A Beginners Guide to Futures and Options Trading - Motilal Oswal

A Beginners Guide to Futures and Options Trading

Opening your futures & options account with a broker is just the first step to trade in this kind of investment method. Futures and options are a lot more complex than equity investing and you need to understand the nuances better. You do not need a Demat account to deal in futures and options as they are only valid till their expiry date. Hence, they are more like contracts rather than like assets. Let us first understand what is F&O trading in share market. Before embarking on your F&O journey you need to first understand how to trade in futures and options. So, here is a quick preparatory guide for futures and options trading for beginners.

What are futures and options?

With an options contract, an investor has the right (but no obligation) to purchase or sell stock at a certain price. This transaction can happen at any time, provided the contract is valid. Contrastingly, in a futures contract, the purchaser has to buy shares (and a seller must sell shares) on a certain date in the future, unless the shareholder’s position closes before the date of expiry. 

Futures and options represent financial products that investors can make use of for making returns or to act as a hedge against any current investments they possess. Both a future and an option allows any investor to purchase any investment at a particular price by a particular time and date. However, the markets for both these products are quite distinctive in the way they work and their risk for investors. 

Understanding F & O Meaning in More Detail

Before getting into your beginner fundamentals about how futures and options actually work in a practical scenario, it is important to grasp f & o meaning in a little more detail. Options are a form of investment that deal with derivatives. They could be offers to purchase or sell stock, but they do not really represent the actual ownership of the underlying investments, at least, not until the agreement is final. Typically, buyers pay a premium for contracts in options, and these reflect a hundred shares of whatever the underlying asset is. Premiums are indicative of the asset’s “strike price” which is essentially the rate to purchase or sell until the contract expires. This is the date that indicates when the contract has to be used. 

Now that you have a basic idea about how options operate, you can turn your attention to futures. In futures and options trading, a futures contract is representative of an obligation to purchase or sell any asset at a future (later) date at a pre-agreed-upon price. Futures act as a veritable hedge as far as your investments go, and are understood well when you consider commodities such as oil or wheat. For example, a farmer may wish to lock on an acceptable value (price) initially, just in case prices in the markets dip before any crop can be delivered. The buyer might also wish to fix an upfront price in case there is a hint of prices soaring by the time of crop delivery. 

Futures and Options Trading for Beginners:

Seven things you need to know before your first F&O trade

1.  Futures are leveraged products and they work both ways. The smart sales guy may have come and told you that since you only pay 20% margin on futures, your profit can be multiplied by 5 times. Here is how it works! You buy stocks worth Rs.100,000 in futures by paying Rs.20,000 margins. If the price goes up by 10% then the profit of Rs.10,000 on your margin is actually 50% as it is 5-times leveraged. So, what the enthusiastic salesman told you was correct. The only thing he did not tell you was that it works similarly for losses also and they also tend to get magnified when you trade in futures. It is fine as long as you are aware that the impact of leverage through margins works both ways; in case of profits and in case of losses.

2.  Buying options means limited risk, but you rarely make money. Many small F&O traders prefer to buy options because your risk is limited to the premium paid. The problem is that globally, over 97% of the options expire worthless. That means, if you buy options then you just stand a 4% chance of making money on options. The truth is that option sellers take a higher risk and therefore they make money more often compared to option buyers. So don’t just get carried away by the argument that your risk in buying options is limited. The truth is that your prospects of making profits are also limited when you buy options. In futures and options trading, you may just find that futures may be better than options for you. It all depends on how you trade and how much you can afford to lose. 

3.  Options are asymmetrical and that is the difference. Let us understand this with an example. If "A" buys RIL futures at Rs.920 and B sells these futures, then the trade is symmetrical for both the parties. If the price goes to 940 then A makes a profit of Rs.20 and B makes a loss of Rs.20. The reverse will hold true if the stock price goes down to Rs.900. But in case of options, the buyer’s loss is limited to the premium, but the seller’s loss is unlimited potentially.

4.  Margins on futures can go up sharply in volatile times. Many of us believe that futures have an advantage over cash market buying as you can leverage by buying on margin. But these margins can go up sharply in times of volatility. Assume that you bought GMR futures by paying margin of 15%. You are prepared with liquidity up to 25%. But volatility in the stock suddenly goes up and the margins are revised to 40%. Now you are in a quandary! You either need to bring in fresh margins or your broker will compulsorily cut your positions. Be aware of this risk when you trade in F&O.

5.  Always trade F&O with stop losses and profit targets. This is true of all leveraged positions. While trading in Futures and Options, your primary focus is that of a trader and not as an investor. Therefore, your accent should be on protecting your capital. That is possible only if you define your loss and profit trade-off for each trade. Stop loss is a discipline; so, don’t try to second-guess it. Irrespective of your view on the stock, the stop loss levels, and profit booking levels have to be adhered to religiously when you trade in F&O.

6.  Keep a constant eye on the costs that you are incurring in F&O. If you think that brokerage and other costs on F&O are lower, then think again. In percentage terms they may be lower than on equity, but you churn more frequently in case of F&O. These costs add up. You pay brokerage, GST, stamp duty, statutory charges and STT on F&O trades. If you sit down and add these up, you first need to get a perspective. Ensure that your ratio of profits to transaction cost is better than 3:1; otherwise you are justifying your effort trading in F&O.

7.  You can trade options even when you are not sure of direction of market. The ability to adopt a non-directional strategy is one of the most enduring features of the F&O market. You can combine options and futures to trade markets where you are not sure of the direction. Options can be used to profit in volatile markets and in lacklustre markets. These aspects of options are more meaningful to you than using options as a substitute for trading in equities.

Trading futures and options is widely conducted based on leverage. Here, the complete cost of trading is not paid initially upfront. Rather, a broker can finance a stipulated portion of the entire contract, provided a minimum amount is maintained by an investor in the investor’s trading account. This makes the profit margin of the investor rise significantly. Although you may be tempted to gain a lot by trading f & o, you should be aware of the risks too. 

Trading in Futures & options is nothing like the rocket science that is normally made out to be. A proper understanding will surely help you make better use of these innovative financial products!

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