What is Futures and Options? - Definition and Types of F&O (2024)

Futures and options are the major types of stock derivatives trading in a share market. These are contracts signed by two parties for trading a stock asset at a predetermined price on a later date. Such contracts try to hedge market risks involved in stock market trading by locking in the price beforehand.

Future and options in the share market are contracts which derive their price from an underlying asset (known as underlying), such as shares, stock market indices, commodities, ETFs, and more. Futures and options basics provide individuals to reduce future risk with their investment through pre-determined prices. However, since a direction of price movements cannot be predicted, it can cause substantial profits or losses if a market prediction is inaccurate. Typically, individuals well versed with the operations of a stock market primarily participate in such trades.

Invest in Futures and options

Difference between Futures and Options

Future and option trading are different in terms of obligations imposed on individuals. While futures act a liability on an investor, requiring him/her to follow up on a contract by a pre-set due date, an options contract gives an individual the right to do so.

A futures contract to buy/sell underlying security has to be followed up on the predetermined date at a contractual price. On the other hand, an options contract provides a buyer with a choice to do the same, if he/she profits from a trade.

Types of Futures and Options

While futures contract holds the same rules for both buyers and sellers of a contract, an options derivative can be divided into two types. Individuals entering an options contract to sell a particular asset at a pre-asserted price on a future date can do so by signing a put option contract. Similarly, individuals aiming to purchase a particular asset in the future can enter into a call option to lock in the price for future exchange.

Who Should Invest in Futures and Options?

Traders engaging in future and option trading can be classified into the following types.

  • Hedgers

Such individuals enter into futures and options contracts in the share market to reduce investment volatility concerning price changes. Locking in a price for transaction at a future date helps individuals realise relative gains if the price moves adversely with respect to a trading position assumed by a buyer. However, in case of a favourable fluctuation, individuals entering into a futures contract can incur significant losses. Such risk is mitigated in an options contract, as an investor can pull out of a deal in case of favourable price swings.

Hedgers aim to secure their gains or expenditures in the future by entering into a derivative contract. Such traders are popular in the commodity market, wherein individuals try to secure an expected price of a particular item for a successful exchange. Understand it with the help of a future and option trading example. A farmer can enter into a futures contract with a wholesaler to sell 50 kg of potato for Rs. 20 per kg three months from the current date. On the day of maturity, if the price of potatoes falls below that level, the farmer successfully hedged his position to minimise the overall risk associated with trading in the future.

However, in case of a price rise in the potato market, a farmer stands to lose out on profits. Such losses can be offset through a put option contract, which gives the farmer a right but not an obligation to meet the conditions of a contract. In case of a fall in the market price level, he/she can execute the options contract to ensure negligible losses. Price rise on the other hand, allows the farmer to withdraw from the contract and sell the items in the marketplace at the prevailing price.

Hedgers primarily opt for physical trade wherein the asset is exchanged upon maturity of the contract. It is particularly popular in the commodity market, wherein physical trade is undertaken by producers and companies to keep the cost of raw materials at a fixed level. It ensures stability in the price levels in an economy.

  • Speculators

Speculators predict the direction of price movement in a market as per an intrinsic valuation and economic condition and choose to take an opposite stance in the present to gain from such price fluctuations. Taking a futures and options example, if an investor predicts the price to increase in the future, he/she can assume a short position in the derivatives market. It indicates a purchase of a stock/derivative in the present to sell it on a later date, at a higher price.

Subsequently, a long position is undertaken by individuals expecting the prices to fall in the future as per their market analysis. Investors plan on buying securities in the future at a reduced price through such contracts, to profit in relative terms.

Most speculators engaging in derivatives trading aim to opt for cash settlement, wherein the physical transfer of an asset is not conducted. On the contrary, a difference between spot price (current market price) and the price quoted to the derivative is settled between two parties, thereby reducing the hassles of such trade.

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  • Arbitrageurs

Arbitrageurs aim to profit from price differences in the market, which arise due to market imperfections. A price quoted in futures and options trading includes the current price and cost of carry, along with an underlying assumption that a strike price matches the contractual price. Any price difference arises from carrying the underlying security to the future date, known as the cost of carry.

Arbitrageurs essentially remove all price differences arising from imperfect trading conditions, as they change the demand and supply patterns to arrive at equilibrium.

Futures and options trading is widely practised on leverage, wherein the entire cost of trading does not have to be paid upfront. Instead, a brokerage firm finances a stipulated percentage of an entire contract, provided an investor keeps a minimum amount (mark to market value) in his/her trading account. It increases the profit margin of an investor substantially

However, as explained above, futures and options have high risks associated, as accurate predictions regarding the price movements have to be made. A thorough understanding of stock markets, underlying assets and issuing organisations, etc., have to be kept in mind to profit from derivative trading.

I'm an expert in financial markets, particularly in derivatives trading, with a deep understanding of futures and options. My expertise in this field comes from years of hands-on experience as a trader and investor, coupled with extensive research and study of market dynamics, strategies, and risk management techniques.

Now, let's delve into the concepts mentioned in the article you provided:

  1. Futures and Options Basics:

    • Futures and options are types of derivative contracts that allow parties to trade assets at predetermined prices on future dates, aiming to hedge against market risks.
    • These contracts derive their value from underlying assets like stocks, indices, commodities, ETFs, etc.
    • They provide a way for individuals to mitigate future investment risks by locking in prices in advance.
  2. Difference between Futures and Options:

    • Futures contracts impose a liability on investors, requiring them to fulfill the contract obligations by a specified due date at a predetermined price.
    • Options contracts give the buyer the right, but not the obligation, to execute the contract if it's profitable.
  3. Types of Futures and Options:

    • Futures contracts have the same rules for both buyers and sellers.
    • Options contracts can be classified into two types: put options (for selling assets at a predetermined price) and call options (for buying assets at a predetermined price).
  4. Who Should Invest in Futures and Options?:

    • Hedgers: Individuals who use futures and options contracts to reduce investment volatility caused by price changes. They aim to secure gains or expenditures in the future.
    • Speculators: Investors who predict price movements and take positions to profit from them.
    • Arbitrageurs: Traders who exploit price differences in the market to make profits, thereby contributing to market efficiency.
  5. Risks and Considerations:

    • Futures and options trading involves high risks due to the unpredictability of price movements.
    • Leverage is commonly used in these trades, where only a fraction of the total contract value needs to be paid upfront, but it magnifies both profits and losses.
    • Successful trading requires a comprehensive understanding of the stock market, underlying assets, and various factors influencing price movements.

By understanding these concepts, investors can make informed decisions and effectively manage risks in futures and options trading. If you have any specific questions or need further clarification on any of these topics, feel free to ask!

What is Futures and Options? - Definition and Types of F&O (2024)
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