If you are an investor or trader in the stock market, you would have often heard about the terms 'Futures and Options'; in short, these are known as F&O.
Futures & Options are the crucial stock derivatives that every stock market participant needs to understand better to trade in the share market like a pro.
Therefore, in this chapter, we have tried to start with quite the basics of Futures & Options, and hence, we have covered every complementary aspect of the Derivatives Market. We hope it will help you clear your fundamental doubts about the subject matter. So, without much ado, let's start with the definition-
Since futures and options are part of a derivative market, it’s obligatory to learn about it first. Let’s understand it with the help of some basic examples-
As we know, petrol and diesel are derived from Crude Oil; hence, both petrol and diesel are the derivatives of Crude Oil. Similarly, the curd is the derivative of the milk as it's the product of milk. Henceforth, anything that is derived from something becomes the derivative of that commodity.
Likewise, there are two types of markets- Cash Market and Derivatives Market. The cash market is the one where we generally buy and sell shares.
On the other hand, the derivatives market is a marketplace where derivatives such as futures and options trade freely on exchanges or counters. The derivatives are a type of security whose value is derived or extracted from an underlying asset.
Besides the differences in definitions, the cash market and the derivatives market are quite divergent. Hence, before we proceed any further, let's dig out the differences between these two.
The cash market and derivatives market are quite distinct from each other and work in an entirely different way. We have enlisted some of the below:
Mainly, there are three types of derivatives in the derivatives market:
A forward market is a marketplace that furnishes financial instruments or sets the price of those financial instruments in advance for future delivery. Essentially, forward markets are utilized for trading various ranges of instruments. But primarily, it is used with the reference to the foreign exchange market.
It’s a kind of auction market where the stock market participants sell or buy commodity and futures contracts for delivery on a specified future date. Mainly, futures are exchange-traded derivatives contracts that lock in the delivery of a security or commodity in future at a price fixed today.
The options market is a derivative market traded in the contract where the contract is made between a buyer and a seller. Each contract controls 100 shares of the underlying stock. Besides, the contract provides the option's buyer with the right, but not the obligation to sell or buy a particular stock at a specific price on or before a specified date.
Let's understand the concept of Forward Market with two hypothetical instances-
Suppose the price of gold on 29th December is Rs. 50,000 per ten grams. But you don't have the required amount to buy the gold at the moment. You will receive that money after a month, and there's a possibility that the price of gold would have increased by then. The hike may be from Rs. 52,000 to 53,000 per 10 grams.
After thinking for a while, you approach a jeweller and ask him to sell you 10 grams of gold for which you will pay later. i.e. after a month when you will receive the amount. But the jeweller denies it. Instead, he tells you that he knows a jeweller who may agree to your terms.
You approach that other jeweller, and he agrees to lend you gold at the same amount even after one month.
As per him, the gold price will go down to Rs. 47,000 to 48,000. You both have a deal on whether the price rises or reduces you can have the gold at the same price as it is now.
On 29th January, when you approach the jeweller, the price of gold has reached Rs. 52,000 per ten grams. Considering the loss, the jeweller denies selling you gold at Rs. 50,000. Even though you remind me of your deal, he completely disagrees. You become sad and return empty-handed. As a result, you suffered a loss.
Let's consider another scenario where the gold's price on 29th January is Rs. 47000. You think that it will be a loss for you to buy gold at Rs. 50000 since the price has dropped. You decide to buy the gold from somewhere else and hence, breaks the deal without informing the jeweller. As a result, the jeweller has suffered a loss.
You and the jeweller had a deal in the future that whatever be the gold’s price on 29th January, you will get it at the same rate as it is now (i.e. 10 grams gold for Rs. 50,000). But neither you nor the jeweller stands to the deal. There were no middlemen involved. As a result, there wasn’t anybody who could take action against the party by default.
Besides, you didn't pay any deposits to anybody for the deal. Hence, the defaults risk or leaving the contract in between is higher in the forward market.
There are myriads of problems associated with the Forward Market. They are as follows:
Firstly, it’s pretty daunting to find a counterparty (just like Case 1 where you had to find a jeweller that may agree to your deal). You have to do this task yourself.
The second biggest problem with the Forward Market is that the default risk is the highest. It means that the counterparty can leave the contract at any point of the deal if the contract doesn't seem in the other's favour.
The third biggest complication is that you can't cancel the contract amidst the deal. You are required to work harder to convince your counterparty for the same.
The Futures Market brings the solution to all the problems associated with the Forward Market. In the Forward Market, any party can leave or break the contract at any point of the deal. However, neither of the counterparties can do the same in the Futures Market.
Similarly, the stock exchange or the derivative exchange is responsible for finding the counterparties for the Futures contract. Hence, this eases the problem of finding the counterparty for the deal.
Besides, the Futures Market has the solution for the third biggest complication of the Forward Market. Either of the parties can cancel the contract at any point of the deal they want.
We will give it a halt. In the upcoming chapter, we will discuss the basics of Futures and Options such as futures and options definition, the difference between futures and options, types of F&O, and more.
In case you have any queries related to the subject, feel free to leave a comment below. We will get back to you sooner!
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Until then, keep learning!