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What are futures and options (F&O) contracts?

Masoom Gupte  |  Mumbai 

These are derivative instruments traded on the stock exchange. The instrument has no independent value, with the same being ‘derived’ from the value of the underlying asset. The asset could be securities, commodities or currencies. Its value varies with the value of the underlying asset. The contract or the lot size is fixed. For example, a Nifty futures contract has 50 stocks.

What is a futures contract?
This means you agree to buy or sell the underlying security at a 'future' date. If you buy the contract, you promise to pay the price at a specified time. If you sell it, you must transfer it to the buyer at a specified price in the future.

How can the contract be settled?
The contract will expire on a pre-specified expiry date (for example, it is the last Thursday of the month for equity futures contracts). Upon expiry, the contract must be settled by delivering the underlying asset or cash. You can also roll over the contract to the next month. If you do not wish to hold it till expiry, you can close it mid-way.

What is an options contract?

This gives the buyer the right to buy/sell the underlying asset at a predetermined price, within, or at end of a specified period. He is, however, not obligated to do so. The seller of an option is obligated to settle it when the buyer exercises his right.

What are the types of options?
These are two types of options — call and put. Call is the right but not the obligation to purchase the underlying asset at the specified price by paying a premium. The seller of a call option is obligated to sell the underlying asset at the specified strike price. Put is the right but not the obligation to sell the underlying asset at the specified price by paying a premium. However, the seller is obligated to buy the underlying asset at the specified strike price. Thus, in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller only has the obligation. As the seller bears the obligation, he is paid a price known as the premium.

Should you invest in F&O contracts?
Investing in F&O needs less capital as you are required to pay only a margin money (5-20 per cent of the contract) and take a larger exposure. However, it is meant for high networth individuals.

How are F&O contracts different from each other?
In futures contracts, the buyer and the seller have an unlimited loss or profit potential. The buyer of an option can make unlimited profit and faces limited downside risk. The seller, on the other hand, can make limited profit but faces unlimited downside.

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First Published: Fri, May 20 2011. 00:31 IST