UNDERSTANDING FUTURES AND OPTIONS: A BEGINNER’S GUIDE

Understanding Futures and Options: A Beginner’s Guide

Understanding Futures and Options: A Beginner’s Guide

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Futures and options are two popular derivatives in the stock market that help investors hedge risks, speculate on price movements, and enhance portfolio diversification. While both are contract-based trading instruments, they work differently. Let’s break them down.



What are Futures?


Futures are standardized contracts that allow traders to buy or sell an asset at a predetermined price on a future date. These contracts are used to hedge against price fluctuations or speculate on market trends.



Key Features of Futures:



  • Obligation to Buy/Sell: Both parties must fulfill the contract upon expiry.

  • Leverage: Investors can control a large position with a smaller capital outlay.

  • Hedging & Speculation: Businesses use futures to hedge against price volatility, while traders speculate on price movements.


Example: If an investor believes that crude oil prices will rise, they can buy oil futures at today’s price and sell later at a higher price for a profit.



What are Options?


Options give traders the right (but not the obligation) to buy or sell an asset at a specific price before or on a particular date. Options come in two types:




  • Call Option: The right to buy an asset at a fixed price.

  • Put Option: The right to sell an asset at a fixed price.


Key Features of Options:



  • No Obligation: The buyer can choose whether to exercise the option.

  • Premium Payment: Buyers pay a premium to acquire the option.

  • Risk Limitation: Maximum loss is limited to the premium paid.


Example: If a trader buys a call option on a stock at ₹100 with an expiry in a month, they can buy the stock at ₹100 even if its market price rises to ₹120, making a profit.



Conclusion


Futures and options are powerful tools in the financial market, but they come with risks. While futures require fulfilling the contract regardless of price movement, options offer flexibility with limited risk. Understanding their mechanics can help traders make informed decisions and develop effective trading strategies.

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