Market regulator Sebi could announce the operational framework for introduction of options in commodities.
Lets have a lowdown on what this will entail.
1. How many functional commodity futures exchanges exist?
Three, the largest being metal and energy bourse MCX, agri bourse NCDEX and plantations exchange NMCE. Of these, NMCE was the first to commence trading in late 2002. MCX and NCDEX began a year later.
2. What products do these exchanges offer?
Trading in futures contracts of commodities only. Unlike in equity markets, options or index trading is not allowed. Also, participation is restricted to retail and wholesale traders, and corporate hedgers. No foreign, NRI or bank participation is permitted at present.
3. What’s in the works?
Sebi, which took over regulation of this market in September 2015 is strengthening regulation -trading, client, broking or exchange related. It also plans to give exchanges permission to start trading in options contracts. Two options -one agri and one non agri could be allowed initially . Also, in due course, it could expand participation to institutional investors.
4. How will options be settled?
Unlike in the equity market, Sebi does not regulate the cash market in commodities.Therefore how to settle options is being worked out. It’s possible that Sebi might allow options to be converted into futures to work around the problem. Therefore the options prices will be influenced by the futures contracts.Spot markets in India are controlled by state governments who issue licenses to markets to function.
5. What’s the difference between an option and futures contract?
A futures contract facilitates purchase or sale of an underlying commodity at a preset price on a future date. Profits and losses in such contracts can be unlimited.
Options similarly facilitate purchase or sale of an underlier. However, loss are limited to the premium paid by buyer to the seller of a call (right to buy) option or a put (right to sell) option.
Markets will always move upside, downside or sideways. Now presence or absence of these movements will be responsible for profits or losses in the portfolio. As an investor or trader, we all understand this.
When we trade in multiple hedged options, it becomes all the more important to know the effect of three different things on our portfolio. Three things which can affect our portfolio are: –
– swing or movement in the market,
– time left for expiry (options are decaying assets) and
– changes in volatility of option contracts.
Let us try to understand with an example: –
Say Nifty is at 9150 and as a trader, you are expecting market to move up. So you purchase a call of 9200 strike price at Rs 80, so that in case market goes up, you make good profit.
The question to be answered is, when will the market move up?
Suppose market moves to 9200 in next five days.
What will be the value of the 9200 call you had purchased in Rs 80 /-?
Will it be profitable?
May be, maybe not.
Quite possible that even when the market has gone to 9200, the price of this call is Rs 60 only. So, if I had purchased this call in Rs 80, thinking market will go up, I will still lose Rs 20, although my judgement of direction of market is correct!
My prediction of market was correct!
My trade of buying a call was correct!
Market has gone up!
Still, I am losing money??
This may seem to be totally illogical.
But, please hold on. Markets are very very efficient.
There is surly a logic behind this.
The answer lies in knowing at least three Greeks – DELTA, THETA and VEGA.
- How much the portfolio value increase or decrease with market movement?
- How much the portfolio or particular option value will increase or decrease every day?
- What will happen if market remains there, but volatility increases?
Knowledge of these Greeks will answer all this questions.
After knowing these Greeks, we can decide whether to do adjustment in our portfolio or not. Not only this, but what adjustment to be done will also become clear with knowledge of Greeks.
These are very important concepts so that you can steer your option strategies towards profits.
Without them, its driving a car without a steering! Dangerous !
Join our Workshop to learn in-depth about Option Greeks and Advance Strategies.
What are Option Spreads?
If we want to use full power and flexibility of options trading, we must spend time in learning what are Option Spreads.
If you are buying a call or a put option, what you are doing is, you are trading in a single contract or we can say single ‘leg’. But if you are trading in multiple contracts or multiple ‘legs’ which are related to each other, it can be termed as a spread. So buying a call option and as well as selling a call option is one kind of spread. Similarly, buying a call option and buying a put option can be another kind of spread.
Although spread trading seems to be pretty simple in concept, but it becomes more complex in practice as we need to take care of market movements and its implications on overall spread profit and loss. One might think that how is it possible to make profit or loss when simultaneously we are buying and selling a call, since both will behave in similar fashion with move in the market. Yes, you are right but the trick lies in choosing different strike prices.
So according to your view of market, different kinds of spreads can be created. The benefit of creating a spread vis a vis a naked buying and selling of call and put is that it reduces your risk, considerably. And in trading options, if we are able to manage risk, we can be sure of profits. So to understand spread, we have different classifications. The most simple classification of a spread can be based on the option premium involved.
With this classification, the spreads can be classified as :-
- Credit Spreads – Credit spreads are spreads which will give credit to your account in terms of premium. For example, if you are selling a call and selling a put, premium of both call and put will be credited to your account and hence this is known as a credit spread. Please bear in mind that for selling a call and a put you will require margin money in your account, which obviously will get blocked. But in terms of premium of call and put, you are getting credit and hence this is known as credit spread.
- Debit Spreads – As the name suggests, if you create a position which is taking money from your account (in terms of premium), it will be a debit spread. For example – if you are buying a call and buying a put, you need to pay the premiums of both call and put to the market and hence the money will flow out from your account and hence it is known as debit spread.
Things cannot be simpler than this. So, what are the different situations in which we create credit spreads or debit spreads. Or what kind of credit and debit spreads are there. Yes, its surly a next logical question but needs more explanation before we jump into any kind of conclusive statement.
We need to understand another classification of spreads to get the whole concept in. As per this, again we can have two kinds of spreads :-
- Vertical Spreads – In case you are taking two positions of call (or put) in the same month for an underlying, it is known as vertical spread. For example – you may buy an 8000 call and sell a 7900 call of Nifty creating a vertical gap between the positions. Since you will be selling and buying both the strikes at different prices, it will give a play to gain or lose money according to the movement in the market. Similar positions can be made on put side also. Again, a vertical spread can be a debit or a credit spread depending on the strike prices chosen. (more on this in next post).
- Horizontal Spread – In case we are taking two position in different expires, it creates a horizontal spread. For example, if we sell 8000 call of Nifty for May month and buy 8000 call of Nifty for June month, we have created a spread with limited profit and limited loss. This kind of spread is termed as calendar spread or horizontal spread. Again, as in case of vertical spread, horizontal spread can also be a net debit or net credit spread depending on the strike prices selected for creating the spread.
Most common belief is that if you want to make money in stock markets, you must be able to predict the direction of market. So, if you predict that markets will go up, you buy and then sell at higher price when it has gone up. Very Simple Logic.
But markets are far far away from something as simple as that.
Logic is correct but how do you predict where the market is going ?
Up ? Down ? Sideways ?
There are huge number of softwares/ technical analysts claiming to predict the direction and correctly doing it almost 50 % of times.
But what about 50 % of times when they go wrong ?
Then you use STOP LOSS.
This is a very common way of trading in the markets .
But let me ask –
Do you require a special software to be wrong 50% of times ?
Anybody can do it anytime. Also , mind it – Stop Loss is a good tool but ultimately it is also a Loss only.
So , what is the way out ?
Most of you will be very sceptical if I say that you can make profits in stock markets without predicting the direction of the market ? Because we are used to think in a particular way and that way is predict and take position and take stop loss.
Most of you will again have huge doubts in your mind if I say that you do not require stop losses to protect your positions. So you don’t loose money through stop losses.
I am talking about strategic hedged positional trading.
This is NON-DIRECTIONAL trading. Non – directional trading means, we are neither bullish , nor bearish about the market. But if we are Non-directional, that doesn’t mean , markets are also non-directional. Markets will definitely make their moves . Nifty , Banknifty will keep on moving up and down. But we will not get ourselves stuck in a process of predicting the direction of the market. We know markets will move and accordingly we will set up the trading strategy and do adjustments as and when required. No software, No market prediction, No stop loss and No intra-day trading.
For doing this, we must understand basic strategies in futures and options, need to have a proper trading plan, proper adjustment plan and keep our positions hedged through usage of Greeks. Ok, its not as complex as it sounds and yes , making money can never be as simple as buy on dips and sell on highs! Its more of a wishful thinking.
We receive Lot of queries on how can we get historical data of options ? Is there a way to get historical data for options at all ?
Yes , you can get historical data for futures, options and prices of these for any historical date . This can be done on NSE website. Let us give you step by step process to check any historical data.
- Go to website www.nseindia.com .
- In the top menu, just go to products. No need to click.
- Under products, click equity derivatives, just below Derivatives column.
- Once you click this, a new page will open. Scroll down and you will see three folders, one of which says Historical Data.
- Click Historical Data. First thing you will see is Contract-wise archives. Click search below this contract wise archive.
- A new page will open with some drop downs. First drop down is instrument. Choose whatever you want – options, futures for stock or index.
- Select symbol for the stock or index you want to choose, select year, date of expiry, type and relevant period.
- Click get data and that’s it. You will get any historical data in a simple table. Data also includes high, low, Open interest, change in Open interest in addition to other useful information. If you want, you can download it also.
So, go ahead and check the data. Use this data for doing any back testing of your strategies.
The Black and Scholes Option Pricing Model didn’t appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can’t take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes’ improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor’s risk preferences.
In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.
Assumptions of the Black and Scholes Model:
1) The stock pays no dividends during the option’s life
Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.
2) European exercise terms are used
European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.
3) Markets are efficient
This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itô process. To understand what a continuous Itô process is, you must first know that a Markov process is “one where the observation in time period t depends only on the preceding observation.” An Itô process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.
4) No commissions are charged
Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor’s pay is more substantial and can often distort the output of the model.
5) Interest rates remain constant and known
The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.
6) Returns are log normally distributed
This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.