If there’s one thing that’s certain about financial and commodity markets, it’s price changes. Prices keep changing all the time. They can go up and down in response to various factors, including the state of the economy, the weather, agricultural production, election results, coups, wars and government policies. The list is practically endless.
Naturally, those who are dealing in these markets will be concerned about price fluctuations, since changes in prices can mean losses – or profits. To protect themselves, they resort to derivatives like futures and options. A derivative is a contract which derives its value from underlying assets; the underlying assets could include stocks, commodities, currency, and so on.
So what are futures and options? Let’s take a look.
What are futures?
One type of derivative is the futures contract. In this type of contract, a buyer (or seller) agrees to buy (or sell) a certain quantity of a particular asset, at a specific price at a future date.
Let’s illustrate this with an example. Let’s say you have bought a futures contract to buy 100 shares of Company ABC at Rs 50 each at a specific date. At the expiry of the contract, you will get those shares are Rs 50, irrespective of the current prevailing price. Even if the price goes up to Rs 60, you will get the shares at Rs 50 each, which means you make a neat profit of Rs 1,000. If the share price falls to Rs 40, however, you will still have to buy them at Rs 50 each. In which case you will make a loss of Rs 1,000! Stocks are not the only asset in which futures are available. You can get futures contracts for agricultural commodities, petroleum, gold, currency etc.
Futures are invaluable in helping escape the risk of price fluctuations. A country that is importing oil, for instance, will buy oil futures to insulate itself from price increases in the future. Similarly, farmers will lock in prices of their products using futures so that they don’t have to run the risk of a fall in prices when they are ready to sell their harvest.
What are options?
Another kind of derivative is the options contract. This is a little different from a futures contract in that it gives a buyer (or seller) the right, but not the obligation, to buy (or sell) a particular asset at a certain price at a specific pre-determined date.
There are two types of options: the call option and the put option. A call option is a contract that gives the buyer the right, but not the obligation, to buy a particular asset at a specified price on a specific date. Let’s say you have purchased a call option to buy 100 shares of Company ABC at Rs 50 each on a certain date. But the share price falls to Rs 40 below the end of the expiry period, and you have no interest in going through with the contract because you will be making losses. You then have the right not to buy the shares at Rs 50. Hence instead of losing Rs 1,000 on the deal, your only losses will be the premium paid to enter into the contract, which will be much lower.
Another type of option is the put option. In this type of contract, you can sell assets at an agreed price in the future, but not the obligation. For instance, if you have a put option to sell shares of Company ABC at Rs 50 at a future date, and share prices rise to Rs 60 before the expiry date, you have the option of not selling the share for Rs 50. So you would have avoided a loss of Rs 1,000.
What is future and option trading?
One advantage of futures and options is that you can freely trade these on various exchanges. E.g. you can trade stock futures and options on stock exchanges, commodities on commodity exchanges, and so on. While learning about what is F&O trading, it’s essential to understand that you can do so without taking possession of the underlying asset. While you may not be interested in purchasing gold per se, you can still take advantage of price fluctuations in the commodities by investing in gold futures and options. You will need much less capital to profit from these price changes.
F&O trading in the stock market
Many people are still unfamiliar about futures and options in the stock market. However, these have been growing in popularity in recent years, so it could be to your advantage to learn more about it.
The National Stock Exchange (NSE) introduced index derivatives on the benchmark Nifty 50 in the year 2000. Today, you can invest in futures and options in nine significant indices and more than 100 securities. You can trade in futures and options through the Bombay Stock Exchange (BSE)
The considerable advantage of investing in futures and options is that you don’t have to spend money on the underlying asset. You only need to pay an initial margin to the stockbroker to trade. For example, assume that the margin in 10 percent. So if you want to trade in stock futures worth Rs 10 lakh, you can do so by paying Rs 1 lakh to the broker in margin money. Larger volumes mean that your chances of making a profit are higher. But your downside is also more significant if share prices don’t move the way you expect, you could end up with huge losses.
Options involve less risk since you can choose not to exercise them when prices don’t move in the way you expect. Your only downside would be the premium you pay for the contract. So once you know what is F&O in share market, it’s possible to make money from it and reduce your risks.
Futures and options in commodities
Futures and options in commodities are another choice for investors. However, commodity markets are volatile, so it’s better to venture into them only if you can bear a considerable amount of risk. Since margins are lower for commodities, there is scope for considerable leverage. Leverage may present more opportunities for profit, but the risks commensurately higher.
You can trade commodity futures and options through commodity exchanges like the Multi Commodity Exchange (MCX) and the National Commodity & Derivatives Exchange Limited (NCDEX) in India.
It’s important to know what are futures and options since they play an essential financial role in the world. They help hedge against price fluctuations and ensure that markets are liquid. A savvy investor can also profit by investing in these derivatives.