What Are Futures & Options? A Beginner’s Overview

Dec 06, 2018 | 6 months ago | Read Time: 4 minutes | By iKnowledge Team

Futures and options are derivative instruments, which have other assets such as stocks, commodities, metals etc., as their underlying. They are primarily used to hedge, that is protect investors from adverse price movements in various assets.

Ram is a baker and requires large quantities of wheat flour. He prefers to buy whole wheat grains from Shyam, his regular supplier. Assume that the wheat price is volatile and fluctuates from week to week. Ram wants to keep his costs steady so that he can manage his cash flows. Shyam also wants to ensure that his selling price is constant. Both apprehend that the sharp movements are hurting their profitability.

They enter into a pact for the next three months. They decide that whichever way the price moves, up or down, they will stick to the price of Rs x per quintal. This has advantages for both Ram and Shyam. If the price increases beyond Rs x, Ram is safe since by the agreement his buying price is locked in at Rs x. For Shyam, if the price falls below Rs x, he is safe because his selling price is locked at Rs x.

This agreement between Ram and Shyam is a forward contract. This is a bilateral agreement between two parties and concerns only themselves. When such forward contracts are standardised and traded on exchanges, they are called as futures. Therefore, a futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. This practice of locking in the price to safeguard from adverse price movements is called as hedging.

Futures

Futures usually have an underlying asset, which can be stocks, commodities, currencies or metals. Theoretically, they should be taking their value from the price of the underlying asset, but in practice this may not always happen. This is due to speculative activity in futures and this can affect the price of the underlying asset, which happens frequently in the oil market.

While futures protect against expected losses in the markets, insurance protects us from unfortunate events in our lives and they are safe investments. Aegon Life’s iMaximise is a unit linked plan that gives you the twin benefits of protection and investment. It ensures your child’s education and future, with its Triple Benefit payout option. 

The current market price of a stock X is called as the spot price; the price of its futures is called as the futures price. Contract cycle is the period over which the contract trades. In India, there are one month, two month and three month contracts. Contracts expire on the last trading Thursday of the month.  Expiry date is the date on which the contract expires. The contract is the size of the asset that has to be delivered. For example, the contract size on NSE’s futures market is 200 Niftys. The lot size differs with each stock and is set by the exchange, according to some rules.

Before trading in futures, investors need to put up some margin money. There are three types of margins all of which are specified by the exchanges according to the regulations. Initial margin is the amount to be put up when entering the futures contract.

For example, if you want to buy one futures contract of Company X. The lot size is 100 shares, and each share of the company X is trading at Rs 50. So one futures contract means you have to pay Rs (50 x 100) = Rs 5000. But you have to deposit only 15% to 20% of this amount when entering the contract. The margins are also decided by the exchanges.

Mark-to-market happens at the end of the day to reflect the gains and losses of the investor that depends on the closing price of the futures. The margin is adjusted accordingly. If there have been losses more margin money has to be brought in.

Maintenance margin is to ensure that the margin in the trading account never becomes negative.

Options

In futures contracts, both parties have the obligation to buy or sell the underlying asset. Now suppose one of the parties does not want to be obliged to buy or sell. For such contracts, there are options.

There are two types of options – call and put options. Call options gives the buyer or the holder of the option the right (but not the obligation) to buy the asset from the seller at the strike price. In case of a put option, it gives the buyer the right (and not the obligation) to sell the asset at the strike price (or exercise) to the seller. The holder of the option, in either case, may or may exercise his right. For this right, the buyer has to pay an amount called as the option premium.

When the option holder does not exercise his right, it expires worthless. In such a case, his losses are limited to the premium paid.

The buyer of a call option is expecting the price of the underlying stock to rise (above the strike price), while the buyer of a put option expects the price of the stock to fall (below the strike price).

Derivatives are complex instruments and investors need to be sure of the basics and the mechanics. They also have to make good calls on which way the underlying asset will move, before they decide where to invest. Since lot sizes are large, they should be prepared for large outlays of money.

II/Oct 2018/4512

You can get tax breaks if you have a life insurance policy as well, provided you have add-ons like medical insurance and critical illness riders.


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