Futures and Options (F&O) – Meaning, Types, Difference

  • November 21, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Futures and Options (F&O) – Meaning, Types, Difference

Subject : Economy

Section: Capital Market 

  • SEBI Chairperson, Madhabi Puri Buch, expressed surprise at the continued participation in F&O trading despite high odds against traders.
  • SEBI’s study indicated that nine out of 10 individual traders in the equity F&O segment incurred net losses.
  • Investment Perspective:
    • Acknowledges a 90% chance of investors losing money in the F&O segment.
    • Advises taking a long-term view and investing with a perspective to create wealth over a sustained period, surpassing inflation rates.

Investor Risk Reduction Access (IRRA) Platform:

  • The IRRA platform was officially launched at Asia’s oldest stock exchange, BSE, in Mumbai.
  • Designed to address operational challenges faced by brokers and allow investors to review and manage their investments during technical glitches.
  • IRRA Platform Functionality:
  • Invocation Process:
    • Trading members facing technical glitches can invoke the IRRA platform.
    • Basic checks are conducted, and the platform downloads trades from all trading venues.
    • SMS/email notifications are sent to investors for accessing the platform.
  • Investor Interaction:
    • Investors can review the status of their investments, orders, and place orders for squaring off or closing positions.
    • IRRA is not available for algo trading and institutional clients.
  • Safety Net:
    • Viewed as a safety net for regular and frequent traders.
    • Particularly beneficial for traders for whom broker downtime is material, and open positions expose them to risk.
  • Risk Reduction Design:
    • Emphasized that the platform is designed for risk reduction, not for fresh position taking.
    • Capable of handling expected volumes with confidence.

Investor Risk Reduction Access (IRRA) Platform

The Investor Risk Reduction Access (IRRA) Platform is a system designed to address and mitigate risks for investors in the Indian stock market. It was officially launched by Securities and Exchange Board of India (SEBI), at the Bombay Stock Exchange (BSE).

Key Features of IRRA Platform:

  1. Purpose:
    • The IRRA platform aims to provide a safety net for investors, particularly those who are regular and frequent traders in the stock market.
  2. Operational Function:
    • The platform is invoked by trading members (brokers) in case they face technical glitches or operational issues that impact their ability to service clients across various exchanges.

Futures and Options (F&O) – Meaning, Types, Difference:

Meaning:

  • Futures and Options (F&O):
    • F&O are financial derivatives that derive their value from an underlying asset, such as stocks, indices, commodities, or currencies.
    • They are contracts between two parties, where they agree to buy or sell the underlying asset at a predetermined price on a future date.

Types of Derivatives:

  • Futures Contract:
    • An agreement to buy or sell the underlying asset at a future date for a predetermined price.
    • Obligatory for both parties to fulfill the contract on the agreed-upon date.
  • Options Contract:
    • Provides the buyer with the right, not the obligation, to buy (call option) or sell (put option) the underlying asset at a predetermined price.

Key Differences:

  • Obligation:
    • Futures Contract:
      • Obligatory for both parties.
      • Buyer and seller must fulfill the contract.
    • Options Contract:
      • Buyer has the right but not the obligation to execute the contract.
      • Seller must fulfill the contract if the buyer chooses to execute.
    • Risk and Reward:
      • Futures Contract:
        • Unlimited profit potential but also unlimited loss.
        • Both parties are exposed to market fluctuations.
      • Options Contract:
        • Limited risk for the buyer (premium paid) with unlimited profit potential.
        • Limited profit for the seller (premium received) with unlimited risk.
      • Flexibility:
        • Futures Contract:
          • Less flexible as it’s obligatory.
          • Both parties are bound to the terms of the contract.
        • Options Contract:
          • More flexible as the buyer can choose not to execute.
          • Seller must comply if the buyer decides to execute.
        • Market Exposure:
          • Futures Contract:
            • Direct exposure to market movements.
            • Profits or losses are tied to changes in the underlying asset’s price.
          • Options Contract:
            • Limited risk for the buyer as losses are capped at the premium paid.
            • Seller faces potential losses beyond the premium received.

Common Usage:

  • Futures Contract:
    • Used for speculation and hedging.
    • Common in commodities, indices, and interest rates.
  • Options Contract:
    • Used for hedging, speculation, and income generation.
    • Common in stock markets for risk management.

Call Option and Put Option: Basics of Options Trading

Options trading involves two primary types of contracts: Call Options and Put Options.

These contracts provide investors with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a specified expiration date.

Call Option:

  1. Definition:
    • A call option gives the holder (buyer) the right to buy the underlying asset at the specified strike price before or on the expiration date.
  2. Key Elements:
    • Buyer (Holder): The individual who purchases the call option.
    • Seller (Writer): The individual who sells (writes) the call option.
    • Strike Price: The pre-determined price at which the buyer can purchase the asset.
    • Expiration Date: The date by which the option must be exercised or it becomes invalid.
  3. Scenario 1 – Call Buyer’s Perspective:
    • If the price of the underlying asset rises above the strike price, the call buyer can exercise the option, buying the asset at a lower price than its current market value.
  4. Scenario 2 – Call Seller’s Perspective:
    • The call seller is obligated to sell the asset at the agreed-upon strike price if the call buyer decides to exercise the option. The seller receives the premium from the call buyer.

Put Option:

  1. Definition:
    • A put option gives the holder (buyer) the right to sell the underlying asset at the specified strike price before or on the expiration date.
  2. Key Elements:
    • Buyer (Holder): The individual who purchases the put option.
    • Seller (Writer): The individual who sells (writes) the put option.
    • Strike Price: The pre-determined price at which the buyer can sell the asset.
    • Expiration Date: The date by which the option must be exercised or it becomes invalid.
  3. Scenario 1 – Put Buyer’s Perspective:
    • If the price of the underlying asset falls below the strike price, the put buyer can exercise the option, selling the asset at a higher price than its current market value.
  4. Scenario 2 – Put Seller’s Perspective:
    • The put seller is obligated to buy the asset at the agreed-upon strike price if the put buyer decides to exercise the option. The seller receives the premium from the put buyer.
economy Futures and Options (F&O)