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Just like buying stocks, Futures and Options are other instruments that traders buy & sell to make profits from the price differences.
Futures and Options are derivatives i.e. a contract between two parties to buy or sell something in the future based on its current price or value.
In other words, F&O is a contract to exchange something at an agreed-upon price at a future date. It derives its value from an underlying asset.
In this, the F&O traders often trade contracts, not the actual stuff like stocks, gold, silver, crude oil, etc.
While these can provide unique opportunities, they also come with risks and challenges.
Your psychology and emotional control are very crucial in F&O so that you don’t turn trading into gambling.
Let’s dive in more!
What is Future Trading
As the name says, a future contract is an agreement to buy or sell an asset/commodity at a “Pre-decided price at a future date”.
Futures contracts are regulated and standardized i.e. they have predetermined contract sizes (lots), expiration dates, and terms.
Key Components of Future Trading
(1) Underlying Asset
The underlying asset can be anything from commodities like gold, silver, and oil to financial instruments like stocks or indexes.
(2) Contract Size
It is just the quantity of the underlying assets in ‘lots’.
Example: You’re buying 5 lots of Reliance shares and the size of 1 lot = 20 shares. So in total, you’re buying 5 x 20 = 100 shares of it.
(3) Expiry Date
The date on which the contract expires. After this date, the contract is settled, and the parties involved must fulfill their obligations.
(4) Contract Price
The agreed-upon price at which the underlying asset will be bought or sold when the contract expires.
Example of Future Contract
(1) Real Estate Example
Imagine you’re looking to buy a new house in Mumbai that’s currently under construction and would be ready to move in next year.
You do an agreement on the price of Rs.2 Crores for the house which is a future contract locking in the price and closing date.
Over the next few months, demand for new houses skyrockets in your area and housing prices increase dramatically.
The best part? You don’t have to worry about the fluctuation of price be it up or down as your future contract guarantees that you can still buy the house for the originally agreed price which is 2 crores, no matter whether the price even doubles.
The builder must sell it to you at the future contract price because he has signed an agreement with you. This provides certainty to both parties.
But what about the risk involved here? The risk is if the opposite happens. The prices dropped instead – then you would still be obliged to pay Rs.2 crore to the builder.
Traders often don’t wait till the expiry and keep swapping these contracts, playing the price game without dealing with the actual stuff. It’s like locking in today’s deal for tomorrow’s goods.
(2) Farmer’s Example
The farmer locks in selling his potatoes for Rs.2000 per quintal now to be paid in 6 months at harvest time.
This locks in the price now, which protects the farmer if corn prices fall before harvest time comes.
On the other side, the buyer locks in paying Rs.2000 per quintal because they agreed to the futures deal.
So in 6 months, they must buy the potatoes from the farmer at that Rs.2000 price, even if potatoes become cheaper in the future. This is known as the “Forward Contract” if the trade is taking place physically.
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Best Part of Futures Trading
The best part of future trading is that you can trade them online via contracts, without exchanging physical goods. You just need a Demat account to do so.
The broker that I use for trading is Upstox.
Example: Trading contracts of gold. In this case, you don’t need to buy physical gold for trading.
Traders are making bets on the future price movements of assets through futures contracts.
A government body regulates this type of trading and involves the broker in the contract.
Therefore, if someone refuses to pay or behaves in a thuggish or criminal manner, there are no issues.
Settlement happens immediately after the contract expires or when the trade is squared off, unlike physical contracts which take time to settle.
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What is Option Trading
An option is a derivative contract that gives the buyer the right, but not the obligation, to buy an asset at a predetermined “strike” price.
As the name says, the option buyer (known as ‘option holder’) here has an option whether to buy it or not till the contract expiry.
This option the buyer gets by paying the ‘premium to the seller’ (token amount).
The option seller is also known as an ‘option writer’.
Key Components of Options
(1) Call Option
Gives the buyer the right to buy the underlying asset at the specified strike price before or at expiration.
“Call (CE)” is purchased when you expect that the stock’s price will go UP
.
(2) Put Option
Gives the buyer the right to sell the underlying asset at the specified strike price before or at expiration.
“Put (PE)” is purchased when you expect that the stock’s price will go DOWN
.
(3) Strike Price
The set price at which the option holder can buy or sell the underlying asset.
(4) Premium (Token Amount)
Premium is the upfront price paid to purchase the option.
(5) Contract Size
It is the quantity size (in lots) of the underlying asset.
(6) Expiration Date
Similar to futures, options have expiration dates by which the contract must be exercised.
Option Buying Example
Umesh buys a call option (known as option holder) to purchase 100 shares of XYZ Company at Rs.500/share by March 1st.
But all it would cost him is a Rs. 250 premium.
If XYZ shares rise to Rs.550/share by March 1st, Umesh can use the right for Rs.500 each and sell at the market of Rs.550.
So, he will earn a profit of Rs.4750 just by paying a premium of Rs.250.
Net Profit = Sale Price – Purchase Price – Premium = Rs. 55,000 – Rs. 50,000 – Rs. 250 = Rs. 4,750
And in case he doesn’t use his option as the market price went down from his strike price, he would just lose his premium amount i.e. R.250 max. So this is the maximum loss he could incur.
Option Selling Example (Option Selling)
Referring to the above example, if Umesh Sells his option (known as option writer), he would receive a premium of Rs.250.
- Profit Scenario: If XYZ shares stay below Rs. 500, Umesh, the seller, makes Rs.250 profit from the premium without any obligation.
- Loss Scenario: If XYZ shares rise to Rs. 550, Umesh has to sell at Rs. 500, resulting in a loss of Rs. 50 per share. The premium cushions this loss, limiting his net loss to Rs. 4,750.
So the maximum loss of a seller is theoretically unlimited if the market price significantly exceeds the strike price.
The premium acts as a buffer, limiting the potential loss for the call option seller.
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