Futures and options (F&O)

There are two broad playgrounds in stock market. The first is the cash market. That’s where you actually buy and sell shares of a company. You pay to own a stock, you get to own one.

Then there’s the derivatives market, where you trade things like F&O (Futures & Options). These get their value from the price of those same shares in the cash market, but you never really own the shares themselves.

Futures

Futures are a type of contracts where there is an obligation on the buyer to buy the asset and seller to sell the asset as per the terms of the contract.

A futures contract is basically a deal you strike today to buy or sell something at a fixed price on a future date. So today, you could agree to buy 100 shares of Company A at ₹1,000 each on, say, 31st July. And come 31st July, even if the stock’s trading at ₹900, you’re still bound to buy it at ₹1,000. That’s the obligation you signed up for.

Options

An options contract gives you a right, but not a compulsion to buy or sell at a set price on or before a future date. And for this right, you pay a small fee called a ‘premium’.

So imagine you pay a small premium today for the right to buy 100 shares of Company B at ₹2,000 each by 31st July. If the stock shoots up to ₹2,100, you’ll use your right and buy cheap. But if it dips to ₹1,900, you’ll just walk away and lose only that small premium you paid.

There are also two sides to options, 'call' and 'put'. You can buy a call option if you think the value of a stock or index will go up. Which technically means that you’re betting on its rise. If you sell a call, you essentially do the opposite. And then there’s a put option, where you bet on prices falling. So you buy a put if you feel that stock or index values will drop and sell a put if you think the price will stay put or rise.

• Call Options: Calls provide the right to the buyer to buy the stock at a specified price under the specified time but don't put any obligation on it. If the buyer thinks that the price of the stock will rise in future he will buy the stock and if it goes down he will sell it. If the stock fails to reach the desired price before the expiration, the options expire and become worthless.
• Put Options: Put options works opposite of call options. It gives the seller right to sell the stock at a specified price under the specified time before expiry. But the seller is not obliged to sell the stock.

Note:

• These premiums have two parts. One, the profit you’d make if you exercised the option now. And two, a bit extra for the time left till expiry. The more time there is, the more chances the market might swing in your favour. But as you inch closer to expiry, that window shrinks, and so does the premium. By expiry day, if your option has no real value left, it’s worth nothing.