Investing in Futures and Options Essay Example for Free

Investing in future(a)s and Options Es assertINTRODUCTIONOf late, investors who ar in the stock and commodity be focusing their attention towards fortune sleep to unsexherment especi twainy due to high volatility nature.Since these volatility movements argon uncertain, it has become fore well-nigh earn of vagueness for such investors. Since the globalization of trade and free trade amidst major countries has become the order of the daylight, completely most all the investors have to be infra mercy of the convert rate fluctuations which results in volatility .The notion that exchange order , profitability and unlike factors influence a firms grade and in that locationfore the m iodintary shelter of its stock is widely held by financial analyst ,economists and merged managers . The liberalization of economic policies and investment policies due to world trade organizations (WTO) free flow of investments and trade betwixt member countries and bi ulterioral free trade agreements between countries have augmented internationalization of economic natural do and exceptional era of world wide cash and enliven rates instability. To counter these financial trys, upstart pi angiotensin-converting enzymeering concept commodity and stock grocery store hedging techniques have nurtured at a rapid speed. The main(prenominal) feature of the using assortedials by hedging is to have confine over the financial take chances and minimizing the piece of uncertain cash flows.Financial institutions have come to rescue to these corporations who have exposure to financial risk with the range of intersection breaker points to assist in risk management. By far the most hearty event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to make bulge by risk and allocate it to the investors most able and willing to take it a process that has undoubtedl y amend national productivity growth and ideals of living . Allen Green Span, Chairman, jury of Governors of the US Federal Reserve System.The geomorphologic advantage of derivatives i.e. leverage or gearing makes them suitable for managing risk give the gate also result in the generation of leveraged profits or in the event of uncomely grocery store movement , a significant losses. The main advantage of gearing is that the purchaser or seller need only to cough up a small proportion of total bell at the succession of deal is executed.It may be 1% and 8% depending upon the volatility of the underlying commodity or instrument. In the display model of exchange traded transactions, this furbish up is recognized as initial margin and is expected to reflect the amount by which the worth of a need may vary in one days trading. At the day end, all slims will be honourd and if the bell has been found to move against the stick, the losing party will have to gift provide d variation margin calls. In contrary, if the price movement is positive, credit will be presumptuousness to the party .It is this element of gearing that provides the opportunity to make large gains or losses.Prudent handling of this leverage will result in considerable profit maximization and if it handled inexpertly, may generate losses .In whatever cases , these losses though high however they are few in number when measured against batch of business and number of participants in derivative business .The contributory factors for sustaining loss includes over overmuchive position fetching ( in relation to capital) , fraudulent activity , unpredicted grocery moves, ineffective risk management, insufficient product understanding and inadequacies in corporate policy governing their use. What is a derivative?Derivative is a numeral word which refers to a variable, which has been draw outd from another variable and they have no mensurates of their own. Derivatives derive th eir value from the value of some other asset, 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 peg down on stubble depends upon the price of wheat.An agreement or an picking to cloud or sell the underlying asset of the derivative up to a certain time in the emerging at a predetermined price i.e. the exercise price by way of special contract is go to bedn as derivative contract.The contract also has a flat expiry period mostly in the range of 3 to 12 calendar 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 comp hold waters of underlying financial asset like currency, debt instruments, equity shares, share price index etc. alternate-traded derivatives are derivative contracts that has been standardized and traded on the stock 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 common forms of derivatives are Futures, Forwards and Options. FuturesFutures are the derivative contracts that give the holder the rule to bribe or sell the underlying asset at a pre- undertake price some time in the near future and usually thy come with standardized form like contract size, dictated expiry time and price.The future market is one where continues auction market and exchanges presenting the recent information about(predicate) the supply and get hold of 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 buying or se lling futures contract, with a price level arrived at this instant, for items to be delivered 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 unobjectionable margin between their purchase and their selling price.In futures, bankers, farmers, bargainers, manufacturers will arrange for the purchase or change of a futures contract. In future market, commodities are broken down into five categories namely agriculture, metallurgical, touch on bearingassets, jndexes and alien currency.Agricultural futures market includes oats, corn , wheat , soybeans , soy meal ,soyoil,sunf pooh-pooh oil ,cattles , live hogs and pork bellies, quality , plywood ,cotton, coffee, cocoa, rice, orange juice and sugar. For all one of these commodities, different contract months are available and it depends upon the garner cycle. More aggressively traded commodities usually have more contract mon ths available and a new caseful of contract is available almost every month to meet the growing institutional and corporate market.Futures on Metallurgical ProductsPetroleum products and metals is being covered 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 cater the needs of ever increasing institutional and corporate market.Assets which bears interest 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 realizable to trade contracts with the identical maturity but different expected interest rate differentials.Futures on advocatores today futures are available on most chief indexes such as New York blood substitute Composite, SP 500, New York Stock Exchange Utility index, Russell 2000, Commodity Research Bureau (CRB), SP 400 Midcap, FT-Se 100 Index (London) and Value line. These stock index features are settled in cash and there is no speech communication 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 post war period, the exchange rates and interest rates were stable and the mechanism of frozen 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 subsequently the war resulted in the introduction of general rootless exchange rates replacing the earlier placed system. The introduction of blow 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 presidential term tried to influence the exchange rates by movements in interest rates. It is to be noted that the frontwards 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 confer the holder the survival of the fittest to buy or sell the under lying at a pre-determined price some time in the future .Call picking 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 known as exercise or strike price indoors 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 trade in contract. In a nutshell, a swap contract can be delimit 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, then it amounts to a currency swap.If the exchange between two parties of interest obligations or receipts in the same currency on an concord amount of conceptional principal 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 differen t 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 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. consequently they have converted a floating rate loan into a fixed rate loan.The express bank may manages its own risk from the preceding(prenominal) swap transaction by backing it out with another swap , say by paying 6.95% for 7m LIBOR and and then they earn a profit of 0.5% going 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 sw aps are mostly used by mortgage 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. stain Currency Swap fixed for 2m CHF LIBOR.Companies derive more flexibility to exploit their comparative advantage 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 bunco end of the maturity spectrum vs. the persistent end of the maturity spectrum. USES OF DERIVATIVESDerivatives are mainly 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 opportunities are the same less the price of the option but the risk is much less as th e 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 fall 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 honour 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 branch exchange for trading derivatives started by Royal Exchange in London, which allowed forward contract. Likewise, the world-class future contract was introduced to Yodoya rice market in Osaka, Japan in 1650. Then in 1848, Chicago Board of apportion was started to han dle futures market of US.Russell judicious, 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 higher than the US usury law permitted.Chicago Mercantile Exchange started global Monetary market place in 1972 which permitted trading in currency futures. The Chicago Board of distribute 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 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 SP 100.During 1980, Swaps and other over-the counter derivatives were introduced. It was in 1994, the derivative trade witnessed a series of Brobdi ngnagian losses and this affected experienced trading firms like Metallgesellschaft and Procter and Gamble. Orange country, California which is the Americas wealthiest urban c insert 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.discovery 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 varan 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 beastly in value by selling pu t options on the contract, thereby producing a pasture and thus betting against volatility of the market. Simex derivative exchange in Singapore were used to book 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. collectable to unexpected volatility in the market, losses were incurred and these losses in fact exceeded the net worth of stave offing Bank .Lesson was later imprisoned for the falsification 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 decent 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 could have been utilized to Baring Bank case to warn its management of the risk they were approach in advance. VOLATILITYVolatility 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 reaction to unexpected changes in economic variables.Volatility is a type of market incompetence and it is a reaction to dubiety and excessive volatility is unreasonable.Volatility in stock and commodity market is represented by needlelike 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 component 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 authenticator 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. pass judgment volatility is an investors forecast of volatility utilized in an option method to gauge the notional value of an option. Implied volatility is the volatility percentage that illustrates the current market price of an option and it is the indicant of an o ptions 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 formula. Black-scholes formula yield results during trends and unsuccessful 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 blue .Stochastic volatility contradicts the assumption required by the Black-Scholes model if volatilities do modify stochastically through fleck 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 informa tion.Black-Scholes formula is lacking on certain issues like the oblique volatilities of various options on the uniform 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 aerial 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 securitys price., its functioning over a period of time and whether its trading its higher or its lower or in betw een these.Traders are very particular in daily, intraday data to forecast short price movements. Investors rely on weekly and monthly charts to mark long term trends and movements. Line chart, Bar chart, undersidedlestick Chart and point and figure chart are some of the examples of stock charting method. Arithmetic and semi-log arithmetic subdues are two methods of price scaling used in the stock charting method.When the price range is hemmed inside 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, Price/Revenues and Price/ retain 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 be 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 divergence from the index price. If the Dow climaxes at the same time, the oscillator peaks in overbought area and suggests a top. Divergence is utter to be negative and momentum is declining when index makes a new high but the oscillator fails to make a higher .One 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 anticipat ed to enter 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 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 resistance 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, mar ket perception will be reinforce that price is unlikely to increase higher and form a resistance level. CANDLE CHARTINGIt is a price chart that shows the open, low, the high and cultivation for a stock each day over a specified period of time .It is known as Japanese atomic number 48s 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 wick 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 strategies in stock and optionsFollowing is the most of common investment strategies for keeping investment objectives, financial means and risk tolerance. Despite of market interrupt 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 futures of stock or commodities .The buy and-hold dodge 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 three of these corrections, the profits of dollar-cost averag ing tend to be maximized.2 .Investment at regular intervals is most preferred.Investment should be made on a regular basis regardless of the price of the stock.Give preference to high quality of stocks or mutual funds and a company or fund with history of habitual dividend payments and possible for capital appreciation is a meliorate choice.One has to make sure that he has enough strength so that he can rive 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 contract s of the same commodity and pervadeing 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 namely calendar spread, inter-exchange spread and inter-market spread. Swing callingIt 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 prosecute 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 moving up and sells the same on even a higher point in a short period of time. A flipper aim is to maxim ize 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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