Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-28T15:38:04+05:30
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Introduction

Futures and options are both significant types of stock derivatives that are traded in the share market. Future option or Option Futures meaning can be quite confusing for a lot of people. Options Futures and other derivatives are traded in the share market. A future is a contract that is legally binding and is put to use when buying or selling a financial instrument or an underlying commodity or asset at a predetermined price on a particular date. 

On the other hand, an Options contract gives an opportunity and the right but does not put the investor under any obligation of buying or selling at a particular date or price, which is known as the expiry date.  
 

What is Future Option?

The future option meaning refers to a futures contract, which comes at a pre-decided price on a fixed date. Moreover, if someone asks what the future option is? The answer is pretty simple, a future option or options on future as it's called, is a contract that awards either the buyer or the seller of the option a right to buy or sell underlying options in future at a predetermined price. This is done on the day of the expiration day of the. 

In India, the expiration date is the very last Thursday of every month for all Options. 
An Option Futures contract is unique in the sense that it is a derivative of another derivative. A derivative gets its value from the value of a commodity or underlying asset. 
 

Different types of future options:-

1.    Options on index futures

Index futures are a type of stock futures. The stock index futures works on the same line as a futures contract or stock futures. A futures contract allows buyers or sellers to buy an underlying commodity or asset at a predetermined price in the future. A stock future enables you to purchase a particular stock quantity at a predetermined price in the future.
Option futures on index futures refers to the right to buy or sell any specific or particular index future. 

2.    Options on currency futures

This is a type of option on futures where the rights to trade currency futures happen at a predetermined or pre-fixed price on the expiration day of the contract. Indian exchanges, like the NSE National Stock Exchange, primarily allow futures trading in four currencies. 

These four currencies are EUR(EURO), GBP(Great Britain Sterling or Pound), USD (US Dollars) and JPY(Japanese Yen). For instance, a buyer can purchase an option to buy a US Dollar futures contract for a month at Rs. 60/$. 

3.    Future Options in the share market

Another type of option on futures is the future options in the share market. It is even called options on stock features and refers to the right of buyers or sellers to purchase or sell (this is also referred to as put option) future options in the share market or as stock futures contract at a mutually agreed price on the date when the tenor of the contract ends. 

Moreover, future options in the share market are binding contracts. It binds the buyer and seller to implement and execute the trade of the stock shares at a predetermined price on a particular date. 

4.    Options on interest rate futures

Options on interest rate futures is a contract that provides the right to buyers and sellers. Under this right, they can claim and trade-off interest rate futures at a mutually agreed price between both parties on a specific date. 

These options on interest rate futures are a kind of obligation of buying and selling debt items or products at a mutually agreed upon a fixed price, which is also known as the strike price. This is done on a specific future date. The underlying commodities or assets for interest rate futures are the government bonds of Treasury bills, also called T-bills.
 

How does a call future option work?

To understand how a call future option works, it is essential first to understand what a call future option is. This call future option is a trading contract in which a buyer has the right to buy either a stock future or commodity, currency which is at a mutually agreed price or, as it's called, stock price on the expiration date of the contract. 

With call future options, the buyer is in a long position which means they will exercise their right to buy an underlying asset if and when the strike price gets lower than the prevailing prices in the futures market. By purchasing a call option, what the buyer is eventually doing is that they are buying the right wherein they may/may not exercise this right by paying a premium on the expiration date.

In the call future option, hedging bets can even go wrong sometimes. If the index futures trades less than the strike price, then another trader involved will suffer a notional loss.
 
In a call option, if the strike price is higher than the prevailing price of index futures on the day expiration day of the contract, the trader is said to be out of cash or money. In this case, the other trader can buy futures contracts instead of the buying right. 
 

What is a put option on the futures?

A put Option Futures trading contract gives the trader a right to sell an underlying asset which is the futures contract, at a predetermined price on the expiration date of the contract.

With the put options, the one owning the option is known to be in a short position, which means they are looking to sell an underlying futures contract. This will be sold at a strike price that is higher than the current price of the futures contract. 
 

How Options On Futures Work

Option Futures are the contracts that give the right, not the obligation to buy (go long) or sell (go short) any underlying asset. In this case, it is the futures contract at a predetermined price on a particular date on the day the contract expires. 

Furthermore, an Option Futures contract is similar to a stock option which is the same and does not put the buyer under any obligation but just the right. This means that a futures option or options on a futures contract are a derivative of derivative security. However, the contract specifications and contract of these do not necessarily add any leverage to an already existing leverage. 

For instance, S&P 500, Standard and Poor's 500, a stock market index and an option on this futures contract, can be considered a second derivative of this S&P 500 index as the futures are derivatives of the index. Time decay which is also known as theta works on Option Futures in the same way as options on other security derivatives. Hence traders must account for this change. 

Furthermore, it would help if you remembered that for call options of futures, the holder enters into a long position of the contract and buys underlying assets at the options strike price. On the other hand, for put options, the holder enters into the short side of the contract and sells the underlying assets at the strike price. 
 

Example of Options on Futures

An example of Option on Futures contracts will make it easier to understand it well and better. Let us understand it with an illustration by taking the S & P 500 Futures contract. S&P 500 is the most popularly traded and is called the E-mini S&P 500. It allows the buyers to control the amount of cash which is worth 50 times the value of the S&P 500 index. Therefore, if the value of the index were to be around $2000, this contract would control the value of $100,000 in cash.

Further, if the value of the index were to increase to $2020, then the cash controlled would be worth $101,000. The difference here would be a $1,000 increment. The increase would amount to a 25% gain, according to this example. 

Buying an option on the index would result in being less expensive. For example, when the index is priced at $2,000. Suppose an option with a strike price of $2,010 might be quoted at $17 within two weeks before the expiration date. A buyer of this specific option would only have to pay the option price, which is $50 times the dollar spent. 

So this would mean that the price of the option would be $850 plus the commissions and fees. Depending on the stroke you buy, the money traded may/may not be leveraged to a greater extent than with futures alone. 
 

Further Considerations for Options on Futures

There are various other moving parts to consider when valuing Option Futures contracts. Their various parts include: 

●    Fair value 

The fair value of the Option Futures contract is the same as the cash or the spot price of an underlying asset.

●    Premium 

The difference on the Option Futures contract is called the premium. 

●    Margin 

Option Futures allow the owners to control large amounts of the underlying assets with smaller amounts of money. This is owed to the superior margin rules, also known as the Span margin. 

This helps in providing profit potential and additional leverage. However, with a potential for profits comes the loss potential for the total amount of options contract purchased.  

It is essential to note that the primary difference between stock options and the futures option is regarding the change in underlying value, which is represented by the stock option price change. 

A $2 change in the stock option is equal to $2(per share), which is going to be uniform for all the stocks. In this example of S&P 500 futures, a $2 change in price is equivalent to worth $50 for each contract that is bought. Although this amount is not uniform for all future options markets and is highly dependent on the number of commodities, bonds or index defined by every futures contract and the specifications surrounding that futures contract. 


 

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Frequently Asked Questions

Future contracts are standardized contracts that can be bought and sold on an exchange by the investors. These contracts allow investors or traders to trade in an underlying commodity or underlying asset at a predetermined price on a pre or prior-specified date, i.e. the expiration date for the options. 

Both options and futures have their own pros and cons. One advantage of options over futures is obvious, which is that an options contract gives the buyer the right and doesn't put them under an obligation to buying or selling a financial instrument or an asset at a fixed and predetermined price on or before the predetermined future month. 

Earlier, in 2015, the limit was Rs.5 lakh. At present, SEBI securities and the exchange board of India have introduced stocks for options trading to be set at Rs. 7.5 lakh. Therefore, the lot size is not fixed and keeps changing with the change in the stock price. 

You can begin trading in F and O by opening a trading account or derivative trading account. With this account, you can start trading from anywhere in F and O. 

Futures and options are two derivatives that are used by traders to buy or sell an asset at a pre-decided price. The profits are made when the price rises when traders are in a buy position and when in a sell position, a fall in price becomes beneficial. 

Futures are better as they have several advantages over options. This is because they are often easier to understand and value, are more liquid and have a higher margin use. However, it is best to know all risks involved first before trading futures. 

When it comes to being safer, options are considered safer than futures. Futures are riskier as they are directly involved in volatility and asset prices. On the other hand, options react in a different manner to the underlying asset price movement and allow a relatively long time to curtain and manoeuvre losses.