Summary:
"Futures" and "options" are commonplace terms in the financial world, representing agreements to buy or sell assets at predetermined prices in the future. Futures and options (F&O) allow individuals to profit from changes in stock, commodity, or currency prices. To understand F&O, there are two crucial terms you need to understand: "strike prices" and "lot sizes". These shape the dynamics of trade. Strike prices fix deal prices, while intervals reflect the risks between them. Lot sizes, pre-set by the Securities and Exchange Board of India (SEBI), determine the minimum number of shares traded.
Did you know that in FY22, the total count of distinct individual traders soared by more than 500% to 39.76 lakh compared to FY19's 7.1 lakh count? Over the past three years, interest in the derivatives market has skyrocketed. But what does trading in derivatives really mean?
In the realm of finance, you may come across the terms “futures” and “options” quite often. They are part of a fascinating system that allows traders to make agreements about buying or selling assets at specific prices in the future. Imagine it like this: F&O is like booking a plane ticket in advance. When you book a ticket for a future date, you agree on a fixed price now, regardless of how the prices of ticket change. This way, you secure your seat at a certain cost, even if the airfare rises or the demand increases. F&O adopts a similar approach to locking in prices. It's a special way of buying and selling contracts that allows you to make money based on the changes in the prices of things like stocks, commodities, or even currencies. This is F&O in a nutshell.
A critical part of F&O is understanding “strike prices” and “lot sizes,” which we're going to explore next. By the end of our exploration, you'll have a clear grasp of what they mean and how they work.
F&O unveiled: Understanding the basics and key differences
F&O are like special financial agreements between two or more parties. They are derivatives connected to other things that people trade in markets like company shares, items we use, or even money from different countries. Among various types of financial derivatives, the most prominent ones found in the stock market are F&O. How does it work? Let’s see:
Suppose you purchase a futures contract to acquire 100 shares of a particular stock at INR 400 each, with a specified date of execution. When the contract expires, you will receive these 100 shares at the agreed-upon price of INR 400 per share, regardless of the prevailing market price. Even if the price rises to INR 420, you will still obtain the shares at INR 400 each, resulting in a profit. Conversely, if the share price drops to INR 380, you will still be obligated to purchase them at INR 400 each, resulting in a loss. So, the worth of the derivative tool changes based on the value of the underlying asset it follows.
An options contract is also integral to the trading landscape but is distinct from a futures contract due to its unique characteristics. They are both special tools that investors use in finance. With both futures and options, an investor can agree to buy something at a certain price before a certain date. In a futures contract, the buyer is obligated to buy the actual thing, like a security or something valuable, on a particular date in the future. And the seller is also obligated to sell it. If the buyer chooses to use a future stock, the seller has to do what the contract says. The buyer gives some money (called a premium) for this special right. The options contract, on the other hand, is not binding. It lets investors decide if they want to buy or sell shares at a certain price before a certain date. They don't have to do it if they don't want to.
There are two types of options:
- Call option: The buyer gets the special right (but not the obligation) to buy something. They do this when they expect the price of that thing to go up.
- Put option: The seller gets a special right (but not the obligation) to sell something. This happens when they think the price of that thing might go down. If the price doesn't change as the trader thought, they can decide not to use the option.
Key takeaways:
- Options and futures are derivative contracts tied to market movements of an underlying index, security, or commodity.
- A futures contract makes the buyer agree to buy, and the seller agrees to sell and deliver, a specific asset on a set future date.
- An option lets the buyer decide to buy or sell an asset at a fixed price anytime during the contract's life, without being obliged to do so.
- There are two types of options: call and put.
Strike prices and lot sizes: Keys to mastering F&O trading
The strike price and lot size are among the most crucial elements of an options contract. Let’s break it down.
Strike prices
The “strike price” is a set price at which the security or underlying asset can be purchased or sold on before a contract ends. It is called the strike price because that is the price at which you strike the deal. On the contract's expiration day, the strike price is sometimes called the “exercise price.” But here's the thing: the buyer of the option would only be interested in the option if it is a good deal. For example, let's say you bought an option of X stock for INR 100, and you chose a strike price of INR 1,000. This option is a good deal only if the X stock price goes higher than INR 1,000. If it doesn't, the option won't work for you.
Now, the concept of “strike price intervals” is tied to this idea. They are the various levels of strike prices for each stock option and depend on the cost of a stock. Exchange authorities decide the strike prices, and these strike intervals are periodically set and adjusted according to price changes. Say the strike price interval is set at INR 250. This indicates the fixed difference between consecutive strike prices within an options contract. To illustrate, if we have available strike prices of INR 500, INR 750, INR 1,000, INR 1,250, and INR 1,500, each subsequent strike price is separated by INR 250. This means that traders can select from these specific price points to execute options contracts, with each interval reflecting a consistent increment of INR 250 between them.
But why do these strike prices and intervals matter anyway?
Well, they actually tell you the specific prices at which you can make standard agreements. And that interval between them? It's like a measure of how risky it can get when you move from one interval to the next. In a way, they help you understand the options you're dealing with and the risks involved. Every person who trades options has to pick a strike price. This choice often depends on an option's price and “moneyness”. Now, the “moneyness” of any option is the extent to which the option is “in the money”. That is, how much the option is worth. For instance, if a stock is priced at INR 1,200, then its INR 1,150 call option is more in the money compared to its INR 1,180 call option. Why? For the INR 1,180 call option, while the option holder could still buy the stock at a price lower than its current market value, the potential profit is not as significant as in the case of the INR 1,150 call option. Therefore, the INR 1.180 call option is also "in the money," but to a lesser extent compared to the INR 1,150 call option.
Lot sizes
Options contracts are grouped into lots. A lot size tells you how many shares there are in one contract. This size varies for different companies and doesn't change even if the asset's price moves. In simple terms, lot size is the amount of something you order to get on a specific day. In trading, it's the number of stocks you buy at once. For options trading, the lot size is the smallest number of stocks you can buy or sell in a contract. The Securities and Exchange Board of India (SEBI) decides this for F&O traders in our country and helps to control market prices.
With set lot sizes, traders always know the price for each unit. Imagine the lot size of a stock is 50 shares. This means if you want to trade in options, you can only do it in groups of 50 shares. Lot sizes in F&O trading primarily exist for the purpose of market standardisation. This holds significant importance in F&O trading. SEBI diligently monitors lot sizes and indicative lot values to curb excessive speculation and safeguard small retail traders from facing substantial losses.
Key takeaways:
- The strike price is a fixed price to buy or sell an asset before the contract ends. On the day of expiration, it's sometimes called the exercise price.
- Strike price intervals are different price levels for each option. They depend on stock cost.
- Authorities (SEBI in India) decide the strike prices and their intervals. They set and adjust them based on movements in stock prices.
- This is important because they define where you make standard agreements and show how risky moving between intervals can be.
- Options traders choose a strike price based on the option price and whether it's in the money, which basically means how much the option is worth.
- Options contracts are divided into lots, which are specific groups of shares.
- Lot size indicates how many shares are present in a single contract.
- Lot sizes differ among various companies and remain fixed despite price fluctuations.
- For options trading, lot size defines the minimum number of shares you can buy or sell in a contract.
- SEBI determines lot sizes for F&O traders to control market prices.
Building wealth with F&O trading: A journey towards investment growth
Trading in F&O isn't as complex as it's often portrayed. You can effectively utilise these innovative financial tools with a proper understanding of the trading landscape. It can magnify your profits, but it's also crucial to familiarise yourself with the potential risks associated with such trades. Partner with India’s fastest-growing broker to simplify trading in equities, futures, options, commodities, and currencies. Learn everything you need to know to #InvestRightInvestNow.