How to Trade in Futures and Options?
Futures and options are known as derivative products, which mean that they derive their value from an underlying commodity or asset. However, futures and options differ in fundamental ways from each other.
Before you open a demat account or look for the best online trading account, ensure that you are familiar with the basics of futures and options trading. Here’s a practical guide to help you get started.
What are options?
An option is a contract that gives you the right to buy or sell an underlying asset at a predetermined price in the future. To enter into an option contract, you have to pay a premium but you are not under any obligation to exercise the contract. You can either sell the contract at a future date or allow the contract to expire if it’s not favorable. Options with stock and indices as underlying assets are most actively traded in the Indian derivatives market.
Two types of options
Options are of two types:
- Call option
- Put option
Let’s understand how they work with examples:
A call option gives you the right to buy an underlying asset such as stock or stock indices at an agreed upon price at or before a future date known as the expiration date.
Below is an example of a call option quote:
XYZ June 30, 2020 600 CALL at Rs. 60
In the above quote, XYZ is the name of the underlying asset (in this case a stock) and June 30, 2020 is the day when the Call option expires. Rs. 600 is the strike price, which means that the buyer has the right to buy the stock at Rs. 600 before June 30, 2020.
CALL is the type of option and Rs. 60 is the premium per lot that you need to pay to buy the option. Option contracts are usually available in lots of 100. So, in that case, you will have to pay a premium of Rs. 6,000 to buy the call option.
Similarly, a put option gives you the right to buy an underlying asset at an agreed upon price at or before a future date known as the expiration date. Remember that traders or speculators don’t have to buy the underlying asset; they can profit by selling the option contract at a higher price before or at the expiration date.
What are futures?
In a futures contract, two parties agree to buy or sell a predetermined quantity of a particular asset at a predetermined price on a particular future date. In India, futures are actively traded on the MCX and NCDEX exchanges. Some popular commodity future contracts include crude oil futures, gold futures, silver futures, etc. You can also trade in currency futures, bond futures, stock index futures and interest rate futures.
Every futures contract has an expiration date and the buyer has to buy or the seller has to sell the underlying asset after the expiration date. However, rather than buying or selling an underlying commodity, you can sell the futures contract at or before the expiration date and profit from the price difference.
Example of a commodity futures contract
Assume you are a farmer who grows cotton which is trading at Rs. 250 per kg. You expect to produce 1000 tons of cotton this year and earn a decent profit if the price remains the same. However, you are unsure and expect cotton prices to decline due to the slowdown. To ensure that you get a fair price for your produce, you buy a futures contract to sell cotton at Rs. 250 per kg in July 2020. This way you are able to protect yourself from losses. This hedging technique is used by producers. But there are also many speculators in the future market who want to profit from price volatility of commodities, stocks and stock indices.
To purchase a futures contract, you need to pay a margin amount which varies according to the underlying commodity. Usually, they are 20% of the value of the commodity. For example, if the size of a futures contract for cotton is Rs. 2,00,000, you only have to pay Rs. 40,000 to buy the cotton futures contract.
Futures and options are very effective instruments for protecting your equity investments or earning income from price changes in the underlying stocks, indices, currencies and commodities. They provide real opportunities for retail investors to maximize their returns or protect their investments. Whether you want to trade in futures and options for hedging or speculation, it’s important to have expert guidance in the initial stages. You should open a demat account along with the best online trading account with a reputable brokerage house such as IIFL, a company with more than 30 years of credibility in the Indian brokerage community. Start with an IIFL demat and trading account and trade in options, futures, equities, mutual funds and currencies with the help of a next-gen trading platform and IIFL’s award-winning research team.