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ET explains how index futures and options are traded to hedge one’s bets or speculate on the market direction:
1.
What’s better to trade — Nifty futures or optionsIt depends on a trader’s risk appetite and whether one is a speculator or hedger, and also volatility.
The better informed and savvy buy or sell futures and write call or put options.
Those with lower risk profile and financial wherewithal could buy a call or put option as it’s cheaper and isn’t marked to market daily.
2.
How does it workAssume a trader has a view that Nifty will rise beyond 11,000 by January 31.
He is well capitalised and has a stomach for risk.
He could simply buy futures at the Friday closing of 10,937 or buy an 11,000 call option for Rs 79 a share (75 shares make one Nifty contract).
The trader could also write a Nifty put option as he is bullish .
He will lose only if the Nifty falls from the current level of 10,937 for futures and stays below 11,000 for options by expiry on January 31.
Assume that the Nifty hits 11,100 by expiry.
The gross profit on futures is Rs 12,225 at contract level — difference between 11,100 and 10,937 multiplied by 75.
The 11,000 call expires Rs 100 ‘in the money’.
On that you make gross profit of Rs 1,575 as you had invested Rs 5,925 (79×75) in the options contract.
(All the figures are rounded off.)
3.
So, is the gain greater from trading futuresBy quantum of money yes, but on a relative basis, return on investment is far greater in options.
To buy the 11,000 option the trader paid Rs 79 a share or Rs 5,925 a contract.
The gain was Rs 21 a share or Rs 1,575.
The return was a gross 27 per cent.
On futures he puts up a 15 per cent margin to buy one contract (10,937×75) or Rs 1.23 lakh.
The return of Rs 12,225 is 9.9 per cent.
The funds are blocked and the trader loses on interest — carrying cost.
4.
Does that mean options are a better choice The takeaway is that trading an out-of-the-money (OTM) option is cheaper than a futures contract as one is not subjected to mark-tomarket losses as in the case of a futures contract or an options seller.
The maximum loss for an option buyer is his premium or the price he pays to buy the option from a seller.
In futures profits can be unlimited but so can losses.
On the flip side, time decay erodes the value of an option, but this doesn’t apply for a futures contract.
Also the sum earned is far greater in futures than for an OTM option given that margin is returned along with the gain.
Option buyers make relatively smaller sums but their risk is lesser than for a futures buyer.
Also those with lower risk taking ability can dabble in liquid options than on index futures.
5.
How can one protect oneself from lossesBy trading with strict stop losses.
