When considering investing, you might imagine buying stocks or mutual funds. But there is another exciting way to trade in the market, known as Futures and Options (F&O). Let’s understand what Futures and Options trading are, their features, and their pros and cons.
What are Futures?
In F&O trading, futures are financial agreements that require the buyer to acquire an asset or the seller to deliver an asset at a predetermined price on a future date. These contracts are standardised to enable trading on futures exchanges and can be based on various underlying assets, including commodities, currencies, and financial instruments.
How Futures Contracts Work
Here is an F&O trade’s futures example for a better explanation:
Suppose you run a small bakery and believe you will need 500 bags of flour in three months for your production. However, you also expect the flour’s rise will increase in the coming days because of the prevalent supply chain issues. You decide to lock in a price now to avoid paying more later.
Here, you enter into a futures contract with a flour supplier. Based on the negotiation you agree to buy 500 bags at today’s price, which will be delivered in three months. This way, you are protected from potential price increases and can manage your costs effectively and keep your bakery running smoothly.
Types of Futures Contracts
The three common types of futures derivatives are:
Stock Futures
Stock futures are contracts that involve a particular stock as the underlying asset. These agreements enable you to speculate on the future price of that stock, offering the chance to profit if the stock price moves as expected.
Index Futures
Index futures derive their value from stock market indices such as the Nifty 50 or the S&P 500. These agreements allow you to speculate on the stock market’s overall direction instead of focusing on individual stocks.
Commodity Futures
Commodity futures encompass contracts focusing on physical commodities like gold, oil, or agricultural goods. These contracts are widely used by traders seeking to hedge against price fluctuations within these markets.
Currency Futures
Currency futures are financial contracts where the underlying asset involves a currency pair, such as USD/INR. These agreements mitigate currency risk or speculate on currency exchange rate shifts.
Key Features of Futures
Standardisation
Futures contracts are regulated in quantity, quality, and delivery period. For example, a future contract in crude oil might detail that 1,000 barrels of oil of a designated grade will be delivered in a specific month.
Margin Requirements
To participate in futures trading, depositing a margin, which is a percentage of the entire contract value, is necessary. For example, if the margin requirement is 10%, you must deposit ₹10,000 to trade a contract worth ₹1,00,000.
Settlement Process
Futures contract settlements are possible in cash or the physical delivery of the asset in the contract. For instance, in a gold futures contract, you can receive the gold itself or settle the contract in cash according to the market price at expiration.
Benefits of Futures Contract
- Leverage: Futures allow you to manage a significant position with a comparatively small capital investment. This feature can amplify your potential returns.
- Liquidity: The futures markets are highly liquidity. This makes it easier for you to enter and exit the positions.
- Hedging: Futures serve as effective instruments for mitigating price risks across various market sectors.
- Diversification: With futures, you can diversify your investment portfolio among different asset classes, be it commodities, equities, or any other tradable instruments.
- Transparency: The futures markets operate under regulatory oversight and are characterised by transparency, ensuring that fair trading practices are upheld.
Disadvantages of Futures Contract
- Leverage Risk: Although leverage can enhance profits, it can equally amplify losses, which may result in significant financial harm.
- Market Volatility: The futures markets can exhibit extreme volatility, presenting risks of rapid and significant price fluctuations.
- Margin Calls: If the market or the security price moves unfavourably against your position, you might be obligated to add more funds to uphold your position.
- Complexity: Trading futures necessitates a comprehensive understanding of both the markets and the specific contracts, rendering it inappropriate for novice traders.
- Counterparty Risk: Even though futures exchanges work to reduce this risk, there remains a chance of default by the counterparty involved.
What are the Options?
Stock options trading are the form of derivatives where you get the right, though not the obligation, to acquire or trade-off an underlying asset at a set price within a defined time frame. These assets can include stocks, indices, commodities, or currencies. Options serve as flexible tools for hedging, speculation, or income generation. Their worth is derived from the price of the underlying asset.
How Options Contracts Work
Here is an example for a better explanation:
As an options trader, you expect the stock price of Company XYZ to increase. You acquire a call option via the FNO app with a strike price of ₹1,000, which expires in one month, for a premium of ₹50 per share. This contract grants you the right to purchase 100 shares of XYZ at ₹1,000 each, regardless of the market price at expiration. If the stock price climbs to ₹1,200, you can exercise your option via the F&O app, buy at ₹1,000, and sell at ₹1,200, generating a profit of ₹150 per share (₹200 gain minus ₹50 premium). However, if the stock price falls below ₹1,000, you can let the option expire, losing just the premium you paid.
Types of Options Contracts
The two types of options are:
Call Options
A call option grants you the right to buy an asset at a prearranged strike price prior to the option’s expiration. For instance, if you expect a stock to appreciate in value, you may decide to buy a call option to secure a purchase price. If the stock price moves over the strike price, you can execute your contract to buy at the lower price. Doing so allows you to sell at a higher market price for a profit.
Put Options
In contrast, a put option gives you the right to sell an underlying asset at a designated strike price before the option expires. This can be beneficial if you foresee a decrease in the asset’s price. For example, if you own shares of a stock and are concerned about a price drop, acquiring a put option allows you to sell the shares at the strike price, minimising potential losses.
Key Features of Options
Strike Price
The strike price refers to the set price at which you can either buy (call) or sell (put) the underlying asset. For example, if you acquire a call option with a strike price of ₹500, you gain the right to buy the asset at ₹500, regardless of its current market price.
Premium
The premium is the amount you pay when purchasing the option contract. This cost is impacted by various elements, such as the underlying asset’s price, the strike price, the time left until expiration, and the current market volatility. For instance, buying a call option with a premium of ₹20 per share covering 100 shares would pay ₹2,000 (₹20 multiplied by 100) for the contract.
Expiry Date
The expiration is the last date on which you can execute your contract. Once this date has elapsed, the option becomes valueless. For example, if you buy an option set to expire on December 31, you must decide whether to exercise it by that date.
Benefits of Trading Options
- Leverage: Options enable you to manage a substantial position with a comparatively modest investment.
- Risk Management: Options can serve as a tool to safeguard against possible losses in your investment portfolio. For example, purchasing put options on a stock you hold can shield you from a decrease in its price.
- Income Generation: Writing options like covered calls can create an extra income from your current stock assets.
- Flexibility: Options provide numerous strategies for profiting in various market scenarios, whether bullish, bearish, or neutral.
- Limited Risk for Buyers: When you purchase options, your maximum financial loss is confined to the premium you paid, unlike owning the underlying asset, where losses can be extensive.
Drawbacks of Trading Options
- Complexity: Engaging in options trading demands a comprehensive understanding of diverse strategies and market scenarios. For example, incorrectly predicting market shifts can result in considerable financial losses.
- Time Decay: The value of options diminishes as their expiration approaches, referred to as time decay. If the underlying asset does not perform as expected, the option can lose value swiftly.
- Potential for Significant Losses: While acquiring options limits your maximum loss to the premium spent, writing options can subject you to unlimited losses if the market moves against your position.
- Market Volatility: The prices of options are particularly sensitive to changes in market volatility. Sudden fluctuations in the market can greatly alter the value of your options.
Conclusion
Futures and options are powerful tools for investors looking to manage risk, speculate, or enhance their investment strategies. By understanding the meaning, types, and differences between these two instruments, you can better decide on which contract suits your style. Remember, while trading FnO can offer exciting opportunities, they also comes with risks. Always consider your financial situation and investment goals before diving in.
To begin trading in F&O stocks, Open Free Demat Account Online first with HDFC SKY.
