Derivatives in Share Market - Futures Trading and Options Trading

In this article, we are going to learn about the basics of Derivatives (a kind of financial instrument), as well as Futures Trading, and Options Trading, and also their differences.

So, before we delve deeper into Options and Futures, let’s first understand what Derivatives are.

Table of Contents

• What are Derivatives?
• What is Futures Trading?
• What is Options Trading?
• Futures Vs. Options
• Use cases of Options

What are Derivatives?

Derivatives (or derivative securities) are a kind of financial instruments that drive their value from an underlying asset, such as a stock or commodity.

Hard to comprehend, isn’t it?

Well, to understand derivatives we need to get some idea regarding how stock market works, and the other kinds of financial instruments available to us.

The share market has been broadly classified into two segments: Cash and Derivatives.

Derivatives include the futures and options segments, often collectively called FNO (Futures & Options). In other words, Options and Futures are neither shares, nor bonds. They are a separate category of financial instruments, called Derivatives.

You can trade in various types of Futures and Options on your Demat account, e.g. Stock Futures and Options, Commodities Futures and Options, Currency Futures and Options, etc.

Stock exchange does not allow all stocks, and commodities to enter the derivatives segment. They need to fulfil some criteria, e.g. a stock which has high market capitalization, high volume trading and good corporate governance etc. may be allowed to have options and futures. The value of this future stock is derived from the underlying value of the stock. That’s why we call it a “derivative” – they drive their value from another underlying financial instrument.

For example, in your broker app you may see TCS stock and TCS May Fut contract, where the prices will be different. But the price of the TCS May Fut is derived from its underlying asset that is TCS stock.

Securities

Securities is a very general term, which refers to a wide range of financial instruments or assets that can be traded in open market. There are basically three types of securities:

• Equity Securities, e.g. stocks, shares of mutual funds, etc. So, stocks (or equity shares) are a type of security.
• Debt, e.g. bonds.
• Contracts, e.g. derivatives (e.g. options contracts, future contracts), etc.

Note

Derivative contracts derive their value based on the value of its respective underlying asset. This value is measured by applying the mathematical concept of “Derivatives”, i.e. calculus (differential equations and stochastic calculus). In other words, financial derivatives are called so because of their dependence on calculus and differential equations (generally called Derivatives).

In fact, there is a class of traders called “Quants” who apply derivative calculus to find trading opportunities.

Some characteristics of Derivatives Trading

• These contracts have monthly or weekly expiries.
• All these derivatives can be traded on Intraday (have to be sold within the same day) or Positional (can be kept for more than a day) basis.
• We can use either cash (our own money) or margin (money borrowed from broker) to trade in derivatives.
• Derivatives are generally bought in lots, i.e. a set of shares or commodity units. For example, the lot size of Nifty is 50, and that of Nifty Bank is 25. So, you need more capital to trade in derivatives. It makes it even riskier.

What is Futures Trading?

In Futures trading, we buy and sell future contracts. Well, what are Futures?

We already know that these are derivatives, but here’s its precise definition:

Futures are a contract that gives the holder the right to buy or sell a certain asset (stock, commodity, etc.) at a specific price on a specified future date. That is, the buyer and the seller are bound by a contract to buy and sell that particular asset at the predetermined price, no matter what the actual price might be on the day the contract is executed.

So, it’s kind of a hedging that buyers and sellers do to minimize their risks. If prices rise too much in future, the buyer will make huge losses, and if they fall, the seller will book losses. That’s why such contracts are made to insulate both the parties against market volatility.

What is Options Trading?

In Options trading, we buy and sell options, i.e. option contracts. Well, what are Options?

We already know that these are derivatives, but here’s its precise definition:

Options give the right, but not the obligation, to buy or sell a certain asset (stock, commodity, etc.) at a specific price on a future date. That is, the buyer and the seller are bound by a contract to buy and sell that particular asset at the predetermined price, no matter what the actual price might be on the day the contract is executed.

However, the options buyers have the “option” to move away from the contract if they wish too. In that case, only the premium amount already paid by them is confiscated. So, losses of options buyers are limited.

Note

Unlike Futures, in Options trading your loss is limited, but there’s no limit on your profits. Herein, you cannot lose more than the premium amount you gave. While in Future trading you may lose all, and may even go in debt.

Though we can use stop loss in options to even further reduce our possible losses, but as per some experts we should not use stop loss if we are buying options – rather assume that the premium paid by us is our stop loss (should use stop-loss in intraday trading though). That’s because, the big players (operators) may intentionally hit your stop loss and force you to book losses (it’s called stop-loss hunting).

So, just like futures, it’s kind of a hedging that buyers and sellers do to minimize their risks. Options insulate both the parties against market volatility to a certain extent.

Call and Put

In options trading we can buy/sell Put (PE). Similarly, we can buy/sell Call (CE).

• Call option gives a buyer the right to buy a security on a certain future date at a predetermined price (called the strike price). We buy a call option when we are bullish (i.e. when we think that the price will go up). Here, we enter the profit zone as soon as the share price goes above a price level that is equal to the sum of the strike price and premium.
• Put option gives a buyer the right to sell a security on a certain future day at a predetermined price (called the strike price). We buy a put option when we are bearish (i.e. when we think that the price will go down). Here, we enter the profit zone as soon as the share price goes below a price level that is equal to the subtraction of the strike price and premium.

In case you are an option seller, you will do the opposite. That is, we sell a put option when we are bullish, and we sell a call option when we are bearish.

Note

The E in CE and PE stands for European. Such contracts are executed only on expiry. Other kinds of contracts are CA and PA, where A stands for American. Such contracts can be executed even before the expiry.

As the expiry time is fixed for CE and PE contracts, it puts option sellers at an advantageous position. On the other hand, in case of CA and PA, option buyers are at an advantageous position.

Closing of options maybe done on a weekly or monthly basis. The weekly closing is done on Thursdays.

Option buyers and sellers

In options trading, you may become an options buyer or an options seller. It’s important that you understand this difference, as options do not work the same for these two categories of traders. The way they make profits/losses vary a bit.

• Options Buyer: These guys buy Put/Call. You do not need a lot of money to become an options buyer, i.e. margin requirement is low here. Your maximum loss will be the money you invested. But on the downside option buyers often make losses due to lack of knowledge. As entry resistance for options buying is low, many people do this and often book losses. They also lose money through premium decay.
• Options Seller: These guys sell Put/Call (also called writer of an option). You do need some amount of money to become an options seller, i.e. margin requirement is high here. Option sellers are generally the more experienced traders with a lot of expertise under their belt. As entry resistance for options selling is high, only a handful of people do this and often book profits. They also make money via premium decay.

So, should we become an option buyer or option seller?

• Options are a safer derivative instrument than futures, but only for buyers. If you are selling options, you run the same risks as futures. For option buyer, his profit may be unlimited, but his losses are limited to the premium paid (or even less if stop loss is used). It’s the opposite with option sellers – their profit is limited, but their losses may be unlimited. However, you can limit your loss by placing appropriate stop loss – that’s what option sellers do. So, loss may be unlimited for option sellers only if they do not use stop loss.
• As profits of option sellers are limited (cannot earn more than the premium), they need to take on multiple trades to make a substantial amount of absolute profit.
• Capital/Margin requirement in case of option selling is much more as compared to option buying.
• Probability of making profit is higher for option sellers (around 0.8 or 80%) than option buyers. In fact, 96% of the options in Indian stock markets expire at zero premium, which means that all the money paid by option buyers as premium was usurped by option sellers 96% of the times. So, if you have enough capital with you, you can earn a regular income from stock market by selling options.
• Option sellers gain profits from the premium they collect from the buyer (for providing the assurance to buy or sell securities at the predetermined price). So, time decay (theta Greek) favours them – more the time passes by, more will be the profits made by option sellers. In fact, when we sell out-of-the-money (OTM) options, it’s even easier to make profits. Option sellers just predict the limits that are almost impossible for the market to break, and sell OTM options accordingly – easy money! For example, NIFTY hardly swings more than 3 to 5% in a month. Selling NIFTY OTM options are pretty safe.

Note

Whether you are buying options or selling them, you should always take help of some indicators and data, e.g. Moving averages indicator.

You may start as an option buyer, as investment requirement is low and risks are limited. As you gain experience, you may decide on your own what suits you more.

Note

European options (CE and PE) are executed on the expiry day only. So, they favour the sellers.

On the other hand, American options (CA and PA) maybe executed by the buyers even before the expiry day, as they deem fit. So, they favour the buyers.

American option sellers are bound to execute the contract if the buyer wishes to – they are obligated, they do not have an “option” of refusing to sell. So, if the price moves unfavourably, American option sellers could incur massive losses.

Futures Vs. Options

To understand the difference between Futures and Options, we can take help of an example. This will also bring out the difference between cash trading and derivatives trading.

Let us see how a transaction in the shares of a company MNO plays out in each segment. Say, shares of MNO are trading at a price of Rs 100 at present.

Cash segment: Let’s buy 500 shares of MNO. For this we will need to spend Rs 50,000 (as 100 x 500 = 50000).

• Case I: The stock rises by Rs. 20 to reach Rs. 120. You will make a profit of Rs 10,000 (profit of Rs 20 per share x 500 shares).
• Case II: The stock falls by Rs. 20 to reach Rs. 80. You will incur a loss of Rs 10,000 (loss of Rs 20 per share x 500 shares).

Futures segment: Let’s buy a contract of 500 shares (lot size) of MNO for Rs 50,000 (as 100 x 500 = 50000).

• Case I: The stock rises by Rs. 20 to reach Rs. 120. You will make a profit of Rs 10,000 (profit of Rs 20 per share x 500 shares).
• Case II: The stock falls by Rs. 20 to reach Rs. 80. You will incur a loss of Rs 10,000 (loss of Rs 20 per share x 500 shares).

Unlike cash segment, in futures/options you may take leverage/margin from the broker and trade in much higher quantity than the capital you have.

Options segment: Let’s buy a call option for 500 shares at a strike price of Rs 103, paying a premium of Rs 2,000 (considering a premium of Rs 4 per share x 500 shares).

• Case I: The stock rises by Rs. 20 to reach Rs. 120. You make a gross profit of Rs 17 per share (Rs. 120 – Rs. 103), from which the premium paid has to be deducted. That makes your net profit per share Rs 13 (Rs. 17 – Rs. 4). Hence, you make a total profit of Rs 6,500 (Rs 13 x 500 shares).
• Case II: The stock falls by Rs. 20 to reach Rs. 80. It is here that you will see the advantage of options. When you buy an option, you only buy the right to exercise an option. If the loss you are making is more than the premium amount paid, you may not execute the options contract. So, you will not book more loss than the premium already paid by you. Here, you would have made a loss of Rs. 23 per share (Rs. 103 – Rs. 80), from which the premium paid has to be deducted. That would have made your net loss per share Rs 27 (Rs. 23 + Rs. 4). Hence, you would have made a total loss of Rs 13,500 (Rs 27 x 500 shares). But as you have bought an option, you will only incur a loss of the premium paid, i.e. Rs 2,000 (the premium paid for possessing the right to buy 500 shares at Rs 103).

Now, let’s jot down a few major differences between them.

• In cash market, you can only buy. So, you will profit only if the market rises. But in futures and options, you can buy as well as sell (call and put). So, here you can profit even if the market falls.
• In cash market, you can buy any number of shares, i.e. there’s no defined number of shares that you are supposed to buy. But in futures and options, you can buy only in lots, with each lot having a predefined number of derivatives. For example, Reliance has a lot size of 250.
• In general, the capital requirement in cash segment is the highest. In futures you get a lot of leverage/margin, so you need less capital. In options, if you are buying, you just need to pay premium and so the margin requirement is the minimum for option buyers (though option sellers have more margin requirement). So, to book the same amount of profit, you need the least capital in options trading, a bit more in futures trading, and the most in cash segment.
• As far as brokerage charges are concerned, you will be charged the most in the cash segment, i.e. when you take delivery of shares. Brokerage charges are much less for derivatives trading (almost 8-10 times less). In general, brokerage charges in case of options are even lesser than that in futures.
• Futures are a bit easier to understand and value than options (though they are more complex than the underlying assets they track). Also, in options there are some fundamental differences between buyers and sellers – you would need to understand that, along with concepts such as premium decay and option greeks.
• Futures Trading is a lot riskier than Options trading, as here there’s no limit on how much you can lose. That’s because here you do not have the option to move away from the contract. You must execute the contract. In Options, the risk is limited to the amount of premium paid (for option buyers, not for option sellers). Though the gains you will get in Futures will be a bit more than Options trading, you also take much higher risks.
• To buy options you need to pay an upfront cost (called premium). There’s no upfront cost in case of futures, but you are obligated to pay the agreed-upon price for the asset eventually. (Though in both cases you may need to pay some commissions.)
• Future contract is executed on the predetermined date only. While in case of American options, the buyer may execute the contract any time before the date of expiry, i.e. you are free to buy the asset whenever you feel the conditions are right. In other words, in case of futures we get the “date on which” it must be traded. While, in case of American options we get the “date by which” it must be traded. Though keep in mind that European options can only be executed on their expiry day (unlike American options). In cash segment (i.e. when you take delivery of shares), there’s no expiry date. So, you can carry forward your position for as long as you want.
• Generally, futures have greater margin use, and are often more liquid.

Warning

Never indulge in Options and Future Trading without proper knowledge, training, and experience. Otherwise, you will not be trading but rather gambling your money away. It’s much more profitable and enjoyable than cash intra-day trading, but we need to learn to check our greed, or else we may lose all our capital pretty soon. In share market, we need to learn how to safeguard our existing capital before we focus on earning profits. Also, if you are a beginner take baby steps – start small!

Use cases of Options

Well, now let’s list some of the use cases of option contracts. Apart from profit-making goal, options are also used for other aims and in specific situations.

Use Case 1: Buying Options as a Hedging tool

Some intra-day traders and even swing traders that invest in stocks/indices for multiple days, also buy options as an insurance cover, just in case the market moves in the other direction.

For example, if you have bought shares of a stock expecting that the market will move up, you may also buy some put options of that stock (or sell call options). If there is a downtrend, the put options bought by you will give you a lot of profit, and will almost nullify the losses that you will make in the normal stock trading. On the other hand, if the market moves up as per your expectation, you will make profits in the stock, and your loss will be just limited to the premium you paid for the put options.

This scenario is similar to an insurance policy. When you buy an expensive car, you tend to insure it too. You are ready to lose the premium you pay to the insurance company in return of the assurance that if anything happens to the car, you will be compensated.

So, options are also used for insurance sake, or for hedging. In fact, trade in options started for hedging only. But now traders do options trading to make profits too.

Use Case 2: Buying Options for Leverage

If you just buy stocks of companies in stock market and take delivery, you will have to utilize a lot of your capital. That’s because you are paying in cash using your own money.

However, if you are buying options, you may make use of leverage (or margin) and take much more trade than the money you have. In case of most options, you can take 3 to 5 times more trade than the capital you have. This allows you to make more profit using less capital (but you may book huge losses too).

However, when you take delivery of stocks you may hold them for as long as you want. But in options there is a monthly or weekly expiry. That is, you will have to execute the trade in a limited time-period, irrespective of whether you are making a profit or loss.

Note

You get leverage/margin in case of future contracts too.