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Futures and Options: All you Need to Know

Futures Contract– A futures contract is an agreement – which is legally binding – to purchase a commodity at a specific date in the future for an agreed upon price. This price is referred to as the futures price. Futures contracts are considered to be safer than many other investment products because they are based on a set of specific, standardized terms.

What is Futures trading?

Futures trading are a type of trading arrangement wherein traders agree to buy or sell assets in the future at a set price and standardized quantity and quality. Under this arrangement, the agreeing parties have to sign futures contracts to make the trade legally binding to avoid any problems when the delivery date arrives.

What assets are typically sold under this agreement?

In futures trading, a good number of assets are sold, and it is not limited to actual commodities only. However, the most common type of assets sold under this kind of agreement is agricultural commodities such as livestock, fruits, wheat, and vegetables, stock indexes, bonds, metals, interest rates, oil, and other assets can also be traded.

Who is involved in this type of trading?

In any futures trading arrangement, there will always be hedgers and speculators. The former buys or sells particular assets, with market price risks in mind, whereas the latter predicts movements in the market to determine whether market prices of certain commodities will go up or down. The speculator plays an important role in any futures trading agreement, as he will determine the actions that the trader should take.

Futures trading contracts are typically regulated by the government, though there are also some independent agencies that regulate such agreements, depending on the country. Those who break any rules in the contract will be held liable and will be required to pay fines for breaking any clauses. This is why it is important to carefully decide on the terms of the agreement before agreeing to it, as you cannot change any part of it once the contract has been signed and if you don’t decide properly, you may incur a lot of losses when delivery time comes.

What are the risks involved in futures trading?

Trading futures involves a lot of risks, as it does not always guarantee profit. However, it is ideal when it comes to situations where market prices are constantly fluctuating, as it offers some level of security. Farmers who sell their crops before they harvest and agree on a fixed price even before the market price at the time of harvest is determined can profit more than other farmers if he sells the price for much higher than the current market price during the delivery date. This is why it is important to have a futures contract, as it finalizes the deal so that none of the parties would back out in the event of an undesirable outcome.

Options– Options are contracts under which individuals get the right but not the obligation to buy or sell an asset for a specific price before a specific date.

What is Options Trading?

Option trading is another investment vehicle that can give you large returns when practiced carefully. In a nutshell, options trading are the trading of options contracts

To start learning some option trading basics, you must first know what options are and how option trading works. As we have already mentioned, options are basically contracts between the buyer and seller of an asset like stocks or futures at a specified price and period of validity.

Under a contract, the purchaser has the option to buy or sell an asset. The purchaser does not actually buy the asset but buys the option to purchase an asset which is referred to as an underlying asset in options trading terms. The seller does not have an option to hold on to the asset. The seller is obliged to sell at the underlying asset at the agreed price when the purchaser exercises the option.

What are the Classes of Options Trading?

The two classes in options trading are, ‘Puts’ and ‘Calls’. When a purchaser exercises a ‘Put’ option, the purchaser has the right (but not the responsibility) to sell a predetermined amount of the underlying asset at a certain price called the, ‘Strike Price’.

When a purchaser exercises a ‘Call’ option, the purchaser has the right to buy the predetermined amount of the underlying asset, regardless of the current market price, at the strike price before the contract terminates. The seller is legally bound under the options contract to sell the underlying asset at the contracted price and cannot demand the market price.

What are the Benefits of Options Trading?

Options trading have many benefits. The main benefit of this type of trading is leverage. The purchaser can buy the underlying asset when the price of the underlying asset is high at the agreed price rather than the market price and sell the underlying asset at the market price to make a profit.

The other benefit is protection. The purchaser is protected when the price of the original asset is low the purchaser will lose a specific quantity of the original asset at a fixed agreed price. By exercising a ‘put’ option, the purchaser can resell the original asset to the seller. Thus options’ trading has a built in insurance against the volatile movements of the market.

What is the Risks Involved in Options Trading?

Options’ trading comes with risks and is not for everyone. Options traders run the risk of losing their entire investment in a short period of time. Options, unlike assets can lose value as the date of expiration comes closer. In some cases the risks involved in options trading are caused by restrictions imposed by government regulation.

Differences between futures and options trading

1. Premium vs. margin

Options: When you buy an option you are not required to put up any margin because you are purchasing the option at a fixed price, which is also referred to as the premium. This premium can decline over the life of the option if the underlying commodity price moves against your position or remains flat. If the option isn’t exercised before expiration you will lose the premium you paid and the seller of the option will profit the amount of the premium paid.

Futures: While the premium for a futures option will waste away with time the futures contract will not. You can think of the margin on a futures contract as earnest money that will make you liable for the full amount of the futures contract. This is very risky if an offsetting position is not opened to help protect you against a negative price move.

2. Risk

Options: As an option purchaser you are only limited to the amount of the premium that you paid for the option therefore your risk is considered to be limited.

Futures: Regardless of whether you purchase a futures contract or you sell a futures contract you are liable for more than just the initial margin you were required to put up to make the trade. This makes this type of trade risk unlimited.

3. Expiration Dates

One last notable difference between futures and options trading is the expiration date of each particular contract. If you were going to exercise an option to control the underlying futures contract you should know that this has to be delivered approximately one month before the underlying futures is set to be delivered. This is for physical delivery of the commodity and doesn’t hold true for the indices, which are not physical commodities and allows the expiration dates to be the same as the delivery dates.

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