Futures and Options! These are two words any person could find on any page of a newspaper! What can we expect in the future and what are our options?
Futures and options are the most common derivatives traded in the market. The selling price of these derivatives is commonly based on an underlying asset and the price of the derivative moves along with the price of the underlying asset. The asset underlying it is usually a stock or an index of a stock market. This means that a company’s price of its futures and options will depend on the price of the company’s shares.
How do Futures work?
Futures are considered a lot easier to understand than the Options as they pretty much work in the same manner as shares. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
Here are some important factors which one needs to consider.
- Not all stocks have Futures:
There are only a handful of shares which have Futures traded on them. You can buy or sell Futures only on these particular shares.
- All Futures have an expiry date:
All Futures have an expiry date, and in India, you can only buy Futures of three duration
– one that expires in the current month,
– one that will expire in the coming month,
– one that will expire in the third month.
All Futures contract must expire on the last Thursday of the month.
For example, In February you can buy a February contract which will expire on
28th February 2019, 31st March, 2019 OR 30th April, 2019.
- Futures are always traded in lots:
You can buy or sell one share of TATA Steel, but Futures allow you to buy pre-planned amounts and you have to buy or sell in those multiples only.
For example, a Tata Steel Future has a lot of 125. When you buy one Future contract of Tata Steel, it is like buying 125 shares at one go. The big difference here is that you won’t have to actually pay the price of 125 shares, but only pay the difference in the buying and selling price which is usually a lot less.
- You can sell a Future without owning it first:
Since a Future transaction is always settled on an upcoming date, it is also possible to sell a Future without actually owning it. This is called as going short and is a very useful feature of Futures.
For example You can sell a March Future today without owning it first, and you have till March 28th to buy back your Future and square your transaction. In this case, you get to make a profit when the price of the share goes down because you have already sold the share to another person and are hoping to buy it back at a lower price.
Why does one buy Futures or Options?
The main reason to buy futures and options is leverage. These derivatives allow you to make a large amount of money in a short period of time with the same amount of capital than one can with a regular cash position.
The second reason is it takes short positions or profit from the reduction in the prices of a share or particular commodity. If one is aware of the weak position of a company and is aware that the stock price is about to collapse – he/ she can profit from it. Profiting from this knowledge is not possible in a normal stock market, but you can sell a future, call option or buy a put option to take a short position in the particular stock or index.
The third reason recently heard is hedging risks, and this is a big reason for all the institutional investors. Retail investors can’t effectively hedge with derivatives. The notional value of these derivatives is often too high, and on the other hand the expiry periods are too short to act as an effective hedge for small investors.
Practically, this is riskier than buying a Future because there is no limit to how high a share can go. Theoretically, the limit is the amount that is present in your account. Once you reach this limit – the broker will square your transaction by buying back the share.
All these may sound tough, but it is all based on simple accounting principles.
BSE Institute Limited, a 100% subsidiary of BSE India, offers multiple courses which allows students and working professionals to learn new financial concepts. It provides a short-term online courses on BSEVarsity.com for all those who wish to learn about Futures and Options. This course can help one learn all about futures and options in just 4 sessions!!