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Futures

Futures and options (F&O) are called derivatives because they derive their value from an underlying stock or an index. Global derivatives market is ginormous - some experts estimate the global derivatives market to be 10 times of the global GDP. Though derivatives were launched in India around 20 years back, we have seen massive growth in the derivatives in India. In 2022, the average daily turnover in the F&O market is Rs 107 lakh crores (compared to just Rs 62,000 crores in the cash market segment). The National Stock Exchange (NSE) is largest exchange in the world of in equity derivatives. In this article, we will discuss about derivatives. For the sake of simplicity, we will discuss only some basic concepts about F&O in this article.

How to trade in F&O?

You need to have a demat account to invest in stock market. You can approach a stock-broker to open a demat account. You will have to provide KYC documents like copies of PAN card, address proof (e.g. Aadhaar card), bank proof (e.g. bank statement, passbook), income proof (e.g. bank statement, ITR) and any other document your stock-broker. You need to mention your broker that you want to trade in derivatives, in order to ensure that you can trade in F&O from your trading account. Investors should note that you need to put cash and / or stocks you own in margin to trade in derivatives (F&O). We will discuss about the concept of margins later in this article.

What are Futures?

Futures contract, in very simple terms, is an agreement between the buyer and seller, to buy / sell a stock at a certain price, on or before a particular date. You can be either a buyer or a seller and the stock exchange (e.g. NSE Clearing) will be the counterparty. For example, if you are buying futures of HDFC Bank, then NSE Clearing will be the seller. On the other hand, if you want to sell futures of HDFC Bank, the NSE Clearing will be the buyer. Let us now understand how futures work with the help of an example. You expect share price of Company XYZ to rise by Rs 100 before the end of this month and you want to profit from the increase by buying future of the stock. Suppose the current market price (CMP) of the stock is Rs 1,000.

Concept of lot size

Before we proceed with this example, we should understand one important difference between cash market and futures market. In cash market you buy any number of shares (you can buy just 1 share), but in F&O market you can only buy or sell lots. One lot has a specified number of shares; let us assume in our example, the lot size is 1000 shares. Buying 1 futures contract of company XYZ is equivalent to buying 1,000 shares of the company. If by expiry (which is the last Thursday of the month), the share price of Company XYZ increases by Rs 100, you will make a profit of Rs 100,000 (Rs 100 X 1,000 shares).

Concept of Margin

You can ask, what is the difference between buying futures contract of Company XYZ and buying 1,000 shares of Company XYZ? The difference is in your capital outlay. To buy 1,000 shares of Company XYZ at CMP of Rs 1,000, you will need to pay Rs 10 lakhs, whereas to buy 1 futures contract of Company XYZ (equivalent to 1,000 shares) you will need a much smaller capital outlay, since their no transfer of shares from seller to buyer in a futures contract. The capital outlay required for futures trading is known as margin. Margin is the money collected by the broker from you to protect the broker from any adverse price movement. You can think of margin as security money for the broker. The margin will be in cash and stocks owned by you. In the above example, let us assume that the initial margin requirement of your stock broker is 20% of the exposure taken by you. Since your exposure is Rs 10 lakhs, the initial margin will be Rs 2. In this case, by investing just Rs 2 lakh, you made a profit of Rs 1 lakh. Sounds very attractive, does it not? It is attractive but risky at the same time. Suppose, instead of rising Rs 100, the share price of Company XYZ, fell Rs 50. In that case your loss will be Rs 50,000 (Rs 50 X 1,000). The broker will recover this loss from your margin.

Selling Futures

In the above example, you bought futures of Company XYZ because you expected price to go up. Let us now take another scenario, where you expect the price of Company XYZ to fall. If you expect the price to fall, you will sell futures at the CMP and make a profit when the price falls below the price at which you sold. Here you need to understand the important distinction to trade in futures market. In India, you cannot sell shares that you do not own. On the other hand, in the F&O market, you can sell futures of a stock even if you do not own the stock (have it your demat account). You just have to fulfil the margin requirements. Going back to our previous example, if you expect share prices of company XYZ to fall, you can make a profit by selling futures contract. Suppose you sold 1 futures contract (lot size of 1,000 shares) of Company XYZ at a CMP of Rs 1,000 and the share price fell by Rs 50, you will make a profit of Rs 50,000 (Rs 50 X 1,000). Whether you are buying or selling the futures contract, the risk remains. If you sell a futures contract and the share price increases, you will make a loss and it will be recovered from your margin.

Futures premium / discount

In the above examples we assumed that the CMP of the share is the price at which you buy / sell futures. However, the futures price is slightly different from the share price. The difference between the futures price and the share price (also known as cash price or spot price) is known as the futures premium (if the futures price is higher than spot price) or discount (if the futures price is less than spot price). The futures premium depends on interest rates, length of the contract (more about this in the next section) and dividends paid by the stock (if applicable). So if the CMP of a Company XYZ shares (spot price) is Rs 100, you may have to buy the futures of XYZ at Rs 101. Investors should note that on expiry of the contract, the futures price and spot price will converge (be the same).

F&O series

Let us recap what future contract. A futures contract is an agreement between the buyer and seller, to buy / sell a stock at a certain price, on or before a particular date. F&O contracts have an expiry date; after the expiry date the contract is no longer valid. In case of futures contract, the contract will be squared off (settled) on the expiry date of the contract, based on the price of the expiry date unless you squared off earlier (we will discuss squaring off in the next section). Different F&O contracts have different expiry dates. The expiry dates of F&O series in India are the last Thursdays of a month. The most actively traded F&O contracts in India are current series i.e. same month; in the current series, the expiry date will be in the same month in which you bought / sold futures. You can also buy / sell futures which expire in the next month or even later. How to decide which futures series to buy / sell? Suppose, you expect share price of company XYZ to go up by Rs 100 but you are not sure if it will go to that level in this month, you can buy the next month futures series. The futures premium will be different for different series.

Squaring off

Squaring off is taking an opposite position to your initial position in a futures contract. In other words, if you bought a futures contract, you can square off by selling the futures contract. Suppose you expected share price of company XYZ to go up by Rs 100 before expiry. After 10 days, the share price is up by Rs 40 and the futures price is up by Rs 39. You decide that, you do not want to wait till expiry and want to book the profits now. You can do that by squaring off (i.e. selling off) your contract; your profit will be Rs 39,000 (Rs 39 X 1,000). It is up to you, when you want to square off, but you have to do it before expiry because on expiry, your position will be automatically squared off.

Mark to market

Mark to Market (MTM) in a futures contract is the process of daily settlement of profit and losses arising due to the change in the security's market value until it is held. The MTM calculations are done daily after the trading hours, based on the closing price for the day. MTM losses may have an impact on your margin requirements and your broker may ask you to bring additional margin or have your position squared off.

Index futures

In this type of futures, the underlying assets are not individual stocks, but stock indices like Nifty or Bank Nifty. Index F&Os are much more popular than stock F&Os; average trading volumes of Nifty F&Os are multiple times the trading volumes of individual stock F&Os. The main reason for this is that in index futures you are predicting the general direction of the market instead of a specific stock. An index is only subject to market risks, while stocks are subject to both market and unsystematic risk (stock and sector specific risks).

Conclusion

F&O trading is more complex than simple share trading / investments. In this article, we have discussed about futures market and how futures trading is done. In the next article, we will discuss about options, which is a bit more complex than futures. However, a lot of the concepts discussed in this futures article like lot size, premium, series, squaring off and MTM applies to options as well. We urge you to go through this article, so that you have a better understanding of options, which by far is the most popular equity related security to be traded in the stock market.

What are Options?

Options are derivative instruments which are traded in the F&O segment of the market. Option grants the buyer, the right to buy or sell the underlying stock at a certain price (strike price), on or before a certain date (expiry date). Please note option will give you the right to buy or sell but it is not an obligation; in other words, you can choose not to exercise the right. Options are more complex instruments compared to futures. You need to know about certain terms before you start trading options. For the sake of simplicity, we will not discuss complex concepts in this article.

How do call options work?

Let us assume you expect share price of Company XYZ to rise by Rs 100 in the next few days or weeks. Suppose the current market price (CMP) of Company A is Rs 1,000. Let us suppose, the options contract lot size is 1,000. You buy 1 call option contract (equivalent to 1,000 shares) of Company XYZ, with a strike price of Rs 1,000. Recall, call option gives the buyer, the right (but not an obligation) to buy the asset at a certain price. If by expiry (which is the last Thursday of the month), the share price of Company XYZ increase to Rs 1,100, you will to buy shares of Company XYZ at Rs 1,000 and sell it at Rs 1,100, thereby making a gross profit of Rs 100,000 (Rs 100 per share X 1,000). In reality, you do not have to actually buy and sell the shares of the company; the profit is built into the price of the option; all you have to do is to sell a call option of the same strike price at expiry and book the profits. You should understand that Rs 100,000 is your gross profit. Your net profit will be Gross Profit - Cost. So if the call option premium is Rs 10, your total cost will be = Rs 10 X 1,000 (lot size) = Rs 10,000. Your net profit will be Rs 100,000 - 10,000 = Rs 90,000

What happens if the share price of Company XYZ falls by Rs 50? Remember, option is a right not an obligation. You will not exercise your right to buy the shares and let the option expire. In that case your loss will be only the price paid by you for buying the call option, in this case, Rs 10,000. For a call option buyer, the potential of profit is unlimited but the loss is limited to the option premium.

How do put options work?

Let us assume you expect share price of Company XYZ to fall by Rs 50 in the next few days or weeks. Suppose the current market price (CMP) of Company XYZ is Rs 1,000 and lot size is 1,000. You buy 1 put option contract (equivalent to 1,000 shares) of Company XYZ, with a strike price of Rs 1,000. If by expiry the share price of Company A falls to Rs 950 then you will buy the shares of the Company XYZ at Rs 950 and sell it at Rs 1,000, thereby making a profit of Rs 50 per share and gross profit of Rs 50,000 (Rs 50 X 1,000). Like call options, you do not have to actually buy and sell the shares of the company; the profit is built into the price of the option; all you have to do is to sell a put option of the same strike price at expiry and book the profits. If the put option premium is Rs 6, your total cost will be = Rs 6 X 1,000 (lot size) = Rs 6,000. Your net profit will be Rs 50,000 - 6,000 = Rs 54,000

What happens if the share price of Company XYZ rises by Rs 50? You will not exercise your right to sell the shares and let the option expire. In that case your loss will be only the price paid by you for buying the put option, in this case, Rs 6,000. Just like a call option, for a put option buyer, the potential of profit is unlimited but the loss is limited to the option premium.

How do options work for options writer / seller?

So far, we have looked at options from the point of view of the buyer. However, as mentioned earlier, you can also write or sell options. The risk return trade-off for the option writer is very different from that of option buyer. For example, if you sold a call option of Company XYZ with a strike price of Rs 1,000 for Rs 10 (option premium). If the share price falls below Rs 1,000 then the call option will expire worthless, since the buyer will not exercise the option. In that case your profit will be Rs 10 X 1,000 lot size = Rs 10,000. However, if the share price rises to Rs 1,100 then you will have to buy shares at Rs 1,100 and sell it to the buyer for Rs 1,000 which is strike price. So you will make a loss of [{Rs 100 X 1,000 (lot size)} - Rs 10,000 (option premium)] = Rs 90,000. While the call option gives the buyer the right but not obligation to buy, it is the obligation of the option writer to sell at the strike price, if the option is exercised. The same applies for put options. If you have sold a put option and the share price fell below the strike price then you will make a loss. For an options writer, the potential for profits is limited to the option premium but loss potential is unlimited. However, in range-bound bound market options writing can be very profitable.

What options to buy?

Buy call options if you expect price to rise; buy put options if you expect price to fall. Call and put options of same underlying stock or index with various strike prices are available in the stock market. The table showing call option price, put option price and open interest for various strike prices is known as an option chain. Please see an example of Nifty 50 option chain for the November Series below.

CALL OPTIONS PUT OPTIONS
OI CHNG IN OI LTP STRIKE LTP CHNG IN OI OI
68,800 28,408 105 18,400 105 30,076 31,903
24,867 6,397 78.5 18,450 130 4,852 5,109
1,05,477 43,225 59.5 18,500 163 15,914 24,745
27,525 6,759 42 18,550 191.45 3,139 3,462
74,002 33,113 28.25 18,600 225.65 3,371 4,245
30,729 9,404 19 18,650 272.1 1,456 1,544
85,417 -8,345 12.2 18,700 312.4 901 1,072
30,400 3,682 8.45 18,750 363.3 292 307
72,626 28,721 5.15 18,800 409.7 191 257
22,425 8,479 3.8 18,850 462 89 89
75,529 53,884 3.6 18,900 509.4 108 118
12,472 10,323 3.15 18,950 580 60 60
1,97,036 11,390 2.7 19,000 603.3 5,743 5,950
7,577 5,942 2.25 19,050 - - 2

In the table above the columns LTP are the call and put option premiums (last traded price) for the respective strike prices. The Nifty closing price on that day was 18,350. If see the option premiums for different strikes relative to Nifty closing price, you will see that the premiums of Near the Money options are much higher than premiums of Out of money options. Though we have not shown In the Money options in this option chain, the premiums of In the Money options are much higher. So you will have to invest more to buy In the Money or Near the Money options. Also, if your In the Money or Near the Money options expire worthless, your loss will be higher compared to Out of the Money options. On the other hand, you can get higher profits by investing in Near the Money options. You should decide based on outlook for the stock / index, risk appetite and risk capital.

Mark to market

Mark to Market (MTM) in an options contract is the process of daily settlement of profit and losses arising due to the change in the option's market value until it is held. The MTM calculations are done daily after the trading hours, based on the closing price for the day. MTM losses may have an impact on your margin requirements and your broker may ask you to bring additional margin or have your position squared off.

Key terms in Options

Types of Option - There are two types of options - call option and put option. Call option gives you the right to buy the underlying stock at a certain price. Put option gives you the right to sell the underlying stock at a certain price. We should remind you again here that, option (whether call or put) is a right but not an obligation.

Strike Price - The strike or exercise price of an options contract is the price at which you can buy or sell the underlying stock. The difference between the market price and the strike price is your gross profit.

Option expiration - Option expires option will expire on the last Thursday of the month in the current series, or last Thursday of following months.

Lot size - In F&O market, you cannot buy or sell any number of shares. You have to buy or sell in lots. Each lot has a specified number of shares known as lot size. For example, lot size of Reliance Industries F&O contracts is 250. So for Reliance Industries futures or options, you have buy or sell in lots of 250 each i.e. 250, 500, 750, 1000 shares etc

In the money option - An option is in the money if a gross profit opportunity already exists, without taking cost into consideration. In a call option, if the market price of the underlying stock is above the strike price, then option is in the money. In a put option, if the market price is below the strike price, the option is in the money.

Out of money option - An option is out of money if a gross profit opportunity does not exist at the present time. In a call option, if the market price of the underlying stock is above the strike price, then option is out of money. In a put option, if the market price is above the strike price, the option is out of money. An out of money option can become in the money later and vice versa depending on price movements.

At the money option - An option is at the money, if the strike price is equal to the market price of the underlying stock.

Near the money option - An option is near the money, if the strike price is close to the market price of the underlying stock.

Option premium - Option premium is the price you have to pay for buying the call or put option. Option premium depends on a variety of factors including the current market price, strike price, time to expiration, interest rates, volatility of the underlying stock etc.

Option writer: The trader selling the option is the option writer. You can be either an option buyer or option seller, depending on how much risk you are ready to take.

Open Interest - Open interest shows the total number of outstanding contracts that are yet to expire.

Index Option - Index option is just like a stock option, the only difference being the underlying asset. In a stock option, the underlying asset is a stock, while in an index option, the underlying asset is an index e.g. Nifty, Bank Nifty etc. Index options are much more popular and actively traded compared to stock options

Conclusion

Options trading can be very profitable if you understand the different aspects of options trading. The risk in options trading is much less than futures trading because your losses are limited (if you are an options buyer). That is why option trading is much more popular than futures trading. However, option trading is also more complex than futures. In this article, we have discussed some basic concepts on option trading and how options work, so that you can get started. Over time you should try to increase your knowledge and try to understand different options trading strategies, so that you can become a better trader and make more profitable trades.