Investors that are new to the markets, generally start off by dabbling in Stocks & Mutual Funds. As one gains a sense of the markets though, advanced instruments like Futures & Options pique interest. However, just as stock investment requires one to be aware of basic terminologies like CMP (Current Market Price) or Stop Loss; this shift too comes with its share of nuances. If you too are exploring futures & options or have already started trading, here’s quick reckoner on its trading terminologies.
1) Future Contracts: It’s a type of a derivative contract that gives you a right to buy/sell an underlying asset for a preset price at a predetermined future date. By being a buyer of a future contract, you benefit from any potential upswing in the price of an underlying asset. On the other hand, if you are a seller of a future contract, you might expect prices to go down during the tenure of the contract. These are standard contracts traded on exchanges.
For instance, Nifty 50 Futures enable you to bet on the movement of the index in future.
2) Option Contracts: Option contracts give you a right—without creating any obligation—to buy an underlying asset for a specific price at a predetermined future date. Like future contracts they are also standardised contracts traded on exchanges.
3) Option Chain: A synopsis of all available option contracts on a particular security or an index is known as option chain. Option chain can be your starting point if you want to do in-depth analysis of call and put options available on a stock or an index.
4) Expiry day/ Option Expiry: Now that you know options are standardised contracts traded on exchanges, it won’t be difficult to understand the concept of option expiry. At any given point of time 3-contract series are traded—current month, next month and far month. Every monthly contract expires on last Thursday of every month. Similarly, weekly contracts expire every Thursday.
5) Strike Price: Strike price is a price at which an option contract can be exercised. For instance, at a time when Nifty trades at 18,092, you can select any contract with a strike price ranging from 15,450 to 19,650. Interval between two strike prices for Nifty 50 contracts is 50 points. For instance, you can choose a strike price of 15,450 or 15,500; not 14,475. Reason? Standardised contracts.
6) Call Option: Call option gives you an option to buy an underlying asset at a predetermined price and date. For instance, a trader who has a positive view on the market may buy 18,200 Nifty call expiring at May 25, 2023 when the spot nifty is quoting 18,092. In plain English, the buyer is expecting Nifty to rise much above 18,200 before the contract expiry.
7) Put Option: Put option gives its buyer an option to sell an underlying asset at a predetermined price and date. For instance, a trader who has a negative view on the market may buy 17,800 Nifty put expiring at May 25, 2023 when the spot nifty is quoting 18,092. In this case the buyer is hoping to see Nifty drifting much below 17,800 by expiry of May 25,2023 contract.
8) Option Premium: Market value of an option—value of a contract that gives you a right to buy/sell the underlying asset—is called premium. If you are an option buyer, you pay premium, whereas, if you are an option seller, you collect premium.
Continuing with the previously discussed example, 18,200-call was quoting at Rs 155 at the time of making this piece. And 17,800-put option traded at Rs 68.
9) In-the-money contracts: In a call option when the strike price is lower than the market price of the underlying asset, the call is said to be in the money. Conversely, a put option is in the money if the strike price is higher than the market price of the underlying asset. Since In-the-money calls can be exercised immediately, they are expensive.
10) Out-of-the-money contracts: In a call option contract when the strike price is higher than the market price of the underlying asset it becomes an out-of-the-money contract. As against this, a put option remains out-of-the-money until the market price of the underlying exceeds the strike price. Since out-of-the-money calls don’t have intrinsic value, they are usually inexpensive.
11) At-the-money contracts: When the strike price of an option and that of the underlying asset are identical, the option is said to be at-the-money. At-the-money contracts are most susceptible to the change in the external environment.
12) Option buying Vs option selling: As we have seen earlier, when you buy an option contract, you pay the premium whereas when you write/sell an option contract you collect the premium. Theoretically, a person expecting a rally in an underlying asset buys a call option. On the other hand, buyer of a put option is said to have a negative outlook. Loss of an option buyer is restricted to the premium paid. However, that of an option writer is unlimited.
In other words, an option buyer hopes to exercise his/her option as soon as possible (thus, bets on volatility). The option seller, on the other hand, expects that the option remains unexercised until expiry (thus, bets on time decay).
In practice, option sellers/writers are considered to be the smartest folks in the room since they bear the maximum risk. Thus, aggressive put writing after a sustained fall or aggressive call writing after a sharp rally is often treated as a trend reversal signal.
13) Put-call ratio (PCR): Simply put, put-call ratio measures the number of puts against every call. Put-call ratio can be calculated on volumes or Open Interest (OI). If you decide to calculate put-call ratio on OI then you should use the formula below.
Put-call ratio (OI)= Total of put-open interest (OI) / call open interest (OI)
Note: Replace OI with volumes in the above formula to get PCR by volumes. However, PCR (OI) is a dominant market sentiment indicator.
[caption id="attachment_12854" align="aligncenter" width="860"] (Check out https://www.nseindia.com/option-chain for further details)[/caption]
In the table above, a put-call ratio based on OI is 1.08 and that on volumes is 1.05. Usually, 0.8 to 1.2 is treated as the normal range. Any reading above or below this may indicate a trend reversal.
14) Open Interest: Open interest refers to unclosed, unexpired and unexercised open future and options contracts at the end of a period, say a day. Open interest is used as a sentiment indicator. That said, more than an absolute number the changes in the open interest positions may offer more cues.
15) Margin: Derivatives contracts such as futures and options are leveraged trades, i.e. they help you take a bigger exposure as compared to monetary resources available at your disposal. Margins, is nothing but money that you need to maintain (as a % of total exposure a contract) with your broker to take any exposure in the F&O market.
There are two types of margins—initial margins and maintenance margins. Initial margins are deposited upfront while the maintenance margins are required to be able hold on the positions. In other words, if you get a margin call from your broker then you need to add fresh margin money to maintain your existing F&O position.
16) Hedge Margin: Total margin required to open and maintain two F&O positions offering a hedge are known as hedge margins.
17) Implied Volatility: The Market’s view on the potential price swings in an underlying asset without any directional forecast is implied volatility. In other words, higher implied volatility means the markets expecting a sharp rise or a fall, however, the direction (up or down) is unknown/not forecasted.
It is imperative for a trader to understand the concept of implied volatility to select the right option trading strategy. Option pricing and implied volatility is positively correlated. In other words, higher implied volatility indicates higher option premiums and vice-a-versa.
18) Option Greeks: A set of parameters that help you mathematically calculate the effects of various factors on option pricing. Delta, Gamma, Theta and Vega are collectively called Options Greeks.
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