Futures and options: All you need to know

Like hidden treasures tucked away in a labyrinth, futures and options have always been whispered about in financial circles, evoking curiosity and awe. Yet, for the majority, they remain shrouded in complexity.

But fear not, for in this article, we shall embark on a quest to understand the essence of futures and options. What are they exactly? How do they function? Do people make money in futures and options?

Let's begin.

What are futures and options?

Futures and options, also known as F&O, are derivatives traded on the stock exchanges that derive their value from underlying assets like shares, ETFs (exchange-traded funds), commodities, etc.

Derivatives are a financial contract between two or more parties. The value of a derivative instrument changes in relation to the value of the underlying asset(s) it tracks.

While there are many types of derivatives, the two most commonly found in the stock market are futures and options.

A futures contract is a binding agreement to buy or sell an asset at a future date for a predetermined price.

Let's illustrate this with an example.

Suppose you have purchased a futures contract to acquire 100 shares of ITC at Rs 400 each, with a specified date of execution. When the contract expires, you will receive these 100 shares at the agreed-upon price of Rs 400 per share, regardless of the prevailing market price.

Even if the price rises to Rs 420, you will still obtain the shares at Rs 400 each, resulting in a profit of Rs 2,000. Conversely, if the share price drops to Rs 380, you will still be obligated to purchase them at Rs 400 each, resulting in a loss of Rs 2,000.

An options contract gives a trader the choice (right) to buy or sell an asset at a set price, but they are not obligated to do so. The seller, on the other hand, must follow through with the contract if the buyer decides to use the option. The buyer pays a fee (called a premium) for this privilege.

There are two types of options:

Call option

A call option gives the buyer the right (but not obligation) to buy an asset. It is purchased when a price rise is anticipated.

Put option

A put option gives the seller the right (but not obligation) to sell an asset. It is bought when a price fall is anticipated.

If the price doesn't move as the trader predicted, they can choose not to exercise the option.

Let's say the current share price of ITC is Rs 440. You feel that the price will go up and buy a call option with a strike price (i.e., the price you will have to pay if you exercise the option) of Rs 450. This option will expire in July and costs you a premium of Rs 8.35 per share.

Since options are traded in lots, and the lot size here is 1,600, you pay a total premium of Rs 13,360 (Rs 8.35 x 1,600).

Now, let's say the share price of ITC increases to Rs 500 by the expiration date (last Thursday of July).

You choose to exercise your option, which means you can buy the shares at the agreed-upon strike price of Rs 450 (not the current market price of Rs 500).

So, for the lot of 1,600 shares, you spend Rs 7.20 lakh (Rs 450 x 1,600). Note that this exercising of the option, i.e., buying ITC shares at Rs 450 can only happen on the expiry date.

Now, you can sell these shares at the market price of Rs 500 per share, earning Rs 8 lakh (Rs 500 x 1,600). Therefore, your gross profit from the transaction would be Rs 80,000 (8 lakh - 7.20 lakh).

However, you need to consider the premium you paid for the option contract. So, your net profit from this transaction would be Rs 80,000 (gross profit) minus Rs 13,360 (premium), which equals Rs 66,640.

On the other hand, if the share price doesn't rise to Rs 450 or above, you are not obliged to exercise the right, and your loss will be limited to the premium you paid, which is Rs 13,360.

This is how futures and options work and how one can make money off them. Now, let's understand some related terms.

Terms related to futures & options

• Lot size: Options contracts are carried out in lots. Lot size represents the number of shares covered by one contract, e.g., 1,600 in the case of ITC. It is different for different companies. The lot size remains constant regardless of price fluctuations of the underlying asset.
• Premium: The premium is the cost you incur to enter the contract. It depends on factors like the time until expiration, the difference between stock price and strike price (known as intrinsic value), and the asset's volatility.
• Expiration date: This is the predetermined deadline after which the contract expires, making the right to exercise it void. Monthly contracts on Indian stock exchanges usually expire on the last Thursday of each month.
• Margin: The premium (Rs 13,360 in the above example) also serves as the initial margin for this contract. Margin acts as a deposit to cover potential losses from adverse price movements. Additional charges like transaction fees, taxes, or brokerage fees (represented by Rs 31.50 in this example) may apply to the contract.

Note that if the market moves against you, you may need to deposit additional margin (known as a margin call) to keep the contract active.

Our take

Futures and options are highly risky financial instruments. While there are success stories of individuals doubling their money quickly, it's important to consider the undisclosed losses that can be substantial and rapid.

Unlike many other investments, F&O trading carries the risk of total capital loss, reducing the value to zero. A SEBI study earlier this year found that 89 per cent of individual traders in the equity F&O segment suffered losses, averaging Rs 1.1 lakh during FY22.

Originally used to hedge against price changes in crops, derivatives are now widely used by speculators for quick profits. Warren Buffett referred to derivatives as "financial weapons of mass destruction" due to their potential for both significant gains and devastating losses.

Therefore, it is vital for investors to thoroughly understand these instruments and associated risks before engaging in F&O trading.

Suggested read: A black hole for your money