- Date : 09/01/2021
- Read: 4 mins
Futures and options are derivative trading for hedgers, speculators, and arbitrageurs who manage risk and make a speculative profit by trading in stocks and commodities in share markets and commodity exchanges
Futures and options are two different types of derivative contracts that can be done in various stock exchanges and across different instruments. You can trade in share futures contracts in a stock exchange while you can trade in commodities (such as a gold options contract) in the commodities exchange.
Futures and options make it possible for you to aim for a larger profit with a very low capital outlay in the beginning. You can trade in futures and options without the need of taking possession. This gives you the liberty to trade even in those commodities that you don’t plan to buy eventually.
Futures contract: It is a derivative contract where one party agrees to buy or sell a particular asset from the other party on a specified date in the future. In this contract, the number or volume of the asset, the rate, and the transaction date is mutually agreed on the date of the agreement. This contract freezes a future price and safeguards the futures trader from any disadvantageous changes in the asset price.
For instance, a gold buyer can enter into a futures contract with the seller to insulate himself from a rise in the gold price. Notably, the gold buyer can sell the futures contract before the expiry of the contract date.
Let’s say the gold buyer in the above example enters into a futures contract with the gold seller to buy 1 kilo of gold after 90 days. They have agreed that the gold rate applicable for the contract would be Rs 5000 per gram. The gold rate on the 90th day will remain Rs 5000 per gram irrespective of what the actual gold price in the market is. If the gold price rises to Rs 5500 by the 90th day, the speculator would end up making a profit of Rs 500 per gram.
Options contract: An options contract can be a call option or a put option. In a call option, the buyer gets the right to buy a particular asset at a particular price and date. Unlike futures, it is not an obligation to buy. In a put option, a person agrees to sell an asset at a particular price in the future. This too is not an obligation.
In a call option, you may have agreed to buy 100 shares of a company on a particular date at Rs 100 per share. However, if the price of the share falls to Rs 60, you would incur a loss of Rs 40 per share if you buy them. However, you can choose not to buy the shares and instead lose the nominal initial premium paid.
A put option is its reverse situation where the seller agrees to sell shares at Rs 60 per share, but the share rises to Rs 100 per share. So instead of selling the shares at a loss of Rs 40 per share, the seller can choose not to sell the shares and instead incur the loss of the initial deposit.
Who trades in F&Os?
F&O trading is used as a market hedge. Hedgers enter into F&O contracts to secure their future gains and expenses. In the case of agricultural commodities, farmers can secure their product price through F&O contracts and avoid losses in case of price fall due to oversupply of the product.
Apart from hedgers, speculators trading in F&O contracts profit from the price movement of the underlying asset. Speculators predict the future price movements and enter into F&O contracts with the aim of speculative income. They may purchase an asset to sell it at a later date, in what is known as taking a short position in the derivatives market. This is taken if, in this case, they predict a future price rise.
Besides, arbitrageurs also enter into F&O contracts to profit from the price differences in the market. Such differences arise due to market imperfections and are known as ‘costs of carry’ of the underlying asset till the future date.
F&O contracts can be traded in shares as well as commodities. The National Stock Exchange has Nifty 50 Futures and Nifty 50 Options for investors to trade in. The Bombay Stock Exchange also has derivative indices to invest in. There are around nine indices in stock exchanges in India through which investments can be made in futures and options, across over 100 securities. Besides, commodity exchanges like MCX have F&O contracts for investors who want to trade in commodities.
For speculative purposes or the purpose of risk management, F&O contracts offer wider profitability at a fraction of the total cost of trading. As they are regulated through recognised stock exchanges, they give parties the necessary assurance towards the safety of the transaction. What happens to your money if the stock you invested in gets delisted?