When it comes to markets, the cash market is where the transactions of tangibles actually take place. Even in equity markets, the cash segment is where shares are bought and sold.
There is always risk associated with one’s investment and the cash market offers no solution to manage risk apart from exiting the investment.
Globally, any cash market is supported by other markets, which help in managing price risk through hedging. These markets are called derivatives markets or futures and options (F&O) markets. Since the instruments – futures and options derive their value from the cash market, they are called derivatives.
Let’s now look at this market closely.
What are futures and options?
Both the instruments are different and derive their price for the underlying stock or index. Both these instruments are bound by a contractual agreement between a buyer and a seller.
- A futures contract is the obligation to buy and sell an asset (called the underlying) at a later date (expiry date) at an agreed upon price.
- Derives its value from the underlying stock or index
- Futures contracts were meant to be used as a hedging tool but have become more popular with speculators and arbitrageurs.
- Most actively traded commodities have future contracts.
- A futures contract has a standardised size (number of shares) and may differ from one company to another.
- For the same contract, multiple contracts, expiring on various dates, are traded.
- A trader can take a long or a short position in the futures contract, unlike in the cash market, where only long positions are possible.
- There are many arbitrage opportunities that a trader exploits using a futures contract between two different months or between futures and the cash market.
Let’s understand the definition with the help of an example.
Suppose a trader is holding shares of Asian Paints. At Rs 3,400 he feels that there is limited upside to the stock and may hover around these levels or come down in the short to medium term.
For various reasons, including tax management, he does not want to sell his shares of Asian Paints but at the same time would like to protect himself from any fall in its share price.
In such a case, he will sell a futures contract of Asian Paints (creating a short position) at Rs 3,400. By doing this, he has locked his profit at Rs 3,400 irrespective of where the stock goes.
Suppose if the price comes down to Rs 3,200, in that case, his shares would have a notional loss of Rs 200, but the short position would result in a profit of Rs 200 (3400-3200). Even if the price keeps on falling, his future position will compensate for the loss in the spot position.
However, since he has sold a futures contract, the trader will not enjoy the benefit of any rise in stock price.
If Asian Paints rise to Rs 3,500 the cash position will sit on a notional profit of Rs 100 but the futures contract will give him a loss of Rs 100 (3400-3500).
Big fund houses use index futures to hedge their portfolios by selling index contracts like Nifty or Bank Nifty to protect their portfolio.
- The textbook definition of an options contract is that it gives an investor the right, but not the obligation, to buy or sell shares (underlying) at a specific price (strike price) within a specified period.
- They derive their value from the underlying stock or index.
- They have the same number of shares or lot size as the futures contract.
- They give the trader the flexibility to trade in either direction of the market
- It is a cheaper way to hedge your position
- Unlike cash and futures markets, options can be profitable even when markets are flat and going nowhere.
- Traders use simple and complex option strategies based on their view of the market.
- Since buying an option is the cheapest form of acquiring the ‘right’ to own a share, it has gained immense popularity among traders, retail and institutional.
- Designed as a hedging instrument, traders are using options for speculating and arbitrage trades.
- There are two types of options – Call and Put
- A Call option is bought when the trader feels that the stock or index will move higher and a Put option is bought when the stock or index is likely to move lower.
- A seller of a Call option feels that the underlying will fall or stay stagnant.
- A seller of Put options initiates the trade if he feels the underlying will rise or remain flat.
An example to help understand the instrument.
Unlike a futures contract, an option contract is slightly complex.
Continuing with the same example of Asian Paints, supposed the trader wants to hedge his position as he feels that the stock may not rise beyond Rs 3,400.
Here, the trader can hedge his cash portfolio by buying a 3400 strike price Put option expiring in the current month. To buy the Put option, he pays a premium of, say, Rs 50.
Now if the share price of Asian Paints falls to Rs 3200, the value of the premium at the time of the expiry will be Rs 200. Thus, the trader will gain from the purchase of the put option, even though there is a notional loss in his cash position. The profit from the Put will be Rs 200 minus the Rs 50 paid for buying the option.
Now if the price of Asian Paints rises to Rs 3,500, the maximum loss to the trader will be the Rs 50 he paid for buying the Put option. He can enjoy the benefit from a further rise in price.
One key difference between Futures and Options in the above example is though both the derivative instruments are protected to a large extent, the futures contract locks the price while the option contracts allow the trader to get the benefit of rising prices to some extent.
What is the difference between Futures and Options?
Trading in futures and options differs in terms of its obligations on the traders. The futures contracts are a liability for the investor, mandating them to buy or sell the contract on or before a predetermined date, and the options contract gives the investor the right to do it.
In other words, the futures contract holder has to buy or sell underlying security following the predetermined date at the decided price. In contrast, the options contract gives the buyer a choice to buy or sell if they profit from the trade.
Types of Futures and Options:
Generally, futures contracts have the same conditions for both sellers and buyers of the contract, and the derivative of the option is divided into two types. Traders can enter into an options contract to sell a type of asset at a certain price on a specific date and can do this by availing of a put options contract. In the same way, traders who want to buy a type of asset on a particular date can do so through a call option to fix the price for future exercising of the contract.
Who Can Invest in Futures and Options?
Traders or investors participating in future and option trading are classified into the following types:
Hedgers opt for futures and options contracts in the stock market to minimise market volatility impact on their investments. Setting a price for a transaction at a predetermined date helps these players to experience the difference in gains if at all the prices move vaguely adverse to the trading position made by the buyer. But, in case of favourable changes, traders buying a futures contract can face significant losses. This risk is rationalised by an options contract, as here, the investor can cut out of the deal if at all price swings are favourable.
Hedgers plan to safeguard their profits or losses in the future by trading a specific derivative contract. Such players can be found more in the commodities market, where the traders try to safeguard an estimated price of certain products from the respective exchange. Let us understand this with a future and option contract example. A peasant can trade a futures contract with some wholesaler to sell 60 kilograms of onions for Rs. 30 per kilogram two months from now. On the contract expiry day, if the price of onions falls below those levels, the farmer has now hedged his stake to minimise the underlying risk linked with trading in the future.
But, in case the prices rise in the onion market, the farmer will lose out on some profits. These losses can be balanced with the help of a put options contract, which provides the farmer a right but not the obligation to match the conditions of the contract. If there is a fall in the market prices of onions, the farmer can exercise their right on the options contract to minimise their losses. Prices rising, on the contrary, will allow the farmer not to exercise any of the contracts and sell the onions in the market at the current market prices.
Hedgers usually go for physical trade settlement in which the asset is exchanged after the expiry of the contract. It is much more prevalent in the commodities market, as here, producers and firms carry out the physical trade of goods to maintain the costs of raw materials at a certain fixed level. This allows stability in the price levels to prevail in the economy.
Speculators predict the trend or the price movement in the market according to the assets’ intrinsic valuation and the economic condition and decide to build a reverse position in the existing markets to profit from any such price movements. Let’s take a futures and options scenario; if the trader bets on the price of any stock to rise in the future, they can take a long position in derivatives or the F&O market. This showcases buying a stock or its derivative in the present to sell it off on a future date at a higher price.
Also, traders or investors can take a short position who expect the prices of an underlying to fall in the coming future according to their market outlook. Here, traders or investors would want to buy the securities in the future at a comparatively lower price via any of the contracts, to relatively make a profit.
A majority of the speculators participating in derivatives or F&O trading would want to make cash settlements, where the physical movement of an asset does not take place. On the other hand, the difference in the spot price, i.e., the current market price and the value mentioned in the derivatives, is settled between two buyers and the seller, thus minimising the problems in these trades.
Arbitrageurs would want to profit from price variance in the market, which occurs because of the market inefficiencies in the first place. A price quotation in the futures and options market includes the contract’s current price and the cost of carrying that contract. It also has a predetermined understanding that the strike price or the present value of the contract will become in sync with the spot price. The price differences incurred for carrying the underlying security to a future date are called carrying costs.
Arbitraging resultantly takes out all the price variations due to inefficient market conditions, as these players vary the demand and supply outlooks to create a price equilibrium.
Futures and options trades are usually leveraged, in which the overall cost of trading must not have to be incurred upfront. On the contrary, a broker finances a specific percentage of the entire contract for its client. The investor maintains a minimum amount called the mark to the market amount in their trading account. This propels the investor’s profit margin significantly if their bet is right.
But, as addressed above, futures and options have seemingly high risks, as efficient and highly accurate predictions about the price movement or trend and market directions are to be made. The complete know-how of the stock markets, the underlying security, and related organisations, etc., have to be known to profit from derivatives trading.
More about F&O trading in the stock market:
A majority of the people today still are unaware of futures and options trading in the share market. But, the trend for this has seen a growth in the recent years, so it can be of great advantage to learn more about this market.
The National Stock Exchange (NSE) implemented trading on index derivatives on its Nifty 50 2000. So, one can invest in futures and options in nine major indices, including more than 100 securities today. Traders can also trade in futures and options through the indices and securities listed on the Bombay Stock Exchange (BSE)
As discussed, options consist of lesser risk as the trader has the right to choose not to exercise the contract on maturity when the prices aren’t in the way they want. The only loss they would bear will be the premium paid for the security. Thus, once a person understands what the F&O is in the stock market, it is possible to make money and hedge your investment risks.
More about futures and options trading in the commodities market:
Futures and options trading in commodities is another chance for investors to make money. But, Commodities markets are very volatile, so it is suggested to trade in them only when one is aware of its risk and can take such a risk. Also, the margin for commodities is lower, so there is a chance of taking significant leverage. Leverage can provide more options for profit, but the risks involved are much higher then.
One can trade commodity futures and options via commodities exchanges such as the Multi Commodity Exchange or MCX and the National Commodity & Derivatives Exchange Limited or NCDEX in India.
Understanding what critical future and options can play an essential financial role in the industry. It also helps traders hedge their positions against any unwanted price movements and ensures liquid markets remain.
Warren Buffett calls derivatives a weapon of mass destruction. But just like nuclear energy, if one learns how to handle the instruments with proper risk and money management, they can result in returns that are much higher than compared to the cash market.