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

Last Updated: 11 Dec 2024

F&O stands for Futures and Options. Futures and Options represent Derivatives of the stock market. These Derivatives are the financial instruments deriving their values from an underlying such as currency, gold, or the stocks of a company. You could earn a profit by trading these derivatives independently of the underlying assets.

Before going into the details of the Futures and Options, let us first understand what Derivatives are and its types.

What are Derivatives?

It is a contract between two parties with a value based on agreed upon underlying financial assets like security or set of assets like an index. The underlying instruments of derivatives are generally bonds, currencies, commodities, interest rates, market indexes and stocks.

Futures and Options commonly known as F&O are popular derivatives.

Types of Derivatives:

Derivatives are primarily of two types namely Exchange-traded and Over the counter.

• Exchange-Traded:

  This kind of derivatives are traded through organized exchanges around the world, where they could be bought and sold just like the stocks. The most popular Exchange Traded Derivatives are Futures and Options. We are going into the details of Futures and Options in the following sections.

• Over the Counter:

  These derivatives are not traded through Exchanges and are not standardized having varied features. Some over the counter (OTC) derivatives are forwards, swaps, swaptions etc.

What are Futures?

A Future refers to a contract for buying or selling the concerned underlying asset for a specific price at a predefined time. Buying a Futures contract would mean that you promise to the pay the price of the concerned asset at a predetermined time. While Selling a Futures contract means you promise to transfer the concerned asset to the buyer at a predetermined price at a specified time. These underlying assets in a futures contract mainly comprise of equity stocks, indices, commodities and, currencies.

While there is a difference in the price of underlying assets for the futures and the spot market (a market where the assets are transferred immediately). This difference is known as Basis and is generally negative due to interest cost, storage cost, insurance premium etc. as incurring expenses. This condition in which the Basis remains negative is called Contango. This negative value depicts the Future to be more profitable.

It depends upon the Basis that you tend to have profit or loss from a futures contract. Sometimes, holding an asset in physical form is more profitable than futures due to dividends earned on it. This can at times cause the value of Basis to be positive. The condition of Basis being positive is called Backwardation, which generally tends to happen when the price of the asset is about to fall. Upon reaching the maturity of the futures contract, the futures prices tend to have a price nearly equal to spot price and thus basis tends to become zero upon reaching the maturity.

What are Options?

Options are investment instruments which give the holder the right to buy or sell the underlying asset at a predetermined price by using an online trading platform or stock trading app. An Option can be a Call option or a Put Option.

While the Call Option gives the buyer the right buy the underlying asset at a predetermined price also known as Strike Price. If you have a Call option you have the right to demand the sale of the underlying asset from the seller, while the seller only has the obligations and not the right. The right here lies with the buyer while the seller only has the obligation for which he gets paid a price called Premium.

Thus, the buyer of a Call option will not exercise his option, in a case on expiry, the price of the asset is lesser in the spot market than that of the Strike price of the call. Similarly, the buyer of a Put Option will not exercise his option, in a case on expiry, the price of the asset is greater than that of the Strike price of the call.

Conclusion:

The Futures and Options are widely practiced Exchange Traded Derivatives which helps people earn by buying or selling underlying assets, whose evaluation is also termed as Open Interest.

Types of Futures

In F&O, Futures contracts are agreements to buy or sell an asset at a predetermined price on a specified future date. There are several types of futures, each catering to different underlying assets:

1. Commodity Futures: This includes physical goods like agricultural products (wheat, corn), metals (gold, silver), and energy products (crude oil, natural gas). They help the producers and the consumers hedge against price fluctuations.
2. Stock Futures: These are individual company stocks contracts where one can trade for the changes in stock prices or hedge positions.
3. Index Futures: This will track any market index such as the Nifty 50 or S&P 500 where one will be able to get market exposure without holding individual stocks.
4. Currency Futures: These contracts can be used for trading against currency exchange rates to mitigate foreign exchange risk.
5. Interest Rate Futures: These are agreements to buy or sell debt instruments, such as government bonds, at a specified interest rate, used primarily for hedging against interest rate changes.

Types of Options

Options, in F&O, are financial derivatives that give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specified expiration date. The two primary types of options are:

1. Call Options: A call option allows the holder to buy the underlying asset at a given strike price within a given period of time. Investors normally buy call options when they believe the price of the asset is going to increase so that they can benefit from the difference between the market price and the strike price.
2. Put Options: A put option allows the buyer to sell the underlying asset at a given strike price before expiration. Investors often buy put options when they feel that the asset’s price is going to decline, and then they will be able to sell it at a price greater than its market value.

Frequently Asked Questions

What are examples of F&O?

Examples of F&O include commodity futures like crude oil and gold and stock index futures like Nifty 50, while options can be of an individual stock. The investor can buy call options in expectation of some price upswing or put options in expectation of a decline.

Is F&O trading profitable?

F&O trading can be very lucrative but also quite risky. It is relatively feasible for good traders to make money from the price movements of the underlying assets. However, with market fluctuations, loss can occur pretty fast; therefore, it is worth having a proper strategy and adequate risk management practices.

Which is better: futures or options?

It is dependent on the individual trading goals and risk tolerance. In F&O, futures contracts obligate traders to buy or sell an asset at a set price, while options provide the right but not the obligation. Options generally offer more flexibility, while futures may yield higher potential profits.

How much money do you need to trade futures?

In F&O, the initial margin to trade futures usually varies by contract and broker but ranges between ₹5,000 to ₹20,000 per contract in India. This is the security deposit against probable losses. Further amounts can be needed for effective position sizing and risk management.

How risky is F&O trading?

F&O trading is inherently risky. The power of leverage increases the potential for both gain and loss. Due to its market volatility, price swings will be wide enough.