Futures and options are financial tools that are widely used in the Indian stock market. If you’re new to trading, you may have heard these terms but might not fully understand what they mean. This blog will break down the basics of what is futures and options, and explore their key factors and limitations to help you understand these concepts better.
What are Futures?
An agreement to purchase or sell an underlying asset is known as a futures contract. This includes stock, commodities, currency etc at a predetermined price on a specific future date. Futures are contracts traded on exchanges. They legally require both parties involved to stick to the terms of the agreement.
Key Factors to Consider with Futures
When trading stocks, currency or commodity futures, it’s essential to keep several key factors in mind for successful trading. Understanding these factors can significantly impact your decisions in the futures market. These key factors include the following:
- Daily Settlement: Commodity futures positions are marked-to-market daily, which means that gains or losses are calculated at the end of each trading day. If your account doesn’t have enough money to cover the maintenance margin, you might get a margin call asking you to add more funds.
- Leverage: Futures contracts allow investors to control a large position with a relatively small initial investment, known as the margin. Using leverage can make both your profits and losses bigger.
- Margin Requirements: Traders are required to deposit a certain amount of money, with their broker, before entering into a futures contract. This is called the initial margin. This margin serves as an initial payment to ensure traders can fulfil their financial responsibilities.
- Expiry of Contract: Futures contracts have a set end date. When this date gets close, traders can either finish their trades or switch them to a new contract for the next month.
What are the Options?
An option is a formal agreement granting the holder the choice, without obligation, to purchase or sell an underlying asset at a fixed price (known as the strike price) within a specified period. There are usually types of options. This includes:
- Call Option: This gives the holder the right to buy the underlying asset at the price agreed upon.
- Put Option: This gives the holder the right to sell the underlying asset at the price agreed upon.
Key Factors to Consider with Options
Options trading involves several important elements that investors must consider before entering into contracts. Understanding the difference between futures and options and key factors is essential for making informed decisions. This includes the following:
- Premium: The upfront cost to acquire an options contract is known as the premium. This payment represents the maximum potential loss for the option buyer.
- Intrinsic Value and Time Value: Option premiums consist of two components i.e. intrinsic value and time value. The difference between the strike price and the underlying asset’s current market price is referred to as the intrinsic value. Time value reflects the possibility of the option becoming more profitable as time elapses.
- Expiry Date of an Option Contract: Options have a specific expiration date, after which they become invalid if not exercised. The time remaining until expiration is a significant factor in determining the option’s premium.
- Exercise and Assignment: Option holders can exercise their right to purchase or sell the underlying asset at the strike price. When this occurs, the option seller (or writer) is obligated to fulfil the terms of the contract.
Limitations of Futures and Options
While futures and options offer various advantages, they also have some limitations that investors should be aware of. This includes the following:
Complexity: Understanding the intricate details of futures and options can be a real challenge, especially for those just starting in the trading world. These financial instruments are not exactly straightforward.
Risk of Loss: Trading in futures and options carries significant risks of loss. Traders may end up losing more than their initial investment, particularly if they’re trading on margin or selling options. It’s crucial to have a firm understand these risks and manage them skillfully.
Market Volatility: Prices in the futures and options markets can be quite volatile, going up and down rapidly. Various factors like supply and demand, economic conditions, and market sentiment can contribute to this factor. It is suggested to keep track of market conditions for making a wise investment decision.
Conclusion
Futures and options can be powerful tools in the world of trading and investing. As a beginner, it’s important to have a good understanding of these key factors and their limitations before entering into these markets. Always remember to practice risk management, start with small positions, and continue learning and refining your skills. One can trade futures and options well, by being patient, disciplined, and willing to learn.
