What are Futures & Options (F&O) contracts?

What are Futures and Options??

Futures: A Future contract is an agreement between buyer and seller for the purchase and sale of a particular asset at a specific future date.

Options: An Option is a contract that gives buyer of the option the right to buy or sell a particular asset at a specified date and at an agreed price. There are two types of options — call and put. Call is the right but not the obligation to purchase the underlying asset at the specified price by paying a premium. Put is the right but not the obligation to sell the underlying asset at the specified price by paying a premium.

 Similarity between Futures and Options

 Futures and Options are similar in many respects.

·       They both are derivative instruments. The Derivative instrument has no independent value, with the same being ‘derived’ from the value of the underlying asset. The asset could be securities, commodities or currencies. Its value varies with the value of the underlying asset. The contract or the lot size is fixed. For example, a Nifty futures contract has 50 stocks.

·         Both are traded in stock exchanges.

·        Both instruments are used for protecting asset positions held and also for pure speculation.

·       In India, both futures and options expire on the last Thursday of every month.

             Major Differences between Futures and Options

1.       Obligation/Right

Futures involve obligations while options involve rights. In future obligation must be fulfilled by both the parties whereas in options only one party has the obligation to perform the contract. The option holder has the right to exercise or not to exercise his option and if he decides to exercise, the option writer must fulfill his obligation.

2.       Payment of Premium

In Futures, there is no premium payable whereas in options the option holder has to pay premium to buy options.

3.       Margin

Purchasing a future contract requires the payment of upfront margin whereas there is no margin payable in case of Options. For Futures, an amount needs to be kept with the broker called margin money. Since futures are settled on daily basis, the margin money will have to be provided accordingly

4.       Maturity Period

Futures have longer maturity period than Options.

5.       Profit/Loss

In Futures, there is an unlimited profit or loss as the profit or loss depends upon the specified price and actual price on the settlement day.

But in case of Options, option holder’s loss is restricted to the premium paid but his gains are unlimited. Similarly, the profit of option writer is limited to premium received but he is exposed to unlimited loss.

6.       Entrance Cost

It costs nothing to enter into a Future contract whereas there is a cost of entering into an Option contract termed as premium.

7.       Users

Futures are used by speculators and arbitrageurs whereas Options are used by hedgers.

8.       Riskiness

As far as the risk part is concerned, futures are more risky than options. The risk arises in futures due to the fixed obligation part.

As far as options are concerned, if you don’t what to exercise the option, you can forget about it. there are no more formalities.

This Article has been Shared by Student of ICAI Palak Aggarwal. She can be reached at aggarwal.palak2809@gmail.com

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