Equity Derivatives has two byproducts – futures and options
For instance, you have one lakh shares holding…now futures and options are tools to lower your risks in the future. Why do you need to lower your risk? In case there’s a crisis situation in the market, and the market crashes or goes negative, then the F & O option can help in this situation through hedging.
What is hedging?
Hedging is similar to insurance as we take an insurance cover to protect ourselves from one or the other loss.
Futures are like a wholesale market…we can only buy the product in bulk. We cannot buy a couple of products like the retail market. The exchange brings a contract along with an expiry date. We can either buy or sell it or sell and buy. Contract cannot be owned by us. It can be held only till its expiry date. Lot sizes are defined in futures. For instance, one lot may contain 500 shares or 1000 shares…now the lot size may differ from stock to stock.
Now imagine the price of a share in equity is 180 rupees, if you purchase 3000 shares, you can only buy those shares by paying 5, 40,000 in a single payment, that is, 180 x 3000
If you predict that the market may go up in future, so instead of making a single payment in equity you may buy in futures. In futures you just need to pay 25 to 40 % span margin. All you need to do is to maintain the span margin on a daily basis. Whenever you want you can exit the market with profit or loss. Futures are unlimited profit and unlimited loss.
Options is a hedging instrument. for instance, I pay an insurance premium of 20,000 for a car that cost me 10,00,0. Likewise in equity you have to pay a premium of 5000 to 10,000 for the one lac shares you have in hand. So how can we insure? There’s a strike price for every share in the market. For every strike price there is a call option and a put option. If the market is in uptrend you choose call option and for downtrend you choose put option. As far as options is concerned it is unlimited profit with minimum risk.