Simplified F&O Tradingwith Expert Advice

What is

F&O Trading?

Futures and Options Trading a.k.a Derivatives Trading, involves predicting how an asset’s price will move in future. Futures and Options contracts, also referred to as Derivatives, are traded on underlying assets such as stocks, indices, commodities, and currencies.

“Derivatives” mean a contract which does not have a value of its own but whose value is derived from price movements of underlying assets like stocks. Derivatives trading is a vital part of the financial markets, serving as a means of managing risk through hedging and encouraging trading by speculating on asset price movements. Derivatives contracts involve a buyer (long) and a seller (short) who agree to buy or sell an underlying asset at a predetermined price on a future date. Derivatives trading began with farmers selling the rights to their future crop at an agreed-upon price to hedge against price movements. Derivatives trading, in the stock market in India, began in the early 2000s with the introduction of index futures and options on two stock exchanges, NSE and BSE.

Commonly used derivatives for trading are - Futures and Options (F&O), which are similar in nature with a minute difference. Futures contract obligates both parties to fulfill the contract, which means the buyer of the future contract has to compulsorily buy the underlying asset and the seller has to sell it compulsorily at the agreed price on an agreed expiry date. On the other hand, an options contract gives the buyer the right but not the obligation to fulfill the contract, which means he can either choose to execute the contract (Buy or sell) or not. But, in options contracts, the seller is obligated to fulfill his contract, meaning he has to compulsorily buy or sell the underlying asset at an agreed price, given the buyer chooses to do so. This limits the risk for Options buyers, which is the reason why Options Trading has become a popular choice in recent times.

All F&O contracts have specific expiry dates, which is the day when the contract ceases to exist and traders must either settle the contract by buying or selling the underlying asset or through cash settlement.

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 -

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.

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).

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.

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.

Derivatives markets, including F&O, are generally highly liquid, making it easier to enter and exit positions without significant price slippage.

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.

F&O markets can be highly volatile, leading to rapid price swings. This can result in unexpected losses for traders.

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.

How to start

trading in F&O?

To start trading in F&O, you will first have to open a Demat Account and activate your trading account for trading in the derivatives segment. To activate your F&O trading account, you will need to submit your income proof, salary slip, bank statement for 6 months or ITR for the latest FY.

To start trading in F&O you need to understand the basics of how Futures and Options contracts work and how you can profit from price movements of the underlying assets. Let’s learn with an example of Nifty.

Long Position (Buyer): The long position holder agrees to buy the Nifty 50 index futures contract at a future date and a predetermined price. This position benefits from a rising index value.

Short Position (Seller): The short position holder agrees to sell the Nifty 50 index futures contract at a future date and a predetermined price. This position benefits from a falling index value.

Suppose you are a trader interested in trading Nifty 50 futures:

You believe that the Nifty 50 index, currently trading at 19,000, will rise in the coming month.

You go long by buying one Nifty 50 futures contract expiring in one month at a price of 19,200.

Over the month, if the Nifty 50 index rises to 19,500, you make a profit of (19,500 - 19,200) * 50 = ₹15,000.

Futures trading can be profitable, but it also involves substantial risk, as gains and losses are amplified due to leverage. It's important for traders to have a good understanding of the market and risk management strategies when participating in futures trading.

What Are Common Strategies for

Successful Derivatives Trading?

Some of the commonly used futures trading strategies are Long futures, Short futures, Pair Trading, Arbitrage Trading, Spread Trading, hedging etc. Some of the commonly used Options trading strategies are Covered call, protective put, Straddle, Strangle, iron Condor etc.

Long futures, often referred to as Buying Futures, is a strategy that yields profits when the price of an underlying asset is expected to move up. E.g. If you buy a future contract of a stock A at say Rs. 150 with a lot size of 2000 units and now the stock moves to Rs. 160 by the expiry date, you make a profit of Rs. 10 per lot i.e. Rs. 20000 on your futures position. (Rs. 10*2000 units). On the other hand, if the price of the stock moves lower to Rs. 145, you make a loss of Rs. 5 per lot. i.e. Rs. 10,000 on your position.

Short futures, often referred to as Selling Futures, is a strategy that yields profits when the price of an underlying asset is expected to move down. E.g. If you sell a future contract of a stock A at say Rs. 150 with a lot size of 2000 units and now the stock moves to Rs. 140 by the expiry date, you make a profit of Rs. 10 per lot i.e. Rs. 20000 on your futures position. (Rs. 10*2000 units). On the other hand, if the price of the stock moves higher to Rs. 155, you make a loss of Rs. 5 per lot. i.e. Rs. 10,000 on your position.

As can be seen from above examples, by buying and selling futures without having the ownership of an underlying asset, traders speculate on the price movement of the underlying asset to profit from it.

Traders who already hold positions either through delivery of stocks or by the way of physical ownership of commodities, often hedge their positions against price volatility by either buying or selling futures. E.g. If a trader owns 2000 units of Stock A currently trading at Rs. 150 and is expecting price volatility due to an external event such as quarterly results, he/she can choose to hedge position by selling a future contract say at Rs. 155 which obligates him to sell his position to the futures buyer at a pre-agreed rate of Rs. 155 on the expiry day, irrespective of the spot price of stock A post the results – thereby locking profits of Rs. 5 per unit.

Arbitrage is a strategy that exploits price differences between related assets or markets or even expiry dates. Traders buy low in one market and sell high in another to make risk-free profits. At times, traders also resort to time arbitrage i.e. if the future of a further month trades at a lower price than the future of the current month, the traders can buy the further month future and sell the current month future to profit from time arbitrage.

Spread trading involves taking simultaneous long and short positions on related contracts. Traders aim to capitalize on price differentials between these contracts, reducing risk exposure.

Pairs trading involves taking both long and short positions on two related assets. Traders aim to profit from the relative price changes between these assets, regardless of the broader market's direction.

Some of the commonly used options strategies are covered call, protective put, long strangle, long straddle, iron condor and many more. Trading in options through strategies involves a deeper understanding of multiple parameters like the market volatility, events affecting the stock price and most importantly the time decay in underlying options.