What are Futures and Options (F&O) in the Share Market?
Futures and Options are derivative products of the stock market with the help of which investors can speculate on market price or hedge market risks. These instruments enable the investors to buy certain stock or commodity at a specific price by a specific date. These are also called the derivative products since they derive their value from the value of other assets. Futures and options are derivatives of various assets like equities, commodities, currencies, etc. When the value of these assets fluctuates, the value of futures and options also fluctuates. But the question arises, why the traders trade in the derivative market?
The traders get benefitted by the derivative market by predicting the future value of an underlying asset.
Options
Options are the contracts which provide an investor the right (not obligation) to buy or sell shares at a specified price at any time before the expiry of the contract. By using options, you can trade the stocks without owning them.
Types of Options
(A) Call Options
A call option provides the investor the right (not obligation) to buy specified quantity of an underlying asset.
(B) Put Options
A put option provides the investor the right (not obligation) to sell specified quantity of an underlying asset.
Futures
Futures are the contracts which are of obligatory nature, means they have to be settled once you enter into these contracts. If an investor enters into these contracts, it is mandatory for the investor, to buy or sell the underlying assets at a pre-specified price on or prior to the certain date.
Types of Futures
(A) Financial Futures
These are stock futures, index futures, interest rate futures, etc.
(B) Physical Futures
These are commodity futures, Energy futures, Metal Futures, etc.
How the Futures and Options Trading Works?
In futures and options the rates are pre- determined and the investor may buy or sell the stocks or other assets at these pre- specified price, on or before the date of these contracts. If the investor has a buy position and the price rises in future, then the investor makes profit because the pre-specified price is less. In case the investor has a sell position and the prices goes down then he will be in profit because the pre-specified price is more.
Difference Between Futures and Options
The only difference in Options and Futures Contracts is of obligation. While the options contracts give right to the investor but not the obligation, the futures contracts are of obligatory nature and these has to be executed mandatorily once the investors enter into these contracts.
Important Terms to Understand in Futures and Options
(i) Underlying Security
The underlying security is the primary element of futures and options by which these instruments drive their value. These securities may be stocks, bonds, interest rate, index or commodity on which the futures and options are based.
(ii) Strike Price
Strike price is price at which the investor agrees to buy or sell the underlying assets at the time of exercising the contract.
(iii) Premium
Premium is the current price (or a fee) of the agreement which is paid by the option buyer to the seller. The higher the volatility of the market, higher is the premium.
(iv) Expiry Date
It is a fixed date up to which the futures or options contract is valid and after the expiry of that date, the futures or options contract cannot be exercised.
For Which Futures and Options Are Suitable?
Futures and options are not the suitable instruments for everyone. If you are new to investing and do not have good understanding of how market works and how the prices of underlying assets fluctuate, you should not invest in these instruments. These instruments are suitable for the following:
(a) Speculators
Speculators predict the price of an asset as per the intrinsic valuation and economic condition and choose to take an opposite position in the present to gain from such price fluctuations. For example, if an investor predicts a price increase in an asset in the future, he/she may take a buying position, means purchasing a stock in the present and selling it at a high price in the future.
Similarly, if a speculator predicts price fall in future, he/she may take a selling position, means selling the stock at a high price at present and buying at a low price in future.
(b) Hedgers
Hedgers are individuals who might get impacted due to price fluctuations in future and hence they try to protect their assets using these derivative instruments.
(c) Arbitrageurs
Arbitragers are the people who make profit form the price differences in the market, which arise due to market imperfections.
Conclusion
Futures and Options are derivative products of the stock market with the help of which investors can speculate on market price of hedge market risks. These are also called derivative products as they derive their value from the underlying assets in the market such as stocks, metals, commodities, etc. These are simply contracts which enable the traders to trade an underlying asset at a pre-determined price on or before the expiry of the contract. The only difference between futures and options is of obligation. While the options contracts give right to the investor but not the obligation, the futures contracts are of obligatory nature and these has to be executed mandatorily once the investors enter into these contracts. The investors make profit from the rise or fall of the underlying assets. If the price of stock or asset rises and the investor has taken a buying position, then the investor makes profit since these instruments enable him/her to buy the asset at the lower price(pre-determined). Similarly, if the price of stock or asset goes down and the investor has taken a selling position, then the investor makes profit since these instruments enable him/her to sell the asset at the higher price(pre-determined). These instruments are not for everyone and suitable only for hedgers, speculators or arbitrageurs. If you are new to investing and do not have good understanding of how market works and how the prices of underlying assets fluctuate, you should not invest in these instruments.
Also read: What is Red Herring Prospectus and How can it be Useful for Investors?
