Trading Futures Versus Options
A derivative is a financial security with a value based on or generated from an underlying asset or group of assets that is set in the future. Futures and options are the two most common types of stock derivatives traded on an online stock exchange.
How is the Future Price Set?
These are contracts signed by two persons, companies, or traders for the purpose of trading a stock asset at a pre-determined rate at a later period. These derivatives contracts attempt to mitigate market risks associated with stock market trading. Price locking establishes a price limit in advance.
Let’s look at a basic real-life scenario to better comprehend futures and options trading. Assume a rice farmer has planted his crop and wants to sell it after three months. He maintains an eye on the market and sees that the current price of INR 500/quintal is an investment recovery price, but that the price is dependent on output and could fall in three months as supply grows. To protect his investment, he needs to lock in the price. This farmer enters into a deal with a trader who is willing to buy at INR 500 with a three-month delivery deadline. Both parties agree to a transaction for 100 quintals of rice at $500 per quintal to be completed in three months.
What is the method for determining the price of futures and options? Futures and options are derivatives that get their price from an underlying asset like equities, bonds, commodities, currencies, interest rates, market indices, and so on. Individuals can use futures and options basics to limit future risk with their investments by investing at pre-determined prices.
Also Read: How is the Price of Option Trading Decided?
What Factors Affect the Price of Options?
Using the preceding example of futures trading, imagine that instead of engaging in the aforementioned transaction, both the farmer and the trader engaged in the following transaction.
Farmer gives trader a price range to choose from and will only sell him for a pre-determined amount if he chooses to buy from the farmer at a later date.
If a trader expects to benefit in the future, he will buy the crop from the farmer at INR X/quintal only if the market sells him at a price higher than INR X/quintal. However, if the price is less than INR X/quintal, the same merchant can buy directly from the market.
The farmer, on the other hand, demands an upfront non-refundable token payment (premium) from the trader. Both have the opportunity of securing their investment by making decisions.
An option trading refers to the same set of transactions in a trading account on a formal exchange regulated by the government.
Future is simple to comprehend, but profit is difficult to achieve. Trading options is a bit of a challenge. An option trading allows smart traders to earn more from a stock’s price decrease. A trader can take a leveraged position that benefits from price declines by obtaining the right to sell stock at a specific price (a put option). Open a Demat account with Nuuu if you want to invest in stocks Market to take advantage of free brokerage and other benefits.
