Sharekhan Blog

What is Futures and Options?

  • Feb 26, 2024

Despite their frequent interchangeability, these two phrases have different meanings and functions in the finance industry. So, let’s explore FNO meaning or what is F&O trading in detail.

What are Futures?

The commitment to purchase or sell an item at a predetermined price at a later time is known as a futures contract. When compared to commodities like maize or oil, India stock futures contracts make the most sense as a hedge investment. For example, if market prices drop before the crop can be delivered, a farmer might seek to lock in a fair crop price. Additionally, the buyer wants to lock in a price to guard against future price increases.

What are the Options?

Options grant the holder the right to buy or sell the underlying asset at a stipulated price. That is either call options or put options.

A call option gives the buyer the right to buy the underlying asset at the agreed price (also called the strike price [or exercise price]). By the call option, the seller can make a demand for the sale of the underlying asset, but they have only the obligation without any freedom. On the buyer’s side, the rights are as such, while the seller shall pay the premium price.

What is the Difference Between BSE Futures and Options?


Aspect

Futures

Options

Definition

Contracts obligating the holder to buy or sell an asset at a predetermined price and date in the future

Contracts give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price and date in the future

Obligation

Both parties are obligated to fulfill the contract

Only the seller (writer) is obligated; the buyer has the choice to exercise the contract

Flexibility

Limited flexibility contracts have fixed terms and cannot be customized

More flexibility: contracts can be tailored with various strike prices and expiration dates

Risk

Potentially higher risk due to the obligation to fulfill the contract regardless of market conditions

Limited risk for the buyer; the most they can lose is the premium paid for the option

Profit Potential

Potentially higher profit due to the leverage effect, amplifying gains (or losses)

Profit potential is unlimited for the buyer while limited to the premium received by the seller

Initial Cost

Typically requires a smaller initial investment, known as margin, compared to options

Usually requires a premium payment upfront, which can vary based on market conditions and contract terms

Market Purpose

Primarily used for hedging against price fluctuations and speculation

Used for speculation, hedging, and income generation through premium collection

Who Should Invest in Futures & Options?

Different kinds of traders make FnO investments.

  1. Hedgers: They make investments in a certain asset to hedge against changes in that asset's price.
  2. Speculators: Speculators solely make investments in assets in order to profit from changes in price. They make an effort to predict price changes and profit from them. Leverage can increase returns, but it's a personal decision (and losses).
  3. Arbitrageurs: They aim to make money by taking advantage of price differences in the state of the asset market. They attempt to take advantage of any inefficiencies in the market.

How do Futures and Options Work?

1.    Market Speculation

The primary purpose of futures and options is for market speculation. Investors can utilize such contracts to bet on the future price trends of an asset without having any ownership of it. They are allowed to wager on whether the price will rise or fall and benefit from their forecast in case.

Yet, this kind of trading is associated with a high level of risk since the market can be unstable, and traders may be in great losses if their predictions turn out to be wrong.

2.    Hedging

Another use of futures and options is for hedging purposes. Companies usually sign such contracts to guard against any future price changes in the market. In this way, stability in their business operations can be guaranteed, and losses that may arise from price fluctuations can be prevented.

Also Read: Option Hedging Strategies

Future and option trading example, a farmer worried that the price of wheat will drop before harvest can sell their wheat at a predetermined price through a futures contract. Thus, they are sheltered from losses in case the price of wheat goes down.

3.    Leverage

Futures and options enable investors to trade with leverage, which means that with a smaller amount of capital, they can control larger quantities of assets. This is very profitable when there is a movement towards them, but it also heavily weighs their losses when they are wrong.

Investors should be cautious when employing leverage as it could lead to substantial financial losses if not used correctly.

The Bottom Line

Futures and options are two essential financial derivatives that serve different purposes in the world of finance. Understanding how they work and their significance in the financial market can greatly benefit investors in making informed decisions for their investments.


Team Sharekhan
by Team Sharekhan

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