How to Trade in Futures and Options?
Futures and options are known as derivative products, which mean that they derive their value from an underlying commodity or asset. However, futures and options differ in fundamental ways from each other.
Before you open a demat account or look for the best online trading account, ensure that you are familiar with the basics of futures and options trading. Here’s a practical guide to help you get started.
Difference between Options and Futures
Managing risk is among the most important functions of security markets and one of the biggest risks is time. Time is a risk because prices change constantly. A profitable deal today can turn sour in a few months. Options and Futures must be understood in the context of commodity markets since is an outgrowth of the commodity market. Unlike bonds or shares, options and futures do not help you earn long term gains, instead, they are used to off-set specific risks which arise due to constant price change.
Futures and Options (F&O) are agreements to buy and sell assets in future at certain princes and in certain conditions. Although both options and futures allow an investor to buy an investment at a specific price by a specific date, one works very differently from the other. An options contract gives an investor the right, but not the obligation, to buy or sell but a futures contract requires a buyer to purchase shares and a seller to sell them on a specific future date.
How to trade in Options and Futures?
Options and Futures are traded in contracts. It could be 1 month, 2 months and 3 months. All F&O contracts expire on the last Thursday of the month. Futures trade at a Futures price which is normally at a premium to the spot price owing to the time value and there is only one futures price for a stock for one contract. For instance, during January 2020, one can trade in January Futures, February Futures and March Futures of a stock X.
Trading in Options is complicated since you trade the premiums. So, there will be different strikes traded for the same stock for Call Options and for Put Options. In the case of stock X, the Call Options premium of 400 call will be Rs 10 while these Option prices will be progressively lower as your streaks go up.
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Options and Futures difference in trade
Futures offer the advantage of trading quities with a margin. The risks, however, are unlimited on the opposite side irrespective of your position - long or short. In case of options, the buyer can limit losses to the extent of the premium paid.
When you buy or sell futures you are required to pay upfront margin and mark-to-market (MTM) margins but when you sell an option also you are required to pay initial margins and MTM margins. Conversely, you are only supposed to pay the premium margins when you buy options.
Traders buy futures on the stock that they expect to go up and sell Futures on the stock when they anticipate a fall. But in the option markets there are 4 possibilities.
Let us understand each one of them with an Options and Futures trading example. Let us assume that company Y is currently trading at Rs 1,000 per share.
Investor A expects Y to go up to Rs. 1,150 over the next 2 months. He will be inclined towards buying a Call Option on Y of 1,050 strike. He will thereby get to participate in the upside.
Investor B expects Y to go down to Rs 900 over the next 1 month. His move to get returns will be to buy Put Options on Y of 980 strikes. He can easily participate in the downside movement and make profits after his premium cost is covered.
Investor C is not sure of the downside in Y. However, he is certain that with the pressure on the stock from global markets, Y will not cross 1,080. He can sell Infosys 1,100 Call Option and take home the entire premium.
Investor D is not sure of the upside potential of Y. However, he is certain that considering its recent management changes, the stock should not dip below Rs. 920. A sound strategy for him will be to sell the 900 Put Option and take the entire premium.
A Future is a right and an obligation to buy or sell an underlying asset at a predetermined price. Options are a right without an obligation to buy or sell equity or index. While a Call Option is a right to buy while a Put Option is a right to sell. Options and Futures are conceptually different but intrinsically same. They act as a hedge since both try to get returns from stock or an index without investing the full sum. You can open a trading account to explore futures and options.