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11 Jun, 2024
6 mins read
India is among the leading markets in futures and options globally. It is considered to be one of the most popular segments of Indian stock markets, with an increasing number of traders taking a plunge into futures and options trading. If you are keen to be part of this exciting journey, then here are a few basics of the futures and options markets to help you understand these concepts better.
Futures and options are derivative financial contracts and part of the stock markets used in hedging risks and speculative trading. The prices or the value of these contracts are based on the price of the underlying asset, which can be stocks, commodities, currency or indices.
A futures contract is an obligation between the buyer and seller to buy and sell the agreed quantity of an asset at a predetermined price on a set future date. It is a binding contract for both parties regardless of the market price at the contract's expiration.
An options contract, on the other hand, is a derivative that provides the right, but not the obligation, to trade an asset at an agreed price. Call options allow the buyer to purchase the asset at a specified price by a specific date, while put options enable the buyer to sell the asset at an agreed price by a specific date. Unlike futures, options do not obligate the parties to execute the contract.
Some of the primary differences between futures and options are as follows:
| Features | Futures | Options |
| Nature of contract | Binding contracts to trade at a set price and date. | Non-binding contracts allow the buyer to trade at a set price and date. |
| Obligation | Both parties must complete the trade, regardless of market conditions. | Only the buyer can choose whether to execute the trade. |
| Risk | Higher risk due to mandatory trade execution. | Lower risk for buyers since they can choose not to exercise the option. |
| Profit and loss potential | Unlimited profit and loss potential based on market movements. | High-profit potential with losses limited to the premium paid. |
| Costs | Requires a margin deposit and daily settlement. | Requires an upfront premium payment, which is the maximum risk for the buyer. |
| Types | Includes equity, index, commodity, currency, interest rate, and VIX futures. | Includes call options (buying the asset) and put options (selling the asset). |
| Execution of contract | Must be executed on the specified future date at the agreed price. | Can be executed by the buyer at any time before the expiry date. |
Traders in futures and options markets have a range of strategies at their disposal to navigate the complexities of these markets effectively. Here is a brief snapshot of a few popular options vs. futures strategies that enable traders to enhance their trading plans.
A few popular futures strategies include,
Trend Following - This is a simple strategy that involves identifying and following market trends (either bullish or bearish). This analysis is used to capitalise on sustained price movements and adhere to strict entry and exit plans.
Breakout Trading - Traders use this strategy to profit from significant price movements after the price breaks through a key support or resistance level. This method aims to harness the inherent rapid price fluctuations characteristic of such conditions, which makes it ideal for navigating volatile markets.
Pullback Strategy - This strategy involves entering a trade after a temporary reversal or pullback in the market. The aim is to profit from the continuation of the prevailing trend after a brief change due to market forces.
Momentum Trading - Traders using momentum strategies focus on assets exhibiting strong price momentum. This ensures that traders can capitalise on the strength of the trend backed by technical indicators, like the Moving Average Convergence Divergence (MACD) or the Relative Strength Index (RSI).
Hedging - Futures contracts are good options for hedging strategies. It involves taking offsetting positions to protect against potential losses when you hold positions in those investments. It helps manage risk by balancing potential gains and losses.
Speculation - Traders using this strategy make educated guesses about where prices might go. Speculative trading strategies can be risky and involve taking positions based on market expectations and forecasts. Traders may go long (buy) if they anticipate price increases or short (sell) if they expect price declines.
After a brief outlook on futures strategies, here is a similar snapshot of popular options trading strategies used by traders across the globe.
Covered Calls - This strategy involves selling call options against an underlying asset that the trader already owns. It generates income as a premium for the trader and can provide downside protection.
Protective Puts - This strategy is the opposite of the covered call, where traders buy put options to offset potential downside risk. This strategy is used to hedge against possible losses in an underlying asset. It involves
Straddles and Strangles - These are volatility strategies where traders buy both call and put options simultaneously. A straddle involves buying options with the same strike price and expiration date, while a strangle involves different strike prices.
Spreads - Options spreads involve buying and selling options contracts simultaneously to profit from price differentials or volatility changes. Bull spreads and bear spreads are typical examples of options trading strategies.
Navigating futures and options stocks effectively requires traders to employ strategies tailored to their investment goals, risk tolerance, and market understanding. Here are some essential tips highlighting their importance.
A thorough understanding of the dynamics of futures and options stocks and trading strategies.
Starting with small capital allocation and diversifying investments across different asset classes, industries, and market segments.
A clear trading plan that outlines key points, such as objectives, risk tolerance, entry/exit points, position sizing, and risk management strategies.
Using stop-loss orders to protect positions from significant losses.
Implementing risk management strategies like position sizing, diversification, hedging, etc.
Monitoring market movements and analysing historical data to identify opportunities and risks of future and options trading.
We have seen a detailed account of futures and options trading and its various aspects above. Let us now consider practical examples to better understand this concept.
The trader decides to enter into a futures contract to sell Nifty 50 futures with an index of 15,000 expiring in three months.
The outcome of the futures contract upon expiry -
If the Nifty 50 index falls to 14,500 due to market volatility, the trader would gain from the futures contract, offsetting losses in their portfolio.
If the Nifty 50 index rises to 15,500, the trader would incur a loss on the futures contract but gain in their portfolio, balancing the impact of market movements.
Consider a trader buying a call option for XYZ Ltd., with a strike price of Rs. 1,500 and an expiration date in two months, with a premium of Rs.100 per share.
The outcome of options contract by expiry -
If XYZ Ltd.'s stock price rises above Rs. 1,600 by the expiration date, the trader can exercise the call option, buying the stock at Rs. 1,500 and selling it at the higher market price, making a profit.
If XYZ Ltd.'s stock price remains below Rs. 1,500, the trader will let the option expire, losing only the premium paid and minimising potential losses compared to owning the stock outright.
Futures and options are among the dominant segments in Indian stock markets. They can enhance the potential of investment portfolios by mitigating risk and taking advantage of diverse market scenarios. Understanding the fundamentals of futures and options trading is important to achieve this and harness the strategic opportunities they present for maximising profits and managing risks.
The key risks associated with futures and options trading for traders include the potential for substantial losses due to market volatility and leverage in futures contracts as they require fulfilling the contract regardless of market conditions. Options contracts face the risk of complexity and time decay in options, which can lead to losses if the market does not move as anticipated.
The primary difference between futures and options is that futures contracts require traders to buy or sell an asset at a predetermined price on a specific future date, obligating them to fulfil the contract. In contrast, option contracts give traders the right, but not the obligation, to buy or sell an asset at a set price before the contract expires, providing more flexibility and limited risk.
Traders should choose futures over options when they seek direct exposure and higher leverage with the potential for unlimited gains and losses. Options contracts are suitable when traders prefer flexibility, limited risk, and the ability to hedge or speculate with controlled potential losses.
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