What Are the Key Risks and Rewards
of trading in F&O?
Key benefits of trading in F&O are 1) Leverage to maximize profits on limited capital, and 2) Hedging - to limit risks arising from price volatility. Risks in F&O trading arise from a lack of proper understanding of the product and inherent leverage worsened by market volatility.
For traders desiring to trade in the derivatives market, it is necessary to learn the key technical analysis and have an expert by your side, to guide you to choose the right strikes and provide you with detailed insights on the target, and its stop loss. Beginner traders are advised to trade in lower volumes as the risk associated with trading in F&O increases with the volume.
Let’s learn in detail what are these risks and rewards associated with trading in F&O and how can one manage to limit losses using some smart trading strategies -
Rewards of trading in F&O
Leverage
Trading in F&O allows investors to own larger positions with a relatively small amount of capital, leveraging their potential profits. Let’s understand the concept of leverage through an example.
Suppose you are interested in trading options on a stock, let's say a company's stock 'ABC Ltd.' is currently trading at ₹2,000 per share. You have a bullish outlook on ABC Ltd. and believe the stock price will rise to Rs. 2,200. If you want to buy 250 shares of ABC Ltd. at ₹2,000 per share, it would cost you ₹5,00,000.
Alternatively, you could buy a Call Option for ABC Ltd. with a strike price of ₹2,000. Let's assume the premium for the call option with a strike price of Rs. 2,000 is ₹50 and the lot size is 250 units. In this case, the total premium for the Call Option would be ₹12,500 (₹50 x 250).
Leverage comes into play when comparing the initial investment in stock purchase versus the premium paid for the call option contract:
Suppose the stock moves up by 10% as you predicted i.e 200 points. In this case, on stock purchase of ₹5,00,000 you will incur a profit of ₹50,000, which is 10% of your capital investment. But, if you had bought the call option of Rs. 2000 strike, it would be worth at least Rs. 200 at the time of expiry. This means you would make a profit of Rs. 150 on 1 Call Option (200-50) and Rs. 37,500 on 1 lot of call options (150 * 250 lot size). On a total investment of Rs. 12,500 to buy the call, you would make a profit of Rs. 37,500 i.e. 300% by trading in Call Option rather than trading the stock in cash.
Hedging
Derivatives in the stock market can be used for risk management. Traders can use derivatives to hedge against adverse price movements in underlying assets, reducing potential losses. Hedging is a risk management strategy that allows traders and investors to protect their positions from potential losses. In the context of trading options, let's explore how hedging works with an example:
Suppose you own 1,000 shares of 'XYZ Ltd.,' at a purchase price of Rs. 1000 and you are concerned that the stock's price may decline to Rs. 900 shortly. To protect your investment from potential losses, you decide to hedge your position using options.
To hedge your losses in the stock price, you can purchase put options on XYZ Ltd. with a strike price of ₹1,000. Assuming that the lot size for the put option contract is 50 shares, and the premium for one contract is ₹20. You decide to buy 20 put option contracts, which will cover your entire stock position (20*50 = 1000 units).
Total premium for put option contract: ₹20,000 (20 premium amount * 50 shares per contract * 20 contracts)
Now, let's consider how this hedging strategy works:
Let’s assume the price of XYZ Ltd. stock declines by 100 rupees and the value of your stock position decreases from 10,00,000 to 9,00,000. Here, you incurred a loss of 1,00,000 on your stock positions.
However, the put options you purchased will increase the same points in value as the stock price falls. This increase in put option value will offset the losses in your stock position. With the stock price at ₹900, each put option contract would be worth ₹100 (₹1,000 - ₹900), and the total value of the 20 contracts would be ₹1,00,000 (20 contracts * 50 shares per contracts * 100 premium price) yielding a profit of Rs. 80,000 (100000-20000). This gain from the put options would offset a portion of the loss in your stock position and thereby help you reduce your losses.
Diversification
Financial derivatives provide access to a wide range of asset classes, including equities, commodities, currencies, and interest rates, allowing traders to diversify their portfolios and manage risk.
Speculative Opportunities
F&O trading in the share market offers opportunities for traders to profit from both rising and declining markets, making it versatile for various market conditions.
Liquidity
Derivatives markets, including F&O, are generally highly liquid, making it easier to enter and exit positions without significant price slippage.
Risks of Trading in F&O
Time Decay
Options contracts have an expiration date, and their value erodes as the expiration date approaches. Traders may lose money due to time decay if their option position doesn't move in the expected direction.
Volatility
F&O markets can be highly volatile, leading to rapid price swings. This can result in unexpected losses for traders.
Margin Calls
Trading on margin means traders can be required to deposit additional funds if the market moves against their positions. Failure to meet margin calls can result in forced liquidation of positions.