FUTURES & OPTIONS SIMPLE EXPLANATION
Futures and Options are financial products, which investors can use to hedge current investments and make money. Both futures and options allow investors to buy an investment at a specific price at a future specified date.
- Futures and Options are similar financial products to hedge current investments.
- An option is a contract that gives the buyer the right to buy or sell an asset at a specific price at a future date.
- A futures contract is an obligation to purchase a specific asset or equity at a specific future date.
- In both future and options, the contract position can be closed prior to expiration.
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Share Market FUTURES:
Share market Future contract is an agreement between the seller and buyer to sell or buy a specified quantity of underlying equity share for a price agreed upon at a future date.
Derivative Products like future and options are derived from other underlying financial instruments. The application of Futures and options is for Hedging & Speculation in the stock market.
REAL-LIFE EXAMPLE:
If A wants to sell a property costing about 5 lakh. B approaches A and made a contract/agreement that, he will take the property or he will find another buyer, within down the time of 3 months, with the current agreed price by paying a premium now ( About 1/3 of the total amount).
Then B finds another buyer ( C ), and he will make a back-to-back agreement that, he will get him a property after 3 months, with price at that time.
- If the price goes up.
C needs to pay a higher amount than the current price.
A will get 5 Lakhs and B will get the difference in amount as profit.
- If the price goes down.
C needs to pay less amount than the current price.
A will get 5 Lakhs. B will be under loss of the difference in amount.
The contract will complete only once the transaction of buy and sell is completed. B will work like a broker, who makes the profit or loss on the basis of market price movement. Premium amount is the only risk amount he put up in the transaction.
- In a stock market future contract, instead of property, the agreement is made on the equity in a lot size.
Application of Future and Options:
Hedging and Speculation are the application of the future and option contacts. Both will help the investors to protect their funds during adverse market movement conditions.
Hedging:
Hedging is the process to protect the fund in the market adverse movement.
Hedging is a strategy to offset losses in investments by taking a reverse position in the asset holdings. Hedging involves derivatives, such as futures and options contracts, which results in a reduction in the loss for the holdings.
Below is a real-life example for an easy understanding of the Hedging operation.
If A had a share of company XYZ, with unit price 1000 for quantity 500 numbers.
If A got information that, the price will go down by 200 rs. He will make a “sell” futures contract for a lot of 500 no’s of XYZ. Lot value is 5 Lakhs rupees.
Scenario price goes down:
If the price goes down by 200 rs.
His asset portfolio will go down by 1 lakhs rupees ( I.e. it will be 4 lakhs rupees ), however, A will be making a profit of 1 lakhs from the futures contracts with a third party, so it will compensate his loss and his total asset will remain 5 lakhs.
Scenario price goes up:
If the price after the contract goes up by 200 rs.
His total portfolio will go up by 1 lakhs ( I.e. it will become 6 lakhs ), however, A will be making a loss of 1 lakhs from the futures contracts with a third party, so it will compensate on his profit from the portfolio and his total asset will remain 5 lakhs.
By executing a futures contract, the investor can protect his total fund in both the market movement conditions.
Speculation:
Speculation is the process of trade and makes a profit on the contracts based on underlying assets.
Speculative trading is an act of conducting trade on the contracts with the expectation of a significant gain on the financial transaction on price fluctuations. Speculative trading has a substantial risk of losing value.
- Speculation is a process of buying an asset or contract or equity in an effort to later sell that at an appreciated rate, or the opposite process of it (sell an asset in an effort to buy later once the price depreciated).
With the insight and on the base of market knowledge, fundamental analysis, and technical analysis, a trader bet on the market movement, if it moves in the direction of the trader expectation, he will get the profit, else he will end up into loss the money, same as equity trading ( Intera day trading / BTST trading …)
Specific terms related to future contract:
- Market lot : Total no of quantity for a future
- Lot size : Decided to become 5 lakhs of total asset value at the time of introduction.
- Quantity of lot : 5 Lakhs / LTP
- Expiry day : Last Thursday of the following third month, if holiday, the day before it.
- Unit of price quotation : Current market price.
- Method of settlement : buy or sell.
- Type of settlements : Cash or Delivery.
The permitted lot size for futures & Options contracts are stipulated by the Exchange from time to time.
Share Market OPTION:
In the share market, an option contract is a contract between the buyer and seller, which conveys its owner, the right, but not the obligation, to buy or sell an underlying asset to or on a specified future date at a specified strike price, by paying the option premium.
- The option premium is the amount a trader or investors pay for an option contract.
- Option premium has 2 parts, Intrinsic value, and time value.
- Premium is a higher value for the assets with higher price volatility.
- The intrinsic value of an option contract is the amount of money a trader would get if they immediately exercised the option contract.
- The time value of an option contract is the amount of money an investor is willing to pay above the intrinsic value, with the hope the investment will eventually pay off.
Understanding the Options Premium:
An option contract gives the buyer the right, not the obligation, to sell or buy an underlying asset or instrument at a specified strike price on a future specified date, depending on the form of the option.
Option contact are of 2 type : Call option & Put Option.
Following are the important terms that need to understand to take an option contract.
- ITM – In the money.
- ATM – At the money.
- OTM – On / Out of the money.
In the money (ITM) and Out of the money (OTM) will be exactly opposite for the Call option and the Put options. If the current market price is the same as the strike price, it is called At the money (ATM).
- “At the Money” is the same for both the Call and Put option.
The Changing Value of Options premium:
The premium of options contracts is continually changing over the time of contact depends on the following factors.
- Current price of the underlying asset
- The amount of time left for the expire of the contract.
The strick price of the contract is in “In the money”, the premium will rise and if goes further out of the money, the contract premium will fall. The premium of the contract will decline as the expire of the contract gets closer.
For Call Option :
The premium for the Call option will increase with the increase in the market price of the underlying asset. Traders can buy the Call option if the underlying asset price is expected to increase. If the price incenses, they can book the profit.
- A call option is In the money(ITM) if the market price is above the strike price.
- A call option is On the money (OTM) if the market price is below the strike price.
For Put Option :
The premium for the Put option will increase with the decrease in the market price of the underlying asset. Traders can buy the put option if the underlying asset price is expected to decrease. If the price decreases, they can book the profit.
- A put option is in the money if the market price is below the strike price.
- A put option is On the money if the market price is above the strike price.
In-the-money options contracts have higher premiums than the options which are not ITM.
Calculate premium for the Call and Put Options:
The premium for the options contract is the sum of “Time Value” and the “Intrinsic Value” of the contract.
Premium = Time Value(TV) + Intrinsic Value (IV)
Intrinsic value and time value are the two basic components to option premium.
- The intrinsic value of an option contract is the amount of money a trader or investors would get if the option is exercised.
- Time value is the extra amount a trader is willing to pay for the time of expiry of the contract.
INTRINSIC VALUE:
The intrinsic value of an option contract is a measure of what an underlying asset is worth.
The intrinsic measure is arrived at by means of a complex financial model or objective calculation, rather than using the current market trading price of an underlying asset. To make it simple for understanding, we can consider the below simple formula.
Intrinsic value is equal to,
- The difference between the exercise price and the strike price when the difference is positive.
- If it is negative, the Intrinsic value will take as zero.
Intrinsic Value for Call and Put Options:
Intrinsic Value for CALL OPTION = Max ( 0, Spot price – Strike price )
Intrinsic Value for PUT OPTION = Max ( 0, Strike price – Spot price )
Example for a simple calculation :
- STRICK PRICE 1: 100 rupees
- STRICK PRICE 2: 110 rupees
- STRICK PRICE 3: 120 rupees
- Last Traded Price: 108 rupees
CALL OPTION Intrinsic Value
- ITM @ Strick Price of 100; Premium : 108 – 100 = 8
- OTM @ Strick Price of 120; Premium : 108 – 120 => -12 = 0 (As Intrinsic Valueis less than zero, Intrinsic value will take as “0”)
PUT OPTION Intrinsic Value
- ITM@ Strick Price of 120; Premium : 120 – 108 = 12
- OTM@ Strick Price of 100; Premium : 100 – 108 => -8 = 0 ( As Intrinsic Value for this put option is less than zero, Intrinsic value will take as “0”)
TIME VALUE:
Options contracts have value, even out of the money due to a significant change in the market price of the underlying assets. That is called the time value of options call and put contract.
Time value indicates whatever price a trader is willing to pay above the current intrinsic value for the contract, in hopes the investment will eventually pay off.
Time Value for Call and Put Options:
In option contact, the time value is the premium a trader would pay over its current exercise value. It is calculated based on the probability value that will increase before contact expiry.
- Maximum at the start of the contract.
- Zero value at the time of Expiry of the contract.
In general, as the expiration of the contract approaches, the values of an option’s time value decrease for both “Put Option” and “Call Option”.
Factors affecting Time value:
The calculation of the time value is a complex equation. For easy understanding, we need to consider the following factors, which are affecting the time value of a put and call option.
- No of days for the expiry of contact.
- Current market price.
- Market Volatility.
- Interest Percentage.
In general, for assets with higher price volatility, the option premium will be higher. Option premiums for volatile stocks, tend to decrease more slowly.
Due to these, options traders need to consider the stock’s volatility before placing an order on the option products. One common way to check is by analyzing the equity’s standard deviation on historical data. The standard deviation of the stock shows measures the degree of up and down movement of the stock in relation to the mean price.
- A lower standard deviation indicates a relatively stable stock (Usually a smaller option premium).
Below rough price reduction pattern of “Time Value” gives you a rough idea about the price reduction and an easy understanding of the pattern.
- Time Value @ Monday : 10 rupees.
- Time Value @ Tuesday: 8 rupees.
- Time Value @ Wednesday: 4 rupees.
- Time Value @ Thursday Morning: 2 rupees.
- Time Value @ Thursday noon: 1 rupee.
- Time Value @ Thursday EOD : 0 rupees.
If you know the Intrinsic value and the option premium, we can calculate the time value as below.
Time Value = Option Premium – Intrinsic Value.
Futures and options tips for the newbie earners.
- Before start trading in futures and options contracts, learn the basics of Futures and Options trades and the methods of price calculations, and the fundamental and technical analysis for the underlying assets.
- Fundamental analysis: At least growth comparison of underlining assets.
- Technical analysis: At least line charts and price movements.
- Understand the brokerage and other charges applicable for the future and option trading.
- Brokerage: Delivery & Intraday.
- Other charges: STT, DP, GST…
- Leverage offered by the broker for option and future trade.
- Need to learn how to do the research instead of blindly follow the recommendations.
- Follow few underlying assets and understand the pattern and the premium movements.
- Study and make your own strategies.
- Start with Investment in quality stock and create a good portfolio and profit by trading on the equity and then enter into the derivative market trading
- While trading on derivative products like futures and options.
- Never trade without a proper stop loss in mind.
- Never trade against the market trend and never go for a revenge trade.
Conclusion:
Both the Options and Futures are derivative products designed to protect the investor’s funds through hedging and for making a profit through speculative trading. Both the financial instruments are slightly complex than the normal trading on Equity and Currency. Hence we recommend learning options trading strategies and from traders or from the books in India by the Indian authors.
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Options support a variety of trading strategies for seasoned investors, but they do carry risks. Learning about different strategies, pricing factors, volatility, option Greeks to books profits.
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