We often hear the phrase: “The more the merrier”. In the context of stock markets, many a time, inexperienced investors try to implement the message entailed in this phrase. They invest with a naïve assumption: a high amount of investments results in higher profits. This is not always true. This is because movements in markets are a culmination of minds, which have access to varied levels of information and knowledge. And this difference has given rise to the concept and tradition of ‘leveraged trades’ in the markets. Those who have more understanding and skills tend to take high exposure to markets than those who have relatively lower information and knowledge.
By following a clearly defined, rule-based trading strategy and adhering to a stop loss, one can build a large capital over a long period of time. This is very well observed in futures and options markets, also known as derivatives markets. Many traders leverage their positions to better the outcomes of their trading activities. Leverage, however, works on both sides—it can multiply your profits as well as losses. Trading using derivatives—futures and options—is akin to trading with leverage. In 2002, Warren Buffett described derivatives as “financial weapons of mass destruction”. Hence, you have to be very careful while using derivatives for trading. Hence, it is important to understand the distinctive features of futures and options to understand how the derivatives markets work:
Before we get into futures and options, we need to understand a basic concept: forward contract. A forward contract is an agreement between two parties wherein a buyer agrees to purchase a certain quantity of an underlying asset at a future date at a predetermined price from the seller. In this contract, on the future date either the underlying asset (shares or goods or commodities) is delivered to the buyer or both parties exchange cash depending on the movement of price and settle the contract through cash. The key risk here is counterparty risk – what if one of the parties to agreement does not honour its obligation?
F&O
To avoid the counterparty risk in derivatives, futures and options contracts are traded on the stock exchange. The stock exchange bears the counterparty risk and the market participants can trade without the fear of the counterparty not honouring its obligation.
What are futures?
A futures contract is akin to a forward agreement. It is an agreement between two parties wherein a buyer agrees to purchase a certain quantity of shares at a future date at a predetermined price from the seller. The future contract gives the buyer and seller the right to buy and sell, respectively, the specified share (or the underlying asset) at a specific future date at a specific price. This can be better explained with the help of an example. Buyer A purchases a future contract to buy shares of XYZ Limited at ₹135 on the last business day of October 2021. This contract is sold by seller B. Here both of them are obliged to perform their duties—buyer has to buy and seller has to sell.
What is an option?
An option is a contract between two parties that give the buyer of the option a right but not the obligation to buy or sell the underlying asset at a future date at a future price. The key difference between futures and options is that futures ensure that both parties of a contract are obliged to perform. However, in case of options, the buyer of the option has the right but not the obligation to perform. However, seller of the option has to perform according to the agreement.
Options are exercised in two different fashions: European options and American options. These are not geographical nomenclatures, but they solely indicate how they can be exercised. While a European option can be exercised only on the expiration date (specified date in the future), an American option allows the flexibility of exercising the option at any time before or on the day of expiration (specified date in the future). In India, all options that are traded on the stock exchanges are European options.
Further, there are two types of options. Call option and put option.
A call option is one that gives the buyer the right but not the obligation to buy the underlying at a future date at a predetermined price from the seller of the option.
A put option is one that gives the buyer the right but not the obligation to sell the underlying at a future date at a predetermined price to the seller of the option.
This can be better understood with an example.
Buyer A purchases a call option of stock XYZ to purchase the stock at ₹140 (strike price) on the last business day of October 2021 (expiration day) by paying a premium of ₹1.5. This option is sold by seller B. In this contract the buyer A may not exercise his right to buy on the expiration date if the market price is below ₹140. In that case he will forego the premium paid. The premium will be pocketed by the seller of the option. The trade becomes profitable for the buyer A when the stock price crosses the strike price plus premium paid. In this case the trade becomes profitable for the buyer when the XYZ stock starts trading above ₹140 + ₹1.2 = ₹141.2 per piece.
Now let us see how a put option works with the help of an example.
Buyer L purchases a put option of stock XYZ to sell the stock at ₹140 (strike price) on the last business day of October 2021 (expiration day) by paying a premium of ₹1.5. This option is sold by seller M. In this contract the buyer L may not exercise his right to buy on the expiration date if the market price is above ₹140. In that case he will forego the premium paid. The premium will be pocketed by the seller of the option. The trade becomes profitable for the buyer L when the stock price goes below the strike price minus the premium paid. In this case the trade becomes profitable for the buyer when the XYZ stock starts trading below ₹140 -₹1.2 = ₹138.8 per share.
We have ignored transaction cost in these examples.
European call option is denoted as CE and European put option is denoted as PE.
Both options and futures involve trading based on the lot sizes. For example, each lot of a derivative (both future and option) contract of Nifty 50 index is 50. For Bank Nifty, it is kept at 25 and for Nifty Financial Index it is at 40. The lot size of each stock is different, and traders need to know it before entering into a trade.
Now, let us understand the difference between futures and options. When you enter into a futures contract, the stock exchange demands a certain fraction of the trade value. For example, for index futures, the margin could be around 10-15% of the value of the trade. For stocks, it could be 20-25% or more of the trade size. The trade size is arrived at by multiplying the lot size with the current market price of the underlying. The margin is payable by both the buyer and seller in case of futures.
In case of options the buyer pays the premium. The seller of the option has to pay the margin as decided by the stock exchange.
If the trade you have entered into goes against the direction you anticipated, then to stay in the trade you have to pay an additional margin. If you do not bring in additional margin then the broker squares off the trade.
To put it simply, by using a small amount of money, you are taking a large position on the underlying asset that you have a view on. You have derivative contracts being traded on stocks, stock indices, currencies, commodities on respective exchanges.
This brings to the key aspect of futures and options: how money is made and lost in this market.
In case of futures, the parties to the contract gain or lose depending on the directional move in the underlying asset. If you have bought a future and the underlying stock goes up then you make money. In that case the seller loses money, and the other way round also holds good. The profit and loss can be unlimited. (Though for a seller of the future, the loss is limited to an extent as the stock price cannot go below zero).
In case of an option trade, the buyer’s loss is limited to the extent of the premium paid. But for the seller of the option the loss is unlimited (for put options it is still limited as the price of the underlying asset cannot go below zero). For the buyer of the option, the gain can be unlimited and for the seller of the option the gain is limited to the extent of the premium received.
You have to be careful while trading futures and options and control the risk involved to earn consistently.