What are Futures and Options?
- 4m0•
- 20 Jul 2023
Futures and options play pivotal roles as stock derivatives in share markets, allowing traders to engage in trading while managing market risks actively. These financial contracts, signed by two parties, facilitate trading stock assets at predetermined prices on specified future dates. These contracts aim to hedge the risks associated with stock market trading by locking in prices in advance.
Futures and Options Meaning
Futures and options contracts in the share market derive their prices from underlying assets such as shares, stock market indices, commodities, ETFs, and more. They offer individuals the ability to mitigate future investment risks through pre-determined prices. However, due to the unpredictable nature of price movements, incorrect market predictions can lead to significant profits or losses. Typically, individuals experienced in stock market operations actively participate in such trades.
What is a Futures Contract?
A futures contract is a kind of consensus to sell or buy an asset, such as stocks, commodities, or currencies, at a specific price (known as the "futures price") and date in the future. The futures contract's buyer agrees to purchase the underlying asset, while the seller agrees to deliver it. Futures contracts are standardized and traded on organized exchanges, ensuring transparency and liquidity.
Key features of futures contracts include -
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Standardized: Futures contracts have standardized specifications regarding the underlying asset's quantity, quality, and delivery terms.
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Expiry Dates: Each futures contract has a specified expiry date, indicating when the contract needs to be settled.
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Margin Requirements: To trade futures, participants must deposit an initial margin as a performance bond. This margin ensures that both parties fulfill their obligations.
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Leverage: Futures contracts allow traders to control a large value of the underlying asset with a comparatively smaller investment.
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Mark-to-Market: Futures positions are marked-to-market daily, with profits or losses settled daily as well.
What are Options?
Options give the holder the right (but no obligation), to sell or buy any asset at the strike price within a specified period. Unlike futures contracts, options contracts do not require holders to fulfill the transaction if they choose not to.
There are two types of options:
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Call Options: With a call option a holder gets the right to purchase the underlying asset at the strike price before expiration.
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Put Options: With a put option the holder can sell the asset at its strike price before the expiration date.
Key features of options include:
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Flexibility: Options offer the flexibility to choose whether or not to exercise the right to buy or sell the underlying asset.
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Premium: The buyer of an option pays a premium to the seller for the rights conveyed by the contract.
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Limited Risk: The risk in options trading is limited to the premium paid, providing a defined risk-reward profile.
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Expiration Date: Options contracts have an expiration date, after which they become invalid.
Difference Between Futures and Options
The table captures the difference between Futures and Options on various parameters:
Parameters
Obligation
Futures
Both parties need to fulfill the transaction
Options
Provide the right, but not the obligation, to buy or sell
Parameters
Profit Potential
Futures
Offers unlimited profit potential
Options
Has limited profit potential depending on the price movement of the underlying asset
Parameters
Risk
Futures
Carries higher risk due to the obligation to fulfill the contract
Options
Limits the risk to the premium paid
Parameters
Cost
Futures
Typically involves lower costs, primarily due to the absence of a premium
Options
Higher cost than futures because of premium presence
| Parameters | Futures | Options |
|---|---|---|
| Obligation | Both parties need to fulfill the transaction | Provide the right, but not the obligation, to buy or sell |
| Profit Potential | Offers unlimited profit potential | Has limited profit potential depending on the price movement of the underlying asset |
| Risk | Carries higher risk due to the obligation to fulfill the contract | Limits the risk to the premium paid |
| Cost | Typically involves lower costs, primarily due to the absence of a premium | Higher cost than futures because of premium presence |
Benefits of Futures and Options Trading
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Risk Management: Futures and options contracts provide a means for managing risk. They allow participants to hedge against potential price fluctuations in the underlying assets. By taking positions in futures or options contracts, traders can protect their investments from adverse market movements and reduce potential losses.
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Leveraged Trading: Futures and options offer leverage, which means that traders can control a larger value of the underlying asset with a relatively smaller investment. This amplifies potential returns on investment. However, it is important to note that leverage can also magnify losses, so proper risk management is crucial.
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Diversification: Futures and options enable traders to diversify their portfolios beyond traditional investments. They provide exposure to various asset classes, such as stocks, commodities, currencies, and indices. By diversifying across different markets, traders can reduce risk and enhance their overall investment strategy.
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Price Discovery: Futures markets play a crucial role in price discovery. As futures contracts are traded publicly on organized exchanges, they reflect the collective opinion of market participants. The transparent nature of futures trading helps establish fair and efficient prices for the underlying assets, benefiting traders and investors.
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Liquidity: Futures and options markets are generally highly liquid, meaning there is a high volume of trading activity and many buyers and sellers. This liquidity ensures that traders can easily enter or exit positions at competitive prices, reducing the risk of being unable to find a counterparty for their trades.
Risks Associated With Futures and Options Trading
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Market Risk: Futures and options trading are subject to market risk. The underlying asset's value can fluctuate significantly, and these price movements can result in gains or losses for traders. Market volatility, unforeseen events, economic factors, and changes in supply and demand can all impact the underlying asset's value, thereby affecting the profitability of futures and options positions.
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Leverage Risk: The leverage offered in futures and options trading can amplify profits and losses. While leverage allows traders to control a larger position with a smaller investment, it also magnifies the impact of price movements. If the market moves against a leveraged position, losses can exceed the initial investment or margin requirements, potentially leading to significant financial loss.
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Counterparty Risk: Futures and options contracts are typically traded on exchanges, which act as intermediaries and guarantee the performance of the contracts. However, there is still a level of counterparty risk involved. If the counterparty doesn't fulfill its obligations, it can result in losses for the trader. Choosing reputable exchanges and clearinghouses with robust risk management systems to mitigate counterparty risk is important.
Who Should Invest in Futures and Options?
Investors who possess knowledge of futures and options in the stock market and a comprehensive understanding of market analysis can engage in futures and options trading. This type of trading involves a speculative element, as it relies on predicting both micro and macroeconomic factors associated with the underlying financial instruments.
Traders must make estimations regarding the market's direction, whether it is trending upward or downward. Based on these assessments, they enter into contracts with other market participants. In essence, futures and options are utilized by both hedgers and speculators to manage risk or take advantage of market opportunities, respectively.
Trading in Futures and Options: The Steps
To trade in F&O:
- Open an account with a registered broker
- Log into your account and browse through various F&O options
- Put the order details and buy futures and options at the strike price
The Kotak Neo app from Kotak Securities helps you easily engage in futures and options trade. Click here to see how you can place F&O orders through this app.
Essential Things to Keep in Mind
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Educate Yourself: Before entering the futures and options market, it is crucial to educate yourself about the intricacies of these instruments. Understand how they work, the various strategies involved, and the potential risks associated with them. Knowledge and continuous learning are vital for successful trading.
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Define Your Goals and Risk Tolerance: Clearly define your trading goals, whether they are income generation, capital appreciation, or risk hedging. Additionally, assess your risk tolerance level, as futures and options trading can involve substantial risks. Determine how much money you are willing to risk and set realistic expectations for returns.
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Develop a Trading Plan: Establish a well-defined trading plan that outlines your strategies, entry and exit points, risk management techniques, and position sizing. A trading plan helps maintain discipline and minimizes impulsive and emotional trading decisions.
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Stay Informed: Stay updated on market news, economic indicators, and relevant events that can impact underlying asset prices. Market trends and news can significantly influence futures and options prices, so staying informed and adapting your trading strategies is important.
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Use Proper Tools and Resources: Utilize reliable trading platforms and tools that provide accurate market data, charts, and analysis. These resources can assist in making informed trading decisions and identifying potential trading opportunities.
In Conclusion
Futures and options contracts in the share market provide individuals with powerful tools to manage risk, speculate on price movements, and diversify their portfolios. Understanding the basics of futures and options is crucial for anyone seeking to engage in share market trading. Individuals can make informed decisions by considering their unique features and differences, maximizing potential returns while effectively managing risk.
FAQs
Futures and options are financial instruments through which traders can speculate on or hedge against the price movements of assets, such as commodities, stocks, or currencies. Futures involve an obligation to buy or sell the asset in the future, while options provide the right, but not the obligation, to do so.
A future contract represents a legally binding agreement wherein the buyer and seller agree to trade an underlying stock at a price decided earlier on a certain date. Conversely, an options contract provides investors with the choice (but not the obligation), to sell or buy assets at a predetermined price on or before a specific date, commonly referred to as the expiration date.
A strategy that combines options and futures enables traders to participate in markets with uncertain directional movements. This approach allows for potential gains in both volatile and stagnant market conditions, providing flexibility and adaptability to different market scenarios.
When the price of futures decreases, the sale price becomes more valuable to a buyer, increasing the value of a put option. Conversely, if the cost of futures increases, the value of a put option decreases.
The F&O contracts expire on the final Thursday of every month.
