What are futures and options?

In module 3 of Smart Money, we briefly discussed the concepts of derivatives, futures, and options with real-life examples. Remember Sudhir and Bheem? And how they traded the right or the obligation to buy or sell a pineapple? That concept, when translated to the stock market, leads us to futures and options, or F&O.

But what are futures and options? Or, in other words, what is F&O in the stock market? If that’s what you are wondering, let’s get started with the basics,

What are futures and options?

Futures and options are essentially derivatives of other assets that are traded in the markets. In other words, they derive their value from the underlying asset. Futures and options can be derivatives of various assets like equity stocks, commodities or even currencies. And if the value of the underlying asset changes, the value of the derivatives - that is, the futures and options - also changes accordingly. 

What is F&O trading?

The next question you may have is ‘What is future and option trading?’ Simply put, futures and options trading is the buying and selling of futures and options. Like their underlying assets, futures and options can also be traded between buyers and sellers. 

In this module, we’ll focus purely on futures and options basics and look into what they mean. Also, to get a better understanding of the concepts, we’ll take a look at some theoretical derivative contracts. Let’s start off with the concept of futures.

What are futures?

In the stock market, futures are basically derivative contracts that obligate a buyer and a seller to trade the stock of a company at a predetermined price, on a predetermined date in the future. Here, both the buyer and the seller are obligated to honour their end of the contract. 

There are essentially four main elements to a futures contract.

• The obligation of the buyer and the seller
• The trade of an underlying asset between the two parties
• The presence of a predetermined price
• The presence of a predetermined date for the trade to occur

And as far as a futures contract is concerned, the buyer of the contract is the person who is obligated to buy the asset, while the seller of the futures contract is the person who is obligated to sell the asset. 

Another point to note is that the buyer of the futures contract expects the share price to go up. But the seller of the contract expects the share price to fall in the future. And so, both of these parties get into an agreement to effectively lock in the prices.   

Let’s look at an example that will help you understand this better and strengthen your knowledge about futures and options basics.

Futures - an example

Let’s take up Reliance Industries, for instance. Assume that the stock is currently trading at Rs. 1,700 per share. You expect the share price of Reliance Industries to rise in the near future and wish to lock in the current price. 

In this case, what do you do? Well, you’ll likely want to buy a futures contract that obligates you to purchase one share of Reliance Industries for Rs. 1,700 at a future date, say one month later. 

And since you believe that the price of the share at that point may be much higher, you believe that this futures contract can help you make a profit by allowing you to purchase a share at Rs. 1,700 instead of at whatever higher price there may be at that time.

Meanwhile, Ram, who is another trader, expects that the share price of Reliance Industries will likely fall in the near future. So, what does Ram do? He’ll probably want to sell a futures contract that obligates him to sell one share of Reliance Industries for Rs. 1,700 at a future date, say one month later. 

And since Ram believes that the price of the share at that point may be much lower, he believes that this futures contract can help him make a profit by allowing him to sell a share at Rs. 1,700 instead of at whatever lower price there may be at that time.

So, both you and Ram enter into a futures contract that has these four main elements.

• You and Ram are both obligated to honour your individual ends of the transaction.
• The transaction is essentially the trade of one share of Reliance Industries.
• The predetermined price for the stock is Rs. 1,700.
• The predetermined date for the trade is one month from today.

Both you and Ram are required to deposit a percentage of the transaction value with your respective stockbrokers to enter into the contract. This amount that you’re required to deposit is termed as the ‘margin.’ Consider this margin as a sort of a security deposit for entering into the contract. And here, Ram, who sells you the futures contract, is obligated to sell the asset. You, being the contract buyer, have the obligation to buy the underlying stock. 

At the end of one month, on the predetermined date for the trade, you will have to buy the share for Rs. 1,700 even if it is otherwise trading in the market for a lower price, say Rs. 1,500. Similarly, Ram will also be obligated to sell you the share at Rs. 1,700 even if it is otherwise trading in the market for a higher price, say Rs. 1,800. 

What are options?     

In the stock market, options are derivative contracts that give the buyer of the contract the right to buy or sell the stock of a company at a predetermined price, on a predetermined date in the future. Here, the buyer has the choice to either buy or sell the asset, while the seller has no such right. 

• If the buyer of the options contract chooses to exercise their right to buy or sell the asset, the seller of the contract will be obligated to act accordingly. 
• And if the buyer of the contract chooses not to exercise their right, then the seller will again have to act accordingly. 

Here, there are essentially four main elements to an options contract.

• The right of the buyer of the options contract
• The trade of an underlying asset between the two parties
• The presence of a predetermined price
• The presence of a predetermined date for the trade to occur

Unlike a futures contract, here, in an options contract, the buyer of the contract can be either the purchaser or the seller of an asset. In other words, the buyer of the contract can buy the right to either buy an asset or to sell an asset.

If the contract buyer purchases the right to buy an asset from the contract seller, the contract seller then automatically becomes the seller of the asset. And if the contract buyer purchases the right to sell an asset  to the contract seller, the contract seller then automatically becomes the buyer  of the asset. 

Types of Options: Call and Put Options

With options contracts, there are two different types - call options and put options. This is quite unlike futures contracts, where there’s only one type. Let’s take a look at both of them now.

Call options

A call option contract gives the buyer of the contract the right to purchase the underlying asset at a predetermined price on a predetermined day. In exchange for receiving this right, the buyer of the call option contract pays a certain sum of money known as the premium to the seller of the call option contract.

Put options 

A put option contract is the inverse of a call option contract. It gives the buyer of the contract, the right to sell the underlying asset at a pre-agreed upon price on a predetermined day. And as with call options, the buyer will have to pay a premium to the seller for receiving this right.

Examples of Options

To understand options better, we’ll now take a look at a few examples.

Call options - an example

If you happen to visit the call options section of the National Stock Exchange or your trading portal, you will likely see something like this - INFY SEP 1600 CE. This is a typical example of a call option contract of Infosys Limited.

Now, when you purchase this call option, you basically get the right to purchase a set number of shares of Infosys (which in this case is 600 shares) at Rs. 1,600 per share on a predetermined date in the month of September. Let’s say that this options contract is priced at Rs. 200 per share, which is the premium that you would have to pay to the seller to purchase this contract. So, to obtain this right, you will have to pay around Rs. 1,20,000 (Rs. 200 x 600) to the seller.

Put options - an example

Similarly, if you visit the put options section, you will see something like this - TCS NOV 2500 PE. This is a typical example of a put options contract of TCS Limited. 

With the purchase of this contract, you essentially get the right to sell a set number of shares (which in this case is 300 shares) of TCS for Rs. 2,500 per share on a predetermined date in the month of November. Now, assume that the contract is priced at Rs. 120 per share. To purchase this contract, you will have to pay the seller Rs. 36,000 (Rs. 120 x 300) as premium. This will give you the right to sell 300 shares of TCS at Rs. 2,500 at a predetermined date in November.

Wrapping up

So, we’ve seen the answers to two of the most basic questions - What are options? And what are futures? With regard to options, depending on the right involved (whether it is to buy an asset or to sell one), options contracts can be any one of two types.

• Call options
• Put options

In the next chapter, we’ll build on the futures and options basics and learn about each of these kinds of contracts and look into relevant examples to understand them better.

A quick recap

• In the stock market, futures are basically derivative contracts that obligate a buyer and a seller to trade the stock of a company at a predetermined price, on a predetermined date in the future. Here, both the buyer and the seller are obligated to honour their end of the contract.
• There are essentially four main elements to a futures contract: the obligation of the buyer and the seller, the trade of an underlying asset between the two parties, the presence of a predetermined price and the presence of a predetermined date for the trade to occur.
• The buyer of the futures contract expects the share price to go up. But the seller of the contract expects the share price to fall in the future.
• In the stock market, options are derivative contracts that give the buyer of the contract the right to buy or sell the stock of a company at a predetermined price, on a predetermined date in the future. Here, the buyer has the choice to either buy or sell the asset, while the seller has no such right. 
• If the buyer of the options contract chooses to exercise their right to buy or sell the asset, the seller of the contract will be obligated to act accordingly. 
• And if the buyer of the contract chooses not to exercise their right, then the seller will again have to act accordingly. 
• Here, there are essentially four main elements to an options contract: the right of the buyer of the options contract, the trade of an underlying asset between the two parties, the presence of a predetermined price and the presence of a predetermined date for the trade to occur.