Futures and options are trading products that institutional investors and retail traders utilize. Both the products are a form of derivative, a financial medium that does not possess any value of their own but rather receives value from an ‘underlying’ asset such as a company-issued share, gold, a currency, etc.
The chief difference between futures and options rests on the duties they set on the buyers and sellers. In the case of a futures contract, the buyer has to buy a particular asset. The seller is obliged to sell and deliver that asset at a certain future date unless the holder’s status is terminated due to expiration. On the other hand, an options contract gives the buyer the power to buy or sell a particular asset at a certain price at any time throughout the life of the contract.
Types of Derivatives
There are essentially two types of derivatives; exchange-traded derivative and over-the-counter derivative. Exchange-traded derivatives are purchased and sold through market exchanges globally, and future and options are exchange-traded derivatives. Stock futures and stock options are deadline-based contracts between the buyer and the seller for a percentage of equities. The contracts present traders with strategic opportunities to earn money and hedge prevailing investments. Stock derivatives are usually available for three months in the future, but index derivatives can be purchased for three years.
Let’s take a more in-depth look at the basics of futures and options that every investor must know about.
Futures trading is distinct from investing in the stock market since an investor doesn’t truly own anything. In futures contracts, the investor speculates on the inevitable direction of the price in the stock you are trading. The futures contract is an instrument to buy or sell an underlying asset at a certain rate at a given time. The price of the futures is generally higher than the prevailing market cost of the security. Instances of a futures contract are commodities, equity stocks, currency, and indices.
Trading in the futures contract is intended for the investors who wish to leverage, speculate, hedge, and arbitrage. An investor can begin trading in futures contracts by becoming a NSE member (National Stock Exchange of India Limited) or BSE (Bombay Stock Exchange) on their online trading platform.
The options contract is an agreement between two parties wherein one agrees to sell stocks to a different party within a definite period of time and for a special price. A stock order, whether it is a “put” (an agreement to sell) or a “call” (an agreement to buy), gives the owner of the stock the right to trade options contract. The holder is equipped to let the options order lapse even without investing further or purchase the stock. Options trading presents a unique investment opportunity to novices and trained professionals investing in the stock market. It provides several benefits such as limited risk, leverage, profits, and insurance in bear markets. The price paid for an options contract is called the premium.
Capital Required For Futures & Options Trading
Investing in the future and options requires lesser capital because you have to spend only a marginal sum of money and get greater exposure. Normally, futures and options are opted by people with high net worth. The trading of futures and options requires a lot of time, effort, and commitment.
Things To Keep In Mind While Trading In Futures & Options
The most significant point to keep in mind while trading in the future and options is that an investor needs to be very cautious as there is a perpetual risk of losing your money quickly. Thus, ideally, the money that you can stand to lose without suffering from a financial setback should not be more than 10 to 15% of your investible funds. Furthermore, it is advised for a novice trader to begin buying options rather than selling or writing them. Once the investor gets adequate information on how to trade efficiently in the future and options, they can perform well in writing and selling them.
Futures and options trading is similar to an insurance policy for investors. For instance, a farmer may trade futures on his crop if he believes the crop’s cost will go down before the harvest period. On the contrary, a bread maker may purchase futures if he believes the wheat cost will rise before the harvesting period. The comparison’s final element is the trader in futures who studies the changes in the futures markets and attempts to obtain benefits by buying or selling at a profit.
Understanding what futures and options, especially the difference between the two, can help investors practice these trading vehicles in the best possible way.