What are Futures and Options (F&O) in Stock Market?

If you are new to stock trading and trying to learn the intricacies of the market for some time, you might have understood some of the basics by now. Companies have their stocks listed on exchanges like NSE and BSE, and you can buy/sell the stocks as per your fundamental and technical analysis to generate profits.This standard way of buying/selling stocks is known as the cash market. There is another segment within the stock market known as the derivatives market, which is abundantly used for speculation, arbitrage, and hedging.Since the introduction of the derivatives or futures and options (F&O) segment in 2000, it has grown exponentially in India. In the first year of its launch between 2000-01, only 90,580 F&O contracts worth turnover of Rs. 2,365 crores were traded. Fast forward it to December 30, 2020, a total of 3,53,83,771 F&O contracts worth a turnover of Rs. 30,84,291.70 crores were traded on a single day.As trading in the F&O segment is only getting popular with time, the derivatives market is something that every beginner should try to learn about.So, what is the derivatives market? What are futures and options ? Here is a detailed explanation-

As the name suggests, derivatives are financial securities that ‘derive’ their value from an underlying security or benchmark. Stocks, currencies, commodities, and bonds are some of the most common underlying securities. Any fluctuations in the price of an underlying benchmark result in a fluctuation in the prices of its derivatives as well.When it comes to buying and selling derivatives, it is a type of contract that is exchanged between parties. Just like the cash segment, you can buy/sell derivatives on exchanges. Futures and options contracts are the most common examples of the derivative segment.

To begin with the definition, futures are derivative contracts that require the buying/selling parties to transact a security at a predetermined future price and date. The contract mandates the buyer to purchase and seller to sell the underlying security at a predetermined price on the expiration date, irrespective of its current price.In simple words, the futures contracts are used by traders to lock the price of an underlying asset or security. Every futures contract has an expiration date and a price. For instance, on NSE, the stock future contracts have a monthly validity and expire on the last Thursday of every month. However, there are 1-month, 2-months, and 3-months contracts available for trading.By the expiry date, the contract holder must mandatorily fulfil the contract terms, regardless of whether he is making profits or losses. Traders and investors commonly use the futures contracts for hedging against the price fluctuations of underlying securities and prevent losses.

To better understand futures contracts, you should know about lot sizes. The lot size is the total number of shares included in a futures contract. It is with the help of lot sizes that the exchanges standardize and regulate the contract prices.For instance, currently, one futures lot of SBIN (State Bank of India) contains 3,000 shares of SBIN. Similarly, one futures lot of TCS (Tata Consultancy Services Limited) includes 300 shares of TCS.But why this difference in the number of shares in a lot?When futures and options were first introduced, SEBI fixed an indicative lot size of Rs. 2 lakhs. The number of shares in a lot is fixed as per the current market price of the stock and the indicative lot size fixed by SEBI. But over the years, SEBI has made multiple changes to the indicative lot size value to discourage retail investors from speculating. Currently, it stands above Rs. 7.5 lakhs.So, the reason why SBIN futures has 3,000 shares and TCS futures only has 300 shares is their current market price. SBIN is currently trading close to Rs. 275 while TCS is quoting a price of around Rs. 2,900. The current price of the stock in the cash segment is divided with the indicative value fixed by SEBI to decide the number of shares that should be included in a futures contract.In other words, the number of shares in a futures contract can vary based on the underlying stock and its price. SEBI adjusts the same at regular intervals as per the price movement of the stocks.

One of the reasons why futures trading is gaining momentum in India is leverage. Brokers now offer very high leverage, sometimes up to 20 times of the capital, to allow customers to trade futures. Leverage eliminates the need for the trader to pay 100% of the value of a future’s contract upfront.For instance, if you want to purchase 3,000 shares of SBIN at a market price of Rs. 275, you will need a capital of Rs. 8,25,000. But a futures contract of SBIN, which contains 3,000 shares, will be available for an initial margin of only close to Rs. 3,00,000. While SEBI has some mandatory leverage rules, brokers are allowed to offer higher leverage to an extent.Now that you’ve got a brief idea about futures, let us have a quick look at the options.

Just as futures, options are also derivatives that derive their value from an underlying asset or security. With an options contract, buyers can buy or sell an underlying asset as per the type of options contract they hold. But unlike futures contracts, options contracts do not obligate the holder to buy/sell the asset if they don’t want to.Similar to futures, options contracts also have a fixed expiration date. The same for stock options is the last Thursday of every month, and contracts are available with a validity of 1-3 months. By the expiration date, the holder has the right to exercise the buy or sell option.

To understand strike price, you should first understand what are call options and put options. With call options, the holder has the right to buy the underlying asset within the expiry date as per the stated price. With a put option, holders can sell the underlying asset until the expiry at the stated price.The strike price is the price at which the underlying assets can be purchased or sold. Similar lot size rules apply in futures and options. For instance, one SBIN 300 CE (call) option contract will allow the holder the right to buy 3,000 shares of SBIN at Rs. 300 by the expiry, irrespective of what the current price of SBIN is. Here, Rs. 300 is the strike price.

You are required to pay a premium for purchasing an options contract. So, let us assume that you purchase an SBIN 300 CE at Rs. 2. The cost of this contract will be Rs. 6,000 as there are 3,000 SBIN shares and premium is Rs. 2. Before the expiry, the cash price of SBIN reaches Rs. 305.But as you’ve purchased the 300CE, you have the right to buy 3,000 shares of SBIN at Rs. 300 and sell the same at the current price of Rs. 305. Your profit here would be Rs. 9,000 before brokerage and taxes.This is calculated by deducting the strike price of SBIN (Rs. 300) from the current price (Rs. 305). From this difference of Rs. 5, you deduct Rs. 2 that you paid as the option premium. The remaining Rs. 3 will be multiplied by 3,000 as one options contract of SBIN has 3,000 shares. The final profit is Rs. 9,000.But you will only be able to generate profits if the spot price or cash price of SBIN closes above Rs. 300 on the expiry day. The same process can also be followed by purchasing put (PE) options if you have reasons to believe that the price of a stock is about to fall.

We hope that now you at least have a basic understanding of what are futures and options . Note that derivatives trading can be very risky and lead to significant losses. If you are new to the stock market, it is better to stick to the cash segment. Trade in smaller quantities in the cash market at least for a few months before experimenting with derivatives.Without adequate knowledge and experience, you can quickly lose a lot of your hard-earned money in the derivatives market. Continue learning from trusted sources as you begin your journey in the stock market if you are in the market for the long haul. Smaller but consistent profits should be your goal when you are new to the market.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.