F&O is a short form of Futures and Options, traded mostly in the derivatives market within the equity market. Understanding F&O trading seems a little tricky as it involves two parties who enter into a contract and speculate the price on a certain period for specific stocks or commodities.
This trade is speculative and mostly executed to hedge market uncertainty. With this trade, one party speculates an increase in prices. In contrast, the other party speculates just the opposite, which is why one gain and the other bears the loss.
Read this article to get a clear and comprehensive explanation of futures and options in the stock market.
What is F&O?
Futures and options (F&O) are financial contracts that take place in the stock market and calculate their value based on the underlying asset. Normally, F&Os are also called derivatives, and the concept of derivatives is vast plus has many elements to understand. We recommend you keep reading this article to get more information about F&O in the stock market.
Future & Options Example
Look at the below-mentioned example to get a more clear understanding of F&O meaning in the stock market.
You buy an F&O contract to purchase 1000 shares of XYZ Co. At Rs 100 each on a specific date. On the expiry of the contract, you can buy those shares at Rs 100 each, even if the stock price increases to Rs 120. As a result, you will make a profit of Rs 20,000. However, if the share price decreases to Rs 80, you will still have to purchase the defined shares at Rs 100 each, where you will face a Rs 20,000 loss.
Things You Must Know About F&O
Before you start trading in F&O, let’s understand some must-know things about futures and options, which are extremely important from a trading perspective.
- Each of the futures and options contracts has its own expiry date.
- Every contract represents the respective stock or index in the spot market.
- The future prices keep moving based on underlying assets.
- The contract is traded in pre-decided lot size and its multiples.
- Index futures can be available on monthly expiry, whereas index options can be available on weekly or monthly expiry.
- Stock F&O can have maximum expiry of up to 3 months, and index contracts can have a maximum expiry date of 5 years.
- It has a strong effect on speculation, and it mainly witnesses hedgers or speculators.
How are Futures & Options Different?
Many traders and investors consider futures and options the same, but both have some major differences. Let’s know about them briefly to get more insights.
Futures are contracts where buyers need to purchase, and sellers need to sell their shares on a predefined date. Whereas options are similar contracts, these contracts give buyers and sellers the right, not the obligation, to execute their future F&O trade on a given date.
In short, future contracts require the buyer to buy the shares, and the seller needs to sell the shares on a given date until they close this position before the expiry date. Options contracts allow the buyer to buy shares and sellers to sell but do not put any obligation to complete the trade on a defined date; they have some flexibility to make future trade decisions.
Types of Futures in Derivatives
Futures are agreements that must be executed if the parties are already entered into them. The buying and selling of underlying assets can occur before or on the agreement’s expiry date. Generally, futures are categorized in mainly two types such as financial and physical securities. The financial securities include stock futures, interest rate futures, currency futures, and index futures. On the other hand, physical securities include energy futures, metal futures, and commodities futures.
Types of Options in Derivatives
There are mainly two types of options in derivatives, such as calls and puts. We have explained both in the below-mentioned sections.
Calls
Call options are the type of options and agreements between sellers and buyers or investors. It gives them the right but not obligation to perform the future trade for stock, bond, commodity, or another instrument. In simple terms, purchasing call options give investors the right to buy a defined number of stocks or indexes at a predefined price on or before a given date. The predefined price set by investors is called the strike or exercise price, and the date till investors can execute a trade is called the expiry date.
Puts
The put option is another type of options derivative, giving the right but not obligation to execute the date for the entered option contract. And they are free to make an informed decision to buy or sell underlying securities, including stocks, bonds, and other instruments at defined prices. In simple terms, if you are bearish in the share market on a stock or index and willing to fall in price, selecting the put option is ideal. On the other hand, a call option is bullish on a stock or index where the investor expects an increase in the price of an underlying asset.
Uses of Derivatives (F&O)
The main use of derivatives of investing in futures and options is to hedge against the price movements of the selected shares or underlying assets. These instruments (derivatives) come with expiry dates and predefined price limits that help to avoid big losses.
- These trades are regulated by SEBI (Securities & Exchange Board of India), contracts that issue the right to purchase the underlying assets on or before expiry.
- The F&Os are traded as financial securities and can have different terms and risk factors.
Conclusion
It can be very destructive if you don’t know how to do F&O trading in the stock market. If you don’t choose favorable derivatives and the underlying assets along with the price factor, you may have to bear a significant risk factor. Although, if one learns about futures and options properly and makes an informed trading decision, it can be a significant trading type that offers great returns at a limited risk level.