Tag: Futures & Options

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. 

One thing that is guaranteed in the stock market is uncertainty. Prices can go up or they go down or even not move at all depending on the market conditions like economic factors, elections, weather, agricultural produce and output. Since there are so many fluctuations that can take place, traders look to protect themselves from such fluctuations and resort to an instrument called derivatives. A derivative is a contract that derives its value from the underlying asset which could be anything like a stock, commodity or currency or so on. And the two most common derivatives are Futures and Options.

Futures and Options are probably the most widely traded derivative instruments across the world. But then, despite having their own inherent advantages, they differ in a few ways. But before we get into the differences between them, it’s important to know what each of them means.

Futures – What are they?

A futures 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. 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. 

Let’s explain this with an example. Let’s say you bought a futures contract of 1000 shares of Nestle at Rs. 100 each at a specific date. On the expiry of the contract, you will get those shares at the agreed price irrespective of the current market price. If the market price is Rs. 110 then you will still get it at Rs. 100 and in the process make a profit of Rs. 10,000. But if the market price of the share is Rs. 90 then you will still get it at Rs. 100 but make a loss of Rs. 10,000.

The whole idea of futures is to help in evading the price fluctuations of the market and is an effective tool used by traders to protect their portfolios.

What are options?

Options are a type of derivative contract wherein the buyer or seller has the right, but not the obligation to buy or sell a particular asset at a specified price and date.

For example, suppose Rahul bought a ticket to a screening of Dilwale Dulhania Le Jaayenge that is due to happen on a future date. Having bought the ticket, he has officially got the right to view and attend the concert but are under no obligation to do so. In fact, he can either attend the movie, sell the ticket for a higher price or do neither and let it go waste. But the seller who sold the ticket has the obligation to play the movie irrespective of whether Rahul exercises it or not. This is how options work in the stock market. 

Options are of two types

• Call 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 and date. 
• Put Option – A put option is a contract that gives the buyer the right but not the obligation to sell a particular asset at a specified price and date. 

How do Futures and Options differ from each other?

While both instruments are similar in hedging the portfolio from market volatility and price fluctuations, they are different on several factors. They are

• Nature of the contract

A futures contract is a derivative 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. Thus, on the agreed expiry date, both parties are expected to fulfil their obligations and honour the contract. The buyer is expected to buy at the agreed price and the seller, to sell.

An options contract, on the other hand, gives the buyer the right to buy the asset at a fixed price. However, there is no obligation on the part of the buyer to buy- they have a right to exercise their option only if the conditions turn favourable. Nevertheless, should the buyer choose to buy the asset, the seller is obliged to sell it. 

Thus, the first point of difference is that an options contract gives a right to the holder while there is no such privilege in a futures contract. 

• The risk involved

As we saw earlier, both parties of the futures contract are expected to honour the contract even if the market moves against them. 

On the flip side, the buyer in an options contract has a privilege here. If the underlying moves in a direction unfavourable to them, the buyer can opt-out of buying it. This limits the loss incurred by the buyer.

In simple terms, a futures contract could bring unlimited profit or loss. Meanwhile, buying an options contract can bring unlimited profit, but it reduces the potential loss.

• Concept of Premium

The holder in an options contract has to pay an upfront payment of what is known as a premium. The payment of this premium grants the options buyer the privilege to lapse or exercise his right depending upon the movement of the underlying either unfavourably or favourably. Should the options contract holder choose not to buy the asset, the premium paid is the amount he stands to lose. This right to exercise or lapse ensures that the maximum loss that the holder can suffer is restricted to the premium paid. The writer though has unlimited loss potential. 

On the contrary, since the futures market grants no such special rights, there is no requirement for any premium payments in the futures segment. A futures trader has on the other hand put up a margin for initiating a position. 

• The Concept of Margin and Profit and Loss

Considering the risk of potentially unlimited loss, the Exchange warrants both the buyer and a seller in a futures market to deposit what is known as a margin. The margin requirement varies based on the scrip traded in and acts as a safeguard for the exchange to mitigate any counterparty risk of default. 

The profits or losses on a futures trade are calculated and marked to market on a live market and adjusted in their margin account. Any fall in the margin levels due to losses might lead to the issue of a margin call. A margin call is when the broker asks the trader to either add more margin in his account or square off the position. Any gains on the trade are credited to the margin account. 

Typically, in the Options market too, the profit or loss is calculated on a real-time basis and reflected in your position. Unlike a futures contract, an option buyer doesn’t have any margin that he needs to maintain if he is a buyer. This is because margin money is a typical requirement by the exchange to protect against the risk of default. 

If I want to buy a TCS option for Rs.9,000 strike at Rs.100 premium for a lot size of 150 shares, I can buy it if I have Rs.15,000 in my account. Now, as a call option holder, we know that the maximum loss I can suffer is Rs.15,000 which happens to be my premium. Therefore, there is no risk of default or loss since I am paying the premium upfront. Thus, an option holder needs to hold no margin. However, in the case of an option seller, the risk of loss is unlimited and hence they are required to maintain a margin with the exchange. This margin too changes based on the scrips, strike prices, expiry and so on. 

The profit on a call option is calculated as follows. 

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 a seller too, the profits are similar:

The profit on their transaction is:

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

In case the options are held to expiry, as per SEBI guidelines, physical delivery of the share could be warranted. 

Conclusion

Futures and Options are a way for traders to protect themself from the constant price fluctuations in the market. Often this kind of trading is seen in the commodity market as well where people trade in futures and options for commodities like crude oil, gold, wheat, maize etc. while trading in this segment gives quick profits over a short period of time, it is imperative that those who trade in such segments are experienced with knowledge of the market as profits are there but the losses are unlimited.

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

In the last couple of years, there has been a significant increase in stock market activity. This was witnessed as the trading volume has increased multifold in India. Most of the trading volume is generated from the derivatives market which comprises buying and selling of futures and options. These derivative contracts derive their value from the underlying asset.

As they do not have a value of their own, their prices change as the value of the underlying asset changes. The traders make the most out of these price fluctuations to gain from it. Options trading has been a fascinating instrument as the prices are very volatile. But at the same time, one cannot ignore the fact that extreme volatility comes with a high risk of loss.

Be it the profitability or risk, in this article, we will look at all the aspects of options trading. Let’s get started with the basics first.

What are the Options?

Options are the derivative contracts that derive their value from the underlying asset. An options contract gives the buyer a right to buy or sell the underlying asset to the seller of the options who are obligated to sell or buy the same asset at a predetermined price and date.

This predetermined future date is called the exercise/expiration date and the predetermined price is called the strike price. The options are of two types, (i) Call option and (ii) Put option. Let us understand each of them below.

• Call Option

A call option is a contract that gives the buyer a right to buy and the seller an obligation to sell. An option buyer pays a premium to the seller. This premium goes up as the price of the underlying asset rises. 

• Put Option

A put option contract, on the other hand, gives the buyer a right to sell and the seller an obligation to buy. The value of the premium paid buyer rises as the price of the underlying asset falls.

What is Options Trading?

Buying and selling the above-mentioned options contracts is what options trading is all about. You can trade options either by buying a call or put option or by selling a call or put option. Many traders also use the combination of all four and trade options based on various strategies.

Let us look at how you can trade in the options one by one for each type.

Call Option Trading

Call options are typically used to initiate a bullish position in the underlying stock or index. To buy the call option, a buyer pays a premium. As the price of the underlying stock or index goes up, the option premium rises and a trader makes a profit. For instance, you are bullish about Stock A, therefore, you buy a call option for Rs. 10 with a strike price of 1200. Let’s assume that the current market price of Stock A is Rs. 1100. So, as the stock price goes up, the premium of Rs. 10 will increase, giving you profit. If the stock price falls, your maximum loss will be Rs. 10 per share.

Put Option Trading

Put options are considered for initiating a bearish position in the underlying index or stock. The premium paid for buying a put option increases as the price of the underlying stock or index falls. The buyer of the put option can benefit from the falling prices as the put option premium and price of underlying stock are inversely related to one another. For example, if you are bearish on Nifty, you can buy a put option. Suppose, Nifty is currently trading at 18000 and you buy a put option with a strike price of 17900 for Rs. 50. As the index spot value goes down, your option premium will increase, giving you the profit. However, if Nifty goes up, the maximum amount of loss will be Rs. 50.

What is Option Writing?

So far, we have discussed buying options. But somebody has to sell the option for us to buy, right? The action of selling options is called option writing and the sellers of options, call or put, are called option writers. An option writer sees options from an opposite perspective. A seller collects the premium paid by the buyer of the option and their maximum profit is limited only to the premium collected.

The risk of potential loss in option selling is practically unlimited. Therefore, option writers always have their positions hedged in the stock market to avoid huge losses. Unhedged option selling is highly discouraged due to its potential of unlimited loss.

However, if options are traded in the right way, it has many advantages. Let us look at them below.

Benefits of Options Trading

We have listed some of the benefits of options trading for you.

• A lot of people who buy options generally have a low initial exposure. The cost of acquiring an option is less than what it would cost to acquire stocks.
• Trading options are usually flexible. Before their contracts expire, traders can execute various strategic moves.
• An options trading strategy helps traders increase their returns by taking advantage of the added income and leverage they provide.
• A strategy that involves using options to limit one’s downside risk can be a great way to generate a recurring income.

Important Points to Note While Trading in Options

Apart from the above, there are certain considerations, which are discussed below, that the options trader must understand.

• If the expected price movement in the direction of your trade does not begin or the price remains in a sideways zone, the premium starts to decay. This phenomenon is called time decay.
• Time decay works against the buyer of the option but favors the option seller as the seller of options contracts benefit from the erosion of options premium.
• The buyer of options will always have a risk limited to the premium paid whereas there is no limit on how much the premium price can rise.
• On the contrary, the seller of options holds unlimited risk whereas the profit is limited to the premium collected.
• Options are traded in multiples of lot sizes. Each lot contains a fixed number of shares. Suppose, the lot size of Stock PQR is 100 shares, then you can trade only in multiples of 100 shares of PQR.

The Bottom Line

Trading options can be very rewarding if they are used in the right way. The added advantage comes from the ability of options to provide unlimited profit potential and limited risk of loss. But due to high volatility in options premium, it is an extremely risky asset class as well. Therefore, options trading requires keeping stop-loss orders in place and demands proper trade management.

Apart from just trading in one option, you can trade multiple options to hedge your position to avoid big losses. However, you might end up paying high brokerage if you have a higher number of transactions. You can choose a plan offered by TradeSmart to save on your brokerage. TradeSmart has the lowest F&O brokerage in India starting from 0.007% or Rs. 15 per order, as per the plan of your choice. Find out more here.