There are many different asset classes that compose an investment portfolio. They include mutual funds, ETFs and bonds. Options and futures can be called as additional assets. However many people are unaware of these two terms. Futures and options can be overwhelming but they can be very remunerative if used properly. So here we are to simplify these two terms. We will try to know what is option and future trading for beginners? As futures and options are derivatives, their values are derived from the underlying assets.
There are a number of assets on which the derivatives depend but our concern is with trading in the stock market. But why do we need futures and options? Basically there are two main purposes. One is to prepare a hedge against price risks. And the other is to gain profit from the changes of price or in other words speculations. The activities included here are mostly speculative. But before we go any we need to know the basics.
WHAT IS OPTION AND FUTURE TRADING FOR BEGINNERS?
To make it easy for us to understand, we will discuss about options and futures one by one. But before going straight to the real market one can practice trading with the help of paper trading.
Options are nothing but contracts that give the bearer rights to sell or purchase an amount of underlying asset. These assets are sold or purchased at a predetermined price at or before the contract is expired. However the bearer is not obligated to this contract. Option trading is different from buying stocks as they do not represent any ownership to a company.
CALL OPTION AND PUT OPTION
Option is known as a derivative because its price is linked with other assets. Here you get two options, either you can buy or you can sell options. In case of buying it is called as a call option and for selling it is called as a put option. A call option is much like a down payment for a future purchase. Whereas a put option is like an insurance, insurance for a long term stock generally.
You can do four things with options:
- Buy call
- Sell call
- Buy put
- Sell put
Holders are the people who buy options and writers are those who sell options. The Holders viz, Call holders and Put holders are not obligated to buy or sell. So this limits the risk of buyers of options to only the premium spent. Whereas call or put writers are obligated to buy or sell. Hence their exposure to risks is high.
One may find options risky as well as confusing but just to tell you that Warren Buffett is one of the biggest option sellers on earth.
Futures are also derivative financial contracts just like options. The difference is that these contracts obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and set price. Similar to options there purpose is also to hedge the underlying assets and for speculative purposes. Futures allow the trader to lock in the price of an asset or a commodity for a certain period of time. During the duration of the contract any fluctuation in the price of the underlying asset in the market won’t affect the cost at which the contract is sealed. Future trading helps the traders to hedge their assets against any loss due to price change. Investors can use this to speculate on the direction in the price of an underlying asset or commodity.
The futures markets use high leverage. This means that the broker would require an initial marginal amount at the beginning of the contract. This amount consists of a fraction of the total contract value. Leverage here means that the investor does not need to pay the entire contract value when entering into a trade.
OPTION TRADING VS FUTURE TRADING
- Both options and futures are similar trading products. They provide investors with the chance to make money and hedge current investments.
- An option gives the buyer the right to buy (or sell) an asset at a specific price at any time during the life of the contract. But this is not obligatory in nature.
- A futures contract however, is obligatory on the buyer. He has to purchase a specific asset, and the seller has to sell and deliver that asset at a specific future date unless the holder’s position is closed prior to expiration.
- For call option the risk of the buyer is limited to the premium paid upfront whereas the seller who opens the put option is exposed to risk to a much larger extent.
- The liability involved in future contracts is maximum for both the buyer and the seller. To fulfill a daily obligation, as the stock price of the underlying assets moves, either party (the buyer and the seller) may have to deposit more money into their trading accounts.
Options and futures are traded in a way similar to any other trade in the stock market. Lately they have gained popularity. Many big wigs put their money in options and futures and get high returns as well. But that doesn’t lessen the risk factor associated with these derivatives. As of now we know what is option and future trading for beginners but there is so much more to it. Before doing any trade make sure that you know fairly enough about the market.