A Beginner's Guide to Derivatives: Understanding Futures and Options

Have you ever heard traders discussing “F&O” and felt like they were speaking a different language? F&O, which stands for Futures and Options, are two of the most common types of financial derivatives. While the term ‘derivatives’ might sound intimidating, the core concept is quite straightforward. They are financial contracts that derive their value from an underlying asset, such as a stock, a commodity, or a stock market index like the Nifty 50.

For beginners, the world of derivatives can seem daunting. However, with a foundational understanding, you can see how they can serve as powerful tools for both protecting your investments (hedging) and for speculation. Let’s break down the basics of futures and options for the Indian market.

Key Takeaways

• Derivatives derive their value from an underlying asset (e.g., stocks, indices, commodities).
• A futures contract is an obligation to buy or sell an asset at a predetermined price on a future date.
• An options contract gives the right, but not the obligation, to buy (Call) or sell (Put) an asset at a specific price.
• Derivatives can be used for hedging (risk protection) or speculation (leveraged trading) but come with significant risks.

What Are Derivatives?

Imagine this: the price of a glass of mango juice depends on the price of mangoes. The juice’s value is derived from the value of the mangoes. Similarly, a derivative contract’s value is linked to an underlying asset. This asset could be a stock like Reliance Industries, an index like the Bank Nifty, or a commodity like gold.

In India, the most popular derivatives are Futures and Options, which are traded on exchanges like the National Stock Exchange (NSE).

Futures Contracts: The Obligation to Transact

A futures contract is a standardized agreement to buy or sell an underlying asset at a fixed price on a future date. The key word here is obligation. When you buy a futures contract, you are obligated to buy the asset at the agreed-upon price on the expiry date. If you sell a futures contract, you are obligated to sell.

Here are some key terms associated with futures:

• Lot Size: You cannot buy a futures contract for a single share. They are traded in standardized bundles called ‘lots’. For example, the lot size for Reliance Industries futures is 500 shares. This means one futures contract of Reliance involves 500 shares.
• Expiry Date: Every futures contract has an expiry date. For monthly contracts in the Indian market, this is typically the last Thursday of the month.
• Margin: You don’t pay the full value of the contract upfront. Instead, you deposit a small percentage of the total contract value, known as a margin. This provides leverage.
• Leverage: Because you only pay a margin, you can control a large position with a small amount of capital. For instance, to buy one lot of Reliance futures worth ₹7,57,700 (assuming a price of ₹1,515.40 per share), you might only need to pay a margin of around 15-20% of the total value. This leverage can amplify profits, but it can also magnify losses.

How are futures used?

1. Speculation: If you believe the price of a stock will go up, you can buy its futures contract. If the price rises, you profit. If you think the price will fall, you can sell a futures contract.
2. Hedging: Imagine you own many shares in a company and are worried the price might fall in the short term. You could sell a futures contract for that stock. If the stock price does fall, the loss on your shares can be offset by the profit from your futures position.

Options Contracts: The Right, But Not the Obligation

Unlike futures, an options contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) on or before a specific date. For this right, the buyer pays a non-refundable amount called a premium to the seller (or writer).

There are two main types of options:

1. Call Option: A call option gives you the right to buy an asset at the strike price. You would buy a call option if you are bullish and expect the price of the underlying asset to rise.
2. Put Option: A put option gives you the right to sell an asset at the strike price. You would buy a put option if you are bearish and expect the price of the underlying asset to fall.

Example of a Call Option: Suppose the Nifty 50 is currently at 25,600. You believe it will rise in the next month. You could buy a Nifty 25,800 call option for a premium of, say, ₹150 per unit.

• If Nifty rises to 26,100 by expiry, your option is profitable. You have the right to “buy” Nifty at 25,800 and can “sell” at the market price of 26,100, making a gross profit of ₹300 per unit. Your net profit would be ₹150 (₹300 gross profit - ₹150 premium).
• If Nifty stays below 25,800, you would not exercise your right. Your maximum loss is limited to the ₹150 premium you paid.

Buying vs. Writing (Selling) Options:

• Option Buyer: Pays the premium, has the right to exercise the option, and has limited risk (the premium paid) with theoretically unlimited profit potential.
• Option Writer (Seller): Receives the premium, has the obligation to fulfill the contract if the buyer exercises it, and has limited profit (the premium received) with potentially unlimited risk.

Use Cases and a Word of Caution

Derivatives are versatile instruments, but they are not suitable for everyone.

• Hedging: As mentioned, derivatives are an excellent tool for protecting your portfolio. If you have a portfolio of stocks, you can buy Nifty put options to protect against a market downturn, acting as an insurance policy for your investments.
• Leveraged Trading: The high leverage offered by derivatives means you can make significant profits from small price movements. However, this is a double-edged sword.

The High Risks Involved: Leverage is the single biggest risk in derivatives trading. A small adverse movement in the market can wipe out your entire capital. Many beginners are attracted by the potential for quick profits but are unprepared for the equally high potential for losses. A recent SEBI study revealed that between FY22 and FY24, about 9 out of 10 individual traders in the F&O segment lost money.

Other risks include market risk, where unexpected events cause sharp price movements, and liquidity risk, where you may not be able to exit your position easily.

Before venturing into derivatives, it is crucial to educate yourself thoroughly, understand the immense risks, and consider paper trading to get a feel for how they work without risking real money.

This article is for informational purposes only and does not constitute investment advice. Always conduct your own research before investing.