Futures and options (F&O) are types of financial contracts. Investors with ample experience in the financial markets can use them to earn huge profits. Having an in-depth understanding of futures and options trading will help you make the right investment decisions.
Read on to know more about the types of futures and options trading, their importance and how you can trade in F&O.
Futures and options are both stock derivative products. Derivatives are financial instruments that allow you to take a position on the future price of assets like stocks, indices, commodities or ETFs (Exchange-traded funds). In other words, these are contracts for trading assets at a predetermined price on a specific date.
Futures are a type of contract that stipulates that a trader buys/sells a specific quantity of a security at a certain price and time. These derivatives help in hedging against losses from price fluctuations. Futures contracts are available for not only stocks but also gold, currencies, commodities and ETFs (Exchange-Traded Funds).
Options contracts give a buyer or seller the right but not an obligation to buy/sell an asset at a specific price on a specific date. Thus, a trader can choose to buy/sell a security if he/she expects a profit from the trade.
Types of Futures and Options
There are several types of futures contracts:
On the other hand, there are primarily two types of options contracts:
If there is one thing certain about the markets, it is that the prices keep changing all the time. Those dealing with the stock or commodity markets need to protect their trades against sudden price changes. They can use futures and options for trading to minimise losses by locking in their desired price.
Futures contracts are essential for escaping the effects of price fluctuations. By locking in the transaction price for a future date, you can generate relative gains if the prices move adversely. For example, traders in a country importing oil often buy oil futures to insulate their investments against surges in oil prices.
However, you can incur considerable losses from your hedging positions if the markets are favourable. Options contracts prevent such losses as you can pull out of the deal when faced with favourable price swings. Hence, buyers face fewer risks with options contracts while sellers face unlimited risks.
Here are some of the important differences between futures and options:
You can trade both futures and options of different securities in their respective markets. For example, you can buy and sell F&Os of stocks on stock exchanges, commodity F&Os in the commodities market, and so on.
You will need a Demat account and a trading account to invest in futures and options. You can buy/sell stock F&Os on the NSE and the BSE. To trade with commodity F&Os, you need to use the commodity exchanges.
Let’s understand futures trading with an example. Suppose you have bought a futures contract to buy 1,000 shares of a company at Rs. 20 each on a specific date. Unfortunately, if the price of these shares falls to Rs. 10 per share on that specific date, you have to buy the shares at Rs. 20 each, with a total loss of Rs. 10,000.
With options trading, you can choose not to execute trades if it results in losses. Your only losses would be the premium amount paid to buy the contract. The premium amount is what traders need to pay to take a position in options contracts.
F&O trading involves buying or selling a security at a pre-decided price. If prices rise, a trader makes a profit if he/she has a ‘buy’ position. On the other hand, he/she will make a profit if he/she has a ‘sell’ position and the prices decrease.
This enables traders to generate quick returns from futures and options trading. By making an educated guess about the direction of the markets, F&O traders can reap substantial profits.
Additionally, individuals can also use futures and options to reduce their future risk by hedging their bets. However, they need to be well versed in the markets to make such trades.
While futures and options trading carries the potential of generating substantial profits, it also poses considerable risk. It is not meant for everybody, and only the following market participants are advised to invest in it:
Here are some of the important factors you should consider when trading futures and options:
Futures and Options trading is essential for traders in the commodities market. When used with proper understanding, it allows the trader to slowly increase his/her gains and protect the investments against a volatile market. Make sure to do careful research and assess your risk appetite before opting for F&O trading.
Ans: This is the price that the trader agrees upon to buy or sell an options contract. The contract also has a predetermined expiry date by which the holder must exercise its terms.
Ans: You can invest in commodity derivatives on commodity exchanges like the Multi Commodity Exchange (MCX) or the National Commodity and Derivatives Exchange Limited (NCDEX). Derivatives are common in these markets due to their high volatility.
Ans: As futures are heavily leveraged products, they present huge risks for the contract holder. A higher margin magnifies both the profits and losses incurred on trades. Moreover, with futures contracts, you do not have the option to back down.
Ans: The following are some of the key details of an F&O contract:
Quantity of assets
The fixed price for trading
The date for carrying out the trade
Type of asset covered by the contract
Ans: A stop-loss sets up the maximum loss that trade can undertake. Experienced traders make sure to put this limit on all their trades to protect their capital.
Before you go…
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.