,Colored candles are used to reflect the days volume. investment funds 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 drasti cally 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 futures 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 platform offers small investors a painless method of make wealth.Dollar Cost AveragingThis is also a long term strategy and one has to invest in a stock or unwashed 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 background 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 an d If one carry on to invest through about three 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 funds and a company or fund with fib 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 pull 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.Spr eads It involve taking benefit of the price difference between two different contracts of the same commodity and spreading is believed to be the most conventional 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 that is to say calendar spread, inter-exchange spread and inter-market spread. Swing TradingIt denotes a technique of placing speech pattern on playing the get abouts 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 quickly 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 running and where the trader buys the stock as it is movi ng 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. 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