Derivatives Explained: A Beginner's Guide to Futures & Options (F&O)

Welcome back to our 15-day journey into the stock market! Having built a solid foundation in equity investing, it’s time to explore a more advanced landscape you’ve likely heard whispered about: Derivatives, specifically Futures and Options (F&O).

While the term may sound complex, the concept is straightforward. A derivative is a financial contract whose value is derived from an underlying asset—be it a stock (like Reliance), an index (like Nifty 50), or a commodity. In essence, you’re trading a contract about an asset, not the asset itself. In India, the F&O market is vast and serves two primary purposes: managing risk and speculating on future price movements.

Let’s demystify these powerful instruments.

What Are Futures Contracts? The Power of Obligation

A Futures contract is a legally binding agreement to buy or sell an underlying asset at a predetermined price on a specified future date. The key word here is obligated—both the buyer and the seller must fulfill their side of the deal upon expiry.

Consider a jeweler who needs gold in three months but fears the price will rise. By entering a futures contract today, they can lock in the current price for delivery in three months, providing cost certainty regardless of market fluctuations.

Standardization and Margin

Futures contracts are not bespoke agreements; they are standardized and traded on exchanges like the NSE. This standardization ensures liquidity and transparency, covering:

• Lot Size: You don’t trade single shares in F&O. You trade in “lots,” a fixed quantity of the underlying asset. For instance, a futures lot for Reliance Industries is 500 shares.
• Expiry Date: Contracts have a fixed expiry. As of April 2025, monthly F&O contracts in India expire on the last Monday of the month.
• Quality: For commodities, even the quality of the asset is standardized.

Because a futures contract allows you to control a large asset value with a smaller upfront payment, exchanges require a margin. This is a good-faith deposit to cover potential losses. If the market moves against your position, you may receive a “margin call” requesting additional funds to keep your position open.

Settlement: Physical vs. Cash

How a futures contract is concluded at expiry is critical:

1. Physical Delivery: For stock futures in India, holding the contract until expiry means you must either take delivery of the shares (if you’re the buyer) or provide the shares (if you’re the seller). SEBI mandated this in 2019 to curb excessive speculation.
2. Cash-Settled: For index futures (like Nifty 50 or Bank Nifty), there is no physical asset to exchange. Instead, the profit or loss is settled in cash, based on the difference between the contract price and the final settlement price.

What Are Options Contracts? The Power of Choice

This is where derivatives offer greater flexibility. An Options contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date.

The distinction is crucial: right, not obligation. As an options buyer, you can walk away from the deal. The option seller (or writer), however, is obligated to fulfill the contract if the buyer chooses to exercise their right.

There are two fundamental types of options:

Calls vs. Puts

• Call Option: Gives the buyer the right to buy an asset. You buy a call when you are bullish and expect the asset’s price to rise.
• Put Option: Gives the buyer the right to sell an asset. You buy a put when you are bearish and expect the asset’s price to fall.

Rights & Obligations at a Glance

Party	Action	Market View	Right/Obligation	Risk	Profit Potential
Call Buyer	Buys a Call Option	Bullish	Right to Buy	Limited (Premium Paid)	Unlimited
Call Seller	Sells a Call Option	Bearish/Neutral	Obligation to Sell	Unlimited	Limited (Premium Rec’d)
Put Buyer	Buys a Put Option	Bearish	Right to Sell	Limited (Premium Paid)	Substantial (to zero)
Put Seller	Sells a Put Option	Bullish/Neutral	Obligation to Buy	Substantial (to zero)	Limited (Premium Rec’d)

Key Terminology

• Strike Price: The predetermined price at which the asset can be bought or sold.
• Expiry: The date the option contract becomes void.
• Premium: The price the options buyer pays the seller to acquire the right. This is the maximum possible loss for the buyer.
• Lot Size: Like futures, options are traded in standardized lots.

Visualizing Profit & Loss: Payoff Diagrams

A payoff diagram is a graph showing the potential profit or loss of a derivative position at expiry, relative to the underlying asset’s price.

• Long Futures: Profit is unlimited as the price rises; loss is unlimited as the price falls. The graph is a straight 45-degree line.
• Short Futures: The inverse of a long future. Profit is unlimited as the price falls; loss is unlimited as it rises.
• Long Call Option: Your loss is capped at the premium paid. Once the stock price surpasses the strike price + premium (the breakeven point), your profit potential is unlimited.
• Long Put Option: Your loss is also capped at the premium. You profit as the stock price falls below the strike price - premium. Your maximum profit is substantial but capped, as a stock’s price cannot fall below zero.

The Two Core Uses of F&O: Hedging vs. Speculation

Derivatives are primarily used in two ways:

1. Hedging (Risk Management): This involves protecting an existing investment portfolio from adverse price movements.

   • Example: You own 500 shares of TCS and worry about a short-term market downturn. Instead of selling, you could buy a Put Option. If TCS’s price falls, the profit from your Put Option can offset some or all of the loss on your shares, acting as insurance.

2. Speculation (Directional Bets): This is about profiting from anticipated price movements without owning the underlying asset.

   • Example: Your analysis suggests Bank Nifty will rally significantly. Instead of buying multiple bank stocks, which requires large capital, you could buy a Bank Nifty Call Option. If you’re correct, the inherent leverage can amplify your returns. If you’re wrong, your loss is limited to the premium paid.

A Final Word on Leverage and Risk

The ability to control a large position (e.g., a lot of 500 Reliance shares worth over ₹7,00,000) with a relatively small margin (e.g., ₹1,50,000) is called leverage. While it can magnify profits, it magnifies losses with equal force.

F&O trading is inherently riskier than investing in the cash market and is not suitable for everyone. It demands deep knowledge, active management, and a clear understanding of the substantial risks involved.

For today’s interactive task, explore an options calculator online (most brokerage websites offer one for free). Enter a stock, a strike price, and an expiry date to see how the premium is priced. This will give you a practical feel for these instruments.

In our next session, we’ll build on this foundation by exploring basic options strategies. Stay tuned