Futures and options are derivative instruments which can be used to hedge against the market and protect profits, minimise losses.
Futures are a derivative product based on an underlying asset. Futures usually are traded at a premium(i. e. Their price is higher than the underlying asset) or discount(i. e. Their price is lower than the underlying asset).
Simplified:
Its always easier to expain with an example:
Share: RELIANCE
Price: 1000 per share
So we can buy 1 share of reliance from the market at 1000 per share if we have 1000 in our account.
Future: RELIANCE FUTURE
Price: 1010 per share
Premium = Reliance price – Reliance future price = 10
Lot: 100 shares
Underlying asset in the example is: RELIANCE share.
Future/Derivative is: RELIANCE FUTURE
So we CANNOT buy/sell 1 share, we have to buy/sell 1 lot which is a 100 shares.The price we have to buy/sell at is 1010 i.e. higher than the current price of RELIANCE.Reliance is the underlying asset for this future.
But we don’t have to pay 1010 x 100 to buy/sell RELIANCE FUTURE, we can pay “margin”usually 5-10% of the value of the future,i.e. (1010 x 100 x 10/100 = 11000), to buy/sell.
If we were buying in normal cash segment we would have to pay: 1000 x 100 = 100,000
The future is only upto a certain date(expiry date) at which time the underlying, RELIANCE in our case,and the future, RELIANCE FUTURE, will come to the same price also known as Settlement price.
You can hold shares till whenever you like, futures are settled at a particular date which is specified and fixed.
Differences between Future and Stocks:
| Futures | Stocks | |
|---|---|---|
| Minimum shares: | Lot or multiple of lot | 1 or multiple of 1 |
| Underlying Asset: | Share price of Company | Company |
| Expiry Date | Specified as per exchange/contract | None, can be held indefinitely |
| Amount Required | Quantity x Price x 10% (approx) | Quantity x Price |
| Settlement Price | Calculated as per Share/stock price on expiry date | Not applicable |
Options are a right to buy or right to sell a particular share on a specified date at a particular price.
Is that confusing?
Let us try and make it as simple as possible.
- Options are a contract between two people.
- There are two types of option contracts: Puts and calls
- a) Puts – Right to Sell
- b) Calls – Right to Buy
- There is a date till which the option/contract is valid aka Expiry date.
- They are based on the price of an underlying share/commodity/other.
Call Options are the right to buy, at a particular date for a pre-fixed price.
Let us try to understand Call Options with an example:
On 01-05-2020:
Share: Reliance
Lot: 100 shares
CMP: 1000 per share
Mr. A says to Mr. B: “I might buy 1 lot of Reliance from you at 1100 per share till 28-05-2020”
Mr. B says: “If you give me 50 per share today, I will sell you 1 lot of Reliance at 1100 per share till 28-05-2020”
Mr. A says: “Ok, I give you 50 per share today and I can choose to buy Reliance shares, 1 lot, till 28-05-2020”
“Call is a right to buy.”
So Mr. A in the above exchange has the choice(right) to buy Reliance shares, quantity 100 shares(1 lot = 100 shares), from Mr. B if he pays Mr. B 50 per share today.
Mr. A
Pays 50 x 100 = -5000
Mr. B
Receives 50 x 100 = 5000
Now on 28-05-2020:
Case 1:
Share: Reliance
Lot: 100 shares
CMP: 900 per share
Mr. A does not want to buy the shares at 1100 per share, he can buy them from the market for 900 per share. So he says to Mr. B keep the 50 per share.
Case 2:
Share: Reliance
Lot: 100 shares
CMP: 1120 per share
Mr. A says I will buy the shares for 1100 per share.
Mr. B sells him the shares as he had promised and keeps the 50 per share.
Mr. B made a profit of 30 per share, i.e. his selling price was 1100 + 50 per share. The market rate of the share was 1120 so his buying price is 1120. Profit-Loss = Sell – Buy = 1150 – 1120 = 30 per share.
Case 3:
Share: Reliance
Lot: 100 shares
CMP: 1200 per share
Mr. A says I will buy the shares for 1100 per share.
Mr. B sells him the shares as he had promised and keeps the 50 per share.
Mr. B made a loss of 50 per share, i.e. his selling price was 1100 + 50 per share. The market rate of the share was 1200 so his buying price is 1200. Profit-Loss = Sell – Buy = 1150 – 1200 = -50 per share.
Make tables for the above. And discuss below the table.
What are the risks in call options?
Mr. A
Buys the call at 50 per share(aka premium)
Maximum Loss: Premium x number of shares = -(50 x 100) = -(5000)
Maximum Profit: Unlimited
Mr. B
Sells the call/right to buy.
Maximum Loss: Unlimited
Maximum Profit: Premium x number of shares = 50 x 100 = 5000
In a nutshell that is calls.
There are various strategies to make sure that Mr. B does not have a potential unlimited stocks. See links at the end of the page*.
Put Options are the right to Sell, at a particular date for a pre-fixed price.
Let us try to understand Put options with an example:
On 01-05-2020:
Share: Reliance
Lot: 100 shares
CMP: 1000 per share
Mr. A says to Mr. B: “I might sell 1 lot of Reliance to you at 950 per share till 28-05-2020”
Mr. B says: “If you give me 50 per share today, I will buy 1 lot of Reliance at 950 per share till 28-05-2020”
Mr. A says: “Ok, I give you 50 per share today and I can choose to sell Reliance shares, 1 lot, till 28-05-2020 at 950 per share.”
“Put is a right to Sell.”
So Mr. A in the above exchange has the choice(right) to sell Reliance shares, quantity 100 shares(1 lot = 100 shares), to Mr. B if he pays Mr. B 50 per share today.
Mr. A
Pays 50 x 100 = -5000
Mr. B
Receives 50 x 100 = 5000
Now on 28-05-2020:
Case 1:
Share: Reliance
Lot: 100 shares
CMP: 850 per share
Mr. A CHOOSES to sell the shares at 850 per share to Mr. B.
Mr. B makes a loss of: (Sell Price – Premium + Buy Price) = 850 + 950 – 50 = -(50) per share
Mr. A makes profit of: Sell Price – Premium + Buy Price = 950 – 50 + 850 = 50 per share
Case 2:
Share: Reliance
Lot: 100 shares
CMP: 930 per share
Mr. A says I CHOOSE to sell the shares for 950 per share.
Mr. B buys the shares as he had promised and keeps the 50 per share.
Mr. B made a profit of 30 per share, i.e. his buy price was 950 – 50 per share. The market rate of the share was 930 so his buying price is 900. He can sell to the market at 930 per share.
Profit-Loss = Sell – Buy = 930 – 900 = 30 per share.
Case 3:
Share: Reliance
Lot: 100 shares
CMP: 1000 per share
Mr. A says I CHOOSE not to sell the shares.
Mr. B keeps the 50 per share.
Mr. B made a profit of 50 per share. Mr. A could potentially sell his shares to the market at 1000 per share.
In a nutshell that is puts.
What are the risks in call options?
Mr. A
Buys the put @ 50 per share(aka premium)
Maximum Loss: Premium x number of shares = -(50 x 100) = -(5000)
Maximum Profit: Unlimited
Mr. B
Sells the put/right to buy.
Maximum Loss: Unlimited
Maximum Profit: Premium x number of shares = 50 x 100 = 5000
There are various strategies to make sure that Mr. B does not have a potential unlimited loss. We will discuss them in later posts.
All information here is for educational/research purposes only, we do not recommend trading.