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How Futures and Options Work with Examples

If you are looking for a single thing that's certain in commodity or financial markets, it is changes in price. Prices change all the time, and they go up and down due to a number of reasons. These include the economic state of a country, results of an election, agricultural produce, wars and coups and particular policies of any government. The list of factors for pierce shifts is limitless.

It is natural that those who are related to the markets, like the share market today, would be concerned over fluctuations in prices. Shifts can mean losses, or they can mean profits. Hence, a good way to protect investors against sudden shifts in price come in the form of futures and options. This is where derivatives enter the picture. Any contract that derives its own value from an underlying asset is known as a derivative. Stocks, currency, commodities, etc, could form the underlying assets. Now, it's time to address futures and options.

Futures Explained

A kind of derivative, whether in the share market today or the commodity market, is the futures contract. In such a contract, a purchaser, or a seller, can agree to purchase or sell a particular quantity of a specific asset, at a fixed price on a certain future date. Futures and options trading does not require investors to open a demat account, but only requires investors to have an account with a brokerage.

An Example of Futures Contracts

The best way for you to grasp the way that futures work is by means of an example. Let us assume that you have purchased a futures contract for 100 shares of XYZ company at a value of Rs. 50 per share at a certain date. When the contract expires, you will receive those shares bought at Rs. 50, the same price at which you agreed to buy them, irrespective of the present price prevailing. Although the price of each share may have climbed to Rs. 60, what you will get are shares at Rs. 50 per share. In this example, you have made a profit of Rs. 1,000. Now, let’s take another view. If the share price has fallen to Rs. 40 by the expiry date of your contract, you would still be buying each share at Rs. 50. In such a case, you would make a loss of Rs. 1,000. In the event your underlying asset is in equity, you may have to open a demat account (for electronic storage of your bought stocks). However, you can partake in futures contracts for petroleum, agricultural commodities, currency, gold, etc.

The Benefits of Futures Contracts

Contracts in futures may turn out to be invaluable ways to escape the risks of shifts in prices. For example, a country that imports oil will purchase oil futures to form a hedge against prices going up in the future. In a similar fashion, farmers may lock in prices of products with the use of futures contracts, so they don’t have to face the risk of a drop in prices later on when they wish to sell off the harvest.

Options Explained

If you are still not sure whether you should choose this way of investing and wish to open a demat account to invest in direct equity, then you should understand what options contracts entail first. An options contract is another type of derivatives contract. It differs from a futures contract in the way that it gives the right to a buyer or seller to purchase or to sell a specific asset at a particular price on a fixed date. You should note that in an options contract there is no obligation on the investor’s part to conduct any of the two transactions (buying or selling).

In options contracts, there are two types: call options and put options. These can be illustrated by the examples below:

Call Options - A contract that gives the purchaser the right to purchase a certain asset at a particular price on a pre-fixed date is called a call option contract. Note, here, there is no obligation on the buyer’s part to buy. Now let us explain this better with an example. If you purchase a call option to buy 100 shares of a company, XYZ, at Rs. 50 for each share on a particular date, and the price of each share drops to Rs. 40 before the contract expires, you can pull out as you will only make a loss. Therefore, you have avoided a loss of Rs. 1,000.
Put Options - In the share market today, there is another kind of option that enables investors to have the right of selling shares at a fixed price on a predetermined date. You may take a put option to offload (sell) your shares of Company XYZ at Rs. 50 at a date in the future. However, if the share price rises to Rs. 60 before your put option contract expires, you may choose not to sell your shares for Rs. 50. Here, too, you prevent yourself from making losses.

Trading in the Stock Market in F & O

Many investors are still not conversant with the nuances of futures and options (F & O) trading in stocks. They would much rather invest their money in any upcoming IPO or direct equity or mutual funds. These are commonly sought-after ways to invest, and ones in which investors have familiarity. The NSE, or National Stock Exchange, has introduced futures and options contracts in nine vital indices with more than a hundred securities to choose from. This may be a push for investors to try their hand at F & O contracts.

Advantages in Investment

The considerable benefit you get with futures and options lies in the fact that you do not have to invest and spend your capital on the asset which is underlying. Only an initial margin has to be paid to your broker. So, although you may have had to open a demat account and indulge in equity, you should try F & O as another investment method. You can also try investing in any promising upcoming IPO and expand your breath of stock investments.