Futures VS Options
Futures and options are derivative contracts.
What are derivatives then
Let me give you an example,
We have coconut oil and coconut
The price of coconut oil will depend on the price of coconuts as it has been derived from it.
Similarly futures and options are contracts derived from underlying assets.
We have futures contracts of Stocks, Indices like bank nifty nifty, Commodities like crude oil , gold etc etc.
So lets say you want to purchase this flat from me, but you don’t want to pay full amount now.Instead you need to purchase it at after 2months.So we both get into a contract where am the seller and you are the buyer of the futures contract that we will settle at the end of 2months.Now 2months is what we call as expiry date.
For entering into this contract both of us need to pay a margin upfront, now if the price of the flat goes up , buyer will be profitable and if it depreciates seller will be profitable because they entered into the contract based on the present day rates.
So lets say that you have a view that price of gold is going to go up in the coming month, but you don’t want to pay full and buy gold due to may be storage issues, or you might not have the required capital etc.
But what you can do is you might purchase futures contracts of gold from the MCX mutlicommodity exchange where you and the counter party get into an agreement that you have to exercise at the expiry of the contract.
Futures are obligations to buy or sell at the expiry and it is compulsory to exercise.You can handover your contract to someone else and leave the contract as well.
In the trading arena, a futures buyer expects the price to move up and a futures sellers expects it to fall down over a period of time .Traders do exit their positions by the expiry date of the contract.
eg) Let’s say I get into a futures contract of company A whose price is Rs 100 today and lot size is 1000 qty.I am the buyer and you are the seller of the futures contract whose expiry is after 1 month.
The total value of contract is 100*1000= Rs.100,000
I need to pay only a margin of the total purchase amount lets assume a 15% that is 15000 rs to get into the contract as futures are by default leveraged pdts.
Case 1:The price of A goes to 110 in a period of 1 week .I make a profit of 10*1000= Rs.10,000 and if required i can passon the contract to someone else who is willing to enter the contract replacing me and exit with a profit of Rs 10,000 .You are in a loss of Rs10,000 because you had entered into a contract with me 1 week back and is obliged to provide me the shares of A at 100 Rs at the end of 1 month.
Case 2:The price of A goes down to 90 by the end of the month that is our expiry date . In that scenario , am in a loss of 10*1000 and you in a profit of the same. I could have bought the same pdt at a discounted rated of Rs 90 , however since i have got into a contract now I have to go with the agreement of Rs 100 per share at the expiry. However if there is someone else who has a view that price might pick up from 90, and if you feel the price may drop further, you could exit the position and the other person comes in.
Since options are obligations , we need to abide with the margin requirements of our brokers .
Now if you have read all till here, there’s a good news 🙂
Futures are pretty like equities in every sense, only difference is you buy in lots and can take overnight short or long positions with leverage and hold till expiry date.Just like taking delivery of your normal intraday positions.
Options on the other hand are rights
An option buyer is just like a person who takes an life insurance, you pay a less amount as premium and if something bad happens with it, you get a good compensation for the mishap. And definitely its a very less probable event or else insurance agencies wouldnt have been able to survive.
Now an options seller is just like an insurance company, the maximum profit he makes is the premium he receives from option buyers and he is the one who compensates to the mishaps of the buyers.
Take care of your health. This is just an example.Health is wealth.
Another example for better clarity
So lets say you want to purchase this flat from me, but you don’t want to pay full amount now.Instead you need to purchase it at after 2months.So we both get into a contract where am the seller or writer and you are the buyer of the options contract that we will settle at the end of 2months. Now 2months is what we call as expiry date of the options contract.
Here you the option buyer pays me an advance called premium to get into the contract.
The premium that you pay will be a small fraction as compared to the price of the flat and I who sell the contract receives the premium .At the time of expiry , we agree to exchange the pdt at the predetermined price
So lets say that price of the flat moves up, then you still get to buy it at the price decided at the time of making contract with me.
Else lets say the price of the flats in the region falls down.Then you might forget about the premium paid and you may buy it at an even lower price from else where.
You end up losing the premium you paid , however it might even be profitable for you to buy it after exiting the contract.
Premium is the key here in options, as the price moves favourable to the direction you predicted, the value of premium keeps increasing and you will be able to exit in profit by replacing someone else in the contract for emplace of yourself as a trader.
Similarly if the premium drops down if the price moves against your view as well as the time to the expiry starts approaching, you will end up in loss.
In the case of options, if you have a view that the price of the underlying asset is going to go up , you buy a call or sell a put
If your view on the other hand is that prices are to fall down you should buy a put, or sell a call.
As an option buyer, either call/ put option buyer, the maximum risk you take is the premium you pay, and the profit depends on howmuch ever the price moves in the favourable direction of your prediction assuming quick moves meaning the profit is unlimited with comparatively lesser risk.
As an option seller, either call or put writer, the maximum profit you make is the premium that you receive from the option buyer at the time of entering the contract. If your view goes wrong the buyer makes money and that loss is incurred by you. Theoretically speak option sellers take unlimited risk ,however you may mitigate risk by hedging or by using stoploss.
Now i get what is running through your mind?
Then why do people even sell options. The answer is that it is just about 20% of the times options buyers make money in the options contracts and the rest 80% of the times options sellers make money. That is why i referred option buyers as people who take insurance and option selliers as insurance companies.
The FII and DII are all mainly, HNIs are mainly option writers and are capable of driving the markets to their interests. This could be one easy answer I can give you. Max Pain theory explains the same logic, at the time of expiry , the underlying assets settle in such a manner that option sellers loose least amount of money .
However we have strategies that make it favourable for option buyers to be in the 20 % with calculated entries and exits 🙂 and without letting time decay affect us.
The enemy of an option buyer is theta or time decay which is the depreciation in the value of premium as the expiry date of the contract approaches.
Let’s take a situation where I am asking you to predicting where the nifty 50 index would head to at 3 30 pm in the first 1 min and asking the same question at the end of the dat at 3 29 pm. Which one do you think would be harder to predict. Definitely the initial qtn and hence a bigger premium would be associated with it as compared to the later one.
Eg)Lets say that price of stock A is 20,000 Rs and you have a view that the price will move upto 21000 in the coming week and I have a view that the price of A is going to stay below 21000. So I become the call writer(seller) and you the call buyer. Lets say the premium you pay me is Rs 500 for 1 qty .
After 2 days, suppose the price of A is Rs 22000, then the premium would have become Rs 700 (assumption). You may continue to stay in the contract and purchase the shares from me for Rs 20,000 itself based on the contract or you may handover it to someone else receiving premium 700 and exit from your position with Rs 200 profit per unit.
After 2 days, suppose the price of A is Rs 20000 itself, then the premium would have become Rs 400 (assumption). You may continue to stay in the contract and purchase the shares from me for Rs 20,000 itself based on the contract or you may handover it to someone else receiving premium 400 and exit from your position with. Rs 100 loss per unit
Time decay is what depreciated the premium of your options contract you bought as the days started approaching the expiry date.
Time decay or theta is what we call this phenomenon
(Time decay is an enemy for option buyer and a friend for option seller.)
As an option buyer, you try to make use of sharp moves in the pricing of the underlying asset to gain money.
If you have a view that the pricing of the underlying asset is going to fall down you buy a put, if you have a feeling that the underlying price is going to move up, you buy a call.
You actually make money by sensing the direction of the underlying( bank nifty, nifty etc)
It is not just the direction, but also the time for the move which is of importance in the case of options.
We understand that both futures and options are leveraged products meaning you can make more both profits and more losses with them. As somebody who is just getting started off with the markets , we at Livelong Wealth always recommend you to start off with cash markets rather than derivatives market.