Basics of Futures and Options trading for Beginners

Today you will learn about the basics of futures and options trading. Futures and Options come under types of Derivatives markets.

Generally, there are four types of Derivative markets;

  1. Forward
  2. Futures
  3. Options
  4. Swap

We will understand all of them one by one. First, let us understand

What are derivatives markets?

Petrol and Diesel are made from Crude oil. Therefore, Petrol and Diesel are derivatives of Crude oil. Similarly, the curd is a derivative of milk as it is, made out of milk. So anything which is derived from something else becomes its derivative.

Similarly, there are types of markets: Cash Market and Derivative Market.

What is Cash Market?

It is the general market, where normally we Buy or sell shares is called Cash Market. Futures and Options generally come under the Derivative Markets.

In the Cash Market, any shares that you buy or sell, are traded on a particular day. That means the shares are bought or sold on that particular day.

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In Derivative Markets, you deal in future dates. This means, selling or buying of commodities on a future date.

In Derivative Markets, you trade in future dates, and in Cash Markets, you trade in current dates, that’s the main difference.

Another difference is that in Cash Markets you can buy and sell any amount of shares. For example, you can buy 1, 2, 5, or 10 shares, you can buy and sell as many as you want.

In Derivatives Market, there are ‘Lots’. Particular companies have particular Lots. You have to trade in Futures and Options in these Lots.

One more difference is that all companies in the Cash market are not in Futures and Options, which means you can trade in any company listed on the Stock Exchange.

On the other hand, there are limited companies where you can trade in Futures and Options.

The third point is that the Derivatives market, which is mainly Futures and Options, is used for Hedging, this means it is used for reducing risks.

Three types of derivatives markets in the stock market:

When it comes to Stock Market, there are three types of Derivatives Markets;

  1. Forward Market
  2. Futures Market
  3. Options Market

Forward Market

Let’s start with Forward Market. We will understand it with a hypothetical example. Today’s date is 3rd December and the rate for gold is 50,000 for 10 grams.

That means, today you can buy Ten grams of gold in 50,000. But the problem is that you don’t have 50,000 right now. You will have the money in one month, which is the 3rd of January.

Now the problem is that you will have 50,000 money in a month, and you think gold prices will go up in a month to 50-53k.

So, you go to a jeweller and tell him that you want to buy 10 grams of gold, at today’s price, which is 3rd December, at the cost of 50,000.

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But you don’t have any money right now, you will get it in a month, on 3rd January. So can you give 10 grams of gold on 3rd January at the 3rd December price?

Basics of Futures and Options trading for Beginners

To which the Jeweller says no but, he knows someone in the market, Who can give you the gold at 3rd December’s price so you go to that Jeweller and tell him that you will have the money in a month and that on 3rd January you want to buy 10 grams of gold at 3rd December’s price.

For this, the Jeweller says yes, he thinks gold prices will go down in a month. It will come down to 47-48k.

 So the Jeweller thinks that, If he sells gold after a month, at today’s price, he will make a profit. So from that point of view, it is the right deal. So this way, you and the Jeweller make a deal.

On 3rd January, whatever the price of gold may be, the Jeweller will give you 10 grams of gold at 50k.

So, on 3rd January you will give the Jeweller 50k and, in return, he will give 10 grams of gold. This simple deal is at a future date, which is the 3rd of January.

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You made the deal today but its execution date is 3rd January. Now, 3rd January is here and gold prices have gone up to 52,000. This means you were right.

 You thought the prices will go up and they did. After this, you go to the Jeweller and give him 50k for 10 grams of gold.

But the Jeweller refuses. He says the prices have gone up and, he can’t sell it for less. You say to him that you had a deal and he can’t back out so easily.

The Jeweller says you can do as you like but, he will not sell it for 50k. 52k is the current price and, he will sell 10 grams only at that price. You get angry and leave.

So in the first condition, the deal was in your favour and, the Jeweller was at a loss. That is why the Jeweller refused and, you could not profit as the deal wasn’t complete.

Let’s take another condition. Assume that on 3rd January Gold prices fall to 48k, you see that your deal is at 50k and, on 3rd January the price is 48k.

You realize you have a loss of 2000, so you don’t go to the Jeweller. The Jeweller waits for you so that he can get his profit worth 2k. Because the gold price now is 48k and the deal was for 50k for 10 gram Gold.

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So in this condition, the Jeweller was at profit and, you were at a loss. Since you were at a loss you didn’t go to the Jeweller.

 You thought that if the current price is 48k then, why should you pay 50k. But this was your deal and, you didn’t go, so the deal was not complete.

So the example we used was the example of Forward Market. Where you and the Jeweller made a deal on a future date without a middleman.

So, if a party defaults, there is nobody to take any action. Neither did you pay a deposit, nor were there any middlemen.

That is why in Forward Markets, there are chances of the counterparty defaulting. This means they abandon the contract and leave. Forward Markets have a lot of problems.

The first one is to look for counterparties. Like you had to look for a jeweller for this deal, who would deal with you on a future date, finding counterparties for that is difficult because you have to look for such counterparties on your own.

Another problem is that the default risk is high. This means the counterparty, the party you are dealing with, can leave the contract anytime.

The third problem is that you can’t cancel the contract mid-way. You will have to complete it. If you want to cancel the contract, you will have to convince the counterparty to cancel the contract.

So these are the three problems with Forward Markets, that Future Markets have solved.

In Forward Markets, people leave the contract when it is not in their favour. But this is not possible in Future Market.

Neither party is allowed to leave the contract. Similarly, the job of looking for a counterparty is done by Stock Exchange or Derivative Exchange.

Because of which it is very easy to find a counterparty in future markets. And the third problem with the Forward Market of not being able to cancel the contract is possible in the Futures market.

Problems in the future market are solved by Forward markets.

What are derivatives markets?

Petrol and Diesel are made from Crude oil. Therefore, Petrol and Diesel are derivatives of Crude oil. Similarly, the curd is a derivative of milk as it is, made out of milk. So anything which is derived from something else becomes its derivative.

What is Cash Market?

It is the general market, where normally we Buy or sell shares is called Cash Market. Futures and Options generally come under the Derivative Markets. In the Cash Market, any shares that you buy or sell, are traded on a particular day. That means the shares are bought or sold on that particular day.

Types of derivatives markets in the stock market

When it comes to Stock Market, there are three types of Derivatives Markets;
Forward Market
Futures Market
Options Market