This column attempts to empower you with the knowledge to trade confidently in the derivatives market. As the world wide web is filled with primers on derivatives, we delve straight into our first topic for discussion in this column: how to choose between futures and options.

We will assume that you have a positive view on, say, the NSE 50 Index. You can arrive at this view by analysing chart patterns or by paying for a research service. Should you buy futures or buy a call option or short a put option?

Futures Vs Options

Your objective when you trade derivatives is to set up a position that will gain the most when the underlying moves in line with your expectations.

Now, futures move closely with the underlying than do options. Suppose you expect the NSE 50 Index to go up 100 points, the movement in the Nifty futures contract will be close to 100 points. The permitted lot size is 75 for the NSE 50 Index; permitted lot size acts as a contract multiplier for an index and represents the number of shares you have to buy for single-stock futures or equity options. Therefore, the total profit you can generate if you buy index futures is close to, if not, ₹7,500 (100 points times 75).

Suffice it to understand that options move slowly compared to futures. Therefore, even though the contract multiplier is the same for options, you will get lower profit if you trade options instead of futures.

This does not automatically make futures the preferred route to trading derivatives. If the NSE 50 Index declines by 100 points instead, you will suffer ₹7,500 loss on your futures! Your loss, in comparison, will be lower for options; the maximum you can lose is the premium you pay to buy the option.

Level of confidence

Given symmetrical nature of profits and losses on futures, the choice between futures and options depends on the level of confidence you have of your view on the underlying. If you read the charts, you may want to ascertain whether the pattern is a high-probability trade.

If you are subscribing to a paid research, your judgment could be based on the tone of the report. Is the analyst confident of his or her view? This is the qualitative aspect to your decision.

The quantitative aspect depends on the reward-to-risk ratio. Typically, a trade is meaningful if you aim for at least 2 points of reward for every point of risk. For instance, if you expect the index to move up by 100 points, your stop loss (based on the charts) should be not more than 50 points below your entry price.

So, now that you have a high-probability setup on the charts and at least a two-to-one reward-to-risk ratio, you are ready to set up your futures trade. The above argument is true for single-stock futures as well. Remember to keep adequate funds in your bank account linked to your brokerage account to provide for initial margin and mark-to-market margin on your futures position.

Optional reading

For a given underlying and maturity, the delta for options is less than the delta of futures. This is because options have high theta or time decay. Remember, the entire time value of an option will have to come down to zero at expiry; the time value of an option comprises the time to maturity of the option and its implied volatility. Futures, on the other hand, is not affected by this factor. This is the reason why futures move closely with the underlying than do options.

In practice, it is not uncommon for index futures contract to move up by more than the spot index. This is because index futures are actively traded in the market whereas the spot index is not a tradable product.

The author offers training programmes for individuals to manage their personal investments.

Looking to understand derivatives better? Send your queries to derivatives@thehindu.co.in

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