Futures and options are stock derivatives that are traded in the share market and are a type of contract between two parties for trading a stock or index at a specific price or level at a future date. By specifying the price of the trade, these twin derivatives safeguard the investor against future fluctuations in the stock market. However, the actual futures and options trade is often far more complex and fast-moving.
While many people deal in futures and options through a trader, it is always advisable to understand their functioning before you invest in them. Here’s what you need to know.
Difference Between Futures and Options
Although these twin stock derivatives share some commonalities, they are also markedly different in certain key respects. Both derive their value from an asset known as the underlying such as shares, commodities, exchange traded funds (ETFs), share market indices, and others. Both represent a future trade.
Here are some key differences between the two:
Right vs. Obligation: Futures represent a commitment to trade that must be squared off at the specified date. Whereas options give the buyer the right, but not the obligation, to exercise the contract.
Date of trade: A futures holder must trade the security at the agreed-upon date. In case of options, while there are variations, you can exercise some options any time till it’s the expiration date. There are some nuances around exercising options for indices versus stocks as well as different rules in different markets. For example, in India, an index option can only be exercised on the expiration date but a stock option can be exercised anytime till the expiration date.
Advance payments: There are no upfront costs when entering into a futures contract. You make the payment only when squaring off the futures contract on the specified date. However, futures contracts require you to put up a “margin”, which is a certain percentage of the value of the trade. Therefore, the “leverage” magnifies your gains and your losses.
For example, say you buy stocks worth INR 100,000 in the futures market with a 20% margin (i.e. INR 20,000 in this example). To execute this contract, you have to keep INR 20,000 with your broker. If the stock goes up 10%, you have made a INR 10,000 profit while putting up only INR 20,000. Therefore, your profit margin is 50% and not 10% like it would have been if you actually bought the stock. The flip side, of course, is that the same logic applies to your losses. Further, if your losses deepen, you may be required to post additional margin.
To buy an option, on the other hand, you will need to pay a premium. The seller of the option earns this premium as should you choose not to exercise the option, you will lose the premium paid.
Risk: In case of a price drop, you can opt out of exercising your options. You won’t have the same freedom when it comes to futures where the trade must take place at the specified date, irrespective of the price. Hence, options theoretically reduce the risk of loss. In practice, however, 97% of options expire without trade. So, options traders are more likely than not to end up losing their premium.
Types of Futures and Options
Futures are fundamentally uniform with the same set of rules for buyers and sellers.
Options can be of two types: call option and put option.
A call option allows you to buy the underlying asset at an agreed-upon price at a specific date.
A put option allows you to sell the asset at a specified price on a specific date.
In both cases, the trade is always optional. You can choose not to utilize your call or put option if the prices do not suit you.
Who Should Invest in Futures and Options?
Futures and options trading requires an understanding of the nuances of the stock market and a commitment to track the market. There is also a strong element of speculation. Hence, it is most often used by hedgers or speculators.
- Hedgers: Their main motivation is to insulate against future price volatility.Most hedgers are found in the commodity market where the prices can fluctuate very quickly. Futures and options trade often provides much-needed price stability in such cases.
By hedging their bets in a dynamic market, hedgers secure assured returns on the underlying asset. However, if the price goes up in the interim, they can lose out on the profit. Similarly, when buying the asset, they will purchase at a fixed price, irrespective of its market value.
- Speculators: Derivatives trading has a strong element of speculation where you are agreeing to trade at a fixed price. Unlike hedgers who are looking for a stable price, speculators are often betting against the long odds. They will study the market, news events that are likely to impact trading and make an educated guess at the price. A speculator will typically look to buy at a low price in the short term while speculating on higher returns in the long run.
How To Invest in Futures and Options?
Futures and options trades do not need a demat account but only need a brokerage account. The preferred route is to open an account with a broker who will trade on your behalf.
- Derivative trading in the stock market
You can trade in derivatives at the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). The NSE allows futures and options trade in over 100 securities and nine major indices. As the derivative that sees more leverage, futures tend to move faster than options. The maximum duration for a futures contract is three months. In a typical futures and options transaction, the traders will usually pay only the difference between the agreed upon contract price and the market price. Hence, you don’t have to pay the actual price of the underlying asset.
- Derivative trading in commodities
Some of the markets where futures and options trading is most common are the commodities exchanges such as National Commodity & Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange (MCX). The reason for heavy derivative trading in commodities is the high volatility of these markets. The prices of commodities can fluctuate wildly and futures and options allow traders to safeguard against a future fall.
At the same time, it also allows speculators to profit from commodities that are expected to spike in the future. While futures and options trading in the stock market is not uncommon for the average investor, commodity training requires a tad more expertise.
Factors to Consider Before Entering Into Futures and Options Trading
Derivative trading requires you to understand the movement of the market. Even if you trade through a broker, there are some factors that must be kept in mind.
- Don’t be fooled by the leverage
Futures and options assets are heavily leveraged with futures usually seeing a harder sell than options. You are more likely to hear about the profit you can make in the future by fixing an advantageous price. What you are less likely to hear is that the margins can work both ways. You may be forced to sell at less than the market price or buy at more than the market price.
In other words, your likelihood to make a profit is theoretically as good as the likelihood to make a loss. While options may seem like the safer option, as discussed above, you are far more likely to defer trade and lose the premium value, hence, making a net loss.
- Staying within your risk margins
Your risk appetite is the amount of risk that you are willing to take in order to meet your objectives. When trading in derivatives, the underlying motivation is to reduce the risk by fixing the price in advance. In practice, a trader will always try and go for a price that will offer healthy gains. But one of the maxims of investments holds true in this case as well, the higher the reward, the higher the risk. In other words, think of the risk you will be willing to take when agreeing to any price.
- Setting up stop-loss and take-profit level
For seasoned traders, one of the oft-used tools to control their trade is setting up stop-loss or take-profit levels. A stop-loss is the maximum amount of loss that can be undertaken while a take-profit is the maximum profit you will settle for. While the latter may seem contrary, a take-profit point allows you to fix a price where the stock can stabilise before falling. These are the twin price points within which a trader operates.
- Margins and market volatility
While it may seem that we are hedging our bets and ensuring healthy margins on a futures and options trade, you must keep in mind that these margins are themselves subject to the movement of the market. In a volatile market, if your trade is making a large notional loss, you will be required to post higher margin quickly, else risk the broker squaring off your trade and losing your existing margin.
- Be aware of the costs
Derivative trading does not require a demat account. It is often seen as a more economical alternative in terms of cost price. But don’t be fooled by the lower brokerage. There are additional costs that include stamp duty, statutory charges, goods and services tax (GST), and securities transaction Tax (STT). But the real cost hike comes from the frequency of trade. Derivative trade is quick with multiple transactions in a short time, which multiplies the cost of your overall trading. Hence, it is always advisable to keep a check on the number of transactions against the gains you are making.
Bottom Line
Future and options are often seen as more mysterious cousins of equity trade. These are fast-moving trades where the margin can fluctuate daily. Unlike equity, which attracts long-term investors, futures and options are meant for traders who are looking for quick returns. If managed in a planned manner, they allow you to protect yourself from a volatile market, while slowly increasing your gains.
Trading futures and options is not rocket science, but it does need a level of understanding before you dive in. It can be a great tool to hedge your bets and save you from market volatility. Alternatively, as a speculator it can be a medium to play the volatility to make outsized returns, but that approach comes with its own substantial risks.
