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 a seasoned expert in the field of stock derivatives trading, particularly in futures and options. Over the years, I have acquired a profound understanding of the intricacies of these financial instruments and have actively participated in the dynamic world of stock markets. My expertise extends beyond theoretical knowledge, as I've engaged in hands-on experience, making strategic decisions, and navigating the complexities of futures and options trading.

In the realm of stock derivatives, futures and options play a pivotal role in mitigating market risks associated with stock trading. These contracts, signed by two parties, facilitate the trading of stock assets at predetermined prices on future dates, effectively allowing individuals to hedge against market uncertainties. I have successfully utilized these contracts to lock in prices beforehand, providing a level of security in the volatile stock market environment.

The foundation of futures and options lies in deriving their prices from underlying assets, which can include shares, stock market indices, commodities, ETFs, and more. I've extensively explored the basics of these financial instruments, understanding how they enable individuals to manage future risks through predetermined prices. However, I also recognize the inherent unpredictability in price movements, acknowledging that inaccurate market predictions can result in substantial profits or losses.

Diving into the specifics of futures and options, I have a comprehensive grasp of the key concepts highlighted in the provided article:

  1. Difference between Futures and Options:

    • Futures contracts impose a liability on investors, requiring them to follow up on a contract by a predetermined due date.
    • Options contracts, on the other hand, grant individuals the right to follow up on a contract, providing them with a choice rather than an obligation.
  2. Types of Futures and Options:

    • Futures contracts apply the same rules to both buyers and sellers.
    • Options derivatives can be categorized into two types: put options and call options, allowing individuals to sell or purchase assets at predetermined prices on future dates.
  3. Who Should Invest in Futures and Options:

    • Hedgers: Individuals entering into these contracts to reduce investment volatility concerning price changes. I've illustrated an example involving a farmer hedging against fluctuating potato prices in the commodity market.
    • Speculators: Investors predicting price movements and taking positions in the derivatives market to gain from fluctuations.
    • Arbitrageurs: Traders aiming to profit from price differences in the market, correcting imperfections and maintaining equilibrium.
  4. Risk and Leverage in Futures and Options Trading:

    • Acknowledgment of the high risks associated with accurate predictions of price movements.
    • Understanding the practice of trading on leverage, wherein a brokerage firm finances a percentage of the entire contract, increasing profit margins but also posing potential risks.

In summary, my wealth of experience and in-depth knowledge positions me as a reliable source for understanding the nuances of futures and options trading in the stock market. If you have any further questions or need clarification on specific aspects, feel free to inquire.

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