Futures and Options
Futures and options both fall under the ‘Derivatives” category. Futures are contracts wherein two parties enter into an agreement to trade (buy or sell) a certain asset at a pre-determined price and at a specific future time.
Options on the other hand, are agreements wherein the buyer gets a right (and not an obligation) to fulfill his/her part of the trade. The seller, though, in case of options trading, has an obligation to perform his part of the contract, basis the buyer’s decision. Options trading in India has two variants: Call Option and Put Option
A call option gives you the choice to exercise your buying rights (at the strike price) before the expiration of the options contract. With a put option you get the right to sell a stock (or an index) before the option expires, at the strike price.
Difference between Futures & Options
The primary point of difference between futures trading and options trading is that while the former is a liability or an obligation, the latter gives a choice to the buyer.The contract remains binding for the seller in case of futures as well as options trading. Here is a quick comparison of futures and options:
|Futures Trading||Options Trading|
|Buyer’s & Seller’s perspective||Buyer and seller both have an obligation to honor the contract||Buyer has a right (not an obligation) to honor the contract. Seller has an obligation to honor the contract, if the buyer exercises his/her right.|
|Margin amount||Little higher than ATM options and OTM options||For buying options there is no margin required (only Premium is paid)
In the case of sale of options, margin depends whether the option is ITM, ATM or OTM. In the case of OTM options, the margin is less then futures
|(* ATM – At The Money, OTM – Out Of The Money and ITM – In The Money)|
|Advance payment||No advance payment needs to be made to the seller. But MTM (Mark to Market) is payable/receivable on a daily basis||Buyer needs to pay a fee (premium amount) upfront to the seller. In the case of buying there is no daily pay-in or pay out. But in the case of sale of options, daily margin keeps on varying to the extent of daily MTM|
|Profit and loss potential||Unlimited||Buying of Options:Profit potential is unlimited and Loss potential is limited to the extent of premium paid.
Sale of options:Profit in the form of premium receipt is limited but the loss potential can be unlimited like futures
|Importance of time||Time holds little significance as the contract can be squared off till expiry date.The difference between cash price and future price depends on several things including prevailing interest rate.||Time plays a crucial role in options contract , as the premium contains the insurance part also, besides interest.|
Who should trade in Future & Options?
Future and option traders can be categorized into the following groups:
Futures and options trading can be used as a risk management tool as they can provide hedging against investment volatility. Hedgers seek to lock-in their future gains or possible loss by getting into such derivative contracts.
For instance, buying futures and buying put for protection, selling futures and buying call for similar protection, buying or selling option at one strike price and simultaneously buying or selling option at another strike price, buying or selling option at one strike price in near month and simultaneously buying or selling option at same or another strike price in far month.
It is important to note that in the case of hedging, the margin is reduced drastically, sometimes even to the extent of 70%.
Speculators try to predict the future price movement basis intrinsic value, economic situations, etc. and take the position to profit from the price fluctuations.
Price differences exist in the market due to inefficiencies and imperfections. Arbitrageurs seek to profit from these price differences between two segments, two exchanges. Sometimes long short strategy is also applied in which one scrip is sold and another scrip is bought.
Benefits of Currency Derivatives Trading
Currency Derivatives serve multiple purposes:
Foreign exchange derivatives are a great hedging mechanism and help protect your forex exposure.
Currency derivative trading presents you with arbitrage opportunities which can be capitalized and turned into profits. For instance, you can leverage on the difference in exchange rates of a particular currency in different exchanges as well as markets.
You are required to pay a minimal margin amount rather than the complete trade value. You benefit from low margin and high leverage.
Currency trading provides you trading opportunities as a result of fluctuations in currency values.
How to trade in future & options?
You need to open a trading account for the same with the help of a registered broker/broking firm. Choosing a good broker plays an important role in making the most out of your F&O trading.
Some key points to keep in mind before you begin your futures and options trading journey.
- Futures are available only on some select stocks based on predefined criteria
- F&O Trading is available on both NSE and BSE.
- An important factor to consider before deciding your futures trading strategies, is Margins. Since upfront margin is required, your account needs to have adequate margin funding before you can place a trade. Margins are like a good-faith deposit meant to cover losses due to adverse price movements. The initial margin is calculated by taking into account SPAN and exposure.
- For your options trading strategy of buying options, you need to factor in the deposit premium amount. Option premium is the reward or fees paid by the buyer to the seller for getting the right to choose without any obligation. If you choose to sell the options, the premium should be approximately same as Futures.
- F&O trading runs on the concept of leverage i.e. the entire cost of trade is not required to be paid upfront.
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Futures trading as well as options trading have their own merits and limitations. The final choice would depend upon factors such as your risk appetite, time horizon, investment objectives, etc.
Here are some futures and option trading tips which will make your trading experience smoother and more fruitful-
- Understand the basics of futures and options trading
- Understand the risks involved.
- Choose adependable and well-established broking partner.
- Start with well-known and robust stocks or indexes as they have higher volumes.
- Develop a quantifiable F&O trading strategy.
Expiration date refers to the last day till which the option contract is valid. In India, it is the last working Thursday of the month for stocks and every Thursday for Index Options with weekly expiry.