When traders look for a way to diversify the market for stocks and bonds, they often end up trading futures and options. Involved in the futures market and options offered the opportunity to speculate on the price of goods or securities without actually owning any time. Future trading can be done in two ways, hedging and speculating. Hedgers are the traders who like to invest in underlying assets and the speculators prefer to predict the market moves and invest according to the same. Valuation of future securities are done by Margin Calculation which is called as span margin.
When you buy a futures contract does not own any physical or security product. Instead, you agree to buy a fixed amount of an asset at a certain price in the future. Select a specific date on which the product will be issued. When you invest in futures contracts, you have to not receive physical delivery of the goods. Instead, you can trade the futures contract to another person and make a profit on what you originally paid for it.
Hedgers are interested in commodities as such and are therefore usually industrial producers, such as farmers, miners, production companies and even oil and financial companies. People are much reduced by the risk involved in their production processes because buying futures. Hedgers are primarily interested in protecting themselves from rising prices that could cut or reduce their profits after the production process. For example, a company that manufactures cotton seeks to protect themselves from rising price of cotton. At any time if you have bought a futures contract may ask to effectively sell cotton at that price saving much of that purchase at a price. We conclude that if the price rises, the contract holder can sell the contract at a price that permits even buy the same raw material in the Spot Market even with a small profit, thus passing the risk to a third party.
For example, if John purchases 100 shares of ITC (STOCK) at $10 per offer, he may hedge by taking out a $5 put option with a strike cost of $8 expiring in one year. This gives John the privilege to offer 100 shares of ITC STOCK for $8 at whatever time in the following year. On the off chance that a year later STOCK is exchanging at $12, John won’t exercise the option and will be out $5; his unrealized income is $200. In the event that STOCK trading at $0, then John will exercise the option and sell his shares for $8, for lost $200. Without the option, he would lose his whole capital invested.
Speculators are people who seek only profit to participate in the futures markets. They do not care what the commodity in question. Speculators seek to achieve big gains. Speculators use the market to win by the fluctuating price of raw materials and earn the loss that may have effectively forced to sell the products; these are undoubtedly the most important players in this market. It is important to reiterate that the futures market does not produce real wealth as they always gain one is based on the loss of another. Therefore, this market is called “ZERO SUM MARKETS” (zero-sum markets).
For example, Assume that Mr. Roy has $2,000 to capital investment, and INFOSYS stock cost $50 and INFOSYS call option costs $2 each with 6 month expiry. A trader can buy 40 shares ($2,000 / $50) of INFOSYS. Whereas he can hold position of 1,000 shares ($2000 / $2) by buying INFOSYS option. In case of profit and loss, if INFOSYS stock drops by $1 in 6 months i.e.. Now trading at $49, in that Mr. Roy current capital would be $1,960 (loss of $1 * $40). Whereas in options total capital value would be $0. Option would be worthless because no one will purchase at a value that is more prominent than the present market value.
Futures options and futures margins are governed by the exchange using a calculation algorithm that is called SPAN margining. SPAN is an online tool that lets one calculate comprehensive margin requirements for futures. Based on a sophisticated set of algorithms, SPAN determines the Span Margin charged by the exchanges and also the exposure margins being calculated by the Exchanges.
How SPAN works:
Span calculates the worst possible loss of derivative and physical instruments that might incur in one trading day and the overall portfolio risk of the same. SPAN calculates the profit and losses that the portfolio may experience under various market conditions. A set of numeric values, better known as the SPAN risk array anticipates how a particular contract may gain or lose value under different market conditions. The gain or loss on a particular contract, in each scenario, is represented through a numeric value that may encounter a specific combination of volatility change, price, change as well as the expiry period.
At specific intervals, the SPAN margin files are sent to IB (interactive brokers) throughout the day and they go through a SPAN margin calculator. An individual futures contract is considered to be at risk until they are closed, or are expired out of the account. All scenarios are considered for what may happen in extreme market volatility, as well as the margin impact of these futures options until the option position ceases to exist.
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Basics of Futures Trading for Beginners
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