Trading is speculating on the market price of an underlying asset without actually owning it. In simple terms, it is forecasting whether the cost of a financial asset will grow or decline. You may trade in hundreds of financial markets, including stocks, forex, commodities, indexes, bonds, etc.
In the stock market, you will come across numerous terms, and one such term is futures and options trading. Understanding key trading terms is important for new and experienced investors and traders alike. It helps you understand the stock market and how investments are made. It also improves your chances of success as an investor or trader.
Understanding Futures Trading
Futures trading is a legally binding agreement to buy or sell a commodity or security at a predetermined price on a future date.
The price and amount of the commodity are set when the agreement is made, and most contracts require actual delivery of the commodity.
However, some contracts allow cash settlement instead of delivery.
Futures contracts are traded on exchanges and require a brokerage account approved to trade futures.
Key Terminology in Futures Trading
These are the most used terms in futures trading:
Lot size
A lot size in futures is the minimum number of shares that can be traded in a futures contract. It’s a way to standardise futures and options contracts.
The stock exchange predetermines lot sizes, which can vary depending on the type of derivative and the underlying asset.
SEBI increased suggested lot sizes above Rs. 5 lakhs and added new entries to the F&O list with notional values ranging from Rs. 7.5 lakhs to Rs.10 lakhs. For example, the lot size for Nifty 50 is 50 shares.
Long position
A long position in futures, also known as a buy position, is when an investor purchases an asset with the expectation that its value will increase over time.
Investors profit if the price of the asset rises, as the price they pay will be less than the market price.
Short position
A short, also known as a short position, occurs when a trader sells securities initially to repurchase or cover them later at a cheaper price.
A trader may opt to short a security because they feel its price will fall shortly.
Hedging
Hedging in futures is a way to protect against adverse price changes by holding a futures position in anticipation of a future transaction in the cash market. Futures contracts are agreements to buy or sell assets at a future date for a predetermined price.
Hedging can be used to hedge cash market positions or any exposure to the market. There are two types of hedging:
- Long hedging: A futures contract is purchased.
- Short hedging: A futures contract is sold.
Clearinghouse
A clearinghouse is a third-party intermediary between a buyer and seller in a financial transaction, such as a futures contract.
Clearinghouses act as a counterparty to both sides of a trade, guaranteeing the performance of each transaction.
They are fundamental to the integrity and credibility of the exchange-traded futures or options market.
Backwardation
Backwardation in futures is a market condition where the cost of a commodity’s futures contract is lower than the expected spot price at contract maturity.
This means the futures contract trades at a discount to the spot price.
Understanding Options Trading
Options trading involves buying or selling a security at a predetermined price within a specific time frame.
Options are contracts that give the buyer the right to buy or sell an asset, but not the obligation, at a specific price within a set period.
Options are available on many financial products, including indices, equities, and ETFs.
Key Terminology in Options Trading
These are the most used terms in options trading:
Call option
A call option is a contract between a buyer and seller that gives the buyer the right to purchase a stock at a specific price, called the strike price, by a specific date, called the expiration date.
The buyer is not obligated to exercise the call and purchase the stock, but the seller is obligated to deliver the stock if assigned by the buyer.
Put option
A put option is a contract that grants the holder the right to sell a specified number of equity shares at a predetermined price, known as the strike price, before a specific expiration date.
If the option is exercised, the option contract writer must acquire the shares from the option holder.
Premium
The premium is the price at which the option is purchased and sold.
The option holder pays the premium to buy or sell the instrument, which grants the holder the right but not the obligation to buy the underlying asset.
The premium is paid to the seller or writer of the option, but they are obligated to sell the underlying to the buyer if they exercise their right.
Expiration date
The expiration date of an options contract is the last day the option holder can exercise the option.
The expiration date is important for both the buyer and seller of the option, as it affects the option’s value and the strategies an investor may employ.
In-the-money
A call option is “in the money” (ITM) when the stock price exceeds the strike price at expiration.
This means that the call option’s strike price is less than the underlying asset’s current market price.
Out-of-the-option
A call option is out of the money (OTM) when the underlying asset’s current market price is below the call option’s strike price.
In other words, the option holder cannot exercise the option profitably at the current market price.
At-the-money
An at-the-money (ATM) call option is a call option where the strike price is the same as the current market price of the underlying asset.
Conclusion
Finally, futures and options trading is a specialised financial market investment that offers both profit potential and risk. Understanding the complexities of F&O trading is critical for anyone trying to enter this industry.
Futures and options, as financial derivatives, have distinct procedures and risk profiles.
Options provide investors the right, but not the responsibility, to purchase or sell assets at a fixed price, whereas futures imply the obligation to buy or sell assets at a later period.
These securities allow investors to hedge their existing positions or speculate on future price changes.
If you wish to start investing and trading, open the best demat account available today and boost your portfolio.
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