Demystifying futures and options: Your comprehensive guide
This comprehensive guide delves into futures and options, covering standardized contracts, key components, leverage, moneyness, and more. Whether you're a seasoned trader or a novice investor, understanding calls, puts, strike prices, and other intricacies can equip you to tread the market confidently. While these tools offer rewards, their inherent risks demand diligent research before engaging in derivatives trading.
In the world of financial markets, futures and options play a significant role in allowing investors to manage risk, speculate on price movements, and potentially maximize returns. While you may find these derivative instruments complex at first, understanding the fundamentals can empower you to use them to your advantage. In this blog, we'll delve into the world of futures and options, explaining what they are, their key components, and how they work.
Futures are standardized contracts that obligate the buyer, i.e., you to purchase and the seller to deliver a specific asset at a price that is predetermined on a future date. These contracts are traded on organised exchanges, providing a platform for you to speculate on price movements, hedge against risks, and speculate on various underlying assets, such as commodities, stocks, indices, and currencies.
Key components of futures
The following elements constitute futures:
- Underlying asset: The asset that the futures contract is based on, such as crude oil, gold, or a stock index.
- Expiration date: The date when the futures contract matures, at which point the contract must be settled.
- Contract size or lot size: The specified amount of the underlying asset that the contract represents.
- Future price or strike price: The agreed-upon price at which the asset will be bought or sold upon contract expiration.
Advantages of futures
Now let us understand a few specific advantages of Futures trading.
- Risk management: Futures allow businesses and investors to hedge against potential price fluctuations. For example, a farmer can lock in a future selling price for their crops to mitigate the risk of price declines.
- Leverage: Futures contracts typically require a smaller initial investment compared to buying the actual asset. This can help amplify returns for you if the market moves in the trader's favour.
- Speculation: Traders can profit from both rising and falling markets by taking long (buy) or short (sell) positions in futures contracts.
Options, like futures, are derivative contracts, but they offer different opportunities and risks. An option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific asset at a predetermined price within a specified time frame.
Let us explore the key components of options.
- Call option: This gives the holder the right to buy the underlying asset at the strike price before expiration date.
- Put option: With this, the holder gains the right to sell the underlying asset at the strike price before expiration date.
- Strike price: The price of the asset at which it can be bought or sold.
- Expiration date: The date by which the option must be exercised, or it becomes worthless.
Calls vs. Puts
There are two types of Options trading: calls and puts.
- Call options: These are used when an investor expects the underlying asset’s price to rise. Buying a call option gives you the right to purchase the asset at a fixed price, even if the market price goes higher.
- Put options: These are used when an investor anticipates the price of the underlying asset to fall. Buying a put option gives you the right to sell the asset at a fixed price, even if the market price drops further.
Option chain and moneyness
An option chain is a comprehensive list of available options for a particular underlying asset, showing various strike prices and expiration dates. The moneyness of an option refers to its relationship to the underlying asset's current market price, and can be:
- In the Money (ITM): It’s a call option where the strike price is below the current market price, or it can be a put option where the strike price is above the current market price.
- At the Money (ATM): When the strike price of an option is approximately equal to the current market price.
- Out of the Money (OTM): In this, the call option has a strike price over and above the current market price and the put option has a strike price that is below the current market price.
Lot sizes and expirations
Options are usually traded in standardized lot sizes. A single option contract typically represents 100 shares of the underlying stock for stocks. As for expirations, options have predetermined expiration dates, usually monthly. Note that shorter-term options will provide you more flexibility if you are out to capitalize on shorter market movements. At the same time, longer-term options offer more time for the market to move in the anticipated direction.
Futures and options are powerful tools that can empower you to manage risk, speculate on price movements, and potentially enhance returns. By understanding the key components of these derivative contracts, including calls and puts, strike prices, option chains, moneyness, and lot sizes, you can navigate the complex world of financial markets with confidence.
Whether you're a seasoned trader or a novice investor, incorporating futures and options into your investment strategy could provide valuable benefits, helping you achieve your financial goals. Remember, while these tools can offer substantial rewards, they also come with inherent risks, so thorough research and understanding are essential before diving into derivatives trading.