Derivatives are financial products whose value is derived from another underlying asset. These assets can be debt or equity securities, currencies, commodities or indices.
Investors use these financial instruments like Derivatives and Futures for hedging risks such as commodity price fluctuations or other factors.
Experienced traders in the stock market use various strategies by using these financial instruments to make profits out of it.
Here is the beginners guide on Futures and Options (F/O) Trading:
What is Derivative?
Derivatives are a type of financial contract whose value is derived from underlying assets such as stocks, bonds, currencies, commodities and market indices whose value keeps changing according to market sentiments.
Traders usually enter into derivative contracts for earning profits through speculating the value of the underlying asset in future.
Suppose the market price of an equity share may go down and you may suffer losses owing to a fall in the stock value. In order to hedge this loss, you may enter a derivative contract to make gains or to cushion yourself from the losses in the spot market where the stock is being traded.
Types of derivative
Here are the types of Derivatives:
A futures contract is a type of derivative contract where there is an agreement between two parties for buying or selling an asset at a particular price at a certain time in the future.
Forwards are just like futures except the latter is standardized contracts, whereas forwards are customized contracts between two parties in which settlement takes place on a specific date in the future at a specific price.
Options are types of derivatives contracts between an option writer and a buyer which gives them the right to buy/sell the underlying such as assets, other derivatives, etc. at a particular price on a given date. If used in combination with option strategies it can be a good profit making machine.
Swaps are private contracts between two parties in which an exchange of cash flows of the financial instruments that are owned by the parties takes place.
The two commonly used swaps are interest rate swaps and currency swaps.
What is Futures Trading?
A futures contract is an agreement between a buyer and a seller wherein the former enters the contract to buy from the latter, a specific number of shares or an index at a pre-determined price at a specific time in the future
A futures contract is a standardized in terms of expiry dates and contract sizes and they can be traded on exchanges.
Types of futures
Here are the types of future contracts:
Index Future is a type of future contract whose underlying value is based on the stock index.
A stock index helps in measuring changes in the prices of a group of stocks over a period of time which is made by selecting stocks of same sector or size.
For instance, the Nifty 50 is comprised of 50 liquid and fundamentally strong companies.
2. Stock Future
Stock futures are derivative contracts which give power to buy or sell a certain set of stocks at a particular price on a certain date. Once the traders buy the contract, they are obligated to uphold the terms of the agreement.
3. Currency & Commodity Future
Currency futures also known as the forex futures, are exchange-traded futures contracts for buying or selling a particular amount of currency at a specific price and date in the future.
An interest rate future is a type of futures contract with an underlying instrument which pays interest. It is an agreement between the buyer and seller for the future delivery of any interest-bearing asset at a particular price.
Jargons in Future Trading
Here are the most common terms that traders should know when trading futures:
1. Instrument Type- The underlying asset for the futures trading can stock of a company, index, currency of interest rate. If we want trade a company stock then the instrument type will be ‘stock futures.’
2. Lot size- In the derivatives market, contracts cannot be traded for a single share but a fixed lot of the underlying share which is determined by the exchange on which it is traded on. For example a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL share that means when we buy one lot of futures contract of RIL, we are actually futures trading 250 shares of RIL.
3. Underlying Value- The underlying value is value of the asset on which the futures contract is based on.
4. Expiry Date- The futures contracts expire on the last Thursday of their respective contract months. If the last Thursday of the month is a holiday, then they are expired on the previous business day.
What is Options Trading?
An option is a derivative contract which is used as hedging tool.
It gives the buyer/seller the right but not an obligation for buying or selling the underlying asset at an agreed-upon price on or before a particular date.
Types of Option Trade
Her are the types of options contracts:
The call option gives the buyer the right, but not the obligation to buy an underlying asset at a specific price for a particular interval of time.
Investors often buy call option when they have bullish view in the near future, while they’ll sell the call if they have bearish view on the stock.
The put option gives the seller the right but not an obligation to sell the underlying asset at an agreed-upon price in the near future.
An investor with the bearish view in the stock price will buy put or sell if they have bullish view on the stock prices.
Jargons in Options
Here are the most common terms that traders should know when trading options:
1. Strike Price- It is the price at which the holder of a derivative contract exercises his right. Selecting a strike price in options trading is very essential.
2. Premium– It isthe cost that is associated with a derivative contract, referring to the combination of intrinsic value and time value.
3. Option Expiry- The options expire on the last Thursday of their respective contract months. If the last Thursday of the month is a holiday, then they are expired on the previous business day.
4. Option Settlement– The settlement is done between the buyer and the writer of the options which can be cash settlement and physical settlement.
5. Underlying price- The underlying price is value of the asset on which the futures contract is based on.
Introduction to Option Greeks
Option Greeks helps in the pricing of the options and they also help the trader in trading options.
With the help of these Greeks, traders are able to price the options premium, understand volatility, manage risk, etc.
There are five different types of option Greeks – Delta, Gamma, Theta, Vega, and Rho and they also have an impact on each other.
Who should invest in Futures and Options?
Traders who are wanting to hedge their position in the equity market should trade in futures and options to hedge their positions in the cash market.
This market is not for beginners as it involves huge risk and one may loose his/her capital if entrered without knowledge.
What is Open Interest (OI)?
In the futures market, a buyer and seller together they make up one contract. Open Interest refers to the number of outstanding contracts in the market.
The changes in the open interest whether an increase or decrease in each stock is recorded both during the live market and also at the end of the day shown by the positive or negative change.
We can see from the below image how open interest helps us in analyzing the stock price movements:
- Derivatives are financial products whose value is derived from another underlying asset. These assets can be debt or equity securities, currencies, commodities or indices.
- A futures contract is a type of derivative contract where there is an agreement between two parties for buying or selling an asset at a particular price at a certain time in future.
- The future contracts can be index, currency, stock and interest rate futures.
- Options give the buyer/seller the right but not an obligation for buying or selling the underlying asset at an agreed-upon price on or before a particular date.
- Options can be put or call options
- Option Greeks helps in the pricing of the options and they also help the trader in trading options.
- Open Interest refers to the number of outstanding contracts in the market.
Disclaimer: One should remember that trading the futures and options involves risks.
Frequently Asked Questions
Q. What is the difference between a Future contract and a Forward Contract?
Here are some basic differences between forward and futures contract:
- A forward contract is an agreement between parties to buy and sell the underlying asset at a certain price on a future date whereas a future contract is a contract whereby the parties agree to buy and sell the asset at a fixed price and a future specified date.
- Forward contracts are customized contracts whereas a futures contract is a standardized one where the conditions such as quantity, date, and delivery are standardized.
- Forward contracts are traded Over the Counter whereas the Futures contract is traded in an organized securities exchange.
- When it comes to settlement, forward contracts are settled on a maturity date whereas the future contracts are marked to market on a daily basis, i.e. the profit or losses are settled daily.
- There is a high counterparty risk involved in forward contract as compared to a futures contract.
Q. Can I have a short position in Futures and Options?
Yes, traders can have short position in the futures and options.
Q. Can I exercise my Option before the Expiry?
Yes, the option can be exercised any time before expiry, regardless of whether the strike price has been reached.