There are numerous investment instruments available in the market. Still, derivatives happen to be the most feared and the least understood ones. Derivatives are financial instruments, ‘deriving’ their value from an underlying asset. The underlying asset can be a commodity or an index. Derivatives can yield good returns when done right. But that’s the catch, and there is no SOP for doing it right. This makes online trading appear complex to investors compared with other investment options.
Difference between futures and options—the two types of derivatives
The two types of derivative contracts—futures and options—are contracts to buy and sell the underlying assets in the future at predetermined prices. Although both options and futures are hedging tools that you can use to buy or sell an asset in the future on a specified date, at a specified price, both are different from each other. Options are the right but not the obligation to trade the underlying commodity, whereas futures are a right along with an obligation to trade.
Though futures and options are intrinsically the same in their objective—to allow investors to hedge, they are different from each other. As the name suggests, options give you the ‘option’ to execute the contract or let it expire, whereas futures do not give you this choice.
Though futures and options are more complex than equity, once you understand the nuances, it no longer remains the rocket science it appears to be. Since futures and options are essentially contracts, you only need a trading account to get started. But before that, let us begin with understanding how to trade in futures and options.
Before you start trading in F&O
1. Gains and losses–two possible outcomes of futures trading
The earnings out of futures trading can oscillate both ways, owing to the intrinsic nature of futures. Since these are highly leveraged, any little volatility in price can lead to multifold fluctuations in your earnings, and the same holds for losses too.
2. F&O, at best, are hedging tools
Options being risk-mitigating tools, the common notion is that the risk is limited to the premium paid. Though it is true to an extent most options contracts expire, it is the options’ seller who makes more money by taking a higher risk.
3. Equal gains/losses for the parties to the contract
In the case of futures, the trade is equivalent for both the parties involved, whereas, in the case of options, it is not. However, in options trading, the option buyer’s risk is limited to the premium paid; it is unlimited for the option seller. Hence, F&O trading only mitigates risks.
4. Higher margins in volatile markets
In volatile markets, futures may trade on higher margins, eating into your earnings. It is imperative to keep a check on margin in futures trading.
5. Use stop loss
Put a stop loss on your F&O trade and have a profit target. Having the floor and cap on your earnings will help you remain organized and disciplined.
6. Options Trading–the best friend of an unsure investor
When you are unsure where the markets are headed, options come to your aid in volatile markets to limit your losses. You can invest in options, instead of equities, in such markets. Whether it’s a call option or a put option, your loss is restricted to the premium amount only, whereas there is no limit to the gains.
Closing words
What helps in F&O trading ultimately is being organized and a probability-oriented approach. Markets have always respected the disciplined investor. There will be no looking back if you go ahead with the right approach and the right options trading app.
