Forex Market Learning Index
Complete guide to master forex market trading
Foundation Concepts
Advanced Trading
Futures and Options (F&O)
Futures and options are financial instruments that belong to a class of derivatives. Derivatives derive their value from an underlying asset, like stocks, commodities, currencies, or indices.
What is Futures and Options? Let's Learn Through Examples
Those instruments which do not have their own intrinsic value and that derive their value from some other thing are called derivatives.
Example: The Locker and Key
Let's suppose you have an empty locker - what's the value of the key? Zero. But if that locker contains ₹1 Lakh and the one who has the key gets ₹1 Lakh, then the key's value is also ₹1 Lakh. The key is the derivative and its underlying asset is the ₹1 Lakh inside the locker.
Example: The Farmer's Forward Contract
Suppose a farmer grows potatoes currently selling for ₹10/kg, but his potatoes aren't ready yet - 3 months left for cultivation. No one knows the future price. Last year, due to oversupply, prices were ₹5/kg. If someone agrees to buy at ₹10 after 3 months regardless of market price, it's profitable for the farmer. This contract signed today but delivered after 3 months is called a FORWARD CONTRACT.
Futures
Future contracts are like Forwards but with an independent third party who ensures both seller and buyer fulfill their obligations - buyer gives money and seller delivers the product on time. Just like in the stock market, we have stock exchanges with SEBI oversight to ensure fair trading.
Practical Example: The Token System
So till now I hope you all understood by some theoretical examples, now let's understand this practically also. Suppose there's land worth ₹1 Lakh, but whoever has a token gets that land for free. The plastic token might cost ₹2-3, but now it derives value from the land, so the token is worth ₹1 Lakh.
Suppose whoever has the token will get that land after 2 months. So that token is now the Future for that land. Because that token will give you land after 2 months in future. So now if you have that token, you can also sell that token for ₹80-90k easily. Replace the LAND with shares of MRF for example and that TOKEN with FUTURE OF MRF. So now whoever has that token will get shares of MRF whose price is ₹1-1 Lakh. So now that token is also worth at least that and anyone will easily buy that for ₹80-90k also. That is Futures in Stock Market.
Stock market has 3 types of future tokens:
Near Month Token
1 month timeline for delivery
Next Month Token
2 month timeline for delivery
Far Month Token
3 month timeline for delivery
You should have options and plans about when you think the price will increase - after 1 month, 2 months, or 3 months - and buy the token accordingly.
Why Buy Futures?
Now you will think why will someone buy futures. Suppose MRF share is currently at ₹1 Lakh and you think after 2 months its value will increase to ₹1.5 Lakh. So if someone will give you that token at ₹1.1 Lakh and you think after 2 months it will be of ₹1.5 Lakh, according to you, you are getting this at cheap price. But suppose after 2 months its value decreases from ₹1.1 Lakh to ₹80-85k. So in Futures, loss and profit both take place same as capital market (like normal stock/share market).
CASE-1: Holding Until Delivery
So that was CASE-1 in which you had token and after 2 months you will get delivery of that stock (delivery means you will get stock in your demat account).
CASE-2: Selling Before Expiry
Now it has one more case. But now in your mind you were thinking why should we buy futures, why can't we directly buy shares of that. So before answering let's first discuss about that other case... Suppose price of MRF share increases in one month itself, so the price of that token (i.e. Future) will have also increased from ₹1.1 Lakh because you will get shares of MRF from that token whose price has increased now. So now in 15 days itself that token price has become ₹1.4 Lakh (because share price of MRF also increased to ₹1.5 Lakh). But now you are fearing and calculated that its price now can decrease from this price in 45 days (as you have 2 months futures, so that's 45 days left after 15 days) and you still have 45 days left to get that share's delivery, but you are fearing what if its price gets decreased in 45 days, so you can sell that token from share market if someone was buying with their calculation or hope that it will increase more from this point.
The Power of Leverage
So now answer for the question that why people not directly buy shares of that stock - the answer is LEVERAGE. Leverage is like you get extra money or you can buy shares at 80-90% discounted price. So like if stock price is ₹1 Lakh, you can buy that for ₹8-9k approximately. But it's not like you can buy 1 share in Future - there is a fixed lot (that is the number of shares you have to buy).
Example: MRF Futures with Leverage
For example, you have ₹1 Lakh then you can buy only 1 share of MRF. But if you buy Future and MRF future is of 10 stocks lot (that is calculation will be of 10 stocks), so 1 Future is of ₹8k, so you can buy 1 lot (i.e. 10 MRF worth) for ₹80k. Your profit and loss both will be calculated for 10 stocks margin.
Profit Scenario: Suppose that share price increases from ₹1 Lakh to ₹1.5 Lakh during your holding period, so profit of ₹50k × 10 = ₹5 Lakh profit you can get with futures.
Loss Scenario: Same as profit, if the share price decreases from ₹1 Lakh to ₹70-80k, then loss of suppose ₹30k × 10 = ₹3 Lakh loss.
But you will think I have only invested ₹80k, so how can I get loss of ₹3 lakh? That's the downside of futures - with that massive profits you also have to deal with those losses also. And you think how can I get if I invested only ₹80k? So if you buy futures, your broker will have power to hold and sell your equity shares also to cover the loss, or they will call you directly. Bank and other strict actions can also be taken to recover money as your bank account details, address - everything they have.
Warning: As you have seen in news or by someone that he lost everything - his house, properties, all empty bank accounts. That's because they trade in futures and after loss the broker has to recover its money. So it has both sides.
Market Reality: The amount of people who buy stocks - 10 times of that buy futures. Like if 1 stock is trading, 8-9 Futures will be trading there because of its Leverage feature. It is both risky and profitable - it's on you how you deal with it.
⚠️ CRITICAL WARNING: For someone new and does not have other source of income, we do NOT recommend buying or trading in futures as it can literally destroy your whole wealth. SO ALWAYS TRADE SAFE WITHIN THE CAPACITY YOU CAN BEAR.
Options
The main difference between futures and options contracts is that futures contracts are binding while options are not binding. You have the option to proceed or leave it at that price.
Car Purchase Example: Understanding Options
For example, suppose you want to buy a car that is currently priced at ₹10 lakhs. However, next month, tax rates are expected to be revised, and you are unsure whether the tax will increase or decrease. But you have the option to secure the car by paying a token amount of ₹10,000 and booking it now. This means that regardless of next month's tax changes, you will get the car at the current price including the current tax rate.
Scenario 1: Tax Increases
So now, if next month tax gets increased and now car is of ₹11 Lakhs, but you have already booked that by buying token, so you will get that for ₹10 lakh - so this is a profitable case for you.
Scenario 2: Tax Decreases
But... what if next month the tax decreases instead of increasing and the car's price drops from ₹10 lakhs to ₹9.5 lakhs, what would you do? Would you go ahead with the booking and pay ₹9.9 lakhs more or let the ₹10,000 token go and buy the car again at ₹9.5 lakhs? In this scenario, if you let the token go, you'll still save ₹30,000 overall from last price you were going to buy. So, obviously, you would choose the second option.
This is exactly how option trading works. It is similar to stock trading, but here, you pay a premium to lock in the price of a stock. These options come with specific expiry dates, such as weekly or monthly. If you don't buy or sell the option before the expiry, it automatically settles at the price on the last date.
Types of Option Trading
Option trading is of two types: Option Buying and Option Selling.