Have you ever wondered how traders make money from price changes in markets without actually owning any products? Futures and Options (F&O) trading is a popular method that lets people speculate on price movements of assets like stocks, commodities, currencies, and more, without needing to own them directly.
If you’re new to these concepts, don’t worry! This guide will explain futures and options in the simplest way possible using everyday examples and plain language.
By the end of this article, you’ll understand what these financial tools are, how they work, and whether they could be a good fit for you.
What Are Futures Contracts?
Imagine you’re planning a wedding next month and you need 100 kilograms of sweets for the guests. You go to a local mithaiwala and agree to pay Rs. 500 per kg, no matter what the price is next month. If the price of sweets rises to Rs. 600, you still pay Rs. 500. But if the price drops to Rs. 400, you’re still locked in at Rs. 500. This is the basic idea behind futures contracts—locking in a price today for something you’ll buy in the future, regardless of how the market moves.
A futures contract is a legal agreement between two parties to buy or sell an asset at a specific price on a future date. These contracts can involve commodities like crude oil, gold, or corn, or financial products like stock indices or currencies.
Key Points About Futures Contracts:
- Obligation: Both parties must stick to the contract, whether the market moves in their favor or not.
- Leverage: Futures trading is highly leveraged, meaning you can control a large position in an asset with a smaller amount of money.
- Risk: The risk can be very high, as market prices can move against you, leading to losses greater than your initial investment.
What Are Options Contracts?
Now, let’s use a modified example to explain options contracts. Instead of committing to buy 100 cupcakes, you pay the bakery a small fee (say, Rs. 20) for the option to buy those cupcakes at Rs. 2 each in one month. You’re not obligated to buy them, but if the price rises to Rs. 3, you can still buy at Rs. 2, making a profit. If the price drops to Rs. 1.50, you can simply choose not to buy, and you only lose the Rs. 20 fee.
This is similar to how options contracts work. In options trading, you pay a small fee (called the premium) for the right (but not the obligation) to buy or sell an asset at a set price before the contract’s expiration date.
Key Points About Options Contracts:
- Right, Not Obligation: You have the option to buy or sell, but you don’t have to.
- Premium: You pay an upfront fee (called the premium) for the right to trade the asset.
- Risk: Your maximum loss is limited to the premium you paid, but the potential profit can be unlimited if the market moves in your favor.
Key Differences Between Futures and Options
To make things clearer, here’s a simple comparison between futures and options:
| Feature | Futures | Options |
| Obligation | You must buy or sell the asset. | You have the right, but not the obligation. |
| Risk | Potentially unlimited risk. | Limited to the premium you pay. |
| Profit Potential | Unlimited profit potential. | Unlimited profit potential, but limited loss. |
| Premium | No premium paid. | You pay a premium for the right to trade. |
Types of Futures Contracts
There are several types of futures contracts, catering to different markets and assets. Here are the most common ones:
- Commodity Futures: These involve trading physical commodities like crude oil, gold, wheat, etc.
- Financial Futures: These involve financial products like stock indices, currencies, or interest rates.
- Index Futures: These track the performance of stock market indices like the S&P 500, Sensex or Nifty 50.
- Currency Futures: These futures involve trading currencies like the US dollar, Euro, or Japanese yen.
Understanding Leverage and Margin in Futures Trading
When you trade futures, you don’t have to pay the full value of the asset upfront. Instead, you only need to deposit a small portion, known as the margin.
This is what makes futures a leveraged product—where you can control a larger position with a smaller investment.
For example, in India, the margin requirement for a futures contract might be just 5% of the total contract value. So, if you want to trade 100 barrels of oil worth Rs. 50,000, you might only need to deposit Rs. 2,500 as margin.
While leverage can lead to bigger profits, it also increases the potential for losses. If the market moves against you, you could lose more than your initial deposit. Be sure to consult with your broker to understand the leverage options they provide..
Types of Options in Trading
In options trading, there are two main types of contracts:
- Call Options: These give you the right to buy an asset at a specific price before the expiration date. If you believe the price will rise, you buy a call option.
- Put Options: These give you the right to sell an asset at a specific price before the expiration date. If you believe the price will fall, you buy a put option.
Important Terms in Futures and Options Trading
To get started, here are some key terms you should know:
- Underlying Asset: The asset (like a stock, commodity, or index) that the contract is based on.
- Strike Price: The price at which you can buy or sell the asset in an options contract.
- Premium: The price you pay for an options contract.
- Expiry Date: The date when the contract expires.
- Open Interest: The total number of outstanding contracts that have not been settled yet.
Pros and Cons of Futures and Options Trading
Pros:
- High Profit Potential: Leverage allows you to make significant profits from small price changes.
- Hedging: Both futures and options can be used to protect (or hedge) against losses in other investments.
- Diversification: F&O trading lets you diversify your investment portfolio and reduce overall risk.
Cons:
- Risk of Losses: Leverage magnifies both profits and losses.
- Complexity: F&O trading can be complex for beginners, and requires understanding market trends and strategies.
- Margin Calls: If your account balance falls below the required margin, you may have to deposit more money to maintain your position.
How to Start Trading Futures and Options
To begin trading futures and options, here’s a simple step-by-step guide:
- Open a Trading Account: Choose a broker that offers F&O trading and open an account.
- Learn the Basics: Take courses, read books, and watch tutorials to understand how futures and options work.
- Use Paper Trading: Practice trading with virtual money to gain experience before risking real capital.
- Seek Professional Advice: Consider consulting with an experienced trader or financial advisor for guidance.
Who Should Trade Futures and Options?
Futures and options trading is not for everyone. It’s best suited for:
- Experienced Traders: Those with a good understanding of market movements and financial instruments.
- Hedgers: Investors looking to protect their portfolios from price fluctuations.
- Speculators: Traders willing to take on risks for potential high rewards.
If you are a beginner, it’s best to start slow, learn the basics, and practice with virtual funds before trading with real money.
Conclusion
Futures and options trading can be an exciting way to profit from price movements in the markets. Whether you want to hedge against risks or take advantage of market volatility, these tools provide flexibility and high profit potential. However, they also carry significant risks, so it’s important to educate yourself, practice, and manage your risks effectively.
Start with small steps, keep learning, and practice your strategies before diving into the world of futures and options.
Frequently Asked Questions (FAQs) on Futures and Options Trading
Which is better, futures or options?
It depends on your risk tolerance and investment goals. Futures are more straightforward but come with the risk of unlimited losses. Options offer flexibility and limited risk but might result in smaller profits if the market moves drastically.
What factors affect futures prices?
Futures prices can be influenced by supply and demand, market sentiment, economic indicators, company-specific news, geopolitical events, and market trends.
What are derivatives?
Derivatives are financial instruments whose value depends on the performance of an underlying asset like stocks, commodities, or currencies. Futures, options, and swaps are common types of derivatives.
How do I trade futures and options?
To trade futures and options, you need to open a trading account, fund it, and understand market mechanics. You can then place your trades through your broker’s platform.
How can I calculate F&O turnover?
F&O turnover is calculated by adding up the total sales or trade value of the futures and options contracts you’ve executed.
For example, if you trade 100 contracts worth Rs. 500 each, your turnover for that trade would be Rs. 50,000.
What is the difference between American and European style options?
The primary difference between American and European style options is when the options can be exercised.
An American-style option allows the holder to exercise the option at any time before or on the expiration date. This provides more flexibility for the option holder.
For example, if you own an American call option, you can exercise it as soon as the price of the underlying asset rises above the strike price, even if the expiration date is still in the future.
A European-style option can only be exercised on the expiration date. Unlike American-style options, they cannot be exercised before the expiration date, regardless of the asset’s price movement.
In which markets are American and European style options popular?
American-style options are predominantly traded in U.S. markets, particularly on the Chicago Board Options Exchange (CBOE). These options allow the holder to exercise them at any time before or on the expiration date. They are commonly used for individual stocks, exchange-traded funds (ETFs), and other financial instruments.
European-style options are more commonly found in European markets and are typically used for stock indices and commodities. These options can only be exercised on the expiration date and are commonly used for indices like the Euro Stoxx 50, FTSE 100, and others.
In India, European-style options are the norm. Options traded on the National Stock Exchange (NSE) are European-style, meaning they can only be exercised on the expiration date. These options are available for individual stocks, as well as indices like the Nifty 50, Sensex and Bank Nifty.
