With a sudden influx of knowledge and interest in the stock markets, many retail investors in India are trying to move towards challenging shores like futures & options trading. Those who are new to it consider F&O to be somewhat similar to stock trading. However, futures and options are far more complex as compared to equity investing and, without understanding the nuances of this investing/trading format, one should not enter the space.
Here, we will share some of the crucial points to know before beginning F&O trading.
Stock investment vs F&O
F&O are derivative contracts and are based on an underlying asset’s price. Therefore, these require a good understanding of the price movements of underlying assets and, effectively, the ability to predict future price movements. Without sufficient knowledge of F&O, pricing of underlying assets, and the fundamentals of the asset, one must avoid venturing into it.
Need for Demat account
Unlike cash trades or regular stock trading, one does not need a Demat account for dealing in futures and options. This is because F&O trades are more like contracts and are only valid until the expiry date.
Risk levels
The risk in cash markets is generally limited to the investment made. However, in F&O, the losses can be higher than the investment made. This is because market volatility can easily erode the entire capital amount even with one wrong trade. Therefore, one must know personal risk-taking ability before getting into futures trading.
Many new entrants in the F&O market prefer to trade options because of their limited risk factor. The risk here is limited to the premium paid. However, if statistics are to go by, more than 97% of the options traded globally expire without getting executed. Hence, there is very little chance of actually making profits through these.
Use of stop-loss
Since F&O trading can involve significant losses if not planned and executed correctly, using stop losses and profit targets is of utmost importance. An investor/trader must ensure to protect his/her initial capital and this is possible only if losses are defined in each trade. Irrespective of how one expects the price of the underlying asset to move, the stop loss levels must be pre-defined and adhered to.
Know the costs
Being mindful of the costs involved in F&O can allow an investor/trader to know the actual return on investment or net profits. Although the brokerage and other associated costs of F&O trading may seem lower in percentage terms, they can be significant due to the constant churn of transactions. Investors must also check the exact brokerage fees, GST, and statutory charges like stamp duty, STT, etc. applicable on F&O trades.
Available underlying assets
Futures trading cannot be done on all the stocks that are listed on stock exchanges. One can trade in futures only for some of the stocks that are eligible. These are selected using multiple criteria such as liquidity, volume, etc. SEBI has allowed approximately 175 stocks that can be traded through Futures contracts.
Know the margins
During volatile market conditions, the margins on futures contracts can rise significantly. While many believe that futures are better than cash market trades, as one can buy on margin, these margins can easily trap an investor. During tough market conditions, one may either need to add more margin or exit the existing positions.
Conclusion
Before getting into F&O trading, one must keep the above-mentioned points in mind, ensure to measure the risk levels against personal risk appetite and adhere to a certain trading discipline. Trading in Futures & options is nothing like the rocket science that is normally made out to be. A proper understanding will surely help you make better use of these innovative financial products!
FAQs
There is a fixed expiry date that every F&O contract must follow. In the case of options, one is not obligated to execute the contract even on the expiry date. Futures contracts have to be fulfilled on expiry, which is the last working Thursday of the month.
Options contracts are better than futures in terms of risk since the risk is limited to the premium paid. However, the extent of profit is also limited in options.
Derivative contracts cannot be traded on a single asset, for example, a single stock. As per exchange rules, there is a fixed lot to be used for the underlying asset.
Forwards and swaps are the other form of derivate contracts apart from futures and options.
Index futures, commodity futures, stock futures, currency futures, and interest rate futures are some of the commonly available futures contracts.
