What Are Futures and Options?

Futures and options are kinds of financial contracts that let a trader take a view on the price of an underlying asset (security) at a future date. A future is an agreement to purchase or sell underlying shares or other assets on a certain date at a predetermined price. Conversely, an options contract offers the investor the chance, but not the duty, to purchase or sell the assets at a given price on a designated date.

 

Futures

A farmer is estimating wheat harvesting three months in the future. The farmer, fearful of a drop in the market price when the time finally comes to harvest, enters into a contract for the sale of wheat at the current predetermined price, although the actual sale shall be in the future. Such an arrangement is known as a Futures contract. In essence, Futures allow parties to lock in a price now for a transaction that is to take place later.

 

Options

Options work a bit differently. Options give you the right to buy or sell an asset at a certain price before some date in the future but with no obligation to act if the market doesn't move in your favor. Think of it like booking a table in your favorite restaurant. You can always cancel it if you are not interested in visiting.

 

Why Do Traders Use F&O?

Here is why futures and options are famous among investors:

 

Hedging

The trader protects themselves through the instruments of F&O against potential losses. For example, you may own some shares of a particular company. Its stock price may drop according to your expectations; in that case, you can use Options to hedge or protect yourself from potential risks.

 

Speculation

This is where futures and options prove useful. Some traders use F&O to bet on price movements. If they get it right, with no need to own the asset, they can make a decent profit.

 

Key Terms You Should Know

Know these terms before investing in the F&O to help yourself get a better grip on your investment:

• Strike Price: Refers to the fixed price at which an Option can be exercised.
• Premium: The cost of buying an Option.
• Expiry Date: The final day an Option or a Future contract is valid.
• Margin: The deposit required to trade Futures.

 

How Do Futures and Options Differ?

Though both of them deal in future transactions, they do differ in terms of risk, cost, and flexibility.

• Risk: Because futures are binding contracts, you have greater risk—you must fulfill the transaction on the expiry date. Options have more room for flexibility since one has the right to walk out if everything doesn't go as per your plan.
• Cost: In Futures, the margin is generally less that is required to be paid upfront, but the loss can be huge. In options, you are bound to pay a premium, which may seem a disadvantage, but still, it's the maximum you may lose.
• Flexibility: In the case of futures, you get locked in the contract. Options give you much more room for leeway since you can exercise the trade call depending on the prevailing market conditions.

 

Why Have F&O Become Popular in India?

The reason for the phenomenal rise in future and options trading in India is that they offer high returns with higher risk. For many investors, the possibility of doubling or tripling their investment within a short period is far more alluring than the risks involved.

 

Second, technological progress and online trading platforms have made F&O trading far more accessible to retail investors. However, one should remember that with higher rewards comes higher risks. This is why it is very important to understand how F&O works before jumping into it.

 

Should You Trade F&O?

Futures and Options are profitable only when done in the right manner. Here's what you need to consider:

• Risk Appetite: While F&O can bring in handsome gains, they may also cause huge losses. If you are risk-averse, these may not be the right instruments for you.
• Market Knowledge: One needs to have a good feel for market trends and price movements in order to successfully trade in F&O. You have to know what you are doing—it's not purely luck.
• Capital: Since F&O involves margins and premiums, you need to have sufficient capital to cover the losses that might occur.

 

Conclusion

Futures and options can be formidable, but they are not bereft of risks and rewards. Whether hedging against market volatility or speculating on price movements, understanding how F&O works is the first step toward making informed decisions. Given the potential for profit, there is also a great element of risk involved. Against that background, it always makes sense to do some good research and take the advice of a financial advisor before getting into the whirlpool of F&O trading.