Futures and options trading: Definition and types of F&O

For investors seeking active market participation beyond standard share-buying, futures and options trading can provide flexible avenues. Understanding the meaning of futures in trading and what are options in trading can pave the way for strategies that hedge risk, generate income, or amplify potential returns.

This article explores futures and options, their variations, examples, and key distinctions.

• Table of contents

1. Defining futures and options
2. Contrasting futures and options
3. Variations within F&O
4. Call vs put options
5. Real-world examples
6. Who should invest in futures and options?
7. Mitigating risk in the derivative space
8. Futures and options in mutual funds

Defining futures and options

Futures and options are two categories of derivatives. Derivatives are financial contracts that derive their value from an underlying asset, such as a stocks, bonds, commodities. They allow investors to seek potential returns or manage risk by anticipating future price movement of the underlying assets.

Futures are a type of derivative that obligates the investor to buy or sell an underlying asset – such as stocks, commodities, or indices – at a predetermined price on a specific future date. Meanwhile, options grant the right (but not an obligation) to buy or sell an underlying asset by an expiration date.

Thus, you can speculate on price direction without necessarily holding the underlying security. While both belong to futures and options derivatives, their risk profiles differ.

Read Also: Options trading: What it is and how it can help investors

Contrasting futures and options

• Obligation vs. right: Futures oblige both buyer and seller to fulfil the contract. Options provide a right without compelling the holder to exercise it.
• Upfront costs: Futures typically involve margin requirements, whereas options require an upfront premium.
• Risk: Holding a futures contract unhedged can bring substantial losses if the market moves against you, whereas options buyers have limited risk (to the extent of the premium paid), while options sellers face high or unlimited risk unless hedged.
• Profit potential: Both can potentially yield significant returns, but futures scale up gains (and losses) proportionally. Options offer leveraged gains with limited downside risk for the buyer.
• Margin vs. premium: Futures require margin, which may fluctuate daily based on mark-to-market. Options need a one-time premium, giving more straightforward cost comprehension.
• Uses: Futures often suit longer-term positions or hedges with a known outcome, while options are flexible for hedging, speculation, or cost-effective directional bets.

Variations within F&O

Types of futures and options can be categorised by the underlying asset or contract style:

• Stock futures/options: Linked to individual shares (e.g., futures on Company XYZ).
• Index futures/options: Tied to broad indices like the NIFTY 50.
• Commodity futures/options: Dealing with gold, crude oil, or agricultural produce.
• Currency derivatives: Focused on exchange rates (USD/INR, EUR/INR).
• European vs. American options: A European option can only be exercised at expiration, while an American option allows exercise any time before expiry.

Call vs put options

Based on the nature of the transaction, options can be classified as call or put options.

A call option gives the buyer the right, but not the obligation, to buy an asset at a fixed price before a certain date. It is used when the buyer expects the price to rise. If the market price increases, the buyer can purchase the asset at the lower agreed-upon price and profit from the difference.

A put option gives the buyer the right, but not the obligation, to sell an asset at a fixed price before a certain date. It is used when the buyer expects the price to fall. If the market price decreases, the buyer can sell the asset at the higher agreed-upon price and profit from the difference.

In both cases:

• The buyer pays a premium for this right.
• The seller (writer) receives the premium but takes on the obligation to fulfill the contract if the buyer exercises the option.
• Call sellers risk unlimited losses if prices surge, while put sellers face high but limited risk if prices crash.

These options are widely used for trading, hedging, and speculation, depending on the investor’s strategy and market outlook.

Real-world examples

Here are some possible cases of how options and future trades could play out:

• Call option example: You anticipate that a particular derivative’s price might rise. By buying a call option, you lock in a purchase price. If the security price rises, you can exercise the option (or sell it) for profit; if it falls, your loss is limited to the premium paid.
• Stock futures example: Suppose you expect a stable upward trend in a company’s stock. You buy a futures contract, effectively controlling more shares with margin. If your forecast is correct, gains multiply; if the price declines, losses can quickly escalate.

Who should invest in futures and options?

You may consider investing in futures and options if you identify with the following criteria:

• Thorough market knowledge: Derivatives need an understanding of underlying assets, price drivers, and derivative mechanics.
• Risk tolerance: Both can amplify gains and losses swiftly. Newcomers might want to start with simpler strategies.
• Clear goals: Whether hedging a stock portfolio or speculating on short-term moves, clarity of purpose is essential.

Investors also need adequate capital to handle margin calls or potential short-term losses. Without discipline, F&O can become a high-stakes gamble.

Mitigating risk in the derivative space

Risk management in F&O trading is crucial. Here are some strategies:

• Position sizing: Only allocate a portion of your capital to derivatives to limit potential drawdowns.
• Stop-loss orders: Helps exit losing trades before catastrophic losses mount.
• Hedging: Use derivatives to hedge against risks rather than for speculation.
• Leverage awareness: High leverage means small price moves can create big swings. If unprepared, you risk margin calls or forced liquidation.

Futures and options in mutual funds

Given the level of complexity and risks involved in derivatives trading, new investors may find it difficult to adopt this strategy. This is where mutual funds come in. Mutual funds in India can use derivatives, including futures and options (F&O), primarily for hedging and efficient portfolio management. Regulatory guidelines do not allow the use of derivatives for speculation, as that involves higher risk.

SEBI has strict guidelines for the use of derivatives by mutual funds, which include maintaining proper risk management systems and ensuring that the total exposure to derivatives does not exceed a certain amount. Additionally, mutual funds are required to disclose their derivative positions in their half-yearly portfolios and annual reports, ensuring transparency for investors. This helps investors access the potential benefits of these trading strategies even if they don’t have the knowledge to do so independently.

Read Also: Can mutual funds invest in futures and options? A detailed guide

Conclusion

Futures and options trading offers expansive opportunities, yet these derivatives demand a solid grasp of market movements and how margin, premiums, and contract obligations work. Choosing between futures and options depends on your risk appetite, the level of premium you can afford, and the desired time horizon for potential moves. Interestingly, for those who prefer a more traditional investment route or lack the time for active monitoring, mutual funds can incorporate derivatives for hedging or strategic exposures, letting you benefit from professional management.

FAQs:

What are futures and options (F&O)?

They’re derivative contracts. Futures bind buyer and seller to transact an asset at a preset price on a future date, while options grant the holder a right (not an obligation) to buy or sell the underlying asset. Both let you speculate on or hedge price moves without necessarily owning the underlying directly.

Is F&O trading profitable?

It can be profitable if you forecast price movements accurately or apply prudent hedging strategies. However, their leveraged nature can magnify losses. Only invest if you understand derivatives and can manage volatility responsibly.

Which is better, futures or options?

Neither is inherently better. The avenue that is more suitable for you depends upon your objectives and risk tolerance. Futures suit those comfortable with margin-based obligations and higher risk. Options can be suitable for those who want to limit downside risk.

How long can you hold futures?

Futures have specific expiration dates—monthly, quarterly, or custom durations—after which contracts settle or must be rolled over. You cannot hold a particular futures contract indefinitely. Each contract typically has a last trading day before settlement.

Which is safer, future or options?

Neither option is safe and derivatives by design can carry higher risk than stocks, bonds etc. However, options let you limit the maximum loss to the premium paid, making them relatively lower risk for novices. Futures can carry unlimited risk if the market swings strongly in the opposite direction. Risk can be mitigated by efficient usage of hedging strategies and stop-loss orders.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.