A Lesson in options and futures
A lot has been written on how investors lose money in the share market. While it is true that our markets are lacking depth and are subject to lot of manipulation since the deterrent laws are not in place, it is also true that people lose money due to excessive gambling tendency that an average Indian has. Some study I had read has shown that after Chinese, one of the most speculative community is Indians. This speculative tendency makes people indulge in stock market investments more to speculate than to invest. An investor talks of returns but a speculator talks of jackpots. Overnight richness and easy money is the target of a lot of people.
Accepted that people resort to share markets out of speculative tendencies, it is necessary to guard them against their own passion and operating on Options market helps in limiting one’s losses in share market. To explain, what is Options and Futures let me give a simple example :
If I promise to sell you a Maruti car after one month at Rs.3 lakhs and you have to buy the car on the appointed date. This is a Future contract. The essential element is a future date of performance of contract at a fixed price and compulsion on both parties to perform. This same promise if I give you to sell you a Maruti car after one month at Rs.3 lakhs but if I also give you an option to buy or not to buy the car after a month, then it becomes an Option contract. For having the option to buy or not to buy you have to pay a small price in the form of a deposit which is non refundable. This is called Option Premium.
To apply this understanding to the stock market, would mean that you can buy Reliance at a price which is fixed today and the date of purchase is also fixed today. If you buy a Futures contract, it would mean that Reliance shares would be given to you on the appointed date at the pre determined price. You have to honour the contract irrespective of the prevailing market price. The risk here is a probable loss of the entire purchase consideration i.e. the price could go as low as 0 or a probable profit of unlimited amount since the price can go to any level.
If you buy an Options contract, it would mean that Reliance shares would be given to you on the appointed date at the pre determined price. You have the option to honour the contract only if the Reliance price has gone above your determined price. If the price has gone down you need not honour the contract. The risk here is the loss of premium that you paid for the contract and probable profit of unlimited amount since the price can go to any level.
If we compare the Options and Futures contract it is very clear that the probability of profit is unlimited in both the alternatives. However, the probability of loss is unlimited in a Futures contract and limited to extent of premium in an Options Contract. Investors who desire to speculate must understand these concepts clearly in order to avoid making huge losses while trading in Derivatives Market.
Derivatives market can be effective used as a hedging tool also. If you have shares that have been purchased with a long term perspective in mind, and in the short run markets are likely to be depressed, the shares can be sold in the Options market by buying a put option and repurchased when the prices go down. If your judgment is wrong, your loss would be the premium amount only and the profit would be the temporary fall in price. By using Options trading you can make profit in the short run due to fall in price and reduce your cost of holding.
To operate in the share market it is necessary to take a view on the market and based on the view a strategy may be decided. If you expect the market to go up, a call option may be purchased. It is nothing but an option to buy. If you expect the market to go down, a put option may be purchased which is nothing but an option to sell at a future date. If you expect the market to be within a particular band, then call as well as put options would both be purchased to take advantage of whichever side the market goes. This is therefore a highly versatile product for making investment decisions.
Investors who have yet to learn about the derivatives market must restrict their activities to the strategies mentioned above. They should experiment by trading in small lots and learn the intricacies of the Derivatives Market. Derivatives are here to stay and Portfolio Return maximization can be achieved by successfully using these techniques.
Author is widely recognized as the Mutual funds investment specialist and IPO investment tips.
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