Understanding Futures and Options: Meaning, Benefits, Types & Risks

Futures and options are essential financial instruments known as derivatives, whose values depend on the performance of underlying assets like stocks, commodities, or currencies. They offer investors and traders opportunities to manage risks, speculate on price movements, and diversify their portfolios.

This article explores the fundamental concepts of futures and options, explains how they work, the types available, the benefits they offer, and the risks involved. Understanding these instruments is crucial for investors who want to participate in more advanced trading and hedging strategies.

Futures

A futures contract is a legally binding agreement to buy or sell a specified asset at a predetermined price on a future date. Both parties are obligated to execute the transaction at the contract expiry.

Futures are standardised contracts traded on exchanges, covering assets like equities, commodities, currencies, and indices.

Options

An option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (strike price) before or on a set expiry date. There are two main types of options:

• Call Option: The right to buy an asset.
  

• Put Option: The right to sell an asset.
  

Unlike futures, options provide flexibility as the holder can choose not to exercise the option.

Futures and options come in various forms, depending on the underlying asset and contract terms. Here's a quick overview of the main types:

Types of Futures

• Commodity Futures: Contracts based on goods like gold, crude oil, or agricultural products.
  

• Equity Futures: Contracts on stock indices or individual stocks.
  

• Currency Futures: Agreements to exchange currency pairs at a future date.
  

Types of Options

• Call Options: Allow buying the asset at the strike price.
  

• Put Options: Allow selling the asset at the strike price.
  

• European Options: Can only be exercised on the expiry date.

The following table highlights the key difference between futures and options:

In summary, futures involve mandatory execution and higher risk, while options offer greater flexibility with limited downside, making them suitable for different risk profiles and strategies.

• Active Traders looking to profit from short-term price movements.
  

• Hedgers, such as institutional investors or large portfolio holders, who use F&O to protect against market volatility.
  

• Speculators aiming to earn from leverage and price fluctuations—though this involves high risk.
  

• Investors with Technical Knowledge, who can analyse charts, trends, and indicators to make informed F&O decisions.
  

F&O trading isn't suitable for beginners or those with low risk tolerance, as the potential for loss can exceed the initial investment if not managed wisely.

To trade futures and options effectively, it’s important to understand how these contracts are structured, traded, and settled. Here's a breakdown of the key components:

Contract Specifications

Futures and options contracts specify details such as:

• Underlying asset: The security or commodity the contract is based on.
  

• Contract size: The amount of the asset per contract.
  

• Expiry date: When the contract terminates.
  

• Strike price (for options): The price at which the option can be exercised.
  

Margin and Leverage

Both futures and options require margin deposits—a portion of the contract value that acts as a security deposit. Margin allows traders to control larger positions with less capital, increasing potential gains and risks.

Settlement

• Physical Settlement: Actual delivery of the underlying asset at contract expiry (common in commodity futures).
  

• Cash Settlement: Payment of the difference between contract and market price (common in index futures/options).

Trading Process

Traders enter positions by buying or selling futures or options contracts on regulated exchanges. Profits or losses depend on the price movement of the underlying asset relative to the contract terms.

Futures and options offer several strategic advantages to traders and investors, helping manage risk, enhance returns, and diversify portfolios:

• Risk Management (Hedging): Protect investments from price fluctuations. For example, farmers use commodity futures to lock prices.
  

• Leverage: Control large market positions with smaller capital.
  

• Market Access: Allows speculation on price movements in rising or falling markets.
  

• Flexibility: Options provide asymmetric risk profiles—limited loss potential with significant upside.
  

• Portfolio Diversification: Introduce different asset classes and strategies beyond stocks and bonds.

While futures and options offer lucrative opportunities, they also come with significant risks that traders must carefully consider:

• Market Volatility: Price swings can cause substantial gains or losses in a short time.
  

• Leverage Risks: Amplifies both profits and losses, possibly exceeding initial capital.
  

• Complexity: Requires understanding contract details and market behaviour.
  

• Margin Calls: If losses occur, traders may need to deposit additional funds promptly.
  

• Time Decay (Options): Options lose value as expiry approaches if the market doesn’t move favourably.

The Securities and Exchange Board of India (SEBI) regulates futures and options trading to maintain market integrity and protect investors. NSE and BSE offer F&O trading platforms with stringent guidelines on margin, disclosure, and surveillance.

Market participants include:

• Hedgers: Use F&O to reduce risk exposure.
  

• Speculators: Aim to profit from price movements.
  

• Arbitrageurs: Exploit price differences between markets.

Futures and options are advanced financial instruments that offer opportunities to hedge risk, speculate, and diversify investments. They come with potential benefits such as leverage and flexibility but also carry significant risks, including amplified losses and complexity. Investors should thoroughly understand these instruments, market dynamics, and regulatory requirements before engaging in F&O trading.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.

• Securities and Exchange Board of India (SEBI)
  

• National Stock Exchange of India (NSE)
  

• Bombay Stock Exchange (BSE)
  

• Investopedia - Futures
  

• Investopedia - Options
  

• Zerodha Varsity - Futures and Options