Basics of Futures and Options (F&O) Trading
Before learning how to invest in Futures and Options (F&O), it is important to get your basics right. Let's look at some concepts.
Futures, and options are derivatives whose value is derived from the underlying asset. There are many different types of assets on which derivatives are available. These include stocks, indices and commodities such as wheat, petroleum, gold, silver, cotton, and many more. We will focus on how to trade futures and options in the stock market.
These futures, and options are used for two main purposes. One is to hedge against price risk; The second is to profit from changes in prices or to speculate. Most of the activity is based on betting.
What you must remember while learning how to invest in futures and options is that every futures and options contract must have a counterparty. Every buyer of a futures or options contract must be a seller, or 'writer'. It is a zero sum game. If you win, someone else loses, and vice versa.
What are futures?
Futures contracts enable a buyer or seller to buy or sell a stock at a specified predetermined price on a specified date in the future. This can be best explained with the help of an example of an expected increase in the share price of Company BZ, which currently stands at Rs.80. You then buy 1,000 BZ futures at Rs.80. So if the share price of BZ goes up to Rs 100, you would make 100-80 × 1000 or Rs 20,000. If the prices fall by Rs.60, you make a loss of Rs.20,000.
what are the options?
Options give the buyer or seller the right, but not the obligation, to buy or sell a stock at a specified price at a predetermined date in the future. The difference between a future and an option is that in the latter, you have the option not to exercise the contract. Taking the above example of BZ, if the prices fall to Rs 60, you have the option of not exercising the contract. So your losses will be limited to the premium paid by you.
There are two types of options – Call option, and Put option. A call option gives you the right to buy a certain stock, while a put option gives you the right to sell a stock. Call option works best when you expect the stock prices to go up. Put options are a better option when stock prices are expected to fall.
What is Margin/Premium?
When you learn how to trade futures, it is important to understand margin and its concept. Margin is what you pay to the broker for trading futures. This is the percentage of the trade you can take, and is fixed at the maximum possible loss you can take. Margin will be higher in volatile times. In options, you pay a premium to the seller, or 'writer', of the option.
What is Impact Efficiency?
Another important thing to learn is the concept of leverage when learning how to invest in futures and options. Remember that leverage is a percentage of the underlying asset. If leverage is 10 per cent, and you invest Rs 10 crore in a futures contract, you need to pay only Rs 1 crore to the broker.So you will be able to trade in multiples of leverage. This is called efficiency. The high leverage makes it possible to carry out large volumes of transactions, thus increasing your chances of making profits. Of course, the downside is that if you choose the wrong time, you can also lose a lot.
What is the closing date?
One of the fundamentals in futures and options trading is that futures and options contracts are not of unlimited duration. They are for a certain period of time, such as one, two or three months. At the end of the expiry period, the contracts must be settled either in cash or by delivery of shares. However, you do not have to retain them till the end of the closing period. You can square off the transaction even before that if you feel that the prices are not moving in your favour.
Which is better – Stocks or Futures?
Is there any advantage in investing in futures instead of directly in stocks? Certainly, there are advantages in futures trading. The biggest advantage is that you do not need to spend capital on acquiring the entire asset, or stock. All you need to do is pay margin to the broker, which is a percentage of the futures transactions you undertake. Plus you get the benefit of leverage, which means you'll be able to grab bigger opportunities, and increase your chances of making money from your transactions.
It appears that options are the better choice as your losses will be limited to the premium you have paid. It can be compared weakly with futures, in which the contract has to be exercised at the strike price, and hence the potential for loss becomes unlimited.However, the probability of making a profit is much higher in futures as compared to options. Around the world, an overwhelming number of option contracts expire worthless. Thus the profit making option would be the writer of the option contracts who sold them.
Futures trading has some disadvantages as compared to stocks. One of them is that you do not own the underlying shares. So you have to give up the benefits of ownership such as dividends from the company, or voting rights. The sole purpose of futures trading is to profit from price movements.
What are index futures?
There are two types of futures available in the stock market. One is index futures, and the other is individual stock futures. An index futures is a contract whose underlying is the stocks that make up an index. What you are doing is betting on the normal movement of the index.You can get Index Futures for Nifty, Sensax, Bank Indices, IT Indices, etc. Since you are betting on multiple stocks instead of just one, the risks are lower than investing in individual stocks. Index futures are cash-settled, and there is no delivery of shares.
Are futures available for all stocks?
No, only certain stock futures are eligible for trading. Futures contracts are available on 175 securities as prescribed by the Securities and Exchange Board of India (SEBI). They are selected according to several criteria which include liquidity and volume.
What is a target for the market in futures trading?
Open futures contracts are automatically target to market at the end of each trading day. That is, the day's base price is compared with the previous day's closing price, and the difference is squared off in cash.This is used to calculate margin requirements. If the current value of the stocks in the futures contract falls, the holder will receive a margin call from the broker to maintain the margin at the required level. If the margin call is not met, the broker may sell the futures, and the holder may suffer heavy losses.
Pros and Cons of Futures and Options Trading
When you are learning how to trade futures and options, you also need to know what you are getting into. Certainly, there are many advantages in investing in futures and options, such as leverage.But futures and options can also be risky. High leverage enables you to take large positions, and if the market does not turn in your favor, can result in huge losses. F&O is all about betting on future price movements, and no one can say for sure which way they will go.
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