loader2
Partner With Us NRI

Open Free Demat Account Online with ICICIDIRECT

Understanding the Workings of Futures and Options

Introduction:

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

Additional Read: Best demat Account for beginners

Additional Read: Can a student open a demat Account?

Additional Read: Can I open a demat account online?

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.

Less investment

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.

Conclusion

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

Disclaimer

ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.

Most Popular

  • 13 May 2022
  • ICICI Securities

The Five-Point Financial Planning Checklist For Your Family

Whether you just got married or planning to have a baby or have dependents, you should have financial plans for every stage in your life to ensure a secured future for your family members. Here are five things you can do financially for your family.   

  • 12 May 2022
  • ICICI Securities

What is a Zero Coupon Bond?

You get fixed returns in the form of interest until maturity when you invest in a bond. Zero-coupon bonds work a little differently. In this article, find out what zero-coupon bonds are, their advantages and whether you should invest in them. 

  • 12 May 2022
  • ICICI Securities

What are Cross Currency Pairs?

The forex market is the largest financial market globally. Currency trading is a lucrative and booming business. While most currencies trading happens in relation to the US Dollar, some don’t. That forms the basis of cross currency pairs. Here’s what you need to know about it. 

  • 12 May 2022
  • ICICI Securities

Investing principles from Benjamin Graham: The Father of Value Investing

Benjamin Graham was a British born economist, professor, and investor who taught at Columbia University. He was also a mentor to some of the most famous investors of the 20th century, including Irving Khan, John Templeton, & Warren Buffett. Buffett called him "the second most influential figure in his life, only after my father". 

  • 12 May 2022
  • ICICI Securities

How to Invest in Nifty 50?

The Nifty 50 is the benchmark index of the National Stock Exchange. It represents the 50 largest companies listed in India. Investing in the Nifty 50 can be a good idea for those looking to make index-linked returns. Here’s how you can invest in the index. 

  • 12 May 2022
  • ICICI Securities

Investment philosophy of Cathie Wood: The most powerful woman on Wall Street

Catherine Duddy Wood, also called Cathie Wood, is an investor who primarily invests in disruptive technologies and is the founder, chief executive officer, and chief investment officer of ARK Investment Management, LLC, an investment management firm mostly active in the United States.

  • 11 May 2022
  • ICICI Securities

How to Use Technology to Improve Your Finances

Technology has made life simpler for everyone. In the realm of personal finance, technology has streamlined many processes—from budgeting to automating your payments. On National Technology Day, let’s look at how technology has transformed our finances. 

  • 11 May 2022
  • ICICI Securities

How to Invest in your Every Goal with Mutual Funds?

Each of us is unique. We have different needs and goals in life. Some of us can ride along swinging markets, while some may need a relatively conservative investment tool. 

  • 11 May 2022
  • ICICI Securities

Four Reasons Why Entrepreneurs should Invest in Equity Mutual Funds

Equity mutual funds provide growth opportunities not just for individual investors but also for entrepreneurs and corporates. They make excellent investments for anyone looking for wealth creation. This article will give you four reasons why businesspeople should consider investing in equity mutual funds.