Futures and Options trading for beginners: A complete guide
After crossing the threshold into the realm of the financial markets, there is no stronger invitation, nor more lucrative form of trading than through futures and options. However, the general term used here may sound a bit challenging to the beginning class of learners. Despite all this financial instruments may not make a first impression to encourage trading, nonetheless the complication is just an illusion, once you get the basics of the two then futures and options are very useful tools for hedging, speculation, and gaining leverage on your investment. As a result, this blog has the goal of giving the reader a simple yet comprehensive overview of futures and options trading for a new investor.
What are Futures and Options?
Evidently, to comprehend how to trade in futures and options, the former must be best understood beforehand.
Futures Contracts
A futures contract is an agreement between two parties to trade an asset-option, which can be commodities, stocks, or index-for a set price in the future. In this case, as in each delivery, the buyer and the seller are bound to physically take delivery of the asset at the expiration date, without regard to the current market price of the underlying asset.
Futures are most commonly used in commodity trading which include oil, gold and wheat among others, but they make their way into financial markets by allowing people to trade futures on stocks, bonds or a particular index.
Key features of futures contracts:
- Standardization: Every contract to sales of the futures is of same type in respect of quantity, quality and time /delivery.
- Leverage: The margin is small and allows you to control a large sum of the underlying asset meaning that you only need to invest a small percentage of the full value of the contract.
- Settlement: Futures contracts can be closed, or settled, by either the actual delivery of the underlying asset or by the exercise of a cash-against-cash agreement.
Options Contracts
Options Contracts
An option contract provides the owner with an opportunity, but not a mandate, to either purchase (call option) or sell (put option) the underlying asset by a stipulated price (exercise price) on or before a specific date. The distinctive aspect still lies in the fact that unlike futures, options do not compel the holder to take physical or cashDelivery. The holder can simply allow the contract to run out if the odds turn against them in the market.
There are two types of options:
- Call Option: This can be used to provide the buyer with a right to take up the underlying asset I question at an agreed price.
- Put Option: This provides the buyer with the ability to sell the asset below him at a fixed price.
Key features of options contracts:
- Limited Risk for Buyers: The maximum risk that the buyer of an option faces is the price he or she paid for the option (this is referred to as the premium).
- Flexible Strategies: Most often options can be applied in speculation and hedging and this proves to be an added advantage to the traders as they have a number of choices to make.
- Leverage: Just like futures, options allow for leverage since you get to control ownership of a large position with a small capital outlay.
How Futures and Options Work
Futures: An Example
Suppose you are a farmer who cultivates wheat. Their concern on the population’s demand and supply for wheat and its price contraction when your crop is ready for the market. Therefore, you may wish to lock the market price for your wheat by trading in a futures contract that allows you to sell your commodities, in this case wheat three months from now at current market price. This allows you to capture the current price and eliminate the possibility of current price surge in the future.
In the same way, a bread manufacturer may use futures contracts to lock in an attractive rate to purchase wheat from in future in case the prices go up.
In both cases, futures contracts enable the segregation of risk of price change and offer the required price assurance to the parties in a price risky environment.
Options: An Example
For instance imagine you are particular on stock in a certain company but you are still in a dilemma as to whether the prices will rise. But, now, you might not want to buy the stock directly; instead, you could buy a call option. For a small sum of money more, you acquire an option to take up the shares of the company at a specified price during a given period. If the price per share goes above your strike price or target level then you can buy the stock listed through exercising the option and at a cheaper price, this is how you make your money.In the worst case the stock will not respond the way you want it to and you can only lose the amount you paid for the option.
Likewise, if you have invested in shares and there is the possibility that the price of the shares will fall, the shareholder can go on to buy a put option whereby he will be able to sell shares at a certain price. In the event that the price per stock goes below the price you set on the strike, you can use the strike as a selling point; hence reducing your loss exposure.
Difference between futures and options trading for beginners
While both futures and options are derivatives—financial instruments whose value is derived from an underlying asset—there are significant differences between them:
- Obligation: Again, a futures contract provides both buyers and sellers with the floor to take delivery of or dispose of the commodity and a call/put option allows the buyer only an option to buy or sell.
- Risk: Futures contracts involve more risks on the contract as opposed to options whereby at least one party can avoid the loss of a great magnitude. Options allow the buyer to transfer most of the risk to the seller of the option for the amount paid to him for the option.
- Leverage: The two instruments have the characteristic of leverage: the trader is able to control large positions with small trading capital. Nevertheless, because options can only result in a maximum loss of the premium, many consider them less prohibitive for newcomers.
Why Trade Futures and Options?
Before you learn the details of it, let me begin with asking the purpose of trading futures and options. There are several reasons why these instruments are popular:
Hedging
Most of the investors employ the futures and options to minimize risk of loss in their current positions. For instance, if you invest in a company and are worried about its fluctuations in the short term then the use of put options will ensure that your shares are not a big loss. Similarly, a business involved in the food industry and dependent on basic necessities such as oil or wheat can fix prices for these through futures and avoid affectations of this kind.
Speculation
Futures and options are generally employed for speculation. In this context, any trader expecting changes in the price can actually benefit from the fluctuations in the market. For instance if they think that the price of oil will increase they can invest in oil futures or call options on oil. If the price does go up though your profit could be quite impressive.
Leverage
Another unique characteristic that has enormous appeal to financial instruments is that they give the holder leverage. With a small initial capital, you can own a greater proportion of an underlying asset thus a greater possibility of earning more profits on your investment. But as most of the readers already know, leverage typically means that an investor can reap even more benefits than from the initial capital but at the same time, it also means that he or she is at risk of suffering even more significant losses.
Income Generation
Options, especially, can be used to derive other earnings by deployment of the covered calls strategy. If you are an investor in a share and expect little fluctuations in the value of the stock you can sell call options on the stocks that you own. In case the price per stock does not go above the strike price you can gain the premium from writing the option and at the same time continue to own the shares.
Understanding of the Major Concepts of Futures and Options trading
To navigate futures and options trading effectively, it’s important to familiarize yourself with the following terms:
Strike Price: The price at which an options contract can actually be exercised to buy for calls and to sell for puts.
Premium: Options have a price to buy, the price that is paid for an option.
Expiration Date: The date on which a futures or options contract has to be squared off.
In-the-Money (ITM): In other words, a call option is In-The-Money (ITM) as time zero stock price is more than the strike price and put option is ITM, when time zero stock price is less than the strike price.
Out-of-the-Money (OTM): Meaning Call option is OTM if the market price of the underlying instrument is less than the price fixed at which the option can be exercised and Put option is OTM when the market price of the underlying instrument is more than the exercise price.
Leverage: The official purchase of financial capital in the form of borrowed money or other assets with the aim of boosting expected returns on an investment.
Margin: The minimum amount of money which a client requires to give to a broker to undertake futures or options trade.
Underlying Asset: This is the stock that supports the futures or any options contract including shares, bullion, stocks, shares indices, commodity, etc.
Strategies for Beginners
For a beginner in futures and options, there is no better way other than beginning with simple trades and then progressing. Here are two basic strategies:
Covered Call
Covered call is one of those option trading strategies where one sells a call option on a specific stock he already possesses. It is a very conservative approach to obtaining income in exchange for a reduction of a certain component of the premium if the share price goes above the strike price.
Protective Put
A protective put entails purchasing a put option on a security you already own. This strategy helps to hedge against actual occurrence of lower prices in the particular stock. For the stock price below the strike price of the put option, the monetary benefits gotten from the put option will be able to counterbalance the monetary losses gotten from your stock position.
Futures and Options Trading
As it has been said before, futures and options are a form of investment and they can be somewhat valuable however, they are fraught with considerable risks. The often mentioned ‘leverage’ used to increase gains in investments can also work to increase your losses. Before starting trading it is crucial to realize what type of risk is associated with the process. Some risks to consider include:
- Market Risk: The probability that the price levels go up or down against the position that has been taken on a particular commodity.
- Leverage Risk: Trading on leverage implies that the minuets you can lose as much as you staked into the specific trading activity.
- Liquidity Risk: At times you find yourself unable to close a position because there is no one to trade with at the existing price.
Conclusion
Similar to the financial instrument from which it has evolved, futures and options trading may indeed seem complex at their first glance but as soon as one gets his orientation right, then it is one of the most powerful instruments of risk management as well as good income generating tools. For a beginner, the approach should be slow, take as much information as possible and begin with small investments. Speculation in both futures and options involve a strict adherence to market rules and operations, a good concept of risks in operation and the current conditions of the market. Making profits should continue learning, enhance recognition of fellow students and do not hesitate to seek instructions from them.
Regardless of how long you have been dealing with the stock market or whether you are new to it, having a good understanding of the market timings can go a long way in helping you in your endeavors and therefore increase your chances of being successful in the stock market.
Also Read :Top 10 Penny Stocks in India
FAQ'S
What are futures and options trading ?
Futures trading is the process of dealing in contracts whereby the buyer acquires a right that entitles him / her to purchase a specific asset at a specific price after a specific period of time in the future. Such contracts relate to standard goods such as oil, gold or stock market indexes. Futures may be, and are often used for hedging, meaning that traders want to guard against risk and can use futures as insurance against market changes; futures may also be used for speculation, where traders are trying to take calculated risks on market changes. Options are financial instruments in which the trader acquires a right to buy or sell the asset at a predetermined price in a given time only. There are two basic forms of options as follows:
call options – the right to purchase, put options – the right to sell.
What is a put option in options trading ?
Put option is an option contract which allows its holder to sell a particular asset on or before a certain date at a predetermined price.
What is a call option in options trading ?
A call option refers to an agreement where the holder has the option, but not the requirement, to purchase an asset at an agreed on price known as the exercise or strike price within a given time frame.
What are the risks in futures and options trading ?
The potential issues are high risk, major of the capital and high possibility of losing the initial capital and owe more than the value of the trade especially when trading in futures. The options can merely restrict the amount of loss to the amount of the premium paid whereas selling options could turn into a limitless risk proposition.
Can beginners start trading futures and options ?
Yes, but futures and options trading for beginners in particular need the market’s knowledge as the beginning; both kinds are rather risky. Paper trading (the process of trading using fake money) and reading through materials produced by the company are suggested for new entrants into the field.
