Introduction to options and futures

Remember the different types of financial markets we saw, back in module 1? You’ll recall that there was one kind - the futures market - where the delivery of the asset happens at a later date. Also known as the derivatives market, this is a really exciting place where a lot of action occurs. 

Future contracts and option contracts, commonly known as futures and options, are two major contracts that are traded in the derivative markets. Futures and options are basically derivative financial instruments, or simply, derivatives. Let’s see what this means.

What are derivatives? 

A derivative is essentially a contract whose value is ‘derived’ from the performance of an asset, known as the ‘underlying asset’. The underlying asset in a derivative contract can be anything, from equity shares and bonds to commodities and currencies.  

Two of the most popular kinds of derivative contracts are futures and options. What are options and futures? Let’s get to this one by one.

What are futures in trading?

Before we get into the technicalities of a futures contract, let’s meet Sudhir and Bheem.

Sudhir owns a fruit stall that’s stocked with fresh, ripe fruits of all kinds. A few feet down from his stall, we have Bheem, who runs a juice shop. One day, during a quick break at teatime, Sudhir and Bheem get into a discussion about the changing prices of fruits. 

Sudhir, the owner of the fruit stall, believes that the prices of fruits are likely to fall in the coming month. Bheem, who runs the juice shop, thinks the prices of fruits will most probably increase instead. 

Before heading back to their businesses, the two of them strike a deal about trading a pineapple. These are the terms of their deal.

• Today, a pineapple sells for Rs. 50.
• Anticipating that the prices will fall and hoping to make a profit, Sudhir agrees to sell a pineapple to Bheem for Rs. 60 one month from now. 
• Meanwhile, Bheem, who believes that the price of the fruit will likely increase at least up to Rs. 80, agrees to buy a pineapple for Rs. 60 one month from now.

This deal that they struck up, that’s a futures contract. 

So, in the financial markets, a futures contract is a deal where a buyer and a seller agree to trade an asset at a predetermined price, on a predetermined date in the future. Both the buyer and the seller are obligated to honor their end of the contract. 

Getting back to our deal with the pineapple, this means that both Sudhir and Bheem must carry out the trade they agreed upon, one month from when they struck the deal. 

• Say that one month later, a pineapple trades at Rs. 70.
• But as per their contract, Sudhir will have to sell the fruit to Bheem for Rs. 60.
• So, Sudhir, the seller, suffers a loss of Rs. 10. 
• But Bheem, who will otherwise need to buy the fruit for Rs. 70 elsewhere, gets to buy it from Sudhir at Rs. 60, thereby getting a notional profit of Rs. 10.

Okay, given all of this, what exactly is the role of a futures contract? Can you trade those contracts to make a profit? Well, it turns out that you can. In fact, futures contracts are regularly traded on stock exchanges by traders who seek to make short-term gains and profit from stock price fluctuations. 

Trading a futures contract

But how do you gain from trading a futures contract? Sudhir can show us how. 

Let’s assume that three weeks after he entered into the contract, he’s in need of some cash urgently. Meanwhile, the price of a pineapple drops from Rs. 50 three weeks ago, to Rs. 40 today. If this trend continues, Sudhir, who has a deal to sell his fruit for Rs. 60, can make a great deal of profit one week later. 

But he wants some money now. So, he devises a smart strategy to profit from his contract. Approaching another fruit seller, Sudhir shows him the contract and offers to trade it for some money. 

“I have a contract that allows you to sell a pineapple for Rs. 60 one week from now,” Sudhir tells the other fruit seller. “And seeing how the price of pineapples is dropping steadily, you can use this contract to make a lot of profit. Minimum Rs. 20,” he says.

In return for the contract, Sudhir asks for Rs. 10 right then, so his needs for some emergency money are met. 

You see, the value of Sudhir’s contract grew because the price of the underlying asset - the pineapple - fell. And since Sudhir had a deal that allowed him to sell the pineapple at a higher price, his contract had greater value. 

This is what we mean when we say that a derivatives contract derives its value from the underlying asset, which, in this case, is a pineapple. 

What are options in trading?

Options are also quite similar to futures in the sense that both the buyer and the seller of the underlying asset agree to buy and sell the asset at a predetermined price, at a predetermined future date. 

However, there’s a slight difference between options and futures. 

A future contract is an obligation for both the buyer and the seller. It cannot be dishonored under any circumstances. 

But in an options contract, there’s no such obligation. It’s merely a right to buy or a right to sell the underlying asset.  

Sounds a little complex? Don’t worry. Our real-life analogy can help you understand this better.

Let’s take the case of Sudhir and Bheem again. 

Say Bheem is doubly sure that the price of pineapples, which are trading today at Rs. 50 each, will rise. Sudhir, on the other hand, believes that the price of pineapples may fall. So, depending on their outlook, they enter into the following contract. 

• Bheem agrees to buy a pineapple from Sudhir one month from now, at Rs. 60.
• Sudhir, on the other hand, agrees that he may sell the fruit to Bheem at that price, on that day. 
• In other words, Sudhir has a right to sell (or not sell) the pineapple on the said date. But if he does agree to sell, Bheem is under an obligation to buy.
• So, Bheem gives Sudhir this right (or this option) to sell. In return for giving Sudhir this right, Bheem charges a small amount of money from Sudhir. 

This deal that they struck up, that’s an options contract. 

Here, Sudhir has the option to sell his pineapple to Bheem at Rs. 60 one month later. 

This right to sell is known as a put options contract in financial terms. Commonly, it’s referred to as a put option. And the money that Sudhir pays Bheem for the right to sell is called a premium in financial terms.

In this case, here’s what happened.

• Bheem sold a put option (or the right to sell) to Sudhir.
• Sudhir, in return, paid a premium to Bheem.

Trading an options contract

This brings us to another question - can you gain from trading an options contract? Of course you can. In fact, just like futures, options are also regularly traded on stock exchanges by traders who seek to make short-term gains and profit from stock price fluctuations. 

So, how do you go about making gains from trading an options contract? Again, Sudhir can show us how. 

Much like the last time, say that three weeks after he entered into the put options contract, he’s in need of some cash urgently. Meanwhile, again, the price of a pineapple drops from Rs. 50 three weeks ago, to Rs. 40 today. If this trend continues, Sudhir, who has the option to sell his fruit for Rs. 60, can make a great deal of profit one week later if he exercises that right. 

But he wants some money now. So, he approaches another fruit seller, shows him the contract and offers to trade it for some money. 

“I have a contract here that gives you the option to sell a pineapple for Rs. 60 one week from now,” Sudhir tells the other fruit seller. “And seeing how the price of pineapples is dropping steadily, you can use this contract to make a lot of profit. Minimum Rs. 20,” he declares. 

“But that’s not all. If, by some chance, the price goes up past Rs. 60, you need not make the sale. You have the option to walk out,” he explains.

The other fruit seller is intrigued and in return for this right to sell, he gives Sudhir Rs. 20. So, Sudhir’s needs for some emergency money are met, once again. 

And that’s how an options contract is traded in the financial markets. 

The other side of the coin: What if Bheem had the right to buy, instead?

We saw in the above example that Sudhir had the right to sell his pineapple one month later. But what if we reversed that scenario? What if Bheem had the option to buy (or not buy) instead? Here’s how that would play out.

Here, let’s say that Sudhir is doubly sure that the price of pineapples, which are trading today at Rs. 50 each, will decrease in the future. Bheem, on the other hand, believes that the price of pineapples may increase. So, depending on their beliefs, they enter into the following contract. 

• Sudhir agrees to sell a pineapple to Bheem one month from now, at Rs. 60.
• Bheem, on the other hand, agrees that he may buy the fruit from Sudhir at that price, on that day. 
• In other words, Bheem has a right to buy (or not buy) the pineapple on the said date. But if he does agree to buy it, Sudhir is under an obligation to sell.
• Here, Sudhir gives Bheem this right (or this option) to buy the fruit. In return for giving Bheem this right, Sudhir charges a small amount of money from Bheem. 

This deal that they struck up, that’s also an options contract. 

Here, Bheem has the option to buy a pineapple from Sudhir for Rs. 60 one month later. 

This right to buy is known as a call options contract in financial terms. Commonly, it’s referred to as a call option. And the money that Bheem pays Sudhir for the right to buy is called a premium in financial terms.

In this case, here’s what happened.

• Sudhir sold a call option (or the right to buy) to Bheem.
• Bheem, in return, paid a premium to Sudhir.

Financially, what happens when you buy an options contract?

When you buy an options contract, here’s what happens. 

• You are required to pay a fee to the seller of the option contract. 
• This deposit that you make is what is known as the ‘premium.’ 
• During the time of delivery of the asset, you could choose to exercise your option and buy (or sell) the asset at the predetermined price. 
• If you choose to walk away and not exercise the option (to buy or sell), you’ll essentially forfeit the premium that you paid to the seller of the options contract.

The two types of options 

As we saw in the examples above, there are two types of option contracts that you need to be aware of - call option and put option. Each kind has its own terms. Let’s take a quick look at these two contracts.  

Put option 

A put option is a contract that gives you the right to sell an asset at a predetermined price, on a predetermined date. You can buy or sell put options in the financial markets. 

• Buying a put option - When you buy a put option, you get the right to sell the asset.

• Selling a put option - When you sell a put option, you give the right to sell the asset.   

Call option

A call option is a contract that gives you the right to buy an asset at a predetermined price, on a predetermined date. As with put options, you can also buy or sell a call option. 

• Buying a call option - When you buy a call option, you get the right to buy the asset. 
• Selling a call option - When you sell a call option, you give the right to buy the asset. 

On the risk-return spectrum, options and futures fare higher than equity. They come with a greater risk, but they also bear the potential for higher returns. 

Wrapping up

With this, we’ve come to the conclusion of this lesson. The objective was to just give you an introduction to futures and options. The world of derivatives is large with a lot more to learn. We’ll be delving even deeper into derivatives in the upcoming modules and chapters on options and futures.       

A quick recap

• A derivative is essentially a contract whose value is ‘derived’ from the performance of an asset, known as the ‘underlying asset’. 
• The underlying asset in a derivative contract can be anything, from equity shares and bonds to commodities and currencies.  
• Two of the most popular kinds of derivative contracts are futures and options. 
• A futures contract is a deal where a buyer and a seller agree to trade an asset at a predetermined price, on a predetermined date in the future. Both the buyer and the seller are obligated to honor their end of the contract. 
• Options are also quite similar to futures in the sense that both the buyer and the seller of the underlying asset agree to buy and sell the asset at a predetermined price, at a predetermined future date. 
• A put option is a contract that gives you the right to sell an asset at a predetermined price, on a predetermined date. You can buy or sell put options in the financial markets. 
• When you buy a put option, you get the right to sell the asset. When you sell a put option, you give the right to sell the asset.   
• A call option is a contract that gives you the right to buy an asset at a predetermined price, on a predetermined date. As with put options, you can also buy or sell a call option. 

• When you buy a call option, you get the right to buy the asset. When you sell a call option, you give the right to buy the asset.