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Options And Futures

IndianMoney.com Research Team | Updated On Wednesday, October 17,2018, 06:21 PM

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Options And Futures

 

 

An option is a type of derivative security whose price is linked to an underlying asset. The buyer of the option has the right to receive delivery or payment for the underlying asset at a specific price, on a specific date in the future. The buyer pays a premium (some money) called option premium for the privilege. The buyer of the option has the right, but not the obligation, to exercise the option. On the other hand, the seller of the option has to make the delivery or the payment for the underlying asset at a specific price on a specific date in the future.

The buyer of the option may or may not exercise the option. This means the seller gets to keep the option premium if the buyer doesn’t exercise the option. Do remember the right to buy is called a call option and the right to sell is called a put option.

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Options And Futures

In the derivatives market you can buy or sell shares at a specific price in the future. You have two options in the derivatives market to do so. These are the call and put options.

1. What is a call option?

Let’s say you purchase a call option which gives you the right to purchase a certain amount of shares, (You could also purchase an index like the Nifty 50), at a predetermined price, within a specified date in the future. The predetermined price is the exercise price, while the date within which you can exercise the option is called the expiry date or the maturity date.

The person who sells the option is called the option seller or writer of the option. You have to pay a premium called option premium to exercise the option. The option writer charges a premium as he has to risk a loss if the market price goes beyond the strike price. While you, the option buyer has the right but not the obligation to exercise the option, the option writer has to exercise the option (He has to sell you the shares if you choose to exercise the option), even though he suffers a loss.

How to Trade Options?

  • Buyer of a call option:

You are a buyer of the call option and make a purchase from the option writer or the seller of the call option. The Nifty is quoting at 10,600 points today. You are bullish and feel the Nifty will rise to 10,700 in a month. So you buy a one month Nifty call option at 10,700. The call is available at a premium of Rs 50 per share. Nifty has a lot size of 50. This means you incur Rs 2,500 to purchase one lot of call option on the index.

If the index remains below 10,700 for the whole month till contract expiry, you (buyer of the call) will not exercise the option as you won’t purchase the index at 10,700 levels. As there’s no obligation to purchase the index, you simply ignore the contract and lose the premium you have paid. The option writer gets to keep the premium.

  • Seller of a call option:

The seller of the call has the obligation to sell the underlying asset (share or index), if the option holder chooses to exercise the option. What happens to the seller of a call? The option writer (seller of a call), has the obligation to sell the underlying asset (This could be a share/index) at the exercise price, if the option holder (buyer of the option), chooses to exercise the option.

If the Nifty crosses 10,700 then the option holder will exercise the option. The option holder will start making profits once the Nifty crosses the 10,750 mark which is the breakeven point. You have to add the premium costs.    

The option writer gets to keep the premium as long as the Nifty doesn’t go beyond the 10,700 levels. Once the index crosses the 10,700 levels but remains less than the 10,750 levels, he starts losing parts of the premium. Once the index crosses the 10,750 the losses of the option writer are in direct proportion to the gains of the option holder.

Example of a stock call option:

  1. Buy TCS 2,000 call option when share price is Rs 1,950 called spot price.
  2. The call option was quoting at Rs 10, and you get 600 units on paying a premium of Rs 6,000.
  3. If TCS share price remains below Rs 2,000, ignore the option. You suffer a loss of Rs 6,000 which is the option premium.
  4. If TCS reaches Rs 2,000, there’s no profit as you have paid the option premium.
  5. Once TCS crosses the Rs 2,010 levels you see profits. The higher it goes beyond this, more are your profits.
  • Buyer of a put option:

The buyer of a put enjoys the right but not the obligation to sell an underlying asset like a share or an index, at a specified price called exercise price, within a fixed date called expiry date in the future. You have to pay a premium to the seller of the put for the privilege.

You have purchased a Nifty put at a strike price of 10,600. You have paid a premium of Rs 50 for a lot size of 50. The Nifty is quoting at 10,700 points today. If the Nifty crosses 10,750 the option holder will not exercise the option. The option writer gets to keep the premium as his profits. If the Nifty stays below 10,600, the option holder will exercise the option. The option holder starts to gain once the Nifty falls below 10,550.

  • Seller of a put option:

The seller of a put has the obligation to sell the asset if the option holder chooses to exercise the option.  If the Nifty stays above 10,600, the option holder will not exercise the option. The option writer gets to keep the premium. If the Nifty goes below 10,550 the option holder will exercise the option. The option writer starts losing once the Nifty goes below 10,550.

Benefits of trading options:

  • It’s good for small pocket traders.
  • It helps to reduce costs significantly.
  • It reduces risk in investment.
  • You earn higher returns compared to stocks.
  • You can alter strategies based on market conditions.

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What are futures?

Futures are exchange traded derivatives which allow you to buy/sell an underlying asset, at a fixed price in the future. In a futures contract, the minimum order size, number of trading units and quality is standardized as trading takes place on exchanges. The exchange functions as counterparty, or the buyer to the seller and the seller to the buyer. The buyer and the seller have to pay a margin to the exchange, which functions as a security to honor the contract.

A future contract is an agreement between the buyer and the seller, where the buyer agrees to purchase a fixed number of the underlying asset like a share/currency/commodity at a specific price in the future. The contract is honored by the clearing house which settles trades on stock exchanges like NSE and BSE.

What are stock futures?

Stock futures are a derivative contract which gives the power to buy/sell a set of stocks at a fixed price, within a certain date in the future. A future contract is obligatory.

Lot size: You cannot trade a single share on an exchange. The stock futures contract consists of a standardized number of underlying shares. Different stocks have different lot sizes. TCS has a market lot size of 500. If you purchase one lot, you are trading in 500 shares of TCS.

Duration: When you say contract, it’s an agreement for the future. Contracts are available in durations of 1 month, 2 months or 3 months. Once the contract expires, a new contract is introduced for each of the three durations.

Expiry: All three maturities are traded simultaneously on the exchange with expiry on the last Thursday of the respective contract months. 

Let’s understand futures with an example. You have purchased a single futures contract of XYZ Co. consisting of 150 shares and expiring in the month of October. The price of XYZ share is Rs 1,000. The share price of XYZ is Rs 1,100 on the last day of October. You will get a profit of Rs 100 a share (This is the settlement price of Rs 1,100 minus the purchase price of Rs 1,000). You make a cool Rs 100*150 shares = Rs 15,000. This amount is added to the margin in your account. If you suffer a loss, money is deducted from the margin.

Benefits of futures trading:

  • You can short sell shares without having them.
  • You can shift risk to speculators.
  • Small investors can enjoy huge profits as margin helps them take big bets with small amounts.
  • You get an idea on the future demand and supply of shares.

Difference between options and futures:

  • An option contract gives the buyer the right, but not the obligation to buy/sell shares. A futures contract is obligatory to both parties.
  • You require a higher margin on futures.
  • Speculators prefer futures contracts while hedgers prefer options.
  • Futures are unlimited profit/unlimited loss. Options are limited loss, unlimited profits.

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