Trading in derivatives such as futures and options was launched in the year 2000 on the Indian stock exchanges. The only futures, and options, were initially for indices. Futures and options in individual inventories followed suit a few years later. Futures and options have become very common since then, and account for much of the stock exchanges’ trading.
These instruments are handy for investors and traders, and if you want to make the most of the ups and downs of the stock market, learning how to trade futures and options is very relevant. And investing in the stock market is a pretty good idea, because equity returns have outperformed most other investments in the past few years. Investing in equity and its derivatives entails market risk, of course, so it is often best to continue with a certain level of caution.
F&O Trading Basics
It’s important to get your basics correct before learning how to invest in F&O. Let’s analyze some of the definitions.
Futures and options are derivatives where the value of the underlying asset is extracted. There are several different types of assets that have derivatives available on them. These include stocks, indices, and commodities such as wheat, gold, silver, cotton, petroleum, and many other such products. We’re going to concentrate on how to trade stock-market futures and options.
Such options and futures are used for two key purposes. That is to hedge against the risks of prices; another is to benefit from market shifts or speculation. The operation is mainly speculative.
What you need to note while learning how to invest in F&O is that there needs to be counterparty for any future and choice contract. Any buyer needs to have a seller or ‘editor’ for a future or options agreement. This game is zero-sum. Everyone else loses if you win, and vice versa.
What Are Futures?
Future contracts allow a buyer or seller, on a certain date in the future, to buy or sell stock at a certain fixed price. An example of an anticipated rise in the share price of company BZ, which is currently at Rs 80, can better explain this. After that, you buy 1,000 BZ futures at Rs 80. So if BZ’s share price increases to Rs 100, you’re going to make 100-80-1000, or Rs 20,000. If prices drop to Rs 60, you’ll lose Rs 20,000.
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What Are The Options?
Options grant a buyer or seller the right to buy or sell stock at a certain price, but not the duty, on a fixed date in the future. The distinction between a future and an alternative is that you have the option not to exercise the contract in the latter. Taking the above example of BZ, you have the option of not exercising the agreement if prices fall to Rs 60. And your damages will be limited to the rate you paid.
There are two types of choices, the option to call and the option to place. A call option gives you the right to purchase a certain stock, while the right to sell the stock is given by a put option. When you expect stock prices to rise, call options work best. Put options are a safer alternative when it is predicted that stock prices will decline.
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What Are Margin/ Premium?
When you learn how to trade in futures, understanding and the notion of margin is critical. Margin is what the broker has to pay to exchange futures for you. It is a percentage of the transactions that you will make and the maximum potential loss you will incur is set. In uncertain times, margins would be higher. You pay a premium in options to the option seller, or the ‘editor’.
What Is The Leverage?
The principle of leverage is another factor that is really important when studying how to invest in F&O. Note that a portion of the underlying asset is the margin. If the margin is 10%, and you invest Rs 10 crore in a futures contract, you just have to pay the broker Rs 1 crore. So a multiple of the margin can be traded. This is known as leverage. The high leverage allows vast quantities of transactions to be made and thereby increases the chances of profit making. The downside, of course, is that you stink, and if you get your timing wrong, you lose a lot more.
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What Is The Expiry Date?
Another of the fundamentals of F&O trading is that contracts for futures and options are not for an indefinite duration. They are like one, two or three months for those set times. The contracts have to be resolved at the end of the expiry period, either in cash or by the delivery of shares. You don’t have to keep them till the end of the expiry era, though. Before that, you should square off the deal if you find that rates are not shifting in your favor.
Which Is Better A Stock Or Futures?
Is there any benefit of investing in futures rather than directly in stocks? Certainly, in futures trading, there are incentives. The biggest thing is that you don’t have to spend money on purchasing the whole asset or inventory. All you have to do is pay the broker a margin, which is a percentage of the future transactions you make. Plus, you get the advantage of leverage, which ensures that you will be able to gain greater exposure from your transactions and improve your chances of making money.
Which Is Better A Stock Or Futures?
Options would appear to be a better option as the risks would be limited to the premium you have paid. This may be poorly equivalent to futures in which the contract must be executed at the strike price, and thus the potential for losses may be limitless. The odds of making a profit, however, are much higher in futures than in options. An vast number of option contracts expire worthlessly in the world. The writers who sell them will therefore be the biggest winners of choice contracts.
There are some drawbacks relative to stocks in futures markets. One is that you have no ownership of the underlying stock. So you have to forgo the privilege of ownership, such as business dividends or voting rights. The sole aim of the exchange of futures is to benefit from the price movement.
What Are Index Futures?
In the stock market, there are two types of futures available. One is index futures, and one is stock futures for individuals. A future index is a contract on which the stocks that make up an index are based. What you are doing is betting on the index’s general movement. The Nifty, the Sensex, bank index, IT index, and so on will get index futures. The risks are smaller than investing in individual stocks, because you are betting on many stocks instead of just one. Index futures are settled in cash, and no shares are delivered.
Are Futures Available For All Stocks?
No, only certain stocks are liable for trading in futures. 175 securities stipulated by the Securities & Exchange Board of India are eligible for future contracts (SEBI). They are chosen on the basis of many parameters, including liquidity and length.
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In Futures Markets, What Is A Brand To Market?
Open at the end of each trading day, future contracts are immediately marked to market. That is, the base price of the day is contrasted with the closing price of the previous day, and the cash difference is resolved. It is used for measuring criteria for margins. If the current value of the stocks in the futures contract falls, the holder will receive a broker’s margin call to keep the margin at the amount necessary. The broker will sell the futures if the margin call is not met, and the holder will incur huge losses.
Pros And Cons Of F&O Trading
You should also be mindful of what you are getting into while you are talking about how to trade futures and options. Certainly, investing in F&O has many benefits, such as leverage. But F&O can also be dangerous. The high leverage allows you to take big positions, and the losses could be massive if the market does not go in your favour. F&O is all about betting on potential price fluctuations, and nobody can predict if they will move for sure.
Should Futures Contracts Or Options Be Traded?
One of the first choices a new commodity trader has to make is determining whether to trade futures contracts or futures options. On this topic, even experienced commodity traders sometimes waffle back and forth. What approach is better for trading?
Contracts and options each have their pros and cons, and, depending on the case, seasoned traders also use both. Some merchants like to concentrate on one or the other. When you decide how to exchange goods, it is best to thoroughly understand the features of each one. From there, it’s just a question of using the methods that make the most sense to you.
Trading Futures Contracts
The purest vehicle to use for trading commodities is futures contracts. Such contracts are more liquid than option contracts, and you don’t have to think about the time decay in value of the constant options that options will undergo.
Future contracts move faster than contracts for options because options move only in relation to the futures contract. For at-the-money options, the number may be 50 percent or maybe just 10 percent for deep out-of-the-money options.
For day-trading purposes, future contracts make more sense. Usually, there is less slippage than there can be with decisions, and since they move quicker, they are easier to get in and out of.
Many skilled traders, especially in the grain markets, like to use spread strategies. Trading calendar spreads, buying and selling front and distant month agreements against each other, and spreading various commodities, such as selling maize and buying wheat, are much easier.
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Many new traders of commodities start with option contracts. The biggest attraction for many people with options is that you can’t lose more than your stake, but if you just gamble a small portion of your account on each trade, the likelihood of running a negative balance is low.
Trading options, especially if you use option spread strategies, can be a more conservative approach. If you buy for a longer-term trade, bull call spreads and bear put spreads will increase the chances of success, and the first leg of the spread is already in the capital.
Options for the future are a wasted asset. With every day that passes, theoretically, options lose value. As options get closer to expiration, the decay appears to increase. Being right in the direction of the trade can be frustrating, but then your options are still useless because the market has not risen far enough to counteract the time decay.
Much as the decay of options in time can work against you, if you use an option sale strategy, it can also work for you. To take advantage of the fact that a large percentage of options expire worthlessly, some traders exclusively sell options. If you sell options, you have unlimited risk, but the chances of winning each trade are better than purchasing options.
Some option traders prefer options that don’t move as quickly as futures contracts. With one crazy swing, you can get trapped out of a futures trade really easily. The risk of options is reduced so that you can ride out much of the wild swings in the prices of futures. As long as your target is reached by the market in the time required, options can be a safer bet.
Both Futures and Options Are Derivatives
Think like a pyramid about the world of commodities. The actual raw material itself is at the very top of the structure. All prices of other cars, such as futures, options and even ETF and ETN goods, are extracted from the physical commodity price action. That’s why derivatives are futures and options.
Futures have dates of delivery or expiry by which time they must be closed or delivery must occur. Options have expiration dates as well.
Long vs. Short Options
Long options are less risky than options that are short. When you purchase an option, all that is at risk is the premium paid for the call or put option. Price insurance options insure a price level for the buyer, called the strike price. The premium, a term used in the insurance business, is the price of the option. Prices for commodity options are premiums that reinforce the nature of price insurance, but when you sell an option, they become the insurance company. The maximum profit is the premium received for selling or granting an option. Never can an insurance company make more money than the premiums paid by those who purchase the insurance.
As option prices can be high, commodities are volatile assets. The price of an option is a function of the underlying market’s variance or volatility. The choice of whether to trade futures or options depends on the risk profile, the time period, and the path of the stock price and the volatility of the price.