Many people perceive that futures and options are alternatives to stocks of the company but, there is a key line of difference between the three and trader has to understand this difference between them before taking a call of action for investment.
Stocks and derivatives
Futures and options are alternatively called as derivatives. We have to understand the big difference between the equities and derivatives. Equity market trading generates the income/ loss to the trader based on daily price fluctuations in the market. The equity market gives the trader to purchase any number of stocks as per their decision.
On the other hand, the derivatives are the financial instruments where pay-off depends on the prices of the underlying stocks. Derivatives are available in two forms namely futures and options. In a derivative, the trader is obliged to sell/ buy a predetermined lot of shares at the current price.
Futures and options
No investors who are looking to earn a good deal of money from trading will never solely depend on the equities to generate income. Derivatives like futures and options that have huge potential to generate the profits should space in the portfolio of the investors. These futures and options market should be understood in detail to make them lucrative for the traders.
Futures is a legal agreement between the seller and buyer to buy an underlying security at a predetermined price for delivery on a future date. The agreement holds key information related to quantity, future settlement date and time along with the pre-determined price. The exchange takes place through centralized marketplace to minimize the risk for both buyer and the seller, the bids and offers are matched electronically, and both the parties remain anonymous to each other
Options, on the other hand, come in two types one is call option, and the other is put option. The option binds a legal agreement between the parties giving a right to the buyer to buy the stock at the current price during the liquid life of the contract.
A put option gives the seller the right to sell the stock at the present price. The call seller is obliged to deliver the stock or index to the buyer at the present price even if the current price is former than the higher. Similarly, the put seller has an obligation to buy the stock at the present price even if the current price is lower than the former.
determined number of shares in a lot, you have to buy a lot from the buyer at the present price with the promise to deliver in future.
• When you buy the contract, the buyer will not pay the entire order value but just the margin amount that you have agreed upon. The margin amount for the stocks is determined by the exchange rates set for the day.
• The profit and loss are calculated every day as per the price fluctuations in the share value till the expiry of the contract. Profit/ loss from the trade is debited or credited to your account accordingly at the end of the day.
• When you buy an option contract, you as a buyer are liable to the premium amount of the option rather than full order value. The premium amount is transferred to the seller account from the exchange through their broker.
• When you sell the option, the seller has to deposit a margin amount with the exchange as security to safeguard adverse price changes. This margin amount is decided by the exchange depending on the volatility of the stock.
• The difference between the purchase price and sale price of the options on the date of expiry or on squaring off date will be settled as profit or loss.
Why should you invest in future and options?
• There are plenty of good reasons to share why you need to invest in futures and options in India.
• Future trading allows the trader to leverage on the trading limit by taking buy/ sell positions more than what you could do in the cash transactions.
• Profits and losses in the derivate market are calculated every day and debited/ credited from the trader account accordingly until the contract expires.
• Though the derivatives can be carried to next day trading and continued till the expiry of the contract date, they can be squared off anytime during the contract life offering the trader more flexibility in conducting transactions.
Few things you should know about futures and options trading
• Derivates are most popular trading instruments across the world and India is not an exception.
• The buyer or seller of the futures market has to place a certain percentage of the order value as margin to conduct the trade. A trader who conducts a trade of 1 lakh stocks has to invest 10% margin amount with the broker, i.e., 10,000. Futures gives the trader an opportunity to trade more stocks with less money.
• Profit/loss from the trade is calculated every day till the trader sells contract or it reaches maturity.
• The trader has to maintain the margin money in the account every day till he holds the position of the derivatives. If not, the broker has every right to sell the contract and make money.
• Derivatives have to be traded within the limits of expiry dater, or else the contract expires, and you will be obliged to share profits with the broker.