What is F&O? – Important Concepts You Must Know

The stock market offers several ways to trade beyond just buying and selling stocks. One of the most powerful tools for traders and investors is Futures and Options.

If you are wondering what F&O is, or what is the meaning of F&O in the share market, here’s a simple explanation.

Futures and Options are known as derivative instruments, which means their value comes from an underlying asset. This asset can be anything like stocks, stock indices, cryptocurrency, crude oil, natural gas, gold, silver, and more.

In F&O trading, you do not buy or sell the actual asset. Instead, you trade contracts based on how you think the price of the asset will move in the future. This is why many traders prefer F&O in the share market—to either make profits or protect their investments from risk.

The full form of F&O is Futures and Options, and both work differently:

• A Futures contract is an agreement to buy or sell an asset at a fixed price on a future date.
• An Options contract gives you the right, but not the obligation, to buy or sell the asset at a set price before the expiry date.

Understanding Derivatives With a Simple Example

Think of an orange as an asset and its juice as its derivative. The price of orange juice depends on the price of oranges. If oranges become expensive, juice prices will rise. If oranges become cheap, juice prices will fall.

Similarly, derivatives like Futures and Options (F&O) depend on the price of their underlying asset. These were originally created for hedging, which means reducing risk. But before we understand F&O, let’s first explore different types of derivatives.

Types of Derivatives

There are four main types of derivatives, and they are generally categorized in the following order:

1. Forward Contracts (Oldest Form of Derivatives)

A Forward Contract is a private agreement between two parties to buy or sell an asset at a fixed price on a future date.

These contracts are customized and are not traded on exchanges.

Example: A wheat farmer agrees to sell 1000 kg of wheat to a buyer at a fixed price after three months. No matter how market prices fluctuate, the deal remains unchanged.

Key Features:

• Customized contract
• High counterparty risk
• Not regulated by exchanges

2. Futures Contracts

Futures are similar to forward contracts but are standardized and traded on exchanges. They eliminate the counterparty risk of forwards because a clearing house acts as an intermediary.

Example: A trader buys a Gold Futures contract expecting gold prices to rise in the next two months.

Key Features:

• Traded on stock exchanges (e.g., NSE, BSE)
• Standardized contract size and expiry
• Requires margin (initial deposit)

3. Options Contracts

An Options Contract gives the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price before expiry.

Types of Options:
Call Option – Right to buy an asset at a fixed price before expiry.
Put Option – Right to sell an asset at a fixed price before expiry.

Example: Suppose you buy a Call Option on Reliance shares. If the price goes up, you can buy the shares at a lower price and make a profit. If the price goes down, you can let the contract expire and only lose the premium paid.

Key Features:

• No obligation to buy or sell
• Limited risk (only the premium paid)
• Used for hedging and speculation

4. Swaps

A Swap is a financial contract where two parties exchange financial instruments, such as interest rates or currencies, over time. Swaps are mostly used by large corporations and financial institutions.

Types of Swaps:
🔹 Interest Rate Swaps – Exchange of fixed and floating interest rates.
🔹 Currency Swaps – Exchange of cash flows in different currencies.

Example: A U.S. company with a loan in Indian Rupees (INR) can swap its interest payments with an Indian company that has a loan in U.S. Dollars (USD) to benefit from lower interest rates.

Key Features:

• Used for risk management
• Not traded on exchanges
• Complex financial structure

Among these, Futures and Options are the most popular derivatives used in the stock market.

F&O contracts were originally created for hedging purposes. But before we move ahead, let’s first understand:

What is Hedging?

Hedging means reducing risk or capping your gains and losses. Here’s a simple example:

Suppose you have two smartphones, and you log in to two different demat accounts with different brokers on different phones.

• On Phone 1, you buy a stock.
• On Phone 2, you short-sell the same stock.

Now, no matter where the stock moves, you won’t make a profit or a loss. This is a basic example of hedging – protecting yourself from market uncertainty.

Example of Hedging Using Options Contracts

Imagine you have invested ₹1 crore in 100 stocks of a company. You’re worried that the stock price might fall, but you don’t want to sell your shares.

• Instead of selling, you buy a Put Option (1 Lot = 100 stocks).
• If the stock price falls, your portfolio will show a loss, but the Put Option will generate a profit.
• Since the price of derivatives mirrors the price of the asset, your loss in stocks is balanced by the gain in the Put Option.

Result? Your overall loss is reduced, or in some cases, you may even end up with no profit, no loss!

This is how Options help in hedging risk.

We will read about hedging as well as hedging strategies in more detail later.

Futures vs. Options – Key Differences

Got confused? Worry not! We will cover this in more detail in upcoming articles. So, relax!

Final Thoughts

Futures and Options are powerful tools that help traders maximize profits and minimize risks. Whether you are a trader looking to speculate or an investor looking to hedge your portfolio, F&O can help.

However, they are complex and risky, so learning and understanding them before trading is important. If used wisely, Options can protect your investments, and Futures can help you take advantage of market movements.