Derivatives, as the name suggest are the derivative products whose price is derived from the underlying assets like stocks, commodities, currency or bullion. Derivatives are financial instruments which are very popular among hedgers and traders. They are traded on exchanges like any other stocks. Derivatives are traded at separate segment of existing exchange like NFO. Derivatives trading is broadly done through Future and Options.
Future and Options are also known as FNO. They are considered as high risk and high rewarding products. Future and options, both are derivative instrument, but are traded differently. They were traditionally being used for hedging but now because of their high rewarding nature, they are attracting fresh breed of aggressive traders.
Future Trading
Future trading is quite different from trading in cash market. In cash market, you buy stock in multiple in one and pay full transaction amount. You can hold it as long as you like where as in future trading, you cannot buy stocks in multiple of one, you have to buy them in lots by paying a margin money and every lot has a expiry which is last Thursday of every month and you can maintain your position for maximum three months. You can go long or short on a stock or index depending upon your short term view on it. When you think that stock or index will move up, you buy it at low and sell it when prices move higher. This is known as going long and when you think that prices will move down, you sell it before buying it and then buy when it is low. Futures are linear product, which means, they posses unlimited gains and unlimited risk, as well.
So, when you buy/sell a future contract, it gives you a obligation to buy or sell the underlying asset at the expiry date. All future contracts are dated. They are settled at a daily basis. So, if you at the end of day, you are having a loss of Rs 100, then you need to add funds to your account and if you have gained Rs 100 then they will be credited to your account.
Options Trading
Options are the second type of derivative trading. In option trading, you pay a margin money and get the right to buy or sell a particular index/scrip but there is no obligation to do that. This makes it quite economical for trader with relatively low capital.An option is available in two form,
1. Call Option
2. Put Option
1. Call Option- When you think that the price of a particular index or scrip will move up, you buy Call Option.
2. Put Option- If a trader believe that price will go down, then Put Options are chosen.
An option is a non-linear product where risk is limited and profit is unlimited. Risk is limited because one will lose the margin money in worst case scenario, but can gain unlimited if markets moves in the desired direction. Strike Price is a key component in Option Trading. The Price at which scrip/index is trading in market is spot price and the price which a trader expect it to achieve in future is strike price. It can be high as well low than spot price, depending upon the call or put options. Theoretically, it is defined as the fixed price at which the owner of an option can purchase (in the case of a call), or sell (in the case of a put), the underlying security or commodity. It’s the price at which the stock will be bought or sold when the option is exercised. Other Important factors in the Options trading are;
In the Money
A call option whose strike price is below the current price of the underlying scrip or index and put option whose strike price is above the current market price.
For example- If Reliance Industries is trading at Rs 1000, then the RIL’s call option strike price below Rs 1000 like Rs 980, Rs 960 would be In the Money.
Out Of the Money
A call Option whose strike is above the current market price and put whose strike price is below the current price.
For Example- Lets refer to the previous example of Reliance Industries, So if it is trading at Rs1000 then the call options with strike rate above Rs 1000 would be Out Of the Money.
At the Money
If the strike price is equal to the current price, then it is At the Money.
It is very important to understand that one should only trade In the Money Options.
Pricing in Future and option is very important, we will look into that in our later posts.
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