What is Future Option?
A future option is a type of contract that gives a trader the right to buy or sell a futures contract at a pre-agreed price on a specific date. Essentially, this contract, also known as an option on futures, lets you trade the underlying futures contract at a predetermined price when it expires.
In India, these options typically expire on the last Thursday of every month, which means you need to be aware of approaching deadlines. Unlike futures, which obligate both parties to trade at a set price on a specific date, an option offers flexibility.
You can decide whether or not to execute the trade based on the terms and market conditions when the expiration date arrives. This right to choose, without an obligation to act, gives options their unique appeal in trading strategies.
Future option contracts stand out because they derive their value from another derivative. To clarify, an option gains its value from the futures contract it’s tied to, while the futures contract derives its value from underlying assets like commodities, bonds, indices, or stocks.
This makes future options a “derivative of a derivative,” adding complexity but also opportunity for traders. You can choose between call or put contracts, which may involve assets such as commodities, stocks, or interest rates, providing diverse strategies for potential gains.
Different Types of Future Options
1. Options on Index Futures
An option contract on index futures gives you the right to buy or sell a specific index future, such as the Nifty 50 or S&P BSE Sensex, at a mutually agreed price on a predetermined date, known as the contract’s expiration date.
For example, you might hold the right to buy Nifty futures at 23,800 points when the contract expires. If the Nifty trades above 23,800 at that time, you can execute the trade and potentially earn a profit.
2. Options on Currency Futures
Currency futures options let you trade futures contracts involving currency pairs at pre-set prices upon expiration. In India, exchanges like the NSE offer trading in currencies like the US Dollar (USD), Euro (EUR), Great Britain Pound (GBP), and Japanese Yen (JPY).
For instance, suppose you buy an option to trade a USD futures contract at ₹84/$. If the market price exceeds ₹84/$ at expiration, you stand to profit by exercising the option.
3. Future Options in the Share Market
Future options in the share market, or options on stock futures, give you the right to buy (via a call option) or sell (via a put option) a stock futures contract at predetermined prices when the contract matures.
For example, let’s say you have a call option to buy Reliance Industries futures at ₹1,400 per share. If the market price rises above ₹1,400, you can exercise your option to profit from the difference.
Conversely, if you hold a put option, you can sell Reliance shares at ₹1,400, safeguarding against any decline in the market price.
Stock futures involve binding contracts between buyers and sellers to trade shares at specific prices on predetermined dates. These contracts serve as tools for speculation, hedging, and strategic trading.
4. Options on Interest Rate Futures
Interest rate futures options give you the right to buy or sell interest rate futures contracts at a mutually fixed price. These contracts often involve government bonds or treasury bills (T-bills) as their underlying assets.
For example, you might purchase an option to trade a government bond futures contract at a 7% interest rate. This strategy helps you manage risk if market interest rates fluctuate significantly.
What is a Call Future Option?
A Call Future Option is a type of financial contract that gives the buyer the right, but not the obligation, to buy a futures contract either a currency, commodity or stock futures at a specified price (known as the strike price) on the date of options expiry.
When you buy a call option, you take a long position, which means you can exercise your right to buy the underlying asset if the strike price is below the current market price of the futures. By purchasing a call option, you gain the right to buy, which you may choose to exercise or not on the expiration date, depending on market conditions. This right comes at the cost of a premium, which you pay upfront.
How Does a Call Option work in Futures?
A call future option gives the buyer the right, but not the obligation, to purchase a futures contract at a specified price (strike price) on or before a specific date. In essence, it allows traders to speculate on the future direction of an asset with limited risk while providing the potential for high rewards.
When a trader buys a call option, they are bullish on the underlying asset and believe its price will increase. Conversely, the seller of the call option is typically bearish or has a neutral stance, expecting the price to remain steady or decline.
For Example, let’s say Trader A holds a bullish opinion that the Nifty index, currently trading at 19,500, will rise over the next month. Trader A decides to buy a Nifty call option with a strike price of 20,000, expiring in one month, for a premium of ₹100 per unit.
Scenario 1: Nifty Rises
If the Nifty index climbs to 20,500 before the option’s expiration date, Trader A can exercise the call option. They effectively purchase Nifty futures at 20,000, below the market level of 20,500. This yields a profit of 500 points per unit, minus the ₹100 premium paid, giving a net gain of 400 points per unit.
Scenario 2: Nifty Falls or Stays Below 20,000
If the Nifty index remains at 19,500 or declines, the call option becomes worthless since buying at the strike price of 20,000 would not make financial sense. In this case, Trader A would choose not to exercise the option, limiting their loss to the ₹100 premium paid.
In this example, Trader A’s bullish outlook on the Nifty index allows them to potentially profit from a market rise, while their risk is capped at the initial premium spent on purchasing the call option.
What is a Put Future Option ?
How Does a Put Option Work in Futures?
A put future option gives the buyer the right, but not the obligation, to sell a futures contract at a specified strike price on or before a particular expiration date. Traders use put options when they have a bearish view on an asset, allowing them to profit if the price of the asset declines while limiting their losses to the premium paid for the option.
For example, let’s say Trader A holds a bearish opinion that the Nifty index, currently trading at 19,500, will drop over the next month. Trader A purchases a Nifty put option with a strike price of 19,000, expiring in one month, for a premium of ₹100 per unit.
Scenario 1: Nifty Falls
If the Nifty index drops to 18,500 before the option expires, Trader A can exercise the put option. They sell Nifty futures at 19,000, which is higher than the current market price of 18,500. This results in a profit of 500 points per unit, minus the ₹100 premium paid, giving a net gain of 400 points per unit.
Scenario 2: Nifty Rises or Stays Above 19,000
If the Nifty index rises to 20,000 or remains above the strike price of 19,000, the put option becomes worthless because it’s more profitable to sell at the higher market price. In this case, Trader A would not exercise the option, limiting their loss to the ₹100 premium they paid.
In this example, Trader A’s bearish outlook on the Nifty index allows them to potentially profit from a market decline, with the risk being capped at the initial premium spent on purchasing the put option.
Difference between Futures and Options
Futures and options are two important types of derivatives in the share market, but they function differently. A futures contract is a binding agreement between the buyer and seller to buy or sell an asset at a fixed price on a specific future date. Both sides must complete the trade even if the market price changes, which can lead to higher risk or gain.
An option contract, or a future option, offers more flexibility. It gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a set price within a certain time. In the case of stock options futures, traders can decide whether to exercise the contract depending on current market trends, allowing them to manage potential profit and limit losses to the option cost.
Who Should Invest in Futures and Options?
Futures and options trading are not suited for every investor. These instruments are ideal for individuals who understand market movements and aim to manage risk or capitalise on changing price trends. Generally, three main types of participants engage in derivatives trading:
Hedgers
Hedgers use futures and options to reduce the effect of unfavourable price changes on their investments. For instance, a farmer may fix a selling price through a futures contract to avoid losses if crop prices fall. Similarly, stock investors may use a future option or put option to limit possible declines in their holdings. By setting prices in advance, hedgers maintain stability and reduce uncertainty in their returns.
Speculators
Speculators aim to profit from expected market movements. They may buy call options if prices are likely to rise or take short positions if they expect a fall. Although this approach carries a higher risk, it also provides opportunities for significant gains. Access to accurate data and research tools is crucial for these traders to make well-informed decisions.
Arbitrageurs
Arbitrageurs benefit from price differences between the spot and derivative markets. By buying in one market and selling in another, they help maintain balanced pricing. Efficient platforms and timely trade execution are essential for such investors to capture these brief market opportunities.
Conclusion
Futures and options are powerful derivatives that help traders hedge, speculate, and balance risks effectively. While futures impose obligations, options offer flexibility to act when profitable. With their potential for both protection and profit, these instruments demand knowledge and discipline. Findoc helps investors with technology, research, and advisory services, making futures and options trading more accessible and efficient. By leveraging Findoc’s expertise, traders can manage risks smartly and tap into opportunities in India’s growing derivatives market.
Frequently Asked Questions
A future option is a derivative contract where buyers gain the right, but not the obligation, to trade an underlying asset at a predetermined price before expiry.
F&O trading can be profitable if done with proper strategies, research, and discipline. However, high risks and market volatility mean profits are not guaranteed for all traders.
To trade F&O, open a Demat and trading account, analyse market trends, choose futures or options contracts, pay margin or premium, and execute trades via a broker.
Yes, F&O trading carries significant risk due to leverage, market volatility, and time-bound contracts. Without knowledge and risk management, traders may lose more than their initial investment.
Options are often better than futures because they provide flexibility. Buyers have the right, not obligation, to exercise, limiting losses to premiums paid, unlike binding futures contracts.
F&O value refers to the notional worth of a futures or options contract, determined by the underlying asset’s price, contract size, and agreed strike or settlement terms.