Futures and Options (F&O) have become increasingly popular over the last few years, especially given the rising participation of young traders.
If you too are curious about futures and options but would like to know more of its workings before trying your hand at it, this article is for you.
What is the biggest advantage of F&O trading?
F&O trading grants you bigger exposure to the markets at lower upfront costs. What does that mean?
Say, the prevailing market price of Reliance Industries is Rs 2,550. If you opt to invest in 250 equity stocks of Reliance, you’ll have to shell out Rs 6,37,500. However, if you opt to enter into a Futures Contract you can take a position for the same value at just 15%-20% of the cost. This is called a Futures Margin. Similarly, you can enter into an options contract of various assets by paying only the options margin which may be as low as 1-2% of the order value.
Note: Index futures have a lower margin requirement as compared to individual stock futures.
Moreover, by combining two or more contracts on the same underlying assets, you can devise a strategy for any market condition—bullish, bearish, and neutral.
However, it is prudent to remember that, while you can make handsome gains on F&O trades its losses can be painful too. So trade carefully and never trade before you understand at least the basics of F&O fairly well.
What does Futures & Options mean?
Simply put, Futures and Options are exchange-traded standardised contracts on underlying assets—these assets may be, stocks, commodities, currencies, or even indices. Futures and Options are types of derivative contracts and don’t have any value of their own. Rather, they derive their value from the movement of the underlying asset. In entering a Futures or options contract one essentially takes a position, (puts their money) on the underlying asset reaching a particular position/price point.
What is a Futures Contract?
Futures are a type of derivative contract that gives you the right to buy/sell an underlying asset for a predetermined price and a date. The buyer of a futures contract has a positive/bullish view of the market/underlying asset. The seller of a futures contract has a negative/bearish view of the market/underlying asset. Similar to any other capital market trade, a futures trader makes a profit by upward price moves.
What is an Options contract?
Options contracts give you a right—without creating any obligation—to buy an underlying asset for a specific price at a predetermined future date. Like futures contracts, they are also standardised contracts traded on exchanges. However, it’s noteworthy that if you are a seller/writer of an options contract, it becomes obligatory for you to own the contract.
What is the difference between futures and options?
|Futures are simpler instruments with a more straightforward behaviour||Options involve more intricacies to their operation with Call & Put options|
|Futures derive their value primarily from the spot price adjusted for the interest rate on risk-free securities (viz. interest on treasury bills) and dividends.||The price of an options contract primarily fluctuates basis a few factors—changes in the price of the underlying asset, anticipated time to expiry, historical volatility, type of the options contract & the announcements of any dividends for the stock.|
Therefore, it’s important to note that any option nearing its expiry can quickly lose its “time value”.
Owing to this, options traders must pay close attention to the “moneyness” of the contract (i.e. whether In-The-Money or Out-Of-The-Money.)
Out-Of-The-Money contracts can lose their time value rather quickly than In-The-Money Options as the expiry nears.
It’s noteworthy that, the change in the price may not be good enough for your options position to fetch you profits since the time decay can play a spoilsport.
|Futures involve an obligation for the buyer||Options give you a right without any binding|
|Futures are relatively riskier than options||Options are relatively less risky as compared to futures|
|Both buyers and sellers of futures can incur heavy losses||Options buyers are exposed to a limited loss. However, option writers can incur heavy losses|
|Trading in futures requires higher initial investment as compared to options||Options buyers can initiate a position with a relatively small amount of capital|
What’s the role of futures and options in the market?
In theory, derivative contracts are meant to be used as hedging tools but in practice, traders approach F&O contracts for making quick speculative gains.
In brief, F&O contracts can be entered into with any of these three motives
What is hedging?
In the literal sense, a hedge is a protective fence. However, in the financial reference, hedging refers to a risk management strategy that aims to achieve a net-zero effect for a trader. A hedger takes a counterbalancing position using futures and options to an already established trade position.
To know more about hedging check out our article: How can Futures and Options be used for hedging?
How do traders speculate using futures and options?
When you don’t intend to sell or buy the underlying asset but "take a punt" on the asset price movement, you might take positions in the F&O market based on your market view and expectations of volatility.
For instance, you might expect silver prices to go up sharply in the short run and hence might create a long position in the futures market without any intent to take delivery at the time of expiry. Here, the motive is to speculate on prices rising and use it to profit from your trade.
Taking advantage of arbitrage opportunities using F&O contracts
Arbitrage opportunities arise when there’s a substantial difference between the prices of the same asset in different markets. For instance, a stock might trade at Rs 100 in the cash market but the same might trade at Rs 110 in the futures market for the nearest expiry. In such a case, an arbitrageur might buy the stock in the cash market and subsequently sell a position in the futures market to lock the arbitrage opportunity of Rs 10.
What are the different options strategies?
When taking a position in options, seasoned traders often go for a combination of orders, depending upon their risk appetite and view of the markets. These are called trading strategies, some common strategies include:
|1||Naked-call buying||Buying a call||Bullish|
|2||Naked-call writing||Writing a call||Bearish|
|3||Naked-put buying||Buying a put||Bearish|
|4||Naked-put writing||Writing a put||Bullish|
|5||Covered call||A long stock position and a short call position||Neutral-to-bullish|
|6||Protective (Married) Put||A long stock position and a long put position||Neutral-to-bullish|
|7||Long Straddle||A long position on a call and a long position on a put with a same strike price||Quick move-direction unknown|
|8||Long Strangle||Long position on a call and long position on a put with different strike price||Quick move-direction unknown|
|9||Short Straddle||A short call and a short put with the same strike price||Range-bound movement; low volatility|
|10||Short Strangle||A short call and a short put with different strikes||Range-bound movement; low volatility|
|11||Bull Call Spread||A long and a short call position simultaneously||Gradual upmove|
|12||Bear Put Spread||A short put and a long put||Gradual decline|
|13||Bear Call Spread||Selling a call with a lower strike and buying a call with a higher strike||Neutral -to-bearish|
|14||Bull Put Spread||Selling a put with higher strike and buying a put with lower strike||Neutral-to-bullish|
|15||Long Butterfly Spread||Two long calls and two short calls||Quick move-direction unknown|
|16||Short Butterfly Spread with calls||Two long calls and two short calls||Range-bound movement; low volatility|
If you’d like to know more, here’s a deep dive into some effective options strategies.
How to be a successful futures and options trader?
Some guidelines for success in F&O trading involve keeping track of:
And that’s it for this article. Hope we’ve been able to help you with a rough understanding of Futures & Options. Before you place your first trade, however, do also check up on the common terminologies used in F&O trading.
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