Why in the News?

The SEBI has proposed a series of short-term measures to curb speculative trading in index derivatives (futures & options).

What’s in Today’s Article?

• About Futures & Options (Meaning, Key Features, Applications, Examples, etc.)
• Difference between F&O
• News Summary

About Futures & Options:

• Futures and options are two fundamental types of derivatives in financial markets.
• They are financial contracts that derive their value from the performance of an underlying asset, such as stocks, commodities, currencies, or indexes.
• These instruments are used for hedging risks, speculating on price movements, and gaining leverage in financial markets.
• About Futures Trading:
  • A futures contract is a standardized agreement to buy or sell a specific quantity of an asset at a predetermined price on a specific future date.
  • Key Features Include:
    • Standardization: Futures contracts are standardized in terms of quantity, quality, and delivery date, facilitating liquidity and ease of trading.
    • Leverage: Traders can control large positions with a relatively small amount of capital, known as margin.
    • Obligation: Both the buyer and the seller are obligated to fulfil the contract terms at expiration unless the position is closed before the expiry date.
  • Applications:
    • Hedging: Producers and consumers of commodities use futures to hedge against price fluctuations. For example, a wheat farmer may sell wheat futures to lock in a price for their harvest.
    • Speculation: Traders use futures to speculate on price movements, aiming to profit from market volatility.
  • Example:
    • If a trader believes the price of crude oil will rise, they may purchase a crude oil futures contract. If the price increases, they can sell the contract at a profit.
• About Options Trading:
  • An options contract gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) before or on a specified date.
  • Key Features Include:
    • Right, Not Obligation: Unlike futures, options give the holder the right to execute the contract, providing more flexibility.
    • Premium: The buyer of an option pays a premium to the seller for this right. The premium is the cost of the option.
    • Leverage: Options provide leverage, allowing traders to gain significant exposure with a relatively small investment.
  • Types of Options:
    • Call Option: Grants the holder the right to buy the underlying asset at the strike price.
    • Put Option: Grants the holder the right to sell the underlying asset at the strike price.
  • Applications:
    • Hedging: Investors use options to protect against adverse price movements in their portfolio. For instance, purchasing put options can hedge against a potential decline in stock prices.
    • Speculation: Traders use options to bet on the direction of market movements. Call options are bought when expecting a price rise, while put options are bought when expecting a price fall.
  • Example:
    • A trader buys a call option for stock XYZ with a strike price of ₹100, expiring in one month, by paying a premium of ₹5.
    • If the stock price rises to ₹120, the trader can exercise the option to buy at ₹100 and sell at ₹120, making a profit (excluding the premium paid).

Differences Between Futures and Options:

• Obligation: Futures contracts impose an obligation on both parties to fulfil the contract terms, while options grant the right without obligation.
• Risk and Reward: Futures involve higher risk as both potential gains and losses are unlimited. Options limit the buyer's loss to the premium paid, though potential gains are also substantial.
• Flexibility: Options provide more flexibility with the right to execute the contract, whereas futures require execution unless closed before expiry. 

Short-term measures to curb speculative trading:

• The Securities and Exchange Board of India has proposed several short-term measures to curb speculative trading in index derivatives (futures and options), protect investors, and ensure market stability.
• Key proposals include restricting multiple option contract expirations, raising the size of options contracts, and implementing intraday monitoring of position limits.
• These measures follow Finance Minister Nirmala Sitharaman's proposal to double the Securities Transaction Tax (STT) on futures and options from October 1, 2024, to address the surge in trading volume.

Need for Such Measures:

• SEBI's consultation paper noted that 92.50 lakh unique individuals and firms traded in index derivatives in 2023-24, incurring a cumulative loss of Rs 51,689 crore, with 85% of traders experiencing net losses.
• The paper recommends increasing the minimum contract size for index derivatives in two phases, reflecting the rise in benchmark indices over the past nine years.
• Additionally, SEBI suggests rationalizing options strikes, requiring upfront collection of option premiums, and eliminating margin benefits for calendar spread positions with contracts expiring on the same day.
• To mitigate high implicit leverage risks near options expiry, SEBI proposes increasing margins on the day before and on expiry day.
• The consultation paper aims to enhance investor protection and promote stability in derivative markets.