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What are the benefits of using commodity Futures?
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Commodity futures offer a variety of benefits to its users. Some of these are:
- Investors can take long-term view on the underlying commodity and trade accordingly using commodity futures.
- Commodity futures offer high leverage. It means that one can control a large position with less amount of capital. For example buying 100 oz. of gold at $ 425/oz will require a cash outflow of 425 * 100 = $ 42,500/-. But to take controls of the same quantity of gold on a futures exchange one requires an initial margin of 5% only. A 100 oz. gold futures contract will require an initial margin of only $ 2125/- (5% of 42500) and yet control underlying asset worth $ 42500/-
- Investors can use futures contracts for hedging the price risk associated with the assets held by them. Hedging involves in the transfer of price-risk associated with the ownership of an asset by taking an equally opposite position in the futures market. For example: X holds 1000 kilos of silver and feels that its price may fall in the short-term. He sells futures contract for equivalent quantity to hedge his position. As a result of hedging, X has locked-in the price of his silver. Any loss resulting from fall in the spot prices will be compensated by an equivalent gain in the futures. Similarly any profit which might result from the rise in spot prices will be set off by the loss that will be incurred on the sale position in the futures market.
- Futures often provide opportunity to arbitrage or earn risk-free profit. This phenomenon usually occurs due to temporary distortions in the price relationship between the futures and spot prices. Example: X holds 500 oz. of gold. The spot price is 430 per oz. Three month future price is at $ 433 per oz. and the cost of carry for 3 months is $ 5 per oz. Now, as the future price of gold must theoretically be equal to spot price plus cost of carry the fair price of the 3 month futures contract should have been 430+5 = $ 435 per oz. Instead, it is available at 433 thereby providing an arbitrage opportunity. X sells spot gold at 430 per oz. and buys 3 month futures at 433 per oz. He makes a risk free arbitrage income of (435 – 433) $ 2 per oz.
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The leverage available using futures contracts appears to be a great opportunity. Should the entire investible
funds be used for leveraging?
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Never! Leverage is like a double edged sword. Yes, the user can benefit immensely in terms of the return on
capital employed if used properly. Leverage can hurt its user equally severely if it is not used judiciously.
The amount to be used for leveraged trades should form a part of the risk capital. One should always try to look
for a balanced and well diversified portfolio for efficient risk management.
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When can an open position be squared up?
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An open position can be squared up at any time before the expiration of the futures contract.
For example: a long (buy) position in June Gold futures expiring on 25th of that month, can be squared up by selling June Gold futures on or before the 25th June.
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What happens if a position is not squared up before expiration of a futures contract?
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If an open position is not closed by squaring it up on or before the expiration date of that contract, depending on the long / short position the trader will have to take / give delivery of the underlying commodity as per the standardized contract specifications in case of a delivery-settled contract. For example, X was long in 1 gold futures contract of 100 oz. he held on to his open position till the expiry of that contract. X will now have pay to the clearing corporation and take delivery of 100 oz. gold from the vault as per directions from the clearing corporation. Similarly, Y was left with an open sale position of 2 contracts on expiration. Y will have to deliver 200 oz. of gold as per the contract specifications to the exchange / clearing corporation designated vault. In turn he will receive from the clearing corporation the value of 200 oz. of gold delivered by him.
In case of cash-settled contracts, the obligations relating to an open position will have to be settled in cash by the obligated parties.
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How does a trader who has the underlying commodity, use commodity futures when he anticipates a short-term fall in commodity price?
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The holder of the physical commodity can sell a futures contract to avoid making a loss without having to sell the commodity. Any loss caused by the fall in the price of the commodity is offset by gains made on the short position taken in the commodity future.
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What are Options?
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Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying asset at a specified price on or before a specified date. On the other hand seller is under obligation to perform the contract (buy or sell the underlying).
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What is important terminology connected with Options?
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- Option Premium - Premium is the price paid by the buyer of the option to the seller of that option to
acquire the right to buy or sell
- Strike Price or Exercise Price - The strike or exercise price of an option is the specified /
predetermined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his
right to buy / sell on or before the expiration date.
- Expiration date - The date on which the option expires is known as Expiration Date. On Expiration
date, either the option may either be exercised or it expires worthless.
- Exercise Date - The date on which the option is actually exercised is called as Exercise Date.In case
of European Options the exercise date is same as the expiration date whereas in case of American Options, the options
contract may be exercised any day between the purchase of the contract and its expiration date.
- Open Interest - The total number of options contracts outstanding (open positions) in the market at
any given point of time.
- Option Buyer / Holder - is one who buys an option. It can be a call, or a put option. The holder /
buyer of an option enjoys the right to buy or sell the underlying asset at a specified price on or before specified time.
His profit potential is unlimited while the loss is limited to the premium paid by him to the option writer.
- Option Seller / Writer - is the one who sells or writes an option in consideration of premium. He is
obligated to buy (in case of put option) or to sell (in case of call option), the underlying asset in case the buyer of
the option decides to exercise his option. His profit potential is limited to the premium received from the buyer whereas
the loss can be unlimited.
- Option Class - Options of the same type relating to the same underlying instrument are options of the
same class.
- Option Series - An option series consists of all the options of a given class with the same expiration
date and strike price.
- Option Assignment - When holder of an option exercises his right to buy / sell, a randomly selected
option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.
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What is European & American Style of Options?
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- American Option: one which can be exercised by the buyer at any time, till the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.
- European Option: One which can be exercised by the buyer only on the expiration day and & not any time before that.
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What is a Call Option?
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A call option gives the holder (buyer / one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date in case of American option. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.
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What is a Put Option?
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A Put option gives the holder (buyer / one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date in case of American option. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.
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Explain 'In the Money', 'At the Money' & 'Out of the money' Options?
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An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.
A call option is said to be 'in the money' when the price of the underlying asset exceed the strike price of the option.
A put option is in-the-money when the price of the underlying asset falls below the strike price of the option.
A call option is out-of-the-money when the price of the underlying asset is below the strike price of the option.
A put option is out-of-the money when the price of the underlying is above the strike price of the option.
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What are the factors that determine the premium (price of the option)?
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- the strike price of the option
- underlying commodity price
- the time to expiration
- volatility of the underlying stock and
- the risk free interest rate
- dividends (in case of stocks)
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Who decides on the premium on options & how is it calculated? Is it determined by the exchange?
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The price of an option (premium) is determined by the interaction of demand and supply forces in the market. The Exchange does not have any role to play in determination of the price of options. It is the buying and selling action of the market participants that leads to price discovery.
The fair value / theoretical price of an option can be known with the help of mathematical pricing models & then depending on market conditions the price is determined by competitive bids & offers in the trading environment.
An option's premium / price is the sum of its intrinsic value & time value. If the price of the underlying asset is held constant, the intrinsic value portion of an option premium will also remain unchanged. Any change in the price of the option will be entirely due to a change in the option's time value. The time value component of the option premium can change in response to a change in the volatility of the underlying, the time to expiry, interest rate fluctuations and dividend payments. Besides, a sudden shift in the supply & demand equation for the underlying or its option can also impact the option price.
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What are Option Greeks?
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The options Greeks measure the sensitivity of the option price with respect to a change in the basic factors that affect the price of options. They are often used by professional traders for trading & managing the risk of large positions in options & stocks. These Option Greeks are:
- Delta: measures the amount of change in option premium / price in relation to a change in the price of the underlying.
- Gamma: measures the estimated change in the Delta of an option due to a change in the price of the underlying
- Vega: measures the change in the option price that is caused by a change in the volatility of the underlying.
- Theta: measures the change in the option price that is caused by a change in the time to option expiry
- Rho: measures the estimated change in the option price that is due to a change in the risk free interest rates.
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Who can participate in Options Market?
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Options markets provide a lot of opportunities to a large variety of people with different financial objectives such as hedging, arbitrage and investment. Developmental institutions, Mutual Funds, Domestic & Foreign Institutional Investors, Traders, Growers Manufactures, Brokers, Retail investors are some of the important participants in the Options Market. One can trade in options on a futures exchange only through a broker member of that exchange.
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What are the main benefits of using options?
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Some of the main benefits of using options are:
- They can be used as instruments for hedging
- Help in diversification of portfolio
- Allow a high degree of leverage to the user.
- They can be used to generate additional streams of income from ideal assets.
- Allow the user a great degree of flexibility – can be combined and structured to typically suit the user’s requirements.
- Can be used in all market conditions – up, down or sideways.
- Buyers can precisely define and fix their risk levels.
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How can I use options?
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One can use options according to one’s investment / risk management needs. A wide variety of option strategies ranging from plain vanilla options to complex combinations are used by the option traders. The strategy to be used at a given point in time usually depend on factors like investment objective, perception of the future market moves, volatility expectation, time frame within which the perceived move is expected and the expected risk / reward ratio.
Some of the simple strategies that are used by market players are:
- Buy Call Option / Sell Put Option – in case the view is bullish.
- Sell Call Option / Buy Put Option – where the view is bearish
- Buy Put Option - for hedging long futures position:
- Buy Call Option - for hedging short futures position:
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How does Option get settled?
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Option is a contract, which has a market value like any other tradable commodity. Once an option is bought there are following alternatives:-
- Sell an option of the same series as bought & close out /square off position in that option at any time on or before its expiration date.
- Exercise the option on the expiration day in case of European Option or before the expiration day in case of an American option.
- Positions that are 'out of the money' at the time of expiry, will not be exercised for the obvious reason that they are not profitable. Therefore, such options will automatically lapse or expire worthless.
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What are the risks for an Option buyer?
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The risk / loss of an option buyer is limited to the premium that he has paid to buy the option.
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What are the risks for an Option writer?
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The risk of an Options Writer is theoretically unlimited, whereas his gains are limited to the premiums earned. When an uncovered call is exercised for physical delivery, the call writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call as reduced by the premium received for writing the call.
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What are Options on individual commodity?
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Options contracts where the underlying asset is a commodity are termed as options on commodity. Most of the options traded are American style options and are either cash settled or settled by physical delivery.
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How will the trading of options in specific commodity benefit an investor?
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Options are an attractive investment tool. They provide investors with the flexibility to plan their investments. Options have the characteristics of an insurance contract. Investors can create hedging positions or entirely speculative positions. Investors in commodity options will stand to benefit from more leverage than their counterparts who invest in the underlying commodity market. The facility is usually available at a small premium cost. Investors can also use options in specific commodity to hedge their holding positions in the underlying (i.e. long in the commodity itself), by buying a Protective Put. Thus they can insure their portfolio of commodity by paying a small premium.
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What is clearing corporation? What role does it play in a futures exchange?
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Clearing Corporations help in smooth and secure clearance and settlement of trades taking place in the exchange. They act as counterparty to each trade and thus provide a performance guarantee to the buyer / seller. In turn they also impose, monitor, and collect margins from brokers on regular basis to keep the market financially secure and orderly.
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