What are Futures and Options (F&O)?
The financial market is a place where different assets like stocks, commodities, and currencies are traded. The prices of these assets fluctuate due to factors like the economy, weather, political decisions, and changes in production. Events like elections, government policies, and global trends also affect these price changes. To manage these fluctuations, traders use derivatives like futures and options. These contracts allow traders to bet on future prices or protect investments from potential losses.
This article explains Futures and Options (F&O), their differences, how they work in stock and commodity markets, and who should consider investing in them.
What are Futures?
Futures contracts are legal agreements between two parties to buy or sell an asset at a predetermined price on a future date. These contracts can be used to hedge against risks or to speculate on price movements in various markets. The parties involved in a futures contract are typically the buyer, who agrees to purchase the asset, and the seller, who agrees to deliver the asset at the agreed-upon price.
For example, if you expect the price of crude oil to rise in the next three months, you might enter into a futures contract to buy 1,000 barrels of crude oil at today’s price of ₹5,000 per barrel. This locks in your purchase price for the future. If the price increases to ₹6,000 per barrel as expected, you can sell the futures contract and make a profit of ₹1,000 per barrel.
Types of Futures:
Futures contracts can be classified into two main types based on the underlying assets they represent:
- Financial Futures – These are contracts based on financial assets like stocks, indices, bonds, or interest rates. For example, Nifty futures or a particular f&o stock like State Bank of India.
- Physical Futures – These are contracts for buying or selling actual physical commodities like crude oil, gold, or agricultural products at a future date.
What are Options?
Options are also legal contracts between two parties to buy or sell an underlying asset at a predetermined price on or before a specified date. There are two types of options: Call Options, Put Options. Let’s understand each one with example:
1. Call Options
A call option gives you the right, but not the obligation, to buy an asset at a specific price (called the strike price) on or before a certain date. You pay a small fee, called a premium, to buy this right. If the asset’s price goes up, you can use the call option to buy it at the lower strike price, allowing you to make a profit.
Let’s say you expect the price of Tata Consultancy Services (TCS) stock to go up in the next three months. You buy a call option to purchase 100 shares of TCS at ₹3,500 per share, with the option expiring in three months. You pay a premium of ₹50 per share for the call option.
- If the stock price rises to ₹4,000 per share, you can use your call option to buy at ₹3,500 and sell it immediately for ₹4,000. You make a profit of ₹500 per share (₹4,000 – ₹3,500), minus the ₹50 premium, leaving you with ₹450 profit per share.
- If the stock price stays the same or falls, you can let the option expire and only lose the ₹50 premium you paid per share.
2. Put Options
A put option gives you the right, but not the obligation, to sell an asset at a specific price (strike price) on or before a certain date. You pay a premium to buy this right. If the asset’s price goes down, you can use the put option to sell it at the higher strike price, making a profit.
Now, imagine you think the price of Infosys stock will drop over the next two months. You buy a put option to sell 100 shares of Infosys at ₹1,500 per share, with the option expiring in two months. You pay a premium of ₹40 per share for the put option.
- If the stock price drops to ₹1,300 per share, you can use your put option to sell at ₹1,500 and buy it back at ₹1,300, making a profit of ₹200 per share (₹1,500 – ₹1,300), minus the ₹40 premium, leaving you with ₹160 profit per share.
- If the stock price rises or stays the same, you can let the option expire and lose only the ₹40 premium per share.
Difference Between Futures and Options
While both futures and options are financial derivatives used for hedging or speculation, they have key differences:
| Feature | Futures | Options |
|---|---|---|
| Obligation | Both parties (buyer and seller) must fulfill the contract. | Buyer has the right but not the obligation. |
| Risk | Risk of unlimited loss if the market moves against you. | Risk is limited to the premium paid. |
| Cost | No upfront cost (unless using margin). | Premium is paid upfront to purchase the option. |
| Profit Potential | Profit or loss is determined by the difference between the contract price and the market price. | Profit potential depends on the difference between the strike price and the market price, minus the premium paid. |
| Expiration | Futures contracts have a fixed expiration date. | Options can expire on or before the expiration date. |
Futures and Options Trading in the Stock Market
On June 4, 2001, the Exchange began trading in Index Options, including those based on the Nifty 50. Then, on July 2, 2001, NSE became the first exchange to offer trading in options for individual securities. Later, on November 9, 2001, futures for individual securities were introduced.
Before this, futures and options trading was mainly limited to commodities. With the launch of F&O trading, the NSE opened up opportunities for traders to hedge, speculate, and gain exposure to stock prices without directly owning the underlying assets.
One of the key advantages of trading futures and options is that you don’t need to own the asset to profit from its price movement. For example, if you want to invest ₹5 lakh in a stock, you may only need ₹1 lakh as a margin, if the leverage is 5x. This means you can control a bigger position with less money upfront.
However, it’s important to remember that the larger the margin, the larger the potential profit or loss. Since leverage makes your trade bigger, both your profits and losses can be much higher. If the price moves in your favor, you can make big profits, but if it moves against you, the losses can also be large. So, while leverage gives you a chance to earn more, it also increases your risk.
Future and Options Trading in Commodity Markets
Futures and options are not limited to stocks or indices; they are also widely used in commodity markets. These contracts provide traders and investors a way to manage price risks or speculate on price movements in commodities like gold, crude oil, natural gas, agricultural products, and more.
In India, commodities are traded on specialized exchanges like MCX (Multi Commodity Exchange) and NCDEX (National Commodity and Derivatives Exchange). Both exchanges started operations in November 2003 and December 2003, respectively, and are regulated by the Securities and Exchange Board of India (SEBI).
You can trade commodity futures and options contracts using the same demat and trading accounts you use for stocks. If you don’t have one yet, you can easily open a free demat account with Findoc in just 5 minutes. Once your account is set up, you can start trading in commodity futures and options.
Who can invest in Futures and Options?
Futures and options are useful instruments for different types of investors, depending on their goals and strategies. The main types of investors in the F&O market are hedgers, speculators, and arbitrageurs. Let’s understand how each type of investor operates:
1. Hedgers:
Hedgers use futures and options to protect themselves from price fluctuations. They typically have an existing position in an asset and want to protect it from price changes that could negatively impact them.
For example, A farmer growing wheat knows that prices can fluctuate. To protect against a price drop by harvest time, the farmer enters into a futures contract to sell wheat at today’s price for delivery in three months. This locks in the selling price, ensuring the farmer will sell at the agreed price, no matter how the price changes. Even if prices fall, the farmer avoids the loss.
2. Speculators:
Speculators are investors who use futures and options to profit from price movements in the market. Unlike hedgers, speculators do not own the underlying asset; they are simply betting on whether the price of an asset will rise or fall.
For example, if you believe crude oil prices will rise due to increased global demand, you might buy a futures contract at ₹5,000 per barrel, set to expire in three months. If the price rises to ₹6,000 per barrel, you can sell the contract for a ₹1,000 profit per barrel. However, if the price drops, you will face a loss. Speculators take on higher risk, but the reward is the potential to profit from price changes.
3. Arbitrageurs:
Arbitrageurs take advantage of price differences between two or more markets by simultaneously buying and selling the same asset at different prices. They look for discrepancies in prices and aim to make a profit from those differences.
For example, If there is a price difference for a product between two exchanges, an arbitrageur can buy the product at the lower price on one exchange and sell it at the higher price on the other exchange. This allows them to make a profit from the price difference, without taking on any price risk, as both transactions happen almost simultaneously. However, such opportunities are short-lived and require quick execution and constant market monitoring.