What are futures and options in the stock market
Futures and options are important instruments in the derivatives segment of the stock market. Unlike directly buying or selling shares, these instruments involve contracts whose value is linked to an underlying asset. Understanding their rights, obligations, pricing, expiry, and risks is important before entering into a derivatives trade. SEBI also advises investors to understand the features and risk characteristics of derivatives before trading in them. With the expertise of Team Taxperts, a trusted financial advisor in Kerala, this blog explains the fundamentals of futures and options, how they work, and the key differences between these two derivative instruments. Understanding these concepts can help investors gain a clearer understanding of how futures and options function in the stock market and the risks associated with them.
What is a Futures Contract?
A futures contract is a standardised derivative contract through which two parties agree to buy or sell an underlying asset at a predetermined price on a specified future date, subject to the terms and settlement mechanism of the contract. The underlying asset may be a security, index, or another eligible asset, depending on the futures contract traded on the exchange.
Obligation
A key feature of a futures contract is that it creates an obligation for both the buyer and the seller. The buyer takes a long position, while the seller takes a short position, and both parties are bound by the contract according to its terms. Unlike an option buyer, a futures participant does not pay a premium to obtain a right. Instead, futures positions are subject to applicable margin requirements and clearing and settlement procedures.
How does a Futures Contract work?
When a trader enters a futures contract, details such as the underlying asset, contract price, quantity or lot size, and expiry are specified. The position is subject to mark-to-market settlement, under which gains and losses are calculated based on the applicable daily settlement price. For example, if a trader takes a long futures position at ₹1,000 per unit and the relevant settlement price rises to ₹1,050, the price difference is ₹50 per unit in favour of the long position. If the settlement price falls to ₹950, the difference is ₹50 per unit against the long position. The actual profit or loss depends on the contract’s lot size, settlement prices, transaction costs, and other applicable contract specifications.
What is an Options Contract?
An options contract is a derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price, subject to the terms and settlement mechanism of the contract. A Call Option gives the buyer the right to buy the underlying asset, while a Put Option gives the buyer the right to sell the underlying asset.
Right
The buyer of an options contract receives a contractual right to buy or sell the underlying asset at the specified strike price, depending on whether it is a Call Option or a Put Option. This right allows the buyer to benefit from favourable price movements without being required to exercise the option simply because it was purchased.
Not an Obligation
The option buyer is not obligated to exercise the option. The buyer can choose whether to exercise the right according to the terms of the contract. In contrast, the option seller, also known as the writer, assumes the corresponding obligation under the contract if the option is exercised or otherwise settled according to the applicable terms.
Premium
The buyer pays an amount known as the premium to acquire the option. The premium is influenced by factors such as the underlying asset’s price, strike price, time remaining until expiry, volatility, interest rates, and prevailing market conditions. For an outright option purchase, the buyer’s maximum loss on the option position is generally limited to the premium paid, along with applicable transaction costs.
Types of Options
There are two basic types of options: Call Options and Put Options.
Call Option
A Call Option gives the buyer the right, but not the obligation, to buy the underlying asset at the specified strike price, subject to the terms and settlement mechanism of the contract. A trader may buy a Call Option when expecting the price of the underlying asset to increase. If the underlying asset moves sufficiently in the expected direction, the Call Option may gain value. If the expected price movement does not occur to a sufficient extent, the option may expire without value, resulting in a loss of the premium paid by the buyer.
For example, if a trader purchases a Call Option with a strike price of ₹1,000 and the underlying asset rises significantly above that level before expiry, the option may become more valuable. However, the movement in the underlying asset must be considered along with the premium paid, expiry, and other factors affecting the option’s price.
Put Option
A Put Option gives the buyer the right, but not the obligation, to sell the underlying asset at the specified strike price, subject to the terms and settlement mechanism of the contract. A trader may buy a Put Option when expecting the price of the underlying asset to decline. If the underlying asset falls sufficiently, the Put Option may increase in value. If the expected decline does not occur or is insufficient, the option may expire without value, and the buyer may lose the premium paid.
Put Options can also form part of hedging strategies. For example, an investor holding an asset may use a Put Option to manage the potential downside associated with a fall in the asset’s price.
Key Differences
The main difference between futures and options lies in the obligations and risk involved. A futures contract creates an obligation for both the buyer and seller, whereas an options contract gives the buyer a right without an obligation to exercise it. Futures positions are subject to margin requirements, while an option buyer pays a premium to obtain the right. As a result, the risk and payoff structures of the two instruments are different. For an outright option purchase, the buyer’s loss is generally limited to the premium paid, while futures can result in substantial gains or losses.
Conclusion
Futures and options are derivative instruments whose value is linked to an underlying asset. They allow market participants to take positions based on the expected movement of the underlying asset, but they operate through different contractual structures.
A Futures Contract creates an obligation for both parties, while an Options Contract gives the buyer a right without an obligation to exercise it. In an option, the buyer pays a premium to obtain that right, while the seller or writer accepts the corresponding obligation.
Understanding these differences is important before considering any derivatives strategy. Futures and options can be used for purposes such as hedging and taking market positions, but leverage and the structure of derivative contracts can also expose traders to substantial losses. A proper understanding of the product, along with appropriate financial and tax planning, can help investors make more informed decisions.
For individuals or businesses seeking professional guidance on taxation, financial planning, and related financial matters, Team Taxperts offers financial advisory and tax consultancy services.