A market much bigger than equities is the equity derivatives market in India. Derivatives basically consist of 2 key products in India viz Options and Futures. The difference between future and options is that while futures are linear, options are not linear. Derivatives mean that they do not have any value of their own but their value is derived from an underlying asset. For example, options and futures on Reliance Industries will be linked to the stock price of Reliance Industries and will derive their value from the same. Options and Futures trading constitutes an important part of the Indian equity markets. Let us understand the differences between Options and Futures and how equity futures and the options market form an integral part of the overall equity market
What are Futures and Options?
A Future is a right and an obligation to buy or sell an underlying stock (or other assets) at a predetermined price and deliverable at a predetermined time. Options are a right without an obligation to buy or sell equity or index. A Call Option is a right to buy while a Put Option is a right to sell.
So, how do I benefit from options and futures?
Let us look at futures first. Assume that you want to buy 1500 shares of Tata Motors at a price of Rs.400. That will entail an investment of Rs.6 lakhs. Alternatively, you can also buy 1 lot (consisting of 1500 shares) of Tata Motors. The advantage is that when you buy futures, you only pay the margin which (let us say) is around 20% of the full value. That means your profits will be five-fold that of when you are invested in equities. But, the losses could also be five-fold and that is the risk of leveraged trades.
An Option is a right without an obligation. So, you can buy a Tata Motors 400 Call Option at a price of Rs. 10. Since the lot size is 1,500 shares, your maximum loss will be Rs. 15,000 only. On the downside, even if Tata Motors goes up to Rs .300, your loss will only be Rs. 15,000. On the upside, above Rs. 410 your profits will be unlimited.
How to trade in Options and Futures?
Options and Futures are traded in contracts of 1 month, 2 months and 3 months. All F&O contracts will expire on the last Thursday of the month. Futures will trade at a Futures price which is normally at a premium to the spot price due to the time value. There will only be one Futures price for a stock for one contract. For example, in January 2018, one can trade in January Futures, February Futures and March Futures of Tata Motors. Trading in Options is slightly more complicated as you actually trade the premiums. So, there will be different strikes traded for the same stock for Call Options and for Put Options. So, in the case of Tata Motors, the Call Options premium of 400 call will be Rs. 10 while these Option prices will be progressively lower as your strikes go higher.
Understanding some Options and Futures basics
Futures offer the advantage of trading equities with a margin. But the risks are unlimited on the opposite side irrespective of whether you are long or short on the futures. When it comes to options, the buyer can limit losses to the extent of the premium paid only. Since options are non-linear, they are more amenable to complex Options and Futures strategies. When you buy are sell futures you are required to pay upfront margin and mark-to-market (MTM) margins. When you sell an option also you are required to pay initial margins and MTM margins. However, when you buy options you are only required to pay the premium margins. That is all!
Understanding the quadrants of Options and Futures
When it comes to Futures the periphery is quite simple. If you expect the stock price to go up then you buy Futures on the stock and if you expect the stock price to go down then you sell Futures on the stock or the index. Options will have 4 possibilities. Let us understand each one of them with an Options and Futures trading example. Let us assume that Infosys is currently quoting at Rs. 1,000. Let us understand how different traders will use different kinds of options based on their outlook.
- Investor A expects Infosys to go up to Rs. 1,150 over the next 2 months. The best strategy for him will be buying a Call Option on Infosys of 1,050 strike. He will get to participate in the upside by paying a much lower premium.
- Investor B expects Infosys to go down to Rs. 900 over the next 1 month. The best approach for him will be to buy Put Options on Infosys of 980 strikes. He can easily participate in the downside movement and make profits after his premium cost is covered.
- Investor C is not sure of the downside in Infosys. However, he is certain that with the pressure on the stock from global markets, Infosys will not cross 1,080. He can sell Infosys 1,100 Call Option and take home the entire premium.
- Investor D is not sure of the upside potential of Infosys. However, he is certain that considering its recent management changes, the stock should not dip below Rs. 920. A good strategy for him will be too sell the 900 Put Option and take the entire premium.
Options and Futures are conceptually different but intrinsically they are the same as they try to profit from stock or an index without investing the full sum!