How Do Put Options and Futures Contracts Work in the Market?

Looking to start derivative trading and get higher returns? You can do it by opening a trading account. However, understanding how they work in a market is essential before you start trading them.

As of September 2024, each retail investor has spent an average of INR 26,000 on futures and options transactions over the past three years. This shows that a lot of people have been interested in derivative trading.

This blog provides a simple guide on how put options and future contracts work in the market.

How Does a Put Option Work in the Market?

A put option is a strategy used in options trading which helps traders hedge against losses or speculate on price declines. It is because it increases in value when the price of an underlying stock declines. By limiting possible losses at a certain level, put options serve as investment insurance.

To hedge against a stock price decrease, investors can purchase a put option, which they can then sell at a strike price if the price declines. If the investor does not own the stock, exercising a put puts them in a short position.

Put Options for Buying

Let us understand put options from the buyer’s perspective with an example. Assume that the stock of company X is trading at INR 100. You bought 100 shares with a strike price of INR 50 by paying a premium of INR 5 each, hoping that the price will drop. The put option has an expiry of three months. Your total investments will be:

INR (100x100 shares + 100 x INR 5 premium) = INR 10,500

The possible scenarios will be:

• Scenario 1: If the price falls to INR 80

You can use your put option to sell the stock at INR 100 and earn:

INR (100 – 80 x 100 shares) – INR 500 premium = INR 19,500

• Scenario 2: If the price increases to INR 105 or stays at INR 100

You may let the contract expire and take the loss of the premium of INR 500.

Put Options for Selling

Following the previous example, imagine yourself as the seller of the put option. You hope to profit from the premiums that buyers pay.

• Scenario 1: If the buyer exercises the option after selling a put

You have to purchase the stock at the strike price of INR 100 per share, bearing a loss of:

INR (100 – 80 x 100 shares) – INR 500 premium = INR 19,500

• Scenario 2: If the buyer lets the contract expire

You can make a profit by charging a premium of INR 500 from the buyer.

How Does a Futures Contract Work in the Market?

Futures contracts are a type of derivative, whether they are traded on the commodities market or the stock exchange. They work almost similarly to an options contract, but the buyer or seller cannot let the contract expire and is obliged to trade.

A buyer or seller may agree in such a contract to buy or sell an asset at a predetermined price on a given future date. Let us understand how it works with an example.

Example of Futures Contract

For INR 100 each, you purchased a futures contract for 50 shares of company X. When the contract expires, you will receive the shares you agreed to buy for INR 100, regardless of the current price—even if they have increased to INR 120. In this instance, you have earned:

INR (120 – 100 x 50) = INR 1,000

Even so, if the share price fell to INR 90 at expiration, you would still be buying each share for INR 100. In this case, you will lose:

INR (100 – 90 x 50) = INR 500

Final Thought

Both put options and futures contracts are derivative contracts that can make you earn unlimited profits. However, they also carry high risks, of which you should be aware. Understanding the procedure of how put options and futures contracts work may help you to avoid risks and make an informed choice for investments.