Tuesday, February 26, 2013

Excellent Trading School - 18 - Comparison between Futures and Options

Comparison between Futures and Options

Options are different from futures in several interesting senses. the option buyer pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.

Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating “guaranteed return products”.

Application of Options: We look here at some applications of options contracts.
Hedging: Have underlying buy puts
Owners of stocks or equity portfolios often experience discomfort about the overall stock
market movement. As an owner of stocks or an equity portfolio, sometimes one may have a view that stock prices will fall in the near future. At other times one may witness massive volatility.

The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using put options.

Index and stock options are a cheap and can be easily implemented to seek insurance from the market ups and downs. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price.

If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index.

When the stock price falls your stock will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level. This level depends on the strike price of the index options chosen by you.

Portfolio insurance using put options is of particular interest to mutual funds who already own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market fall.

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