Futures and options are the major types of stock derivatives trading in a share market. These are contracts signed by two parties for trading a stock asset at a predetermined price on a later date. Such contracts try to hedge market risks involved in stock market trading by locking in the price beforehand.
Future and options in the share market are contracts which derive their price from an underlying asset (known as underlying), such as shares, stock market indices, commodities, ETFs, and more. Futures and options basics provide individuals to reduce future risk with their investment through pre-determined prices. However, since a direction of price movements cannot be predicted, it can cause substantial profits or losses if a market prediction is inaccurate. Typically, individuals well versed with the operations of a stock market primarily participate in such trades.
Invest in Futures and options
Difference between Futures and Options
Future and option trading are different in terms of obligations imposed on individuals. While futures act a liability on an investor, requiring him/her to follow up on a contract by a pre-set due date, an options contract gives an individual the right to do so.
A futures contract to buy/sell underlying security has to be followed up on the predetermined date at a contractual price. On the other hand, an options contract provides a buyer with a choice to do the same, if he/she profits from a trade.
Types of Futures and Options
While futures contract holds the same rules for both buyers and sellers of a contract, an options derivative can be divided into two types. Individuals entering an options contract to sell a particular asset at a pre-asserted price on a future date can do so by signing a put option contract. Similarly, individuals aiming to purchase a particular asset in the future can enter into a call option to lock in the price for future exchange.
Who Should Invest in Futures and Options?
Traders engaging in future and option trading can be classified into the following types.
- Hedgers
Such individuals enter into futures and options contracts in the share market to reduce investment volatility concerning price changes. Locking in a price for transaction at a future date helps individuals realise relative gains if the price moves adversely with respect to a trading position assumed by a buyer. However, in case of a favourable fluctuation, individuals entering into a futures contract can incur significant losses. Such risk is mitigated in an options contract, as an investor can pull out of a deal in case of favourable price swings.
Hedgers aim to secure their gains or expenditures in the future by entering into a derivative contract. Such traders are popular in the commodity market, wherein individuals try to secure an expected price of a particular item for a successful exchange. Understand it with the help of a future and option trading example. A farmer can enter into a futures contract with a wholesaler to sell 50 kg of potato for Rs. 20 per kg three months from the current date. On the day of maturity, if the price of potatoes falls below that level, the farmer successfully hedged his position to minimise the overall risk associated with trading in the future.
However, in case of a price rise in the potato market, a farmer stands to lose out on profits. Such losses can be offset through a put option contract, which gives the farmer a right but not an obligation to meet the conditions of a contract. In case of a fall in the market price level, he/she can execute the options contract to ensure negligible losses. Price rise on the other hand, allows the farmer to withdraw from the contract and sell the items in the marketplace at the prevailing price.
Hedgers primarily opt for physical trade wherein the asset is exchanged upon maturity of the contract. It is particularly popular in the commodity market, wherein physical trade is undertaken by producers and companies to keep the cost of raw materials at a fixed level. It ensures stability in the price levels in an economy.
- Speculators
Speculators predict the direction of price movement in a market as per an intrinsic valuation and economic condition and choose to take an opposite stance in the present to gain from such price fluctuations. Taking a futures and options example, if an investor predicts the price to increase in the future, he/she can assume a short position in the derivatives market. It indicates a purchase of a stock/derivative in the present to sell it on a later date, at a higher price.
Subsequently, a long position is undertaken by individuals expecting the prices to fall in the future as per their market analysis. Investors plan on buying securities in the future at a reduced price through such contracts, to profit in relative terms.
Most speculators engaging in derivatives trading aim to opt for cash settlement, wherein the physical transfer of an asset is not conducted. On the contrary, a difference between spot price (current market price) and the price quoted to the derivative is settled between two parties, thereby reducing the hassles of such trade.
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- Arbitrageurs
Arbitrageurs aim to profit from price differences in the market, which arise due to market imperfections. A price quoted in futures and options trading includes the current price and cost of carry, along with an underlying assumption that a strike price matches the contractual price. Any price difference arises from carrying the underlying security to the future date, known as the cost of carry.
Arbitrageurs essentially remove all price differences arising from imperfect trading conditions, as they change the demand and supply patterns to arrive at equilibrium.
Futures and options trading is widely practised on leverage, wherein the entire cost of trading does not have to be paid upfront. Instead, a brokerage firm finances a stipulated percentage of an entire contract, provided an investor keeps a minimum amount (mark to market value) in his/her trading account. It increases the profit margin of an investor substantially
However, as explained above, futures and options have high risks associated, as accurate predictions regarding the price movements have to be made. A thorough understanding of stock markets, underlying assets and issuing organisations, etc., have to be kept in mind to profit from derivative trading.
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Now, let's discuss the concepts mentioned in the article about futures and options in stock derivatives trading.
Futures and Options Basics
Futures and options are types of stock derivatives trading in the share market. These contracts are signed by two parties to trade a stock asset at a predetermined price on a later date. The purpose of these contracts is to hedge market risks involved in stock market trading by locking in the price beforehand.
Futures and options derive their price from an underlying asset, such as shares, stock market indices, commodities, ETFs, and more. They provide individuals with the opportunity to reduce future risk with their investments through pre-determined prices. However, since the direction of price movements cannot be predicted, trading futures and options can result in substantial profits or losses if market predictions are inaccurate.
Difference Between Futures and Options
Futures and options differ in terms of the obligations imposed on individuals. A futures contract acts as a liability on an investor, requiring them to follow up on the contract by a pre-set due date. On the other hand, an options contract gives the buyer the right, but not the obligation, to follow up on the contract.
In a futures contract, the buyer or seller of the underlying security must fulfill the contract on the predetermined date at a contractual price. In contrast, an options contract provides the buyer with a choice to do the same if they profit from the trade.
Types of Futures and Options
While futures contracts hold the same rules for both buyers and sellers, options derivatives can be divided into two types:
- Put Option: Individuals entering an options contract to sell a particular asset at a pre-asserted price on a future date can do so by signing a put option contract.
- Call Option: Individuals aiming to purchase a particular asset in the future can enter into a call option to lock in the price for future exchange.
Who Should Invest in Futures and Options?
Traders engaging in futures and options trading can be classified into the following types:
-
Hedgers: Hedgers enter into futures and options contracts in the share market to reduce investment volatility concerning price changes. They aim to secure their gains or expenditures in the future by entering into derivative contracts. Hedgers are popular in the commodity market, where individuals try to secure an expected price of a particular item for a successful exchange. Hedgers primarily opt for physical trade, wherein the asset is exchanged upon maturity of the contract.
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Speculators: Speculators predict the direction of price movement in a market based on intrinsic valuation and economic conditions. They choose to take an opposite stance in the present to gain from price fluctuations. Speculators engage in derivatives trading to profit from relative price changes. They often aim for cash settlement, where the physical transfer of an asset is not conducted.
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Arbitrageurs: Arbitrageurs aim to profit from price differences in the market that arise due to market imperfections. They remove price differences arising from imperfect trading conditions by changing demand and supply patterns to arrive at equilibrium. Futures and options trading is widely practiced on leverage, wherein the entire cost of trading does not have to be paid upfront. Instead, a brokerage firm finances a stipulated percentage of an entire contract, increasing the profit margin of an investor substantially.
It is important to note that futures and options trading carries high risks, as accurate predictions regarding price movements have to be made. A thorough understanding of stock markets, underlying assets, and issuing organizations is necessary to profit from derivative trading.
I hope this information helps you understand the concepts mentioned in the article about futures and options in stock derivatives trading. If you have any further questions, feel free to ask!
