Options and futures have grown in popularity among investors in recent years, particularly in the equity market. This is considering the several benefits they provide, including decreased risk, leverage and high liquidity.
Futures and options are derivatives, which are instruments whose value is determined by the value of an asset that underlies them. Derivatives are accessible for a wide range of assets, including currencies, equities, gold, indices, cotton, silver, petroleum, wheat and so on. In simple terms, a derivative refers to any financial instrument or commodity that can be traded.
Futures and options serve the purpose of speculation and hedging, respectively. Pricing can be variable, resulting in losses for traders and investors. As a result, these types of derivatives can be useful for hedging against this volatility. Speculators employ derivatives to profit from price fluctuations. They can profit from such derivatives when they can precisely predict price fluctuations.
Futures are contracts that give the holder the authority to purchase or sell an asset at a fixed price on a particular date in the future. Options grant the authority, but not the responsibility, to purchase or sell an asset in particular at a predetermined price on a predetermined date.
Assume you believe that the current price of a share of XYZ Corp, Rs 100, would rise. You want to take advantage of this opportunity to make a little profit. So you purchase 1,000 futures agreements of XYZ Corp for Rs 100 (the strike price). When the cost of XYZ Corp rises to Rs 150, you can take advantage of your opportunity and trade your futures contracts for Rs 100 apiece, earning a profit of Rs 50,000. Suppose prices moved in the reverse direction, with XYZ Corp stock prices falling to Rs 50. In such an instance, you would have lost Rs 50,000!
Keep in mind that options allow you the authority, but not the responsibility, to buy or sell an asset. If you had purchased the same number of options on XYZ Corp, you might have exercised your right to trade the options at Rs 150 and profited by Rs 50,000, identical to the contract for futures. Yet, if the price of a share falls to Rs 50, you can choose not to exercise your contract, saving you Rs 50,000. The sole loss that you will experience is the price you would have received to purchase the agreement from the seller (referred to as the "writer").
Futures and options can be purchased in the share market for indexes and equities. Nevertheless, these derivatives aren't accessible across all securities, but rather for a select group of approximately 200 stocks. Because futures and options are sold in lots, you are unable to trade in a single unit. The size of the lots, which varies from share to share, is determined by the stock market.
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Margin and premiums are essential factors in the futures vs options debate. When you enter into a futures contract, you must pay a margin, and when you buy options, you must pay a premium.
Margins vary per asset and are often expressed as a proportion of total futures transactions. This is utilized by the broker as insurance against any losses you may experience while trading futures. Both margins and premiums can be utilised as leverage, that is, to execute huge volumes of transactions at a multiple of the amount paid to the writer or broker.
When prices fall, you will receive a margin call directing you to deposit extra funds to meet the margin requirements. This means that changes in the value of the futures, whether positive or negative, are transferred to the futures holder's account at the end of each trading day. If you do not pay the margin call, the broker may sell your stake, resulting in significant losses for you.
In terms of options, your risks will be much reduced because you have the option of not exercising your contract if prices do not go your way. In that instance, your only loss will be the premium you paid.
Futures and options can be settled in two ways. The first way is to do it on the expiry date, either in cash or physical delivery of shares. You can also do it before the transaction expires by squaring it off. This is also possible with options contracts.
We've discussed the difference between futures and options. You must make decisions based on your risk tolerance and investing objectives. As previously stated, futures include additional risk because you have to bear the brunt of any price movements. In the case of a price change that is unfavorable, your losses are limited to the premium that you have paid. However, the likelihood of profiting from futures is greater than those of options. Most options contracts expire worthless, which means no profits are booked.
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