People who have participated in equity investing have known to feel that trading in the future & options is more complex. However, those with a basic knowledge of the subject and regularly studying their trends and updates could find it easier to deal with the same. And registering a futures & options account with a broker shall be the right step in such kinds of investments. For participating in futures & options trading, there is no requirement of a Demat a/c since they are like future contracts rather than assets and hold legal validity till they expire.
If you are someone planning to start trading in futures & options anytime sooner or even looking to gather all basic information about the F&O trading in the share market, this article is for you. Read further to find out about what F&O means, its significance, the difference between them, the advantages of F&O trading, and how to start trading F&O trading.
F&O Trading- Meaning and Purpose
Future & Option trading is financial investments that are in the nature of a future contract and ultimately give such an investor a right (but no obligation) to trade a stock at a certain pre-determined price. Such transactions could take place at any point in time, provided the contract to be signed by the parties is legally valid. Futures and options are financial products that investors/traders could use either for higher returns or to act as a hedge against their current investments held by them. Although, there are certain remarkable differences between the two in their trading mechanism and the risks involved.
In the case of a futures contract, the buyer agrees to purchase the shares and sell the same at a pre-determined date in the future, except in case the shareholder’s position closes before the date of expiry. On the other hand, the buyer of the options gets the right without any legal obligation to either sell or purchase the stock at a pre-fixed price on a future date known as the date of expiry. Altogether, the futures and options contracts comprise the derivative trading in the share market.
The purpose of F&O trading is to help minimise the risk of the investment on a future date by determining a pre-determined price to hedge against the price movements of the underlying assets. Thus, the investor has the option to either square off the position before expiry if lucrative profit is at hand, or carry out with the contract until its expiry.
Features of F&O trading-
- F&O is regulated by the Securities and Exchange Board of India and can be traded on the stock exchange along with other listed securities.
- In terms of working & the risks associated with conventional trading, derivative trading is completely different.
- Derivatives allow investors to take a leveraged position by requiring lower payments than other kinds of trading.
How does F&O work?
Futures & Options were launched as an investment option in the stock exchange in the year 2000. Similar to other securities like shares & debt instruments traded in the stock exchanges, futures and options are also traded on recognised public exchanges in India and worldwide. To start F&O trading, you would require a trading account, i.e., a derivative trading account, which will be necessary to start trading from anywhere with such an account. Thus, F&O trading could be undertaken upon indices such as NIFTY50, NIFTY Bank, NIFTY Financial Service, and NIFTY Midcap.
Furthermore, it is also to be noted that when you begin trading in F&O trading, it is important to understand the concept of margins. For this, whether you are buying or selling futures contracts, the broker will gather margins. Additionally, to buy options, you will be required to have deposit premiums which are to be paid to the seller by the buyer. Generally, stockbrokers/ financial platforms also offer an online margin calculator, which allows them to compute margins. Such margin percentage varies from one stock to another depending on the risks involved. Such F&O contracts could be purchased for one/two/three-month periods.
Contracts could only terminate on the final Thursday of every month. Nevertheless, if such a particular Thursday is a holiday, the former day will be taken into account as the expiration date. But option contracts could be exercised at any time before the stipulated date of expiration. If the owner does not exercise his or her right to buy or sell the underlying security at the strike price within the stipulated time frame, the contract becomes worthless, and the option holder loses his right to buy/sell the underlying asset at the strike price.
Difference between Future & Options
|Definition||Futures contracts are investments in the form of contracts for trading in an underlying asset at a certain price at a point in the future. Both parties are obligated in this case to conclude the transaction on that date.|
|Futures contracts can be traded on the stock exchange by investors since they are standardized contracts.|
|Risks||Futures are regarded as higher in risk.|
|Profits/Losses||Futures could offer the highest profit and/or causes the greatest losses.|
|Obligation to parties||The buyer is bound to buy the asset under a futures contract at the stipulated expiration date.|
|Execution of the Contract||Once agreed upon, a future contract shall be executed on such a pre-determined date. On such a date, the buyer shall be obligated to purchase the underlying asset.|
|Advance Payment||There are no upfront costs involved while entering into a future contract. Nevertheless, the buyer has to ultimately pay for the agreed underlying asset.|
Different Types of future contracts
- Stock Futures: Stock futures are the most common variety of futures, which were introduced in India in the year 2000. These investments include an array of investments, such as leverage, which enables them to trade futures valued at least Rs 5 lakh, but up to the maximum of Rs. 50L.However, there are equally involved risks, such as the condition of the initial margin deposit with the concerned broker before starting to trade in futures. Further, stock futures are only accessible for a specific list of stocks, while they could be traded on stock exchanges like the BSE and NSE.
- Index Futures: BSE Sensex futures are used to make forecasts about the future movements of indices like the Sensex or Nifty. When stock prices decline, portfolio managers utilise them to protect their equity positions, such as a 40,000-rupee option with a 5,000-rupee expiration date. India offers index futures for Nifty 50, Nanny Bank, and Nifty IT, among others.
- Currency Futures: Currency futures are among the various kinds of financial futures. With this futures contract, you can exchange one currency for another at a pre-determined rate (for example, the euro against the dollar) at a future date. Both speculators and those looking to hedge risks employ these. As an illustration, an importer in India would buy USD futures to protect against any currency increase against the rupee.
- Commodity Futures: Commodity futures involve the hedging of the prices of significant commodities such as agricultural items, gold, silver, crude oil, etc. Large institutional entities like Government bodies & private entities frequently utilise these derivatives to protect themselves against price changes. Such commodity futures are traded on stock exchanges like MCX and NCDEX. Though there is tremendous scope for gains in commodity futures, it equally involves a considerable risk of heavier losses.
- Interest Rate Future: Among the several futures products is an interest rate future. It is an agreement to purchase or sell a debt instrument at a given price on a particular date. Government bonds or treasury bills make up the underlying assets. These can be traded on the BSE and NSE.
Different Types of Options
Call Option A call option contract grants the owner the option, but not the responsibility, to buy an agreed-upon quantity of the underlying security at an agreed-upon price within a certain amount of time, where the underlying security usually comprises a stock, bond, commodity, or other asset or instruments, etc.
Buyers must fork out a specific sum known as the option premium in order to purchase a call option. The buyers of the call option make profits when the value of the underlying security increases. When the call option holder exercises his option, the price at which he exercises such option is the strike price, and the time in which the sale may be made is referred to as the expiration or time to maturity.
If the call option holder fails the greatest, he may lose a call option the premium, which is the cost that the call option buyer must pay to purchase a call option. In contrast to the call option, a put option allows the holder to sell the underlying asset at a pre-determined price on or before the expiration date. As a result, the call option gives the trader a chance to make huge profits while limiting losses to the amount of the premium paid.
Let’s use an example to understand a call option. Investor C purchased a call option for the stock of the company DEF on a specified date at a strike price of Rs.130, with an expiration date one month later. Even if the stock’s actual price is greater than or equal to Rs. 160 on the expiration date, he can nevertheless purchase it at the same price. Owning a call option allows him to acquire the asset at a lower price and sell it at a higher price, even if it means that the underlying security is expected to rise in value in the future.
Call options could be further categorised into three types-
- In the money call option- In this case, the strike price is lower than the existing market price of the respective security.
- At the money call option- When the strike price is equal or close to the current market price of the underlying asset.
Out-of-the-money call option- When the strike price of a call option is higher than the current value of the underlying security, the option is said to be “out of the money.”
- Put Options
Put options grant the option holder the right to sell an underlying security at a specific strike price before the expiry of the option. Then, investors can decide on a minimum selling price for a certain security. However, the put option doesn’t obligate the option holder to exercise the right in this situation where if the market price exceeds the strike price, he could sell the asset at higher prices without even exercising the option. If the value of the underlying security drops, the option seller could reduce the risks by selling it at the strike price.
To get a better understanding of a put option, let’s take a practical example. Suppose a trader purchases a put option from GYZ corporation on a specified date hoping to sell it for Rs 100 before the date of expiry. But, if the value of the put option unexpectedly falls below Rs 80, he could still have the advantage of selling it for Rs 100. Likewise, the put option holder is not obligated to exercise the option even if the share price increases to Rs 120 later.
Now, similar to call options, put options can also be divided into three categories “in the money,” “at the money,” and “out of the money,” which have been stated as follows-
- In the Money- An option shall be considered an “In the Money” option when the strike price of the security is higher than the current value of the security.
- At the Money Put Option– A put option shall be regarded as “At the money” when the strike price is either equal to or closer to the premium paid for the option as compared to the existing price of the underlying security.
- Out-of-the-Money Put Options- An out-of-the-money option is a put option where the strike price of the security is lower than the current price on the market.
How to trade in Futures & options?
Provided below is the step-wise process of trading in futures & options contracts in the stock market-
Step 1- The first step towards understanding and learning to trade in future & options is necessary to open a trading account with a brokerage firm to buy/sell futures and options contracts. Such contracts shall be purchased through registered brokerage firms on the BSE/NSE.
Step 2- After creating your account, you must access the portal by logging in. Additionally, you have the option of selecting a mobile application and perusing the many F&O choices.
Step 3- After choosing a site, conduct some research on the futures and options that are offered and see which ones fit you better.
Step 4- Now, it would be possible for you to purchase futures and options contracts at the strike price once you make a choice and punch order.
Step 5- The spot price played a significant role in the pricing negotiations for the futures contract. Every asset has a current market price, including money and commodities. This is the spot price, which aids in the quick purchase or sale.
There are three possible outcomes for an Options contract that you have just purchased to assist you in moving forward.
- Offset the Position: Offsetting the position refers to selling an option contract to close a position before its expiration. Depending upon the price of the security of the sold, the sale of the underlying asset could offer either a profit or loss for the seller.
- Execute the Position: When the price of the underlying asset exceeds the strike price, the call option contract can be executed. Holding a put option allows the trader to do the same once the price of the underlying asset falls lesser than the strike price.
- The Contract Expires Worthless: In the case of a call option, the contract loses all of its value if the price of the underlying asset drops below the strike price. When a put option’s strike price is exceeded, the price of the underlying asset has succeeded.
What are the Advantages of F&O Trading?
- Leverage And Margins: Compared to equity trading, purchasing a futures contract doesn’t require making payment in full. While purchasing/selling futures, a person simply needs to make a payment of a certain percentage of the overall contract value. The margin, which is expressed as a percentage, varies for different stock futures. With such a specific sum of money, a trader could purchase/sell many more futures shares than equity. For instance, in cases where a stock’s future is around 20%, the trader might sell/buy five times as many shares in the futures market as in the equity market, which shall be referred to as leverage. Hence with a 20% margin, the leverage shall be 5. There are two sides to leverage, i.e., there could be a significant increase in both profits and losses. If a stock’s futures contract has a leverage factor of 5, the gains would be five times greater than those from the underlying equities. Futures profit percentage equals equity profit percentage multiplied by leverage; thus, if the equity generates a 20% profit, they provide a 100% return. This is achievable because of the small amount of money (margin) required to purchase futures. But losses would also be amplified in the same way. A 20% decline in equity would result in a 100% decline in futures contracts with a leverage of 5.
- Hedging Against Potential Risks: Investing in a single stock or a portfolio of stocks has a systemic risk that can be reduced or protected by using futures. By selling futures at a price higher than the price at which equity was purchased, hedging for individual stocks can be accomplished quickly and effectively. The quantity of futures traded must match the number of equity shares held by one. As a result, if prices drop, the gain from the selling order in stock futures would balance out the decline in equity value and vice versa. Market fluctuations have no impact on the returns, which are assured at a fixed rate. Futures can be utilised as a risk management tool for investments in a stock portfolio.
- Offers Access to the Markets to Investors: F&O trading allows investors holding a certain risk appetite to consider investing in future contracts and allow them to participate in stock markets for trading.
- Requirements for stable margins: The futures market has well-established margin requirements for the majority of commodities and currencies. As a result, a trader is aware of the amount of margin he should deposit in a transaction. The value of assets decreases over time in options, which significantly lowers the trader’s profitability. Time decay refers to this phenomenon. Time decay is not a concern for futures traders.
- Strong Liquidity: In particular, for currencies, indices, and frequently traded commodities, the majority of futures markets provide considerable liquidity. Since they can do this whenever they choose, traders can enter and quit the market.
- Plain Pricing: Futures pricing is fairly simple to comprehend in contrast to the exceedingly complex Black-Scholes Model-based options pricing. It is typically based on the cost-of-carry concept, in which the futures price is created by multiplying the asset’s spot price by the cost of carrying.
- Price Fluctuation Protection: Forward contracts are used as a hedging technique in businesses with significant price volatility. Using these contracts, for instance, farmers can safeguard themselves from the possibility of a decline in crop prices. Take a farmer who is planting wheat as an example. Once the crops are ripe, the farmer reaping 8,000 bushels of wheat. He could trade the entire crop at a pre-determined price in advance before the actual harvest in case he is unsure about the pricing at such time with an agreement to provide delivery at a later date, i.e., five or six months after the date of the agreement. Such agreement shall assure protection from any potential loss even though she does not receive the sale funds at the time of the arrangement.
Who Should Invest in Futures and Options?
Traders who participate in F&O could be subdivided into the following categories-
Hedgers: A futures contract is a sort of trading arrangement that enables people to enter into futures and options contracts in the share market to lessen investment volatility caused by price swings. Individuals enrolling in futures contracts may suffer substantial losses in the event of a favourable fluctuation, but this risk is reduced by the availability of options contracts, which let participants exit a transaction in the event of favourable price fluctuations.
The commodities market, where traders attempt to lock in the projected price of a certain good in preparation for a successful exchange, is a popular place to use a derivative contract. A put option contract can be used to counter a farmer’s potential profit loss in the event of a potato price increase. Then, to maintain the cost of raw materials at a set level and maintain price stability in an economy, producers and businesses engage in physical trade.
Speculators: Important concepts in the derivatives market include price volatility, economic factors, and intrinsic valuation. To profit from such price swings, speculators forecast the direction of price movement in a market and take a contrary posture in the present. For instance, if a trader is of the view that the price of the security will improve in the future, he might take a short position on the futures market and trade it at a higher price in the future.
People who trade derivatives want to choose cash settlement, which avoids the actual transfer of an asset and settles the difference between the spot price and the price indicated for the derivative between two parties, lessening the inconveniences of such a transaction.
Arbitrageurs: Arbitrageurs seek to benefit themselves from the price fluctuations occurring in the market due to market incompetencies by making two simultaneous offsetting trades. In futures and options trading, the price quoted includes the current price, the cost of carry, and the underlying assumption that the striking price corresponds to the agreed-upon price. Any price discrepancy results from the cost of carrying or transporting the underlying security to a future date. Since they alter demand and supply patterns to reach equilibrium, arbitrageurs virtually eliminate any price discrepancies resulting from poor trading conditions.
Tips for F&O trading
Here are a few basic tips that traders need to comprehend about futures and options trading-
- The profit-to-transaction cost ratio: Keeping the profit-to-transaction cost ratio at 3:1 may assist traders in increasing their returns. The costs associated with trading F&O, including brokerage, stamp duty, taxes, statutory fees, and STT, have an impact on overall results. If investors keep their costs low, they can generate decent returns.
- When the market’s direction is ambiguous, trade options. Options trading is an option that inexperienced F&O traders can engage in, even if they are unclear about the market’s direction. Traders can exercise their rights in option contracts up until the contract’s expiration date.
Along with market volatility, be mindful of additional risks.
- Brokerage margins increase dramatically during periods of high market volatility; thus, traders must maintain these margins to keep transaction costs as low as feasible.
- How do you determine F&O turnovers?
The sale of futures and options by traders across the entire year can be used to determine turnover. The turnover of trading in futures and options is referred to as total sales.
- Are futures and options the same thing?
No. Despite certain similarities, futures and options differ in several ways, including the risk they carry, the rights and obligations they give their holders, and the fundamental laws and rules that apply to them.
- Among futures or options, which has more leverage?
Future and options both have benefits as well as drawbacks. While futures contracts cannot be transferred during the term, options contracts give the option to exercise the right up until the date of expiry. However, compared to option contracts, futures may provide significantly better returns. All of this relies on the trader’s tolerance for risks.
- What do stock market derivatives (F&O) entail?
The value of these derivative contracts, such as shares of firms, is based on the underlying stock market instruments, which is the essence of future and option trading.
- What margin requirements apply to trading derivatives?
Based on how volatile the market is, the margin needs are determined. The larger the proportion of margin that brokerage firms charge, the more volatile the market is.