Know What is Futures and Options: Definition & Types | Espresso

What are Futures and Options in Trading?

Futures and options are both stock derivatives that are traded in the share market. Investors use them to hedge their current investments in highly volatile situations.

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What are Stock Derivatives?

Derivatives are contracts that derive their value from a specific underlying asset. They are made between two parties willing to buy or sell the underlying asset at a fixed price and time. By stipulating the trade price, you can safeguard yourself against future fluctuations in the stock market.

Futures trading and options trading form an integral part of Indian equity markets. However, these two products are very different in functioning as well as how risky they are to the investor.

Now, let us understand options trading and futures trading by looking at the differences between the two:

1.Obligation - A future is a contract between two parties to buy or sell an asset at a specific time in the future at a certain price. In this case, the buyer is obligated to purchase the asset on the specified date.

When it comes to options, the investor has the right to buy the asset at a specified price but is under no obligation to go through with the purchase. However, the seller is bound to sell at the specified price if the buyer goes through with the purchase.

2.Types - Futures trading is fundamentally uniform, with the same set of rules applicable to sellers and buyers. On the other hand, options are of two types: put option and call option.

A call options contract allows you the right to buy the underlying asset on an agreed-upon date at a specific price, which is called the exercise price or strike price. In contrast, the put option lets you acquire the right to sell the underlying asset in the future at a predetermined price.

In both conditions, the trade is optional. You can decide against utilizing your call or put option if the prices are not in your favour.

3.Advance Payment - There's no upfront cost when entering into a futures trading contract. The buyer is required to pay only the agreed-upon price for the asset eventually.

The buyer in an options trading contract has to pay a premium for having the option not to buy the asset on a future date should it become less attractive. Thus, he stands to lose the premium should he choose not to go through with the purchase.

4.Contract Execution - A futures trading contract gets executed on the predetermined date, and the buyer has to purchase the underlying asset.

Meanwhile, as the buyer of an option, you can administer the contract any time before the expiry date, making you free to buy the asset whenever you feel the conditions are right.

5.Risks - Futures offer the advantage of trading equities at a margin. Still, they are higher in risk value than options because futures involve maximum liability to both the buyer and the seller.

To the buyer of a call option, the risk is limited to the premium paid upfront. Therefore, futures trading can net you unlimited profit or loss, while an options trading contract offers an immeasurable profit possibility along with the benefit of reduced potential losses.

How to Invest in Futures and Options?

You can trade derivatives on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). The former lets you trade futures and options in over 100 securities and nine major indices. Even commodities exchanges like the National Commodity & Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange (MCX) witness frequent futures and options trading.

The volatile nature of the commodities market makes it a hotbed for derivative trading with traders looking to safeguard against a future fall. Unlike intraday trading, investing in futures or options does not require a Demat account. The preferred method is to open a trading account online with a broker who will trade on your behalf.
Also Read: How to Open a Demat Account?

Who Should Invest in Futures and Options?

Futures trading and options trading both require an in-depth understanding of the nuances of the stock market, not to mention a commitment to track financial ups and downs. They also come with an element of speculation. Hence, the methods are used most often by hedgers or speculators.

1.Hedgers

Hedgers are mostly found in the commodity market, where the prices can fluctuate very quickly. Their primary motivation is to insulate themselves against future price volatility. By hedging bets in a dynamic market, hedgers are able to secure assured returns on the underlying asset.

2.Speculators

Derivatives trading inherently involves a healthy amount of speculation as you agree to trade at fixed prices. Unlike hedgers, who prefer a stable price, a speculator's priority is to buy low in the short run while speculating on higher returns in the long run. They try to study the market and make an educated guess about the price.

Conclusion

Derivatives are fast-moving trades in which the margin tends to fluctuate every day. Unlike equity, which appeals to long-term investors, futures and options trading is meant for people looking for quick returns. Trading on leverage can increase your profit margins substantially. However, they have high associated risks, as accurate predictions have to be made regarding price movements. You need to demonstrate a thorough understanding of stock markets and underlying assets to profit from derivative trading.

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Frequently Asked Questions

Derivatives trading is considered economical because of the lower brokerage. However, additional costs such as stamp duty, statutory charges, Goods and Services Tax (GST), and Securities Transaction Tax (STT) can apply to your trading account. The majority of cost hike comes from the frequency of trade with quick, multiple transactions in a short time, multiplying the cost of your overall trading. It is advisable to keep a check on the number of transactions against the gains you are making.

Margins work both ways: your likelihood of making a profit is as good as the likelihood of making a loss. Think of the risk you are willing to take when agreeing to any price. While trading in futures and options, the underlying motivation is to reduce risk by fixing the price in advance. Options may seem like the safer bet, but you are far more likely to defer trade and lose the premium value, thus incurring a net loss.

The lot size is the number of shares you can trade on a particular index. You can only trade in multiples of the lost size.

Option Pain is the rate at which an option buyer with Bank NIFTY as an underlying asset can lose the maximum amount.