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Futures & Options

To understand Futures and Options, it is important to have an understanding of Derivatives. In the financial markets, a Derivative is a contract that derives its value from underlying assets. These assets can be stocks, bonds, gold, currencies, market indices, commodities, etc. When you buy a derivatives contract, you earn profits by estimating the future price of the asset(s). There are four types of derivative contracts:

• Options
• Futures
• Forwards
• Swaps

Futures are Derivatives contracts in which both buyers and sellers have the obligation to buy/sell the underlying asset at a predetermined price respectively. A Futures Contract is an agreement between the buyer and the seller to buy or sell a specified quantity of the underlying asset at a future date at a price agreed upon between them. Hence, at the expiration date, the buyer must buy and the seller must sell the agreed quantity of the asset at the set price regardless of the current price of the asset. Further, these contracts are marked to market every day. In other words, the contract value is changed every day until the expiration date. They are traded on exchanges just like stocks.

Options are Derivates contracts that offer the buyer the right (but not the obligation) to buy/sell the underlying asset at a predetermined price. The buyer can also choose to allow the Option to expire. The seller has an obligation to execute the contract. They are traded on exchanges just like stocks. An Option contract has four elements:

• Strike price: This is the price at which the seller and the buyer of the Option agree to enter the Option contract.
• Premium: The buyer of an Option contract makes a payment to the seller to earn the right to an Option contract. This is called Premium.
• Expiration day: An Option contract gives the buyer the right to buy/sell the underlying asset. The Expiration Day is the last day that the owner of the Option can exercise the right.
• Lot Size: Every Options contract has a fixed number of units of the underlying asset. This is the Lot Size.

It is important to note that the buyer of an Option does not purchase the assets. Investors pay the premium amount to buy the Option and exercise their right if the market moves in their favor.

There are two types of Options contracts:

1. Call Option – Gives the owner of the Option the right to buy the underlying asset at the strike price on or before the expiration date of the contract.
   Example: Let’s say that you buy a Call Option on ABC Limited for June having a strike price of Rs.1000 and a premium of Rs.50 for a lot size of 100 shares. This means that you have the right to buy 100 shares of ABC Limited at Rs.1000 anytime until the 30th of June. To buy this right, you have to pay a premium of Rs.5000 (Rs.50 x 100 shares). On the expiration date, if the price of the share is Rs.1100, then the buyer of the Option can exercise his right to buy the shares at Rs.1000 and sell them immediately for a profit. The net earnings would be: Net Profit = Selling Price – Buying Price – Premium Net Profit = 110000 – 100000 – 5000 = Rs.5000 However, on the expiration date if the price of the shares falls to Rs.900, then the buyer of the Option can allow the contract to expire and book a loss of Rs.5000 (premium amount) as opposed to buying the shares at Rs.1000 and selling them at Rs.900 and booking a higher loss of Rs.10000. Therefore, the Call Option allows the buyer to limit losses while securing unlimited profit potential. This is a good investment avenue for investors who believe that the stock price will rise in the near future.
2. Put Option – Gives the owner of the Option the right to sell the underlying asset at the strike price on or before the expiration date of the contract.
   Example: Let’s say that you buy a Put Option on ABC Limited for June having a strike price of Rs.1000 and a premium of Rs.50 for a lot size of 100 shares. This means thatyou have the right to sell 100 shares of ABC Limited at Rs.1000 anytime until the 30th of June. To buy this right, you have to pay a premium of Rs.5000 (Rs.50 x 100 shares). On the expiration date, if the price of the share is Rs.900, then the buyer of the Option can exercise his right to buy the shares at Rs.900 and sell them immediately at Rs.1000 for a profit. The net earnings would be: Net Profit = Selling Price – Buying Price – Premium Net Profit = 100000 – 90000 – 5000 = Rs.5000 However, on the expiration date if the price of the shares climbs to Rs.1100, then the buyer of the Option can allow the contract to expire and book a loss of Rs.5000 (premium amount) as opposed to buying the shares at Rs.1100 and selling them at Rs.1000 and booking a higher loss of Rs.10000. Therefore, the Put Option allows the buyer to limit losses while securing a wide range of potential profits. This is a good investment avenue for investors who believe that the stock price will fall in the near future.

Strike Price is the price at which the Option contract can be executed.

• Call Option – it is the price at which the owner of the Option can buy the underlying asset
• Put Option – it is the price at which the owner of the Option can sell the underlying asset.

The Expiration Date of an Option is the last date by which the owner of the contract can exercise the right to buy or sell the underlying asset. In India, monthly Options Contracts expire on the last working Thursday of the month. If that day is a market holiday, then the Option expires on the previous working day. In the case of weekly Options, the contract expires every Thursday

There are various factors that affect the calculation of the premium of an Options Contract:

• Price of the underlying asset(s) – The premium of an Options contract changes with the price of the underlying asset(s).
  • Call Option – If the price of the underlying asset(s) increases the premium of a Call Option increases too and vice-versa.
  • Put Option – If the price of the underlying asset(s) increases the premium of a Put Option decreases and vice-versa.
• Intrinsic Value – Intrinsic Value is calculated as the difference between the strike price and the current market price of the option. This is calculated assuming that you exercise the option today
  • Call Option – If the intrinsic value increases the premium of a Call Option decreases and vice-versa.
  • Put Option – If the intrinsic value increases the premium of a Call Option decreases and vice-versa.
• Volatility of the underlying asset(s) – The volatility in the price of the underlying asset(s) also impacts the premium of the Options contract. If the volatility is higher, the premium will be higher and vice-versa.
• Time to expire – The time left for the contract to expire has a bearing on the premium too. If the expiration date is close, the premium will be lower since the buyer of the contract will have a shorter duration to get the price of the underlying asset(s) to move in a favorable direction.
• Prevailing interest rates – The existing risk-free interest rates in the country also have a minimal impact on the premium of an Options contract. If the interest rates increase, the premium tends to increase too and vice-versa.
• Dividends – If an Option is based on stocks and the company declares a dividend, then it can impact premium pricing. SEBI mandates Options prices to be adjusted for non-dividend days when the company announces a dividend of more than ten percent. Typically, a higher dividend leads to a drop in premium.

All Options that have a Stock Market Index as the underlying are Index Options. This allows investors to trade on the entire market instead of individual securities.

An American Option is an Options contract that can be exercised on or before the expiration date. Options on individual stocks are American Options. A European Option is an Options contract that can be exercised only on the expiration date. Index Options are excellent examples of European Options.

You can buy/sell Options contracts through broking firms that are registered members of the BSE or NSE. These brokers provide online platforms and/or mobile applications allowing you to trade in Options at will. Before opening an account, ensure that the broker offers Options trading and supports all kinds of Options like equity, currency, commodity, etc.

• Open an account with a stockbroker
• Login to the portal or mobile application
• Go through the Options contracts available
• Select the desired one
• Enter order details
• Place the order

Trading in Options is similar to trading in shares.

There are different strategies followed by investors while trading in Options.

• When you exercise your right to sell an Option but hold the underlying asset in case the buyer exercises the right, it is called a Covered Option.
• If you don’t hold the underlying asset, then it is called a Naked Option.

These are terms that signify the position of the strike price of the Option compared to the current price.
In The Money

• Call Option – If the current price of a Call Option is higher than the strike price, then it is said to be In The Money or ITM.
• Put Option – If the current price of a Put Option is lower than the strike price, then it is said to be In The Money or ITM.

At The Money
If the current price equals the strike price, then the Option is said to be At The Money or ATM.

Out of The Money

• Call Option – If the current price of a Call Option is lower than the strike price, then it is said to be Out Of The Money or OTM.
• Put Option – If the current price of a Put Option is higher than the strike price, then it is said to be Out Of The Money or OTM.

When you are looking at an Option, assess the underlying asset(s) and try to estimate the direction its price might take in the coming month.

If you think the price will increase...
In these cases, you can consider BUYING a Call Option or SELLING a Put Option as it will put you in a position to earn profits.
If you think the price will decrease...
In these cases, you can consider SELLING a Call Option or BUYING a Put Option as it will put you in a position to earn profits.

There are many differences:

• Expiration Date – Options have an expiration date. You need to trade them on or before the said date. However, there is no expiry date for stocks.
• Delivery of stocks – When you buy stocks, you need to pay the market price and take delivery. On the other hand, when you buy Options, there is no delivery. These contracts are settled in cash. So, if your Options contract expires and you are in profit, then you will receive the profit amount credited to your bank account.
• Amount of investment – When you buy a stock, you have to pay the market price of the stock. However, if you buy an Options contract with the same stock as the underlying asset, you have to pay a marginal amount. Hence, the amount of investment is low despite offering exposure to the same stock.

In India, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are Options trading exchanges.

Trading in Options offers a range of benefits including:

• Low investment – When you buy an Option, you don’t have to pay the entire price of the underlying asset. Instead, a marginal amount needs to be paid called the premium. This allows you to gain exposure to the asset/instrument with a low investment.
• Higher profit percentage – Think of a share of a company having a market price of Rs.100 per share. If you were to buy 100 shares, then you will need to make an investment of Rs.10000. Within a month, if the share price increases to Rs.120 and you sell all 100 shares, then you book a profit of Rs.2000. With Options, you can book the same profit by investing a much lower amount.
• Works in all market conditions – The best benefit of trading in Options is that you can benefit in all market conditions. All you need to do is create strategies accordingly.

Options contracts with a maturity of up to three years are called Long Dated Options. While the features of these Options are the same as the monthly Options, they offer certain benefits like:

• Long-term exposure to the underlying asset(s)
• Allows investors to hedge their equity position
• Reduces risk since investors get a larger window to book profits.

It is important to remember that these Options usually have a higher premium.

When you buy an Option, you will incur the following costs:

• Premium amount
• Brokerage (depending on the broker)
• STT or Securities Transaction Tax
• Transaction charges (depending on the stock exchange)
• GST of 18% on brokerage and transaction charges
• SEBI turnover charges of 0.00015%.
• Stamp Duty (as per the applicable state laws)

Here are some common types of Futures Contracts:

• Stock Futures – In these Futures, the underlying asset is a stock. Hence, the buyer and seller agree to buy and sell a specified quantity of the said stock at a set rate on the expiration date of the contract.
• Index Futures – Investors use Index Futures to speculate the direction in which the indices will move in the near future.
• Currency Futures – In these Futures, the underlying asset is a currency. Hence, the buyer and seller agree to buy and sell a specified quantity of the said currency at a set rate vis-à-vis another currency on the expiration date of the contract. This is a good tool to hedge against foreign currency risks.
• Commodity Futures – In these Futures, the underlying asset is a commodity like gold, petroleum, silver, etc. These are traded on the National Commodity & Derivatives Exchange and Multi Commodity Exchange in India.
• Interest Rate Futures – In these Futures, the underlying asset is a debt instrument like treasury bills or government securities.

Here are some differences between Options and Futures Contracts:

• Obligation to honor the contract – In a Futures Contract, both the buyer and the seller are obligated to honor the contract. On the other hand, in an Options Contract, only the seller is obligated to honor it. The buyer has the right to honor it or allow it to expire.
• Margin requirement – Trading in Futures requires a higher margin than Options.
• Risks – Since the buyer of an Options Contract has the choice of not exercising it, the losses are limited to the amount of premium paid. On the other hand, in a Futures Contract, the buyer and seller have to honor it. Hence, the risks are higher.

Like Options, most Futures Contracts are settled in cash. The final settlement price is the closing price of the underlying asset.

Yes. You need to pay the Initial Margin before taking the position – upfront. Also, the outstanding positions in Futures are marked-to-market every day. Hence, you might be required to pay the MTM Margin to the broker too.