The Know-How of Futures & Options Markets
In markets, there are two types of investors – one a long-term and other short-term. A long-term investor buys stocks to build wealth and earn dividend. On the other hand, a short-term investor tends to trade with the market trend and earn quick profits.
Other than trading in the cash market. The short-term investor or trader also has the option to trade in the futures & options market. What is the futures & options market, and how can one trade and profit from it is explained in the following article.
1) Future Contracts – It is a contract to buy/sell specific quantities of a particular stock at a specified price on or before a specified time in the future. Both the buyer and seller are obliged to buy/sell the underlying share.
In futures, you buy a contract which will have a specific lot size and the lot size is differs from stock to stock. You don’t need to pay entire value of the contract but just the margin which is prescribed by the exchange.
Let’s say you buy a Wipro Futures contract. The lot size of Wipro is 100. And the price of each Wipro share is Rs 600. This will amount to Rs 60,000 (Rs 600 X 100 shares).
You don’t pay the entire amount of Rs 60,000 You only pay 15 per cent to 20 per cent of that amount and this is called the margin amount.
So, if the price goes up then the difference will be credited to your account and vice verse. This will go on till you square off your the Futures contract position or it expires. The contract expires on last Thursday of every month.
That means, on a daily basis you book either profit or loss.
2) Options Contract : Options is one of the most widely traded derivative instruments in the stock market. In stock options, the option buyer has the right and not the obligation, to buy or sell the underlying share. Please note that, it is just a kind of promissory note are settled in cash with no actual delivery of shares at the option expiry date which is last Thursday of every month.
Option trading lets you enjoy greater leverage. That means you deposit smaller amount in asset that is of much higher value. Secondly, in option trading you have less risk involved as you can always let the contract expire without any action if your speculation goes wrong.
Options are basically of two types – Call Option and Put Option.
a) Buying Call Options – Buying a call option or making a ‘long call position’ is a simple and straightforward strategy for taking advantage of a bullish market or upside trend. A buyer for a Call options is taking a position that the share price would rise in value before expiry date.
A long call option gives you the right, but not the obligation, to buy the stock at the specified price (strike price) for a set period of time.
In simple terms, you buy call options at premium is because you believe the underlying stock will appreciate before expiration. So in this case, the maximum amount you can lose with a long call is he initial cost of the trade i.e.
premium you paid, but if the stock rallied then you can earn unlimited profit.
b) Buying Put Options – A buyer of Put options is taking the opposite position that the underlying instrument would actually fall in value before expiry date.
This strategy is useful to earn profit from a down move. Many people use this strategy for hedges on stocks they already own if they expect some short-term downside in the shares.
It gives you the right (but, not the obligation) to sell a stock at the specified price for a set time period.
c) Selling Call Options – Selling Call options is another way of going short in the market. Here the advantage is that the trader can sell out-of-money (meaning far strike price) call option and earn profits.
For e.g., in case, Wipro is trading at Rs 600, and the call option at a strike price of Rs 650, trades at a premium of Rs 5. The writer (one of sells the call option), can sell at Rs 5, and will run the risk of loss only if Wipro crosses above Rs 655 during the expiry period.
D) Selling Put Options – Bulls tend to sell put options during bullish phases. As while the markets trend higher or consolidate, the value of Put tends to go lower as the expiry nears.