Understanding Futures and Options Trading in India: Old Trafford Manchester known as the “Theatre of Dreams” brings a joy that is unmatchable to any football lover. It sends them into a euphoria of dreams. And if you were to compare this analogy to the world of trading, Derivatives trading is like “Stuff of Dreams” to all the Traders.
Now through this article, we will try and understand the world and gamut of Futures and Options Trading in India.
Futures and Options Trading in India – Overview
To define, “Futures and Options are derivatives products that derive their value from the value of the underlying asset. The Underlying asset could be securities traded in the stock market, commodities (both Agricultural and Non- Agricultural) or any other products eligible to be traded in the Derivatives segment”.
Although Both Futures & Options Trading form a part of derivatives trading, they have their own differences in their structuring and also in the price’s movement, their expiry etc.
So simply putting, Futures are derivative products to buy or sell the underlying at an agreed price upon the expiry of the contract. Under futures trading, both buyer and seller of the contract are obligated to honour and fulfil their obligations towards the counterparty.
Options on the other hand are also derivatives contracts that derive their value from the value of the underlying asset. But what differentiates Options from Futures is a simple fact, Futures contracts are obligatory to both the parties involved, but an Options contract gives the buyer, the right (not the obligation) to exercise the contract on expiry and the seller of the contract is obligated to honour the contract upon expiry.
Now you must be wondering, “In Options Trading, why buyer has the right and seller obligate to honour the contract upon expiry”. The simple answer is the word, “Premium”. Premium is the fees/token money paid by the buyer of the option to the seller of the option to have the right on the underlying asset to be bought or sold upon expiry.
Quick Read: How to Calculate Profit in Options Trading?
Important Terminologies used in Futures & Options Trading
- Underlying Asset: The whole premise of F&O trading is based on the underlying asset. This is the security based on whom the price of Futures and Options are derived. Say, if you are Trading an F&O contract of Nifty50, then the underlying asset here is Nifty50.
- Premium: This is the token/fee money paid by the buyer of the option to the seller of the option to forgo his right on the underlying asset.
- Strike Price: This is the price at which the buyer of the option agrees to buy/sell the underlying asset in the market.
- Intrinsic Value (IV) of an Option: This is the current value of the option contract that has been bought if they were to be exercised immediately. Say, you are a buyer of the call option and you buy the call option of 3000 strike price. And if the existing price of the underlying asset is Rs. 3100, then the option (if) exercised today would have an IV value of Rs. 100 (3100 – 3000)
Moneyness of an Option
The Moneyness of an Option is the current status of the Option. They are divided into three verticles:
- In the Money (ITM): These are those options which would be making money if they were to be exercised immediately. In case of a Call option, all the strike pieces that are below the existing spot prices are deemed to be In the Money. And in the case of the Put Option, all the strike prices that are above the Spot price are said to be In the Money. Say, the spot price of Nifty is 16675 and in that case, all the call option strike prices like 16600, 16550, 16500 and so on would be ITM and for a put option, the ITM strike prices would be 16750, 16800, 16850 and so on.
- At the Money (ATM): These are those strike prices that are closest to the spot price of the Underlying asset.
- Out of Money (OTM): These are those Option strike prices that would not make any money if they were to be exercised immediately. Say, the spot price of Nifty is 16675 and in that case, all the Put options, strike prices like 16600, 16550, 16500 and so on would be OTM and for a Call option, the OTM strike prices would be 16750, 16800, 16850 and so on.
Types of Futures Contracts
Essentially Futures contracts have an exact movement as the price of the underlying asset. The Delta of a futures contract is 1, implying that for a 1 unit increase/decrease in the value of the underlying asset, the price of the futures contract also changes by the same value. The Futures contract treats both sellers and buyers in the same way.
There are two types of Options Contracts:
1. Call Option
To express one’s Bullish view, one uses Call Option. They give the buyer of the option, the right to buy the underlying asset upon expiry. The Seller of the option has to sell the underlying asset upon expiry if the buyer if the option chooses to exercise his option.
2. Put Option
To express one’s Bearish view, one uses Put Option. They give the buyer of the option, the right to sell the underlying asset upon expiry. The Seller of the option has to buy the underlying asset upon expiry if the buyer if the option chooses to exercise his option.
Players Trading Derivatives in India
Now having understood the types of both Futures and Options COntract, let us understand the various Market Participants of Derivatives trading in India:
Hedgers are those participants in the Derivatives market that aim to hedge or protect their existing position in the market. To Explain, say you have bought 250 shares of Reliance industries in the Cash Market at Rs. 2600. But you fear that rumours doing rounds in the market could have a negative impact on the share price of Reliance Industries. So, to safeguard your interest, you could choose to use Futures or Options trading instruments.
To hedge using a Futures contract, you could sell one lot of Futures contracts and ride the downward move and protect against the downside movement of the share prices.
To hedge using an Options contract, one could do one of the following two modes. Either buy a Put option (by paying the premium) and make a profit on the Put option bought, when the market goes down. Or you could also choose to write/sell the Call option (receive premium) and in case the share prices go down, the premium pocketed improves the entry price of the shares bought in the cash market.
To put it in simple words, speculators are those market participants who bet on the directional movement of the market. If someone is of the view that the market has good upside potential, he or could express his/her view in the Derivatives market by either Buying a Futures contract or by buying a Call Option or Selling/writing a Put Option.
Similarly, bearish views on the market can be expressed by shorting/selling a Futures contract or by buying a Put Option and can also be expressed by writing/selling a Call Option.
These are those forms of Market participants who take advantage of the price differences or imperfections in the market. The price of both Futures and Options is a combination of the Current Price and the Cost of carrying (Time factor). So, what arbitrageurs do is remove all the price differences arising out of imperfect trading situations by reducing and benefitting from the spread.
Margin Required For Futures and Options Trading in India
The margin required to trade any Derivatives product depends on the contract that we choose to trade.
Say, if you are trading Futures, then the margin requires is generally a percentage of the contract value. Let us understand it with the help of an example.
- If you were to buy 250 shares of Reliance Industries at the current spot price of Rs. 2500.
- Then the total cost for buying in the cash market would be = 250*2500 = Rs. 6250000
- Buy 1 lot (250 shares) of Reliance Industries can be bought in the Futures market by just paying a Margin of Rs. 1,39,744. Near leverage of almost 4 times for expressing the same views in the Futures Market.
Now, let us understand the P/L calculation for this trade.
Say, the share price of Reliance Industries jumps to Rs. 2540, then the profit in this trade would be-
P/L = (2540-2500)*250 = Rs. 10,000
ROI in Cash Market = (10,000/625000)*100 = 1.6%
ROI in Futures Marekt = (10,000/139744)*100 = 7.15%
Similarly, the bullish view can also be expressed by trading options. The Margin Required to trade using Options is much lower compared to the margin required to trade Futures.
- Say you buy 2460 ce (Call Option) of Reliance Industries and the Premium required to buy the same is 60 units (say)
- Total Margin paid to option seller = 60*250 = Rs. 15000
Now, upon expiry if the share price of Reliance Industries goes to Rs. 2540, then the profit for the Option buyer would be = (2540-2460-60)*250 = Rs. 5000
ROI in Options Trading = (5000/15000)*100 = 33.33%
So, from the above example, it can be easily deduced that Options trading has the highest potential of generating the highest return on Investment followed by Futures Trading.
Futures and Options Trading Expiry in India
The most important thing about Derivatives trading in India is that they are Cash Settled, meaning only the cash differential has to be paid. One need not have physical possession of the shares.
- In India, Futures contracts are settled on the last Trading Thursday of the month. And if the last trading Tuesday is a holiday then the previous is the expiry day.
- For Stock options trading, the contract settles/expire on the last trading Thursday of the month. But index options expire on every Trading Thursday of the week. And if Thursday is a holiday, then the contract expires on the previous trading day. In India, stock options have monthly expiry and Index options have both weekly and monthly expiries.
So, from the above discussion, it can be clearly and easily deduced that both Futures and Options Trading in India not only provide another trading instrument but also act as hedging instruments to the buyers in the cash market.
And the most important advantage that Derivatives have is the power of leveraging, you could trade contracts whose values are very high by just paying a fraction of the cost.
We hope you enjoyed our article on Futures and Options Trading in India, do let us know your thoughts in the comment section below. Happy Trading and Money Making!!