When most people think of investment, they think of buying stocks on the stock market and making huge returns very quickly. They are probably completely unaware of terms like futures and options trading. But the only way to make huge returns in a very short term is by using futures and options (F&O).
There are a lot of financial instruments that can be actively traded in the Indian market.
Futures and Options, in particular, have proven to be very popular among traders and is becoming more and more common in the investment market.
In this article
What are futures?
A future is a legally binding contract to buy or sell an underlying asset at a future date at a pre-determined price.
This underlying asset could be a share issued by the company, gold, currencies, commodities, interest rates, bonds etc.
The Contract is standardized in terms of quantity and quality of assets, delivery time and place for settlement at a specified future date.
Both parties, in trading of futures, are obligated to complete the contract at the end of the contract period with the delivery of cash or underlying asset.
Assume two traders agree to $80 per barrel on a crude oil futures contract.
The buyer agrees to buy crude oil at $80 per barrel after a specified period in the future, and the seller agrees to sell oil at $80 per barrel.
If the price of crude oil moves up to $85 per barrel, the buyer of the contract at $80 per barrel is making money because they have an agreement to buy at $80 per barrel even though oil is currently trading at $85 per barrel.
The seller, on the other hand, is losing because they could be selling at $85 per barrel, but instead, they agreed to sell at $80 per barrel.
As futures contracts are the function of an underlying asset, it is a derivative product.
Purpose of trading in futures contracts
The actual purpose of a futures contract is to minimize the risk of price or exchange rate fluctuations by allowing two parties to fix prices or rates in advance for future transactions in an underlying asset.
Futures contracts also offer opportunities for speculation in that a trader who predicts that the price of an underlying asset will move in a particular direction (up or down) can contract to buy or sell it accordingly in the future at a price which, if the prediction is correct, will yield a profit.
Terms you should know for trading in futures
- Buying in futures trading means a promise to pay the underlying asset’s price at a specific time.
- Selling in futures trading means a promise to transfer underlying assets to the buyer at a specified price and duration.
- The predetermined price the parties in futures contract agree to buy and sell the underlying asset for is known as the forward price.
- The specified time in the future, which is when delivery and payment occur between the parties, is known as the delivery date.
- Trading of futures contract takes place on a Futures Exchange that acts as an intermediary to minimize the risk of default by parties involved.
The Futures Exchange also provides a centralized marketplace with ease and with access to all market information, price movements and trends for buyers and sellers.
What are options
An option is a legally binding contract between two parties in which the buyer purchases the right (but not the obligation) to buy or sell an underlying asset at a pre-determined price (strike price) from or to the seller (the writer) at a specified future date.
This underlying asset could be stocks, gold, currencies, commodities, interest rates, bonds etc.
Trading in options involves buying and selling options contracts on the public exchanges and is very similar to stock trading.
Whereas stock traders aim to make gains by buying stocks and selling them at a higher price, options traders can make gains by buying options contracts and selling them at a higher price.
Purpose of trading in options contracts
Options contracts are for the investors who don’t like to invest heavily in stocks directly.
It is basically an agreement between two parties to sell or purchase the right to an underlying asset like commodities, stocks etc.
With options contracts, investors have an opportunity to practice a wide range of strategies with limited or unlimited risk and profit potential, create hedging and speculative trading opportunities for themselves.
Type of Options
There are two type of Options:
1. Call Option:
A Call Option is an Option where the buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular underlying asset from the seller of the option at the expiration for strike price.
The seller is obligated to sell the underlying asset to the buyer if the buyer so decides.
For this right, the buyer pays a fee, known as a premium, for this right.
2. Put Option:
A Put Option is an option to sell an underlying asset on or before its expiration date.
Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down in coming times.
To make a profit, the price of the underlying asset should go down from the strike price of the Put Option that you have purchased before or at the time of its expiration.
Trading in futures and options is an increasingly popular form of investment that is accessible to anyone and does not require a huge amount of starting capital.
If you ready to put some time and effort into learning how to trade well, you can potentially make significant sums of money in less time.
Example of how options make money
Let’s say Bharat Petroleum Corp. Ltd. (BPCL) stock is currently trading at ₹300 per share on Bombay Stock Exchange (BSE).
Now, say an investor purchases one call option contract on BPCL with a ₹300 strike price and at a price of ₹2.00 per contract.
As each options contract represents an interest in 100 underlying shares of BPCL, the actual cost of this option will be of ₹200 (100 shares x ₹2.00 = ₹200).
Here’s what will happen to the value of this call option under a variety of different market scenarios:
# When the option expires, BPCL is trading at ₹305.
Remember that the call option gives the buyer the right to purchase shares of BPCL at ₹300 per share.
In this scenario, the buyer could use the option to purchase those shares at ₹300, then immediately sell those same shares in the open market for ₹305. This option is therefore called in the money.
Because of this, the option will sell for ₹5.00 on the expiration date. Since each option represents an interest in 100 underlying shares, this will amount to a total sale price of ₹500.
So, the net profit to the buyer from this trade will be ₹300, as the investor purchased this option for ₹200.
# When the option expires, BPCL is trading at ₹301.
Using the same analysis, as shown above, the call option will now be worth ₹1 (or ₹100 total for 100 underlying shares)
Since the investor spent ₹200 to purchase the option in the first place, he or she will show a net loss on this trade of ₹100 total.
As the transaction is essentially washed away, this option would be called at the money.
# When the option expires, BPCL is trading at or below ₹300.
If BPCL ends up at or below ₹300 on the option’s expiration date, then the contract will expire out of the money.
It will now be worthless, so the option buyer will lose ₹200 (100%) of his or her money spent on the money.
Advantages of Trading Options
Trading in Options has many advantages and there are plenty of reasons why this form of trading is worthy of consideration for anyone looking to invest.
1. Capital Outlay and Cost Efficiency
One of the best reasons for trading in options is the fact that it is possible to make significant gains out of doing so without necessarily having to have large sums of money.
Because of this, it is ideal for investors with less starting capital as well as those with large budgets.
Let’s say you had ₹1,000 to invest and you wished to invest it in the shares of company ABC, currently trading at ₹20, which you expected to rise in value.
If you chose to simply buy those stocks using your ₹1,000, then you could purchase 50 shares of company ABC.
If the stock did rise to, say, ₹25 then you would make a profit of ₹5 per share for a total of ₹250. This is a clean 25% return on your original investment.
But rather, you choose to buy call options on the same shares, giving you the right to purchase the share.
If call options with a strike price of ₹20 were trading each option contract at ₹2.00, you could buy 500 options (using ₹1000 initial investment) which would enable you to buy 500 shares if the share price did go up in the market.
With the share price rising to ₹25, you could exercise your option to buy 500 shares and then sell them immediately for a profit of ₹2,500.
After taking away your original investment of ₹1,000 to buy the options, you are still left with ₹1,500 profit and a return on your money of 150%.
2. Risk and Reward
There is a limited downside for option buyers.
When you buy a put or call option, you are not obligated to follow through on the trade.
If your assumptions about the time period and direction of a stock’s trajectory are incorrect, your losses are limited to whatever you paid for the contract and trading fees.
3. Flexibility for traders
Investors have several strategic moves they can deploy before an options contract expires.
- Exercise the option and buy the shares to add to the investor’s own portfolio.
- Exercise the option, buy the shares and then sell some or all of them to open market.
- Sell the in the money options contract to another investor in the market.
- Potentially make back some of the money spent on an out of the money options by selling the contract to another investor before it gets expired.
When most people think of investment in the financial market, they think of buying shares of listed companies on the stock market, and many are probably completely unaware of terms like futures and options trading.
But trading in futures and options is an increasingly popular form of investment that is accessible to anyone and does not require a huge amount of starting capital.
If you ready to put some time and effort into learning how to trade well then you can potentially make significant sums of money in less time.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.