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How do Futures and Options Work?

How do Futures and Options Work?

With increased market volatility, the chances of price fluctuations are high. Market fluctuations may cause a change in the price of commodities, currencies, and securities, among others. One of the most effective ways to tackle market fluctuations is through hedging.

Hedging is basically an investment strategy deployed to lower the risk of adverse price movements of a particular asset. Investors use derivatives as an effective hedging tool. Such a financial security does not have its own independent value. Its value is determined on the value of an underlying asset.

Out of the numerous types, futures and options are the most common and popular ones. It is important to understand the process of functioning of both the types while trading in the capital market.

Understanding futures and its functioning

Futures trading is an agreement between the buyer and the seller, wherein the buyer has the obligation to purchase a security, and the seller has an obligation to sell the asset, at a specified future date and price. Every futures contract represents a specific amount of a security, commodity, or any financial instrument.

It is imperative to know that some future contracts are settled in cash, while some require physical delivery of the asset. You may also note that such a contract can be on an index or stock. Hence, if you buy a stock future, it indicates that you have purchased the stock with an obligation to pay at a future date. Similarly, if you sell a stock future, it indicates that you are under the obligation to deliver the stock to the buyer at a specified future date and price.

About options and its functioning

An options contract is an agreement between two parties wherein the buyer does not have the obligation, but the right, to purchase or sell the security at a fixed price on a specific date or during a certain period of time.Options are oftwo types, namely call and put. The right to purchase the underlying asset for a particular amountis known as call option, whereas in a put option, the underlying asset can be sold at a particular price.

In an options contract, the buyer enjoys majority of power. It is his choice whether to conclude the transaction or not.Once the contract expires, the buyer decides if he wishes to make use of the option or not. In such a transaction, therefore, there is no obligation to meet the terms of the contract as a premium is paid for buying the option. This helps limit losses to a certain extent.

It is necessary to know the functioning process of both the aforementioned types of the derivatives market. By having a proper understanding, you may make sound investing decisions.


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