Futures And Options: Understanding Some Basic Facts

Futures and options are also called "derivative" trades since they derive their values from an underlying asset. Futures and Options come with their own limitations and advantages.

What are futures and how do you trade them?

In a futures contract the buyer purchasing stock or commodity, needs to settle his position before the expiry of the contract. On the other hand a seller, who has sold stock or commodity in the futures segment has to buy it back before a specific future date, unless the holder's position is closed earlier.

Let us now explain this with an example. Let us say you are optimistic on the stock price of company A going up. The stock now trades at Rs 1000 in the futures market. You can buy the stock in the futures market with a specified lot size. One lot size can be any amount of stock that is large. If you buy Company A as an example with 1 lot size (500 shares), than your total exposure is (1000x500) = Rs 5 lakhs. However, you do not have to pay the entire amount of Rs 5 lakhs, but, just margin money fixed by the exchanges. The margin could be 5%, 10%, 15%, 20% or any such amount depending on the volatility of the stock. Now, if the stock futures price goes from Rs 1000 (your purchase price) to Rs 1010, you make a profit of Rs 10 and since you have exposure to 1 lot size of 500 shares, your profit would be = 500x10= Rs 5000. Similarly, if the price falls from Rs 1000 to Rs 990, you would make a loss of Rs -5000 (500x-10).

Remember, you have to settle your position before the expiry of the contract.

Now, this was as far as futures buying is concerned. If you believe that the stock futures price of Company A is likely to go down, you could sell first and buy again at a lower rate. In the above example, if you sold first at Rs 1000, one lot (500 shares) and the shares fall to Rs 990, you can buy it back at Rs 990 making a profit of Rs 5000 (10x 500 shares 1 lot). However, if the price climbs you would end-up making a loss.

Understanding options trading

An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specified price at any time before the contract's expiration.

1) Buying a call option

This is best explained with an example. Let us say an investor studies a stock well and decides he wants to buy company XYZ with a call option as he sees an upside on the stock. He decides to buy 2000 strike call option by paying a premium of Rs. 8.

In this case, if the price goes down even way below the price of Rs 2000, his loss would be restricted to Rs 8, which is the premium paid. Now, if the prices move higher above Rs 2000 strike, he would make a profit only when he also recovers the premium paid of Rs 8, which means a profit would be made only beyond Rs 2008. However, the loss to the call option buyer is restricted to the extent of the premium he has paid.

2) Selling a call option

Now, in the above example, if an investor sees that there is a potential for the stock to fall he sells at the strike price of Rs 2000 options and collects a premium, Rs 8 in the above case. So, he would lose money only if the price falls below Rs 1992. In short, he would experience a loss only after he losses the entire premium. Hence for an option seller to experience a loss he has to first lose the premium he has received, any money he loses over and above the premium received, will be his real loss.

3) Buying a put option

A 'Put Option' is a contract where two interested parties agree to enter into a transaction based on the price of an underlying. The party agreeing to pay a premium is called the 'contract buyer' and the party receiving the premium is called the 'contract seller'. In this case the buyer pays a premium and buys himself a right, while the contract seller receives the premium and obligates himself.

Interestingly, the contract buyer will decide whether or not to exercise his right on the expiry day. Let us assume Company XYZ is trading at Rs 900. The Contract buyer buys the right to sell the put option for Company XYZ to contract seller at Rs. 900 upon expiry. However, to acquire the right, the contract buyer has to pay a premium to the contract seller. Against the receipt of the premium, contract seller will agree to buy Company XYZ at Rs 900 upon expiry, but only if the contract buyer wants him to buy it from him. On expiry, if Company XYZ is trading at Rs.880, then the contract buyer can demand the seller to buy Company XYZ at Rs 900 from him. This means contract buyer can enjoy the benefit of selling XYZ at Rs. 900, even when it is trading at a lower price of Rs 880.

4) Selling a put option

Let us now understand what selling Put Option is with the help of an example. Let us say that for the Nifty a seller sells the 18500 Put option and collect Rs 350 as the premium. As long as the spot price stays above 18500, the premium becomes his profit. On the other hand losses begin only when the values of the spot price fall below (18500-350 premium received) =8150. Even at price of 8150 he is at zero, but, below this spot price he starts incurring a loss.

Key takeaways

• Options and futures are both types of derivatives contracts that derive their value from market movements for the underlying index, security or commodity.
• An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract.
• A futures contract obligates the buyer to purchase a specific asset, and the seller to sell and deliver that asset, at a specific future date.
• Futures allows you to hedge your risk against market volatility. For example, if your portfolio consists of stock holdings and you expect the markets to crash, you can sell in the Futures market and to an extent hedge yourself.

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