Why to trade in Futures and Options?
March 30, 2020
Have you ever wondered why the stock market is so complicated and flooded with futures and options? Let us assess from the starting. From the wants of an investor.
The best thing an investor wants from the stock market is to have maximum profits. And that is exactly possible from the extra leverage that is provided by the discount brokers like Zerodha. But with great earning opportunities come great risks also. There are many instances when the technical analysis as well as the fundamental analysis of a particular stock might be correct. But the excess volatility might push a person out of the stock market. And that is very often in share market.
Now there is a way out of this risk, meaning the reward will be the same but the risk can be reduced. The one best method being hedging the investment. Hedging basically means to reduce the movement in the stock price or in other words to minimize the fluctuation. And that is possible by trading in the contracts based on the underlying assets or securities. Which in share market language means, derivatives.
There are two main types of Derivatives:
Futures and Options
Futures are those derivatives or those set of contracts that gives the investor a right as well as an obligation to buy(or sell) the particular stock at any point of time in future. Also futures are most understandable in terms of commodities like oil or corn. For instance, a farmer may want to lock in an acceptable price upfront in case market prices fall before the crop can be delivered. The buyer also wants to lock in a price upfront, too, if prices soar by the time the crop is delivered.
Futures were invented for institutional buyers. These dealers intend to actually take possession of crude oil barrels to sell to refiners or tons of corn to sell to supermarket distributors. Establishing a price in advance makes the businesses on both sides of the contract less vulnerable to big price swings.
Retail buyers, however, buy and sell futures contracts as a bet on the price direction of the underlying security. They want to profit from changes in the price of futures, up or down. They do not intend to actually take possession of any products.
Options are based on the value of an underlying security such as a stock. An options contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific price while the contract is still in effect. Investors don’t have to buy or sell the asset if they decide not to do so.
Options are a derivative form of investment. There may be offers to buy or to sell shares but don’t represent actual ownership of the underlying investments until the agreement is finalized.
Buyers typically pay a premium for options contracts, which reflect 100 shares of the underlying asset. Premiums generally represent the asset’s strike price—the rate to buy or sell it until the contract’s expiration date. This date indicates the day by which the contract must be used.
Types of Options: Call and Put Options
There are only two kinds of options: Call options and put options. A call option is an offer to buy a stock at the strike price before the agreement expires. A put option is an offer to sell a stock at a specific price.
Let’s look at an example of each—first of a call option. An investor opens a call option to buy stock XYZ at a $50 strike price sometime within the next three months. The stock is currently trading at $49. If the stock jumps to $60, the call buyer can exercise the right to buy the stock at $50. That buyer can then immediately sell the stock for $60 for a $10 profit per share.
So when the investor wants to hedge the investment and he wants to expand his portfolio, that is when the futures and options come into play.