If there’s one thing that’s certain about financial and commodity markets, it’s price changes. Prices keep changing all the time. They can go up and down in response to various factors, including the state of the economy, the weather, agricultural production, election results, coups, wars and government policies. The list is practically endless.
Naturally, those who are dealing in these markets will be concerned about price fluctuations, since changes in prices can mean losses – or profits. To protect themselves, they resort to derivatives like futures and options. A derivative is a contract which derives its value from underlying assets; the underlying assets could include stocks, commodities, currency, and so on.
So what are futures and options? Let’s take a look.
What are futures?
One type of derivative is the futures contract. In this type of contract, a buyer (or seller) agrees to buy (or sell) a certain quantity of a particular asset, at a specific price at a future date.
Let’s illustrate this with an example. Let’s say you have bought a futures contract to buy 100 shares of Company ABC at ₹50 each at a specific date. At the expiry of the contract, you will get those shares are ₹50, irrespective of the current prevailing price. Even if the price goes up to ₹60, you will get the shares at ₹50 each, which means you make a neat profit of ₹1,000. If the share price falls to ₹40, however, you will still have to buy them at ₹50 each. In which case you will make a loss of ₹1,000! Stocks are not the only asset in which futures are available. You can get futures contracts for agricultural commodities, petroleum, gold, currency etc.
Futures are invaluable in helping escape the risk of price fluctuations. A country that is importing oil, for instance, will buy oil futures to insulate itself from price increases in the future. Similarly, farmers will lock in prices of their products using futures so that they don’t have to run the risk of a fall in prices when they are ready to sell their harvest.
Types of Futures
There are two main types of futures contracts: financial and physical.
- Financial futures contracts are agreements to buy or sell a financial asset at a predetermined price on a future date. This asset could be a stock, bond, currency, or even an index fund.
- Physical futures contracts, on the other hand, are agreements to buy or sell a physical commodity at a predetermined price on a future date. These commodities can include things like oil, gold, wheat, or corn.
What are options?
Another kind of derivative is the options contract. This is a little different from a futures contract in that it gives a buyer (or seller) the right, but not the obligation, to buy (or sell) a particular asset at a certain price at a specific pre-determined date.
Types of Options
There are two types of options: the call option and the put option.
1. Call Option
Call option is a contract that gives the buyer the right, but not the obligation, to buy a particular asset at a specified price on a specific date. Let’s say you have purchased a call option to buy 100 shares of Company ABC at ₹50 each on a certain date. But the share price falls to ₹40 below the end of the expiry period, and you have no interest in going through with the contract because you will be making losses. You then have the right not to buy the shares at ₹50. Hence instead of losing ₹1,000 on the deal, your only losses will be the premium paid to enter into the contract, which will be much lower.
2. Put Option
Another type of option is the put option. In this type of contract, you can sell assets at an agreed price in the future, but not the obligation. For instance, if you have a put option to sell shares of Company ABC at ₹50 at a future date, and share prices rise to ₹60 before the expiry date, you have the option of not selling the share for ₹50. So you would have avoided a loss of ₹1,000.
What is future and option trading?
One advantage of futures and options is that you can freely trade these on various exchanges. E.g. you can trade stock futures and options on stock exchanges, commodities on commodity exchanges, and so on. While learning about what is F&O trading, it’s essential to understand that you can do so without taking possession of the underlying asset. While you may not be interested in purchasing gold per se, you can still take advantage of price fluctuations in the commodities by investing in gold futures and options. You will need much less capital to profit from these price changes.
Difference Between Futures and Options
Futures and options contracts are both investment vehicles used to speculate on the future price movements of assets. However, they differ significantly in terms of obligations for the investor.
- Futures Contracts: These create a binding obligation to buy or sell an underlying asset at a predetermined price by a specific expiry date. Investors must fulfil this contract regardless of the prevailing market price at expiry.
- Options Contracts: These offer the right, but not the obligation, to buy or sell an underlying asset at a specific price by a certain date. Investors have the flexibility to exercise the option if it becomes profitable or let it expire worthless without penalty.
In essence, futures contracts require fulfilment, while options contracts offer the choice to act based on market conditions.
F&O trading in the stock market
Many people are still unfamiliar about futures and options in the stock market. However, these have been growing in popularity in recent years, so it could be to your advantage to learn more about it.
The National Stock Exchange (NSE) introduced index derivatives on the benchmark Nifty 50 in the year 2000. Today, you can invest in futures and options in nine significant indices and more than 100 securities. You can trade in futures and options through the Bombay Stock Exchange (BSE)
The considerable advantage of investing in futures and options is that you don’t have to spend money on the underlying asset. You only need to pay an initial margin to the stockbroker to trade. For example, assume that the margin in 10 percent. So if you want to trade in stock futures worth Rs 10 lakh, you can do so by paying Rs 1 lakh to the broker in margin money. Larger volumes mean that your chances of making a profit are higher. But your downside is also more significant if share prices don’t move the way you expect, you could end up with huge losses.
Options involve less risk since you can choose not to exercise them when prices don’t move in the way you expect. Your only downside would be the premium you pay for the contract. So once you know what is F&O in share market, it’s possible to make money from it and reduce your risks.
Futures and options in commodities
Futures and options in commodities are another choice for investors. However, commodity markets are volatile, so it’s better to venture into them only if you can bear a considerable amount of risk. Since margins are lower for commodities, there is scope for considerable leverage. Leverage may present more opportunities for profit, but the risks are commensurately higher.
You can trade commodity futures and options through commodity exchanges like the Multi Commodity Exchange (MCX) and the National Commodity & Derivatives Exchange Limited (NCDEX) in India.
It’s important to know what are futures and options since they play an essential financial role in the world. They help hedge against price fluctuations and ensure that markets are liquid. A savvy investor can also profit by investing in these derivatives.
Who Should Invest in Futures and Options?
Hedgers
As you may be able to tell from their name, hedgers are the ones who try hedging their risks. Hedgers in derivatives use futures and options (F&O) to fix the price at which they can buy/sell an asset so that future market volatility does not affect their cost of acquiring the asset. This helps the hedgers ascertain their costs/revenue related to a certain asset early on. This is beneficial for those entities who are trying to reduce volatility in their costs and want to be able to calculate their costs of assets as early and accurately as possible.
In the case of futures, both parties can be sure of the price at which they are going to buy or sell the asset. In option contracts, the buyer of the contract is the hedger, as they get the surety of being able to buy or sell the asset at the strike price in the contract. However, the level of risk here is even less as they may even choose not to go ahead with the trade in case the market price or spot price is more favourable than the strike price.
Hedgers are usually those who actually want to use an asset via physical delivery and are willing to limit their profits in order to limit their losses.
Now it is not true that there is no risk or possibility of negative impact for the hedgers if they enter into an F&O contract. If the market price of the asset moves favourably beyond the strike price of the contract, then the hedger may face a potential loss.
For example, if you signed a contract to sell 10 gm of gold at ₹50,000, but the spot price on the day of the delivery is ₹55,000, then you face a potential loss of ₹5,000. This is because you could have gained ₹5,000 more if you had not entered the contract. However, this is a price that hedgers must pay in order to hedge against the risk of an unfavourable movement in the spot price.
Now that we know who is a hedger, we can move on to knowing about those on the other end of the spectrum, that is, speculators.
Speculators
Unlike hedgers, speculators are the ones who take on risk in search of higher returns. They are the ones who sell the option contract to the hedger and thereby take on the larger risk of price fluctuation. For example, the seller of a call option must sell the asset to the option holder at the strike price, no matter how much loss it leads to.
Usually, speculators conduct market research and then enter an F&O position based on the expectations of higher profits. In other words, they are willing to take on more calculated risks in order to maximise the potential for profits. Since they are interested in profit only, most speculators opt for a cash settlement and often sell their contracts in the open market even before expiry.
Arbitrageurs
These are traders who wish to take advantage of inefficiencies or price differences in the F&O markets and exploit these opportunities to earn profits. However, the existence of arbitrageurs actually helps in increasing the efficiency and accuracy of capital markets over time.
For example, if there is a difference in the prices of a commodity future between two exchanges then the arbitrageur can buy the product at the exchange with the lower price and sell the product at the exchange with the higher price and pocket the difference as profit.
Such opportunities due to differences in prices may arise due to differences in the cost of carry. This is the cost of holding an asset, especially a physical world. The cost of carry adds to the cost of the asset, over and above the cost of buying the asset, leading to a change in the asset’s price when it is being sold.
As seen above, both hedgers, speculators and arbitrageurs carry some amount of risk. Sometimes, they pay margins in order to make the trades less risky. Overall, each has a role to play in the capital markets and trading of F&O and assets would not take place as efficiently as they do if one of these players did not exist or perform as well as the other.
