Futures and Options

Futures and Options

Futures and Options:

In a place like stock market, where there are immense risks related to fluctuations in prices. Derivatives acts as an important financial tool to counter those risks and aid investors in generating desirable outcomes. The desirability can vary from hedging to speculation to arbitrage. Derivatives are fundamentally defined as contracts which derive their value from or dependent upon underlying assets. These underlying assets could be financial assets such as equity, commodity, currency, stock or market indices, interest bearing securities etc. Today, around the world, derivatives are even traded on electricity, temperature, weather and volatility. Derivatives are of many types such as Futures, Forwards, Options, Swaps, etc. Here in this discussion, we will mainly emphasize on Futures and Options in great detail and try to understand them practically.

A futures contract is basically defined as an agreement between two parties to buy or sell an asset at a certain time in future at a certain price.

Options contracts are those contracts that give the buyer or holder a right but not an obligation to buy or sell an asset in future.

Futures Options
  • These are generally exchange traded, standardized contracts. The exchange acts as a guarantor to all transactions and eliminates counterparty risk.
  • Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
  • The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. Notably, this is similar to any asset market where anybody who buys is long and the one who sells in short.
  • One can buy and sell each of the contracts. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position.
  • Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other tradable assets. They are highly popular on stock indices, interest rates and foreign exchange.
  • Buyers of the options typically pays a premium for option contracts that reflects a lot of underlying assets. There also exists a strike price which is the rate at which the asset can be bought or sold before the contract’s expiration date.

Prices in Futures and Options market reflect the perception of the market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. The Futures and Options market helps to transfer risks from those who have them but do not like them to those who have an appetite for them. The Future and Options provide other benefits such as greater leverage, lower trading costs and longer trading hours. Further, these derivative products also offer diversification and hedging benefits which make them an attractive option for investment related purpose.

An options investor may purchase a call option for a premium of Rs. 3 per contract with a strike price of Rs.100 expiring in July 2020. The holder of this call has a bullish view on stock and has the right to assume the underlying stock futures position until the option expires after the market closes on July 30, 2020. If the price of stock rises above the strike price of Rs.100, the investor will exercise the right to buy the futures contract. Otherwise, the investor will allow the options contract to expire. The maximum loss is the Rs.3 premium paid for the contract.

The investor may instead decide to buy a futures contract on stocks. One futures contract has as its underlying asset as 100 stocks. This means the buyer is obligated to accept 100 stocks from the seller on the delivery date specified in the futures contract. Let’s assume the trader has no interest in actually owning the stocks, the contract will be sold before the delivery date or rolled over to a new futures contract.

For trading in Futures and Options, a person needs to have the thorough understanding of Futures and Options. Although the Futures and Options seem to have lot of benefits but at the same time they involve a lot of risks as well such as Market risks, leverage risks etc. So, a proper knowledge of Futures and Options help the traders to overcome certain risks and generate decent returns. Traders should also have the understanding of the terminologies such as Margins in Futures, Premiums in Options, Leverage, expiry date etc. As described above, Futures and Options are exchange traded. In India, they trade on Indian stock exchanges like NSE and BSE. For trading in Futures and Options, opening a Demat and a Trading Account is essential. Demat Account should always be opened with a trusted brokerage services firm that readily cater to the investment needs of the investors.

Conclusion

From the above discussion, we have learnt about the derivatives like futures and options in great detail and tried to understand their nuances. Having proper understanding of the market, discipline, expert’s guidance and decent experience is the key to excel in the stock market.

  • What is the basic difference between the Futures and Options?
  • A futures contract is basically defined as an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. Whereas, options contracts are those contracts that give the buyer or holder a right but not an obligation to buy or sell an asset in future.

  • Are Futures and Options traded in India?
  • Yes, Both Futures and Options are traded on Indian stock exchanges like NSE and BSE.

  • What is the first step to start trading in Futures and Options?
  • The first and foremost step is to open a Demat and Trading Account that can facilitate trading in Futures and Options.

  • What is a long position and what is a short position?
  • The buyers of the futures or options contract are said to have taken a long position, whereas the sellers of the futures or options contract are said to have taken a short position.

  • What are the advantages of investing in Futures and Options?
  • The advantages of investing in Futures and Options are greater leverage, lower trading costs, diversification benefits and longer trading hours.

  • What are the risks of investing in Futures and Options?
  • The risks of investing in Futures and Options include market risks, leverage risks, greed, inadequate knowledge, experience, guidance and lack of self-discipline.

  • What are the desirable outcomes of investing in Derivatives Market?
  • The desirable outcomes can vary from hedging to speculation to arbitrage.

  • What are the different types of Options?
  • The two types of Options are Call Options and Put Options.

  • What is the leverage?
  • Leverage is the ability to manage large transactions even with limited capital. It has its both advantages and risks. Either a person can earn huge amount of profits in good scenario or can suffer heavy losses if the markets don’t perform well.

  • Is investing in Futures and Options safe?
  • Investing in Futures and Options is safe as long as the person has sufficient amount of patience, knowledge, desire to learn and sustain in the market.