Futures and Options (F&O) 101

What are futures and options?

Futures and Options are types of derivatives. They are traded on the stock market.

Note: Derivatives are financial instruments whose value is derived from an underlying asset. Eg. NIFY 50

Example: NSE contract breakdown

In NIFTY 50 22500 CE May xx, NIFTY 50 is the underlying asset, 22500 is the strike price, CE is short form for call option and May xx is the expiry date of the contract.

Definitions

• Future: A future is a contract where the holder (purchaser) of the contract is obliged to buy a specific quantity (aka. lot size) of the underlying asset  on a specific day (aka. expiry date)
• Options: An option is a contract where the holder (purchaser) of the contract has the option but not the obligation to buy or sell (aka Call or Put Option) a specific quantity (aka. lot size) of the underlying asset at a specific price (aka. strike price) on/before a specific day (aka. expiry date)

Note :

1) Whether or not an option contract can be executed before expiry varies from country to country. In India we have European option contracts which are automatically executed only on the day of expiry after the trading session for the day ends.

2) Whether or not an options contract is executed depends on the profitability of the contract buyer (aka. long position). Because the buyer is the one who pays the premium for the contract. Conversely, the seller (aka. short position) of the options contract receives the premium.

3) The options contracts are always executed at the strike price irrespective of the market price (trading

price on the stock exchanges) of the underlying asset.

4) Since the execution of the contract depends on the profitability of the option buyer, it has a special

and important term associated with it called Moneyness

5) Once a derivative is purchased/sold, we don’t have to wait till expiry. We can sell/buy the

derivative at the current price to nullify our position.

Moneyness of Option Contracts

The moneyness of options contracts are always determined on the basis of the current market

price (MP) of the underlying asset and the strike price (SP) of the derivative contract. The moneyness of a contract can be one of the following 3

• In the money: MP > SP for call option (option to buy) and MP < SP for put option (option to sell). i.e execution of the contract results in profit for the option buyer.
• At the money: MP = SP for both call and put option. i.e execution of the contract results in no profit  or loss for the option buyer.
• Out of the money: MP < SP for call option and MP > SP for put option. i.e execution of the contract results in loss for the option buyer.

Note:

1) Since the execution of the “Out of the money” contracts results in a loss for the option buyer, it is not executed.

2) Do not confuse between buying and selling of derivatives with buying and selling of the

underlying asset. Buying a Call option gives it’s buyer the option to buy the underlying asset at a

given price and buying of the Put option gives it’s buyer the option to sell the underlying asset at

the given price. The seller of these contracts (both Call and Put) has no say in the execution of

these contracts because he receives the premium from the buyer (of the derivative) for selling these

contracts.