InvestorQ : What are the major functions that the derivatives market (F&O) market performs?
Sam Eswaran made post

What are the major functions that the derivatives market (F&O) market performs?

swati Bakhda answered.
2 years ago

Like the stock market, the futures and options market is also a platform for buyers and the sellers to come together. But the futures and options also offers some additional facilities like standardization of contracts and management of risk. In fact, F&O are a good method of distribution risk in the market, which go a long way in attracting investors to the market. It plays 3 key roles.

Enable standardization of contracts

Permit management of risk by investors

Gives a democratic platform for buyers and sell to interact

Here is how the F&O market enables standardization of contracts

The beauty of any stock market is that it permits standardization of contracts. Let us understand this concept of standardization through the example of futures and options. Today if you want to trade Reliance Futures, you can only buy and sell in standard lots of 500 shares each. This is called 1 lot. This simplifies the transaction since the buyer and the seller will necessarily only have to place orders in these specific lot sizes. In the absence of lot sizes imagine what could happen? There could a buyer trying to buy 494 shares of Reliance in futures and a seller trying to sell 920 shares in futures. Unless there are matching buy and sell orders this matching cannot be achieved. This problem is solved by making contracts standard. For example, you can only buy Reliance Futures & options in multiples of 500. This ensures that buyers and sellers do not have problems in matching their transaction.

Here is how the F&O market permits management of risk in stock markets...

Investment in stock markets has its own set of risks. This risk cannot be avoided and hence has to be managed. The stock market provides a platform to manage this risk through the use of futures and options. Here is how it will work... Let us assume that you have purchased 600 shares of Tata Motors in the cash market. You are worried that lower sales by Jaguar may lead to prices falling but you are confident of the long term prospects of Tata Motors. You can manage your risk by buying a put option on Tata Motors. We will see the operation of put options in detail later, but for the time it is enough to understand that a put option helps you to gain when the price of Tata Motors falls. For this you pay a small price which is called the option premium.

Here is how the F&O market gives a democratic platform for buyers and sellers to come together...

The advantage of a stock market is that it is democratic and it is also anonymous. You can see the trades and the execution on the screen but you do not know the identity of the person who is placing these orders. To that extent your anonymity is maintained. To understand the concept of a democratic platform in exchanges, you need to understand how equity trading used to happen in the days prior to 1995. The investors would never know if he was getting the best price or not as the trades were negotiated between brokers. Today the stock market has become so transparent that an investor can immediately know if they are getting the best price or not and that makes a lot of difference to your confidence as an investor!