How Future and Option Works?

Futures and options (F&O) trading involves making agreements for buying and selling an asset at a price that is predetermined. Traders can receive potential returns if the price goes in their direction as they predicted. However, they can also lose money if the price goes the opposite way. A futures contract is a deal to buy or sell a stock or another asset at a set price on a certain date in the future. An options contract allows the investor to buy or sell the asset at a set price by a specific date but does not require them to do so. In this article, we will understand what futures and options are, how future and option work, and how they can be useful in your investment strategies.

What are Futures and Options?

A futures contract is an agreement to buy or sell an asset at a predetermined price on a specific future date. When you purchase a futures contract, you commit to paying the agreed price at that designated time. Conversely, when you sell a futures contract, you agree to deliver the asset to the buyer at the specified price on the agreed date. Futures contracts can involve assets such as stocks, indices, commodities, and currencies. 

A call option grants the purchaser the right to acquire the underlying asset at a predetermined price, also known as the strike price. In the case of a call option, the seller possesses the right to request the sale of the underlying asset, but they are obligated without any discretion. In this scenario, the buyer holds the rights, and the seller is compelled to pay the premium price.

Future and Option Trading Examples

Let’s now look at some futures and options examples to understand these financial instruments better. Below are the F&O trading basics with examples: 

Example of Futures

To understand how futures operate, consider an example. Suppose you've acquired a futures contract for 100 shares of XYZ company at ₹50 per share with a specified expiration date. Upon contract expiration, you receive these shares at the agreed-upon ₹50 per share, regardless of the current market price. Even if the current share price has risen to ₹60, your acquisition cost remains at ₹50 per share, resulting in a profit of ₹1,000. Conversely, if the share price has dropped to ₹40 at contract expiry, you still purchase each share at ₹50, incurring a loss of ₹1,000. 

If your underlying asset is equity, you might need to open a Demat account for electronic storage of your purchased stocks. However, futures contracts are not limited to equities. You can also participate in them for commodities like petroleum and agricultural products, currencies, gold, and more.

Example of Options

If 'A' purchases a futures contract at ₹800 and 'B' sells those futures, the transaction remains balanced for both parties. If the price climbs to 820, 'A' gains ₹20. At the same time 'B' incurs a loss of ₹20. Conversely, if the stock price falls to ₹780, 'A' experiences a loss of ₹20, and 'B' realizes a profit of ₹20. Nevertheless, 'A' is obligated to pay a premium to secure the right to buy at the predetermined price. This premium represents the potential maximum loss for the option buyer.

Difference Between Futures and Options

Futures and options trading are different because of the obligations they place on the trader. With a futures contract, the trader is obligated to buy or sell the asset at a specific price on a set date, no matter what happens to the price. This means they must complete the deal when the contract expires, whether the price has gone up or down. 

On the other hand, an options contract gives the trader more flexibility. It gives them the right, but not the obligation, to buy or sell the asset at a specific price by a certain date. This means the trader can choose whether or not to go through with the trade. They will usually do so only if it will result in a profit. If it doesn’t look profitable, they can decide not to exercise the option, avoiding any obligation.

How do Futures & Options Work?

Let’s now find out how futures and options work. Futures and options are financial instruments known as derivatives, as their value is derived from an underlying asset. They are widely used in financial markets for risk management, speculation, and portfolio diversification. In a futures contract, two parties agree to buy or sell an asset at a predetermined future date for a price agreed upon today. These contracts are standardized and traded on organized exchanges, obligating both parties to fulfil the contract terms at the specified date. 

Options, on the other hand, provide the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price before or at the contract's expiration date. Options offer flexibility, allowing investors to hedge against potential losses or speculate on price movements. Therefore, this can help you better understand how F&O works.

Who Should Invest in Futures & Options?

Traders in futures and options trading can be grouped into different types based on their goals and strategies: 

1. Hedgers

Hedgers are traders who confidently use futures and options contracts to shield against price changes. By locking in a price for a future transaction, they ensure protection from losses if the price moves against them. 

For example, a farmer might agree to sell potatoes at a set price, in three months, He is safeguarding them against the decrease of the market price. To control the risk of potential missed profits due to price increases, hedgers might engage in options contracts, which provide them with the right, but not the obligation, to buy or sell assets. 

2. Speculators

Speculators are the ones who trade futures and options based on their guesses about future prices. They try to make potential returns from price changes without owning the actual asset. 

 For example, if they think prices will go up, they buy now to sell later at a higher price. If they think prices will go down, they sell now to buy back later at a lower price. Most speculators prefer cash settlements, where they only receive the difference between the market price and the contract price. 

3. Arbitrageurs

Arbitrageurs use price differences in different stock markets or versions of the same asset, purchasing low in one market and selling high in another. They take advantage of the difference between the current market price and the futures price, including extra costs like carrying charges. By doing this, arbitrageurs help balance prices and reduce inconsistencies in the market. 

Futures and options trading offer high potential returns but also involve high risks, as traders can lose more than their initial investment if the market moves against them. It's crucial to understand different trading strategies for risk management.

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Key Things to Know about Futures & Options

To succeed in futures and options trading, you need to understand these financial tools well. Here are some key insights to help you learn more and make better decisions in this type of trading. 

1. Losses Extend Beyond Margin Money: The potential losses in futures and options trading are not restricted to the initial margin money. While spot market trades typically limit risk to the invested capital, the use of margins in futures and options trading. This is often less than the total capital at risk and can obscure the true extent of potential losses. It is crucial to be mindful of this aspect before engaging in F&O trading. 
2. Overlooking Liquidity: Novice traders in options and futures often underestimate the significance of liquidity. While focusing on effective trading strategies is important, it is equally vital to ensure that the derivatives being traded possess sufficient liquidity for a smooth exit. Avoiding this oversight is imperative for successful trading. 
3. Consideration of Option Moneyness: Before venturing into options trading, understanding the moneyness of the option is crucial. Although out-of-the-money (OTM) options may seem more cost-effective, they often lack liquidity. Therefore, it is essential to strike a balance between affordability, profitability, and liquidity when evaluating option opportunities. 
4. F&O Trading as a Hedging Tool: Recognizing the risks inherent in F&O trading, beginners can employ a combination of a regular trade and a futures or options trading strategy. This approach acts as a hedge for the overall portfolio, mitigating risk while providing a practical understanding of the derivative market dynamics.

Conclusion

Understanding the complex nature of futures and options is important for anyone who wants to know how F&O works. The risk and reward dynamics, the influence of leverage, and the various strategies employed highlight the complexity of these derivatives. Continuous learning becomes a cornerstone for success, ensuring adaptability to evolving market dynamics. For investors seeking real-time insights and convenient portfolio management, utilizing a reliable stock market app is crucial in today’s fast-moving financial world.