What are futures and options?

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In module 3 of Smart Money, we briefly discussed the concepts of derivatives, futures, and options with real-life examples. Remember Sudhir and Bheem? And how they traded the right or the obligation to buy or sell a pineapple? That concept, when translated to the stock market, leads us to futures and options.

In this module, we’ll focus purely on futures and options basics and look into what they mean. Also, to get a better understanding of the concepts, we’ll take a look at some theoretical derivative contracts. Let’s start off with the concept of futures.

What are futures?  

In the stock market, futures are basically derivative contracts that obligate a buyer and a seller to trade the stock of a company at a predetermined price, on a predetermined date in the future. Here, both the buyer and the seller are obligated to honour their end of the contract. 

There are essentially four main elements to a futures contract.

  • The obligation of the buyer and the seller
  • The trade of an underlying asset between the two parties
  • The presence of a predetermined price
  • The presence of a predetermined date for the trade to occur

And as far as a futures contract is concerned, the buyer of the contract is the person who is obligated to buy the asset, while the seller of the futures contract is the person who is obligated to sell the asset. 

Another point to note is that the buyer of the futures contract expects the share price to go up. But the seller of the contract expects the share price to fall in the future. And so, both of these parties get into an agreement to effectively lock in the prices.   

Let’s look at an example that will help you understand this better and strengthen your knowledge about futures and options basics.

Futures - an example

Let’s take up Reliance Industries, for instance. Assume that the stock is currently trading at Rs. 1,700 per share. You expect the share price of Reliance Industries to rise in the near future and wish to lock in the current price. 

In this case, what do you do? Well, you’ll likely want to buy a futures contract that obligates you to purchase one share of Reliance Industries for Rs. 1,700 at a future date, say one month later. 

And since you believe that the price of the share at that point may be much higher, you believe that this futures contract can help you make a profit by allowing you to purchase a share at Rs. 1,700 instead of at whatever higher price there may be at that time.

Meanwhile, Ram, who is another trader, expects that the share price of Reliance Industries will likely fall in the near future. So, what does Ram do? He’ll probably want to sell a futures contract that obligates him to sell one share of Reliance Industries for Rs. 1,700 at a future date, say one month later. 

And since Ram believes that the price of the share at that point may be much lower, he believes that this futures contract can help him make a profit by allowing him to sell a share at Rs. 1,700 instead of at whatever lower price there may be at that time.

So, both you and Ram enter into a futures contract that has these four main elements.

  • You and Ram are both obligated to honour your individual ends of the transaction.
  • The transaction is essentially the trade of one share of Reliance Industries.
  • The predetermined price for the stock is Rs. 1,700.
  • The predetermined date for the trade is one month from today.

Both you and Ram are required to deposit a percentage of the transaction value with your respective stockbrokers to enter into the contract. This amount that you’re required to deposit is termed as the ‘margin.’ Consider this margin as a sort of a security deposit for entering into the contract. And here, Ram, who sells you the futures contract, is obligated to sell the asset. You, being the contract buyer, have the obligation to buy the underlying stock. 

At the end of one month, on the predetermined date for the trade, you will have to buy the share for Rs. 1,700 even if it is otherwise trading in the market for a lower price, say Rs. 1,500. Similarly, Ram will also be obligated to sell you the share at Rs. 1,700 even if it is otherwise trading in the market for a higher price, say Rs. 1,800. 

What are options?     

In the stock market, options are derivative contracts that give the buyer of the contract the right to buy or sell the stock of a company at a predetermined price, on a predetermined date in the future. Here, the buyer has the choice to either buy or sell the asset, while the seller has no such right. 

  • If the buyer of the options contract chooses to exercise their right to buy or sell the asset, the seller of the contract will be obligated to act accordingly. 
  • And if the buyer of the contract chooses not to exercise their right, then the seller will again have to act accordingly. 

Here, there are essentially four main elements to an options contract.

  • The right of the buyer of the options contract
  • The trade of an underlying asset between the two parties
  • The presence of a predetermined price
  • The presence of a predetermined date for the trade to occur

Unlike a futures contract, here, in an options contract, the buyer of the contract can be either the purchaser or the seller of an asset. In other words, the buyer of the contract can buy the right to either buy an asset or to sell an asset.

If the contract buyer purchases the right to buy an asset from the contract seller, the contract seller then automatically becomes the seller of the asset. And if the contract buyer purchases the right to sell an asset  to the contract seller, the contract seller then automatically becomes the buyer  of the asset. 

Wrapping up

So, we’ve seen the answers to two of the most basic questions - What are options? And what are futures? With regard to options, depending on the right involved (whether it is to buy an asset or to sell one), options contracts can be any one of two types.

  • Call options
  • Put options

In the next chapter, we’ll build on the futures and options basics and learn about each of these kinds of contracts and look into relevant examples to understand them better.

A quick recap

  • In the stock market, futures are basically derivative contracts that obligate a buyer and a seller to trade the stock of a company at a predetermined price, on a predetermined date in the future. Here, both the buyer and the seller are obligated to honour their end of the contract.
  • There are essentially four main elements to a futures contract: the obligation of the buyer and the seller, the trade of an underlying asset between the two parties, the presence of a predetermined price and the presence of a predetermined date for the trade to occur.
  • The buyer of the futures contract expects the share price to go up. But the seller of the contract expects the share price to fall in the future.
  • In the stock market, options are derivative contracts that give the buyer of the contract the right to buy or sell the stock of a company at a predetermined price, on a predetermined date in the future. Here, the buyer has the choice to either buy or sell the asset, while the seller has no such right. 
  • If the buyer of the options contract chooses to exercise their right to buy or sell the asset, the seller of the contract will be obligated to act accordingly. 
  • And if the buyer of the contract chooses not to exercise their right, then the seller will again have to act accordingly. 
  • Here, there are essentially four main elements to an options contract: the right of the buyer of the options contract, the trade of an underlying asset between the two parties, the presence of a predetermined price and the presence of a predetermined date for the trade to occur.
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