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Derivatives Market: A Detailed Guide On Futures And Options For Beginners

Derivatives Market: A Detailed Guide On Futures And Options For Beginners

Last Updated on: 7th March 2022, 09:19 am

Using Futures and options, whether together or separately, provides a large number of trading opportunities and massive returns. They are the best way to hedge your trades against risk. However, it is essential to go through all concepts and terminologies before entering the derivatives market. This guide presents everything you require to know about futures and options. We will wrap up the article by providing you with a reliable broker list with whom you can trade without fear. 

What is the derivatives market?  

A derivative is an agreement signed between two or more individuals whose value and expiry time are determined beforehand. Some of the most commonly traded derivative instruments include commodities, interest rates, bonds, currencies, stocks, and market indexes. There are four primary types of derivatives market participants, including arbitrageurs, hedgers, speculators, and margin investors. There are four primary kinds of derivative agreements: futures, options, swaps, and forwards. 

Who are speculators in the derivatives market?

We can divide derivatives market participants into four broad categories: 

 1) Hedgers 

Hedging is when a trader spends in the financial market to mitigate or eliminate the risk due to price volatility or sudden price shift in the market. Derivatives are the most popular tools in the arena of hedging. It is due to the fact that they are effective hedges in accord with their related underlying security. 

2) Speculators 

Speculation is the most widely used financial market activity in which traders participate. However, it is the riskiest activity that traders pursue. The activity involves buying any financial tools or security that a trader speculates to turn remarkably worthy in the future. It is done to earn extraordinary gains in the future. 

3) Arbitrageurs 

Arbitrage is a popular activity for making a profit in the financial markets. It proceeds by profiting or taking benefit from the market or price volatility. These types of participants earn massive returns from the difference in the price of a financial tool (the one in which traders invest money) such as derivatives, stocks, bonds, and several others. 

4) Margin investors 

In the financial arena, margin refers to the collateral deposited by a trader spending in a trading asset to the counter party to balance the risk linked with the investment. 

Key Terminologies of the derivatives market 

Here are some popular terminologies of the derivatives market which will help you while trading. 

1) Call option: The call option is a financial agreement that does not oblige but provides the owner with the right to purchase a particular amount of underlying assets at a fixed price on maturity or predetermined future date. 

2) Forward contracts: An OTC (or over the counter) obligation to sell and buy underlying financial assets. It is settled between the two parties. 

3) Futures Contracts: It is an exchange-traded obligation to sell or purchase any financial asset. 

4) Hedging: It is a transaction that compensates for the risk or fluctuation in the market price of some other agreements. 

5) Options: It is a legal contract where the trader is not obliged but has the right to purchase and sell an underlying security at a fixed price on a set future date or expiration date. 

6) Premium: It refers to the price linked with the derivative agreement, referring to the union of time value and intrinsic value. 

7) Put option: A put option refers to a financial agreement that provides the right (but the trader is not obliged) to the owner to sell a specific amount of the underlying asset at a fixed price. 

8) Spot price: The spot price is the value of delivery in the cash market. This delivery is done using the standard financial market convention. 

9) Strike price: Strike price is the value at which the derivative agreement holder exercises his right. 

What is the futures contract in the derivatives market? 

The futures market comes under the derivatives markets, and traders use them for trading futures agreements. A futures aggregate is a legal contract signed between seller and buyer to sell or buy securities such as stock, currency, commodity, etc. The price and the expiration date for selling and buying assets are decided beforehand.

This type of trading is common in the commodity market. For instance, if a trader purchases a May brent oil futures agreement (BL). It means that he/she is aggreging on the fact that he/she will buy 2,000 barrels of Brent oil at a fixed or agreed price on the expiration date (May). He/she is obliged to buy irrespective of whether the market price of oil surges or declines on the expiration date. 

Similarly, the seller agrees to sell 2,000 barrels of Brent oil at a fixed or decided price. Unless either party trades their agreement to another seller or purchaser by that expiration date, the initial seller will provide 2,000 barrels of Brent oil to the initial purchaser. 

We mentioned earlier that these contract types are common in commodity trading, but it is not confined to this market. Investors use them to buy stock in a firm, forex pairs, index funds, and several others. Regardless of price, product, situation, the seller and buyer are obliged to meet the contract’s requirements at the end of the expiry. 

Note: Futures contracts and futures are the same. 

Famous futures markets and their symbols 

Traders can trade futures contracts with a financial service provider. Some of the famous and reliable financial service providers include HFTrading, T1markets, and GlobalTradeATF. Here is the list of some popular futures markets traded by investors. 

  1. E-mini S&P 500 or ES index futures
  2. British pound to United States dollar or 6B futures 
  3. 5,000 SI or troy ounces silver futures 
  4. 1,000 barrels CL or crude oil futures 
  5. E-mini Dow (Dow Jones Industrial Average) or YM futures 
  6. Euro to the United States dollar or 6E futures
  7. 100 GC or troy ounces future 

A letter and number succeed symbol for the futures agreement. The number reflects the expiration year, and the letter reflects the month in which the future agreement expires. For instance, a buyer takes an ES contract. If it expires in June, then we will use code ‘M’. If it expires in March, we will use code ‘H’. Similarly, for December and September, the codes are ‘Z’ and ‘U’. 

For instance, an ES agreement with the expiry month of December and the expiry year of 2019 will have the symbol ESZ9. Some charts or broker’s platforms may display the last two digits of the expiry month, such as ESZ19.  

What are the options contracts in the derivatives market? 

An option contract is a derivative or legal agreement signed between two parties (buyer and seller). Here, the individual is not obliged but has the right to sell or purchase the underlying security on an expiration date (fixed beforehand) at a predetermined price. This value is referred to as the strike price. There are two types of options: puts and calls (described in the terminologies given above). 

One can exercise United States options any time before the date of expiration. The European options are a bit different. Here, traders can only exercise the contract on the expiration date. To trade with an option contract, the purchaser pays an option amount known as a premium.

How to read the symbol of options contracts? 

The symbol of options seems to be pretty confusing. Let’s take an example to understand what it represents. BAC140519C00700000. 

There are six parts in this single symbol: options root, year, month, expiration date, kind of option, and strike price. The detail of each part is as follows:  

1) Option root- BAC- The first three letters in the above example represents options root. It is mainly between one to six characters reflecting the underlying security. In this case, the underlying security is Bank of America Corporation 

2) Year- 14- These two letters indicate the year in which the options contract will expire. In this example, the expiration year is 2014. 

3) Month- 05- The succeeding letter of the year indicates the month in which the options contract will expire. The Bank of America Corporation share will expire in May. 

4) Expiration date- 19- There two letters indicate that the options contract will expire on this date. Typically speaking, the options contract expires on the third Saturday of every month. However, because the financial market remains close on Saturday, the contact will expire on Friday (one day before). In the above example, technically, the options will expire on May 19, 2014. 

5) Kind of option- C- The character represents whether the contact is put or call. P indicates put options, and C shows a call option. 

6) Strike price- 00700000: The last is the strike price and comprises one to nine numbers. The last four numbers reflect the strike decimal. The first five numbers represent the strike dollar. In this particular example, the chain demonstrates that the Bank of America Corporation’s strike price is $700. 

Similarities between options and futures 

There are some similarities between options and futures. 

1) Derivative products: Both of these are derivative products that mean you can trade any underlying financial market without actually taking ownership of the concerned security. 

2) Speculative: You can sell and buy both of these at the underlying financial market price. Trading on financial markets that are falling and rising in value. 

3) Leveraged: Through this leverage, you can trade a relatively larger asset by paying only a small percentage of the total price. But, remember that margin trading is risky. Margin is a double-ended sword. It enhances losses along with profits. So, it will help if you take care. 

Note: It is essential to note that when traders trade futures or options contracts with the broker, they are actually opening a CFD position or a spread bet on the underlying financial market.

What is Difference between futures and options?

1) Date of expiration

Futures contract: Yes, there are many expiration dates of futures contracts throughout the year. 

Options contract: Yes, there are quarterly, monthly, weekly and daily expiries of options contact. 

2) Asset class available for trading 

Futures contract: Indices, bonds, commodities, and forex

Options contract:  Indices, bonds, commodities, and forex

3) Obligation to trade 

Futures contract: Yes, you are obliged to settle trade on the expiry date with futures contracts. You can select between cash or physical settlement. 

Options contract: Here, in the options contract, you are not obliged to settle the trade. You have the authority to choose between cash and physical settlement.

4) Medium of exchange

Futures contract: Exchange-traded 

Options contract: Over the counter or Exchange-traded 

Derivative alternatives to options and forex 

There are many ways to meditate on the spot price of markets through CFD trading and spread betting. 

Spread betting

Spread betting is a type of trading in the derivatives market where investors do not own an asset. Rather, they bet on these assets, such as commodities and stocks. These traders bet on the future price of a given security, whether the prices will surge or decline in the future. They bet using the price provided by the financial service provider. 

For spread betting in the stock market, traders quote two prices. The buying or bid price and selling or ask price. The difference between these two values is known as the spread. These spreads are the major source of earning for financial service providers. Thus, all trades in spread betting are commission-free. Major benefits of spread trading include a wide range of markets, leverage trading, the ability to go short and long on trade, tax advantages, and several others. 

CFD trading

CFD or contract for difference is just like a legal agreement signed between two parties: the seller and buyer. It designates that the contract’s purchaser must pay the difference between the present value of security and its worth when the seller signed the agreement. The major advantage of trading CFD is that it provides traders with an opportunity to earn massive returns from the price shifts without actually holding the underlying security. The overall CFD value only includes the price shifts between the exit and entry points in trade rather than the underlying securities value. 

It is fulfilled by an agreement between the customer and financial services provider and does not employ any forex, futures exchange, stocks, and commodity. There are many benefits of CFD trading. It is the major reason behind its increasing popularity. The United States of America does not permit a contract for different trading. CFDs are generally permitted in listed OTC financial markets in several countries, including New Zealand, Norway, Belgium, Germany, UK, Singapore, France, South Africa, France, Canada, Hong Kong, Italy, Denmark, Switzerland, Sweden, Netherland, and Thailand. 

Advantages and disadvantages of futures and options through derivatives

Advantages of futures and options with spread bets 

  1. There is no requirement for paying stamp duty or capital gains tax. 
  2. It entirely deals with declining and surging prices.
  3. You can trade 24 hours a day. 
  4. You can trade on leverage. 
  5. With the broker, you do not need to pay a commission.
  6. Brokerage firms entirely earn through spreads. 

Disadvantages of futures and options with spread bets 

  1. Leveraged trading is extremely risky. There is no doubt that it enhances your profits, but it also enhances your losses. 
  2. In the high volatility, condition spreads may widen. 

Advantages of futures and options with CFDs 

  1. There is no requirement to pay capital gains tax. 
  2. You can trade 24 hours a day. 
  3. It entirely deals with declining and surging prices.
  4. You can trade on leverage. 
  5. You can offset losses against the gains for tax purposes. 

Disadvantages of futures and options with CFDs

  1. Leveraged trading is extremely risky. There is no doubt that it enhances your profits, but it also enhances your losses. 
  2. You are required to pay stamp duty or charges on your returns. 

How can you start trading in the derivatives market? 

You will require a broker to start trading in the derivatives market. The derivative broker is the one who assists and guides traders and firms on how to sell and buy derivatives. It also provides traders with all advanced tools and platforms to make financial trading easy going. There are all types of financial service providers in the market, fake ones and authentic ones. It is on you whether you can differentiate between them or not. With a fake firm, you can lose your entire hard-earned money. So, it is necessary to keep each step carefully. 

You can go with T1markets. It is a reliable broker and best for trading derivatives. The steps for opening an account with the broker are:

  1. Register yourself
  2. Upload documents
  3. Choose asset and account type 
  4. Deposit the fee
  5. Start trading

The Bottom Line

Derivatives market trading needs are a deep understanding of the market and products. It requires expertise and research. It is vital on the trader’s part to conduct thorough market research regarding the entire mechanism and make effective trading strategies to mitigate losses and enhance profits.

There are various financial services providers which offer top research tools for determining precise exit and entry points. You can go with one of the reliable and legitimate firms, T1markets. The broker works under the Cyprus Securities and Exchange Commission guidelines and offers tools such as economic calendar, report season calendar, latest financial news, and trading signals. The minimum deposit to open a trade with the broker is just $250. 

Frequently asked questions 

What are derivatives in stock market?

A derivative is an agreement signed between two or more individuals whose value and expiry time is determined beforehand. Some commonly traded derivatives include commodities, bonds, currencies, stocks, etc. 

What is the strike price?

A strike price is a value at which the derivative agreement holder exercises his right. 

What are the options contracts?

An option contract is a derivative or legal agreement signed between two parties (buyer and seller). The individuals are not obliged but have the right to sell or purchase the underlying security on an expiration date (fixed beforehand) at a fixed price.

Where can I trade derivatives?

You can trade derivatives with top brokers such as T1markets. It is a legitimate firm working under the guidelines of the Cyprus Securities and Exchange Commission. The minimum deposit of the firm is $250.

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