Source: The Hindu Businessline.
Futures and options have become increasingly important in the world of finance and investments. On the back of a manifold rise in volumes in the stock market's derivative segment, it has become imperative to understand the basic nuances of these instruments. To begin with, derivatives can be defined as financial instruments, which derive their value from the underlying asset. For example, while nifty futures derive their value based on the nifty spot value (the prevailing index value), ITC futures get it from the underlying stock price of ITC (in the cash market). Derivatives can be divided into four types — forwards, swaps, futures, and options. We shall, however, focus on futures and options in this article, as they hold more relevance to the capital markets.
FuturesConsider this: Say 'X' goes to a shop to buy a mobile phone, which costs Rs 30,000. Due to cash constraints, he decides to postpone the purchase by three months but feels that the price might increase during this period. Keeping this in mind, `X' decides to enter into a contract with the seller to buy the mobile after three months at the current market price (that is, Rs 30,000). In other words, we can say that 'X' has entered into a forward contract with the shopkeeper to buy a mobile phone for a certain price after three months (the expiry day). Similar contracts when effected in a stock exchange are called futures. Thus, a futures contract can be called an agreement to buy or sell an asset at a certain time in the future for a certain price. For instance, you feel that the stock price of company 'A', now trading at Rs 500, is likely to rise in the short-term. You can consider buying futures contract (or enter into a long position) for that stock. Now, if the stock price moves to Rs 525 before the expiry of the contract, you stand to gain Rs 25 per share. However, if the stock falls to Rs 450, you would lose Rs 50 per share. Similarly, you can also consider selling the futures (going short) when you are bearish on some counters.
OptionsTo understand options, let us assume that you want to buy a new car (worth Rs 15 lakh) that has been recently launched in the market. It will take about a month before you can take delivery of the car. So, instead of paying the whole amount, you can consider booking the car by paying only Rs 50,000. This will give you the right (but not the obligation) to buy the car at the end of the month. However, the delivery of the car will be made only after you pay the rest of the amount due to the seller. This, in fact, is the principle of an option, which gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a fixed price, on or before a specified date. The amount that you paid for booking (Rs 50,000) can be said to be the option premium. However, if for any reason you decide not to buy the car, you can always cancel the booking (you stand to lose the premium paid).Options can be divided into two types — call and put. A call option gives the buyer the right to buy the underlying asset, whereas a put option gives the buyer the right to sell the underlying asset, at a fixed price on or before the expiry day. In the previous example, you had bought a call option for the car (the right to buy) after paying an option premium of Rs 50,000. In trading, call options are normally bought when the buyer expects a rise in the price of the underlying asset (stock or index) and put options are bought when the expectations are generally bearish. For example, if you are bearish on the short-term trends in the market and fear that ITC, which forms a significant portion of your portfolio, might lose value if the market crashes. In such a case, you can consider buying a put option on ITC, which will give you the right to sell the stock at a fixed price even if the stock price of ITC in the equity market is lower. On the contrary, if you are bullish on the stock, buying a call option on the stock might be of help.
The above gives just an overview of derivatives. Note that trading in derivatives is not the same as trading in the cash market. So before you decide to dabble in derivatives, make sure you fully understand the technicalities of both the derivatives and derivatives market.
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