Trading & Options: An Overview
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
Options & Futures Trading
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.
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.