What Is Futures And Options? Meaning, Difference, Types and Example

Commonly referred to as derivatives, futures, and options provide investors with unique opportunities to mitigate risk and make predictions about the direction of future prices. They contribute to many different markets, such as stocks, currencies, and commodities, and they give investors ways to diversify their portfolios and increase profits.

Since futures and options are only valid until expiration, you do not require a Demat account to trade them. As a result, they resemble contracts more than assets.

Compared to stock investment, futures, and options trading is far more complicated; thus, you need a deeper understanding of what is future and option in stock market and how to invest in futures and options.

What Is Futures and Options Trading?

Futures and options are financial derivatives that let traders predict an underlying asset’s price changes without owning it. These are contracts between two parties for trading stocks at a fixed price at a later date. These contracts attempt to mitigate the market risks associated with trading stocks by fixing the price in advance.

As discussed earlier, futures and options allow investors to lower future risk using predetermined pricing. However, as price swings have no predictable direction, a wrong market prediction might result in significant gains or losses. People who are knowledgeable about how a stock market works usually make most of these trades. Thus, you’ll need a clear understanding of how future and option works, and then you’ll know how to trade in futures and options.

What are Futures Contract?

A contractually binding agreement between two parties to purchase or sell an item at a fixed price on a specified future date is a futures contract. An asset might be a financial instrument like a stock index or currency pair or a commodity like gold or oil.

When you acquire a futures contract, you are obligated to pay the purchase’s fixed cost at a specific time. Similarly, an asset is transferred to the buyer at a given price at a particular time when a futures contract is sold. Currencies, indexes, equities, and commodities comprise most of the underlying assets in futures contracts.

Types of Futures Contract

Currency Futures

Currency exchange rate-based contracts are known as currency futures. When two currencies are exchanged at a future date, the contractual parties agree on an exchange rate. The currency rate risk arising from ongoing international trade can be reduced using these contracts. To suit their requirements, the parties usually conclude these contracts before expiration.

Both speculators and those looking to hedge their risks use them. The main currencies against which currency futures are traded in India are the US dollar (USD), the euro (EUR), the British pound (GBP), and the Japanese yen (JPY).

Commodity Futures

At a fixed price and date, contracts to purchase or sell certain commodities, such as gold, crude oil, silver, agricultural goods, etc., are known as commodity futures. Speculators also use them to place bets on fluctuations in price.

These contracts are traded on commodities exchanges, including the National Commodities & Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). Producers, buyers, and traders can use commodity futures to control the price risk associated with unpredictable commodities markets.

Stock Futures

Contracts for purchasing or selling stocks at a specified price on a future date are known as stock futures. You must make a margin deposit with the broker to trade stock futures. You must make a margin deposit with the broker to trade stock futures.

You may trade in futures worth Rs 20 lakh by paying the broker just Rs 2 lakh if the first margin is, let’s say, 10%. Your profit increases as the number of transactions increases. However, risks also grow significantly. Stock exchanges such as the BSE and NSE allow you to trade stock futures in India. They are, however, limited to a certain selection of stocks.

Interest Rate Futures

One way to safeguard yourself from the potential of future volatility in the interest rate of a financial instrument is to purchase interest rate futures. They let traders bet on fluctuations in the yield curve or act as a hedge against changes in interest rates. IRF contracts assist companies, investors, and financial institutions in controlling the interest rate risk exposures in their holdings.

Index Futures

The value of index futures contracts is derived from an index of the stock market, such as the Sensex or the Nifty 50. Despite trading specific stocks, they let investors make predictions about the general direction of the stock market.

For example, you purchased BSE Sensex futures for Rs 50,000 with a month-end expiration date. You stand to gain Rs 5,000 if the Sensex reaches 55,000. Your losses will be Rs 5,000 if it drops to Rs 40,000 in such a scenario. Portfolio managers utilise index futures as a safety net in case the price of their shares declines.

What are Options Contract?

Options contracts are financial agreements that grant the holders the authority, but not the obligation, to purchase or sell an underlying asset within a designated time frame at a stated price. They let you trade an underlying asset’s price without really owning it.

The value of these contracts is derived from the underlying asset’s price shifts, and variables like volatility, time decay, and the difference between the striking price and selling price influence their pricing. Those looking to diversify their holdings while effectively mitigating financial risk in the Indian market must have an excellent grasp of options contracts.

Types Of Options Contract

Call Options

An options contract that grants the contract holders the right, but not the obligation, to purchase the underlying asset associated at the strike price before or on the expiration date is known as a call option.

When traders and investors believe that the value of the underlying shares will rise before the option expires, they purchase a call option on stocks. In these situations, investors take advantage of the rise in share price by buying a long call option.

Put Options

A put option gives the buyer the right, however not the obligation, of selling a certain asset within a given time frame (till expiry) at a predefined price (the strike price). Buyers of put options profit whenever the cost of the underlying asset drops beneath the option’s strike price minus the option premium.

Investors buy put options when they believe underlying asset prices will fall from their current levels before or on the expiration date.

This can also analyze PCR Ratio.

Difference Between Futures & Options

Now that you know what is future and option trading, let us look at their differences. Despite being both derivatives traded on stock markets, futures and options have several notable differences. Futures contracts bind sellers to sell a given product at a fixed price at a later date or buyers to acquire the asset.

On the other hand, options provide you the choice, but not the obligation to purchase (call) or sell (put) an asset at a defined price within a specific period.

Futures are riskier since they have a limitless potential for profit or loss. Conversely, options provide less risk because the maximum loss is only the premium amount.

Furthermore, options give investors strategic freedom by enabling them to speculate on price changes or act as a hedge against risk. Under the derivatives section of stock exchanges in India, futures and options are governed by SEBI (Securities and Exchange Board of India). This gives investors various tools to control risk and maximise rewards in the financial markets.

How to Trade in Futures and Options?

To know how to invest in futures and options, you need to follow this procedure simply:

• You need to open a trading account with a SMC global Securities, where you may purchase and sell futures and options contracts via registered brokerage companies with the BSE or NSE.
• You must log into the portal after creating your account. Additionally, you can explore the different F&O alternatives by using the mobile application of your registered broker, just like SMC.
• Learn about the F&O trading methods, such as expiration dates, margin requirements, and settlement procedures. To reduce risk, use techniques like leverage management and hedging.
• You may now purchase the futures and options at the strike price after deciding on your choice and entering the order information. It is the price at which an option contract is exercised as a put or call.
• Remember, the spot price is a key element in the price negotiation of future contracts. Every asset has a current market price, including currency and commodities. The basis for the pricing of the futures contract is this spot price, which aids in the quick purchase or sale of the commodity.

Thus, this is how to trade in futures and options. Implementing a clear trading plan tailored to each trader’s unique risk tolerance and financial objectives, discipline, and ongoing learning are essential for success in futures and options trading in India.

Conclusion

Trading options and futures have a high degree of risk and complexity. Thus, now that you know what is futures and options, are, you’re aware that futures and options are designed for traders seeking rapid profits, as opposed to equity, which draws long-term investors. They let you gradually increase your earnings while shielding you from an erratic market if they are handled carefully.

Numerous factors, including changes in interest rates, market volatility, and currency exchange rate movements, can impact
the value of these derivatives. If a trader’s position moves against them, they might suffer significant losses. So trade wisely!

Author:
All Content is verified by SMC Global Securities.

Reference :
https://www.nseindia.com/get-quotes/derivatives?symbol=NIFTY
https://investopedia.com/terms/o/options-on-futures.asp