Examples of options and futures
Here are some practical examples to help understand the concepts of options and futures more clearly:
Example of futures
Imagine a trader enters into a futures contract to buy 100 shares of ABC Industries at Rs. 2,500 per share, with the contract expiring at the end of the month. If the market price at expiry is Rs. 2,600 per share, the trader earns a profit of Rs. 100 per share (Rs. 2,600 - Rs. 2,500), totalling Rs. 10,000. Conversely, if the price falls to Rs. 2,400, the trader incurs a loss of Rs. 100 per share, totalling Rs. 10,000. Both the buyer and the seller are obligated to settle the contract.
Example of options
Suppose an investor buys a call option to purchase 50 shares of XYZ Limited at Rs. 3,000 per share, paying a premium of Rs. 50 per share. If the share price rises to Rs. 3,100, the investor can exercise the option, earning a profit of Rs. 50 per share (Rs. 3,100 - Rs. 3,000) after accounting for the premium paid. The total profit would be Rs. 2,500 (50 shares x Rs. 50). If the price drops to Rs. 2,900, the investor can choose not to exercise the option, limiting the loss to the Rs. 2,500 premium paid.
Difference between futures and options
Future and option are two derivative instruments where the traders buy or sell an underlying asset at a pre-determined price. The trader makes a profit if the price rises. In case, he has a buy position and if he has a sell position, a fall in price is beneficial for him. In the opposite price movement, traders have to bear losses.
In the case of futures trading, a trader has to keep a certain percentage of the future value with the broker as a margin to take the buy/ sell position. To buy an option contract, the buyer has to pay a premium.
Who should invest in futures and options?
Futures and options (F&O) trading offers significant profit potential but also carries considerable risks. It is not suitable for every investor, as it requires market knowledge, risk tolerance, and strategic planning. F&O trading is typically used by different types of market participants, each with specific objectives.
Hedgers – Managing risk in market fluctuations
Hedgers are investors or businesses that use futures and options to protect themselves against unfavorable price movements in an asset. They invest in derivative contracts to minimize the risk associated with volatility. For example, a farmer may use futures contracts to lock in crop prices, or a company reliant on oil may hedge against rising crude prices. By doing so, hedgers aim to stabilize their financial exposure and reduce uncertainty.
Arbitrageurs – Profiting from price differences
Arbitrageurs capitalize on price discrepancies of the same asset in different markets or exchanges. They buy in one market at a lower price and simultaneously sell in another where the price is higher, making a profit from the difference. This strategy requires quick decision-making and an understanding of market inefficiencies. Arbitrage trading in futures and options helps enhance market liquidity and efficiency by narrowing price gaps across different trading platforms.
Speculators – Taking advantage of market movements
Speculators invest in F&O contracts with the sole objective of profiting from price movements. They do not own the underlying asset but take positions based on expected price changes. If their market prediction is correct, they can make significant returns, but incorrect speculation can lead to substantial losses. Due to the high risk involved, speculation is best suited for experienced traders who can analyse trends and manage risk effectively.
Retail and institutional investors – Leveraging market opportunities
Both retail and institutional investors participate in futures and options trading for various reasons. Institutional investors, such as hedge funds and mutual funds, use derivatives to manage portfolio risks and optimize returns. Retail investors, on the other hand, often trade F&O for short-term gains or hedging purposes. However, due to leverage and potential volatility, retail traders should approach F&O with caution and proper risk management strategies.
Futures and options trading can be rewarding but is complex and requires a strong understanding of the market. Investors should assess their financial goals, risk appetite, and trading expertise before entering the derivatives market.
Risk Management in F&O Trading
Effective risk management is essential in future and options trading to minimise potential losses. Key strategies include:
- Position sizing: Limiting the percentage of capital risked in each trade.
- Stop-loss orders: Setting automatic exits to cap losses.
- Diversification: Reducing risk by spreading investments across various assets.
- Hedging: Using derivatives to offset potential losses in other investments.
- Leverage control: Cautiously employing leverage to avoid amplifying risks.
These measures ensure long-term financial stability by protecting against volatility.
Conclusion
However, as previously stated, since precise price movement projections must be made, futures and options carry a significant level of risk. To make money from trading derivatives, it is important to have a solid understanding of stock markets, underlying assets, issuing companies, etc.
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