Get Your F&O Basics Tools and Analysis

Everything I need to know about Futures and Options Trading and Analysis. No this is not what you will read in a text book so keep an open mind this is the real market.

I think most people are familiar with the Basics of this topic still I will try to explain the instruments in simple and brief to start with

Then follow it up with some simple advanced ideas and metrics to use while trading either instrument.

Two forms of derivatives exist, futures and Options

People chose derivatives to get leverage from the market. In other words you do not want to pay the entire sum to buy the stock or index but only a small margin and will settle the profit loss as it happens. That is why it is also called margin trading.

Futures : are like buying the stock by borrowing them from someone for the current month or next month or month of choice.

Who do you buy it from? A lender of that stock, who sells it to you for a small interest cost. The seller of futures either has stock or will buy the stock and sell you the futures contract. For this reason the futures market trades at a premium where the premium represents the interest cost of buying stocks on margin.

The seller of futures may then be either selling futures naked [like a speculator wanting to go short] or an arbitrageur wanting to buy stocks and sell you the futures to earn an interest on the stock.

The important thing to understand here are two that being a parallel market to the cash market, for every buyer of a futures contract there is a seller of the futures contract. So a contract comes into existence only when two people interact with each other.

Thus on the futures market Mr. A buys 500 shares of Infosys from Mr B then the Open interest in Infosys becomes 500 shares. So when someone says that Infosys has an Open Interest of 20000 shares, he means that some people bought 20,000 shares and some people sold 20,000 shares of Infosys. Open Interest therefore represents one side of the book. We do not say Open interest is 40,000 shares [20,000+20,000] for the buyer and seller of the same shares. No double counting.

To ensure that only people with sufficient capital participate in the F&O market SEBI specifies a minimum contract size. According to them one contract should be worth Rs. 500,000. So when the stock exchanges introduce a new contract for any stock it is for a number of shares whose market value is closest to at least 500,000. So if Infosys stock is priced at 1000, then the contract will be of 500 shares when Infosys starts trading in the futures market.

When futures and options trading was introduced in India in 2001, the contract size was 200,000, but has been raised over the years on the grounds that it is only meant for investors with the risk appetite for big positions and the potential losses that come with it.

Now as the futures prices move up and down every day the daily Profit/Loss has to be settled everyday with the broker. This is called the mark to market[MTM] loss or profit

But to buy a futures position in anything you have to keep a margin with the broker/exchange. This margin is calculated based on math, to cover the risk of you taking a speculative position. You may pay 10-20% of the value of the contract up front and then the daily profit loss is paid or received or marked to market. The initial margin has to be paid before taking a position and MTM has to be has to be paid for else you attract violation charges on a daily basis from the exchange. New SEBI guidelines do not allow your broker to fund this for you as they did earlier.

Advanced ideas: Good now you know all about futures trading. You can either have a view bullish or bearish and go long or short the futures, or become an arbitrage guy, who buys stock and sell futures against it to earn the return at the end of the month mostly risk free.

Professional arbitrage traders do something more, they place the trade when the difference is high between the cash and futures based on recent high low history and then square it up if the difference reduces or even better goes negative. Yes that happens as market volatility leads to the discount/premium of the futures market to change everyday v/s the cash market and reversing the trade and entering it again when the difference goes up increases the yield on the arbitrage fund.

There are also times especially in the Month of June when most futures contracts trade at a discount to the market price because they are due for dividends. Unlike a stock that you buy for dividend, whose price will decrease on the day of the dividend being paid, also called XD, or X Dividend, in the futures market the stock futures go at a discount before the dividend date and adjust upwards later.

Options Basics: If you buy and sell options there are a few variations. Options might sound complicated but are a simple way of buying or selling something to profit from by paying the risk up front. In other words you can decide that you want to profit if prices go above a certain price and buy the available Call options of the strike prices for the position.

So If Infosys is trading at 900, and you think you want to make a profit if it goes above 1000, you can buy a Call option at the 1000 strike price. Note you do not decide the strike price. These are decided by the exchange and you can choose any strike available. So you can choose 1000 or 1100 or 1200 strike price. If prices go above that strike you can make money. If prices do not go to the strike you choose you lose only what you pay to buy this option. The purchase price of any option is called a premium.

Simple? Think of it as a lottery ticket. Infosys is at 900, and you buy a lottery ticket that is selling for Rs.50, that says you can own 500 shares of Infosys and if it goes above 1000 all the profit above 1000 price of the stock is yours for the taking. In technical language you bought a Call Option on Infosys with the strike price of 1000, by paying a premium of Rs. 50.

So if Infosys goes to 1050 you make a profit of 50, but wait you paid 50 for it so really your profit is 50-50=zero! You actually make real money only after it goes above 1000+50=1050. So if it goes to 1100 then you can make a profit of 100-50=50 Rs., on 500 shares. 50*500=25,000/-

In other words you buy an option for 50, and when it goes to 1100 you will see the market price of the options near 100 for the option [1100-1000], and you can sell your options for 100. You invested 50*500, or Rs. 25,000 as premium and got back 50,000 [100*500], doubling your money. 100% profit

Wow. But wait. Reward has never been in existence without risk. And that is why we call it the risk reward ratio. When risk goes up so does the reward. So Options trading attracts attention because of the higher rewards because of the built in leverage. You bought 500 shares of Infosys when it was trading at 900. If you had to take delivery it would cost you 900*500 or 450,000 to buy those shares in the open/cash market. But you paid only 25,000, a little over 5%, and then doubled your investment. By paying very little you can make a lot.

So where is the risk? The risk in options trading is that if you are wrong you may lose the entire premium paid. Of course if you think you made a bet wrongly you can exit early and get your premium back. But premiums or the price of options change very fast based on market fluctuations.

As in the case of Futures trading, for every buyer there is a seller. If you buy a Call option then someone sells it to you and Open Interest in the ‘’Infy 1000 CE strike’’ goes up by 500 shares.

Importance of OI: Open Interest[OI] tells us how many people are interested in a particular contract and by that we come to know the liquidity in the contract. If a lot of buyers and sellers exist then when you want to get out someone will be there to buy your options from you. Where OI is small chances of finding a buyer when you want one is low. So always trade an instrument where OI is high for liquidity.

Options selling: Curious is what is the seller of options doing? He is betting that you are wrong. Some consider selling options as akin to selling insurance to someone else at a small price. To do so the seller has to pay a margin like in a futures trade [10-20%] for the underlying shares that you want to buy at Rs.1000 strike. He has to buy it and give it to you if you want. He takes the risk that you can be right, and for doing so he collects that premium you are paying as the price for his risk taking. Imagine the stock attracts a margin of 20% so 20% of 500,000=100,000, is paid as margin, and he sells you this lottery ticket for Rs, 25,000 and you are wrong. At the end of the month the option loses its value and he makes the entire 25,000 on his 100,000 margin investment. A return of 20% almost. So the game is also attractive for the person selling lottery tickets or insurance, whatever you call it.

In fact he might believe that he has better chances at the game. Because he is selling you ownership of stock at a prices away from the actual market price, and collects his possible profit up front for it.

Remember all this has to happen before expiration.

Reality : 90% of options expire out of the money meaning that the buyers lose the entire sum if they do not close out a profit in time or get the market or stock view wrong. This is why options selling has become attractive. Especially when volatility has been low as in the last 5 years it has been a dream run and the options market now dominates F&O with 60-70% market share. Till 2008 it was below 30% as people preferred futures contracts during a trending bull market.

Higher volatility and overnight gaps often get options sellers off guard and many books of options sellers shut shop when the unexpected happens. Still they earn money 90% of the time. It is that 10% of the time that they have to guard against. The last 5 years have many believe that such risk does not exist but you should make it part of your risk management.

Part 2- Beyond basics

Futures are straight forward you need a view that something will go up or down and you can make a profit or loss. Choose a contract that has high OI so that it is liquid and you can always find an exit.

In options you need to think about time value. If prices go no where then the option price will go to zero by the end of the month when the options expire. So An option worth 50 rupees at the start of the month is zero at the end of the month unless prices move above the strike price [or below it in case of Put options]. A Put option is used to take a bearish bet on a stock or index, that it will fall below a particular strike price.

So what are the chances that prices will move to that level?

For that you look at the Delta of the option. Where? In an options calculator. It is on the NSE terminal or available for download from many sources. It is built into the Trade tiger platform from Sharekhan.

Delta has a standard meaning but a hidden meaning. Delta is usually between 0-1

Standard meaning is that if the stock price moves up by 10 Rs and the delta of the option is 0.50 then the price of the option moves by 10*0.50=5rs, so the option of 50 rupees would become worth 55. That is the text book meaning.

But as I was taught long ago the useful meaning for a trader of options is that delta represents the probability of an option expiring in the money. In the money means in profit or when prices go above the strike price in your favour.

So a delta of 0.50 means a 50% change and a delta of 25% means a 25% chance. If price of a stock is 1000 the Call option of the 1000 strike price of the stock would usually have a delta of 0.50. In other words at the money options carry a 50% chance of being right. 50/50 makes sense without a view.

Now most people like to buy out of the money options as they cost less. But you should not buy a strike that has a delta of less than 0.25, because that means you have a 75% chance of losing your entire premium. The ideal strike price to buy is where delta is 0.35-0.40 so you are out of the money but not too far out that your chances of winning are nullified.

On the other hand if you are in the business of selling options you want the probability to be low for the buyer to be right. You would sell options of delta 0.25 or lower so 75% chance or more that the options will expire worthless and you earn the premium.

Note that the above rules do not apply standalone. In options trading you have to have a directional view. A buyer wants that prices move up or down, a seller wants that prices move in the opposite direction or simply go nowhere. Both need a view. You can sell an option low on delta but if Volatility of the market rises you can still go wrong. Options buyers do best if they bet on a view that is not more than 5 days in time horizon while buying one month options, not risking time in their calculations. If in 5 days nothing is happening get out. Sometimes markets give outsized directional moves and only then should you hold with a trail on your position else not. If you are betting on long term views then buy far moth options so that time is not an issue. These were not liquid till 6 years ago but are very liquid now. You can even go out 12 months in some contracts especially December contracts.

What the above rules ensure is that you get paid when right and exit before things go wrong. Meaning that if you buy out of the money options but they are so deep out of the money that even after a stock moves in your favour it does not go to the strike price you will lose everything.

Delta is a great risk management tool and simple to understand in application.

Delta for options sellers. Professional options sellers use delta to hedge their sold options. They hedge their bets to the extent of Delta at any time. So if you have sold 1000 out of the money calls with a delta of 0.25, you should also buy 250 futures to cover overnight risks [0.25*1000=250] As the delta changes everyday so does the amount you need to cover for risk.

Covered Calls : One of the simplest activities that long term investors should adopt in difficult markets is covered calls. By difficult I mean when all stocks appear to be falling or the one you own is not performing for some reason but you do not want to sell it. Selling Call options of the stocks you own to the same extent is like asking the company to pay you a 2-3% dividend every month risk free. 12 months of 3% dividends can mean 36% in returns. The only view you need is that markets are in trouble for now and sell ATM calls against your holdings at the start of every month and collect the premiums. I am not sure why everyone with a portfolio that they do not want to sell will not indulge in this activity. When things turn better you can always stop doing it. Some market timing maybe needed to avoid selling into bear market rallies but at the end of each meaning full rise in a downtrend selling Calls can payoff .

Money management in trading

It goes without saying that some money management rules apply to trading the F&O market. Develop rules to pull out profits as and when they accrue and not put all of it back into the next trade. This will help build a pile of gains on the side that can be invested in real stocks later. The object of trading always is to build capital for other needs faster and when those needs can be fulfilled, kindly fulfil them. Trading is not a one way street. There will be bad months or even years because a particular strategy you are following will not work that year. So doing what you set out to do will help your soul. In options trading this becomes more critical as options payoffs are skewed. At times you need to keep buying them month after month before a trend develops. Keeping Capital available for the next 4 trades is important in options. And setting aside profits from options trading allows for that as well. Make this a rules based process.

F&O Analysis: the open interest data published every day strike wise stock wise and participant wise is a wealth of information to decipher the bullish/bearish bias of the market. It is also useful in being a contrarian. After all this data is what I classify as sentiment data and analysis. Sentiment comes out of a survey of people but when you study their actions in data you are reading actual behaviour.

The Open Interest Put call ratio is a directional tool. It goes up when the market rises and goes down when it falls. Divergences in the ratio often precede market turns. So if the market is making new highs and the indicator is not then we could be nearing a market high. A change in trend by the indicator may confirm a change in trend for prices short term

Volume Put/Call ratio measures the actual volume of trading in options and is a medium term indicator of trend. At a multi week bottom in stocks usually the volume PCR reading maybe very high as everyone is buying Puts. Similarly at a market high the readings can be very low or at the lower end of the range.

The FII/Client side data for F&O shows their bullish bearish bias and when it is at an extreme markets maybe too. Sometimes the positions can also show divergence with prices as an advance indication of a coming change.

Strike wise Open Interest. Nifty strike wise OI or Options Chain is studied by traders for points of support and resistance. Many website post a chart of this for a quick visual. Here is one from https://snap.capitalmind.in/#/pcr

 

All the above data is available on the NSE website, I am sure there are vendors who maintain it, Sharekhan publishes a “Derivatives InfoKit†with it every day as well, an Excel sheet of all OI data stock wise and cumulative.

For me the combination of EW analysis along with Sentiment analysis like the one above and others like A/D ratios, VIX, Index premiums etc, is all part of getting the market view right as that is key to any position that you may want to take. I publish all these charts as part of the Long Short Report at Indiacharts as and when relevant readings show up. Some of the above Charts are the latest ones from this months report.