Futures and options (F&O)

Futures and options, called F&O in India, are contracts whose value depends on the price of something else, such as a share, a stock market index, a currency or a commodity like gold. Contracts like these are called derivatives, because their value is derived from that other thing. India's stock exchanges now trade more equity options contracts than any other market in the world.

The two kinds work differently. A futures contract is an agreement to buy or sell something at a fixed price on a fixed future date. Both sides must go through with it. An option gives its buyer the right, but not the duty, to buy or sell at a fixed price until a certain date. The buyer pays the seller a fee for this right, called the premium.

Here is how a contract runs on an exchange. A buyer and a seller agree the contract through their brokers. Both sides of a futures contract, and the seller of an option, put down a deposit, called margin, with the exchange's clearing house, which guarantees that each side will pay. As the price of the underlying asset moves, the contract gains or loses value. For futures, the clearing house moves the gains and losses between the two sides at the end of each day. An option buyer instead pays the whole premium at the start. On the expiry date, the contract is settled, either in cash or by handing over the asset itself.

For instance, a jewellery maker that must buy gold in three months can buy gold futures today. If the price of gold rises, the gain on the futures pays for the higher price. This protection is called hedging.

Consider a company that trades electricity. Energy trading and risk management software records its power futures and shows how much it could lose if prices move.

Say an individual investor buys options through a stock trading app. Lakhs of individual traders in India trade options in this way. SEBI, the market regulator, has found that most of them lose money, and it has tightened the rules on retail options trading. Firms such as high-frequency traders often take the other side of those trades.

How are futures and options different from buying the share itself? A share is a piece of ownership in a company, and it can be held for years. A futures or options contract gives no ownership. Its value depends only on the asset's price, and it ends on an expiry date. On a futures contract, a small price move can win or lose much more than the margin paid. An option seller can also lose much more than the margin, but an option buyer can lose at most the premium. A contract for difference (CFD) is a similar contract, but it is made with a broker, not on an exchange.