F&O - Futures and Options Expiry: All you need to know
Summary: Trading in Futures and Options (F&Os) is ideal for investors and traders who are keen on short-term contracts and are willing to take risks. With the right broking house, access to research material, and effort, getting a grip on the basics of the F&O market is easy.
Futures and Options (F&O) are complex financial instruments that are traded in the derivatives market. They are derived from underlying assets such as commodities, indices, and stocks. The distinguishing factor for F&O trading is that these contracts are terminate on a pre-determined date (expiry date). This blog will break down the concept of monthly F&O expiry, what it entails, and how traders deal in them.
What is the big deal about the expiry date?
F&Os are complex, derived instruments that come with expiration dates. These are agreements to purchase or sell the underlying asset at a pre-determined price before the expiration date. However, the repercussions aren’t as simple as the agreement. On the expiry date, the F&O contracts are settled, which means traders adjust their positions, resulting in high market volatility. The assessment of underlying assets influences pricing as the expiry date nears; coupled with traders’ adjustments, this leads to significant changes in stock prices.
The last Thursday of each month is the standard expiration date for F&O contracts. However, the date is different for the BSE’s sensex and Bankex F&O contracts. They expire on the last Friday of each month.
What takes place on a derivates expiry date
Traders resort to a range of measures to tackle the volatility in the market. Put simply, the difference between the futures contract price and the option’s strike price, as well as the premium paid determines the profitability of an F&O contract. A common technique used by traders is to square off positions before the expiration date. This helps in avoiding loss of the entire premium that has been paid, along with brokerage charges and taxes. Analysts make predictions based on resistance and support levels, which lead to reactions among traders that affect trading volumes and volatility.
Futures vs options
There is however a distinction between futures and options. It is mandatory to settle futures before the expiry date. Options contracts, however, do not levy penalties if they are not settled. They grant the right, but not the obligation, to sell or buy, making it flexible for traders. This implies that options traders can buy/sell (or not) if they feel the outcome is not profitable. This is a convenience that options traders are extended in exchange for a premium that they pay in advance. The futures traders need to mandatorily buy or sell before the expiration of the contract to fulfil the obligation.
Types of settlement
Here are the two types of settlement mechanisms available to traders:
- Physical delivery: This is the most common method, where the trader purchases the underlying asset to make up for the shortfall in the contract.
- Cash settlement: Instead of making purchases, the settlement is made in cash.
However, as stated, futures contracts must be settled, which isn’t the case for options.
Dates for settlement
So that there is no confusion regarding the date of settlement, the last Thursday of each month is the expiry date for F&O contracts. If the date happens to be a public holiday, the day before it is the expiry date. Starting September 4, the NSE has disclosed a change in the expiration schedule for Nifty Bank weekly index options. Instead of expiring on Thursdays, these options will now reach their expiration on Wednesdays. The initial Wednesday weekly expiry for Nifty Bank is set for September 6.
How F&Os are traded
The F&O derivatives are of four key types:
- Swaps: Here, two parties exchange their cash flows or liabilities.
- Forwards: These are private contracts between a seller and buyer and involve over-the-counter trading.
- Futures: These contracts can be traded in the secondary market and are sold at a specified price on the expiry date.
- Options: With options contracts, the trader has the option to sell or buy an underlying asset at a particular price.
For options, there are two contracts: put and call. For a call/put, the buyer has the right to buy/sell (but is not required to) a quantity that is agreed upon. In both cases, a premium is paid by the buyer. The value of a call contract increases as the value of the asset appreciates, but for a put, it decreases.
Launched in the stock market in 2000, these contracts do not extend to all stocks, but only selected ones. Nifty Midcap, Nifty Bank, Nifty50, and Nifty Financial Service are among the indices on which F&O trading can be done. Traders must have margins on their account before they can trade F&Os and premiums are paid by the buyer to the seller. The biggest advantage of F&O trading is that it can be transferred to someone willing to undertake the risk. The transaction costs are low and can provide price discovery in the underlying market. F&Os are easy to master and doesn’t take long for traders to optimise.