Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-12-08T14:41:24+05:30

Introduction

People love variety. For food and finances, the more options, the better. With the rise in technology, multiple options are available to grow your wealth. What traditionally started from gold has transformed into derivatives and algo-trading. Futures and Options trading is a financial innovation that provides extreme results. Learn about futures and options in detail in this article.

 

Understanding F&O Meaning in Detail: What is F&O?

Futures and Options are exchange-traded derivatives that derive value from an underlying asset.

A futures contract includes buying or selling an underlying asset at a specific price on a predefined date. Buying a futures contract means committing to paying the fixed cost of the purchase at a given time. Selling a futures contract means transferring the asset to the buyer at a specific price at a particular time. The underlying holdings of futures contracts mainly consist of stocks, indices, commodities, and currencies.

Options give the holder the right to buy or sell the underlying asset at a specified price. They can be call options or put options.

A call option gives the buyer the right to buy the underlying asset at a specified price (also called the strike price). With a call option, the seller has the right to demand the sale of the underlying asset, but the seller has only an obligation and no freedom. Here the rights belong to the buyer, and the seller is obliged to pay the premium price.

 

Futures and Options Trading for Beginners

Here’s what futures and options are from a beginner’s perspective. 

1.    Futures are leveraged products that work on margins. It is noteworthy that the margins work similarly for losses as well.

2.    Buying options means limited risk, but you rarely make money. Many small F&O traders prefer to buy options as their risk is limited to the premium paid. Option sellers take more risks and earn more than option buyers more often. However, it is prudent to remember that there is limited risk when buying options.

3.    Options are asymmetrical, and that's the difference between FnO. However, the buyer's loss is limited to the premium, while the seller's loss can be unlimited.

4.    The futures margin may increase sharply during volatile times. Many believe that futures are more advantageous than spot buying because buying on margin gives you leverage. However, these margins can increase sharply during periods of volatility.
 

Difference between Futures & Options

While the fundamental ground of the two derivatives instrument remains the same, some key differences among the FnO include the following.

1.    Rights and Obligations: Futures trading offer the contract buyer the obligation to square off at the specified date. On the other hand, Options trading gives the buyer the right to exercise the contract.

2.    Trading Date: Futures holders must trade the security on the expiry date. Investors can exercise some options at any time up to the expiration date, although there is volatility. There are nuances to exercising options on indices and stocks, and different markets have different rules.

3.    Premium: Futures contracts do not have any upfront costs while entering into the contract. The option contract buyer has to pay a premium while getting into the contract with the option seller. 

4.    Risk: If the price falls, the buyer of the options can refuse to exercise the contract. With futures, you can trade on a specified date regardless of price. In theory, options reduce the risk of loss.
 

Who should invest in Futures & Options?

Futures and options trading can be profitable, but it is also risky. Therefore, FnO has advantages and disadvantages. Various types of traders invest in FnO.

1.    Hedgers: They invest in a particular asset to protect themselves from price fluctuations of that specific asset.

2.    Speculators: A speculator invests only in securities to leverage price fluctuations. They try to anticipate price movements and profit from that movements. It is a personal choice, but leverage can magnify returns (and losses).

3.    Arbitrageurs: They seek to profit from price differentials in asset market conditions. They try to exploit the market’s inefficiency of any kind.

 

Examples of Options and Futures?

Example of Futures

Suppose someone wants to buy a January corn futures contract. They enter into a futures contract to buy 200 kgs of corn at an agreed price by the end of January 2023, regardless of the market price. The seller also agrees to sell these 200 kgs of corn at the agreed price. 

Both buyers and sellers are now obligated to buy or sell that 200 kgs of corn unless they deal with other buyers or sellers. Depending on the price fluctuations, the market would decide the profit or loss for the buyer/sellers.

Example of Options 

If 'A' buys a futures contract at Rs 920 and ‘B’ sells those futures, the transaction is symmetrical for both parties. If the price rises to 940, A earns 20 rupees, and B loses 20 rupees. The opposite happens when the stock price drops to Rs.900. However, ‘A’ has to pay a premium to avail of the right to buy at the pre-defined price. This premium can be the maximum loss to the buyer of the option. 

Futures Options - Points to Remember

1.    F and O trading has an excellent profitability opportunity but risks huge losses for novice traders. Hence, the execution must be done with utmost care.

2.    F&O always trades with stop loss and profit targets. It applies to all leveraged positions.

3.    With FnO, keeping the cost in check is necessary. Constantly monitor costs incurred in F&O. If you think F&O brokerage fees and other charges are low, you might be mistaken. F&O has a higher turnover rate, although at a lower percentage than equities. 

F&O transactions include brokerage fees, GST, stamp duty, statutory duty, and STT, and this cost may add up to losing your pocket. Make sure the profit-to-transaction cost ratio is optimal.

4.    You can trade options even if you need to know the market's direction. The ability to pursue directionless strategies is one of the most enduring features of the F&O market. Combine options and futures to trade directional markets. 

5.    Options help to profit in volatile or lacklustre markets. These aspects of options make more sense than using options instead of stock trading.
 

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Frequently Asked Questions

F&O is a highly leveraged investment instrument, and it is safe till you keep in mind that the margin implications work similarly in profits and losses.

Typically, you can hold an F&O contract till the last Thursday of every month.

With more leverage, the potential to earn money in F&O is more.

Depending upon the trader’s understanding, they can choose futures or options. Futures are relatively straightforward but might have unlimited downsides than options.

Futures turnover = Sum of positive and negative differences.
Options turnover = Net of profit and the premium paid/received.