A Simple Guide To Futures & Options.

Future and options are two terms in stocks and the share market that are commonly used together. These are but two different terms with similar trading products. These came up as a hedging tool and for risk management but now they are used as a trading tool due to it's rising popularity.

Future and options are very beneficial tools. In the Future and options, you can make a huge profit with a small amount in less time and at the same, you can face a huge loss. If you very well know how it works, you can certainly make profits. In both cases, you need small marginal money or capital.

Before we move into the detail of Futures and Options, we need to know what derivatives are Derivatives is a financial instrument that derives its value from an underlying asset. In simple terms, it's a security that derives its value from an underlying asset, has no value of its own. That is the value of derivatives increases as the value of its underlying asset increases. That is they derive their value from an underlying asset or market such as stocks, indexes, interest rates, and commodities.

Like bonds and shares, it's also a financial instrument where you can invest. There are four types of derivatives:

1. Forwards

2. Futures

3. Options

4. Swaps

out of the four, only Futures and Options can form a part of trading, that is they can only be traded in the stock market. They are two different asset classes. In the derivative market, a contract or an agreement is trade. That is you buy and sell contracts. A buyer will find a seller, they enter into a contract to buy and sell it at its expiry date.

First, we will see what Futures are. Future is a contract made between the buyer and the seller. In Future, they decide on the price of an asset in the present, and buyer and seller adhering to it. By the expiry date, the seller is obliged to fulfil the contract.

So the buyer agrees to buy the asset by the end of the expiry date by an amount already agreed by both parties. By the term, the price of the asset may increase or not, he will have to honour it, he is compelled to buy it at them to agree to the price whatsoever.

By the time of expiry there can be three possibilities:

1. The price may increase

2. The price remains the same

3. The price may decrease

If the price increases it's profitable for the buyer and if not for the seller.

Here, for example, a buyer is agreeing with a farmer who grows wheat. The buyer agrees to buy it at Rs. 50 per Kg by the end of a month. The buyer would always hope that the price of wheat would rise by the time of expiry. It can go either way as well. By the end of the month, the price of wheat goes down to Rs. 45 per Kg but the buyer has to buy it at the agreed amount that is Rs.50.

Now, we will take a look into what options are. It's similar to Futures in the way it works. As the name suggests you have an option whether to buy the asset or not. The buyer has an option of whether to buy the asset or not, he may or may not fulfil the agreement. Isn't it discriminating on the part of the seller as he has no say? There is a small twist. It includes Option Premium. As in a premium amount or a token of advance is paid to the seller initially which is not refundable even if the agreement is fulfilled or not. Thereby the buyer is reducing the risk if the market goes down.

Also, the buyer has an option to sell the contract at a higher price to another person even before the expiry of the contract.

We will take the same example of the farmer who grows wheat. So they both agree on selling the wheat at Rs. 50 per Kg in a month. The buyer pays a token amount. By the end of the month, the market price goes down to Rs. 45 per Kg. In such an instance, in Option, the buyer can decide on whether to buy it or not. He might not buy it and the only loss he faces is on the token amount he has spent. Also, it's profitable for the seller who gets the token amount and can sell the contract to another person to yield the desired amount.

There is a call option and put option as well. A call option is the right to buy, the buyer agreeing to buy at a higher price at a future date and the Put Option is the right to sell. Call Option obliges the seller to sell the contract at the agreed price even if the market price is higher.

The premium option or the token amount, as it's a part of the derivative depends on the underlying assets and other factors. As the price of the asset increases the premium option increases too. That Is when the buyer sells the contract, at a higher price thereby making a profit. From this, it's evident that you can use the option to trade.

The expiry date in futures and options can be 1 month, 2 months, or 3 months but it will always be on the last Thursday of the month.

In the Futures, you require more money than in Options. Future has this downside that it's too risky that might make big losses at the same time you could make huge profits out of it if it's going in your direction. So It's not viable for beginners. Even if you don't take margin money.

In Options, you can either be an Options seller or an Options buyer. Option selling has a hedge over Option buying. Sellers are bound to make more money and be smarter than buyers. The Option sellers are intelligent people who analyze the charts and market and decide whether to call option or put option. You have to spend less and can yield more. This is a probability, you may or may not yield. It's like a lottery ticket: you either win the prize or not but you have to pay the ticket amount.

So you have three choices; future trade, option buying, and option selling. Option sellers make huge profits out of the three. Even if things don't go in your direction, Option sellers still make profits from the premium option they have. In the case of Option buyers, things need to go in the direction to make profits. For Future traders, if the market goes in their direction, make profits and even if not, make a small profit.

Therefore from this, we can conclude that future and options are generally used for

1. Risk management and hedging

2. Speculative Trading

Both have their advantages and disadvantages but you can cope with them if you have a clear idea of how things work and where things can go wrong. There is a higher level of risk in futures whereas Options carry a lesser risk. In options, the most you can lose is the premium amount or the token amount you spent initially.

As it is said, "The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong".

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Author - Tess Bobby

Content Writer at Escribo.