Future and Options (F&O) – Meaning, Types, and Difference

Futures and Options are the major types of stock derivatives trading in a share market. Read on to know more about F&O.
Future and Options (F&O) – Meaning, Types, and Difference
3 mins
12 Nov 2023

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. They are 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 between Future 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 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.
  • 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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Frequently asked questions

What are futures and options (F&O)? Explain with examples.

Futures and options are derivative contracts that can be bought and sold in the share market. Futures contract is where the buyer and seller of the contract agree to transact in the underlying asset on a future date at a price determined in advance. For example- Consider a futures contract of company ABC with an expiry date of August 25 is available at Rs. 100 (current price of ABC shares in live market is 105.) The buyer of this futures contract is making deal with the seller that on August 25, he will buy ABC shares at Rs. 100 per share irrespective of what the market price is on August 25.

On the other hand, in options contract, the buyer and seller of contract agree to transact in the underlying asset on a future date at a predetermined price. However, here the option buyer has the right but not the obligation to execute the contract on the expiry date.

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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