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Futures and Options
Derivatives are financial instruments that derive their value from the value of another asset. Futures and options are two such derivatives of other assets. Futures and options are derivatives of various assets, including equities, commodities, and currencies. When the value of the underlying asset fluctuates, the value of the derivatives, such as futures and options, fluctuates as well.
Traders tend to enter into derivatives markets to benefit by predicting the future value of the underlying asset.
Assume that the stock price of a company drops, and you can lose money due to the drop in the stock price. In this scenario, you can enter into a derivative contract, i.e., stocks' future and options to profit or protect yourself from losses on the spot market where the stock is traded to hedge this loss.
Read on to know what are futures and options and the meaning of futures and options in detail.
What is Future and Options Trading
Futures and options are two derivative instruments where investors buy and sell the underlying financial instruments at a pre-determined rate. Traders book their profit or bear the loss as per their prediction when buying futures and options.
A future is a forward contract between two parties in which the buyer promises to buy a specified quantity of stocks from the seller at a pre-determined price at a future date. A future grants a buyer and seller the right to purchase and sell a certain share at a set price.
A contract between two parties that offers a buyer the right but not the obligation to purchase or sell the underlying at a future date and at a future price is known as an option.
In futures and options trading, traders will get profits when they have to buy positions and prices of F&O are moving upwards. On the contrary, when traders have a selling position in the market, it is profitable for them if prices fall.
While trading in futures and options in the share market, traders have to keep a specific percentage of the future value of F&O stocks as a margin with the broker. It helps the traders to maintain their position in the market as a sell or buy position.
In the case of buying an option contract, traders have to pay a premium over and above the price of underlying futures and options stocks.
The prominent purpose of derivatives like futures and options is to hedge against the price movements of underlying financial instruments.
However, one point to be noted is that futures and options do not provide ownership of underlying financial instruments.
Difference between Futures and Options
Futures and options are derivative products as both the terms are usually used simultaneously and share some commonalities. Both drive their value from underlying assets like stocks, ETFs, commodities, and indices. But there is a lot of difference between futures and options. Let's understand what are the differences between futures and options.
Rights or obligations
Future contracts represent the commitments or obligations to complete the squared-off transaction as per the contract requirement at a specified date.
On the other hand, in the case of option contracts, traders have a right to exercise the contract at a particular time. They have an option to implement the contract but not an obligation.
In future trading, traders must exercise the agreed action at the specified date of the contract only.
Unlike futures, in the case of the option contract, traders can exercise their right at any time till the specified date in the contract.
However, different rules are applicable in different financial markets depending upon the type of underlying financial security.
Advance payment requirements
In the case of futures contracts, traders are not liable to pay an entry fee to brokers. But, they must maintain a margin, a certain percentage of the future value of contracts, to leverage the gains and losses in trading.
On the other hand, in the case of options contracts, traders have to pay a premium to buy options.
Prevailing risks in trading in F&O
In the case of futures contracts, traders have to exercise their contract irrespective of the price movements and willingness to pay for the financial instrument. In such a case, the risk of bearing loss exists as there can be a scenario where prices are low at the time of selling the instrument than the price at which the trader bought it.
On the other hand, in the case of options trading, traders can exercise their right to sell or buy the derivative as they seem fit and profitable.
Steps To Open F&O Account on Upstox
For trading in any financial instrument like stocks, debts, or derivatives, traders must open a Demat trading account with the broker. You need to open a futures trading account to do futures and options trading.
How to open an F&O account
|1||The first step to opening a futures and options account is to open a Demat account by downloading the Upstox app from your play store or completing the online registration process.|
|2||After opening up a Demat account, you need to activate futures and options trading from the Upstox app. Click on the menu and select “activate F&O, MCX”|
|3||Click on the "activate segment" and select the segment you are willing to trade. NSE Futures and Options and NSE Currency Derivatives will be selected by default. If you want to trade in commodity derivatives, you can also select commodities.|
|4||To complete the procedure, you need to upload their income proof as per their value of holdings. Proof of income is not required if the value of holding is less than 5,000.|
|6||For MCX (Multi Commodity Exchange of India), India’s first listed exchange for trading in derivatives online, traders need to upload live photos and geolocation in the application.|
|7||Traders need to upload the documents like Aadhaar with eSign.|
|8||To verify eSign, an OTP will be sent to the registered mobile number with Aadhar and bank account.|
|9||You will need to submit the OTP, and they will be re-directed to the website of NSDL for submission.|
|10||Lastly, you will receive an OTP from the NSDL website for verification of the documents.|
|11||Traders have to wait for the activation of the futures and options account for 24-48 hours.|
Who Should Invest in Futures and Options Trading
Investors who have knowledge of futures and options in the stock market and an in-depth understanding of tracking the market can invest in futures and options. The F&O trading has an element of speculation based on predicting micro and macroeconomic factors of underlying financial instruments.
Traders have to estimate whether there is an upward trend or downward trend in the market, based on which they come into a contract with other market traders.
In other words, we can say that hedgers and speculators use futures and options. Let us understand who are hedgers and speculators.
Hedgers are usually found in a commodity market where prices are highly volatile. The hedgers intend to insulate against future price volatility. They predict the market based on their experiences and analysis to secure their returns on underlying financial security.
However, if prices go up in the meanwhile, future traders lose their profits. While buying an asset, they have to purchase it at a fixed price irrespective of the current market price.
In speculation, traders need to have an educated guess while studying the market and current economic situation in the country and respective industries. Unlike hedgers, speculators do not look for price stability, and they intend to bet at the long odds. The speculator is willing to buy at lower prices in the short term to gain high returns when selling.
How to trade in Options and Futures on Upstox
Upstox is one of the best futures and options brokers in India.
Step 1: To begin trading and learning how to trade futures and options, you must first create a trading account that allows you to buy and sell futures and options contracts. You can buy F&O through Upstox.
Step 2: When you have completed the process of signing up for an account, you can log in to your account by accessing the login page. You can access your trading account using the app on your mobile device or by using the website on any computer.
Step 3: You may do some research to see what futures and options are available to you and which ones would best fit your needs.
Step 4: After you've chosen your option, fill in the order details. The strike price is then used to purchase futures and options. The strike price of a put or call option is the price at which the contract is exercised. If you think prices will climb or fall, you'll purchase a call option or sell a put option.
The spot price is an important component to consider when determining the price of a futures contract. The spot price is the current market price of the underlying asset and is used to predict the price of future contracts.
When purchasing an option contract, you can do the following three steps:
Offset the position: When an option contract is sold to close a position before it expires, it is referred to as ‘offsetting the position.’ Depending on the price at which the underlying item is sold, this selling may result in a profit or loss for the seller.
Exercise the position: You can execute the call options contract when the underlying asset's price is higher than the strike price. Once the underlying asset's price is under the strike price, you can do the same with a put option.
The contract expires worthless: In a call option, the contract expires valueless if the underlying asset's price falls below the strike price. This occurs when the underlying asset's price expires above the strike price in a put option.
Here are a few basic tips that traders need to learn about futures and options.
The ratio of profits to transaction cost
If traders keep the ratio of profits to transactions cost 3:1, it might help them gain better returns. Traders have to pay brokerage, stamp duty, taxes, statutory charges and STT on F&O trades, which affects the overall returns. If investors try to keep their costs to a minimum, they can earn decent returns.
Trade options when directions of the market are unclear.
Beginner F&O traders can trade options if they do not understand the direction of the market clearly. In the option contracts, traders can exercise their rights until the contract.
Be aware of the other risks along with market volatility.
At a time of high volatility in the market, the margin charged by the broker rises sharply, and traders need to keep the margins of brokerage firms to keep the transaction cost as low as possible.
Types of Futures and Options
Before undertaking future and option trading, it is essential to know about the different types of futures and options.
Let us see the different types of futures based on the underlying asset.
Index Future: Futures contracts whose underlying value is based on a stock index are known as index futures.
Stock Future: Stock futures are contracts that allow you to purchase or sell a certain group of shares at a specific price on a specific date. The traders are bound to follow the conditions of the contract after they have purchased it.
Currency & Commodity Future: Currency futures, also known as foreign exchange futures, allow you to purchase or sell a certain quantity of currency at a particular price and time.
Interest Futures: A futures contract with an underlying asset that offers interest is an interest rate future. It is an agreement between the buyer and seller to provide an interest-bearing asset at a specific price in the future.
Different types of options
Here are the two types of options trading:
Traders can buy the underlying financial security at an agreed price on the specified date in the call options.
A put option allows you to sell underlying financial security at the pre-determined price on the specified date.
Basic Terms Of F&O
Here are some basic terms for future and option trading.
It is a prominent element of F&O trading as price movement depends upon the underlying security through which it derives its value. It can be stock, bond, commodity, interest rate, indices, or currency.
It is a price at which the owner of the contract agrees to sell or buy the derivative at a pre-determined price on the specified date.
It is a current price of an option paid by the option buyer to the option seller. The higher the underlying assets' volatility, the higher will be the premium.
It is a particular date fixed by the contract owners at which traders must exercise rights or obligations.
Futures and Options Examples
Example of Future contracts
On the final business day of March 2021, Trader A acquires a futures contract to buy shares of ABC Limited for $500. Seller B is the one who sells this contract to A. In a futures contract, the buyer must either purchase the stock at a later date or execute the contract in cash. A similar situation takes place with the futures contract seller.
Example of Options contracts
A pays a premium of 7 to buy a call option on stock ABC at Rs.500 (strike price) on the expiration day. Seller B is the one who sells this option. The option seller will retain the premium. When the stock price exceeds the strike price and the premium paid, the deal benefits buyer A. When the ABC stock starts trading over 500 + 7 = 507 per piece, the contract becomes beneficial for the buyer.
P pays a premium of Rs9 to acquire a put option on stock ABC at 500 (strike price) on the expiration day. M is the seller of this option. The option seller will retain the premium. When the stock price falls below the strike price less the premium paid, the deal becomes attractive for buyer P. When the ABC stock starts trading below 500 – 9 = 491 per share, the trade becomes beneficial.
Frequently Asked Questions
How to calculate F&O turnovers?
Turnovers can be calculated as per the sale of futures and options traders sold during the whole year. Total sales can be termed as the turnover of futures and options trading.
Are futures and options the same?
No. Futures and options have some commonalities, but they are different in various aspects like the risk associated with them, rights and obligations, and fundamental rules and regulations.
What are derivatives (F&O) in the stock market?
The meaning of future and option trading is that the value of these derivative contracts is based on the underlying stock market instruments, like shares of the companies.
How do I buy futures and options?
Traders can buy futures and options through Upstox with their Demat accounts. They have to activate the future and option trading account and start trading.
How do futures and options work?
The price movements of futures and options are based on the traders' predictions of underlying financial assets. They buy and sell according to their educated guess and bet on the instruments.
What are the advantages of F&O?
While trading in F&O, traders can get the benefits of liquidity, decent returns, no time decay, and straightforward pricing. By studying the market movements of the underlying assets well, traders might be able to earn well.
What are the margin requirements for trading in derivatives?
The margin requirements are based on the volatility of the market. The higher the volatile market, the higher percentage of margin charged by the brokerage firms.
Which has more leverage, options or futures?
They both have their advantages and disadvantages. Futures contracts don't have the option to sell in between the term. Options contracts have the option to exercise the right till the specified time. On the other hand, future options can give traders relatively high returns than options contracts. It all depends on the risk appetite of the traders.
What are derivatives?
A derivative is a contract between traders whose values are based on the underlying financial instruments like stocks, bonds, currency, commodities, and indices.