What are Futures and Options

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First to understand F&O i.e. Future and Options we need to understand what is hedging?

Hedging is an activity which is carried out to reduce or limit a risk against an event .
Let me elaborate with the following examples

Example 1

Say you had a bet with your friend [Say Friend A] that it will rain after 2 days. You had a bet of Rs.100.The next day it becomes cloudy you feel that you will loose the bet.

However there is another friend [Friend B] who believes that due to these clouds it will rain today but will not rain tomorrow. He is willing to bet Rs.50.

So you bet with friend B that it will not rain hence you have reduced your potential loss from Rs.100 to Rs.50 .However in doing do you have also reduced the profit.

So if it rains you get Rs.50 from friend B and pay Rs.100 to friend A.
Thus losing Rs100-50 = 50 rupees.

Now lets take a case when it does not rain so you win Rs.100 & lose 50 Hence a net profit of Rs.50

Example 2

A more practical example is that of airline industry where you know the approximate business in the future and expect the oil price to rise one enters in to a contract that he will buy the oil at Rs. X per barrel. This helps him to manage his finance with more reliability and accuracy. The down side being that if the price decreases then he has to pay higher price as compared to his competitors.

Hence Futures and Options are risk management tool’s its when one enters an oil contract with an intention to sell or book profits the same tools become speculative tool.

This is dangerous when it is done without fully understanding the potential losses.

One of the reasons why sub prime in US occurred was due to the “ leveraging “ option available with the various institutions It’s like you have a job so you take a personal loan and buy an asset on that asset, say a house you take another loan .Thus you have leveraged twice the loan amount you can actually pay.

Even in future and options in stock market you just pay the margin money [the maximum money you can loose or profit like Rs.50 ] & you can trade on much more than the margin amount you can trade Rs.100 in the above example.

As a financial planner’s that an individual should be prepared to loose 100% of the money & this amount should not be included in the financial planning process. This is speculation and Presha Investments does not endorse speculation

We have explained Futures in this article
A related post on Futures and Options coming soon