What is Future Option?
A future option is a type of contract that gives a trader the right to buy or sell a futures contract at a pre-agreed price on a specific date. Essentially, this contract, also known as an option on futures, lets you trade the underlying futures contract at a predetermined price when it expires.
In India, these options typically expire on the last Thursday of every month, which means you need to be aware of approaching deadlines. Unlike futures, which obligate both parties to trade at a set price on a specific date, an option offers flexibility.
You can decide whether or not to execute the trade based on the terms and market conditions when the expiration date arrives. This right to choose, without an obligation to act, gives options their unique appeal in trading strategies.
Future option contracts stand out because they derive their value from another derivative. To clarify, an option gains its value from the futures contract it’s tied to, while the futures contract derives its value from underlying assets like commodities, bonds, indices, or stocks.
This makes future options a “derivative of a derivative,” adding complexity but also opportunity for traders. You can choose between call or put contracts, which may involve assets such as commodities, stocks, or interest rates, providing diverse strategies for potential gains.
Different Types of Future Options
1. Options on Index Futures
An option contract on index futures gives you the right to buy or sell a specific index future, such as the Nifty 50 or S&P BSE Sensex, at a mutually agreed price on a predetermined date, known as the contract’s expiration date.
For example, you might hold the right to buy Nifty futures at 23,800 points when the contract expires. If the Nifty trades above 23,800 at that time, you can execute the trade and potentially earn a profit.
2. Options on Currency Futures
Currency futures options let you trade futures contracts involving currency pairs at pre-set prices upon expiration. In India, exchanges like the NSE offer trading in currencies like the US Dollar (USD), Euro (EUR), Great Britain Pound (GBP), and Japanese Yen (JPY).
For instance, suppose you buy an option to trade a USD futures contract at ₹84/$. If the market price exceeds ₹84/$ at expiration, you stand to profit by exercising the option.
3. Future Options in the Share Market
Future options in the share market, or options on stock futures, give you the right to buy (via a call option) or sell (via a put option) a stock futures contract at predetermined prices when the contract matures.
For example, let’s say you have a call option to buy Reliance Industries futures at ₹1,400 per share. If the market price rises above ₹1,400, you can exercise your option to profit from the difference.
Conversely, if you hold a put option, you can sell Reliance shares at ₹1,400, safeguarding against any decline in the market price.
Stock futures involve binding contracts between buyers and sellers to trade shares at specific prices on predetermined dates. These contracts serve as tools for speculation, hedging, and strategic trading.
4. Options on Interest Rate Futures
Interest rate futures options give you the right to buy or sell interest rate futures contracts at a mutually fixed price. These contracts often involve government bonds or treasury bills (T-bills) as their underlying assets.
For example, you might purchase an option to trade a government bond futures contract at a 7% interest rate. This strategy helps you manage risk if market interest rates fluctuate significantly.
What is a Call Future Option?
A Call Future Option is a type of financial contract that gives the buyer the right, but not the obligation, to buy a futures contract either a currency, commodity or stock futures at a specified price (known as the strike price) on on the date of options expiry.
When you buy a call option, you take a long position, which means you can exercise your right to buy the underlying asset if the strike price is below the current market price of the futures. By purchasing a call option, you gain the right to buy, which you may choose to exercise or not on the expiration date, depending on market conditions. This right comes at the cost of a premium, which you pay upfront.
How Does a Call Option work in Futures?
A call future option gives the buyer the right, but not the obligation, to purchase a futures contract at a specified price (strike price) on or before a specific date. In essence, it allows traders to speculate on the future direction of an asset with limited risk while providing the potential for high rewards.
When a trader buys a call option, they are bullish on the underlying asset and believe its price will increase. Conversely, the seller of the call option is typically bearish or has a neutral stance, expecting the price to remain steady or decline.
For Example, let’s say Trader A holds a bullish opinion that the Nifty index, currently trading at 19,500, will rise over the next month. Trader A decides to buy a Nifty call option with a strike price of 20,000, expiring in one month, for a premium of ₹100 per unit.
Scenario 1: Nifty Rises
If the Nifty index climbs to 20,500 before the option’s expiration date, Trader A can exercise the call option. They effectively purchase Nifty futures at 20,000, below the market level of 20,500. This yields a profit of 500 points per unit, minus the ₹100 premium paid, giving a net gain of 400 points per unit.
Scenario 2: Nifty Falls or Stays Below 20,000
If the Nifty index remains at 19,500 or declines, the call option becomes worthless since buying at the strike price of 20,000 would not make financial sense. In this case, Trader A would choose not to exercise the option, limiting their loss to the ₹100 premium paid.
In this example, Trader A’s bullish outlook on the Nifty index allows them to potentially profit from a market rise, while their risk is capped at the initial premium spent on purchasing the call option.
What is a Put Future Option ?
How Does a Put Option Work in Futures?
A put future option gives the buyer the right, but not the obligation, to sell a futures contract at a specified strike price on or before a particular expiration date. Traders use put options when they have a bearish view on an asset, allowing them to profit if the price of the asset declines while limiting their losses to the premium paid for the option.
For example, let’s say Trader A holds a bearish opinion that the Nifty index, currently trading at 19,500, will drop over the next month. Trader A purchases a Nifty put option with a strike price of 19,000, expiring in one month, for a premium of ₹100 per unit.
Scenario 1: Nifty Falls
If the Nifty index drops to 18,500 before the option expires, Trader A can exercise the put option. They sell Nifty futures at 19,000, which is higher than the current market price of 18,500. This results in a profit of 500 points per unit, minus the ₹100 premium paid, giving a net gain of 400 points per unit.
Scenario 2: Nifty Rises or Stays Above 19,000
If the Nifty index rises to 20,000 or remains above the strike price of 19,000, the put option becomes worthless because it’s more profitable to sell at the higher market price. In this case, Trader A would not exercise the option, limiting their loss to the ₹100 premium they paid.
In this example, Trader A’s bearish outlook on the Nifty index allows them to potentially profit from a market decline, with the risk being capped at the initial premium spent on purchasing the put option.