Change is the only constant. Although this holds true in everyone’s life, price changes are inevitable in financial and commodity markets. Now, these changes in prices, caused due to different factors, may eventually lead to profit or losses. Many investors or traders, in order to protect themselves from these fluctuating prices, may resort to derivatives like futures and options. Read on to learn more about these contracts.
What are Futures?
A futures contract is a type of derivative wherein the buyer agrees to buy or a seller agrees to sell a certain quantity of an asset at a specific price at a future date. In simple words, as a farmer, if you are worried that the price of the crop will fall in the future, you may enter into a future contract. This means you agree to sell the crops at a predetermined price on a future date.
The same concept applies to futures trading. If you expect a particular stock’s price to rise, you might buy a futures contract at a fixed price. For example, if you purchase a futures contract to buy 50 shares of XYZ company at ₹50 each at a predetermined date, at the expiry of the contract, you will get these shares for ₹50 only, regardless of their actual price.
What are Options?
Options differ from futures contracts as they give you the option (as the name suggests), that is, the right, but not the obligation, to sell or buy an asset at a specific price before or on the expiration date. Options are of two types – call and put. A call option gives the buyer the right without an obligation to buy an asset and a put option allows the seller the right without the obligation to sell an asset at a certain price on or before a specified date.
For example, if you buy a call option to buy 50 shares of XYZ company at ₹50 each on a specific date and the share price falls to ₹40 before the end of the expiry. You certainly would not want to make losses and exercise this option. You can then choose not to buy the shares at ₹50 and refrain from suffering losses. You will only lose the premium paid to enter into the contract.
Difference Between Futures and Options
| Parameter | Futures | Options |
| Obligation | Buyer and seller are under the obligation to buy or sell the underlying asset | No obligation on the buyer or the seller to exercise the option |
| Risk level | Exposed to higher risk level as a future contract must be exercised | Exposed to limited risk, as in case of potential losses, you can choose not to utilise the option. |
| Premium | No premiums are paid | Options buyer pays a premium to the options seller |
| Time Frame | Future contracts have specific future delivery dates on which the transaction is executed. | Options have expiry dates after which they cease to exist. |
Factors to Consider When Trading Futures and Options
Trading in futures and options is different from trade in stock, mainly because it involves more complexities. Look at the below factors before trading in futures and options.
- It is imperative to do market analysis and research before entering these contracts.
- You must possess good knowledge of the underlying asset, market trends, historical data, latest news and updates, etc., to choose a trading strategy wisely.
- Liquidity in the derivative market is the ease of buying and selling an asset, whereas open interest is the number of outstanding contracts. Possess a good understanding of both.
- Since options have expiry dates, as time passes, the value of options declines. Consider time decay before purchasing options.
Conclusion
Trading in futures and options may be complex. Still, a proper understanding of the market conditions and the product is highly valuable to help you use these financial products better.
Reference Links:
https://www.angelone.in/knowledge-center/futures-and-options/what-are-futures-and-options
https://www.motilaloswal.com/blog-details/A-Beginners-Guide-to-Futures-and-Options-Trading/1662
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