What are futures and options?
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Future and options are derivative contracts. Their value is based on the value of an underlying asset, which can be a stock or a commodity.
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Futures and options are types of derivatives contracts. Their value is based on that of their underlying asset. For example, if you have an option on a stock, its value will rise or fall depending upon the value of that stock.
F&O should be used for risk management. However, some traders start buying F&O purely for speculating, which can be risky. Besides, futures and options are more complex than stocks and bonds. Hence, if you want to trade in them, you should understand all the complexities involved and only then start trading.
Future and options (F&O) are two popular derivatives. They are called derivatives because their value is derived from the value of an underlying asset. Trading in F&O does not require you to have a demat account. This is because futures and options are valid only till their date of expiry. After that, they are not valid and hence you don’t have to hold them in a dematerialised form.
However, trading in F&O requires you to have a brokerage account. Using this account with a broker, you can trade in future and options. In India, F&O on stocks are traded on stock exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Meanwhile, the F&O on commodities are traded through National Commodity & Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange (MCX).
Now that you have learnt how to trade futures and options, let’s delve deeper into this topic.
Futures and options are far more complex instruments than stocks and bonds. Hence, it’s important to understand their basics well:
A futures contract is a legal contract between two parties. Under this contract, one party has to buy/sell a certain asset from the other party at an already fixed price and on a specified date in the future.
In a futures contract, a buyer is legally obligated to buy an asset and a seller is legally obligated to sell it.
In an options contract, the buyer of an option has the right (but not an obligation) to buy or sell an asset at a predetermined price within a specific period.
If you buy a futures contract to buy an asset, you are under an obligation to buy it based on the terms of a contract.
However, if you buy an option to buy an asset, you have the option to buy it but not an obligation to buy it based on the terms of a contract.
If you’re just getting started with futures trading, here’s what you should keep in mind:
A futures contract involves a commitment to meet your obligation on a particular day.
For example, if you have a future to buy a stock “X” on August 31 at a fixed price of Rs. 100, then you have to buy X at Rs. 100 on August 31. In other words, you’re obligated to do it.
You’re obligated to buy X at Rs. 100 even if its price on that day is much lower.
Therefore, you buy a futures contract when you expect the price of its underlying asset to increase by the time this contract expires.
Let’s use the same example. If you expect the price of X to rise beyond Rs. 100 by August 31, it makes sense to buy a futures contract which allows you to buy it at Rs. 100.
You don’t have to pay any upfront cost while entering a futures contract. However, you’ve to put up something called a margin.
Suppose you want to buy X at Rs. 100 on August 31. Your broker may ask 25% margin. So, you have to keep Rs. 25 with your broker for this contract.
If X’s price moves up to Rs. 105, you’ve made a profit of Rs. 5 on just Rs. 25 investment, which is 20%.
If you had bought this stock at Rs. 100, you’d have made only 5% profit. However, just as a futures contract can multiply your gains, it can also multiply your losses.
Are you just about to begin trading in options? This is what you should keep in mind:
When you buy an option, you have the right to either buy or sell an asset within a specified period at a predetermined price.
The important point to note is that you have a right not an obligation. If you choose not to sell or buy the asset, it’s perfectly fine. However, in a futures contract, you are obligated to fulfil your commitment.
To buy an option, you have to pay a premium, which is the price of that option.
There are broadly two types of options: a call option and a put option.
If you buy a call option, you’ve the right to buy an asset at a predetermined price and on a specific date.
If you buy a put option, you’ve the right to sell an asset at a predetermined price and on a specific date.
The primary objective of entering into a futures or options contract is to manage your risk. However, at times, traders take more risks by buying an F&O contract. So, keep these things in your mind:
While entering an F&O contract, you must keep the downside in mind.
If you have a future contract to buy a stock “X” on August 31 at a fixed price of Rs. 100, then you have to buy X at Rs. 100 on August 31. Even if the price of X falls to Rs. 80, you'll have to buy it at Rs. 100.
In the case of an option contract, you don’t have an obligation to buy X; however, you will lose your premium if the price of X falls below Rs. 100.
Just as in the case of other investments, even in the case of futures and options, the higher the risk, the higher the reward. So, you shouldn’t get attracted by only looking at the reward of an F&O. First, you should check the risk and if you’re comfortable bearing that risk, you should enter that position.
You should set up a stop-loss level or a take-profit level. A stop-loss order sells a contract at a fixed price to limit your losses. And, a take-profit order sells a position at a fixed price to book profits.
In a futures contract, the margin depends upon the volatility in the market. If the market is extremely volatile, you may have to deposit more margin with your broker. Otherwise, your broker may square off your position and you may lose your margin. So, always keep an eye on volatility.
Some of the famous option trading strategies are explained below:
Covered call strategy: This is a famous option strategy. Under this, an investor buys an asset and then he writes a call option on it. This means he sells the right to someone to buy that asset from him at a predetermined price on a specific date.
Married put strategy: This is another popular option strategy. Under this, an investor buys an asset and buys a put option. The put option gives him the right to sell the asset at a predetermined price on a specific date.
Pullback strategy: When there’s a slight change (or reversal) in an existing trend of an asset’s price, traders can employ the pullback strategy. When there’s a slight dip in the price in an overall uptrend, traders can buy an asset, hoping that the price will go back to the original uptrend. On the other hand, when the overall trend is of a price decline, but there’s a momentary increase in price, traders can sell when the price increases a bit, expecting that the price will ultimately fall.
Spread trading: Under this strategy, traders buy and sell two futures contracts that are correlated at the same time. Their objective is to make use of the discrepancy in the price of these two futures.
If you’re thinking of opening a trading account, chances are that you’ve heard about futures and options. Bear in mind that futures and options should be used mostly for risk management. If you buy F&O purely for speculative reasons, you may lose a lot of money. Therefore, the first thing that you should do is understand their basics well. And then you should buy such contracts only if you need to.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Future and options are derivative contracts. Their value is based on the value of an underlying asset, which can be a stock or a commodity.
You don’t need a demat account to trade in futures and options. However, you need a brokerage account to trade in these contracts. Stock-based F&O are traded on the NSE and BSE. And, commodity-based F&O are traded on NCDEX and MCX.
The main risk is that the price of the underlying asset may not move in the direction you think. And in the absence of a stop-loss order, your losses can be huge.
First, learn the basics of futures and options. Second, open a brokerage account. Third, start with small amounts.
For option-trading, you can use these strategies: covered call and married put. For trading in futures, you can employ these strategies: pullback strategy and spread trading.
Budget 2024 has increased the taxes on F&O. The budget has increased the tax on futures transactions from 0.0125% to 0.02% of the traded price. Meanwhile, the tax on options transactions has been increased from 0.0625% currently to 0.1% of the option premium.
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