What is Futures and Options in financial market?
Futures and options (FnO) are two types of financial derivatives that are used in trading in financial markets. Derivatives are introduced in financial markets with an objective of hedging. Hedging a portfolio helps the market participants to limit or eliminate potential losses that may arise from adverse price movements. Traders use this as a tool to trade and to make an income from the financial market. Jargon and lack of proper understanding makes the derivatives market complex for investors and other market participants.
Trading in financial derivatives carries risk and proper market experience and knowledge is very prominent. It is prominent to acquire relevant market knowledge and experience before entering the world of derivative market. Proper risk management is the golden tool used by a successful trader in derivative market. Let us understand in detail how to trade in futures and options to start your trading journey. Before learning about buying and selling of derivatives it is important to learn futures and options basics.
Let us understand with a real-life example of Tata motors stock chart
When Underlying Asset is in an Uptrend
When the underlying asset is in an uptrend, we can generate profits by entering a long position in futures, buying call options, and selling put options. The image shown above is the stock price of tata motors. We can consider the entry price as 510 and exit price as 534 as mentioned in image.
Entering long position in futures
When the asset is in an uptrend, market participants can go long on the underlying asset and can generate profit. Let us imagine that you have bought Tata motors futures at Rs 510 and made an exit at 534. Buying Tata Motors JUN FUTURE at 510 requires an estimated margin of Rs 1,71,721.
Lot size of Tata Motors Futures is 1425.
Buying one lot of Futures at 510 and selling it at 534 you were able to capture Rs 24 profit for one share.
As the lot size is 1425 the total profit will be 1425 * 24 i.e., Total profit of Rs 34,200
Always remember when the stock or the asset is in an uptrend, there is a high probability for the asset price to move up. Always go for long position in an uptrend.
If you have shorted futures when Tata motors was trading at Rs 510. You will end up making losses in trading. Doing proper research and analysis is prominent before entering a trade.
Buying a Call option
Traders can buy a call option when the underlying asset is in an uptrend and there is a high probability for the asset price to move up. Let us imagine buying a call option when the stock price of Tata motors is at 510 Rs.
Imagine you have bought Tata Motors JUN 510 CE when the premium was at 40 Rs anticipating the price will move up. Lot size of the Tata motors call option position is 1425 and capital required for one lot is around Rs 45000.
As expected, the Tata motors stock price has given an up movement to Rs 534.The premium has spiked to 90. Making an exit, the trader captured a premium of 50 (90–40) for one lot.
As the lot size is 1425 the total profit will be 1425 * 50 i.e., Total profit of Rs 71,250
Selling a put option
Market participants can sell a put option contract of stock anticipating the underlying asset to move up to make profit. When a trader sells an option contract, traders make profit when the premium moves down. For an option seller there will be limited profits and unlimited risks.
Let us imagine selling a put option contract of Tata Motors Jun 500 PE at a premium of 20 Rs. Lot size of the Tata motors call option position is 1425 and capital required for one lot is around Rs 125000.
As expected, the Tata motors stock price has given an up movement to Rs 534, and the premium has fallen to 6 from 20. Making an exit, the trader captured a premium of 14 (20 – 6) for one lot.
As lot size is 1425, total profit from short position will be 1425 *14 i.e., Total profit of Rs 19,950.
When underlying asset is in a downtrend
When the underlying asset is in a downtrend, we can generate profits by entering a short position in futures, selling a call option, and buying put options. The image shown above is the stock price of tata motors. We can consider the sell price as 530 and exit price as 512 as mentioned in image.
Entering Short position in futures
When the asset is in a downtrend, the market participants can enter short positions anticipating the underlying asset to move down. Traders can sell an asset at a higher price and buy it back at a lower price to generate profits.
Let us imagine that you have entered a short position in Tata motors futures at Rs 530 and made an exit at 512. Selling Tata Motors JUN FUTURE at 530 requires an estimated margin of Rs 1,70,000.
Lot size of Tata Motors Futures is 1425.
selling one lot of Futures at 530 and buying it back at 512 you were able to capture Rs 18 profit for one share.
As the lot size is 1425 the total profit will be 1425 * 18 i.e., Total profit of Rs 25,650.
Selling a Call Option
Let us imagine selling a call option when the stock price of Tata motors is at 530 Rs.
Imagine you have sold Tata Motors JUN 530 CE when the premium was at 30 Rs anticipating the price will fall. Lot size of the Tata motors call option position is 1425 and capital required for one lot is around Rs 1,20, 000.
As expected, the Tata motors stock price has fallen from Rs 530 to Rs 512, and the premium has fallen from 30 to 11. Making an exit, the trader captured a premium of 19 (30 – 11) for one lot.
As the lot size is 1425 the total profit will be 1425 * 19 i.e., Total profit of Rs 27,075.
Buying a Put Option
Let us imagine buying a put option contract of Tata Motors Jun 530 PE at a premium of 12 Rs. Lot size of the Tata motors call option position is 1425 and capital required for one lot is around Rs 45000.
As expected, the Tata motors stock price has Fallen from Rs 530 to Rs 512, and the premium has spiked to 46 from 12. Making an exit the trader was able to capture a premium of36 (46 – 12) for one lot.
As lot size is 1425, total profit from short position will be 1425 *36 i.e., Total profit of Rs 51,300.
