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Futures and Options Trading
Part - 1
There are many instruments available for trading in the stock market. Some like to trade in cash, some in futures & options. You all know cash trading, for example, you have 10,000 thousand rupees and there is a stock whose price is 1000 Rs. So, you bought 10 shares, but this is not the case in futures & options trading, it is a completely different type of trading, and it requires a different kind of skill. New traders should first start with cash trading and simultaneously keep learning f&o trading. If you start with F&O without knowledge, then your trading career can end very quickly.
Don't let this happen to you, I have brought for you the Futures & Options Trading Series. In this series, I will teach you f&o trading from basic to advanced level. If you have any questions, you can ask me by email or comment.
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| Futures and Options Trading |
Difference Between Futures and Options Trading
Futures and options are both types of derivatives, which are financial contracts that derive their value from an underlying asset, such as a stock, commodity, or currency.Futures: A futures contract is an agreement to buy or sell an underlying asset at a specific price on a future date. Futures are typically used by traders and investors to speculate on the price movements of an asset or to hedge against price risk. Futures trading can be used for a variety of purposes, including speculation, hedging, and arbitrage. Speculators may use futures to bet on the future price movements of an asset, while hedgers may use futures to offset the risk of price movements in an asset that they own or produce. Arbitrageurs may use futures to take advantage of price discrepancies between different markets for the same asset. Futures contracts are typically standardized and traded in large quantities, with a specific delivery date and price. They also require a margin deposit, which is a form of collateral, to be made to the exchange to ensure that traders can meet their obligations under the contract.
Options: An options contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a future date. Options are typically used to speculate on the price movements of an asset or to hedge against price risk. Investors may also use options to generate income through the sale of options contracts (Which we will talk about in the coming parts of this series.). Options contracts are typically standardized and traded in large quantities, with a specific expiration date and strike price. Unlike futures, options contracts do not require a margin deposit, but they do have an expiration date. Options trading can be complex and risky, as the potential for large financial losses is significant. It's important to have a solid understanding of the mechanics of options trading, including the various types of options (e.g., call options and put options) and the risks involved before entering into any trades.
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Both futures and options trading can be risky, as they involve the potential for large financial losses. It's important to understand the mechanics of these derivatives and the risks involved before trading.
I told you the difference between futures and options, but today in this blog we will only talk about futures trading.
Today on 24 Jan 2023, the quarterly results of Axis Bank, a leading Indian Private bank were declared, the market did not like the results, and the stock of 22 Rs. fell as we can see from the Axis Bank spot market quote, the stock went down by over 2.4%.
In the snapshot below, the price per share is highlighted in expectations. the blue highlight: we will discuss it shortly.
ICICI Bank, HDFC Bank, and Kotak Bank gave good numbers, but Axis Bank could not meet the market expectations. Hence, I believe the stock sank by 2.4%. I also feel this could be an opportunity to buy Axis Bank (this is only an assumption don't take it as a tip or recommendation), as I believe the stock price will eventually go up. Hence, I would be a buyer in Axis Bank.
Notice, based on my thoughts, I have developed a ‘directional view’ of the asset’s price (axis bank). I believe the Axis Bank (underlying asset) stock price will increase in due course of time from my analysis. In other words, I am bullish about Axis Bank at the current market price.
Instead of buying Axis Bank shares in the spot market, I decided to buy Axis Bank Futures (for reasons I will discuss in the next chapter). Having decided to buy futures, all I need to see is the price at which the Axis Bank Futures is trading. The contract details are readily available on the NSE's website. In fact, the link to get details for an Axis Bank futures contract is available on-the-spot market quotes. I have highlighted the same in blue in the image above.
the futures price should always mimic the spot price, meaning if the spot price has gone down, the futures price should also go down. Here is a snapshot from NSE's website showing the Axis Bank Futures price.
As expected, the futures price has mimicked the spot price, and therefore the Axis Bank Futures is also down by 2.74%. You may have two questions at this point –Axis bank in the spot market is down by 2.4%. However, TCS futures are down by 2.74%? Why the difference?
TCS spot price is at Rs.910.30, but Futures price is at Rs.907.65? Why the difference?
Both these are valid questions at this point, and the answer to these questions depends upon the “Futures Pricing Formula”, a topic we will deal with at a later point in time. But the most important point to note at this stage is that the futures price has moved in line with the spot price, and both of them are down for the day. Before we proceed any further, let us relook at the futures contract and inspect a few key elements. Allow me to repost the futures contract with a few important features highlighted.
Instrument Type – Remember, the underlying asset is the stock of a company, and we are interested in the asset’s future contract. Hence, the instrument type here is the ‘stock futures.’
Symbol – This highlights the name of the stock, Axis bank in this case.
Expiry Date – This is the date on which the contract ceases to exist. As we can see, the Axis bank futures contract specifies 25 Jan 2023 as the expiry. You may be interested to know that all derivative contracts in India expire on the last Thursday of the month. We will discuss more what happens on the expiry date at a later point.
We had looked at the blue box a little earlier; it just highlights the future price.
Lastly, the black box highlights two important parameters – the underlying value and the market lot.
Underlying Value – This is the same as the price at which the underlying is trading in the spot market.
2. Market lot (lot size) – Remember, a futures contract is a standardized contract. The parameters are prefixed. The lot size is the minimum number of shares that we need to buy/sell if we wish to agree. The lot size for the Axis bank futures is 1200, which means a minimum of 1200 shares (or a multiple of 1200 shares) have to be transacted while trading the Axis bank futures.
Contract Value = Lot size x Price of futures
= 1200 x 907.65
= 10,89,180
The idea is to buy a futures contract as I expect the Axis bank stock price to go up. The price at which I would buy Axis bank Futures is Rs.907.65 per share. Remember, the minimum number of shares that I need to buy is 1200. The minimum number of shares is also colloquially called ‘one lot’.
So how do we buy the ‘Futures Contract’? This is quite simple we can call our broker and ask him to buy 1 lot of Axis bank futures at Rs.907.65 - or we can buy it ourselves through the broker’s trading terminal.
The moment I buy the Axis bank futures a couple of things happen in the background.
Margin Validation – Remember, whenever we enter into a futures agreement, we need to deposit a margin amount (sort of a token advance), which is simply a percentage of the contract value. We will discuss margins shortly. If there is insufficient margin, we cannot agree. So as the first step, the broker’s risk management system/ software checks if I have sufficient money in my trading account (to suffice the margin requirement) to enter into a futures agreement.
The counterparty search – After validating the margins, the system scouts for a relevant counterparty match. The match has to be made between me – the buyer of the Axis bank futures and the Axis bank futures seller. Remember, the stock exchange is a ‘Financial supermarket’ where one can find many participants with different views on an asset’s price. The seller of Axis bank futures obviously thinks Axis bank futures price will go further down. Like my rationale as to why the Axis Bank stock price will go higher, the seller has his own rationale for his directional view. Hence, he wants to be a seller.
The signoff – Once Step 1 and 2 are through, i.e., the margin validation and finding the counterparty, the buyer and the seller digitally sign the futures agreement. This is mainly a symbolic process. By agreeing to buy (or sell) the futures agreement, one gives the other consent to honour the contract specifications.
The margin block – After the signoff is done, the required margin is blocked in our trading account. We cannot use the blocked margin for any other purpose. The money will be blocked as long as we hold the futures contract.
With the completion of these 4 steps, I now own 1 lot of Axis bank Futures Contract. You may be surprised to know, in the real markets, all the above-mentioned steps happen sequentially in a matter of a few seconds!
Here is a critical question – What does it mean by “I now own 1 lot of Axis bank Futures Contract”? Well, it simply means by purchasing Axis bank futures on 24 Jan 2023, I have digitally agreed with a certain counterparty agreeing to buy 1200 Axis bank shares from me (the counterparty) at Rs.907.65 per share. This futures agreement between me and the counterparty expires on 25 Jan 2023.
The 3 possible scenarios post the agreement.
Scenario 1 – Axis Bank stock price goes up by 25 Jan.This is a case where my directional view on Axis Bank shares has come true. Therefore, I stand to benefit.
Assume on 25 Jan 2023, the stock price of Axis Bank has gone up from Rs.907.65 to Rs.920 per share; by the increase in the spot price, the futures price would also increase. This means, as per the agreement, I am entitled to buy the Axis Bank shares at Rs.907.65 per share, which is a much lower price compared to what is available in the market. My profit will be Rs.12.35 per share (Rs.920 – Rs.907.65). Since the deal is for 1200 shares, my overall profit will be Rs.14,820 (Rs.12.35 * 1200).
The seller obviously incurs a loss, as he is forced to sell Axis Bank shares at Rs.907.65 per share instead of selling them in the open market at a much higher price of Rs.920 per share. Clearly, the buyer’s gain is the seller's loss.
This is a case where my directional view on Axis Bank shares has gone wrong. Therefore, I would stand to lose.
Assume on 25 Jan 2023, the stock price of Axis Bank went down from Rs.907.65 to Rs.900 per share; by this decrease, the futures price will also be around the same level. This means, as per the agreement, I am obligated to buy the Axis Bank shares at Rs.907.65 per share, which is a much higher price compared to what is available in the market. My loss will be Rs.7.65 per share (Rs.907.65 – Rs.900). Since the deal is for 1200 shares, my overall loss will be Rs.9,180 (Rs.7.65 * 1200).
I would obviously incur a loss as I’m forced to buy the Axis Bank shares at Rs.907.65 per share instead of buying it in the open market at a much lower price of Rs.900 per share. Clearly, the seller's gain is the buyer’s loss.
Under such a situation, neither the buyer nor the seller benefits, hence there is no financial impact on either party.
The futures agreement is tradable. Meaning, that at any point after entering into a future agreement, I can easily get out of the agreement by transferring the agreement to someone else. Closing an existing futures position is called “square off”. By squaring off, I offset an existing open position. In the case of the Axis Bank example, I initially bought 1 lot of Axis Bank futures, and when I square off, I have to sell 1 lot of Axis Bank futures (so that my initial buy position is offset)
When I intend to square off a position, I can either call my broker and ask him to square off the open position or do it myself at the trading terminal. In the example, we have a buy open position in Axis Bank futures (1 lot). To offset this open position, the square-off position would be to “sell 1 lot of Axis Bank futures”. The following things happen when I opt to square off the Axis bank position –
The broker (via trading terminal) scouts for a counterparty that would be willing to buy the futures position from me. In simpler words, “My existing buy position will simply be transferred to someone else”. That ‘someone else’ by buying the contract from me now bears the Axis Bank price’s risk of going up or down. Hence this is referred to as the “Risk Transfer.”
Note, that the transfer will happen at the current futures price in the market, i.e., 920 per share.
My position is considered to offset (or squared off) after the trade is executed.
Once the trade is executed, the margins that were initially blocked will now be unblocked. I can utilize this cash for other transactions.
The profit or loss made on the transaction will be credited or debited to my trading account the same evening itself.
And with this, the futures trade is now set to be complete.
you have a directional view of an asset's price, you can financially benefit from it by entering into a futures agreement.
To transact in a futures contract, one needs to deposit a token advance called the margin.
When we transact in a futures contract, we digitally sign the agreement with the counterparty; this obligates us to honour the contract.
The futures price and the spot price of an asset are different; this is attributable to the futures pricing formula (we will discuss this topic later)
One lot refers to the minimum number of shares that needs to be transacted.
Once we enter into a futures agreement, there is no obligation to stick to the agreement until the contract expires.
Every futures trade requires a margin amount; the margins are blocked when you enter a futures trade.
We can exit the agreement anytime, which means you can exit the agreement within seconds of entering the agreement.
When we square off an agreement, we are essentially transferring the risk to someone else.
Once we square off the futures position, margins are unblocked.
The money that you make or lose in a futures transaction is credited or debited to your trading account the same day.
In a futures contract, the buyer’s gain is the seller’s loss, and vice versa.
If you have any questions or suggestions, you can email me or comment.🙏🙏
