Do you want to hedge your portfolio against market vagaries or speculate on future price movements to earn profits? If yes, you can contemplate undertaking futures and options trading. F&O trading is a form of derivative trading that has gained significant momentum in India, of late. However, it is vital to understand the various aspects of this form of trading and this beginner’s guide can help you know all about futures and options.
What is Futures and Options Trading?
Futures and options are financial derivatives that give you the right to buy or sell other securities by locking in a price in the future. They are called derivatives because their price is dependent on that of the underlying securities they represent, which could be stocks, bonds or commodities. Futures and options are two components that make up an F&O trade.
What is Futures Trading?
Futures trading refers to financial contracts where two individuals – a buyer and seller – agree to exchange an underlying security for a fixed price on a future date. Futures are obligatory contracts, meaning both buyers and sellers need to fulfil the contract’s terms and conditions upon expiry. Let us understand futures trading with an example.
Suppose you are a wheat farmer, and the present price of wheat is ₹2,000 per quintal. You feel by the time your wheat is all set for harvest, prices may fall. To safeguard yourself from it, you enter into a wheat futures contract with a buyer.
Per the contract, you agree to sell 100 quintals of wheat at ₹2,000 per quintal after 3 months. In other words, you have locked in the wheat’s price at ₹2,000 per quintal, irrespective of its market price, after 3 months. If the wheat’s price falls after 3 months, say to ₹1800 per quintal, the futures contract helps you safeguard from the losses.
What is Options Trading?
Options trading is another kind of derivative trading which is similar to futures, with a slight difference. In options trading, both parties have the right, but no obligation as such, to purchase or sell a particular asset at a certain cost in the future. As an options trader, you can execute two options – call and put.
While a call option gives you the right to buy a particular asset at a specific price in the future, a put option bestows the right to sell an asset at a certain cost in the future. Let us understand them with an example.
Suppose you feel the stock of a particular company currently trading at ₹500 per share will go up in the future. You buy a call option at a strike price of ₹520 with an expiry date after one month by paying a premium of ₹10 per share. If the stock price rises to ₹550 before expiry, you can exercise your call option to buy it at ₹520 and sell it at ₹550.
Thus, you make a profit of ₹20 (₹30 – ₹10 premium paid) per share. However, if the price goes below ₹520 or stays at ₹500, you don’t exercise your option, and your losses are limited to only the premium paid, i.e., ₹10 per share.
On the other hand, if you own shares of a particular company trading at ₹ 300 per share but you feel prices may drop, you buy a put option with a strike price of ₹ 280 after an expiry date of one month and pay a premium of ₹ 10 per share.
If prices fall to ₹250, you can use your right to sell at ₹ 280, thus giving you a profit of ₹ 20 per share (₹ 30 – ₹ 10 premium paid). If prices stay above ₹ 280, you do not exercise the put option as you can sell the stock at a higher price and in this case, your losses are limited only to the premium paid, i.e., ₹ 10 per share.
Important Terms Associated With Options and Futures
To carry out F&O trade effectively, you need to be aware of certain terms. The table highlights some of them:
| Terms | Meaning |
| Underlying asset | It represents the asset on which a futures or options contract is based. |
| Expiry date | It is the date of contract expiry. |
| Strike price | It is the predetermined price at which you can purchase or sell the underlying asset |
| Premium | In stock options trading, it is the cost the buyer pays to acquire the option. |
| Margin | It is the money you need to deposit to your broker to open and maintain a futures position. |
Differences Between Futures and Options
Futures and options differ from each other on several aspects (see table)
| Aspects | Futures | Options |
| Risks Involved | Carries higher risk as both parties need to fulfil the contract’s terms and conditions | Buyer has limited risk while the risk quotient is higher for seller |
| Costs Involved | No upfront costs but only margin requirements | Upfront costs involves paying premium for the buyer |
| Profit Potential | Unlimited based on the underlying asset’s price movement | Buyer’s profit is unlimited but seller’s profit is capped only at the premium received. |
How to Start Futures and Options Trading?
To get started with F&O trading, you need to:
- Open a free Demat account online with a reputed brokerage firm offering access to the derivative market
- Grasp the fundamentals of futures and options market through education from various sources
- Practice risk management techniques to minimise chances of losses
How Risky are Futures and Options?
Along with profit potential, futures and options also carry high risk. Some potential risks involved are:
- If you trade future options, you can incur high losses if the market moves against your position. In such situations, your broker can initiate margin calls, which may require you to add additional funds to maintain your position.
- Some futures contracts may not have the liquidity needed, which can make it difficult for you to exit.
- F&O trades are complex to execute, and you need vast experience.
In Conclusion
It is advisable to venture into F&O trading only after you have gained significant knowledge about them. You can practise mock trading with virtual money before starting to test the waters. Also, do not get carried away and continue trading even if you suffer losses. To kickstart your F&O trading journey, you can use HDFC SKY. This F&O trading app allows stock trading options in various underlying assets. That is not all.
Through this F&O app, you can also invest in stocks, mutual funds, and initial public offerings to meet your goals.
