When it comes to the stock market, there are different instruments for investors to put their money in. One such mode of investment for short-term traders and investors is futures and options.
What are futures and options?
Futures and options are derivative contracts. Derivatives are instruments whose value is determined by an underlying asset. For example, a stock future’s value is determined by the price movements of the underlying share. A copper commodity option’s value is based on the price movements of copper.
Derivative contracts are basically a contract between two or more people with regards to the underlying asset. These contracts are not settled. Only the price difference is exchanged between the parties.
Basics of Futures and Options:
Let us understand futures and options meaning.
A futures contract is an agreement between two or more parties where the delivery is fixed or committed. The difference between the market price and the contract price will have to be paid on delivery of the contract. A futures contract binds the two parties, i.e., the contract has to be settled. This means that at least one party benefits from the contract.
A futures contract can be based on any of the following:
Futures contracts must be settled between the parties even if one of the parties makes a loss in the process. The settlement date is usually mentioned in the futures contract.
There are two positions you can take in a futures contract. You can go “long”, which means you can decide to purchase or you can go “short” where you decide to sell.
Delivery or settlement in a futures contract is mandatory. However, in an options contract, you have the choice whether to settle the contract or not. It gives the investor a right but not an obligation to buy or sell the assets. This means an options buyer can disregard settling the contract if he finds there is no profit in it. The option holder can exercise the option at any point of time before the settlement date as well.
When buying an option, you need to pay a small sum called option premium. In case you don’t wish to settle the option, your loss will be restricted to the option premium amount paid. There are two types of options contracts:
• Call option
• Put option
In the call option, you go along with regards to the underlying asset, i.e., you are bound by the contract to purchase the underlying asset. A put option is the exact opposite where you are bound by the contract to sell the underlying asset. A call option trader believes the price of the underlying will exceed the contract price. In contrast, a put option trader believes the price of the underlying asset will fall below the contract price.
It is very important to understand the futures and options basics before investing in these instruments. Derivatives are inherently risky since the price movements cannot be predicted. You may want to take help from the research reports that are given by experts at IndiaNivesh Ltd. that will help you better understand the futures and options market.
How to trade in futures and options?
Futures and options are standardised contracts that are governed by the stock exchange rules. Since these are standardised, the minimum quantities of underlying assets are already stated by the stock exchange. The contracts between the two parties are fairly consistent with only the underlying assets, the delivery date and the price changing.
To invest in futures and options, you need to open a demat account and a trading account with a reputed broker like IndiaNivesh Ltd. It is possible to purchase futures and options online since these are listed on the stock exchange.
You can pick the futures or options contract you want to invest in through the trading account. For example, if you wish to purchase one lot of the index futures, you can pick that on your trading account and invest in it. In case of options, you need to pay a premium on the options contract.
The prices of futures and options change every day. As a trader, you can decide to sell your futures or wait till the end of the contract. These contracts can generally be of the following durations:
- Near month – one month
- Next month – two months
- Far month – three months
The profit or loss on futures and options is calculated daily and either debited or credited from the trader’s margin.
To trade in futures and options in stock market, each trader needs to maintain a margin amount with his broker. When a derivative contract is purchased, the entire amount doesn’t have to be deposited. Only a small margin amount has to be deposited. The profit or loss isn’t debited or credited to this margin account unless the derivative contract is sold or settled. In case the minimum margin amount is reached, the trader gets a call to infuse further funds into the margin account.
Brokerage on futures and options has to be paid when the futures or options contract is bought or sold.
A futures contract is settled daily and the value is carried forward the next day. For example, suppose a trader purchases Nifty futures for 8000. The first day, the Nifty goes down to 7900. This means the trader has made a loss of Rs. 100. This loss is debited from his margin account and the price of 7900 is carried forward the next day for settlement. This is called Marked to Market or MTM settlement. When the futures contract expires, the price on the day before the settlement date is compared with the spot price and the difference is settled.
The settlement for options contracts are a little different. While purchasing options, a premium has to be paid. The entire premium amount doesn’t have to be paid, only the difference based on premiums outstanding and receivable for each investor.
The options trader has a choice to sell the option before expiry and book his profits. The system automatically settles options contracts by matching them on expiry. The settlement value is the difference between the options value and the spot price.
Derivatives are complicated instruments which require a level of expertise before investment. If you are considering investing in F&O segment, then it is better to get the futures and options basics understood perfectly before investing to prevent losing any money. Be sure to restrict your trades till you get experienced to reduce your losses. However, if you’re a savvy investor, derivatives provide another means to earn from the price differentials in the market.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.