Futures and options (F&O) trading is entirely different and more complex than equity trading. F&O are contracts rather than assets. Before embarking on the F&O trading journey, it is necessary to understand the nuances better. Let us elaborate on various aspects of futures and options with this guidepost.
F&Os are derivative products utilised for hedging purposes. Derivatives do not offer the ownership of the underlying assets. You can exercise the rights upon the expiration of the contract.
- These are binding contracts. They are based on precisely defined terms. Their properties are based on the values of their underlying financial securities, such as scrips or indexes.
- They are traded in derivative markets as these two are completely different in terms of the working system and carry different types of risk.
Futures contract is an obligation, not a right. It brings liability for investors to buy or sell the underlying financial asset at a fixed price. Types of futures are stock futures, index futures, energy futures, currency futures, interest rate futures, commodity futures, etc.
Options contract is a right, not an obligation. Investors have the choice to buy or sell the underlying asset at a pre-fixed price on expiry or even before the contract is in effect. Options are preferred to trade stocks.
It is the right to buy. Traders believing that the underlying security price is to be increased prefer call options.
It is the right to sell. Traders believing that the underlying security price is to be decreased prefer call options.
Options can be based on the expiration cycle also. Online trading and demat accounts are mandatory for stock trading, but it is not the case in futures and options, as they are only valid until their expiry date.
Traders need to only pay a percentage of the asset values to invest in futures. If you buy stocks worth Rs. 2 lakhs in futures against a margin of Rs.40,000 and the stock price increases by 10%, then the profit is Rs.20,000, and your profits are 50%. It can work to magnify losses also.
Futures are closed and settled on the day of expiry, the last Thursday of the month and profits/losses are debited or credited to the trader’s account.
Suppose you buy futures against a margin of 15%, and you are prepared for liquidity up to 25%, but margins are revised to 40% due to increased volatility in the stock market. You need to bring more margins, or the broker will cut your positions.
Stop-loss is a discipline. Like any other leveraged positions, F&O trades should be placed with stop losses and profit targets to protect your capital.
Keep an eye on the costs you incur in F&O trading. You need to pay brokerage, stamp duty, statutory fee and GST on F&O trades. The ratio of profits to transaction costs should be better. Otherwise, it is hard to justify your effort in F&O trading.
Options have the potential to profit in volatile markets also. You can trade options in an uncertain market’s direction.
Futures and options have high risks, and traders need to predict price movements accurately. It is necessary to have a thorough understanding of the stock market to profit from the derivative market.