InvestorQ : What role does futures trading plan in India and why do we pay margins? Also what are the different things we can do with futures and options?
Niraja Mehta made post

What role does futures trading plan in India and why do we pay margins? Also what are the different things we can do with futures and options?

Answer
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Mahil Khan answered.
1 year ago


Futures are used by traders to take positions in index or in stocks by just paying a small margin instead of the entire amount. Thus returns can be magnified in case of futures. Secondly, futures can help you play the index and stocks both ways. You can either sell futures or buy futures. Similarly, you can either buy call options or you can buy put options. But why do we pay margins on futures and options trading?

Since futures and options are margin products, you have to pay an initial margin to cover the risk of price movement against you. Long futures, short futures and short options will attract initial margins and mark-to-market (MTM) margins based on price movement. However, long options will only attract premium margin since your maximum loss is limited to the premium paid and that is already a sunk cost at the time of entering into the trade itself. Let us now look at some unique applications of futures and options in India.

Firstly, futures can be used to replicate a fixed instrument in India through a methodology called cash-futures arbitrage. Futures normally quote at a premium to the cash market price. By buying shares in the spot market and selling in the futures market, you can lock in the spread. Normally, this spread is slightly higher than the prevailing interest rates and becomes a kind of an assured return product for you. These arbitrage positions are either unwound in the market or the cash position is held on but the short futures position gets rolled over.

Secondly, options are very useful when it comes to protecting your risk in the market. Assume that you bought shares of SBI but are afraid that the price of the stock could move down. You can protect your risk by buying an OTM put option. On the other hand, if you are short on futures then you can protect your risk by buying an OTM call option. Because options are non-linear products they can be useful in protecting risk with insurance.

There is also another interesting application of options. You can also use options to reduce your cost of holdings in a stock. Here is how it works. Let us go back to the SBI example. You have purchased SBI at 350 but the stock is down to 320. While you are confident of the future prospects of SBI, you can use options to reduce your cost of holdings. Each month you can sell higher OTM calls and eat away the premium. The premium earned reduces your cost of holding. If the stock price goes you have nothing to worry as you are holding on to your cash position. It is this unique asymmetric proposition of options that makes them specifically attractive to traders.