Strategies with Futures and Options — the whole chapter in plain English

Chapters 3 and 4 taught you what futures and options are. This chapter is about what people actually do with them. Everything here is an application — hedging, trading, arbitrage — and almost all of it is arithmetic.

Part One: what you do with futures

Long hedge — locking in a price you will pay later

You want to buy 1,500 shares of ABC Ltd. Today is 10 May and the shares trade at ₹455. But you do not have the money today — a bank deposit matures on 20 June, and only then can you buy.

What is the risk? The share price may rise sharply before 20 June. You would then buy fewer shares, or pay much more for the same 1,500.

The fix: go long a futures contract today. The contract expiring 29 June trades at ₹457.30 with a lot size of 1,500 — exactly what you need, so you buy one lot.

Now watch what happens either way.

If the stock rises to ₹520 by 20 June:

If the stock falls to ₹390 by 20 June:

Look at those two answers: ₹456.10 and ₹456.20. Both sit almost exactly at ₹457.30, the futures price at which the hedge was put on.

That is the whole point of a hedge. You did not make money and you did not avoid loss — you removed the uncertainty. Whether the market rose 14% or fell 14%, you paid about the same.

Short hedge — locking in a price you will receive later

Mirror situation. You plan to sell 1,200 shares of PQR Ltd on 10 July to repay a personal loan. Today is 10 May, the shares trade at ₹1,690, and the July futures trade at ₹1,706 with a contract size of 600.

The risk now is a fall in the price before 10 July. So you short 2 contracts (2 × 600 = 1,200 shares) at ₹1,706.

If the stock falls to ₹1,440:

If the stock rises to ₹1,800:

Cash market gives 1,800 × 1,200 = ₹21,60,000, but the short futures squared off at ₹1,802 loses (1,706 − 1,802) × 2 × 600 = ₹1,15,200. Net = ₹20,44,800, or ₹1,704 per share.

Again — ₹1,705 and ₹1,704, both hugging the ₹1,706 at which the hedge was placed.

Notice the discipline this demands. In the rising scenario you gave up ₹1,15,200 of upside. A hedger who complains about that has misunderstood what he bought. He bought certainty, and certainty costs the upside.

Hedging a whole portfolio with index futures

You hold 15 large-cap stocks from different sectors. Because it is well diversified, the specific risk is almost zero — but the systematic (market) risk remains, and you fear a crash next month.

Two choices: sell the entire portfolio and sit on cash, or reduce the systematic risk using index futures. The second keeps you invested.

To hedge you short index futures. How many? Use the hedge ratio from Chapter 3:

Number of contracts = (Portfolio beta × Portfolio value) ÷ (Index futures price × Lot size)

With a portfolio worth ₹90,00,000, beta 1.3, index futures at 17,700 and a lot size of 50:

(1.3 × 90,00,000) ÷ (17,700 × 50) = 13.22 contracts

So you short 13 index futures contracts.

Using futures to trade — the leverage story

Bullish view: go long futures.

A trader expects XYZ Ltd to rise from ₹1,298 to ₹1,350. The near-month futures trade at ₹1,300 with a lot size of 850. Contract value = 1,300 × 850 = ₹11,05,000. The margin is 20%, so his cash outlay is ₹2,21,000.

A week later the stock is at ₹1,345 and the futures at ₹1,346. Compare the two routes:

Nearly the same rupee profit, but the return is almost five times higher — because the capital committed was five times smaller. That is leverage, and it is why futures are so popular.

Bearish view: go short futures.

A trader expects RSB Bank to fall from ₹1,595 to ₹1,520. The futures trade at ₹1,602 with a lot size of 550. Contract value = 550 × 1,602 = ₹8,81,100, margin at 20% = ₹1,76,220.

The stock falls to ₹1,525 and futures to ₹1,527. Gain = (1,602 − 1,527) × 550 = ₹41,250. Return on investment = 23.41%.

There is a second, subtler benefit here. To sell shares in the cash market you must already hold them in your demat account, because you must deliver on settlement date. Shorting a futures contract lets you express a bearish view without owning the stock at all.

Cash-and-carry arbitrage

Compare the fair futures price with the traded price. Traded price higher → cash-and-carry is profitable. Traded price lower → reverse cash-and-carry is profitable.

Stock A: cash price ₹1,500, 3-month futures ₹1,550, contract multiplier 100 shares, cost of carry 9% per annum (around 0.75% per month).

Fair price = 1,500 × e^(0.09 × 3/12) = ₹1,534.13. The futures at ₹1,550 are overvalued by ₹15.87.

So the arbitrageur buys 100 shares and sells 1 futures contract. Expected profit = 100 × 15.87 = ₹1,587.

Test it both ways:

Case I — stock rises to ₹1,580 on expiry:

• Profit on underlying = (1,580 − 1,500) × 100 = ₹8,000
• Loss on futures = (1,580 − 1,550) × 100 = ₹3,000
• Gain on arbitrage = ₹5,000
• Cost of arbitrage (financing, ₹34.13 × 100 shares) = ₹3,413
• Net gain = ₹1,587

Case II — stock falls to ₹1,480 on expiry:

• Loss on underlying = (1,500 − 1,480) × 100 = ₹2,000
• Profit on futures = (1,550 − 1,480) × 100 = ₹7,000
• Gain on arbitrage = ₹5,000
• Less financing cost ₹3,413
• Net gain = ₹1,587

Identical, either way. That is what "risk-free" means in practice.

Reverse cash-and-carry arbitrage

Now the futures trade at a discount to cash — a negative cost of carry, which is expected to reverse to positive at some point in the contract's life.

Stock B: cash ₹100, one-month futures ₹90, multiplier 200 shares.

The arbitrageur buys one futures contract at ₹90 and sells 200 shares at ₹100 in the cash market. Expected profit = 200 × ₹10 = ₹2,000.

Important assumption: the arbitrageur already has the stock to sell, and will buy it back when reversing. If he does not have it, he must borrow the stock — and the cost of borrowing must be counted in the profitability.

Case I — stock rises to ₹110: loss on underlying (110 − 100) × 200 = ₹2,000; profit on futures (110 − 90) × 200 = ₹4,000. Net gain ₹2,000.

Case II — stock falls to ₹85: profit on underlying (100 − 85) × 200 = ₹3,000; loss on futures (90 − 85) × 200 = ₹1,000. Net gain ₹2,000.

And there is an extra piece most candidates forget. He sold shares for ₹20,000 and can invest those proceeds at 9% p.a. for one month. With continuous compounding that earns (20,000 × e^(0.09 × 1/12)) − 20,000 = ₹150.56. So the total gain is ₹2,150.56.

He need not wait for expiry. Suppose on the 15th the spot is ₹130 and futures ₹135. He can reverse both legs:

• Loss on underlying = (130 − 100) × 200 = ₹6,000
• Profit on futures = (135 − 90) × 200 = ₹9,000
• Net gain = ₹3,000
• Plus interest for 15 days: (20,000 × e^(0.09 × 15/365)) − 20,000 = ₹74.11
• Total = ₹3,074.11

Calendar spread as arbitrage

A calendar spread is arbitrage between futures contracts of different expiration months. The principal rule of arbitrage applies: buy the underpriced contract and sell the overpriced one. So you must compute the fair price of both and compare each with its traded price.

A stock trades at ₹120. Near-month futures at ₹121.30, mid-month at ₹121.50. Interest rate 8% p.a.

• Fair near-month = 120 × e^(0.08 × 1/12) = ₹120.80
• Fair mid-month = 120 × e^(0.08 × 2/12) = ₹121.61

The fair gap is about 81 paise. The actual gap is only 20 paise. So the near-month is overpriced relative to the mid-month.

Action: short the near-month at ₹121.30 and go long the mid-month at ₹121.50. The spread is expected to return to its fair difference, and the arbitrageur unwinds then.

Case 1 — stock closes at 122 on near-month expiry, mid-month at 122.82: loss on near-month 0.70, gain on mid-month 1.32, net gain ₹0.62.

Case 2 — stock closes at 120, mid-month at 120.80: gain on near-month 1.30, loss on mid-month 0.70, net gain ₹0.60.

Calendar spreads are low risk, low return. The return is low because you are only capturing a small mispricing; there is no directional bet. The risk is low because you hold opposite positions in both contracts.

Two practical warnings. Such opportunities are difficult to find, because index and stock futures are liquid and mispricings vanish fast. And both legs must be entered simultaneously and squared up at the same instant — any delay after the first leg reduces profitability or turns it into a loss.

Part Two: what you do with options

Spreads

Spreads combine options on the same underlying and of the same type (all calls, or all puts) but with different strikes and maturities. They are limited profit, limited loss positions. Three categories:

• Vertical spreads — same expiry, different strike prices
• Horizontal spreads — same strike, different expiry dates
• Diagonal spreads — different strikes and different expiry dates

The four vertical spreads

All four examples below use a spot of 17,500.

Bull call spread. View is bullish, but you want to cut the cost. Buy a lower strike call, sell a higher strike call. Because the lower strike call costs more than the premium from the higher strike call, this is a net cash outflow to start.

Buy the 17500 call at ₹185, sell the 17800 call at ₹61.

• Net premium paid = 185 − 61 = ₹124 = maximum loss
• Maximum profit = ₹176
• Break-even = 17,500 + 124 = 17,624 (lower strike plus net premium paid)

Why cap the upside at all? Because all gains on the long call beyond the short call's strike get negated by losses on the short call. You could short a call with a much higher strike to capture more profit — but higher strike calls fetch less and less premium, so your cost falls only marginally.

Bull put spread. Also bullish, but built from puts. Sell a higher strike put to earn premium; buy a lower strike put as insurance against the short put's otherwise unlimited losses. This is a net premium receipt strategy.

Sell the 17500 put at ₹125, buy the 17000 put at ₹34.

• Maximum profit = ₹91 (125 − 34, the difference in premiums)
• Maximum loss = ₹409
• Break-even = 17,500 − 91 = 17,409 (higher strike minus net premium received)

Bear call spread. Bearish. Short a low strike call with a high premium; to cap the unlimited loss on a naked short call, go long a higher strike call costing less. You start with a net inflow.

Short the 17500 call at ₹185, long the 17800 call at ₹61.

• Maximum profit = ₹124 (net premium received)
• Maximum loss = ₹176
• Break-even = 17,624

Bear put spread. Bearish. Buy a higher strike put; to reduce cost, short a lower strike put.

Long the 17500 put at ₹125, short the 17000 put at ₹34.

• Maximum profit = ₹409
• Maximum loss = ₹91
• Break-even = 17,409

Notice the symmetry. The bull call spread and the bear call spread use exactly the same two options, just with the long and short sides swapped — so the maximum profit of one is the maximum loss of the other, and they share the same break-even, 17,624. The same is true of the two put spreads at 17,409.

Horizontal spread. Same type, same strike price, different expiry dates. Also called a time spread or calendar spread. You cannot draw a payoff chart here, because the expiry dates differ. The rationale is that the two options have different time values, and the trader is betting that the difference between those time values will shrink or widen.

Diagonal spread. Same underlying, different expiry dates as well as different strikes. Again no payoff diagram is possible. These are much more complicated in nature and execution, and are more suitable for the OTC market than for exchange-traded markets.

Straddles

A straddle uses two different types of options — a call and a put — with the same strike price and the same maturity.

Long straddle = buy the call and buy the put. Short straddle = sell both.

A stock trades at ₹6,000. The ATM call costs ₹257 and the ATM put ₹136.

Long straddle:

• Maximum loss = ₹393 (257 + 136), and it occurs exactly at the strike, 6,000
• Two break-even points: Strike − total premium = 5,607 and Strike + total premium = 6,393
• Profit is unlimited in both directions beyond those points

Check it. If the stock falls to 5,300: the long call loses its ₹257 premium, the long put makes −136 − 5,300 + 6,000 = ₹564. Net = ₹307. If the stock rises to 6,700: the long put loses ₹136, the long call makes −257 − 6,000 + 6,700 = ₹443. Net = ₹307.

When do you use it? When you are not certain of the direction the stock will move, but you expect a significant movement either way.

Short straddle is the exact inverse — the chart is simply flipped. It is a limited profit (₹393), unlimited loss strategy, and the workbook warns it should be undertaken with significant care. It incurs substantial loss if the market moves significantly in either direction. The view behind it is that the price will not move much, or will remain stable.

Strangles

Same outlook as a straddle, but different implementation, aggression and cost. In a straddle both options share a strike; in a strangle they use different strikes, and both options are out-of-the-money, so the premium paid is lower.

Cash market price ₹6,100. The 6200 call costs ₹145 and the 6000 put costs ₹140. Both are out-of-the-money.

Long strangle:

• Maximum loss = ₹285, occurring anywhere between 6,000 and 6,200 — a flat-bottomed loss zone, not a single point
• Two break-evens at 5,715 and 6,485
• Unlimited profit in either direction

Check it. Spot falls to 5,700: long call loses ₹145, long put makes −140 − 5,700 + 6,000 = ₹160. Net = ₹15. Spot rises to 6,800: long put loses ₹140, long call makes −145 − 6,200 + 6,800 = ₹455. Net = ₹315.

Short strangle is the exact opposite: maximum profit ₹285, unlimited loss in both directions, same break-evens at 5,715 and 6,485. The outlook, as with a short straddle, is that the price will remain stable.

Covered call

This strategy generates extra income from an existing cash market holding. You own a stock, you intend to hold it, and you would like to earn income without selling it — which reduces your cost of acquisition.

Buy the stock at ₹1,590 and sell a 1600 call, earning ₹10 premium.

If the stock rises to ₹1,640: cash profit 1,640 − 1,590 = ₹50; short call −1,640 + 1,600 + 10 = −₹30. Net = ₹20.

If the stock falls to ₹1,520: cash loss = −₹70; short call = +₹10, because the call holder can buy cheaper in the market and lets the option expire, so the seller keeps the premium. Net = −₹60.

Read the payoff shape carefully. Gains are capped at ₹20 above 1,600, while losses keep growing as the stock falls. That is exactly the shape of a short put with a strike of 1,600. Hence: a covered call is a synthetic short put.

That equivalence creates a genuine arbitrage. If the 1600 put is available at any price other than ₹20 — say ₹17 — the trader can create the synthetic short put (the covered call), earn ₹20 premium, and use it to buy the 1600 put for ₹17, pocketing a risk-free ₹3. The workbook is careful to add: one must also provide for market frictions — brokerage, taxes, administrative costs, funding costs.

Choosing the strike is the most important decision here. A strike close to the current price fetches a higher premium but locks in the potential gain early. A strike far from the current price fetches a low premium but leaves a longer ride on the underlying. A simple way to think about it: pick your target exit price, keep writing calls at that strike while the stock stays below it, and the moment spot reaches that level, sell the stock in the cash market and cover the short call.

Collar

A collar is an extension of the covered call. The covered call still has that ugly downside — as a synthetic short put, its losses keep growing as the price falls. To put a floor under it, buy a put.

Same covered call as before — long stock at ₹1,590, short 1600 call for ₹10, break-even 1,580 — and now add a long 1580 put for ₹7.

If the price falls to ₹1,490: long stock −100, short call +10, long put −7 − 1,490 + 1,580 = +83. Net = −₹7 (it would have been −₹90 as a plain covered call).

If the price rises to ₹1,690: long stock +100, short call 10 − 1,690 + 1,600 = −80, long put −7. Net = +₹13 (it would have been +₹20).

The trade-off is explicit: the long put reduces the downside risk, but it also reduces the maximum profit, and the break-even moves higher by the premium paid for the put. Insurance is never free.

Butterfly spread

As the collar extends the covered call, the butterfly extends the short straddle. A short straddle has unlimited downside if the underlying moves significantly either way. To limit that, the trader buys one out-of-the-money call and one out-of-the-money put alongside the short straddle. The resulting payoff picture looks like a butterfly.

A butterfly can be built from only calls, only puts, or a combination. Built from calls, with the same maturity:

• Long call, strike 6000, premium paid ₹230
• Short call, strike 6100, premium received ₹150
• Long call, strike 6200, premium paid ₹100
• Short call, strike 6100, premium received ₹150 (the middle strike is sold twice)

Cost of creating it = −230 + 150 − 100 + 150 = −₹30.

• At 6000 or below: all calls expire out-of-the-money, buyers lose premium and writers keep it. Flat loss of ₹30.

• At 6100: long call 1 gives −230 − 6,000 + 6,100 = −130; both short calls keep ₹150 each; long call 3 loses ₹100. Net = +₹70 — the maximum profit.

• At 6200 or above: long call 1 = −30 (and rising), each short call = +50 (and falling), long call 3 = −100. Net = −₹30, permanently.

• Lower break-even = 6,000 + 30 = 6,030

• Higher break-even = 6,200 − 30 = 6,170

To build the same position from puts only: buy one highest strike, sell two middle strike, buy one lowest strike. From a combination: buy one call at the lowest strike, sell one call at the middle strike, buy one put at the highest strike, sell one put at the middle strike.

A butterfly is a limited profit, limited loss strategy.

Hedging with options

Options are known for providing insurance against unexpected movements in the underlying price.

Buying a call locks in a future purchase price. An investor expects money from a maturing fixed deposit at month-end and plans to buy 1,500 shares. His risk is a rally before then. The stock is at ₹463; he buys a near-month 460 call at ₹19.

• If the stock rises to ₹520 by expiry, the rise in the call premium compensates for the rise in the stock price.
• If the stock falls to ₹430, he simply buys at the market price, which is cheaper than exercising the option.

That asymmetry is the whole appeal of an option hedge over a futures hedge.

Protective put

Any investor long in the cash market runs the risk of a price fall — falling portfolio value and MTM losses. A fund manager anticipating a fall could sell the entire portfolio or short futures. But in both cases he is out of the market as far as upside profits are concerned.

How do you stay in the market, reduce losses, and still gain from the upside? Buy insurance — a put.

Buy the stock at ₹1,600 and buy a 1600 put for ₹20.

If the price falls to ₹1,530: cash loses ₹70, the put makes −20 − 1,530 + 1,600 = +₹50. Net = −₹20.

If the price rises to ₹1,660: cash makes ₹60, the put loses its ₹20 premium. Net = +₹40.

For all falls, the loss is capped at the premium paid (when the strike equals the purchase price — with different strikes the loss differs from the premium). For all rises, profits keep growing, because the put's loss is capped at the premium while the stock's gain is not.

Unlimited gain with limited loss is exactly the payoff profile of a long call. Hence: a protective put is a synthetic long call.

Part Three: arbitrage with options — put-call parity

Just as arbitrage exists when a futures price deviates from fair value, arbitrage exists when an option's traded price deviates from its fair price. The tool is put-call parity, which states the relationship between calls and puts with the same strike price and the same time to maturity:

c + X × e^(−rt) = p + S₀

where c is the call premium, p the put premium, X the strike, S₀ the spot price, r the interest rate and t the time to expiry.

Knowing the stock price and a call price, you can derive the fair price of the put with the same strike and expiry. If the put's traded price differs, there is a risk-free arbitrage.

Put-call parity applies only to European options. That restriction is tested.

The worked case. A stock trades at ₹1,251. A 1240-strike call expiring in one month quotes ₹47.50. Interest is 8% p.a. Substituting into the formula gives a fair put price of ₹28.26.

Suppose the put actually trades at ₹23.15. The put is underpriced, so:

Buy the put (₹23.15) and buy the stock (₹1,251), and simultaneously short the call (₹47.50).

Net cash outflow = 1,251 + 23.15 − 47.50 = ₹1,226.65, borrowed at 8% p.a. That borrowing grows to 1,226.65 × e^(0.08 × 1/12) = ₹1,234.86.

• Stock rises to ₹1,275: sell shares for ₹1,275; the put expires worthless; the short call is in-the-money and loses ₹35. Repay ₹1,234.86. Net = 1,275 − 35 − 1,234.86 = ₹5.14.
• Stock falls to ₹1,200: the short call expires worthless; sell the stock for ₹1,200; the long put pays ₹40. Repay ₹1,234.86. Net gain = ₹5.14.

Same answer both ways, and it equals the gap between the fair price and the traded price of the put.

The practical warning matters: these strategies are difficult to execute, because they need the simultaneous buying and selling of the stock, the put and the call. Any delay on one leg loses the anticipated gain, and if one leg cannot be executed after the other has been, the arbitrageur is left with a naked long or short position exposed to large losses.

Part Four: delta hedging

Delta measures the sensitivity of an option's value to a small change in the price of the underlying. A call delta of 0.6 means a ₹1 change in the stock price produces a ₹0.60 change in the option price.

The worked case. A stock trades at ₹100. A trader shorts 10 ATM call options with a lot size of 50. The call delta is 0.50.

Having sold calls, he is at risk from a rise in the stock price. If the stock rises ₹1, his loss = 0.50 × 50 × 10 = ₹250.

To offset that he must go long the underlying. How much? A stock futures contract has a delta of roughly one, because the futures price moves hand in hand with the spot. With a lot size of 50, he needs 5 futures contracts:

• Long 5 futures: delta = 1 × 5 × 50 = +250
• Short 10 lots of calls: delta = −0.5 × 10 × 50 = −250
• Combined delta = 0

This is a delta-neutral position — not affected by any small changes in the stock price.

The key word is "small." The delta itself changes as the underlying moves. If the stock rises from 100 to 110, the call delta may rise from 0.50 to 0.60. He must then go long one more lot, taking the futures position to 6 lots, to restore neutrality.

Continuously buying or selling futures to keep the combined delta near zero is called delta hedging. It is the option trader's way of managing the risk of a short option position.

Part Five: reading open interest and the put-call ratio

Open interest is the number of positions opened by market participants and not yet closed. An open interest of 2,56,000 contracts in the May index futures means participants have bought or sold 2,56,000 contracts to date, all still open.

Total traded quantity (volume) is the number of contracts that changed hands during the day — say 2,00,000 contracts today. Volume is a flow; open interest is a stock.

The new delta-adjusted open interest

SEBI has changed how open interest is measured. Open interest is now measured at a portfolio level by computing the net delta-adjusted open positions across futures and options for an underlying. The stated aim is that futures markets mirror underlying markets, enhancing risk management and trading convenience.

The delta values used:

The workbook's worked table for Future Equivalent Open Interest (FutEq OI):

Client 2 shows the mechanic: what used to count as a notional OI of 500 is now 500 × 0.5 = 250. Across the market, OI falls from 2,800 notional to 900 future-equivalent. This aligns equity futures and options markets more closely with the cash market and strengthens risk management.

Trading on open interest and price together

Four scenarios, and the interpretation of each:

The two "increasing OI" rows are the ones with a trend behind them, because new money is entering. The two "declining OI" rows are just existing positions unwinding.

Put-call ratio

The put-call ratio is the ratio of the trading volume of put options to call options. It can be computed either on trading volumes or on open interest.

With put open interest of 8,000 and call open interest of 12,000:

PCR = 8,000 ÷ 12,000 = 0.67

The put-call ratio is generally treated as a contrarian indicator. Read it through the eyes of the option sellers:

• PCR less than 1 — call open interest exceeds put open interest, so option traders prefer to sell more calls than puts. Sellers do not expect the index to rise. This signals a bearish trend.
• PCR greater than 1 — say 1.25 — put open interest is higher than call. Sellers do not expect a fall. This is a bullish signal.

If that feels back to front, that is precisely what "contrarian" means here — a market full of put buyers is a market whose sellers are comfortable, and it is the sellers' comfort the ratio is reading.