Futures and options are derivatives that are traded on the stock exchange and derive their price from the underlying asset. Hedgers, speculators, and arbitrageurs use these contracts to make profits or hedge the risk with the underlying asset. A futures and options contract helps secure a price of an asset when the market volatility is high. This article covers what futures and options are and how they are traded in detail.
What are Futures and Options?
A futures contract is an agreement to buy or sell an underlying asset at a future date at a predetermined price and quantity. Once entered into a futures contract, a buyer and a seller are obligated to fulfil the contract regardless of the current market price. The underlying asset can be shares, ETFs, other financial instruments and even commodities like oil. The quantity, price and date of transaction are clearly mentioned in a futures contract.
A futures contract is a derivative contract that trades on the stock exchange. It can also be used for speculation or hedging the risk. However, one of the main purposes of a futures contract is to secure and fix the price of an asset against market volatility. The main aim behind a futures contract is to exchange the underlying asset. But speculators do not really look for product exchange. Instead, they want to take advantage of price changes and make money.
This derivative instrument is very liquid as they are traded a lot on the stock exchange. However, they can be quite risky as well. In a futures contract, one can take advantage of margins and leverage. An exchange sets a margin requirement, which is the minimum amount that the trader needs to deposit to trade in futures. The lower the margin, the higher the leverage.
For example, if the exchange sets a margin of 5% for a commodity, the leverage is 20 times. This means one can trade for INR 100 by investing only INR 5. After the contract expires, the trader has to pay back the entire amount. Hence more the leverage, the higher is the risk.
Options are also derivative contracts that derive value from an underlying security. Buyers can buy or sell an underlying asset depending on the type of option they hold. With an options contract, the holder is not obligated to buy or sell the asset if they do not want to. Options contracts have an expiry date which is the last Thursday of every month.
Options are of two types: Call option and Put option.
- Call Option: In a call option, the buyer has the right but not the obligation to buy the particular asset at the specified price on the specified date. For example, if you buy a call option of a company X to buy 100 shares at INR 100 on a specified date. On the date of expiry, the share price of Company X has fallen to INR 80, and you are not willing to execute the contract because you will be making a loss. You have the right not to buy the share, and as a result, you will only lose the premium paid to enter the contract. Therefore, instead of losing the INR 2,000, you will be losing only the premium paid.
- Put Option: In a put option, the option holder has the right but not the obligation to sell the particular asset at the specified price on the specified date. For example, if you buy a put option of a company X to sell 100 shares at INR 100 on a specified date. On the date of expiry, the share price of Company X has gone up to INR 120, and you are not willing to execute the contract because you will be making a loss. You have the right not to sell the share and avoid the loss of INR 2,000.
How Futures and Options are Traded?
In F&O trading, margin and premium are important. Margin in a futures contract is the minimum amount you have to pay to the broker to trade in futures. The margin requirements change as per market volatility. The lower the margin, the higher the leverage. Premium in options is the amount the option buyer pays to the seller to obtain the right to execute the contract.
To trade in futures, you will need to pay a margin, and you can start trading in futures. For example, if you want to trade in shares worth INR 1 lakh, with a margin requirement of 10%, you can trade with an investment of INR 10,000 only. To trade-in options, if you want to buy an option, you will have to pay a premium. Premium is the current market price of an options contract.
Futures are obligatory contracts, and hence the exchange squares off all the futures positions at the time of expiry. This means that if you bought a futures contract at the time of expiry, you would have to sell it even if you incur a loss. Options, on the other hand, are not obligatory contracts. If you bought an options contract, you could exercise your right only if the market is in favour of you.
Who Should Invest in Futures and Options?
Trading in futures and options requires a high level of understanding of the stock markets. It also requires investors’ time to track the market movements. Therefore, investing in futures and options isn’t often everyone’s game.
- Hedgers: Hedgers mainly focus on protecting themselves from future price fluctuations. The majority of hedgers work in the commodities market, where prices change rapidly. In such situations, futures and options trading can often provide them with much-needed price stability. Hedgers secured their return from an underlying asset by hedging their best in the volatile market. However, if the price rises in the meanwhile, they risk losing the profit.
- Speculators: Derivative contracts have a good element of speculation, i.e., agreeing to trade at a fixed price. Speculators try to bet against the long odds. They actively analyse the markets, news, and any other information that is likely to have an impact on their trading. Therefore, speculators take an educated bet at the price of the underlying asset. Simply put, speculators aim to buy the asset at lower prices in the short term and speculate on higher returns in the long term.
- Arbitrageurs: Arbitrageurs take advantage of the price volatility across different exchanges. In other words, they make profits from the price differences in the underlying asset across different exchanges. Arbitrageurs buy low priced securities in one market and simultaneously sell them at a higher price in another market.
- Margin Traders: Margin traders are individuals who deposit a margin amount (a minimum amount) with their broker in order to participate in the derivatives trades. Through this, the trades are able to leverage the derivative trades by maintaining a sizable outstanding position.