To understand the concept of Futures and Options the best way is to go through the definition. Futures and Options abbreviated as F&O are common forms of financial instruments called derivatives. Derivatives are financial instruments which derive its value from the underlying asset. A Futures contract is a legally binding agreement to buy or sell a financial instrument in a designated future month at a price agreed upon when the initiation of the contract took place between the buyer and the seller.
Future contracts are suitably standardized according to the quality, quantity, delivery time and location with respect to dealing with commodity derivatives. In a Futures contract, both agreeing parties are obligated to perform their agreed responsibilities, and the guardian here is the exchange, who takes responsibility to ensure that the agreed trade is done justly.
To further elaborate on the same lets analyze it with an example; suppose you are a fruit merchant selling mangoes and are in trade talks with a prosperous farmer who is the owner of many mango trees. The farmer before the onset of the mango season agrees to sell his produce of one year for a predetermined fixed price to you. A similar type of trade involving Futures takes place but through the exchange; where exchange actually plays the role of a respected arbitrary functionary to ensure that the trade is carried out in a fair manner as pre-decided.
Some inherent advantages of trading with Futures contract include:
It is a contract between two parties through an exchange.
Exchange is the legal counterparty to both parties.
Quantity and Quality both are decided on the same day as per standard denominations as specified by the exchange.
Futures in a certain sense can be said to be a further specialized system of forwards which is supported by our stock exchange. The biggest advantage of trading through futures options is that the buyer or seller can enjoy a fair play as the trade is routed through the exchange. Hence here the exchange or its clearing department obligates the concerned party to buy or sell the specified quantity of the underlying product for a specific price on a specific date.
The underlying assets could be commodity, stock index, security, or currency. Here the biggest advantage is that since all the terms of a listed futures contract are structured by the exchange, you cannot offset your contract and get out of your obligation by buying or selling an opposing contract before the settlement date.
This is surely a blessing for some investors called hedgers as this scheme offered a sense of protection from the volatility of markets. For e.g. rice farmers can protect themselves against a bad season when yield is less by buying a futures contract at a lower price similarly the farmers can protect themselves to ensure a minimum sale price by buying contracts which are higher to shield against a bumper harvest. Thus they are making sure that even if there is a bumper crop, they will still get the price as decided while purchasing of contract.
For both Futures and Options, I believe it still early days in the Indian markets and with the number of investors increasing every year, people participating to use this product as a good tool of investments is only on its ascendance and the best is yet to come in the coming years.
1. Views as are mentioned in the article are personal views of Author and nothing to link with Co., its Director and Employees.
2. All investments are subject to market risk and you need to consult your financial advisor/consultant before investment.