What is Futures and Options?

F&O contracts, signed by two parties, facilitate trading assets at predetermined prices on specified future dates. These contracts aim to hedge the risks associated with stock market trading by locking in prices in advance. Today, let’s learn about them in detail.

Key Takeaways

• Futures and options (F&O) are derivative contracts whose value is based on their underlying assets. Futures are agreements to buy or sell at a predetermined price and date, while options grant the right but not the obligation to buy or sell within a specified timeframe.

• Types of futures include commodity, currency, interest rate, and stock futures. Calls and puts are the two types of options.

• F&O trading aids in risk management and facilitates leveraged trading for potential higher returns. Moreover, F&O markets are pretty transparent and liquid.

• F&O trading may lead to losses due to changes in market conditions. Leverage can also increase the potential losses. In addition, there is counterparty risk, where parties fail to fulfil the contract.

• Participants in the F&O market are hedgers and speculators. Hedgers aim to reduce volatility by locking in prices, and speculators try to profit from future price swings.

What are Futures?

Futures are agreements to sell or buy an asset, such as stocks, commodities, or currencies, at a specific price (known as the "futures price") and date in the future. The futures contract's buyer agrees to purchase the underlying asset, while the seller agrees to deliver it. Futures contracts are standardised and traded on organised exchanges, ensuring transparency and liquidity.

Key features of futures include -

1. Standardised: Futures have standardised specifications regarding the underlying asset's quantity, quality, and delivery terms.

2. Expiry Dates: Futures have a specified expiry date, indicating when the contract needs to be settled.

3. Margin Requirements: Participants must deposit an initial margin as a performance bond to trade futures. This margin ensures that both parties fulfil their obligations.

4. Leverage: Futures allow traders to control a sizeable underlying asset value with a comparatively minor investment.

5. Mark-to-Market: Futures positions are marked-to-market daily, with profits or losses settled daily.

Types of Futures

The following are the different types of futures.

1. Commodity Futures:

The underlying assets of these futures contracts are commodities. Physical things that investors can purchase and sell are commodities. The most common commodities investors buy futures contracts for are food, grains, metals, oil, and natural gas. The security for these kinds of agreements comes from the assets themselves.

Futures on commodities are significant for controlling price risk, especially for farmers. A futures contract could be signed by a farmer or producer of important crops to sell the produce at a given price on a specified date in the future. In this manner, he is fully aware of the amount he will receive. He won't have to worry about losing money, even if the price declines in the future.

2. Currency Futures:

Contracts based on currency exchange rates are currency futures. The two parties agree upon an exchange rate for the future exchange of two currencies. These contracts may remove the potential currency rate risk associated with international trade. To fulfil their requirements, the parties usually close these contracts before expiration.

3. Interest Rate Futures:

Interest rate futures consist of underlying assets which offer regular interests. Investing in them is a way to protect yourself from the possibility of future fluctuations in the interest rates of a financial instrument. Usually, money market or bond market instruments like government bonds, bills, and the underlying securities. These assets are the basis of these futures contracts.

4. Stock Futures:

Stock futures are contracts that make purchasing or selling a stock at a specific price on a given future date mandatory. Investors who own a sizable position in one or a few stocks benefit from them. If the stock price drops, they want to safeguard their risk position.

Investors use futures on individual stocks and stock market indexes to speculate, trade, and manage risk. They represent the sentiments and levels of confidence of investors. Futures on a single stock hedge against the stock's potential price. However, index futures for the stock market follow an index's movement.

What are Options?

Options give the holder the right (but no obligation), to sell or buy any asset at the strike price within a specified period. Unlike futures contracts, options contracts do not require holders to fulfil the transaction if they choose not to.

Key features of options include:

1. Flexibility: Options offer the flexibility to choose whether or not to exercise the right to buy or sell the underlying asset.

2. Premium: The buyer of an option pays a premium to the seller for the rights conveyed by the contract.

3. Limited Risk: The risk in options trading is limited to the premium paid, providing a defined risk-reward profile.

4. Expiration Date: Options contracts have an expiration date, after which they become invalid.

Types of Options

There are two types of options:

1. Call Options: With a call option a holder gets the right to purchase the underlying asset at the strike price before expiration. However, there is no obligation to exercise the contract. As a result, value of a call option will rise if the price of the underlying securities. A long call has limitless upside potential and the maximum loss is equal to the option's premium. So, it may be used to bet on the underlying's price rising.

2. Put Options: With a put option the holder can sell the asset at its strike price before the expiration date. Here also, there is no obligation to fulfill the contract. The option gains value when the price of the underlying asset declines. So, a long put is essentially a short position in the underlying security. Investors can purchase protective puts as a kind of insurance. This provides them with a price floor to hedge their positions.

Who Should Invest in Futures and Options

The traders in the F&O market can be categorized into two types. They are as follows.

• Hedgers:

Hedgers engage in futures and options trading to reduce the volatility of their investments due to price fluctuations. Individuals may achieve profits if the price swings negatively in relation to a trading position. They can lock in a price for a transaction that will occur at a later date. However, those who enter a futures contract may suffer large losses if prices rise. In this case, an options contract is useful. It reduces the risk by allowing an investor to back out of a transaction.

Hedgers also try to hedge their future income or expenses. In the commodities market, they look to agree on a certain price of a commodity to make a profit. Use an example of futures and options trading to better understand it. A farmer may sell 50 kg of potatoes for Rs. 20 per kg three months from now by entering into a futures contract with a distributor. The farmer has effectively hedged his position to reduce the overall risk of future trade. There will be no significant losses, even if the price of potatoes falls below that amount on the day of maturity.

Yet, a farmer may lose his earnings when potato prices increase. Here, a put option contract can be used to offset such losses. It shall grant the farmer the right but not the responsibility to fulfil contract terms. He can execute the options contract to guarantee minimal losses in the event that the market price level drops. In contrast, a price increase facilitates the farmer to back out of the agreement and sell the goods at market value.

Hedgers typically go for physical trading, in which the asset is traded when the contract matures. It is especially well-liked in the commodities market, where manufacturers and businesses engage in physical trading to maintain stable raw material costs. It makes sure an economy's pricing levels remain stable.

• Speculators:

Speculators opt to take an opposing position to profit from future price swings. They forecast the direction of price movement in a market based on an asset’s intrinsic value and prevailing economic conditions. Using futures and options as an example, an investor can take a short position in the derivatives market if they believe the price will rise in the future.

Those who anticipate that prices will decline in the future based on their understanding of the market, take a long position. Through these contracts, investors intend to purchase stocks at a discount in the future in order to profit proportionately.

The majority of traders who engage in derivatives trading choose cash settlement. It does not involve the actual physical transfer of an asset. Conversely, the problems associated with this type of trade are avoided when a difference between the spot price, or current market price, and the price specified for the derivative are paid between two parties.

Conclusion

Futures and options are derivative contracts whose value is based on the underlying assets they hold. Hedgers and speculators are the two kinds of traders who participate in the F&O market. While hedgers look to mitigate the risk from price fluctuations, speculators try to profit from price swings. They are powerful financial tools to manage risk, speculate on price movements, and diversify one’s portfolio. However, price fluctuations of assets and changes in market conditions may lead to losses. Sometimes, the parties may not fulfil the agreements of a contract. So, understanding the basics of futures and options is crucial for anyone seeking to engage in share market trading.