Future and Options ( Basics for Beginners )

A lot of people have ambiguity in understanding the basics of futures and options. There are a lot of stuffs available these days on Internet as well as plethora of knowledge based books. But, due to time constrain a lot of people are unable to go through them.

Here I will explain everything in nutshell only the stuff which is required for trading! So let’s begin :

Futures :

What is it?

A contract between to parties where both of them agree for delivery of a commodity/asset at a predetermined future date and price. It is a derivative instrument.

Where is it traded?

Legally in registered exchanges. In India it is traded in NSE i.e. National Stock Exchange.

Can we just buy/sell one future share?

Future scripts are always traded in lot sizes. For instance If you wish to buy Dish TV (an Indian share), you need to buy 7000 qty i.e. 1 lot at once to trade. That’s the minimum you need to buy and for every other lot you need to go with the same multiples. So, if you wish to buy another lot of Dish TV, you need to buy 14000 qty and so on. The lot sizes are different for various stocks.

What’s the difference between spot ( Cash/equity) and future prices?

Cash gives you ownership, futures are contracts which don’t give ownership. Further you can even buy 1 share in cash market, but in future you need to stick to lot sizes (standard but keeps revising on monthly/quarterly as per exchange mechanism).

What’s the major advantage then in future as compared to cash?

Leverage or Margin is the word. In cash to buy 1000 shares of 100, you will need to pay Rs100000 at once, while in futures for the same 1000 shares (assumed to be lot size) you will have to pay aprox Rs 30,000. This gives you an edge in terms of gains. But risk is also more. So, with lesser funds you can gain more.

Are future and cash prices same?

Only on expiry days.This brings the question is what is expiry day. As mentioned, all future contracts end at some point of time, this is usually Last Thursday in terms of equity futures (India). On this day the value is more or less same. Usually futures quote either in premium or discount. Premium means an additional price which buyer pays to buy a contract as market players are expecting the script to perform in the series and discount means a smaller amount to be paid as compared to market price as most participants are bearish on scripts. Illustration : If spot of stock X is at 100 and market players expect it to rally, the future may quote at 103 or so. Where as if market players are selling it or expect it to move down, they may keep futures@ 99! There are several factors which decide premium or discount in a script.

What is the risk and reward?

Rewards could be enormous if you you picked right script with right analysis. All you need to do is maintain an additional margin with your broker for intra day adjustments in fall of stocks. If your margin falls short, broker may compel you to put additional funds or you run the risk of square offs.

In a downfall risk could be unlimited as compared to options.

Now, lets understand Options…

What are options?

For a non refundable amount a buyer gets into a contract. It gives buyer the right to buy or sell an asset and not the obligation at a predetermined price and predetermined time (expiry).

Types?

Call - A person buys a call when he is expecting the price of a stock to move up in future.

Put - A person buys a put in the anticiaption that the stock will fall in future.

Both calls and Puts become void or null on expiry day.

Further classification :

In the Money Call and Put - For easier understanding, any call stike price which falls within the closest range or under range of script. Example- Stock X quoting @100 and now if you expect it to move up and buy a 95 call, it is an in the money option. On the contrary if you buy 110 call, it is out of the money call. So, out of the money options are the once whose strike price are higher than the current spot price.

Advantage of In the Money options : 

a. Moves closely and swiftly as compared to OTM options.

Disadvantage of In the Money options :

a. One needs to pay higher premiums to take one as compared to OTM so risk is more.

Advantage of OTM options :

a. Moves slowly, has low volume but is less risky as lower premiums are paid. Multiplies is good manner if stock moves in your direction.

Difference between futures and options?

In options you have various strike prices to choose from based on risk appetite. High risk takers can go for ITM options and others can choose OTM. In futures, you don’t get that Option. Premiums paid are usually lesser than futures. You can trade options with an amount as low as INR 1000 (OTM) but you cant do the same in futures. Of course risk reward ratio has to be considered.

Risk is unlimited in future. If the stock moves against you, you may burn all the cash. In Options, risk is limited that means you take risk only for the premium paid (the initial payment by buyer)

Selling future doesn't require additional margin, while selling or shorting option does require as that is a risk taken by broker. You usually have to pay 5–6 times more. Here risk is unlimited but on most occasions you will gain at the end of series, as premiums are bound to become zero.

Options are usually used for hedging portfolios by big players i.e. to minimize risk.Options loose premium that is with time and volatility the value goes low. Its not same in the case as before. With the following difference, you can also understand the advantages and disadvantages.

So, here I explained in a nutshell all about future and options for layman. For any confusion, feel free to ask.