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How do futures work?

Expert View. Technicals Technical Chart Visualize Screener. Commodities Views News. Forex Forex News Currency Converter. Precious Metal. Market Watch. Pinterest Reddit. By Ram Sahgal. Apart from a cash market where shares are bought and sold, the exchanges have a segment where futures and options on shares and indices like Nifty and Bank Nifty can be purchased and sold.


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What is a future and what is an option contract? A futures contract allows you to buy or sell an underlying stock or index at a preset price for delivery on a future date.

Options are of two types -- call and put. A put option lets a buyer sell the share at preset price during the contract life.

Futures Market Explained

A call seller has the obligation to give delivery to the buyer at the preset price even if current market price is higher than former. A put seller has the obligation to buy underlier from the buyer at preset price even if CMP of the share is lower.

What Are Options?

If the stock price at expiration is below the exercise price by more than the premium paid, he will make a profit. If the stock price at expiration is above the exercise price, he will let the put contract expire and only lose the premium paid. In the transaction, the premium also plays a major role as it enhances the break-even point.

For example, if exercise price is , premium paid is 10, then a spot price of to 90 is not profitable. He would make a profit if the spot price is below It is important to note that one who exercises a put option, does not necessarily need to own the underlying asset.

Specifically, one does not need to own the underlying stock in order to sell it. The reason for this is that one can short sell that underlying stock. A trader who expects a stock's price to decrease can sell the stock short or instead sell, or "write", a call. The trader selling a call has an obligation to sell the stock to the call buyer at a fixed price "strike price". If the seller does not own the stock when the option is exercised, he is obligated to purchase the stock from the market at the then market price.

If the stock price decreases, the seller of the call call writer will make a profit in the amount of the premium.

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Options, swaps, futures, MBSs, CDOs, and other derivatives

If the stock price increases over the strike price by more than the amount of the premium, the seller will lose money, with the potential loss being unlimited. A trader who expects a stock's price to increase can buy the stock or instead sell, or "write", a put. The trader selling a put has an obligation to buy the stock from the put buyer at a fixed price "strike price". If the stock price at expiration is above the strike price, the seller of the put put writer will make a profit in the amount of the premium. If the stock price at expiration is below the strike price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the strike price minus the premium.

Combining any of the four basic kinds of option trades possibly with different exercise prices and maturities and the two basic kinds of stock trades long and short allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several. Strategies are often used to engineer a particular risk profile to movements in the underlying security.

Difference between Futures and Options | Kotak Securities®

For example, buying a butterfly spread long one X1 call, short two X2 calls, and long one X3 call allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss. Selling a straddle selling both a put and a call at the same exercise price would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss. Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the risk of loss in the trade.

One well-known strategy is the covered call , in which a trader buys a stock or holds a previously-purchased long stock position , and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially offset by the premium received from selling the call.

Overall, the payoffs match the payoffs from selling a put. This relationship is known as put—call parity and offers insights for financial theory. Another very common strategy is the protective put , in which a trader buys a stock or holds a previously-purchased long stock position , and buys a put.


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  5. This strategy acts as an insurance when investing on the underlying stock, hedging the investor's potential loses, but also shrinking an otherwise larger profit, if just purchasing the stock without the put. The maximum profit of a protective put is theoretically unlimited as the strategy involves being long on the underlying stock. The maximum loss is limited to the purchase price of the underlying stock less the strike price of the put option and the premium paid. A protective put is also known as a married put. Another important class of options, particularly in the U.

    Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options. There are two more types of options; covered and naked. Because the values of option contracts depend on a number of different variables in addition to the value of the underlying asset, they are complex to value.

    There are many pricing models in use, although all essentially incorporate the concepts of rational pricing i. The valuation itself combines a model of the behavior "process" of the underlying price with a mathematical method which returns the premium as a function of the assumed behavior. The models range from the prototypical Black—Scholes model for equities, [17] [18] to the Heath—Jarrow—Morton framework for interest rates, to the Heston model where volatility itself is considered stochastic.

    See Asset pricing for a listing of the various models here. As above, the value of the option is estimated using a variety of quantitative techniques, all based on the principle of risk-neutral pricing, and using stochastic calculus in their solution. The most basic model is the Black—Scholes model.

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    More sophisticated models are used to model the volatility smile. These models are implemented using a variety of numerical techniques. More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates. The following are some of the principal valuation techniques used in practice to evaluate option contracts.