Futures and options are derivative contracts traded in the stock market that derive their value from an underlying asset such as shares, indices, or commodities. They allow market participants to manage price risk or take exposure to future price movements without owning the underlying asset directly.
A futures contract is an agreement to transact an asset at a fixed price on a specified future date. Both parties are obligated to honour the contract at expiry. Options, on the other hand, give the buyer the right, but not the obligation, to transact the asset at a predetermined price within a specified period.
Difference between futures and options
Future and option are two derivative instruments where the traders buy or sell an underlying asset at a pre-determined price. The trader makes a profit if the price rises. In case, he has a buy position and if he has a sell position, a fall in price is beneficial for him. In the opposite price movement, traders have to bear losses.
In the case of futures trading, a trader has to keep a certain percentage of the future value with the broker as a margin to take the buy/ sell position. To buy an option contract, the buyer has to pay a premium.
Different types of futures and options
Futures and options come in various forms, depending on the underlying asset, contract structure, and exercise style. Understanding these types helps you choose instruments that align with your risk profile, market view, and investment objective.
- Stock futures and options
These are based on individual company shares. Stock futures involve an obligation at expiry, while stock options give the right to transact the underlying share at a predetermined price.
- Index futures and options
Index-based contracts derive value from indices like Nifty or Sensex. They are widely used for broad market exposure and portfolio risk management.
- Call options
A call option gives the holder the right to transact the underlying asset at a fixed price before or on expiry, subject to contract terms.
- Put options
A put option provides the right to transact the underlying asset at a predetermined price, often used to manage downside risk.
- Commodity and currency derivatives
These futures and options are based on commodities or currencies and help manage price or exchange rate fluctuations.
- American and European options
American options can be exercised anytime before expiry, while European options can only be exercised on the expiry date.
How does F&O trading work?
Futures and Options (F&O) trading works by allowing market participants to take positions on the future price movement of an underlying asset such as shares, indices, commodities, or currencies. These contracts are standardised and traded on recognised exchanges, with defined lot sizes, expiry dates, and pricing rules.
In futures trading, both parties enter a binding agreement to transact the underlying asset at a fixed price on a future date. Margins are paid upfront, and positions are marked to market daily, meaning gains or losses are settled each day.
Options trading works slightly differently. The buyer pays a premium for the right, but not the obligation, to transact the underlying asset at a predetermined price. The seller, however, has an obligation if the option is exercised.
Who should invest in F&O trading?
Futures and options (F&O) trading offers significant profit potential but also carries considerable risks. It is not suitable for every investor, as it requires market knowledge, risk tolerance, and strategic planning. F&O trading is typically used by different types of market participants, each with specific objectives.
1. Hedgers – Managing risk in market fluctuations
Hedgers are investors or businesses that use futures and options to protect themselves against unfavorable price movements in an asset. They invest in derivative contracts to minimise the risk associated with volatility. For example, a farmer may use futures contracts to lock in crop prices, or a company reliant on oil may hedge against rising crude prices. By doing so, hedgers aim to stabilise their financial exposure and reduce uncertainty.
2. Arbitrageurs – Profiting from price differences
Arbitrageurs capitalise on price discrepancies of the same asset in different markets or exchanges. They buy in one market at a lower price and simultaneously sell in another where the price is higher, making a profit from the difference. This strategy requires quick decision-making and an understanding of market inefficiencies. Arbitrage trading in futures and options helps enhance market liquidity and efficiency by narrowing price gaps across different trading platforms.
3. Speculators – Taking advantage of market movements
Speculators invest in F&O contracts with the sole objective of profiting from price movements. They do not own the underlying asset but take positions based on expected price changes. If their market prediction is correct, they can make significant returns, but incorrect speculation can lead to substantial losses. Due to the high risk involved, speculation is best suited for experienced traders who can analyse trends and manage risk effectively.
4. Retail and institutional investors – Leveraging market opportunities
Both retail and institutional investors participate in futures and options trading for various reasons. Institutional investors, such as hedge funds and mutual funds, use derivatives to manage portfolio risks and optimise returns. Retail investors, on the other hand, often trade F&O for short-term gains or hedging purposes. However, due to leverage and potential volatility, retail traders should approach F&O with caution and proper risk management strategies.
Future and options trading can be rewarding but is complex and requires a strong understanding of the market. Investors should assess their financial goals, risk appetite, and trading expertise before entering the derivatives market.
Risk management in F&O trading
Effective risk management is essential in future and options trading to minimise potential losses. Key strategies include:
- Position sizing: Limiting the percentage of capital risked in each trade.
- Stop-loss orders: Setting automatic exits to cap losses.
- Diversification: Reducing risk by spreading investments across various assets.
- Hedging: Using derivatives to offset potential losses in other investments.
- Leverage control: Cautiously employing leverage to avoid amplifying risks.
These measures ensure long-term financial stability by protecting against volatility.
Conclusion
However, as previously stated, since precise price movement projections must be made, futures and options carry a significant level of risk. To make money from trading derivatives, it is important to have a solid understanding of stock markets, underlying assets, issuing companies, etc.
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