Home Money Futures and Options – the basics you should know!

Futures and Options – the basics you should know!

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Futures and Options
F&O market, stock market trading

Derivatives come handy for protection against price fluctuations. There are two types of derivatives – futures and options. Apart from being a hedge against price fluctuations, they can be traded on exchanges such as commodities, stocks, and currency.

Future and option trading enable those, who are disinterested in the underlying asset to profit from price fluctuations. For example, you are interested in F&O trading of wheat. You aren’t interested in hoarding tonnes of grains in your garage but, are keen to benefit from price fluctuations. Then, you can buy wheat futures and options without getting the commodity delivered to you. Most participants in the F&O market are speculators, who are not quite interested in the product. This is good as it contributes to the market’s liquidity.

WHAT ARE FUTURES AND OPTIONS?

If there’s one thing that’s certain about financial and commodity markets, it’s price changes. Prices keep changing all the time. They can go up and down in response to various factors, including the state of the economy, the weather, agricultural production, election results, coups, wars and government policies. The list is practically endless.

What are futures?

One type of derivative is the futures contract. In this type of contract, a buyer (or seller) agrees to buy (or sell) a certain quantity of a particular asset, at a specific price at a future date.

Let’s illustrate this with an example. Let’s say you have bought a futures contract to buy 100 shares of Company ABC at Rs 50 each at a specific date. At the expiry of the contract, you will get those shares are Rs 50, irrespective of the current prevailing price. Even if the price goes up to Rs 60, you will get the shares at Rs 50 each, which means you make a neat profit of Rs 1,000. If the share price falls to Rs 40, however, you will still have to buy them at Rs 50 each. In which case you will make a loss of Rs 1,000! Stocks are not the only asset in which futures are available. You can get futures contracts for agricultural commodities, petroleum, gold, currency etc.

Futures are invaluable in helping escape the risk of price fluctuations. A country that is importing oil, for instance, will buy oil futures to insulate itself from price increases in the future. Similarly, farmers will lock in prices of their products using futures so that they don’t have to run the risk of a fall in prices when they are ready to sell their harvest.

What are options?

Another kind of derivative is the options contract. This is a little different from a futures contract in that it gives a buyer (or seller) the right, but not the obligation, to buy (or sell) a particular asset at a certain price at a specific pre-determined date.

There are two types of options: the call option and the put option. A call option is a contract that gives the buyer the right, but not the obligation, to buy a particular asset at a specified price on a specific date. Let’s say you have purchased a call option to buy 100 shares of Company ABC at Rs 50 each on a certain date. But the share price falls to Rs 40 below the end of the expiry period, and you have no interest in going through with the contract because you will be making losses. You then have the right not to buy the shares at Rs 50. Hence instead of losing Rs 1,000 on the deal, your only losses will be the premium paid to enter into the contract, which will be much lower.

Another type of option is the put option. In this type of contract, you can sell assets at an agreed price in the future, but not the obligation. For instance, if you have a put option to sell shares of Company ABC at Rs 50 at a future date, and share prices rise to Rs 60 before the expiry date, you have the option of not selling the share for Rs 50. So you would have avoided a loss of Rs 1,000.

What is futures and option trading?

One advantage of futures and options is that you can freely trade these on various exchanges. E.g. you can trade stock futures and options on stock exchanges, commodities on commodity exchanges, and so on. While learning about what is F&O trading, it’s essential to understand that you can do so without taking possession of the underlying asset. While you may not be interested in purchasing gold per se, you can still take advantage of price fluctuations in the commodities by investing in gold futures and options. You will need much less capital to profit from these price changes.

Futures Contracts and Trading:

A futures contract gives the buyer (or seller) the right to buy (or sell) a specific commodity at a specific price at a predetermined date in the future.

Let’s illustrate this with an example. Let’s say you work in a company making baked goods and want to purchase large amounts of wheat at frequent intervals. You will need 100 quintals a month down the line. However, wheat prices are volatile, and to protect yourself; you enter into this type of contract to purchase 100 quintals of wheat at Rs 2,000 a quintal a month down the line. In the meantime, wheat prices go up to Rs 2,500 a quintal. However, you will still be able to buy it at Rs 2,000. Thus, you would have saved Rs 50,000 because of this type of contract! However, if wheat prices fall to Rs 1,500, you would have lost Rs 50,000.

However, futures contracts aren’t restricted to them alone. Speculators too are enthusiastic participants in the futures market. They can reap the benefit of movements of asset prices without having to purchase the underlying asset through futures trading.

If you want to make money by betting on wheat futures, you don’t have to take delivery of large quantities of the commodity. You don’t have to spend large amounts either since you don’t have to deal in the underlying asset.

Futures contracts enable you to trade large quantities. This is because to trade, all you need is to deposit an initial margin with the broker. For example, if the margin is 10 percent, if you want to buy and sell futures worth Rs 20 lakh, all you need to deposit is Rs 2 lakh.

Generally, margins in commodities are low so that traders can deal in massive amounts. This is called leverage and can be a double-edged sword. The opportunities for profits are enormous because of the large numbers involved. However, if you don’t get it right, the losses can be considerable indeed. When you make losses, you may get margin calls from brokers to meet the minimum requirement. If you don’t meet it, the broker can sell the underlying asset at a lower price to recover it, and you could end up with more losses.

It’s essential to understand what are futures before venturing into them. Commodity markets are especially risky since price movements are volatile and can be unpredictable. The high leverage also adds to the risk. Generally, the commodities markets are dominated by large institutional players who can deal with risk better.

Also Read: Mutual Funds – All you need to know about this care taker!

Futures trading in the stock market:

What are futures in the stock market? Like many other assets, you can also trade in futures contracts on the stock exchange. Derivatives made their debut in the Indian stock market a couple of decades ago, and since then have become popular with investors. You can get these contracts for specified securities as well as indices like Nifty 50 etc.

Prices of stock futures contracts depend on demand and supply of the underlying. Usually, stock futures prices are higher than that in the spot market for shares.

Here are some of the features of a futures contract in stocks:

Leverage: There is considerable scope for advantage. If the initial margin is 20 percent and you want to trade in Rs 50 lakh worth of futures, you need to pay only Rs 5 lakh. You can get exposure to a significant position with little capital. This increases your chances of making profits. However, your risks will also be higher.

Market lots: Futures contracts in shares are not sold for single shares but in market lots. For example, the value of these on individual stocks should not be less than Rs 5 lakh at the time of introduction for the first time at any exchange. Markets lots vary from stock to stock.

Contract period: You canget these types of contracts for one, two and three months.

Squaring up: You can square up your position till the expiry of the contract.

Expiry: All futures and options contracts expire on the last Thursday of the month. A three-month contract will then become one for two months, and a two-month contract turns into a single-month contract.

Types of Futures:

There are many types of futures, in both the financial and commodity segments. Some of the types of financial futures include stock, index, currency and interest futures. There are also futures for various commodities, like agricultural products, gold, oil, cotton, oilseed, and so on.

Let’s look at different types of futures.

Stock Futures:

Index futures first appeared in India in the year 2000. These were followed by individual stock futures a couple of years later. There are several advantages of trading in stock futures. The biggest one is leverage. Before trading in stock futures, you need to deposit an initial margin with the broker. If the initial margin is, say, 10 per cent, you can trade in Rs 50 lakh worth of futures by paying just Rs 5 lakh to the broker. The larger the volume of transactions, the higher your profit. But the risks are also more significant. You can trade stock futures on stock exchanges like the BSE and NSE. However, they are available only for a specified list of stocks.

Index Futures:

Index futures can be used to speculate on the movements of indices, like the Sensex or Nifty, in the future. Let’s say you buy BSE Sensex futures at Rs 40,000 with an expiry date of the month. If the Sensex rises to 45,000, you stand to make a profit of Rs 5,000. If it goes down to Rs 30,000, your losses, in that case, would be Rs 5,000. Index futures are used by portfolio managers to hedge their equity positions should share prices fall. Some of the index futures in India include Sensex, Nifty 50, Nifty Bank, Nifty IT etc.

Currency Futures:

One of the different types of financial futures is currency futures. This futures contract allows you to buy or sell a currency at a specific rate vis-à-vis another currency (Euro vs USD, etc.) at a predetermined date in the future. These are used by those who want to hedge risks, and by speculators. For example, an importer in India may purchase USD futures to guard against any appreciation in the currency against the rupee.

Commodity Futures:

Commodity futures allow hedging against price changes in the future of various commodities, including agricultural products, gold, silver, petroleum etc. Speculators also use them to bet on price movements. Currency markets are highly volatile and are generally the domain of large institutional players, including private companies and governments. Since initial margins are low in commodities, players in commodity futures can take significant positions. Of course, the profit potential is enormous, but the risks tend to be high. In India, these futures are traded on commodity exchanges like the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange.

Interest rate futures:

An interest rate future is one of the different types of futures. It’s a contract to buy or sell a debt instrument at a specified price on a predetermined date. The underlying assets are government bonds or treasury bills. You can trade these on the NSE and the BSE.

Options Contract:

Options are a type of derivative, and hence their value depends on the value of an underlying instrument. The underlying instrument can be a stock, but it can also be an index, a currency, a commodity or any other security.

Now that we have understood what options are, we will look at what an options contract is. An option contract is a financial contract which gives an investor a right to either buy sell an asset at a pre-determined price by a specific date. However, it also entails a right to buy, but not an obligation.

When understanding option contract meaning, one needs to understand that there are two parties involved, a buyer (also called the holder), and a seller who is referred to as the writer.

When the Chicago Board Options Exchange was set up in 1973, modern options came into being. In India, the National Stock Exchange (NSE) introduced trading in index options on June 4, 2001.

Features of an option contract:

Premium or down payment: The holder of this type of contract must pay a certain amount called the ‘premium’ for having the right to exercise an options trade. In case the holder does not exercise it, s/he loses the premium amount. Usually, the premium is deducted from the total payoff, and the investor receives the balance.

Strike price: This refers to the rate at which the owner of the option can buy or sell the underlying security if s/he decides to exercise the contract. The strike price is fixed and does not change during the entire period of the validity of the contract. It is important to remember that the strike price is different from the market price. The latter changes during the life of the contract.

Contract size: The contract size is the deliverable quantity of an underlying asset in an options contract. These quantities are fixed for an asset. If the contract is for 100 shares, then when a holder exercises one option contract, there will be a buying or selling of 100 shares.

Expiration date: Every contract comes with a defined expiry date. This remains unchanged until the validity of the contract. If the option is not exercised within this date, it expires.

Intrinsic value: An intrinsic value is the strike price minus the current price of the underlying security. Money call options have an intrinsic value.

Settlement of an option: There is no buying, selling or exchange of securities when an options contract is written. The contract is settled when the holder exercises his/her right to trade. In case the holder does not exercise his/her right till maturity, the contract will lapse on its own, and no settlement will be required.

No obligation to buy or sell: In case of option contracts, the investor has the option to buy or sell the underlying asset by the expiration date. But he is under no obligation to purchase or sell. If an option holder does not buy or sell, the option lapses.

Types of options:

Now that it is clear what options are, we will take a look at two different kind of option contracts- the call option and the put option.

Call option:

A call option is a type of options contract which gives the call owner the right, but not the obligation to buy a security or any financial instrument at a specified price (or the strike price of the option) within a specified time frame.

To buy a call option one needs to pay the price in the form of an option premium. As mentioned, it is upon the discretion of the owner on whether he wants to exercise this option. He can let the option expire if he deems it unprofitable. The seller, on the other hand, is obliged to sell the securities that the buyer desires. In a call option, the losses are limited to the options premium, while the profits can be unlimited.

Let us understand a call option with the help of an example. Let us say an investor buys a call option for a stock of XYZ company on a specific date at Rs 100 strike price and expiry date is a month later. If the price of the stock rises anywhere above Rs 100, say to Rs 120 on the expiration day, the call option holder can still buy the stock at Rs 100.

If the price of a security is going to rise, a call option allows the holder to buy the stock at a lower price and sell it at a higher price to make profits.

Call options are further of 2 types

1. In the money call option: In this case, the strike price is less than the current market price of the security.

2. Out of the money call option: When the strike price is more than the current market price of the security, a call option is considered as an out of the money call option.

Put options:

Put options give the option holder the right to sell an underlying security at a specific strike price within the expiration date. This lets investors lock a minimum price for selling a certain security. Here too the option holder is under no obligation to exercise the right. In case the market price is higher than the strike price, he can sell the security at the market price and not exercise the option.

Let us take an example to understand what a put option is. Suppose an investor buys a put option of XYZ company on a certain date with the term that he can sell the security any time before the expiration date for Rs 100. If the price of the share falls to below Rs 100, say to Rs 80, he can still sell the stock at Rs 100. In case the share price rises to Rs 120, the holder of the put option is under no obligation to exercise it.

If the price of a security is falling, a put option allows a seller to sell the underlying securities at the strike price and minimise his risks.

Like call options, put options can further be divided into in the money put options and out of the money put options.

In the money put options: A put option is considered in the money when the strike price is more than the current price of the security.

Out of the money put options: A put option is out of the money if the strike price is less than the current market price.

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