Month: February 2022

Futures contract is a derivative financial instrument within which an agreement is entered into between a buyer and a seller where the buyer agrees to purchase the underlying at a specified time in the future for a fixed price.

They are powerful derivative financial instruments made use of by hedgers and speculators alike depending on their individual financial interests.

To give clarity, let’s take an example. Suppose there are two traders, Aman and Nitin. Aman has a point of view that the value of a particular stock will rise from it’s present value in the future while Nitin believes that the value of that same stock will fall. So Aman and Nitin both get into a contract with Aman buying the shares of the stock from Nitin at the present price sometime in the future. If Aman’s prediction comes true where the value of the stock increases then he can buy the stock at a discounted price where is the price if the stock falls as predicted by Nitin, then Nitin can sell the stocks at a premium which is higher than the current price.

How does future trading work?

In futures trade, there is no actual exchange of assets that takes place like normal trading. They only take advantage of the price changes and buy and sell the contracts in short time and earn profits for themselves. Below is the process of how it works.

• It is available in both the BSE and NSE
• The trader can either place a buying order which means agreeing to buy it at a certain price or place a selling order which means selling it at a fixed price
• In this case the buyer takes a bullish approach while the seller takes a bearish approach
• Futures can only be bought in lots. Each lot size depends from company to company. Some may have a lot size of 250 shares or 500 shares or even 100 shares, it varies.
• Each future contract expires on the last Thursday of every month by which all payments are settled and new contracts are created.
• Once you buy a future contract, you can also end up selling it to others.
• A futures contract position, either on the buy or sell side can be held by paying a small amount called the margin. Say, if a trader wants to buy one contract of Nifty consisting of 50 units of Nifty he has to pay a margin as specified by the exchange. If Nifty is trading at 17500 the cost of buying a lot of Nifty would have been Rs 875,000 (17500 X 50). But in futures market one can hold a contract of Nifty by paying as little as Rs 120,000. 

Benefits of Future contracts

Some of the main benefits of trading in a futures market are as follows:

• Effective hedging mechanism

Futures are instruments that can be employed effectively to mitigate or hedge against systemic risks of movement in the underlying. One of the common ways in which a future is used as hedging tool is in the currency segment. Companies and even Governments use futures contracts to hedge against any potential currency fluctuations especially when they indulge in international trade. For example, Infosys expecting a dollar payment of 1 million dollars six months down the line for a software project could mitigate the risk of fluctuations in the USD INR market by entering into a currency futures trade. Airline companies wanting to hedge risk of rising fuel costs can enter into oil commodity futures to hedge and manage this risk. Likewise, even traders in the equity markets who hold positions in the Cash market often make use of the futures market to hedge the risk of volatile movements.  

• The power of Leverage trading

Yet another important benefit of trading futures is the power of leverage it offers making it a more attractive investment than a cash market trade.

Let us demonstrate how with an example. 

Assume that you decide to buy Reliance shares today since you feel that the price will go up in the next few days and you can profit from this transaction. Your capital is Rs.1.5 lakh and timeframe is going to be the end of December because you want money for your new year celebrations. You have two options.

Option-1

Buy Reliance shares in the Spot market

Reliance currently happens to be trading at Rs. 2,411.25 (The value of the underlying is the value of the share in the spot market if you remember. The spot market is nothing but the cash market or the equity market)

So, with Rs. 1 lakh, I can buy 1,50,000/ 2411.25 which is about 62 shares. On December 31st, if the share price grows to Rs.2,500 as you had predicted, you would make a profit of Rs. (2,500- 2,411 = Rs.89) per share. In total, your profit will be Rs. 5,518 when calculated for 62 shares and the return on your investment about 3.65%. Now let us evaluate option-2.

Option-2: Buy Reliance Futures

The December expiry Reliance future is trading at Rs.2,425 per share (Last price in the above snap) and the lot size is 250 shares as we had discussed before. So, the contract value would be Rs.2,425 * 250 = Rs.6,06,250. But wait, this is outside my investment limit, right? 

Now this is where the derivatives market offers leverage facility. To trade in Reliance futures, you need not pay the entire amount. It is sufficient if you pay what is known as margin amount, which is usually a percentage of the contract fixed by the Exchange. For Reliance, the margin happens to be 22%. Thus, you need to may about 22% of Rs.6,06,250 which is about Rs.1,33,375, which happens too be within your investment limit. 

Now, upon expiry, your profit per share would be Rs. (2,500-2,425= Rs.75 per share). When multiplied for 250 shares, your profit is Rs. 18,750 and your return on investment, about 12%. Impressive right! To be able to make about Rs. 13,000 more with the same capital does amount to something significant. 

In conclusion

In general, the futures market is a highly liquid market that offers a great mechanism to hedge risks and also the power of leverage trading to maximise your gains. It is a bet on the direction of the movement of the stock and buyer profits with a rise in price while a seller profits from a drop in the price.

 

 

A future is an important derivative trading financial instrument. Before we dive deep into the subject it is essential for us to know what a derivative trading instrument is. 

What is a derivative?

A derivative, as the name suggests, is a product whose value is derived from one or more underlying variables. The underlying variables can be either stock, foreign currency or even interest rates like LIBOR, OIS etc.

For example, the below is a snip of futures of Tata Motors shares, with different expiry dates. Let’s understand about expiry dates later, for now, our focus remains on understanding what I mean by a derivative. 

Source: NSE India

Notice that the last column has details about the underlying value? 

For a Tata Motors future, the underlying is obviously going to be a Tata Motors share. So, going by this logic, the share price of Tata Motors for today must be Rs.496, isn’t it?

Well, here you go!

Source: NSE India

If we revisit our understanding of what is a derivative, which is a product whose value is derived from one or more underlying variables, we see that it seems to make more sense. 

There are several types of derivative instruments in the market namely Forwards, Options, Futures, Swaps, Swaptions, Collars etc. Our present discussion is going to be limited to understanding what we mean by futures. 

Understanding forward contracts.

A futures contract is a standardised form of what we call a forward contract. So, to understand a future better, let us first take a simple example to understand a forward contract. Now imagine a wheat farmer in Punjab. Let’s say that his harvest cycle is 6 months which means that if he sows in March, he can reap the wheat in September. In March, when the wheat costs Rs. 400 per kilo, he decides to begin his cropping mentally calculating his profits from this harvest. In September, once he has harvested his grains, he sets forth towards the mandi, mentally fantasising the good profits he is about to reap at Rs.400 a kilo. At the mandi though, owing to markets conditions, the price of wheat has fallen to Rs.350 a kilo, leading to a significant fall in the forecasted profits of the farmer. 

In order to avoid this risk of fall in prices at a future date, what can the farmer possibly do while standing in March? If he has a mechanism to agree at a locked selling price of Rs.400/ kg with a promise of delivery at a later date, he would be able to lock his profits and hence mitigate his risk. Now, this is what we call a forward contract. 

A forward contract is an agreement between two parties, where one party agrees to by an underlying instrument, be it stock, currency, index or a commodity at an agreed price on a future date from another party. 

Transitioning from forwards to futures

Now, imagine about one lakh farmers wanting to do the same thing. All of them gather at a market, desperately seeking out potential buyers to agree upon prices for a future harvest. Apart from causing chaos, it could also have other repercussions like say, the risk of default on the part of the farmer or the buyer. To avoid all this, there enters a crucial player, the one called an Exchange. The exchange acts as an intermediary between the buyer and the seller to facilitate the trades, streamline quantities and delivery dates and so on. This standardisation of a forward trade through the system of exchange leads to the creation of a powerful derivative instrument called Futures. Also, another benefit of having an exchange as a middle man is that the burden of finding a counterparty is shifted onto them. 

As with forward contracts, the agreement is completed on a future date, either by actual delivery of goods or by cash settlement of the difference between the current market price on the future date and the agreed price. In general, the futures market is used as an effective hedge tool to lock your price, however, in practice, there are several people who speculate through futures market as well. 

Some of the common features of a futures trade that are worth understanding are as follows:

• The price of a future is correlated to the underlying. 

• Futures contract sizes are standardised.

• Futures contracts are regulated by Exchanges. 

• Futures contracts are time-bound. 

• Futures trades are mostly cash-settled

How is profit or loss made on futures trade?

Now assume that you are buying one lot of Reliance futures December expiry at the current price of 2,425. 

Let us assume that you are holding the contract until the expiry date i.e. 30th December. The value of your contract as on today will be Lot size multiplied by price today which is 250 * 2425 = Rs.6,06,250. 

As on the expiry date, three possible scenarios enfold. 

1. The price moves to Rs.2,500

In this case, you are making a profit because your selling price which is Rs.2500 is more than your agreed price which is Rs.2,425. Thus, you are making a profit of Rs.75 per share. Your total profit which is 250 shares * Rs.75 per share = Rs.18,750 will be credited to your account. 

1. The price moves to Rs.2,400 

You make a loss here. Your loss of Rs. 25 per share multiplied by 250 shares which equals Rs.6,250 will be debited from your account. 

1. The price remains at 2,425

In this case, your agreed price and the actual price is the same. You neither make a profit, nor a loss. 

Note that you could either opt for a buy or a sell future. What this means is that you could either have an agreed price of Rs.2,425 per share at which you will buy the share on expiry or agreed selling price of Rs.2,425 upon expiry. Depending upon your assessment of how the market is going to unfold, you could choose your position. 

A person who anticipates the market to fall would make a profit by selling futures now while a person who believes that the market would rise would make a profit by buying futures now. 

Margins and Futures Profits or Loss

We saw above, theoretically, how one could profit from a futures trade. But in the practical world, with huge volume of players involved, how does the futures market operate? When the exchange acts as a regulator for huge volumes and several counterparties, what are the potential risks it faces?

What if all sellers chose not to honour the contract for a particular expiry? Since the NSE is the regulator, it has to compensate the buyers. But doing so would result in a huge loss for the NSE. Hence, to protect the financial risk of the contract and to prevent unnecessary speculation, the NSE often fixes a margin to be paid for each share or index to be traded in the futures segment. The calculation of margin is based on complicated algorithms, inherent volatility, value at risk and several other company-specific and market-specific factors. It is not a constant number and is subject to change. SEBI comes up with margin requirement modifications. 

The initial margin percentage is a combination of what we call SPAN margin and exposure margin. The SPAN is a tool used to calculate the SPAN margin and it uses a portfolio-based approach. Exposure margin is usually charged in addition to the SPAN margin as an added security. The SPAN margin is usually needed to be maintained at all times failing which a penalty is charged while the exposure margin generally adjusts for any mark to market losses.

What is MTM?

MTM or Mark to Market is the mechanism by which profit in futures contracts are calculated. 

Typically, in futures market, the profit or loss is calculated on a daily basis and reflected in your margin account. 

Assume that you buy Reliance futures today at Rs.2,425 per share for a 250 lot size. Tomorrow, if the price rises to Rs. 2,450, a profit of Rs.25 per share or a total profit of Rs. 6,250 will be credited to your margin. 

On the next day, if the futures price falls to Rs.2,400, the loss of Rs. (2,450-2,400) = Rs.50 per share or Rs. (12,500) is debited from your margin account. 

Combining margin requirements and MTM

The below table shows you a snapshot of how your margin account appears like. 

As you can see, the cash balance is nothing but your initial margin plus or minus your mark to market profit or loss. As long as your balance exceeds the SPAN margin, it is fine. On 16th, when your cash balance falls below your SPAN margin, your broker will do what is known as a Margin Call asking you to pump money into your margin account. 

Futures Pricing

The next exciting thing to understand is the mechanism of futures pricing. Although much of technical trading doesn’t really require an understanding of this, advanced strategies might require one to understand this mechanism. 

In the above example for Reliance Industries, we noticed that the current market price was Rs.2,411.25 whereas the futures price today was Rs. 2,425. This difference between the spot and the futures price is known as spread.

Futures Price = Spot Price * (1 + Risk free rate of interest * Days to expiry/365) – Dividends if any

Please note that the actual market future price may not equal the theoretical price calculated above due to demand-supply differences, any news, brokerage and other charges etc.

But in general, the actual futures price is very close to the theoretical futures price calculated.

If the future price is higher than the spot, then the future is said to be trading at a premium or what is called Contango. Our Reliance example reflects this.

However, it is also possible for a future to be trading at below the spot price due to a negative outlook for the stock. Then the future is said to be trading at a discount or backwardation. 

Upon expiry, the spot price and the futures price Converge since Reliance share and futures price on 31st December must essentially be the same.

Open Interest

Another important measure, that is used frequently in derivatives trading is what is known as the open interest. In simple terms, Open Interest refers to the number of outstanding contracts open in the market for a particular expiry. 

For instance, see the below snap shot.

In the above, we see Open Interest as 3,65,16,500. We also see a change in Open interest which is nothing but new contracts added or deleted to the particular scrip. 

Conclusion

In summary, the future is an important derivative instrument used by hedgers and speculators for their respective requirements in the market. 

• Its price is correlated to the underlying base
• It is cash-settled and traded in lots
• It gives you the benefit of leveraged trading
• It is regulated by Exchanges

An option is a financial derivative instrument that derives its value from the underlying instrument. The underlying could be a stock, a commodity, an index or an interest rate.  

One of the specialities of the option as a derivative instrument is that it gives the buyer an extra privilege of having the right to exercise his option if the conditions turn in his favour. 

An Option contract that give the holder the right to buy is called a Call Option and an Option contract giving the right to sell is called a Put Option. 

Example of Option Trading

Now that we have understood what an option is with an example, let us try to extend the same understanding to the financial markets and see if our understanding holds good.

The above is a snapshot of Tata Consultancy services Call Option quote from the NSE India website. What does it indicate?

It indicates that this contract gives you the right to buy a TCS share on 27th January, 2022 expiry date at Rs.3920 per share which is the strike or the agreed price. The value of the underlying is currently Rs.3885.35 and the premium or upfront payment to enjoy this right to buy is Rs.91.25 today. Also, if you notice above, there is a field called market lot which says 150. Typically, futures and options are traded in lot size. In this case, you can buy in lots where one lot would give you the right to buy 150 shares of TCS. Thus to buy one lot, your investment would be Rs.91.25 multiplied by 150 shares which is Rs.13,687.5.

Now, as a trader, say you are bullish on TCS stock with the results and feel that a good move is on the cards and decide to enter this trade. Let us see what could be the possible scenarios that could unfold. 

Scenario 1: The share price moves up to Rs. 4100 on expiry

In this case, you would feel elated. You have the right to buy this share at Rs.3920. Assume that you exercise this right and buy this at Rs.3920 and sell it immediately at Rs.4100. Your profit from the trade would be Rs.180 per share! But then, to have this right to buy at Rs.3920, you have paid Rs.91.25 which is also a cost you bear. So, the next profit from the trade you make will be Rs.180-Rs.91.25 = Rs.88.75 per share! For one lot you purchased, your profit would be Rs.88.75 X 150 which is Rs.13,312.25! This act of buying at the agreed price is called exercising the contract.

Scenario 2: The share price falls to Rs.3800 on expiry

In this case, you would be feeling sad since you’ve a right to buy at Rs.3920, but the price falls to Rs.3800. So, if you buy and sell at these respective levels you will be left with a loss of Rs.120 per share. 

But wait, an option contract gives you a right to buy, not an obligation. As the name suggests, it is an option. So, in this case, since the share movement is not in your favour, you will not exercise or in other words, lapse your right. 

You will still be losing the premium of Rs.91.25 per share that you paid or in other words, your investment in premium for 150 shares of Rs. 13,687.5, but then, this is better than a potential loss of Rs.120 per share, isn’t it?

Scenario 3: The share price touches Rs.3920 and holds

At this level, you are indifferent. You could buy and sell at Rs.3920, but then, you aren’t making any gains from this. So, typically, you would let the right to lapse. Still, you would be losing the premium of Rs.91.25, that is, your investment of Rs.13,687.5

In any sort of worst case, your maximum loss will be limited to the premium you paid. On the flip side, if the share turns in your favour, your gains could be unlimited. Also, another added advantage is that the Options segment lets you use the power of leverage. To buy 150 actual shares of TCS at Rs.3920 would cost your Rs.5,88,000! But now, at a minimal investment of Rs.13,687.5, you could enjoy the profitable movement in the price of this stock. 

Now, you might wonder, why would someone be interested to transact with you as a Call writer with the risk of unlimited loss, gains limited to the premium amount and an obligation to sell when you exercise your right to buy?

Well, a simple answer to that is seen from the above scenarios. If you look closely, in two out of three instances, your contract lapses. In other words, the Writer has a 2/3rd chance of pocketing the premium which makes the risk of unlimited loss attractive to them. 

Types of Options

Call Options and Put Options

Now that we have understood how options contracts work, let us understand the two types of options, a call option and a put option. 

The ‘Call Option’ gives the holder of the option the right to buy the underlying at the strike price on or before the expiration date in return for a premium paid upfront to the seller. The value of a call option increases when the price of the underlying increases.

The Put Option gives the holder the right to sell the underlying at the strike price anytime on or before the expiration date in return for a premium paid upfront. The value of a Put option increases when the price of the underlying decreases. 

Intrinsic value vs time value of options

Based on the price of the underlying and the strike price, the intrinsic value of an option can be classified as either In the Money, At the Money or Out of Money.  This classification helps the trader to choose their strike price wisely. 

In simple terms, the intrinsic value of an option refers to the money the trader could make from the underlying if given a chance to exercise the right on that day. 

For example, in the above chart, the TCS Share price of the underlying was Rs. 3883.35. The Strike price was Rs.3920. Thus, if the trader were to exercise the right on that day, they would be buying at the Strike price of Rs. 3920 and selling at Rs.3883.25 resulting in a loss of Rs.36.65 per share. 

Thus, the intrinsic value of this TCS Call option is Rs. (36.65) per share which is calculated as the Spot Price of the underlying minus the Strike price. 

The same logic can be applied to a put option to and the method of calculations would be Strike Price minus the Spot price since the put gives us a right to sell. 

Broadly, the intrinsic value of an option is classified into three.

• In the money
• At the money
• Out of money

To make our understanding easier, let us understand this with the help of a call option. The logic can then easily be extended to put options. 

An in the money call option is an option whose spot price exceeds its strike price or an option with a positive intrinsic value. Assume that the shares of TCS are trading at Rs.9,000 today. When you go to the market, you find call options for January expiry with strikes ranging from Rs.8,000 to Rs.10,000. 

An option with a strike price of Rs.8,500 would be an in the money call option because if you choose to buy this, your intrinsic value today would be Spot price minus the Strike price would result in Rs.500, a positive intrinsic value. So, if this option is exercised today, you would be gaining Rs.500 per share.

On the flip side, a call option with strike price of Rs.9,500 would be classified as an out of money options because the spot price happens to be below the strike price. In this case, since the conditions don’t favour you, you would let the option lapse, leaving you with a zero intrinsic value.

An at the money option is an option whose spot price is the same or approximately the same as the strike price. In our case, an option with a Rs.9,000 strike price would be an at the money option. Again, here too, you typically let the option lapse and have a zero intrinsic value. 

The intrinsic value of an options contract can never be negative. It can be either zero or a positive number

Call option Intrinsic value = Spot Price – Strike Price

Once you understand this, the same logic can be extrapolated to put options as well.

Put option Intrinsic value = Strike Price – Spot price 

Option Pricing

The pricing of an option premium is typically controlled by two factors. One is the intrinsic value that we understood above and the other is called as time value. 

Time Value basically puts a premium on the period remaining to exercise an options contract. This means if the time left between the current date and the expiration date of a contract is longer than that of another, the first contract has higher value.

This is because of the simple logic that contracts with longer expiration periods give the holder greater flexibility on when to exercise their option. This longer time window lowers the risk for the contract holder and prevents them from landing in a bad scenario. 

In the above chart from NSE India for TCS call option for a strike of Rs.3,920, you can see that the last traded option premium for January expiry is about Rs.92.45 while the same for February expiry is Rs.143.45, that is, the longer expiry has higher premium due to the advantage that time value bestows upon it. 

Initially, the time value of the contract is high. If the option remains in-the-money, the option price for the same would also be high. If the option goes out-of-money or stays at-the-money this affects its intrinsic value, which becomes zero. In such a case, only the time value of the contract is considered and the option price goes down.

As the expiration date of the contract approaches, the time value of the contract falls, negatively affecting the option price.

The popular valuation model to value an option is known as the Black Scholes model, named after the people who devised the model. 

Profit and loss on options trade.

Calculation of profit or loss on options varies based on two scenarios. 

1. Options squared off before expiry
2. Options held to expiry

Squared before expiry

Since there are no margin requirements, this calculation is fairly simple. 

The profit on a call option squared off before expiry is:

P&L = [Difference between buying and selling price of premium] * Lot size * Number of lots

If you buy a TCS Call options with January expiry on 5th January for a lot size of 150 shares at Rs.80 and sell it on January 15th at Rs. 95, then the profit on your trade is (95-80) *150*1= Rs.2,250.

In practice, there could be brokerage and other charges deducted from your profits. 

For an option seller too, the same holds good. However, since in the case of an option seller, his risk of loss is unlimited, he is required to maintain a margin with the exchange. Let us try to understand what this margin actually is. The seller, unlike the buyer has the risk of unlimited loss. Similar to futures traders, to protect the counterparty from any risk of default, the exchange levies a margin upon the option seller. In simple terms, this is nothing but a minimum amount of money based on calculations made by the exchange that needs to be maintained by the seller in his margin account all the time, like say, a savings bank with a minimum balance. If the balance in the margin account falls below this level, your broker directs you to deposit the requisite amount in your account.

The margin percentage is a combination of what we call SPAN margin and exposure margin. The SPAN is a tool used to calculate the SPAN margin and it uses a portfolio-based approach. Exposure margin is usually charged in addition to the SPAN margin as an added security. Any failure to meet the margin requirements could lead to a levy of penalty

The profit on their transaction is:

[Difference between the buy price and sell price of premium] * lot size * number of lots

Once the position is squared off, the margin of the seller is released after adjusting for profit or loss. 

Held to Expiry

In the money (ITM), options which have been held to expiry get physically settled. If the option is Out of money (OTM), then as we know, since the contract is lapsed, the buyer loses the premium paid, and the seller gets to retain the entire premium received at the time of writing the option.

In our case, if you buy a TCS Call options with January expiry on 5th January for a lot size of 150 shares at Rs.80 and a strike price of Rs.9000 and the actual price of the underlying share is Rs.9500 on expiry leaving your option in the money, then you would be delivered 150 shares of TCS shares at Rs.9000 per share on a T+2 settlement basis. Your cost price overall here will be Rs.9000 + Rs.80 premium totalling to Rs.9,080. You can either sell it in the market at Rs.9,500 levels at which it is currently trading and make a profit of Rs. (9500-9080) = Rs.420 per share or hold on to the share if you deem it fit. 

How does the same look like from the position of an option writer?

The seller, being obliged to sell has to physically deliver the TCS shares to you at Rs.9000 per share. But since he has received a premium of Rs.80 per share, his effective price is Rs. 9,080 and his loss will be Rs.9,500- Rs.9,080 which is Rs.420 per share.

Conclusion

Options are complex and powerful financial derivative instruments used by speculators and traders alike. Options in the currency markets help companies hedge their open exposures in any foreign currency transactions. These are widely traded instruments in the share markets making them one of the most important derivative financial instruments. 

When it comes to markets, the cash market is where tangible transactions occur. In equity markets, the cash segment is where shares are bought and sold.

Risk is always associated with one’s investment, and the cash market offers no solution to manage risk apart from exiting the investment. 

Globally, any cash market is supported by other markets, which help manage price risk through hedging. These markets are called derivatives or futures and options (F&O). Since the instruments – futures and options derive their value from the cash market, they are called derivatives. 

Let’s take a closer look at the nuances of derivatives.

What are Futures and Options?

Both instruments differ and derive their price from the underlying stock or index. A contractual agreement between a buyer and a seller binds these instruments.

1. Futures 

A futures contract is an obligation to buy or sell an underlying asset at an agreed-upon price at a later date and derives its value from the underlying stock or index. Initially intended as a hedging tool, futures contracts have gained popularity among speculators and arbitrageurs. 

They are prevalent in actively traded commodities and feature a standardised size, although this may vary across companies. Many contracts for a single asset are being actively traded with different expiration dates. In contrast to the cash market’s restriction to long positions, futures contracts offer traders the flexibility of long or short positions. 

Additionally, traders leverage futures contracts to exploit numerous arbitrage opportunities between different months or capitalise on disparities between futures and the cash market. 

Let’s understand futures contracts with the help of an example. 

Suppose a trader is holding shares of Asian Paints at ₹3,400. He feels there is limited upside to the stock and it may hover around these levels or come down in the short to medium term. 

For various reasons, including tax management, he does not want to sell his shares of Asian Paints but would like to protect himself from any fall in its share price. 

Therefore, he will sell a futures contract of Asian Paints (creating a short position) at ₹3,400. By doing this, he has locked his profit at ₹3,400, irrespective of where the stock goes. 

Suppose the price comes down to ₹3,200, in that case, his shares would have a notional loss of ₹200, but the short position would result in a profit of ₹200 (3400-3200). Even if the price keeps falling, his future position will compensate for the loss in the spot position. 

However, since he has sold a futures contract, the trader will not benefit from any stock price rise. 

If Asian Paints rises to ₹3,500, the cash position will sit on a notional profit of ₹100, but the futures contract will give him a loss of ₹100 (3400-3500).

Big fund houses use index futures to hedge their portfolios by selling index contracts like Nifty or Bank Nifty to protect their portfolio. 

2. Options

An options contract is an investment tool that provides investors with the right, but not the obligation, to buy or sell shares at a predetermined price within a specific timeframe. Its value depends on the underlying stock or index and has the same shares or lot size as futures contracts. 

This flexibility allows traders to participate in various market directions, making it an affordable method for hedging positions. Unlike cash and futures markets, options can generate profits even in stagnant markets. Traders can employ simple and complex option strategies that align with their market perspectives. 

The allure of options lies in their affordability; buying an option grants traders the cheapest access to share ownership, making it an attractive option for retailers, traders, and institutions. Although initially created as a hedging tool, options are now widely used for speculation and arbitrage. 

There are two primary kinds of options: Call and Put. Call options are purchased when traders expect upward movement in the stock or index, while Put options are preferred when anticipating a decline. Call option sellers predict a fall or stagnant movement in the underlying, while Put option sellers foresee a rise or stagnancy.

An example to help understand options is as follows:

Unlike a futures contract, an option contract is slightly complex. 

Continuing with the example of Asian Paints, suppose the trader wants to hedge his position as he feels the stock may not rise beyond ₹3,400. 

Here, the trader can hedge his cash portfolio by buying a ₹3400 strike price put option expiring in the current month. To buy the put option, he pays a premium of ₹50. 

Now, if the share price of Asian Paints falls to ₹3200, the value of the premium at the time of the expiration will be ₹200. Thus, the trader will gain from purchasing the put option despite a notional loss in his cash position. The profit from the put will be ₹200 minus the ₹50 paid for buying the option. 

If the price of Asian Paints rises to ₹3,500, the maximum loss to the trader will be the ₹50 he paid for buying the put option. He can enjoy the benefit of a further rise in price. 

One key difference between Futures and Options in the above example is that though both the derivative instruments are protected to a large extent, the futures contract locks the price while the option contracts allow the trader to benefit from rising prices to some extent. 

What is the Difference Between Futures and Options?

Trading in futures and options differs in terms of its obligations to the traders. The futures contracts are a liability for the investor, mandating them to buy or sell the contract on or before a predetermined date, and the options contract gives the investor the right to do it.

In other words, the futures contract holder has to buy or sell underlying security following the predetermined date at the decided price. In contrast, the options contract gives the buyer a choice to buy or sell if they profit from the trade.

Types of Futures and Options

Generally, futures contracts have the same conditions for both sellers and buyers of the contract, and the derivative of the option is divided into two types. Traders can enter into an options contract to sell an asset at a certain price on a specific date and by availing of a put options contract. Similarly, traders who want to buy a type of asset on a particular date can do so through a call option to fix the price for future exercise of the contract.

Types of Futures	Description
Stock Futures	Contracts that allow trading based on the future value of individual stocks at an agreed-upon price and date.
Index Futures	Derivative contracts that reflect the future value of a stock market index, enabling speculation or hedging.
Commodity Futures	Agreements that enable the trading of commodities at predetermined prices for future delivery.
Currency Futures	Contracts that allow the exchange of currencies at a predetermined price on a future date.

Types of Options	Description
Call Options	Provide the holder the right (but not the obligation) to buy an underlying asset at a predetermined price within a specified period.
Put Options	Offer the holder the right (but not the obligation) to sell an underlying asset at a predetermined price within a specified period.

Who Can Invest in Futures and Options?

Traders or investors participating in futures and options trading are classified into the following types:

Attributes	Hedge Players	Speculators	Arbitrage Players
Objectives	Minimise the impact of market volatility on investments by hedging through F&O contracts.	Predict price trends and profit from anticipated price movements.	Exploit price variations due to market inefficiencies for profit.
Approach to Transaction	Set predetermined prices to mitigate adverse price movements.	Take long positions for anticipated rises in prices or short positions for expected price declines.	Exploit discrepancies between contract costs and spot prices to create market equilibrium.
Usage	Found in commodities markets, safeguarding estimated prices of certain products.	Widespread across markets, especially in stocks and derivatives.	Engage in various markets but focus on minimising price variations due to inefficiencies.
Risk Management	Safeguard profits or losses through derivatives trading, using contracts to balance potential losses.	Emphasise profit generation from price movements; cash settlements are commonly preferred.	Balance contract costs with spot prices, aiming for market equilibrium; leverage used for trade, requiring accurate market predictions.
Trading Approach	Prefer physical trade settlement for stability in commodity markets.	Prefer cash settlements, minimising physical asset movements.	Utilise leveraged trades to minimize upfront costs; accurate market predictions and comprehensive market understanding required.
Profit Strategy	Focus on risk mitigation and stability to maintain a predetermined price level.	Aim for profit generation from price movements; cash settlements are often used.	Aim to exploit market inefficiencies for profit, using leveraged trades to minimise upfront costs.
Example	Trading onion futures to fix a selling price; using put options to balance loss if prices fluctuate.	Buying derivatives expects a future price rise to sell at a higher price or short-selling to buy back at a lower price for profit.	Price variations are used to align contract values with current prices, minimising market inefficiencies.

More About F&O Trading in the Stock Market

Most people today are unaware of futures and options trading in the stock market. But, the trend for this has grown in recent years. Hence, learning more about this market can be advantageous.

The National Stock Exchange (NSE) implemented trading on index derivatives on its Nifty 50 in 2000. So, one can invest in futures and options in nine major indices, including more than 100 securities today. Traders can also trade in futures and options through the indices and securities listed on the Bombay Stock Exchange (BSE)

Understanding futures and options can play an essential financial role in the industry. It also helps traders hedge their positions against unwanted price movements and ensure liquid markets remain.

Risks Associated With Futures and Options Trading

Futures and options trading in commodities are other chances for investors to make money. But commodity markets are very volatile, so it is suggested to trade in them only when one is aware of the risk and can take it. Also, the commodity margin is lower, so there is a chance of taking significant leverage. Leverage can provide more options for profit, but the risks are much higher.

Options are less risky as the trader can choose not to exercise the contract on maturity when the prices aren’t the way they want. The only loss they would bear would be the premium paid for the security. Thus, once a person understands what F&O is in the stock market, it is possible to make money and hedge investment risks.

One can trade commodity futures and options via commodities exchanges such as the Multi Commodity Exchange or MCX, National Commodity & Derivatives Exchange Limited, or NCDEX in India.

Conclusion

Warren Buffett calls derivatives a weapon of mass destruction. But just like nuclear energy, if one learns how to handle the instruments with proper risk and money management, they can result in much higher returns than the cash market. 

Derivatives, in simple terms, means the financial instruments which derive their value from the underlying. The underlying could be a share, an index, an interest rate or a currency. In India, in the share exchange segment, we have two markets in operation. One is the cash market and the other, is the F&O market. 

The cash market is easy to understand as it indicates the buying/selling of shares at the current market price. 

When you visit the NSE India website, you see more than 1300 companies’ shares have been listed and are being traded, but then, in the F&O space, you see only about two hundred securities. This raises the important question- What qualifies security to be added to the F&O segment?

How are stocks added to the F&O Segment?

Securities and Exchange Board of India (SEBI), the primary body to regulate capital markets in India, has laid down the criteria for the introduction of stocks in the derivatives segment. They are as follows –

• The stock shall be chosen from amidst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis.
• The stock’s median quarter sigma order size (MQSO) over the last six months, on a rolling basis, shall not be less than Rs 25 lakh. Median quarter sigma order size in essence means the order size (in value terms) that is needed to cause a change in the stock price equal to one-quarter of its standard deviation. In simple terms, it is the order size needed to impact the share price. The NSE website has a detailed note on how this calculation is made. 

https://www1.nseindia.com/products/content/derivatives/equities/selection_criteria.htm#:~:text=A%20stock%20which%20is%20excluded,re%2Dintroduced%20for%20derivatives%20trading

• The market-wide position limit in the stock shall not be less than Rs 500 crore on a rolling basis. This, in essence, refers to the liquidity of the security in terms of market-wide position limit, a means to evaluate if a stock is a widely traded or a closely held stock.
• Average daily delivery value in the cash market shall not be less than Rs 10 crore in the previous six months on a rolling basis.

The important point is that the above criteria need to be met for a continuous period of 6 months. 

The NSE keeps monitoring and adding new scrips to the F&O space from time to time. If you follow the news, you could see many such inclusions being made from time to time. The list of stocks trading in this segment can be accessed from the NSE website.

Now that we have understood how security gets added to the F&O space, let us also know when security is removed. 

Why do stocks get excluded from F&O space?

If a stock is not in conformity with any of the above-mentioned criteria, the exchange removes it from the segment. What this essentially means is that this stock has lost its liquidity in the eyes of the Exchange and is not fit for the derivatives segment.

Please note that removal from the F&O segment is not the same as an F&O ban. An F&O ban is temporary, a span of a few days, but a stock excluded from the F&O space needs to meet the above criteria for a period of six months to have a chance of re-entry.

It is mainly in the interests of investors and to maintain the transparency that the Exchange removes stocks that don’t meet the criteria from the F&O space.

Latest F&O stock list with lot size

https://www.nseindia.com/content/fo/fo_underlyinglist.htm