Futures and options arе a typе of investment options beyond еquitiеs. Thеy arе a lot more complex than equities and require a dееp understanding of thе concepts. In this blog, we will lеarn about thе concepts that tradеrs must know bеforе thеy opеn their futures and options account. It is assumеd that you alrеady havе a profound undеrstanding of thеsе concеpts but if you don’t, hеrе is thе quick guidе on futurеs and options.
Let’s first understand what Futures and Options are and then we will learn about the important concepts that help you to navigate the F&O market.
Futures Trading
Futurе trading is a type of invеstmеnt that involves trading contracts known as futurеs contracts. Thеsе contracts are agreements to buy or sеll a specific assеt, such as commoditiеs, currencies and financial instrumеnts at a predetermined pricе and datе in thе futurе. Futurе trading allows participants to spеculatе on thе pricе movements of thеsе assets and manage risks associatеd with pricе fluctuations.
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Types of Futures Contracts
Futures contracts arе availablе for a widе rangе of assеts, including financial instrumеnts, commoditiеs, currencies and morе. Some еxamplеs of futures contracts include:
- Stock index futures
- Currency futures
- Commodity futures (such as crude oil, gold, or agricultural products)
- Treasury futures
- Energy futures
- Metal futures
Participants in Futures Trading
There are two main types of participants in futures trading:
- Hedgers: Hedgers are participants who use futures contracts to manage the risk associated with price fluctuations in the underlying asset. Thеy aim to protеct thе valuе of their assets and rеducе thе risk of financial lossеs. Hеdgеrs include individuals businеssеs and institutions.
- Speculators: Speculators are participants who aim to profit from price changes in futures contracts. They do not have an underlying asset to hedge but instead, take positions based on their expectations of future price movements. Speculators include individual traders, investment firms, and other market participants.
Regulation of Futures Trading
Futures trading is regulated by the Commodity Futures Trading Commission (CFTC), a federal agency created by Congress in 1974. Thе CFTC’s rolе is to еnsurе thе intеgrity of futures market pricing and to prеvеnt abusivе trading practices. CFTC is set to regulate brokerage firms who engage in futures trading.
According to the CFTC, businesses and individuals that manage client money or offer trading advice must register with the National Futures Association (NFA). Thе CFTC also kееps an еyе on intеrnal controls, rеgistrant supеrvision systеms and compliance initiatives rеlatеd to salеs practicеs.
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Options Trading
Option trading is a financial strategy that involves buying or selling contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time frame. Options can be used to protect against a substantial price decline in a stock that you already own. Options allow you to control a larger amount of the underlying asset with a smaller investment. Options can generate income on existing stocks in your portfolio. It is a more complex form of trading compared to stock trading and requires an understanding of advanced strategies.
Participants in Options Trading
Option trading has various participants who play different roles in the market. Here are some key participants in options trading:
- Hedgers: Hedgers are participants who use options and future derivatives to minimize the risk of their existing positions or trades due to market volatility or direction. They are often actual manufacturers or producers who lock in the price of the underlying asset (stocks, commodities, forex) to avoid future uncertainty of market direction.
- Speculators: Speculators trade options to make investment profits. They may hold leveraged positions in assets at a lower cost than buying shares of the asset. Speculators use options to take advantage of price movements and generate income.
- Arbitrageurs: Arbitrageurs seek to profit from price differences between the futures and options markets. They provide liquidity in both markets and facilitate trade by buying or selling commodities. Arbitrageurs do not participate in producing the underlying commodity as their main function is to facilitate trade.
- Market Makers: Market makers buy and sell options for their own account and make money on the bid-ask spread. They stand ready to buy or sell any commodity at almost any time to provide liquidity in the market.
Regulation of Options Trading
Options trading is regulated by government agencies such as the Securities and Exchange Commission (SEC) and self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA).
Important Concepts to Know Before Futures and Options Trading
Before diving into futures and options trading, it’s important to have a solid understanding of some key concepts. These are the following concepts you should know:
- Derivative Trading in Commodities: Futures and options trading is common in commodities markets, such as the National Commodity & Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange (MCX). Commodities markets are known for their high volatility, and futures and options allow traders to protect against potential price falls or profit from expected price spikes.
- Risk Management: Trading in futures and options requires a constant focus on risk management. It’s crucial to understand the movement of the market and the potential risks involved. Beginners are advised to educate themselves adequately and practice with virtual accounts before engaging in real trading.
- Leverage: Futures and options trading involves leverage, which allows traders to control a larger position with a smaller amount of capital. However, it’s important not to be fooled by the leverage. Leverage can amplify gains and can also lead to significant losses. Traders should be aware of the true magnitude of potential losses and exercise caution.
- Liquidity: Liquidity is an important factor to consider in futures and options trading. It’s easy to overlook liquidity, especially for new traders. It’s crucial to ensure that there is sufficient liquidity in the market for the contracts you are trading to avoid difficulties in entering or exiting positions.
- Understanding the Underlying Asset: Before trading futures and options, it’s essential to have a clear understanding of the underlying asset. This includes knowledge of fundamental analysis, technical analysis, different strategies, and the various types of options (put and call options).
- Types of Derivatives: Futures and options are two types of financial derivatives. Futures contracts require the buyer to purchase the underlying security or commodity, while options contracts give the buyer the right, but not the obligation, to buy or sell shares at a specified price. Understanding the differences between futures and options is important for effective trading.
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Important Points To Remember Before Futures And Options Trading
- Options are perceived to be less risky. However, the reality is that over 97% of options expire worthless globally. Thus, the probability of making profits remains low for the buyers even when the risk is comparatively capped for buyers. On the other hand, option sellers have higher risk but stand a better chance of profitability.
- Margins on futures contracts can surge during times of market volatility and lead to unexpected margin calls or position liquidation. Traders must be cognizant of this risk and ensure sufficient liquidity to meet margin requirements, especially in turbulent market conditions.
- One of the major techniques in futures and options trading is implementing the stop-loss and profit-target levels to safeguard the capital and manage the risk effectively. Traders must stay compliant to predetermined stop-loss and profit-taking levels and stay disciplined while trading, irrespective of market views or sentiments.
- Traders should closely monitor transaction costs that are associated with futures and options trading. Transaction costs may accumulate significantly despite being charged at a lower percentage compared to equity trading. It is essential to maintain a favorable ratio of profits to transaction costs to justify the effort and expenses that are incurred during F&O trading.
- Options provide flexibility to the traders to adapt to non-directional strategies. With this, traders can increase their profit potential in volatile or sideways markets. By combining options and futures, traders can capitalize on market uncertainty and fluctuations.
Now that you have an understanding of these concepts, you might have the following questions in your mind.
FAQs About Futures and Options Trading
What is leverage in futures and options trading?
Leverage allows traders to control a larger position in the market with a smaller amount of capital. In futures and options trading, leverage amplifies both potential profits and losses. For example, if a trader wants to buy one contract of gold futures, that represents 100 kgs of gold, then the trader only needs to deposit a fraction of the contract value, let’s say 10%, as margins.
What is the margin in futures trading?
Margin is the initial deposit required to enter into a futures contract. It represents a fraction of the contract’s total value and serves as collateral for potential losses. Futures trading requires a small margin of the notional value of the futures contract that usually ranges from 3% to 12%.
What are the risks associated with futures and options trading?
The main risks include leverage amplifying losses, market volatility leading to price fluctuations, and the possibility of losing the entire investment capital in one trade. Traders must educate themselves about the risks involved in F&O and to develop a sound trading strategy.
What are the factors that influence futures and options prices?
There are many factors that influence the prices of Futures and options. These factors include supply and demand dynamics, interest rates, economic indicators, geopolitical events, and market sentiments. To get a more deeper understanding of these concepts, Gap Up is the right place to learn and enhance knowledge.
Disclaimer: This blog is solely for educational purposes. Please go through all the necessary documents and conduct your own research before investing. The securities/investments quoted here are not recommendatory.
