“Stock market offers several products for investment and trading purposes. Few of them are mutual funds, equity, IPO, NCD’s , bonds, derivatives, etc.”
One segment of investment market generally ignored by individual investors is derivatives. It invokes a sense of fear in the minds of investors. But are derivatives all that bad? There must be something very attractive in it because the turnover of derivatives is more than three times that of the cash segment in the National Stock Exchange (N.S.E). The derivatives market has grown exponentially in the last 6-7 years.
It’s possible that many retail investors do not operate in derivatives because they don’t know how derivatives work and find the technical jargon too difficult to decipher So let us understand what derivatives are.
What are futures?
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase, or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
There are many types of futures contracts available for trading including:
- Commodity futures such as in crude oil, natural gas, corn, and wheat
- Index futures such as Nifty & Bank Nifty
- Currency futures including those for the euro and the British pound
- Precious metal futures for gold and silver
- U.S. Treasury futures for bonds and other products
What are options?
An option is a contract between two parties to buy or sell a given amount of underlying assets at pre-specified price on or before a given date. There are two types of Option – Call option and Put Option.
Call Option is an option which gives the right to buy the underlying at a specific price on a specific date.
Put Option is an option which gives the right to sell the underlying at a specific price on a specific date.
Buyer of an option by paying option premium buys the right but not the obligation to exercise his option on the seller/writer.
The writer of Call/Put option receives the option premium and thus it becomes obligatory for them to sell/buy the underlying if the buyer wishes to exercise his option.
Now that we have understood what Futures & Options are, Let us understand the Pros & Cons of Futures & Options Trading.
Pros of Future Trading
- Investors can use futures contracts to speculate on the direction in the price of an underlying asset
- Companies can hedge the price of their raw materials or products they sell to protect from adverse price movements
- Futures contracts may only require a deposit of a fraction of the contract amount with a broker
Cons of Futures trading
- Investors have a risk that they can lose more than the initial margin amount since futures use leverage
- Investing in a futures contract might cause a company that hedged to miss out on favourable price movements
- Margin can be a double-edged sword meaning gains are amplified but so too are losses
Pros of Options Trading
- A call option buyer has the right to buy assets at a price that is lower than the market when the stock’s price is rising.
- The put option buyer can profit by selling stock at the strike price when the market price is below the strike price.
- Option sellers receive a premium fee from the buyer for writing an option.
Cons of Options Trading
- In a falling market, the put option seller may be forced to buy the asset at the higher strike price than they would normally pay in the market
- The call option writer faces infinite risk if the stock’s price rises significantly and they are forced to buy shares at a high price.
- Option buyers must pay an upfront premium to the writers of the option.
How do Future Contract work?
Futures Contract is a contract to buy or sell pre-defined quantities of an instrument at a specified price and time.
- Future contract has standardised conditions such as price, quantity, and time.
- The owner of the contract has the obligation to buy or sell in future.
- Price is determined by supply and demand factors in secondary market.
- Index futures was the financial derivative launched in India.
- Every contract expires on last Thursday of the expiry month.
- Derivatives act as a good hedging tool against price volatility.
- You can take a high exposure on a stock or security by paying a small margin. For example: If the stocks are priced at Rs 10 lakh and you have only Rs 2 lakhs in hand, this product will still help you take a position.
My experience of Derivatives Trading.
My experience in Futures and Options Trading has been very challenging and learned a lot too both in terms of losses as well as profits.
Here are few of my experience in 12 years of journey:
- Traded equity index futures and identified arbitrage opportunities in related securities.
- Evaluated factors such as volatility, liquidity, and expected profit to determine appropriate price and size of trades.
- Formulated and executed hedging strategies based on type of risk and market factors.
- Learned options theory and trading strategies and generated decent profits without excessive risk or volatility.
Derivatives are gaining popularity day by day and are used successfully throughout the world. Derivatives are leveraged instruments and hence unless you have a complete grasp of how the markets work, the swings in your capital can be very volatile.