Stock Market is too volatile (full of ups and downs) these days and we often watch on TV reporters talking about the investment and divestment of FII (foreign institutional investor) in Futures and options or increase and decrease in OI (open interest). Many people wonder what these reporter are talking about? In this article I will tell you the concept of Futures and Options but wont tell you how speculations are done as there are infinite strategies dependent on scenarios.
So what exactly is futures and options?
Futures and options are instruments that give Derivatives (will discuss about it in other post) their flexibility and make them lucrative for traders.
What are futures?
A ‘Future’ is a contract to buy or sell the underlying asset (The underlying can be a stock issued by a company, a currency, Gold etc.) for a specific price at a predetermined time (that is expiry date of the contract). If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time but If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. In simple words you will have to square off your position (if you are buying you will have to sell and if you selling you will have to buy) on or before the expiry date.
Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long (buy) or short (sell) using futures.
What are options?
An option is common form of a derivative. It’s a contract, or a provision of a contract, that gives one party the right, but not the obligation to perform a specified transaction with another party according to specified terms. Options can be embedded into many kinds of contracts. For example, a corporation might issue a bond with an option that will allow the company to buy the bonds back in ten years at a set price. Standalone options trade on exchanges or OTC. They are linked to a variety of underlying assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or baskets of assets).
There are two main types of options: calls and puts:
- Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ”writing” an option.
- Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers – those who hold a “long” – put are either speculative buyers looking for leverage or “insurance” buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a “short” expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlying is at or above the option’s strike price at expiration. The maximum loss is unlimited for an uncovered put writer.
Put call ratio
A ratio of the trading volume of put options to call options. The put-call ratio has long been viewed as an indicator of investor sentiment in the markets. Times where the number of traded call options outpaces the number of traded put options would signal a bullish sentiment, and vice versa.
One of the most important point of consideration in the case of option trading is time value. The more time(longer expiry date) you take for the determination of value of asset, the value of asset will be more and it changes rapidly as the expiry date comes nearer. It exactly forms upward pyramidal structure where assets value shrinks to zero (above the stroked price in the case of call option and below the stroked price in the case of put option) and hence profit is limited and loss can make your asset worthless.
Then what is difference between futures and options? Both seems same.
The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract. In simple words you can carry forward your position in futures but you cannot in the case of options.
The basic things and activity involves in futures and options trading
- Buy :- when you buy some contract
- Sell :- when you sell some contract
- Price :- the price at which trade happens
- Expiry :- the predetermined date for the expiry of the contract.