Futures and Options are a type of trading tool for short term trading in the financial markets. They constitute the derivatives segment of the markets.
Derivative is defined as something which has been derived from an underlying security.
In case of Futures and Options, the underlying security is the stock or currency or any other security. These underlying securities trade in cash segment in the markets.
Derivatives are unique as they allow the trader to play the market both ways ; up or down.
This is in contrast to cash market where you can only buy in anticipation of selling that security on higher price.
In derivatives, you can sell the market or stock on a higher price if you are expecting a decline in the stock and buy later at lower price when stock has fallen. The difference between the selling and buying price is your profit.
Futures and Options generate quick money to the traders. You should understand how to trade futures and options to add versatility to your trading and make quick money.
Table of Contents
What is Futures Trading
A Future is a contract which gives the buyer or seller of that Future Contract a right to buy or sell the underlying security at a specific time and price.
A single contract remains valid for a month and it usually expires on the fourth Thursday of each month.
So a trader have to close his buy or sell position on or before the expiry day in Futures Trading.
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Futures trading constitutes a significant part of the daily trading volumes.
It is enabled in market indices, stocks or currencies by the market regulators (SEBI or Securities and Exchange Board of India).
Futures trading is not available in all the stocks trading on the stock exchanges.
A trader may create long position in Futures by buying at low prices in anticipation of price rise in near future.
Alternatively, short position can be created in Futures by selling at higher prices in expectation of price decline or market fall in near Future.
What is Options Trading
An Option is also a contract which gives the buyer or seller of Option a right to buy or sell the underlying security at a later time.
Options trading gives too much leverage and flexibility for trading in stock markets.
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Profits are made in stock markets when the buying price for Options is lower than the selling price.
Traders may choose not to close their position if the desired prices are not achieved or as per their wish till the expiry period, the Option may be left to expire.
Hence in case of Option Contract, it is not the obligation of the trader to close this position and the position may be left to expire.
To learn more about Options Trading, you may read about various determinants of Option pricing here.
Advantages of Futures and Options Trading
Futures & Options offers versatile options for the traders with short term view, say, a month or two.
Futures trading is good for few weeks or months while options trading is ideal for trading of a few days only.
As we discussed above, by derivatives it is possible to trade the markets both ways.
Besides, they also provide much needed cash leverage for trading position.
Lets have a look at the advantages of F&O :-
An investor holding big portfolio of stock may not want to sell his/her all portfolio even if he/she is expecting significant fall in the markets. But it is also important to protect the portfolio from downside risk.
Here derivatives come into play as hedging tools.
The risk can be managed by taking short position in the portfolio stock by taking short position either by selling Futures or buying Put Options.
So loss due to downside in the stock price is neutralized by gains in short position in Derivatives.
Derivatives are used by speculators as trading tools who have very short time view. Moreover, they can be used for making money by trading when there are declines in the markets or any specific stock.
Derivatives are trade-able in the form of Lots which have monthly contracts.
A Lot is a fixed number of stocks of any one company. We can trade in derivatives by investing only 15-20 % amount of the total cash value of that Lot.
For Options trading, the margin is even less which is called as Option Premium.
The cash leverage ensures that you can earn much higher return on the money you invested than you have otherwise earned by trading in cash.
But you should remember that losses are also much higher in derivatives trading.
Risks associated with Futures and Options Trading
Futures and Options involve cash leverage which is actually a double edged sword. Cash leverage although ensures higher returns but losses are also equally substantial.
Futures trading can be highly devastating for financial health of a trader if not done with proper research and following a strict discipline.
Options, comparatively, are much safer where you can not lose more than the premium you have paid to buy an Option.
Futures and Options add much needed versatility to the trading arsenal of a trader which can be highly paying in terms of returns. The need is to trade them wisely and with necessary research and discipline.
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