How Future and Option Works?

How Future and Option Works?

Trading in futures and options involves following agreements for individuals. Futures trading places a responsibility on investors, compelling them to fulfil a contract by a specified deadline. In contrast, an options contract grants individuals the privilege to exercise the contract at their discretion.

In the case of a futures contract for buying or selling an underlying security, the investor is obligated to adhere to the predetermined terms on the agreed-upon date and at the contractual price. Conversely, an options contract affords the buyer the flexibility to exercise the contract only if they realise a profit from the trade.

What are Futures and Options?

A futures contract involves the purchase or sale of an underlying asset at a predetermined price on a specified future date. When one buys a futures contract, they commit to paying the agreed-upon cost at a designated time, while selling a futures contract entails delivering the asset to the buyer at a specific price on a particular date. The assets underlying futures contracts typically include stocks, indices, commodities, and currencies. Options provide the holder with the choice to buy or sell the underlying asset at a set price, and they come in the form of call options or put options.

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.

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Table of Content

  1. What are Futures and Options?
  2. Examples of Future and Options
  3. How Do Futures & Options Work?
  4. Who Should Invest in Futures & Options?
  5. Key Things to Know about Futures & Options

Examples of Future and Options

Here is an example of F&O contract:

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 Rs.50 per share with a specified expiration date. Upon contract expiration, you receive these shares at the agreed-upon Rs.50 per share, regardless of the current market price. Even if the current share price has risen to Rs.60, your acquisition cost remains at Rs.50 per share, resulting in a profit of Rs.1,000. Conversely, if the share price has dropped to Rs.40 at contract expiry, you still purchase each share at Rs.50, incurring a loss of Rs.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 Rs.800 and 'B' sells those futures, the transaction remains balanced for both parties. Should the price climb to 820, 'A' gains Rs. 20. At the same time 'B' incurs a loss of Rs. 20. Conversely, if the stock price falls to Rs.780, 'A' experiences a loss of Rs. 20, and 'B' realises a profit of Rs. 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.

How Do Futures & 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 standardised and traded on organised 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 clear your thoughts about how F&O works.

Who Should Invest in Futures & Options?

Futures and options (F&O) trading has the potential for profitability but is accompanied by inherent risks, leading to both advantages and disadvantages. Different categories of traders engage in F&O trade.

  1. Hedgers

    Individuals in this category invest in a specific asset with the primary objective of shielding themselves from the adverse effects of price fluctuations in that particular asset.

  2. Speculators

    Speculators focus solely on securities, aiming to capitalise on price fluctuations. Their strategy involves predicting and benefiting from these market movements. While this approach is a matter of personal choice, it's important to note that the use of leverage in speculation can amplify both returns and losses.

  3. Arbitrageurs

    This group of traders seeks to capitalise on price differentials within asset market conditions. Their goal is to exploit any inefficiencies present in the market, aiming for profitable outcomes through strategic trading decisions.

Key Things to Know about Futures & Options

Successfully engaging in the world of futures and options demands a solid grasp of these financial derivatives. Presented below are essential insights aimed at enhancing your understanding and facilitating informed decision-making in futures and options trading.

  1. Losses Extend Beyond Margin Money

    The potential losses in futures and options trading are not confined 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, which is often less than the total capital at risk, 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.

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 underscore 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, utilising a reliable stock market app is essential in today's fast-paced financial landscape.

FAQs on How Future and Option Works

Futures obligate both parties to fulfil the contract, while Options provide the right but not the obligation to buy or sell.

Liquidity is the ease of buying or selling an asset, and it's crucial to ensure seamless entry and exit from positions in the market.

Yes, by combining futures and options with regular trades, investors can minimise risks and gain insights into derivative market dynamics.

Protective puts provide a strategy to limit potential losses by allowing investors to sell the underlying asset at a predetermined price.

Market sentiment, whether bullish or bearish, can impact trading strategies and decision-making in futures and options markets.