Futures and options are terms related to capital market. Futures and options are basically financial product which are used to acquire or trade underlying shares, commodities or currency. If dealt with correctly, futures and options could be a big money making opportunity.
Futures and options are contract between two parties to buy or sell underlying shares of listed companies or commodities or currencies etc. at a given price and time in future. Since it is derived from underlying financial asset, they are also known as Derivatives. Traders book their profit or bear the loss as per their prediction while buying futures and options also called F&O contract. It is regulated by SEBI.
Difference between future and options
- A future is a contract between two parties where the buyer promises to buy a specified quantity of shares, commodities or currency from the seller at a pre-determined price on a future date. Since the action will happen in future, it is also called forward contract. A future grants a buyer and seller the right to purchase and sell the underlying asset. An option is a similar contract where buyer has the right but not the obligation to purchase or sell the underlying financial asset at a future date.
- A future contract to buy/sell underlying financial assets is concluded with the transaction on the predetermined date at a contractual price. On the other hand, an options contract may or may not conclude with a transaction. If no transaction carried out, the option will expire and become null and void after the due date.
- In case of future, the trader must exercise the agreed action at the specified date of the contract only. In the case of option, traders can exercise their right at any time till the specified date in the contract expires.
- In the case of futures contracts, traders are not liable to pay an entry fee to brokers. But, they must maintain a margin, a certain percentage of the value of contracts, to leverage the gains and losses in trading. On the other hand, in the case of options contracts, traders have to pay a premium to buy options.
- In the case of futures contracts, traders have to exercise their contract irrespective of the price movements and willingness to pay for the financial asset. In such a case, the risk of bearing loss exists as there can be a scenario where prices are low at the time of selling the asset than the price at which the trader bought it. On the other hand, in the case of option, traders can exercise their right to sell or buy the derivative as they seem fit and profitable.
Types of Futures and Options
In case of futures the contract holds the same rules for both buyers and sellers. However, depending upon underlying assets type of futures could be as below:
Index Future: Futures contracts whose underlying value is based on a stock index are known as index futures.
Stock Future: Stock futures are contracts where underlying asset is certain group of shares.
Currency & Commodity Future: Currency futures, also known as foreign exchange futures, allow you to purchase or sell a certain quantity of currency at a particular price and time.
Interest Futures: A futures contract with an underlying asset that offers interest is an interest rate future.
An option can be divided into two types.
Put option – contract to sell a particular asset at a pre-defined price on a future date.
Call option – contract to purchase a particular asset on a future date at pre-defined price.
If the trader think the contractual price will climb or fall, he will purchase a call option or sell a put option accordingly. The current price is an important component to consider the contractual price of a futures contract.
Basic Terms Of Futures and Options
Here are some basic terms for future and option trading.
Underlying asset – It is a prominent element of F&O trading as price movement depends upon the underlying security through which it derives its value. It can be stock, bond, commodity, interest rate, indices, or currency.
Strike price – It is a price at which the owner of the contract agrees to sell or buy the derivative at a pre-determined price on the specified date.
Premium – It is a current price of an option paid by the option buyer to the option seller. The higher the underlying assets’ volatility, the higher will be the premium.
Expiry date – It is a particular date fixed by the contract owners at which traders must exercise rights or obligations.
Futures and Options Examples
Example of Future contracts
A trader Mr. X acquires a futures contract to buy shares of Diamond Limited for ₹500 from seller Mr. Y after 3 months. In a futures contract, the buyer must purchase the stock at the end of 3 months and execute the contract in cash. A similar situation takes place for sell.
Example of Options contracts
Call option
Further to above example, Mr. X pays a premium of ₹7 to buy a call option to execute the deal when actually share price goes above ₹500 not on the contract expiry date . Seller Mr. Y is the one who sells this option along with the future contract. The option seller will retain the premium. When the share price exceeds the strike price i.e ₹500 and the premium paid, the deal benefits buyer Mr. X and he execute the transaction at the contractual price of ₹500 per share. If the share price goes down then the strike price, he may not exercise the call option.
Put option
Mr. P pays a premium of ₹9 to acquire a put option on shares of Diamond Limited at ₹500 (strike price) on the expiration day. Mr.Q is the seller of this option. The option seller will retain the premium. When the stock price falls below the strike price less the premium paid, the deal becomes attractive for buyer Mr.P. and he execute the transaction by selling the shares at strike price of ₹500 per share. This situation is called ‘In the money’. If the share price rise, he may not execute the put option and the situation is called ‘out of money’.
It for any reason the strike price and current price is equal, it is call ‘at the money’.
Who Should Invest in Futures and Options?
Futures and options are preferred by the trader not general investors. The reason for choosing future and option by traders are
Hedging
Traders can reduce investment value volatility, which is called hedging. By signing a future contract the trader can lock the price for transaction on a future date if he foresee adverse price movement in future. Thereby, he can book profit when actually price move adversely. However, if the price move favourably, the trader holding the future contract will incur loss. Such risk is mitigated in an options contract, as the trader can pull out of the contract in case of unfavourable price swings. Let us understand with an example.
Mr. A enters into a futures contract with Mr.B to sell 1000 shares of Company X for ₹100 per share three months from the current date. On the day of maturity, if the price of the share falls below that level, then Mr.A successfully hedged his position to minimise the overall risk associated with trading in the future.
However, if the price of the share rise then Mr. A stands to lose out on profits. Such losses can be offset through a put option contract, which gives Mr. A right but not an obligation to meet the conditions of the future contract. In case of a fall in the market price level, he/she can execute the options contract. Price rise allows Mr. A to withdraw from the contract and sell the shares in stock exchange at the prevailing price.
Hedging is more popular in the commodity market, wherein physical trade is undertaken by producers and companies to keep the cost of raw materials at a fixed level.
Speculation
The traders speculate the price movement of assets as per its value and economic trends. If an investor predicts the price to increase in the future, he/she can buy a future, which is also known as taking position, contracting to purchase of a stock/commodity in the present to sell it on a later date, at a higher price. This is also known as short term position.
Alternatively, if he presumes fall of price in the future, he can take a long position contracting to buy securities in the future at a reduced price to book profit.
Most speculators engaging in derivatives trading aim to opt for cash settlement, wherein the physical transfer of an asset is not conducted. On the contrary, a difference between spot price (current market price) and the price quoted to the derivative is settled between two parties, thereby reducing the hassles of such trade.
Arbitrage
Arbitrage is a process of buying a security in one market and simultaneously selling it in another market at a higher price. Thereby enabling the investor to book profit. Futures and options help in removing price difference due to imperfect trading conditions in different market.
Leverage
Futures and options trading is widely practised on leverage, wherein the entire cost of trading does not have to be paid upfront. Instead, a brokerage firm finances a stipulated percentage of an entire contract, provided an investor keeps a minimum amount (mark to market value) in his/her trading account. It increases the profit margin of an investor substantially.
Futures and options tips
Here are a few basic tips that traders need to learn about futures and options.
The ratio of profits to transaction cost
If traders keep the ratio of profits to transactions cost 3:1, it might help them gain better returns. Traders have to pay brokerage, stamp duty, taxes, statutory charges and STT on F&O trades, which affects the overall returns. If investors try to keep their costs to a minimum, they can earn decent returns.
Trade options when directions of the market are unclear
Beginner F&O traders can trade options if they do not understand the direction of the market clearly. In the option contracts, traders can exercise their rights until the contract.
Be aware of the other risks along with market volatility
At a time of high volatility in the market, the margin charged by the broker rises sharply, and traders need to keep the margins of brokerage firms to keep the transaction cost as low as possible.
Conclusion
As explained above, futures and options have high risks associated, as accurate predictions regarding the price movements have to be made. Therefore it can not be categorised as best investment option for a retail investor. However, a thorough understanding of stock markets, underlying assets and issuing organisations, etc., can help in making profit from derivative trading.
In futures and options trading, traders will get profits when they have to buy positions and prices of Futures and options are moving upwards. On the contrary, when traders have a selling position in the market, it is profitable for them if prices fall.
The prominent purpose of derivatives like futures and options is to hedge against the price movements of underlying financial instruments.
However, one point to be noted is that futures and options do not provide ownership of underlying financial instruments.
They both have their advantages and disadvantages. Futures contracts don’t have the option to sell in between the term. Options contracts have the option to exercise the right till the specified time. On the other hand, future options can give traders relatively high returns than options contracts. It all depends on the risk appetite of the traders.
Such contracts try to hedge market risks involved in stock market trading by locking in the price beforehand.
Futures and options basics provide individuals to reduce future risk with their investment through pre-determined prices. However, since a direction of price movements cannot be predicted, it can cause substantial profits or losses if a market prediction is inaccurate.