In the share market and commodities market, along with shares and commodities cash trading, trading is also carried in futures and options. These are also known as derivatives.
Many persons knows that in future market you have to purchase and sell in lot and you have to deposit only the margin money. But doesn’t know what is an actually future and options are.
Futures
Futures is a contract between two persons to sell or purchase a described item (share or commodity) and described quantity at a future date. When you are buying a future of Tata Chemicals, it means that you are contracting with seller to buy the no. of shares in lot of Tata chemicals at a future date.
In Indian share market, the settlement is done on last Thursday of the month and settlement is done in cash only. It means that you don’t need to and can’t purchase share from the seller on last Thursday. The difference between the future price at which you purchased the lot and the end of day of last Thursday market price will be paid or taken from you in cash.
If the last Thursday of month is a trading holiday then settlement will be on the previous trading day.
Options
Option is a contract in which the purchaser of option has an option to purchases/sell the described share or commodity at described price in described quantity at a future date. Since the purchaser of option is not binded to purchase or sell this is called an option.
The option in which purchase of option can purchase the share or commodity is called call option and the option in which purchaser of option can sell the share or commodity is called put option.
Settlement date of options is also same as that of futures i.e last Thursday of the month and also settled in cash.
For example – A person Mahesh has purchased Call option of Tata Chemicals of lot of 500 shares of Rs. 100 for Rs. 2. Now Mahesh has an option to purchase 500 shares of Tata chemicals at Rs. 100 on the settlement date. If the price of share is more than Rs. 100 on settlement date then mahesh will exercise the option and purchase the share at Rs. 100 and earned a profit of (Market price – rs. 100 – Rs. 2) . If price is less than Rs. 100 then Mahesh will not exercise the option and don’t purchase the share and will be in a loss of Rs. 2 per share.
However as previously stated the settlement is done in cash only. Therefore if market price is Rs. 110 then the seller has to give Rs. 5000 to Mahesh.
Also note that it is not compulsory to carry forward the contract by a person up to the settlement date and can buy or sell before settlement date to clear his position.
Related Concepts
In cash market you can sell only what you have. If you don’t have shares of a company then you can not sell it. (Although you can sell first but you have to cover up it in same day). But in future and options you can sell them first. After selling you can buy them later to clear position or it will settle on the settlement date. So if you believe that the price of a share/commodity will fall you can make money from the price decrease also.
In share market, the number of shares is fixed for a company. For example a company issues 1 crore shares, so the number of shares remains 1 crore only other than in a case when the company issues more shares or buy back shares.
But in futures and options there is contract for shares or commodity, no real shares or commodity is involved. When you buy a future and other sells it, a position is opened in market. For you its a buy position and for seller its a short position. The number of contracts open in a market is referred as open positions and declared by the stock exchanges.
European options and American options
In American options the purchase of options can exercise its option to purchase or sell at any time before or at the day of maturity. In European options the purchaser of options can exercise the option at the end of maturity only. In Indian stock market, only European options are traded therefore the price at end of settlement date is considered.
Turnover of trading in futures and options is calculated on the basis of difference between buying and selling price of futures and the selling price of options. Audit is also required under section 44AB of the Income tax Act if the turnover amount exceeds the specified limits.
