What is meant by Futures and Options?
Futures and options are two major types of derivatives trading in the stock market. These contracts are entered into by two parties, allowing them to trade a stock asset at a predetermined price on a later date. The purpose of such contracts is to hedge market risks associated with stock market trading by locking in the price beforehand.
Futures and options derive their price from an underlying asset, such as shares, stock market indices, commodities, and ETFs. They enable investors to reduce their future risk by fixing prices in advance. However, predicting the direction of price movements is not always possible, and this can lead to substantial profits or losses if market predictions are inaccurate. Typically, experienced individuals who are well-versed in stock market operations participate in such trades.
Futures and options are types of financial contracts that allow traders to speculate on the price movements of underlying assets such as stocks, commodities, and currencies. While they are both derivatives, they differ in several ways.
A futures contract is an agreement to buy or sell an underlying asset at a predetermined price on a specific date in the future. The buyer and seller are obligated to fulfill the terms of the contract, regardless of whether the price of the underlying asset increases or decreases. Futures contracts are traded on exchanges and are often used by investors to hedge against price fluctuations.
An option contract, on the other hand, gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (known as the strike price) on or before a specific date. The buyer of an option pays a premium for this right but is not obligated to exercise it. Options contracts are also traded on exchanges and are often used for speculation or hedging against potential losses.
Both futures and options trading involves risks and rewards. The primary risk is that the trader's prediction of the price movement of the underlying asset is incorrect, leading to losses. The potential rewards of futures and options trading come from the ability to leverage capital and profit from both rising and falling markets. However, it is important to note that leverage can also amplify losses.
In summary, futures and options are types of financial contracts that allow traders to speculate on the price movements of underlying assets. While futures contracts are obligations to buy or sell an asset at a predetermined price and date, options contracts provide the right, but not the obligation, to buy or sell at a specific price on or before a specific date. Both types of trading involve risks and rewards, and it is important to have a thorough understanding of the underlying assets and the market before engaging in trading.
Examples of long and short future trading with the Nifty 50 index:
Long Futures Trading Example: Assume that the Nifty 50 index is currently trading at 15,000, and you believe that it will go up in the near future. You can enter into a long futures contract by buying one Nifty 50 index futures contract at the current market price of 15,000. Let's say the futures contract size is 50 units. In this case, you are agreeing to buy 50 units of the Nifty 50 index at a future date (expiration date) at a predetermined price (futures price). If the futures price is 15,100, and you close the contract on the expiration date, you will earn a profit of 100 points per unit, which is 50 x 100 = 5,000. However, if the futures price decreases to 14950, you will incur a loss of 50 points per unit, which is 50 x 50 = 2500.
Short Futures Trading Example: Now assume that instead of being bullish, you are bearish on the Nifty 50 index, and you believe that it will go down in the near future. You can enter into a short futures contract by selling one Nifty 50 index futures contract at the current market price of 15,000. In this case, you are agreeing to sell 50 units of the Nifty 50 index at a future date (expiration date) at a predetermined price (futures price). If the futures price is 14,900, and you close the contract on the expiration date, you will earn a profit of 100 points per unit, which is 50 x 100 = 5,000. However, if the futures price increases to 15,100, you will incur a loss of 100 points per unit, which is 50 x 100 = 5,000.
Call options and put options
Call options and put options are two types of financial contracts known as options. They are both derivatives, meaning their value is derived from an underlying asset such as a stock, index, or commodity. In options trading, the maximum risk and reward depend on the type of option, the strike price, and the premium paid or received. Here are the maximum risk and reward scenarios for buying call and put options:
Buying a call option:
Maximum risk: The maximum risk when buying a call option is limited to the premium paid for the option. If the price of the underlying asset doesn't rise above the strike price by the expiration date, the option will expire worthless, and the buyer will lose the entire premium paid.
Maximum reward: The maximum reward when buying a call option is unlimited. If the price of the underlying asset rises significantly above the strike price, the buyer can make a profit equal to the difference between the market price and the strike price, minus the premium paid.
Buying a put option:
Maximum risk: The maximum risk when buying a put option is limited to the premium paid for the option. If the price of the underlying asset doesn't fall below the strike price by the expiration date, the option will expire worthless, and the buyer will lose the entire premium paid.
Maximum reward: The maximum reward when buying a put option is limited to the difference between the strike price and zero. If the price of the underlying asset falls to zero, the buyer can make a profit equal to the strike price minus the premium paid. However, it is rare for a stock or index to go to zero, so the maximum reward is typically lower than the maximum risk.
It is important to note that options trading involves risks and is not suitable for all investors. Traders should have a thorough understanding of the underlying assets and the market before engaging in options trading.
Call option
A call option is a contract that gives the buyer the right, but not the obligation, to buy the underlying asset at a predetermined price (known as the strike price) on or before a specific date. When an investor buys a call option, they are hoping that the price of the underlying asset will rise above the strike price. If the price does rise above the strike price, the investor can sell the option at a higher price than the purchase price, and make a profit from the difference.
Example
Assuming that you have bought a single call option contract of Nifty50 at a strike price of 17200 with a premium of Rs.102 per share, where the lot size is 50, then your total premium paid for the options contract will be: Premium per share x Lot size = 102 x 50 = Rs. 5100. Now, let's calculate the break-even level for this call option. The break-even level is the level at which the option buyer neither makes any profit nor any loss.
Break-even level = Strike price + Premium paid. 17200 + 102= 17302
Therefore, the Nifty50 index needs to close above 17302 for you to make a profit from this call option. Now, let's assume that the Nifty50 index closes at 17365. To calculate the profit, we need to consider the following formula:
Profit = (Closing price - Break-even level) x Lot size, = (17365 - 17302) x 50 = 3150.
Therefore, the profit in this scenario will be Rs.3150.
On the other hand, if the Nifty50 index does not go above the strike price of 17200 and closes at 17100, then you will incur a loss. The loss in this scenario will be equal to the premium paid, which is Rs.5100.
Put option
A put option, on the other hand, is a contract that gives the buyer the right, but not the obligation, to sell the underlying asset at a predetermined price (strike price) on or before a specific date. When an investor buys a put option, they are hoping that the price of the underlying asset will fall below the strike price. If the price does fall below the strike price, the investor can sell the option at a higher price than the purchase price and make a profit from the difference.
Example
Assuming you bought a put option for Nifty50 with a strike price of 17200 and a premium of 92, with a lot size of 50. This means you have the right, but not the obligation, to sell Nifty50 at the strike price of 17200 on or before the expiration date.
Your break-even level can be calculated as follows: Break-even level = Strike price - Premium paid
Break-even level = 17200 - 92 = 17108. This means that if the Nifty50 closes below 17108, you will start to make a profit on your put option.
Now, if the Nifty50 closes at 17045, your profit can be calculated as follows:
Profit = (breakeven level - Closing price) x Lot size, Profit = (17108 - 17045) x 50 = 3150
So, in this scenario, you would make a profit of Rs. 3150 on your put option.
On the other hand, if the Nifty50 goes above the strike price and closes at 17230, then your loss can be calculated as follows:
Loss = Premium paid, Loss = 92*50=4600
So, in this scenario, you would incur a loss of Rs. 4600 on your put option.
Both call-and-put options can be bought or sold by investors in the options market, and they can be used for a variety of purposes such as speculation, hedging against potential losses, and generating income through options trading strategies. It is important to understand the risks and rewards of trading options, as they can be highly leveraged and can result in significant losses if not properly managed.