Futures and options: jackpots or time bombs?

Definition and Risks of Derivatives

• Derivatives are financial contracts whose value depends on the price of an underlying asset.

• The primary asset based on which a derivative’s value is derived is the underlying asset.

• Derivatives can be stocks, stock indices, or commodities such as crude oil, natural gas, gold, silver, copper etc.

Futures and Options in India

• Futures are a derivative contract where both buyers and sellers have an obligation to buy or sell an underlying asset at a predetermined price on a future date.

• Options are contracts where buyers have the right, but not an obligation, to buy or sell an underlying asset via the call or put option.

• Options are highly risky, with the premium losing value owing to the passage of time (Option Greek Theta).

Areas of Derivatives

• F&Os are not long-term assets; after the expiry of the contract, the possession of the underlying asset is not possible.

• Retail investors trade in F&Os under the assumption of diversification, but F&Os are not long-term assets.

Hedging and Leverage Risks

• Derivatives are a helpful tool for informed traders, but most retail investors enter the derivatives market without proper skill and knowledge.

• Leverage risk is one of the main risks of derivatives, allowing traders to take larger positions with a relatively small capital.

• Even a small negative movement in the price of the underlying asset can cause huge unbearable/irrecoverable losses.