If there's one thing about financial and commodity markets that's certain, it's price swings. All the time, rates keep changing. In response to different factors, including the state of the economy, the weather, agricultural production, election results, coups, wars, and government policies, they may go up and down. It becomes pertinent to ask What is Futures & Options and What is Future and Option in stock market? The list is infinite, literally.
In the Stock Market there several products for investment and for the purpose of trading such as mutual funds, equity, IPO, NCDs, bonds, derivatives, etc. The aim of this article is to enlighten the readers about Derivatives the components of that it contains. Futures and options fall under the category of derivatives. There are 4 kinds of derivatives: Forwards, Futures, Options, and Swaps.
Moreover, F&O minimizes the risks when used as hedging strategies. This article aims to highlight the important aspects of Futures and Options and simplify what is future and option in stock market for the readers. Let's dive in!
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What are Futures and Options?
Having a better understanding of F&O trading will help investors manage the risks efficiently.
It might sound scary to ask as to what is future and option in the stock market? Among Futures and Options, the futures contract is one form of derivative. A buyer (or seller) agrees to buy (or sell) a certain quantity of a specific commodity in this type of contract, at a particular price at a future date.
Example 1: -
Let's assume you purchased a futures contract on a particular date to purchase 100 shares of Company ABC at Rs 50 each. You will receive those shares at the expiry of the contract at Rs 50, regardless of the current prevailing price. You'll get the shares at Rs 50 each, even if the price goes up to Rs 60, which means you're making a neat Rs 1,000 profit.
However, if the share price drops to Rs 40, you will still have to purchase them at Rs 50 each. In which case, you're going to lose Rs 1,000! Stocks are not the only commodity with links to futures. For agricultural commodities, oil, gold, money, etc., you can get futures contracts.
In helping avoid the danger of price volatility, futures are invaluable. For example, a nation that imports oil may purchase oil futures to insulate itself in the future from price rises. Similarly, farmers use futures to lock in the value of their goods so that when they are ready to sell their crop, they do not have to run the risk of falling prices.
Among the Futures and Options, Another form of a derivative is the option contract. This is a bit different from a futures contract in that it gives a buyer (or seller) the right at a certain pre-determined date to buy (or sell) a certain product at a certain price, but not the obligation.
Two types of options exist the option to call and the option to put. A call option is a contract that gives the buyer the right to purchase a particular asset at a specified price on a particular date, but not the obligation to do so.
Example 2: -
Let's assume you bought a call option to buy on a certain date 100 shares of Company ABC at Rs 50 each. But the share price drops below the end of the expiry period to Rs 40, and since you can make losses, you have no interest in going forward with the deal.
You're free to not buy the shares at Rs 50. Therefore, the fee charged to enter into the contract will be your only loss, which will be much smaller in contrast to losing Rs 1000.
The put choice is another form of the option. You can sell assets at a negotiated price in the future, but not the obligation, in this form of contract. For example, if you have an option to sell ABC Company shares at Rs 50 at a future date, and share prices increase to Rs 60 before the expiry date, you have the option of not selling the Rs 50 share. So you would have avoided a Rs 1,000 loss.
What is Futures and Options trading?
One benefit of futures and options is that they can be openly exchanged on different exchanges. You can trade stock futures and stock exchange options, commodities on commodity exchanges, and so on, for instance. It is important to realize that you can do so without taking ownership of the underlying asset when learning about what futures and options trading is. Although you might not be interested in buying gold per se, through trading in gold futures and options, you can still take advantage of price volatility in commodities. In order to benefit from these price increases, you would need far less money.
Difference between Futures and Options
This table aims to highlight the key difference between Futures and Options.
|1. A futures contract requires a buyer to buy shares on a particular future date, and a seller to sell them unless the position of the holder is closed before the expiry date.||1. An option contract gives an investor the right to buy (or sell) shares at a particular price at any time, but not the obligation, as long as the contract is in effect.|
2. For the individual investor, however, futures are riskier. Future contracts enable both the buyer and the seller to have full liability.
As the underlying stock price moves, to satisfy a regular commitment, either party to the arrangement will have to deposit more money into their trading accounts.
This is because returns on futures positions are automatically marked daily on the exchange, meaning that the change in the value of the positions, up or down, is transferred at the end of each trading day to the futures accounts of the parties.
|2. Since they tend to be very complicated, contracts for options tend to be risky. In general, all call and put options come with the same degree of risk. |
The only contractual obligation when an individual purchases a stock option is the expense of the premium at the time the contract is acquired.
Types of Futures and Options
There are different types of Futures and Options, the different types futures are Stock Futures which first appeared in the year 2000, Index futures which can be used to speculate on the movements of Indices in future, currency futures which can be used to buy or sell a currency at a specific rate, Commodity futures which allows hedging against price changes in future for different commodities and last but not the least Interest rate futures.
The different types of Options are the option to call and the option to put. A call option is a contract that gives the buyer the right to purchase a particular asset at a specified price on a particular date, but not the obligation to do so.
Who should invest in Futures and Options?
The general classification of people who can invest in futures and options are:-
In order to minimize investment uncertainty surrounding price shifts, these individuals enter into futures and options contracts in the equity market. Locking in a sale price at a future date allows individuals to recognize relative profits if the price changes negatively with respect to a buyer's assumed trading position. However, people entering into a futures contract can incur significant losses in the event of a favorable fluctuation. In an options contract, such risk is mitigated as an investor can pull out of a deal in the event of favorable price swings.
By entering into a derivative contract, Hedgers aim to secure their gains or spending in the future. In the commodity market, where individuals try to secure an expected price of a particular item for successful exchange, such traders are popular.
In order to benefit from such price fluctuations, speculators forecast the course of price change in a market according to an inherent valuation and economic situation and prefer to take an opposite role in the
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 the spot price (current market price) and the price quoted to the derivative is settled between two parties, thereby reducing the hassles of such trade.
Arbitrageurs seek to take advantage of the market price differences that occur as a result of market imperfections. The current price and cost of transport, along with the underlying presumption that a strike price suits the contractual price, are included in the price quoted in futures and options trading. Any price differential results from the carrying, known as the cost of carrying, of the underlying security at a future
Arbitrageurs essentially remove all price differences arising from imperfect trading conditions, as they change the demand and supply patterns to arrive at equilibrium.
Trading of futures and options is widely practiced on leverage, in which it is not necessary to pay upfront the entire trading cost. Instead, a brokerage firm finances a specified percentage of an entire contract, provided that an investor keeps a minimum amount in his/her trading account (mark to market value). It significantly increases an investor's profit margin.
As explained above, however, futures and options have high risks associated with them, as precise predictions have to be made regarding price movements. To benefit from derivative trading, a thorough understanding of stock markets, underlying assets and issuing organizations, etc., must be kept in mind.
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