Futures and Options — A Maldivian Theory
TL;DR — Advanced Options Traders can give this a miss.
With the markets hitting new lows (Nifty was 7000 odd points) in the last week of March 2020 — we have seen wider participation and interest from the retail in equity markets. COVID-19 has surely set back the world economy by a few months (or possibly a few years), but the broking industry has tried to get the best out of this crisis. Traditional investors are looking for diverse investment opportunities. First-time investors (read Millenials) are trying their hands on different instruments after exhausting all the series/movies on Netflix, Prime, Hotstar, and whatnot.
There are enough resources available on the internet to understand how markets function, what are the different instruments which you can explore, and the most important — How to make easy, quick returns in the market? I believe everyone starts venturing into capital markets with these thoughts in mind. Sooner or later, they would come across this beautiful world of options trading. The glorified articles on Derivative Options make options sound like a normal trading instrument emphasizing mainly on — high ROIs, quick returns, smaller margin needs, and so on. One thing that newbie option traders tend to ignore is the fact that the underlying concepts of options are driven by probability theory and differential equations — yea I get it, the math doesn’t fascinate you, but yes if you want to succeed as an Option’s trader then brushing up those high school math concepts would not hurt.
A lot of my friends, relatives, colleagues have started exploring different investment opportunities — thanks to the digital penetration of security firms and simplified digital onboarding experience. Although most of them started off with equities and SIPs, within 3 months, they are looking to explore other complex instruments like futures and options. The margin requirement for futures being relatively higher, people feel options look like a better bet. People do reach out to me asking how you can trade options and they have a very superficial understanding of the jargons used in options trading — expiry, calls, puts, strike price, premium.
Without delving much into the core option theories, let’s understand how you can draw parallels between futures & options trading and real-world examples. This is one example I have been using to explain the concept of options to all newbies, just thought of putting it down here as well.
Person A owns a resort in Gili Lankanfushi, Maldives which is priced at $2 billion as of today’s market rate. Person B reaches out to Person A with an offer.
Let’s see how a future’s trade between Person A and Person B would look like:
Person B: I am willing to buy your resort but I would not be able to do it as of today (13th July 2020). I can buy it from you in the month of December 2020.
Person A: I can sell you the resort in the month of December 2020, let’s agree on the transaction date — last day of 2020. However, you would have to agree on a price for it today. I can sell you the resort at $2.3 billion. Let’s sign a contract today for this transaction.
The contract states A will sell the resort to B on 31st December 2020 at a price of $2.3 billion and this was agreed upon on 13th July 2020. The contract cannot be breached by anyone involved in the transaction.
In this transaction, B has a bullish view on the property and believes that the price of the property will be more than $2.3 billion. Whereas, A has a bearish view on the property and believes that the price of the property will not exceed $2.3 billion. Two contrarian thoughts resulted in this future purchase-sale transaction.
If you have to draw parallels between the entities in this transaction and the entities in futures trading then it would look like:
- Price of the underlying asset as on 13th July 2020 — $2 billion
- The expiry date of the future’s contract — 31st December 2020
- Price of the underlying asset’s future expiring on 31st December 2020 as on 13th July 2020 — $2.3 billion
- The date on which contract was agreed upon — 13th July 2020
Who would make profits in this transaction? Let’s look at all the possibilities.
Resort’s price moves up and is above $2.3 billion on 31st December 2020
Resort’s price moves down and is below $2 billion on 31st December 2020
Resort’s price remains unchanged as of 31st December 2020
As you can see, there was an agreed contract signed between Person A and Person B on 13th July 2020 for a transaction that is supposed to take place on 31st December 2020. Here, both parties were under an obligation to honor the contract. Irrespective of the price movement of the resort, both parties have to execute the contract on 31st December. We have seen the three cases which could happen in terms of the resort price appreciation or depreciation. Any appreciation or depreciation could result in an equal amount of profit and loss for both parties involved. If the resort price hits $2.3 billion on 31st December 2020, then in that case both parties would break even since this is the price agreed upon in the contract. Just extend this entire analogy to the securities market and you have futures trading workflow. The underlying definition of a futures contract is that — the involved parties cannot back out from the agreement mentioned in the future’s contract.
When the contract was signed, it was between A and B, however, this contract can be handed over to different individuals as well. The circulation of this contract between different individuals results in future market liquidity. Say, there is some news about the resort - the Maldivian government has provided grants to the resort for building a private airport on the island. This could bring in more investor interest. This would push the price of the futures contract considering that the price of the resort by year-end could touch new highs based on this news. Similarly, if the sentiment is negative, the prices of the futures contract exchanging hands could go down.
Let’s see how an option’s trade between Person A and Person B would look like:
Person B: I am willing to buy your resort but I would not be able to do it as of today (13th July 2020). I can buy it from you in the month of December 2020.
Person A: I can sell you the resort in the month of December 2020, let’s agree on the transaction date — last day of 2020. However, you would be under no obligation to buy. I can sell you the resort at $2.5 billion on 31st December 2020. You can chose to buy the resort from me or ignore the contract. You have the option to back out from this contract if you don’t find the situation favourable. However, I would be obliged to sell it. For this flexibility, I will charge you a small premium of $0.1 billion. On 31st December 2020, you can buy the resort from me at $2.5 billion irrespective of the resort’s price then. If you don’t buy it from me on 31st December, then I get to keep the premium of $0.1 billion.
The contract states A will sell the resort to B on 31st December 2020 at a price of $2.5 billion and this was agreed upon on 13th July 2020. However, B would have the flexibility to dishonor the contract and back out any time, whereas A would have to honor the contract norms. For this flexibility, B would pay a premium of $0.1 billion to A.
In this transaction, B has a bullish view on the property and believes that the price of the property will be more than ($2.5 + $0.1) billion. Whereas, A has a bearish view on the property and believes that the price of the property will not exceed $2.5 billion. Two contrarian thoughts resulted in this possible purchase-sale transaction.
If you have to draw parallels between the entities in this transaction and the entities in options trading then it would look like:
- Price of the underlying asset as on 13th July 2020 — $2 billion
- The expiry date of the option’s contract — 31st December 2020
- Price of the resort for which contract is agreed upon aka Strike Price — $2.5 billion
- The premium of the option contract — $0.1 billion
- The date on which contract was agreed upon — 13th July 2020
Who would make profits in this transaction? Let’s look at all the possibilities.
Resort’s price moves up and is above $2.5 billion on 31st December 2020
Resort’s price moves down and is below $2 billion on 31st December 2020
Resort’s price remains unchanged as of 31st December 2020
As you can see, there was an agreed contract signed between Person A and Person B on 13th July 2020 for a transaction that is supposed to take place on 31st December 2020. Here, Person A was under an obligation to honor the contract, however, Person B had the option to not exercise the contract. To have this flexibility, Person B had paid a premium to Person A. Person B had the option to exercise the contract only if the situation was in his/her favor. We have seen the three cases which could happen in terms of the resort price appreciation or depreciation. Any appreciation or depreciation could result in an equal amount of profit and loss for both parties involved. If the resort price hits $2.6 billion on 31st December 2020, then in that case both parties would break even since this is the price agreed upon in the contract along with the premium value. Just extend this entire analogy to the securities market and you have options trading workflow. The underlying definition of an options contract is that — the buying party can back out from the agreement mentioned in the option’s contract, however, the selling party is always obliged to honor the contract for which they get a premium value paid upfront.
When the contract was signed, it was between A and B, however, this contract can be handed over to different individuals as well. The circulation of this contract between different individuals results in options market liquidity. Say, there is some news about the resort — the Maldivian government says the island is vulnerable to earthquakes and tsunamis. This could bring deter investors from pumping in more money for the resort. This would push the price of the options contract considering that the price of the resort by year-end could reach new lows based on this negative news. Similarly, if the sentiment is positive, the prices of the options contract exchanging hands could go up.
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