Equity Derivatives: Futures and Options Basics

Introduction: Beyond Buying and Selling Stocks

“Derivatives let you bet on price movements without owning the underlying asset.”

When you hear traders talk about “Nifty futures,” “call options,” or “hedging with puts,” they’re discussing derivatives. These instruments derive their value from underlying assets (stocks, indices) and enable trading, hedging, and speculation with leverage. Understanding derivatives opens up a new dimension of market participation.

What Are Derivatives?

Definition

A derivative is a financial contract whose value is derived from an underlying asset (stock, index, commodity, currency). The contract specifies rights and obligations based on the underlying’s price movements.

Key Characteristics

Types of Derivatives

Futures Contracts

What Is a Futures Contract?

A standardized agreement to buy or sell an asset at a predetermined price on a specified future date.

Futures Terminology

Example: Nifty Futures

Specifications:

• Underlying: Nifty 50 Index
• Lot Size: 25 units
• Expiry: Last Thursday of month
• Settlement: Cash settled

Position Example:

• Nifty Spot: 22,000
• Nifty Futures (Near Month): 22,050
• Buy 1 lot (25 units)
• Contract Value: 25 × 22,050 = ₹5,51,250

Margin Required: ~₹1,10,000 (approximately 20%)

Leverage: Control ₹5.5 lakh position with ₹1.1 lakh

Futures Pricing

Cost of Carry Model: $$Futures\ Price = Spot\ Price + Cost\ of\ Carry$$

$$F = S \times e^{(r-d) \times t}$$

Where:

• F = Futures price
• S = Spot price
• r = Risk-free rate
• d = Dividend yield
• t = Time to expiry

Typically: Futures trade at premium to spot (contango) due to cost of carry.

Profit/Loss Calculation

$$P&L = (Exit\ Price - Entry\ Price) \times Lot\ Size$$

Example:

• Buy Nifty Futures at 22,000
• Exit at 22,300
• Lot Size: 25
• Profit: (22,300 - 22,000) × 25 = ₹7,500

Options Contracts

What Is an Option?

A contract giving the buyer the right (not obligation) to buy or sell an underlying at a specified price before/on a specified date.

Options Terminology

Call Options

Definition: Right to buy the underlying at strike price.

Buyer’s View: Bullish (expects price to rise)

Example:

• Nifty Spot: 22,000
• Buy Call Option: Strike 22,200
• Premium: ₹150 per unit
• Cost: 25 × ₹150 = ₹3,750

At Expiry:

• If Nifty at 22,500: Profit = (22,500 - 22,200 - 150) × 25 = ₹3,750
• If Nifty at 22,000: Loss = Premium = ₹3,750

Put Options

Definition: Right to sell the underlying at strike price.

Buyer’s View: Bearish (expects price to fall)

Example:

• Nifty Spot: 22,000
• Buy Put Option: Strike 21,800
• Premium: ₹120 per unit
• Cost: 25 × ₹120 = ₹3,000

At Expiry:

• If Nifty at 21,500: Profit = (21,800 - 21,500 - 120) × 25 = ₹4,500
• If Nifty at 22,000: Loss = Premium = ₹3,000

Moneyness

Example (Nifty at 22,000):

• Call 21,500: ITM (₹500 intrinsic value)
• Call 22,000: ATM
• Call 22,500: OTM

Options Pricing

Premium Components

$$Premium = Intrinsic\ Value + Time\ Value$$

Intrinsic Value:

• Call: Max(Spot - Strike, 0)
• Put: Max(Strike - Spot, 0)

Time Value:

• Additional premium for time remaining
• Decreases as expiry approaches (time decay)
• Maximum for ATM options

Factors Affecting Premium

The Greeks

Most Important:

• Delta: How much premium changes for ₹1 move in underlying
• Theta: How much premium erodes daily (negative for buyers)

F&O Segments in India

Index Derivatives

Stock Derivatives

• ~200+ stocks with F&O
• Individual lot sizes vary
• Higher margins than index F&O

Expiry Schedule

Index Options:

• Weekly expiry (Nifty, Bank Nifty)
• Monthly expiry

Stock Options:

• Monthly expiry only

Futures:

• Monthly expiry (3 consecutive months)

Basic Strategies

Long Call (Bullish)

View: Strongly bullish Action: Buy Call Option Max Profit: Unlimited Max Loss: Premium paid

Payoff Diagram:

Profit
  |     /
  |    /
  |___/____Strike_____ Spot
  |Premium Lost
Loss

Long Put (Bearish)

View: Strongly bearish Action: Buy Put Option Max Profit: Strike - Premium (if spot goes to 0) Max Loss: Premium paid

Covered Call

View: Mildly bullish Action: Own stock + Sell Call Purpose: Generate income from holdings Risk: Give up upside above strike

Protective Put

View: Bullish but want protection Action: Own stock + Buy Put Purpose: Insurance against downside Cost: Premium paid reduces returns

Straddle

View: Expect big move, unsure of direction Action: Buy Call + Buy Put (same strike) Max Profit: Unlimited Max Loss: Both premiums

Iron Condor

View: Range-bound market Action: Sell OTM Call + Sell OTM Put + Buy further OTM Call + Buy further OTM Put Max Profit: Net premium received Max Loss: Defined by strikes

Risk Management

Margin Requirements

SPAN Margin + Exposure Margin

Position Sizing

Rule of Thumb:

• Risk only 1-2% of capital per trade
• Never risk more than you can afford to lose
• Account for leverage amplification

Stop Losses

Essential for:

• Futures (unlimited loss potential)
• Sold options (unlimited loss potential)

Option Buyers:

• Loss limited to premium (built-in stop loss)
• But can still set stops to preserve capital

Common Mistakes

1. Over-leveraging: Taking too large positions
2. No stop loss: Hoping losing trade will recover
3. Fighting the trend: Picking tops and bottoms
4. Ignoring time decay: Holding OTM options too long
5. Not understanding: Trading without knowledge

Taxation

Futures

Treated as speculative business income:

• Profits/losses: Business income
• Taxed at slab rate
• Can offset against other business income
• Carry forward losses 8 years

Options

Similar treatment as futures:

• Business income
• Premium received = income
• Premium paid = expense

STT (Securities Transaction Tax)

Note: STT makes frequent trading costly.

Getting Started

Prerequisites

1. Knowledge: Understand basics before trading
2. Trading Account: F&O enabled with broker
3. Capital: Adequate margin money
4. Risk Appetite: Accept potential losses

Learning Path

1. Paper trading: Practice without real money
2. Small positions: Start with 1 lot
3. Index options: Begin here (more liquid)
4. Simple strategies: Buy calls/puts first
5. Complex strategies: Only after mastery

Capital Requirements

Minimum Practical Capital:

• Index Options: ₹50,000-1,00,000
• Index Futures: ₹1,50,000-2,00,000
• Stock F&O: ₹2,00,000+

Key Takeaways

1. Futures = Binding agreement – Both parties obligated
2. Options = Right, not obligation – Buyer has choice
3. Leverage cuts both ways – Amplifies gains and losses
4. Time decay hurts buyers – Options lose value daily
5. Risk management essential – Stop losses, position sizing
6. Start small – Learn with limited capital
7. Knowledge first – Understand before trading

Disclaimer

This article is for educational purposes only. Derivatives trading involves substantial risk of loss. Most retail traders lose money in F&O. Only trade with capital you can afford to lose. This is not trading advice or recommendation.

Frequently Asked Questions

Q: Can I lose more than I invest in options? A: As an option buyer, maximum loss is the premium paid. As an option seller, losses can be unlimited. Futures positions can also result in losses exceeding initial margin.

Q: Why do most traders lose money in F&O? A: Leverage amplifies losses, time decay works against option buyers, emotional trading, inadequate knowledge, and poor risk management. Statistics show 90%+ retail traders lose money.

Q: When should I use futures vs options? A: Futures for directional views with higher leverage. Options for defined risk (buying) or income generation (selling). Options also useful for hedging.

Q: What’s the best strategy for beginners? A: Start with buying options (limited loss) on indices (more liquid). Learn single-leg strategies before complex ones. Paper trade first.

Q: How much capital do I need? A: Technically, you can start with one lot margin (~₹50,000 for index options). Practically, ₹2-3 lakh gives more flexibility and risk management room.

Derivatives are like power tools—incredibly useful in the right hands, but dangerous without proper training. They can help you hedge risk, generate income, and profit from market movements. But they can also quickly destroy capital if misused. Respect the leverage.