Futures and options (F&O) are financial instruments designed for hedging, speculation, and arbitrage in the stock market. They are derivatives since their value is derived from the underlying asset, which could be shares, indices, or currencies. Thus, here is a way for a trader to manage his risks with F&O contracts and still earn gains from the price movement of the underlying assets without directly holding them.

F&O Contrived Futures and Options Definitions.

A futures contract is defined as a contract between two parties to buy an asset or sell a commodity at a certain date in the future for an agreed-upon price. On the expiration day, both the buyer and the seller would be forced to adhere to this contract. An options contract gives the holder the right, if he so chooses, to either buy or sell the underlying asset at a specified price, as dictated by the terms of the options contract, on or before the expiry date. The seller of the option is obliged to perform the contract if the buyer wants to exercise it.

F&O Trading Basics with Examples

1. A Futures Contract Example:

A trader thinks that a particular stock worth ₹500 now may experience a rise in its price within the next month and enters into a futures contract to buy 100 shares of the stock at ₹500. On the due date, the stock trades at ₹520, and the trader makes a gain of ₹20 per share or ₹2,000. Conversely, if the stock price declines to ₹480, the trader will make a loss of ₹2,000.

2. An Options Contract Example:

A trader is anticipating that the price of the stock will go up and purchases a call option with a strike price of ₹500 at a premium of ₹10. If the stock goes up to ₹520 before expiry, the trader will exercise the option and buy the stock at ₹500, making a gain of ₹10 per share after deducting the premium. If, however, the stock price is below ₹500 until expiry, then the trader does not exercise the option and loses, at most, the ₹10 premium per share.

What Happens on F&O Expiry Day?

Expiry day is the last Thursday of a month when all open F&O contracts for that month expire. If Thursday is a holiday, then the contracts expire on the previous trading day. Contracts shall be settled by physical delivery or cash settlement on that day, depending on the asset and exchange rules.

So, traders and investors close or amend their positions for the impending expiry dates to preclude any contract settlements. Many traders will roll over their positions into the next month by closing out their current contracts and opening new contracts for the next expiry cycle.

What Is The Direct Effect On Traders?

The expiry days strongly affect the price movements and trading patterns in the market. Traders are affected by the following factors:

• Increased Volatility: Expiry days tend to be extremely volatile as many participants are trying to close or modify their positions. Sudden spikes in volatility caused by increased trading activity can send the prices of underlying assets on a wild ride.
• Time Decay on Options: The value of options depreciates closer to expiry, and this applies especially to out-of-the-money options. A trader holding onto those puts may suffer a total loss of the premium paid with the underlying price not moving in their direction.
• Last-Minute Moves: Traders may witness sharp price changes near the end of the trading session as large volumes of contracts are squared off or rolled over, resulting in unexpected profits or losses, depending on the direction of the price movement.
• Margin Requirements: These will likely increase on expiry days due to a higher risk of holding a position until settlement. Traders must ensure they have enough funds in their accounts to meet margin requirements.
• Settlement Process: Depending on the rules of the exchange, a contract may be settled through either physical delivery or cash settlement. Traders must note what type of settlement applies to their contracts so as not to be faced with unexpected delivery obligations or charges.
• Roll-over Cost: When traders move their position from the current month to the next month, they will either incur a cost or receive a credit depending on the price difference between the two contracts; this difference is called roll-over cost.

Conclusion

F&O trading is characterized by ninety-one contracts that give traders opportunities to hedge, speculate, or arbitrage based on the price movements of underlying assets. Thus, one must know about what is f&o and the basics of the workings of futures and options before entering the derivatives segment.