Future and Options

A futures contract is an agreement to buy or sell assets at a set price on a future date. An option gives the buyer the choice to buy or sell at a set price before a certain date.
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Future and Options
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3 mins
26 November 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.

Key Takeaways

  • The new STT (Securities Transaction Tax) rates for Futures and Options (F&O) have been revised and started on October 1.
  • The STT on futures went up from 0.0125% to 0.02%, and on options it increased from 0.0625% to 0.1%.
  • This means higher transaction costs for traders. Additionally, both BSE and NSE have introduced a uniform fee structure.

Pro tip

Invest in equities, F&O, and upcoming IPOs effortlessly by opening a Demat account online. Enjoy a free subscription for the first year with Bajaj Broking.

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What are futures?

Futures are contracts that must be settled (paid for) upon entering. 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

Futures contracts are classified based on the underlying assets they represent.

  • Commodity futures: These focus on physical goods such as crude oil, gold, and agricultural products. Traders use them for speculating on price changes or mitigating price risks.
  • Equity futures: Based on individual stocks or equity indices like the Nifty 50, they allow investors to speculate on stock price movements.
  • Currency futures: These involve trading in currency pairs, enabling participants to hedge against foreign exchange fluctuations.
  • Interest rate futures: Tracking interest rate movements, these are widely used for managing risks related to rate volatility.

Each category serves distinct roles in risk management and hedging strategies.

What are options?

An options contract is the right, but not the obligation, for its buyer to buy or sell the underlying asset at a given price on or before 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

Options are financial derivatives that come in two main forms:

  1. Call options: Grant the holder the right, but not the obligation, to buy an asset at a specified price (strike price) within a certain timeframe. These are favoured when an asset’s price is expected to rise.
  2. Put options: Provide the holder with the right to sell an asset at a predetermined price within a specific period, useful when anticipating a price decline.

Examples of options and futures

Example of futures

Imagine a trader enters into a futures contract to buy 100 shares of ABC Industries at Rs. 2,500 per share, with the contract expiring at the end of the month. If the market price at expiry is Rs. 2,600 per share, the trader earns a profit of Rs. 100 per share (Rs. 2,600 - Rs. 2,500), totalling Rs. 10,000. Conversely, if the price falls to Rs. 2,400, the trader incurs a loss of Rs. 100 per share, totalling Rs. 10,000. Both the buyer and the seller are obligated to settle the contract.

Example of options

Suppose an investor buys a call option to purchase 50 shares of XYZ Limited at Rs. 3,000 per share, paying a premium of Rs. 50 per share. If the share price rises to Rs. 3,100, the investor can exercise the option, earning a profit of Rs. 50 per share (Rs. 3,100 - Rs. 3,000) after accounting for the premium paid. The total profit would be Rs. 2,500 (50 shares x Rs. 50). If the price drops to Rs. 2,900, the investor can choose not to exercise the option, limiting the loss to the Rs. 2,500 premium paid.

Difference between futures and options

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.

Additional read: What is Fear and Greed Index

Futures and options in commodities

Investors can trade commodity futures and options through platforms like the Multi Commodity Exchange (MCX) or the National Commodity & Derivatives Exchange Limited (NCDEX) in India. While these markets offer significant leverage and opportunities for profit, they are highly volatile and better suited to those with a high-risk tolerance.

Derivatives like these help hedge against price fluctuations, promote liquidity, and provide profit potential for savvy investors.

Who should invest in futures and options?

Futures options trading have profit potential but also involves 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.
  • Arbitrageurs: Arbitrageurs are those who try to make profits from the difference in the prices of an asset due to market conditions.

Risk Management in Futures and Options Trading

Effective risk management is essential in futures and options trading to minimise potential losses. Key strategies include:

  • Position sizing: Limiting the percentage of capital risked in each trade.
  • Stop-loss orders: Setting automatic exits to cap losses.
  • Diversification: Reducing risk by spreading investments across various assets.
  • Hedging: Using derivatives to offset potential losses in other investments.
  • Leverage control: Cautiously employing leverage to avoid amplifying risks.

These measures ensure long-term financial stability by protecting against volatility.

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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Frequently asked questions

What are futures and options (F&O)?

Futures and Options (F&O) are financial derivatives traded on exchanges, and their value is derived from an underlying asset, such as stocks, commodities, currencies, or indices.

A futures contract is an agreement between two parties to buy or sell the underlying asset at a predetermined price on a specified future date. When you buy a futures contract, you are committing to pay the agreed price at the set time, regardless of the market price at that point. These contracts are typically used for hedging risks on price movements.

Options, on the other hand, grant the right but not the obligation to buy or sell the underlying asset under certain conditions, offering greater flexibility compared to futures contracts.

Is F&O trading profitable?

It is possible to be profitable in F&O trading. One reason retail investors’ interest in Future and options trading is that it is a margin base trading, that is, a higher value position can be taken by just paying a portion of the full amount.

Which is better futures or options?

The choice between futures and options depends on your financial goals, risk tolerance, and trading strategy. Both futures and options are derivatives contracts that can be used for speculation or risk management, but they have distinct characteristics:

Futures Contracts:

Obligation: Futures contracts obligate the buyer to purchase and the seller to sell the underlying asset at a specified price and date in the future.

Risk: Futures carry higher risk because you are obligated to execute the contract regardless of the market conditions.

Potential Returns: Higher potential returns but also higher potential losses.

Options Contracts:

Choice: Options provide the buyer with the choice (not obligation) to execute the contract. The seller, however, is obligated if the buyer chooses to execute.

Risk: Options offer more flexibility and lower risk because the buyer can choose not to exercise the option if it's not profitable.

Potential Returns: Lower potential returns than futures but limited risk.

How long can you hold futures?

You can hold future contracts till the expiry date.

Which is a safer future or options?

Both futures and options carry risk. Also, since these are leveraged instruments the extent of profit and loss, both are magnified.

How much money do you need to trade futures?

You can trade in the future of indexes and stocks in the stock market. Each future contract has a different contract price. The margin requirement is specified by the exchange and depends on the volatility of the underlying asset.

How do I buy futures and options?

To invest in futures and options, you would need an F&O Demat and trading account.
To invest in futures, the investor pays a margin which is a portion of the total stake to take a position. Once the margin is paid the exchange matches your order with available buyers or sellers in the market.

On the other hand, in options, the buyer of the contract selects the desired strike price and pays the respective premium to the seller of the contract. Whereas the seller of options deposits a margin to take the position.

Is future option trading good?

The answer to whether future option trading is good or not depends on an individual's investment goals, risk tolerance, and their ability to make informed trading decisions. Futures and options are complex financial instruments that come with a significant level of risk, and it's essential to do thorough research and seek professional advice before trading in them.

What is the difference between future and options trading?

The main difference between futures and options trading is that futures are a contract that obligates the buyer to purchase or sell an asset at a specified future date and price, while options give the buyer the right, but not the obligation, to purchase or sell an asset at a specified price and date.

How risky is F&O trading?

F&O trading carries significant risks due to leverage and price volatility. Risks include market fluctuations, liquidity issues, and unexpected events affecting prices. Traders should have a thorough understanding of F&O products, employ risk management strategies, and only trade with funds they can afford to lose.

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