If you are wondering what are futures and options, you may be looking at the derivatives market to make an investment. Well, these can be highly profitable investments but can also come with risks associated with them.
Derivatives are financial instruments which are valued as per the underlying asset on which it is based on. If you are looking at commodities market, then derivative have underlying assets as commodities such as gold, crude oil, food grains and so on. Then again, price indices, market indices can also be the underlying assets of derivatives.
Two main forms of derivatives are futures and options.
Those who are involved with futures and options trading, usually dapple in commodity markets. Futures are tradable contracts which are formed between buyers and sellers who wish to determine the price of a commodity in a future date. The contract binds the seller to sell at the price decided no matter what the future market scenario will be while the buyer agrees to buy a certain amount of commodity from the seller at a pre determined price no matter what the actual market conditions are at the future date so fixed.
Futures trading can be done in three principal ways – by squaring off your contract, by making actual delivery or by making a cash settlement. When you square off a futures contract, you take a position opposite to your initial stance. Such as, if you have purchased a gold futures contract then you square it off by selling a similar contract. In case of actual delivery, it signifies physical delivery of the goods as agreed on the specified date. Cash settlement means the difference that one has to pay when selling a contract, that between the futures price and the spot price of the asset on that day.
Options amongst futures and options trading is a safer financial instrument to play with. It signifies the right to sell or buy an underlying asset but poses no obligation on one to actually buy or sell the asset. There are two types of options – the call option is the right to sell at the strike price at which the contract is bought; the put option is the right to buy the asset at the strike price. Options are again classified into the American style and the European style. The previous style means that such an option can be exercised any time before the expiry date while the European style represent options which can be exercised only after the expiry date.
These are the main defining characteristics of these financial instruments if you want to know what are futures and options.
If you consider the bearish trends, the strategies vary accordingly. Bearish options indicate when investors feel that the price movement of the underlying asset is going to be negative. In such cases, investors assess as to how low the price will go and then decide on their trading strategy accordingly. Many novice investors decide to exercise their put options and sell in such circumstances. Since stock prices generally do not go down steep, most bearish options investors will set an average price decline estimate and will use bear spreads to minimize cost. Bear call spread, bear put spread are the common strategies employed in such cases.
Each stock exchange has its own characteristics which govern the trading that takes place in its premises. When we talk of futures markets, BSE or NSE function like such markets themselves. For instance, the equity market at NSE functions as a weekly futures market which closes on the Tuesday of every week. If a person decides to go long on Thursday, he or she will not be obligated to perform the transactions right away. Hence, the long position maintained can be reversed on Friday due to which there would be no net obligations remaining on the clearing house. This scenario does not take place in a T+3 makret. Trading at NSE provides a centralized platform due to which the futures market in India remains liquid at best and hence reduces counter-party risks to investors.
When you look at the Indian market for derivatives, the National Stock Exchange has a market index which is traded in the form of derivatives. Known as Nifty, it represents a market index which is formed of as many as 50 company stocks highly rated across the country and representing as many as 24 different sectors in the country. Similarly, one may find the Sensex at the BSE or Bombay Stock Exchange for derivatives trading.
A major stock tip is to trade in bulk. This is possible due to the small amount required to either buy futures contracts or options. In case of futures contracts, one needs to pay 20 to 30% of the stock price which is known as margin money. Similarly in case of options, the strike price of such a contract needs to be paid as a premium to hold such instruments.
When we talk of options, these involve rights to buy or sell the underlying assets but no necessary obligations to carry them out. Options can be of two types – while a call option is used when one wants to buy an underlying asset, the put option is utilized when someone wants to own the right to sell the underlying asset of a derivative.
If we look at the Indian markets, NIFTY represents a market index which is computed from the performance of high ranking stocks amongst the various stocks listed in the National Stock Exchange or NSE. Nifty market index consists of around 50 companies stocks which come from various sectors, as many as 24 different sectors of the Indian industry. These companies in the Nifty index may vary based on several considerations. BSE has a similar market index that is traded as a derivative known as SENSEX.
Options on the other hand, are less risky instruments. These are contracts which provide investors the right to buy or sell an underlying asset within a specified period of time. Usually, such investors need to pay a premium to buy such contracts since their right to exercise such rights are purely intentional and brings on them no obligation to actually buy or sell the asset. Options can be of two types – call options provide the buyers the right to buy the asset while the put options are right to sell an asset within the expiry date. The options which are floated of the American style, the rights can be exercised any time within the expiry date while those of the European style can only be exercised on the expiry date.
On the other hand, options are rights to buy or sell an underlying asset but does not impose the actual obligation to buy or sell the asset on the buyer. There are two types of options that one can purchase – call options provide one with the right to buy an asset while the put option provides one the right to sell an asset. Then again, the American style of options contracts can be executed any time within the expiry date while the European style options contract can be exercised only on the expiry date.
On the other hand, an option is a contract by which a buyer gains the right to buy or sell a certain amount of an underlying asset but comes under no obligation to perform the transaction. The price is called the strike price which comes with an expiry date. You could have a “call” option whereby you have the right to buy an underlying asset or the “put” option which provides the right to sell such an asset. All that a buyer needs to pay is the option premium to the brokerage firm. There are two types of options – European and American in India. The European system provides the exercise date same as the expiry date whereby the American system allows a buyer to exercise his or her rights any time before the expiry date of the contract.