Stock market offers several products for investment and trading purposes. Few of them are mutual funds, equity, IPO, NCDs, bonds, derivatives, etc. Futures and options fall under the category of derivatives.
Derivatives are contracts that are made between two parties willing to buy or sell the underlying asset at a fixed price and fixed time. These are risk management tools that help in transferring risk to those who are ready to take the risk.
Derivatives are of 4 types: Forwards, Futures, Options and Swaps. Future and options contracts are used as hedging tools to reduce risk and make profits in a highly volatile situation. The prices of goods may suddenly rise or even fall.
Futures and Options trading is the trading in derivatives where the ‘contracts’ for the underlying asset are bought and sold.
Futures and options are the major types of stock derivatives traded in a share market. These are contracts signed by two parties for trading a stock asset at a predetermined price on a later date.
Such contracts try to hedge market risks involved in stock market trading by locking in the price beforehand.
2.0 OPTION TRADING
Options are based on the value of an underlying security such as a stock. As noted above, an options contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific price while the contract is still in effect.
Investors don’t have to buy or sell the asset if they decide not to do so. Options are a derivative form of investment. They may be offers to buy or to sell shares but don’t represent actual ownership of the underlying investments until the agreement is finalized.
There are only two kinds of options: call options and put options. A call option is an offer to buy a stock at the strike price before the agreement expires. A put option is an offer to sell a stock at a specific price.
Because they tend to be fairly complex, options contracts tend to be risky. Both call and put options generally come with the same degree of risk. When an investor buys a stock option, the only financial liability is the cost of the premium at the time the contract is purchased.
However, when a seller opens a put option, that seller is exposed to the maximum liability of the stock’s underlying price. The option writer is on the other side of the trade. This investor has unlimited risk.
Either the option buyer or the option writer can close their positions at any time by buying a call option, which brings them back to flat. The profit or loss is the difference between the premium received and the cost to buy back the option or get out of the trade.
3.0 FUTURE TRADING
Futures are contracts made between two parties wherein they agree to buy or sell a particular asset at a fixed price at a particular time in the future. This helps in reducing the risk and losses involved.
A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price. Futures contracts are a true hedge investment and are most understandable when considered in terms of commodities like corn or oil.
For instance, a farmer may want to lock in an acceptable price upfront in case market prices fall before the crop can be delivered. The buyer also wants to lock in a price upfront, too, if prices soar by the time the crop is delivered.
Futures were invented for institutional buyers. These dealers intend to actually take possession of crude oil barrels to sell to refiners or tons of corn to sell to supermarket distributors. Establishing a price in advance makes the businesses on both sides of the contract less vulnerable to big price swings.
Retail buyers, however, buy and sell futures contracts as a bet on the price direction of the underlying security. They want to profit from changes in the price of futures, up or down. They do not intend to actually take possession of any products.
Options may be risky, but futures are riskier for the individual investor. Futures contracts involve maximum liability to both the buyer and the seller. As the underlying stock price moves, either party to the agreement may have to deposit more money into their trading accounts to fulfill a daily obligation.
This is because gains on futures positions are automatically marked to market daily, meaning the change in the value of the positions, up or down, is transferred to the futures accounts of the parties at the end of every trading day.
Futures offer the advantage of trading equities with a margin. But the risks are unlimited on the opposite side irrespective of whether you are long or short on the futures.
When it comes to options, the buyer can limit losses to the extent of the premium paid only. Since options are non-linear, they are more amenable to complex Options and Futures strategies.
Categories: EARNING FROM MUTUAL FUND, IPO AND EQUITY SHARES