What are Futures and Options in Share Market? Types, Example, Pros, Cons & How to Trade

Topic of Contents: –

What are Futures and Options in Share Market?

What are Futures and Options Trading in Share Market?

Types of Futures and Options

How to Trade in Futures & Options?

Examples of Futures and Options Trading

Pros and Cons of Futures and Options Trading

What are Futures and Options in Share Market?

In Share Market, Futures and Options (also known as F&O) are financial derivatives that allow investors to speculate on the price movements of underlying assets without owning them directly.

A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price on a future date. It obligates both parties to fulfil the contract at the agreed-upon price and date, regardless of the current market price. Futures contracts are commonly used by traders to hedge against price fluctuations or to speculate on the future price of commodities, currencies, stocks, or other assets.

Options, on the other hand, provide the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price within a specified time period. The buyer of an option pays a premium to the seller for this right. Options offer flexibility to investors by allowing them to profit from both rising and falling prices or to protect their positions against adverse price movements.

What are Futures and Options Trading in Share Market?

Future and option trading in the share market is the buying and selling of financial derivatives known as futures contracts and options contracts based on underlying stocks.

In future trading, investors agree to buy or sell a specified quantity of shares at a predetermined price (known as the futures price) on a future date. These contracts are standardized and traded on exchanges. Future trading allows investors to speculate on the price movement of shares without owning the actual shares. It provides potential opportunities for profit through both long (buying) and short (selling) positions. However, it also carries the risk of potential losses if the market moves against the investor’s position.

Option trading involves the buying and selling of options contracts, which provide the right, but not the obligation, to buy (call option) or sell (put option) a specific quantity of shares at a predetermined price (known as the strike price) within a specified time period. Option contracts also trade on exchanges and have standardized terms. Options offer investors the ability to hedge their positions, speculate on price movements, and implement various trading strategies. However, options involve time decay and the risk of losing the premium paid if the option expires out of the money (when the strike price is unfavourable compared to the market price).

Both future and option trading can be used for various purposes in the share market, including speculation, hedging, and leveraging investment positions. However, it is essential for traders to have a good understanding of these derivatives and the associated risks before engaging in such trading activities.

Types of Futures and Options:

There are various types of futures and options contracts available in financial markets of different countries. Here are some common types:

Types of Futures Contracts:

1. Commodity Futures: These contracts involve the delivery of a specific quantity of a commodity, such as oil, gold, wheat, or natural gas, at a predetermined future date and price.
2. Equity Futures: Equity futures are based on individual stocks or stock market indices. They allow investors to speculate on the future price movements of stocks or market indexes without owning the underlying shares.
3. Currency Futures: Currency futures are contracts that enable traders to speculate on the exchange rate between two currencies. These contracts can be used for hedging or for taking positions on future currency movements.
4. Interest Rate Futures: Interest rate futures are based on the future value of interest rates. They are used to manage interest rate risk and speculate on changes in interest rates.
5. Bond Futures: Bond futures involve the delivery of a specific bond or a basket of bonds at a predetermined future date and price. They allow traders to speculate on interest rate movements and manage bond-related risks.

Types of Options Contracts:

1. Call Options: Call options give the holder the right to buy an underlying asset at a specified price within a specific time period.
2. Put Options: Put options give the holder the right to sell an underlying asset at a specified price within a specific time period.
3. American Options: American options can be exercised at any time before the expiration date.
4. European Options: European options can only be exercised on the expiration date itself.
5. Index Options: Index options are based on market indexes, such as the S&P 500 or the Dow Jones Industrial Average. They allow investors to gain exposure to the overall performance of a specific index.
6. Stock Options: Stock options are based on individual stocks. They provide the right to buy or sell shares of a specific company at a predetermined price within a specified time frame.

These are the just few examples about types of futures and options contracts available in financial markets. Each type has its own characteristics and specific uses, catering to different trading and investment strategies.

How to Trade in Futures & Options?

Trading in futures and options involves rich experience and several steps & considerations. Here is general overview a trader may choose to trade in options and futures:

1. Education and Research: Start by gaining a solid understanding of options and futures trading. Educate yourself on the concepts, terminology, and strategies involved. Research the underlying assets, market conditions, and factors that can affect their prices.
2. Select a Brokerage: Choose a reputable brokerage firm that offers options and futures trading. Consider factors such as fees, trading platform features, research tools, and customer support. Open an account with the chosen brokerage.
3. Risk Assessment and Strategy: Assess your risk tolerance and financial goals. Develop a trading strategy that aligns with your objectives. Determine whether you want to speculate on price movements, hedge existing positions, or engage in other trading strategies.
4. Analyse and Select Contracts: Identify the specific options or futures contracts that match your trading strategy. Analyse factors such as the underlying asset, expiration date, strike price, and contract specifications. Evaluate the implied volatility and pricing of the contracts.
5. Place Trades: Using the trading platform provided by your brokerage, enter the desired details of the trade, including the contract type, quantity, and price. Specify whether you want to buy (long) or sell (short) the contract. Review the order details before submitting the trade.
6. Monitor and Manage Positions: Once your trade is executed, actively monitor your positions. Keep track of market developments, news, and price movements related to the underlying assets. Adjust or close your positions if they are not performing as expected or if market conditions change.
7. Risk Management: Implement risk management techniques, such as setting stop-loss orders or employing hedging strategies, to limit potential losses. Consider the potential impact of leverage and adjust your position sizes accordingly.
8. Stay Informed and Continuously Learn: Stay updated with market trends, economic news, and developments in the options and futures markets. Continue to enhance your knowledge and skills through ongoing education and research.

Examples of Futures and Options Trading:

Commodities:

1. Crude Oil Futures: A trader anticipates that the price of crude oil will increase due to geopolitical tensions. They decide to go long on crude oil futures by buying a contract at the current price of $70 per barrel. Each contract represents 1,000 barrels. If the price of crude oil rises to $80 per barrel at the contract’s expiration, the trader can sell the contract, making a profit of $10,000 ([$80 – $70] * 1,000 barrels).
2. Gold Options: An investor believes that the price of gold will remain stable in the near term. They purchase a put option on gold with a strike price of $1,800 and an expiration date in three months. If the price of gold falls below $1,800 within that period, the investor can exercise the put option, selling gold at the higher strike price and limiting potential losses.
3. Wheat Futures: A farmer growing wheat wants to lock in a price to protect against potential price declines before the harvest. They sell wheat futures contracts for the quantity they expect to produce. If the price of wheat drops by the time of harvest, they would benefit from the higher price set in the futures contract, offsetting any losses in the spot market.
4. Natural Gas Options: A trader expects an increase in natural gas prices during the winter months due to higher demand for heating. They purchase a call option on natural gas with a strike price of $4 per million British thermal units (MMBtu) and an expiration date of one month. If the price of natural gas rises above $4 per MMBtu within that period, the trader can exercise the call option, buying natural gas at the lower strike price and profiting from the price increase.
5. Coffee Futures: A coffee retailer wants to secure a stable price for purchasing coffee beans in the future. They enter into a long coffee futures contract, agreeing to buy a specified quantity of coffee beans at a predetermined price. This allows them to hedge against potential price increases, ensuring a consistent supply of coffee beans at a known cost.

Indexes & Shares:

1. Stock Futures: A trader expects that the stock price of a particular company will increase in the near future. They decide to go long on stock futures by buying a contract representing a specified number of shares. For instance, if the current price of the stock is $100 and the trader buys 100 futures contracts, each representing 100 shares, they would have exposure to 10,000 shares. If the stock price rises to $110 at the contract’s expiration, the trader can sell the futures contracts, making a profit of $100,000 ([$110 – $100] * 10,000 shares).
2. Call Options: An investor is bullish on a particular stock and believes its price will rise in the coming months. They purchase call options on the stock with a strike price of $150 and an expiration date of three months. If the stock price surpasses $150 within that period, the investor can exercise the call options, buying the shares at the predetermined strike price and benefiting from the price increase.
3. Put Options: A trader expects that a company’s stock price will decline due to poor earnings results. They purchase put options on the stock with a strike price of $200 and an expiration date of one month. If the stock price falls below $200 within that period, the trader can exercise the put options, selling the shares at the higher strike price and profiting from the price decline.
4. Index Futures: A trader wants exposure to the overall performance of a specific stock market index, such as the S&P 500 or the Dow Jones Industrial Average. They can enter into index futures contracts that track the respective index. By buying or selling these contracts, the trader can profit from the anticipated movements in the underlying index.
5. Index Options: An investor expects increased volatility in the stock market and wants to protect their portfolio from potential losses. They purchase index put options with a strike price below the current level of the index. If the index declines significantly, the value of the put options will increase, offsetting the losses in the investor’s portfolio.

Pros and Cons of Futures and Options Trading:

Pros of Futures and Options Trading:

1. Leveraged Trading: Futures and options allow traders to control a larger position with a smaller investment. This leverage can amplify potential profits.
2. Diversification: Futures and options provide access to a wide range of underlying assets, such as commodities, currencies, and stock indices. This allows traders to diversify their investment portfolio and potentially mitigate risk.
3. Hedging: Futures and options can be used as hedging tools to protect against adverse price movements in the underlying assets. Traders can offset potential losses in their existing positions by taking opposite positions in futures or options contracts.
4. Speculative Opportunities: Futures and options offer traders the ability to profit from both rising and falling markets. This flexibility allows for a wider range of speculative trading strategies.
5. Liquidity: Futures and options are actively traded on exchanges, providing high liquidity. Traders can enter and exit positions quickly with minimal impact on the market.

Cons of Futures and Options Trading:

1. Risk of Losses: While leverage can amplify profits, it also increases the risk of losses. Traders can potentially lose more than their initial investment if the market moves against their positions.
2. Complexity: Futures and options trading involve complex strategies and concepts. Traders need a good understanding of these instruments and the associated risks to make informed decisions.
3. Volatility: Futures and options markets can be highly volatile, leading to rapid price fluctuations. This volatility can increase the risk of losses and make it challenging to accurately predict market movements.
4. Time Decay: Options contracts have a limited lifespan, and their value erodes over time. Traders need to account for time decay when trading options, as it can reduce their profitability.
5. Counterparty Risk: Futures contracts are subject to counterparty risk, as traders rely on the financial stability and integrity of the exchange and clearinghouse. Although measures are in place to mitigate this risk, it is still a consideration.

Summary: Both futures and options are commonly used in financial markets to manage risk, leverage investments, and engage in speculative trading. However, they involve inherent risks and complexities so it is advisable to trade with limited capital if you are not expert and experienced in F&O trading.

It is also very important to note, trade with capital you can afford to lose. Consider seeking guidance from F&O trading professionals or experts for better understanding about the intricacies of options and futures trading and to minimize risks.

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