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Futures Trading Options An Overview21 November 2019

Futures Trading & Options: An Overview

Keywords: futures trading (x6), stock trading (x2), share market (x3)

In recent years, the equity derivative market in India has experienced a quick turnover and trading in derivatives compared to the cash market in the Indian market was observed to be the highest globally. Option trades dominate Indian derivatives and account for over 80 per cent of turnover. But what are these financial products of derivatives – futures trading and options – and how have they come to dominate the share market landscape?

Options & Futures Trading

Options and futures are both financial products that investors use to hedge current investments or make money by stock trading (or buying or selling any underlying asset). Both are agreements to buy an investment at a specific price by a specific date but are very different in how they work.

·        A futures contract requires a buyer to purchase shares, and a seller to sell them, on a specific future date unless the holder`s position is closed before the expiration date.

·        An option gives an investor the right, but not the obligation, to buy (or sell) in the share market at a specific price at any time - as long as the contract is in effect.

Benefits of Both Derivatives

Have a look at futures trading first. Assume that an investor wants to buy 1500 shares of Reliance at a price of Rs 400, equalling an investment of 6 lakhs. They can also buy 1 lot (consisting of 1500 shares) of Reliance. The advantage is that when an investor buys futures, he or she only pays the margin which (approx) is around 20% of the full value. That means profits will be five-fold that of when invested in equities. Butthe losses could also be five-fold and that is the risk of futures trading.

An option is a right without an obligation. So, an investor can buy a Reliance 400 call option at the price of Rs10. Since the lot size is 1500 shares, your maximum loss will be Rs15,000 only. On the downside, even if Reliance goes up to Rs300, the investor’s loss will only be Rs15,000. On the upside, above Rs410, profits will be unlimited.

Risks of Both Derivatives

When an investor takes part in futures stock trading, the only financial liability is the cost of the premium at the time the contract is purchased. However, when a seller opens a put option, that seller is exposed to the maximum liability of the stock’s underlying price. Futures contracts also involve maximum liability to both the buyer and the seller. With movement of the stock price, either party may have to deposit more money into their trading accounts to fulfil obligations.

When it comes to options, the risk to the buyer of a call option is limited to the premium paid up front. This price rises and falls throughout the life of the contract and is based on a number of factors. Assume in this example that the share in the share market goes up to Rs 500. The option writer (the investor who opened the put option) would be forced to buy the shares at Rs 500 per share in order to sell them to the call buyer for Rs 250 a share. In return for a small premium, the option writer is losing Rs 250 per share.

Conclusion

A key takeaway to remember is that while options and futures trading are similar trading products that provide investors with the chance to make money and hedge current investments, each comes with its own risk and should be dealt with according to the financial goals, income and experience of the investor.

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