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. Theyare 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.
Future and Options and their types
Futures and options, both are referred to as derivatives. However, they are slightly different from each other.
In future contract, the buyer has the obligation to buy/ sell the assets. Whereas, in option contract, customers have no obligation to buy or sell the assets. Given below is a detailed difference betweenFuture and options and their types:
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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
- 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, 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
- 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.
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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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