What is Futures & Options: An Introduction

 

Futures & Options are crucial tools for traders concerned about price swings in the financial and commodity markets. Price fluctuations are the one constant in these markets, driven by a myriad of factors including the health of the economy, climate conditions, agricultural output, election outcomes, coups, conflicts, and governmental policies.

Given that price changes can result in significant losses or profits, market participants use derivatives like futures and options to protect themselves. A derivative is a contract whose value is derived from underlying assets, which could be currencies, equities, commodities, or other assets. By utilizing these instruments, traders can hedge against potential adverse price movements and manage risk more effectively.

What is futures & options?

F&O stands for Futures and Options. Futures and Options represent Derivatives of the stock market. These Derivatives are the financial instruments deriving their values from an underlying such as currency, gold, or the stocks of a company. You could earn a profit by trading these derivatives independently of the underlying assets.

Before going into the details of the Futures and Options, let us first understand what Derivatives are and its types.

What are Derivatives?

It is a two-party contract whose value is determined by predetermined underlying financial assets, such as a securities or group of assets, such as an index. In general, bonds, currencies, commodities, interest rates, market indices, and stocks are the underlying instruments of derivatives.

What are Futures?

An agreement to buy or sell the underlying asset in question at a specific price within a predefined time frame is known as a future. Acquiring a futures contract means pledging to pay the asset’s price on a predetermined date. Selling a futures contract entails pledging to provide the buyer with access to the asset on a preset date at a fixed price. These underlying assets in a futures contract are primarily made up of stocks, indices, currencies, and commodities related to the stock market.

While the spot market (a market where the assets are exchanged instantly) and futures have different underlying asset prices. Since incurred expenses like interest, storage, insurance premiums, and other charges are included, the basis, or difference, is usually negative. An instance of contango occurs when the Basis remains negative. This negative figure demonstrates how profitable the future will be.

The basis of a futures deal determines whether you usually make money or lose money on it. Sometimes it makes more sense to possess physical assets than futures because of the dividends that are paid out. Occasionally, this will cause the value of Basis to increase.

A phenomena called backwardation happens when Basis is positive, and it usually happens when the asset’s price is about to drop. At contract maturity, the futures prices tend to approach the spot price, which means that the basis tends to drop to zero.

What are Options?

Options are investment instruments which give the holder the right to buy or sell the underlying asset at a predetermined price. An Option can be a Call option or a Put Option.

While the Call Option gives the buyer the right buy the underlying asset at a predetermined price also known as Strike Price. If you have a Call option you have the right to demand the sale of the underlying asset from the seller, while the seller only has the obligations and not the right. The right here lies with the buyer while the seller only has the obligation for which he gets paid a price called Premium.

Thus, the buyer of a Call option will not exercise his option, in a case on expiry, the price of the asset is lesser in the spot market than that of the Strike price of the call. Similarly, the buyer of a Put Option will not exercise his option, in a case on expiry, the price of the asset is greater than that of the Strike price of the call.

Difference between futures & options

Contracts for futures and options are investment vehicles that are used to make predictions about how asset prices will change in the future. On the investor’s obligations, however, they diverge greatly.

1. Futures contracts establish a legally-binding commitment to purchase or sell an underlying asset at a fixed price by a given deadline. It is the investors’ responsibility to fulfill this contract, regardless of the market price at expiration.
2. Options contracts provide the buyer or seller the option, but not the obligation, to purchase or sell the underlying asset by a specified date and at a specified price. Investors can choose to let the option expire worthless or exercise it if it starts to turn a profit.

Essentially, contracts for futures demand fulfillment, whereas contracts for options provide the option to act in accordance with market conditions.

(To begin trading in futures and options, it’s essential to open a demat account. Once that’s set up, you can start investing. )

Impact of futures & options Ban on the Price of Shares

The F&O ban’s effect on stock price is contingent upon a number of factors, including the fundamentals of the stock, the state of the market as a whole, and the rationale for the restriction.

A stock’s trading volume and liquidity drop when it enters the F&O ban period because investors are unable to open new holdings. It lessens market volatility and could lead to a stable or marginally declining stock price.

On the other hand, the stock price can plummet if the ban is the result of unfavorable reports or incidents involving the company, as investors might liquidate their current holdings. However, if the stock’s fundamentals are solid and the ban is the result of excessive speculation, the price of the stock might stay unchanged or even rise.

Depending on the rationale for the restriction and the state of the market overall, the effect of the F&O ban on share prices could be either short- or long-term. After one trading day, the prohibition might expire and regular trading in the stock might resume. In other situations, the exchange can prolong the prohibition and experience protracted volatility.

As a result, the effect of the F&O ban on stock price may vary and be dependent on a number of variables. To make wise investment selections, investors must keep a careful eye on the state of the market and the rationale behind the prohibition.

Why do futures & options contracts enter a ban period?

When a stock’s open interest in futures or options contracts surpasses 95% of the Market-Wide Position Limit (MWPL) set by the stock exchanges in India, the stock is subject to a stop-trade restriction.

For instance, a specific stock’s MWPL is 10,000 contracts. The stock enters the F&O prohibition period when the open interest in futures or options contracts for that stock reaches 9,500 contracts. Investors are prohibited from adding to their positions in futures or options contracts pertaining to that specific stock during this time. Those with active contracts, however, are still able to exercise their options or square off their positions.

In India, the F&O prohibition usually lasts for one trading day. The exchange has the option to prolong the restriction for further trading days if the stock rises above the MWPL.

For example, Vodafone Idea’s stock entered the F&O ban period in April 2021 after its open interest exceeded the MWPL. News stories and market speculation have caused a spike in open interest and trading activity for the stock. Consequently, the stock was prohibited from trading for one trading day in the F&O market. Following the lifting of the ban, investors were permitted to open fresh holdings in the stock.

Who Should Invest in Futures & Options?

Traders engaging in future and option trading can be classified into the following types.

• Hedgers

To lessen the volatility of their investments with regard to price fluctuations, these people engage in futures and options contracts on the stock market. When a buyer assumes a trading position and the price swings against it, locking in a price for a future transaction lets the investor earn a relative gain.

However, those that enter a futures contract may suffer large losses in the event of a positive fluctuation. An options contract reduces this risk by allowing the investor to back out of the agreement in the event of positive price fluctuations. Hedgers enter into a derivative arrangement in order to hedge their future income or expenses.

These traders are well-liked in the commodities market, where people attempt to lock in an anticipated price of a specific item for a successful exchange. Use an example of futures and options trading to better understand it. A farmer can sell 50 kg of potatoes for Rs. 20 per kg three months from now by entering into a futures contract with a distributor.

In the event that the price of potatoes drops below that threshold on the day of maturity, the farmer has effectively hedged his position to reduce the total risk involved in future trade.

Nonetheless, a farmer may forfeit earnings in the event of an increase in potato market prices. A put option contract, which grants the farmer the right but not the duty to fulfill contract terms, can be used to offset such losses. He or she can execute the options contract to guarantee minimal losses in the event that the market price level drops.

In contrast, a price increase gives the farmer the option to back out of the agreement and sell the goods at market value. Hedgers typically go for physical trading, in which the asset is traded when the contract matures. It is especially well-liked in the commodity market, where manufacturers and businesses engage in physical trading to maintain stable raw material costs. It guarantees an economy’s price levels remain stable.

• Speculators 

Speculators choose to take an opposite position in the here and now in order to profit from such price swings. They forecast the direction of price movement in a market based on intrinsic valuation and economic conditions. Using futures and options as an example, an investor can take a short position in the derivatives market if they believe the price will rise in the future. It denotes buying stock or a derivative now with the intention of selling it later for a profit. Those who anticipate that prices will decline in the future based on their analysis of the market then take a long position. Through these contracts, investors intend to purchase stocks at a discount in the future in order to profit proportionately.

• Arbitrageurs

The goal of arbitragers is to make money off of pricing discrepancies in the market that result from flaws in the system. In futures and options trading, a price quote comprises the strike price and carry cost, with the underlying assumption being that the striking price corresponds to the contractual price. The cost of carry is the difference in price that results from carrying the underlying security to a later date. Arbitrageurs alter supply and demand patterns in order to reach equilibrium, which effectively eliminates any price discrepancies resulting from unfavorable trading circumstances. Trading on leverage, in which all trading expenses are deferred, is a common technique in futures and options trading.

Instead, if an investor maintains a minimum quantity (marked to market value) in his or her trading account, a brokerage business finances a certain percentage of the entire contract. It significantly raises an investor’s profit margin. However, as previously said, there are significant risks involved with futures and options because precise price movement predictions are necessary. Profiting from derivative trading requires a deep understanding of stock markets, underlying assets, issuing companies, etc.

7 things you need to know before your first futures & options trade 

1. Futures are bidirectionally leveraged products. It’s possible that the astute salesman informed you that your profit may increase fivefold on futures because you only have to pay a 20% margin. This is how it functions! You pay Rs. 20,000 in margins to purchase equities valued at Rs. 100,000 in futures. Given that your margin is five times leveraged, a 10% increase in price translates into a 50% profit on your Rs. 10,000 investment. That’s why what the gregarious salesperson said you was accurate.

The one thing he omitted to mention is that trading in futures tends to magnify losses, which also operate in a similar manner. It’s acceptable as long as you understand that margins have an effect on leverage in both positive and negative scenarios.

2. Purchasing options reduces risk, but profits are seldom realized. Purchasing options limits your risk to the premium you paid, which is why many small F&O traders prefer to do so. The issue is that more than 97% of options expire worthless worldwide. This implies that your chances of profiting from options are only 4% if you purchase them. In actuality, option sellers profit more frequently than option buyers because they assume a larger risk. Therefore, resist the temptation to believe that there is little risk involved in purchasing options.

The fact is that purchasing choices reduces your chances of earning money as well. You might discover that, while trading futures and options, futures work better for you than options. How you trade and how much you can afford to lose will determine everything.

3. What makes options different is that they are asymmetrical. Let’s use an example to better grasp this. In the event that “A” purchases RIL futures at Rs. 920 and “B” sells them, both parties will profit equally from the trade. In the event that the price hits 940, A will benefit by Rs. 20 while B will lose Rs. 20. If the stock price drops to Rs. 900, the opposite will be true. With options, however, the seller’s loss is theoretically limitless while the buyer’s loss is restricted to the premium.

4. In periods of volatility, futures margins might increase significantly. Many of us think that because you can buy on margin using futures, they are better than cash market purchases. But during volatile times, these margins may increase significantly. Assume that you paid a 15% margin to purchase GMR futures. You have up to 25% of liquidity ready. However, the stock’s volatility spikes out of nowhere, and the margins are revised to 40%. You’re in a pickle now! Your broker will automatically reduce your positions until you bring in new margin. When you trade F&O, keep this risk in mind.

5. Always set profit and loss targets while trading F&O. For all leveraged positions, this is true. Your main priority while trading Futures and Options is as a trader, not an investor. As a result, you should emphasize capital preservation. Only if you specify your trade-off between profit and loss for every trade will that be feasible. It is a discipline to stop loss, therefore don’t try to question it. When trading F&O, the stop loss and profit booking levels must be strictly followed, regardless of your opinion on the stock.

6. Continue to monitor the expenses you are spending on F&O. Rethink your assumptions if you believe that brokerage and other F&O expenses are lower. Although they may be smaller in percentage terms than equity, you experience more churn with F&O. These expenses mount up. On F&O trades, you pay STT, statutory costs, stamp duty, GST, and brokerage. Before you sit down and start adding these up, you should gain some perspective. Make sure that your profit to transaction cost ratio is greater than 3:1; if it isn’t, you are essentially making a profit off of your F&O trading.

7. Even if you are unsure about the direction of the market, you can still trade options. The F&O market’s capacity to implement a non-directional strategy is among its most durable characteristics. To trade markets in which you are uncertain of the direction, you can combine futures and options. Options can be used to make money in both erratic and stable markets. You find greater value in these characteristics of options than in utilizing them to replace stock trading.

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