This article contains some basic and introductory level knowledge about Futures and Options.
It is often seen that new traders start with Futures and Options instead of futures contracts, while professional traders usually trade in options. New traders start with options because there is less risk and volatility involved.
What are Futures and Options?
In simple terms F&O can be defined as, forms of exchange- regulated forward trading in which investor enters into transaction today, the settlement of which is scheduled to take place at a future date. The settlement date is called the expiry of the contract.
Futures
A Futures contract is an agreement between the seller and the buyer for the sale and purchase of a particular asset as a specific future date. The price at which the asset would change hands in the future is agreed upon at the time of entering into the contract.
The actual purchase or sale of the underlying involving payment of cash and delivery of the instrument does not take place until the contracted date of delivery. A future contract involves an obligation on both the parties to fulfill the terms of the contract.
Options
An option is a contract that goes a step further and provides the buyer of the option the right without the obligation, to buy or sell put as specified asset at an agreed price on or up to a specified date. For acquiring this right the buyer has to pay a premium to the seller. The seller on the other hand has the obligation to buy or sell that specific asset at the agreed price. The premium is determined taking into account a number of factors, such as current market price of the underlying , the number of days to the expiration the strike price of the option, the volatility of the under lying assets, and the risk less rate of return. Specifications of the options contract like the strike price, the expiration date and regular lot are specified but the exchange.
Options are of two types – Call and Put, explained below.
Some basic terms involved in Futures and Options:
Calls - You would buy a call option if you believe the underlying futures price will move higher. For example, if you expect wheat futures to move up or follow a upward trend, you will want to buy a call option.
Puts - You would buy a put option if you believe the underlying futures price will move lower. For example, if you expect soybean futures to move lower, you will want to buy soybean put option.
Premium - This term is used for the price of an option. This is the price you pay to buy an option. You can think of the pricing of options as a bet. The bigger the long shot, the less expensive they will be. Oppositely, the more sure the bet is, the more expensive it will be.
Contract Months (Time) - Options have an expiration date, which means they only last for a certain period of time. When you buy an option, you cannot hold it forever. For example, a December wheat call expires late November. You will need to close the position before expiration. Generally, the more time you have on an option, the more expensive it will be.
Strike Price - This is the price at which you could buy or sell the underlying futures contract.
Conclusion and Advantages
Options can provide these advantages to your portfolio like: Greater Cost Efficiency, Less Risk, Higher Potential Returns, and more Strategic Alternatives.
With low commission costs and direct access to the options market through the internet provided by the brokerages the average retail investor now has the ability to use the most powerful tool in the investment industry just like the pros do.
So, take the initiative and dedicate some time on learning how to use Futures and Options properly.
