Investing in the stock market can be a rewarding yet challenging endeavour. Apart from buying and selling stocks, investors can participate in Futures and Options (F&O) trading, especially those who want to amplify their returns with limited investment. F&O trading allows investors to not only speculate on market movements but also hedge against potential losses.
However, this potential for higher rewards also brings higher risks, and understanding how futures and options trading works is critical for anyone looking to succeed in this space. This blog aims to demystify the complexities surrounding derivative trading or FnO trading, explaining how these instruments function, the risks involved, and the various strategies you can use to maximise returns. Keep reading.
What is F and O in Share Market?
F and O in the share market stands for Futures and Options. They are types of derivatives, i.e., financial instruments that derive their values from underlying assets, including stocks, indices, or commodities. F&O contracts give investors certain rights or obligations to buy or sell the underlying asset at a predetermined price and date.
Futures
What are futures in stocks? It is a contract between two parties to buy or sell an asset at a predetermined future date and price. Both parties are obligated to fulfil the contract, regardless of the market price at the expiry. Investors use futures to hedge against price fluctuations or speculate on an asset’s future price.
For example, if you expect the price of an asset to climb in the future, you can enter into a futures contract to buy those shares at a specified price on a future date. If the price increases as you predicted, you can profit by buying the shares at a lower price than the current market price (CMP).
Options
An options contract, on the other hand, gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price before the contract expires. The buyer of the option pays a premium to the seller for this right, and if the market moves in their favour, they can exercise the contract for a profit. In the case of adverse market movement, the option holder can choose not to exercise their right and let the contract expire.
What is F and O Trading?
Unlike traditional stock trading, where you buy or sell shares of a company, F and O trading involves buying and selling contracts that give the buyer the right (in the case of options) or the obligation (in the case of futures) to buy or sell a particular quantity of an underlying asset at a pre-determined price on a specific date.
Future options trading allows you to mitigate investment risks by locking in stock prices. However, because price movements are unpredictable, incorrect market predictions can lead to significant gains or losses. F&O trades are, hence, typically undertaken by investors who have a deep understanding of stock market operations.
How Future and Options Trading Works?
In the case of futures trading, both parties are bound to execute the trade at the contract’s expiry, regardless of the market price. Let’s understand this with the help of an example.
Case 1
Suppose you have entered into a futures contract, agreeing to buy 100 company shares for ₹1,000 each at a future date. However, the stock price drops to ₹900 per share upon expiry. But since you are obligated to exercise your contract, you will need to buy 100 shares for ₹1,000 each, incurring a loss of ₹10,000 (100 x 100).
Case 2
Suppose you have entered into the same futures contract, but the share price rose to ₹1,200 per share on the expiry date. In such a case, you will incur a profit of ₹20,000 by buying 100 shares for ₹1,000 each.
In the case of options trading, you’re not obligated to buy or sell. You can choose to exercise the contract only if it benefits you. So, in the first case mentioned above, if you would have bought a call option to purchase shares at ₹1,000 each but the stock price drops to ₹900, you can let the option expire worthless, minimising your losses to the premium paid for the option.
However, if the stock price climbs to ₹1,200 (as in case 2), you can exercise your call option and buy underlying shares for ₹1,000 each. While doing so, you will incur a profit of ₹20,000 minus the premium paid for the option.
Can We Trade In FnO?
Anyone with a Demat account can trade future options in India, but it is generally suited for more experienced traders due to the complex nature of these instruments. F&O trading is ideal for those looking to hedge risks in their investment portfolios or speculate on short-term market movements.
For retail traders, stock options trading provides an opportunity to leverage their positions, but it requires a good understanding of the market and the ability to manage risks. Many options traders use strategies like hedging or arbitrage to minimise risk.
How To Do Options And Futures Trading?
With advancements in technology, trading FnO has become easier than ever. Several FnO app allow stock trading options seamlessly from your smartphone. Here’s a breakdown of the process:
Opening a Demat Account
To start FnO trading in India, you must open a Demat account with a brokerage firm that offers FnO services. Several stockbrokers allow online Demat account opening in just five minutes.
Selecting F&O Stocks
F&O trading is available only for a selected list of stocks, known as F&O stocks. The stock exchanges determine the list of FnO stocks based on various factors, such as liquidity, market capitalisation, etc.
Buying Futures and Options
Once you’ve identified an opportunity, you can buy a future or options contract depending on your outlook on the stock or index.
Incurring Loss or Gain
If you have purchased a futures contract, you will be obligated to buy or sell underlying shares on the contract expiry date. But if you have an options contract, you will get the right (but not an obligation) to exercise it. This transaction may result in a loss or profit, depending on which side the market moves.
The Final Word
F&O trading in India is a powerful financial tool, offering an opportunity to maximise profits, hedge risks, and take advantage of market volatility. However, you must be well-versed in market intricacies and how F&O trading works before taking the plunge.
FnO trading app such as HDFC Sky can make your journey seamless with features such as real-time market updates, analytical tools, and round-the-clock support.
