Futures and Options (F&O)

Key things to know:

• Futures: Both parties must honour the contract on expiry.
• Options: Buyers can choose whether to exercise their rights.
• Effective date: STT changes came into effect on 1 October 2024.
• Options impact: Sell-side STT has increased, making active options trading more expensive.
• Participants: Hedgers, arbitrageurs, speculators, retail investors, and institutions actively use F&O.
• Example: Buying a call option with a premium of Rs. 50 per share for 50 shares could generate a Rs. 2,500 profit if prices move favourably.

• Risk: Incorrect market predictions may lead to losses.

  
  

Before trading in F&O, understand how contracts work, assess your risk tolerance, and build a clear trading strategy. Derivatives can be powerful tools, but they require market knowledge and disciplined risk management.

The Securities Transaction Tax (STT) structure for futures and options has been revised, increasing trading costs, particularly for options traders.

Key changes:

The STT hike on F&O is driven by the rapid growth in derivatives trading and rising retail participation. The objective is to improve market quality while balancing tax revenues.

• F&O volumes, particularly options trading, have surged sharply in recent years.
• Higher STT helps increase government tax collections from speculative activity.
• The move aims to discourage excessive intraday and high-frequency trading.
• It promotes more responsible participation amid larger contract sizes.
• The increase also helps offset low effective taxation on derivative profits.

These instruments help investors:

• Protect themselves against market volatility.
• Manage portfolio risk.
• Take advantage of expected price movements.

By fixing a future transaction price, traders can better plan their market exposure.

Example of an options trade

Suppose an investor buys a call option for 50 shares of XYZ Limited.

If the market price instead falls to Rs. 2,900, the investor can allow the option to expire and limit the loss to the premium paid.

Although both are derivative instruments, they work differently.

In futures trading, traders must deposit a percentage of the contract value as margin.

In options trading, buyers pay a premium to obtain the contractual right.

1. Stock futures and options:

These contracts are linked to individual company shares.

• Futures create an obligation.
• Options provide flexibility.

2. Index futures and options:

These derive value from market indices such as:

• Nifty
• Sensex

They are commonly used for portfolio risk management.

3. Call options

Call options give buyers the right to transact an asset at a predetermined price before expiry.

They are generally used when traders expect prices to rise.

4. Put options

Put options give buyers the right to transact at a predetermined price.

They are often used to protect against falling prices.

5. Commodity and currency derivatives

These contracts help manage:

• Commodity price fluctuations
• Currency exchange rate movements

6. American and European options

These contracts are standardised and traded on recognised exchanges.

Every contract has:

• A defined lot size
• An expiry date
• Standardised pricing rules

How futures trading works

Both parties enter a legally binding agreement.

They agree to transact an asset at a fixed price on a future date.

Daily gains and losses are settled through a process called mark-to-market settlement.

How options trading works

Options trading operate differently.

Buyer:

• Pays a premium.
• Receives a right.
• Has no obligation to exercise.

Seller:

• Receives the premium.
• Must honour the contract if exercised.

It may not be appropriate for beginners without sufficient knowledge.

1. Hedgers: Managing market risk:

Hedgers use derivatives to reduce uncertainty.

Examples include:

• Farmers locking in crop prices.
• Companies protecting against rising oil prices.

Their primary objective is risk reduction rather than profit generation.

2. Arbitrageurs: Benefiting from price differences:

Arbitrageurs identify price gaps between markets.

They:

1. Buy an asset in one market.
2. Sell it simultaneously in another.

This activity helps improve market efficiency.

3. Speculators: Profiting from market movements:

Speculators aim to generate returns from price changes.

They:

• Do not own the underlying asset.
• Rely heavily on market predictions.

This strategy carries substantial risk.

4. Retail and institutional investors:

Different investors use F&O differently.

Retail participants should exercise caution because leverage can amplify losses.

Futures and options are powerful derivative instruments that can help you manage risk, protect investments, and take advantage of market opportunities. However, they require strong market knowledge, disciplined risk management, and realistic expectations. Before participating in F&O trading, understand how each contract works, evaluate your risk appetite, and build a structured trading plan.

Investments in securities market are subject to market risk, read all the related documents carefully before investing.