The volatile financial markets provide excellent opportunities to take advantage of price movements. Typically, futures and options (F&O) are called derivatives as they derive value from the underlying assets. The derivatives market offers a unique way of building wealth using speculations on the future direction of stocks, commodities, currencies, and more. It allows you to capitalise on all types of markets – bullish, bearish, and neutral.
Trading futures options allows you to create options contracts with futures as the underlying asset. It is a derivative of derivatives because a futures contract is already a derivative. In this blog, let's explore the key strategies to navigate this sophisticated market.
A quick overview of futures and options in the derivative market is given below:
Options on futures contracts is an options contract, where the underlying asset is a futures contract. Here, traders speculate on the future price of the futures contract without taking on the full commitment of a futures contract. Futures contracts come with two types of options:
Futures contracts require a large upfront investment with greater risk. The profits and losses are also amplified based on the price movement of the underlying asset. Some of the benefits of trading options on underlying futures are:
For the same level of exposure, options on futures contracts provide more risk control with a cap on profit potential. Let's understand this difference with an example.
Consider the Nifty index (underlying asset for the futures contract) at 18,000 and a futures price of 18,100. Assume an option premium of Rs 100 and a lot size of 4, equating to 100 quantities. We will compare the outcomes of a futures contract versus a call option for Nifty futures.
Futures Price: 18,100 Margin Requirement: Rs 90,000 (5% of Rs 18,00,000, the notional value) Notional Value: Rs 18,00,000 (Nifty index level of 18,000 × 100) If Nifty rises to 18,500, Change in Futures Price: 18,500 - 18,100 = 400 Option premium: Rs 100 Total Profit: 400 × Rs 100 = Rs 40,000 If Nifty falls to 17,800, Change in Futures Price: 17,800 - 18,100 = -300 Option premium: Rs 100 Total Loss: 300 × Rs 100 = Rs 30,000 |
So, with Nifty futures, with a Rs 90,000 investment, you control Rs 18,00,000. If the price increase aligns with your speculation, you gain Rs 40,000; if the price falls against your speculation, you lose Rs 30,000.
When you choose to trade options on Nifty futures, the scenario is explained below:
You buy a call option on Nifty futures with a strike price of 18,200 and a premium of Rs 100.
Premium: Rs 100 Contract size: 75 Total Premium Paid: 75 × Rs 100 = Rs 7,500 Consider the scenario when Nifty rises to 18,500: Intrinsic Value of the Call Option: 18,500 - 18,200 = 300 Premium: Rs 100 Total Value of Option: 300 × Rs 100 = Rs 30,000 Profit: Total Value of Option - Premium Paid = Rs 30,000 – Rs 7,500 = Rs 22,500 If Nifty falls to 17,800 and goes against your speculation: Intrinsic Value of the Call Option: 17,800 - 18,200 = -400 (option expires worthless) Total loss: Premium Paid = Rs. 7,500 |
Choosing options for futures lets you get started with just Rs 7,500 for the same exposure to futures contracts. Your profit is Rs 22,500, and your loss is Rs 7,500 for the same scenario.
As you can see, the profit for trading options on futures is lower than the futures contract itself. At the same time, the loss is limited to the premium. The futures contracts capture the full index movement. The potential profits are higher, and the risk is significantly more remarkable. Options on futures offer defined and controlled risks, making them an attractive method for managing exposure with a smaller investment.
Some of the common strategies for trading futures options are:
Trading futures options requires a sophisticated approach to risk management with opportunities to capitalise on market movements. It can enhance portfolio diversification with advanced tools for hedging and calculation. With options on futures, you can navigate the derivatives market with controlled risk and increased exposure due to the leverage. However, disciplined risk management and a deeper understanding of the financial instruments are crucial to growing wealth.