An index tracks and measures the price of a collection of stocks. For instance Nifty 50 tracks and measures the price of top 50 listed Indian stocks.
As an investor or trader, you can not directly invest or trade in an index. Therefore, we have index futures and options which can be bought and sold.
These index future and option contracts derive their value from the underlying asset, in this case, the index.
In India, the top 5 indexes which are largely followed by market participants are: Nifty, Bank Nifty, Sensex, Finnifty and Bankex.
Index futures and options are derivative financial contracts which provide buyers an investment price based on the expectation of the underlying index’s future value.
Investors and traders in the financial market follow these indexes closely as they act as an indicator of market movements.
Nifty50, Sensex, Banknifty, Finnifty and Bankex futures and options allow investors to hedge or speculate on the future value of the respective underlying indices by buying and selling futures and option contracts.
In the US, S&P 500 futures are one of the most liquid and traded futures. Currently, in India, Nifty50 and Bank nifty futures are the most liquid and traded futures. Nifty50 and bank nifty futures and option contracts are cash settled and listed by the National stock exchange (NSE).
Index futures are contracts in which both buyer and seller agree to buy or sell a contract on an index and settle it at a future date. Investors or traders are basically speculating on where prices move for indexes like nifty and bank nifty.
Futures and options are more complex financial instruments than stocks. These financial instruments should only be traded by experienced traders and investors.
Index future and option contracts are cash settled. Don’t expect that you will be delivered with the actual stocks associated with the index.
In India, most equity options are physical delivery contracts, which means that shares of stock must change hands at the time of exercise.
Most index options are cash settled. Which means, holders of in-the-money option contracts receive a certain amount of cash upon exercise.
Frequently Asked Questions – FAQs
What is the call and put option?
In a call option, the buyer has the right but not the obligation to buy the underlying asset at the specified price on the date of expiry. In the case of American style call option can expire any time before the expiry date. In European style, call option can expire only on the expiry date.
In put option the buyer has the right but not the obligation to sell the underlying assets at a fixed price on a specific predetermined date.
To get the right of the contract, the buyer pays a premium and the seller receives it.
Index futures and option contracts are cash settled, therefore no physical delivery of the underlying asset is required. Here are top 5 index futures and options traded in India;
When traders buy option contracts?
When a trader is bullish on the market, they prefer to buy calls or they short put. In a bearish scenario, the trader will prefer to buy puts or short calls.
The main objective is to make profit.
What is implied volatility?
Implied volatility can be found in the option chain mentioned as IV.
Traders used implied volatility to predict how volatile the underlying asset will be. In the case of high implied volatility, option premium will be higher.
What is open interest?
Open interest is the number of open positions or contracts for a particular option series on an exchange. High open interest indicates that there are many open positions on a particular option.
Open interest is also referred to as OI. It’s calculated by the exchange. OI determined the liquidity of an option contact.
What is liquidity?
Liquidity means availability of buyers and sellers in a market. If more buyers and sellers are available for an option contract, it means the greater the liquidity.
If an option contract has less or no buyer or seller, then it has no liquidity.
High liquidity means you can easily buy or sell contracts or security without unduly affecting the price.
What is contract size?
Contract or unit size means the number of shares of stock that are linked to an option contract.
In the US, one option contract generally represents 100 shares of the underlying stocks. In India, we have different sizes based on the stock you have selected. In India contract size is not fixed.
What are the strategies used to trade options?
Before you buy or sell options, you need a strategy. You have to understand how options will help you to build a portfolio. Here are the important strategies that you explore if you are interested in option trading;
- Call buying
- Naked Call writing
- Covered call writing
- Naked Put writing
- Covered put writing
- Put buying
- Bull Spread
- Bear spread
- Butterfly spreads
- Calendar spreads
- Ratio spread
- Ratio calendar spread
- Straddles
- Strangles
- Synthetic Calls and Puts
- Synthetic Longs and Shorts
Disclaimer: In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
