What are Futures & Options (F&O)?

What are Futures & Options (F&O)?

Financial instruments known as derivatives account for the value of other assets.  F and O in share market are two examples of derivatives from another purchase. Knowing Futures and options meaning is essential. They are derivatives of various assets like stocks, commodities, or currencies. If the price of an asset changes, the value of derivatives like futures and options will likewise fluctuate. Market participants typically join derivatives markets to profit from asset value predictions.

If the company's stock price drops, you can lose money. To hedge these risks and profit from them, you can enter into a derivative contract, which entails the futures of the stock and options on the spot market where the stock is traded. Let us understand more about futures and options meaning and how it works. 

Difference between Futures and Options

Contracts for futures and options are investment vehicles that predict how asset prices will change. However, they differ significantly in terms of the investor's obligations.

Futures Contracts: Futures contracts establish a legally binding commitment to purchase or sell an underlying asset by a certain deadline at a defined price. The investors are responsible for fulfilling this contract, regardless of the market price at expiration.

Options Contracts: Options contracts provide the buyer or seller the option, but not the obligation, to purchase or sell the underlying asset by a specified date and at a specified price. Investors can choose to let the option expire worthless or exercise it if it starts to turn a profit.

Essentially, contracts for futures demand completion, whereas contracts for options provide the flexibility to respond to market conditions.

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Table of Content

  1. Difference between Futures and Options
  2. What are Futures?
  3. Types of Futures
  4. What are Options?
  5. Types of Options
  6. Basic Terms to Know for Futures & Options Trading
  7. Who Should Invest in Futures and Options?
  8. Example of Options and Futures Trading
  9. How to Trade in Futures and Options?

What are Futures?

A futures contract is a type of derivative. This type of contract involves the buyer and seller agreeing that certain assets will be bought or sold at an agreed price in due course. You can buy futures contracts for agricultural commodities, petroleum, gold, currencies, etc.

Futures are very important to avoid price fluctuations. For example, a country that imports oil buys oil futures to protect itself from rising prices in the future. Likewise, as soon as they have sold their harvest, farmers use futures to set product prices to avoid a price fall.

Types of Futures

Let's see which kinds of futures are based on the underlying asset:

Index futures

Index futures are contracts whose underlying value is based on an index of stocks.

Currency and Commodities Future

Currency futures, also known as foreign exchange futures, allow specific quantities of currency to be purchased or sold in a specified time frame. 

Interest Futures

Interest futures are interest rate futures contracts with an underlying asset that pays interest. The buyer and seller shall agree to provide an interest-bearing asset at a specific price in the future.

Stock futures

These contracts allow you to buy or sell a specific stock group at a specified price on a particular date. Once you purchase the product, traders are bound to observe the conditions of the contract.

What are Options?

Options contracts are another type of derivative. They differ from a futures contract in that they confer the right to buy and sell an asset at a specific price but do not impose any obligations on the buyer or seller. The two options are a call option and a put option. These contracts offer flexibility for investors to hedge against risks, speculate on price movements, or generate income through premium collection. Options are traded on various assets, including stocks, commodities, and indices, and their value is derived from the price fluctuations of the underlying asset.

For example, if you own a put option to sell Company ABC shares at Rs 50 at another moment, and the share price increases to Rs 60 before the put option expiration date, you can choose not to sell the share at Rs 50. Additionally, you would not have lost INR 1,000.

Types of Options

There are two types of options trading: 

1. Call option

In call options, traders can buy the underlying financial security at an agreed price on the specified date. 

2. Put option

The put option allows you to sell your underlying financial security on a predetermined date.

Basic Terms to Know for Futures & Options Trading

Now that we understand what is F & O in stock market ,  let's study some key terms:

Underlying Security: The underlying security is crucial to F&O trading since it determines the worth of a derivative. This can include currencies, indices, commodities, equities, bonds, and interest rates.

Strike Price: The price at which the derivatives trader or contract owner agrees to purchase or sell the derivative on a certain date.

Premium: The current option price that the buyer now pays the seller. As the underlying assets become more volatile, premiums rise as well.

Expiration Date: The deadline contract owners provide for traders to act regarding their rights or responsibilities.

Who Should Invest in Futures and Options?

Investing in futures and options is possible for investors who know the stock market and thoroughly understand how to monitor it. In the F&O market, speculation is based on anticipating micro and macroeconomic factors underlying financial instruments. Traders must estimate whether the market is moving upward or downward, based on which they enter into contracts with other traders.

Futures and options are used more often by hedgers and speculators. Let's understand hedgers and speculators.

1. Speculators

When speculating, traders must make an educated guess about the market and the current economic situation in their country and industry. Unlike hedgers, speculators want to bet at long odds and are not concerned with price stability. To obtain high profits in selling, the speculator will consider buying at cheaper prices.

2. Hedgers 

In commodity markets, where prices are highly volatile, hedgers are regularly found. In the event of future price volatility, hedgers intend to protect themselves. They predict the market based on their experience and analysis to ensure their return on the underlying financial security. But the profits of future traders will be lost if prices rise in the meantime. When they buy an asset, it must be purchased at a price that is fair to the current market value.

3. Arbitrageurs

The goal of arbitrageurs is to make money off of pricing discrepancies in the market that result from flaws in the system. In futures and options trading, a price quote comprises the strike price and carry cost, with the underlying assumption being that the striking price corresponds to the contractual price. The cost of carry is the price difference that results from carrying the underlying security to a later date.

As arbitrageurs alter supply and demand patterns to reach equilibrium, they effectively eliminate price discrepancies resulting from unfavourable trading circumstances.

Example of Options and Futures Trading

Below are the 2 examples for options and futures trading that can illustrate how these financial instruments are used in practice:

Example of futures trading

Let us illustrate this with an example. Suppose, on a specific date, you bought a futures contract to buy 100 shares of Company ABC at Rs. 50 per share. You will receive these shares of Rs. 50 at the end of the agreement, irrespective of the current prevailing price. If the price goes up to Rs. 60, you'll get shares of Rs. 50, which means you'll make a nice profit of Rs. 1,000. However, you will still have to buy them at a value of Rs. 50 each if the stock price drops below Rs. 40. In this scenario, you will lose Rs. 1,000. There are other assets besides equities on which futures can be traded.

Example of Option Trading

Let's take an example where you have bought a call option to purchase 100 shares of Company ABC for Rs 50 per share on a specific date. However, when the expiry term ends and the share price drops to Rs 40 or below, you lose interest in carrying out the contract because you would lose money. You can then decide not to purchase the shares at Rs 50. Therefore, the only thing you will lose on the deal, rather than losing Rs 1,000, will be the considerably smaller premium you paid to enter the contract.

How to Trade in Futures and Options?

Follow the steps below to trade futures and options.

Step 1: You need to set up an account for buying and selling futures and options contracts to start doing business and learn how to deal with them. 

Step 2: After signing up, you can log into your account by clicking the login page. You can also access your trading account via a mobile application or the website from any computer.

Step 3: You can research what kind of future or option you have and which will best suit your needs. 

Step 4: Enter the order details when you have chosen an option. To purchase futures and options, the strike price will be applied. The strike price for the put or call options shall be the market value at which those contracts are performed. If you believe prices will increase or decrease, you'll buy a call or sell a put option.

Futures and options are tools investors can use to hedge their trading risks and leverage. Instead of being paid upfront, the brokerage business provides the deal's cost in exchange for a portion of the contract being paid as margin money. Futures and options offer the possibility of making huge profits through speculation. Still, they also raise the risk of suffering heavy losses if the assets fail to reach the predicted price level. After knowing what is F & O trading in share market, it is important to enter these markets only after thoroughly understanding the F & O meaning, securities and the effects of market volatility. A share market app called BlinkX enables investors to seamlessly monitor stock prices, execute trades, access real-time market data, and manage their investment portfolio on the go. Investors can begin by making smaller initial investments to develop experience and a better knowledge of these ideas and ultimately improve their wealth over time.

FAQs on Futures & Options

There is nothing like which is better, a Futures or Options contract. Both financial contracts have their pros and cons. Each trading contract has its risks and limitations, which any trader needs to overlook before making any trading decisions.

An option is a financial instrument that grants the buyer the right, but not the responsibility, to purchase the underlying asset at a particular price on or before a specified date, in the case of a call option, or to sell it, in the case of a put option. Options are used by traders, investors, and risk managers as a way to generate income.

A derivative is a financial contract where its value depends on the underlying asset, group of assets or benchmark. A derivative is set up between two or more entities that are capable of trading on an Exchange or over the counter.

Intraday trading is the purchase and sale of stocks in one day. These types of transactions are usually carried out by day traders who try to profit from small price movements on the market. An F&O transaction is when contracts are bought and sold for a fixed price on future dates giving you the option of buying or selling an asset.

On T+1 day and the next working day, you may withdraw funds received from the exit of your F&O position.

Future contracts are held until their expiration date.

Leverage and price volatility make F&O trading extremely risky. Among the risks are Market volatility, liquidity problems, and unexpected pricing events. Traders should only use money they can afford to lose, practise risk management techniques, and have a solid understanding of F&O products.