Futures and Options (F&O) – A Beginner’s Guide with Example

September 30, 2022January 16, 2023 Shyam Kumar 0 Comments

Futures and Options (F&O), also commonly called ‘Derivatives’, are financial contracts, which derives its value from an underlying asset. A Future is a contract to buy or sell an underlying stock or other asset 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.

The concepts related to derivatives are vast and have many nuances. We encourage you to read the following modules on Varsity to understand the concepts better.

There are two types of derivatives:

What are futures?

First type of derivative is the Future contract. In this type of contract, a buyer (or seller) agrees to buy (or sell) a certain quantity of a particular asset, at a specific price at a future date.

Example:

Suppose you bought a future contract to buy 100 shares of ABC Company at Rs 100 each. Once the contract expires, you will get those at Rs 100 each, irrespective of increase or decrease in the current price. If the price goes up to Rs 110, then you will have profit of Rs. 1,000 and if the price goes down by Rs. 10 each share then you will bear loss of Rs 1000.

Stocks are not the only asset in which futures are available. You can get futures contracts for agricultural commodities, petroleum, gold, currency etc. In simple words, An electronic shop buys electronics items in winter in order to make profits in summer. Similarly country like India that is importing oil, for instance, will buy oil futures to insulate itself from price increases in the future.

Types Of Futures:

Financial Futures: Stock futures, currency futures, Index futures.
Currency Futures: Commodity futures, Energy futures.

What are options?

Second type of derivative is the options contract. This is a little different from a futures contract in that it gives a buyer (or seller) the right, but not the obligation, to buy (or sell) a particular asset at a certain price at a specific pre-determined date.

Types Of Options:

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

Example:

Suppose you bought a call option to buy 100 shares of ABC Company at Rs 100 each. But once your trade has been executed and the share price falls below 90 then you will be bearing Rs 1000 loss in case of share purchase but however you have the right not to buy the share at Rs 100, and instead of losing Rs 1,000 on the deal, your only losses will be the premium paid to enter into the contract, which will be much lower.

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

Example:

For instance, if you have a put option to sell shares of Company ABC at Rs 50 at a future date, and share prices rise to Rs 60 before the expiry date, you have the option of not selling the share for Rs 50. So you would have avoided a loss of Rs 1,000.

An options investor may purchase a call option for a premium of Rs. 5 per contract with a strike price of Rs.100 expiring in November 2022. The holder of this call has a bullish view on stock and has the right to assume the underlying stock futures position until the option expires after the market closes on July 30, 2020. If the price of stock rises above the strike price of Rs.100, the investor will exercise the right to buy the futures contract. Otherwise, the investor will allow the options contract to expire. The maximum loss is the Rs.3 premium paid for the contract.

The investor may instead decide to buy a futures contract on stocks. One futures contract has as its underlying asset as 100 stocks. This means the buyer is obligated to accept 100 stocks from the seller on the delivery date specified in the futures contract. Let’s assume the trader has no interest in actually owning the stocks, the contract will be sold before the delivery date or rolled over to a new futures contract.

Also Read: How To Buy Shares [Complete Guide]

Futures and Options:

Investors can use futures and options as a form of leverage or hedging the risks while trading. The cost of such trade is not to be paid upfront but is provided by the brokerage firm by paying them a percentage of the contract as margin money. Futures and options provide the potential to gain huge profits through speculations but also can increase the potential for huge losses if the estimated price level is not reached by the securities.

It is therefore essential to enter these markets after careful understanding of the securities and the impact of market fluctuations. Investors can start by investing in smaller quantities to gain experience and understanding of these concepts to eventually increase their wealth in the long run.