Futures and Options
Stock market offers several products for investment and trading purposes. Few of them are mutual funds, equity, IPO, NCDs, bonds, derivatives, etc. Let us learn about futures and options that fall under the category of derivatives. Derivatives are contracts that are made between two parties willing to buy or sell the underlying asset at a fixed price and fixed time. These are risk management tools that help in transferring risk to those who are ready to take the risk. Derivatives are of 4 types: Forwards, Futures, Options and Swaps. Future and options contracts are used as hedging tools to reduce risk and make profits in a highly volatile situation. The prices of goods may suddenly rise or even fall. This necessitates the importance of future contracts. Firstly, let us read about what is future trading in stock market
What are futures?
Futures are contracts made between two parties wherein they agree to buy or sell a particular asset at a fixed price at a particular time in the future. This helps in reducing the risk and losses involved. Let’s say you are a soybean farmer, there is good rainfall and hence the supply of soybean is high and so the prices come down. You will be at loss as a farmer. Think of the soybean buyer now. Due to unexpected drought, the price of soybean goes up. So as a buyer, he has to shell out more and hence he faces loss. To avoid these losses, it is essential to enter into futures contract. This will protect you irrespective of the market fluctuations. For example, the price of soybean hits Rs. 350 after 3 months, but if you have already made a futures contract at Rs. 400, you will gain a profit of Rs. 50 even though the market price is Rs. 350. By this way, you can predict the future demand, price and also reduce the losses. You can actually trade using lesser margins in case of futures contract
What are options?
Option contract gives buyer the right, but he is under no obligation to buy or sell the asset. Whereas the seller of the options contract is under obligation to buy or sell the asset based on the option contract buyer’s decision. For example, you have a bike and purchased insurance for the bike at Rs. 10000. If your bike is damaged, you will get your insurance claim as per the agreement. But if no such damage happens, the premium you paid becomes the income for the insurance company. In case of option buyer, the return potential is unlimited whereas risk or loss is limited to premium only. In case of option seller, return is limited to the premium whereas the risk involved is unlimited. There are 2 types of options namely call option and put option
1. Call option
In this case, the owner has the right but has no obligation to buy the asset. For example, you made a call option contract with say Kumar for buying TCS share at Rs. 500. The price of TCS in the market is Rs. 600. So you will definitely prefer to buy share from Kumar at Rs. 500 rather than paying Rs. 100 more. Your profit is Rs. 100 in this case. If the price of the share is Rs.400 in the market, you would prefer to buy it from the market rather than buying it from Kumar. So what profit does Kumar get here? When you enter into a contract, you are required to pay a premium. So even if you don’t buy the shares from Kumar, he is benefitted due to the premium you have paid earlier.
2. Put option:
Put option buyer has the right to sell but has no obligation to sell the contract and put option seller has the obligation to buy. In this case too, the buyer of the contract pays premium. Profit is unlimited in case of contract buyer whereas it is limited in case of contract seller
What are stock futures:
In case of stock futures, the underlying asset is an individual stock. Market lot, tick size, expiry date, price quote and other standard specifications are mentioned in these contracts. Futures price is based on the sum of spot price and cost of carry. >
What are index futures:
These are based on an underlying index. This is a very important tool with which you can hedge your risk. It gives an opportunity to buy shares indirectly by buying the index. Start trading in futures as it offers tremendous potential to make profits. Hope you got a glimpse of future and options contract by reading this article. Happy Trading!