Understanding the Workings of Futures and Options
Prices of every instrument in the financial markets fluctuate to a large extent. There are numerable factors that cause this volatility. These price swings can give you abundant profits as well as heavy losses. To safeguard yourself against the sharp lows, you can invest in derivative instruments such as Futures and Options.
The origin of Futures and Options
Financial markets can be stirred by a string of factors including economic conditions, political crisis, government policies, etc. The buyers and sellers in the physical goods and services markets are most affected by such fluctuations. Price fluctuations can alter the overall demand-supply equation of the markets. Traders have created binding contracts amongst themselves for buying/selling a certain quantity of goods at a pre-set price on a fixed date in the future. This has been done with the objective of protecting themselves against these unforeseen circumstances. Since these contracts derive their value from the underlying assets, they are called derivatives. Derivatives can comprise stocks, commodities, indices, currencies, etc. The two popular variants of derivative are Futures and Options.
What is a Futures contract and how does it work?
A Futures contract allows you to purchase or sell a particular quantity of an asset on or before a future date at a predetermined price. This is a binding contract, that is, both the buyer as well as seller must execute the trade on the decided date. This has to be done irrespective of the prevailing market price of that asset. The price at which you trade the underlying Futures contract is called the ‘strike price’. An investment in a Futures contract can fetch you high profits or losses, making it a high-risk instrument. You can trade Futures like shares on an exchange.
What is an Options contract and how does it work?
An Options contract allows you, the buyer, to purchase or sell a particular quantity of an asset at a predetermined price on or before the expiry of the agreement. This is not a binding contract for the buyer. Apart from having the right to trade, you also have the option to not proceed with the transaction. However, if you want to proceed with the purchase, the seller is obligated to sell it as per the contract terms. This implies that a buyer has the upper hand in an Options contract. But you have to pay a premium to the seller in advance to avail of this privilege. So, if you decide to not execute the purchase, you lose the premium paid. Thus, in Options, as a buyer, your loss is restricted to the premium. However, as a seller, the potential of your loss can be unlimited.
Call and put are two types of Options. A Call Option is a contract to purchase the underlying asset at a pre-determined price on or before the expiry of the contract. A Put Option is a contract to sell the underlying asset as per the contract terms. Just like Futures, you can trade Options on an exchange too.
How to trade in F&O
Trading in the F&O market is like trading in shares. You require a demat account to hold the purchased F&O and a trading account to transact. A registered broker can help you with the opening of both these accounts. It can also furnish you with valuable research material to help you with the basics and many other crucial aspects.
Additional Read: How to trade shares online using Demat Account
Benefits of Futures & Options:
Protection from price fluctuation:
The biggest benefit you enjoy from an investment in F&O is protection from price fluctuations. For example, in India, since oil is imported, companies buy oil Futures to lock in a favourable price. In this manner, they are safeguarded from any rise in prices. In the agricultural sector, farmers sell their grains through derivative contracts. Then, even if there is a drop in product prices, they are protected.
You can trade in Futures and Options without taking possession of the underlying asset. You can profit from trading owing to price fluctuations, without the need to invest a sizeable portion of capital. You will only be paying an initial margin to the broker in order to trade.
Investing in derivatives is still fairly unchartered territory for many, but it can be very beneficial if you understand the concept well. Let your risk appetite dictate whether a Future should be your pick or an Option. Research regarding the nature of the underlying assets and the factors affecting trade are also key in deciding which category of derivatives is best suited for you.
Additional Read: Comparison between Gold ETF and Gold Futures
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