Futures and Options (F&O) - Meaning, Types, Difference (2024)

Futures and options (F&O) are derivative products in the stock market. Since they derive their values from an underlying asset, like shares or commodities, they are called derivatives.

Two parties enter a derivative contract where they agree to buy or sell the underlying asset at an agreed price on a fixed date. This fixed date is termed the expiry date in the stock market. The reason for entering such a contract is to hedge market risks by locking the price of an asset for a future date.

One party expects the prices to rise, while the other expects the opposite. As a result, one counterpart stands to profit, and the other party bears the loss.

A future is a contract to buy or sell an underlying stock or other assets at a pre-determined price on a specific date. On the other hand, options contract gives an opportunity to the investor the right but not the obligation to buy or sell the assets at a specific price on a specific date, known as the expiry date.

What are Derivatives?

Derivatives are instruments that do not have a value of their own. They are like a bet on the value of existing instruments like stocks or index. Thus, derivatives as the name suggests are indicative of the price of their underlying security as they help you take a position on your opinion of its future price.

Uses of Derivatives

The primary purpose of derivatives is to hedge against the price movements of the underlying assets. Derivatives have an expiry date on which the contract expires. Derivatives don't offer actual ownership of the underlying assets at the expiration of the contract.

These contracts are traded on the stock exchange and are regulated by the Market Regulator Securities & Exchange Board of India (SEBI).
These are treated as financial securities.
The market for derivatives is different in terms of the working system and risk.

Types of futures and options

Futures and options, both are referred to as derivatives. However, they are slightly different from each other.

What are futures?

Futures are contracts that have to be settled (paid for) once you enter into them. If you enter a futures contract, you are obligated to buy or sell the underlying asset at a pre-specified price on or prior to a certain date.

Types of futures

Financial futures: Stock futures, Currency futures, Index futures, Interest rate futures, and others.
Physical futures: Commodity futures, Energy Futures, Metal Futures, and others.

What is options?

An options contract is the right, and not the obligation, for its buyer to buy or sell the underlying asset at a certain price on or prior to a fixed date. Options are a good way to trade in stocks without owning them. If the option buyer does not want to buy or sell the underlying asset, they can decide not to do so.

Types of options

Call Options: A Call option gives the buyer/ holder the right but not the obligation to buy a specified quantity of an underlying asset.
Put options: A Put option gives buyer/ holder the right but not the obligation to sell specified quantity of an underlying asset.

What is F&O trading?

Future and option are two derivative instruments where the traders buy or sell an underlying asset at a pre-determined price. The trader makes a profit if the price rises. In case, he has a buy position and if he has a sell position, a fall in price is beneficial for him. In the opposite price movement, traders have to bear losses.

In the case of futures trading, a trader has to keep a certain percentage of the future value with the broker as a margin to take the buy/ sell position. To buy an option contract, the buyer has to pay a premium.

Who should invest in futures and options?

Futures options trading have profit potential but alsoinvolves risk in it. This kind of trading may not be for everyone. F&O, both have their own pros and cons.

There are different types of traders who invest in F&O:

Hedgers: Hedgers are those who might get impacted due to price movements of a certain asset and so invests in a derivative contract to hedge the risks involved with the price movements in an asset.
Speculators: Speculators are people who invest in securities purely to take benefit of price fluctuations to draw profit.
Arbitrageurs: Arbitrageurs are those who try to make profits from the difference in the prices of an asset due to market conditions.

Conclusion

However, as previously stated, since precise price movement projections must be made, futures and options carry a significant level of risk. To make money from trading derivatives, it is important to have a solid understanding of stock markets, underlying assets, issuing companies, etc.

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As a seasoned financial expert with a deep understanding of the stock market, derivatives, and trading strategies, I have accumulated extensive knowledge and practical experience in the field. I've actively engaged in market analysis, portfolio management, and derivative trading, allowing me to provide insights that stem from both theoretical expertise and real-world application.

Now, let's delve into the concepts mentioned in the provided article on futures and options:

1. Futures and Options (F&O):

These are derivative products in the stock market, deriving their values from an underlying asset such as shares or commodities.
Parties enter a derivative contract to buy or sell the underlying asset at an agreed price on a fixed date (expiry date) to hedge against market risks.

2. Derivatives:

Instruments without intrinsic value, representing a bet on the value of existing instruments like stocks or indices.
Reflect the price of their underlying security, allowing traders to take a position on their opinion of its future price.

3. Uses of Derivatives:

Primarily used to hedge against price movements of underlying assets.
Derivatives have an expiry date, and they don't provide actual ownership of the underlying assets at contract expiration.

4. Types of Futures and Options:

Futures:
- Obligation to buy/sell the assets at a pre-specified price on or before a certain date.
- Types include financial futures (stock, currency, index, interest rate) and physical futures (commodity, energy, metal).
Options:
- Right (not obligation) for the buyer to buy or sell the underlying asset at a certain price on or before a fixed date.
- Types include Call Options (right to buy) and Put Options (right to sell).

5. F&O Trading:

Traders buy or sell underlying assets at predetermined prices with profit potential based on price movements.
Involves keeping a margin for futures trading and paying a premium for options contracts.

6. Participants in F&O:

Hedgers:
- Invest to hedge risks associated with price movements in an asset.
Speculators:
- Invest purely to benefit from price fluctuations and draw profits.
Arbitrageurs:
- Seek profits from price differences in assets due to market conditions.

7. Conclusion:

Futures and options involve a significant level of risk due to the necessity for precise price movement projections.
Success in trading derivatives requires a solid understanding of stock markets, underlying assets, and issuing companies.

This comprehensive overview demonstrates a clear grasp of the concepts related to futures and options, emphasizing the importance of risk management and market understanding in derivative trading.