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While Futures & Options can be a profitable investment opportunity, it is necessary to first understand the risks involved
Many investors prefer Futures & Options (F&O), as these generally offer higher returns than other assets. However, just like any other investment, there are risks involved. Let us take a closer look at Futures & Options (F&O) trading and how you can maximize your returns.
What is Futures and Options (F&O) trading?
In technical terms, Futures and Options (F&O) are classified as derivatives. They are essentially a contract, whose value is derived from an underlying asset. However, it is important to note that Futures and Options (F&O) trading is based primarily on speculation. Investors often use Futures and Options (F&O) for two primary purposes – one for hedging against price risks and the other to book profits when prices fluctuate. For a Futures and Options (F&O) trade to take place, there must be two parties involved. If one wins, the other is bound to lose and vice-versa. Futures and Options (F&O) contracts can be linked to any of the various assets such as stocks, gold, silver and commodities like wheat, petroleum, etc.
What is Futures?
A Futures contract allows the investor to benefit from a potential price hike in the future. For example, assume that you expect the price of ABC stocks to rise in the future. You then make a Futures contract with the other party and buy 100 shares of the company. Let us assume the current share price to be Rs 200. Now suppose the share prices increase to Rs 220. You can then execute the Futures contract and book profits of Rs 2,000 (100 X 20/share). However, if the prices fall below Rs 200, you will have to bear the loss.
What are Options?
Options are slightly different from Futures, as you have the option to not execute the contract. If we take the above example of the stock price falling below Rs 200, you have the option to reject the contract. That way, you can limit your losses. Your only loss in such cases will be the premium that you had paid earlier. There are two types of Options, a call option and a put option. In the call option, you have the right to buy a specific stock. You do this when you expect the stock price to increase. In the put option, you have the right to sell. Here, you are expecting a drop in the price of the stock.
Understanding margin / premium in Futures and Options (F&O)
Margin is the amount that you are required to pay to the broker for trading in Futures. It establishes the maximum losses that you may have to bear. In comparison, Premium is the amount you pay to the Options seller, also known as the ‘writer’.
What is expiry day in Futures and Options (F&O) trading?
To make Futures and Options (F&O) trading work, an expiry date is mentioned in the contract. Without an expiry date, both parties will keep waiting for the perfect timing. In that case, the contract will never get settled. An expiry date ensures that a Futures and Options (F&O) contract can be settled within a specified period. Usually, an expiry date of up to 3 months is applicable on Futures and Options (F&O) contracts. You have the option to execute the contract even before the expiry date.
Why not buy stocks directly?
If you buy stocks directly, you will need huge capital to acquire the stock in full. In comparison, Futures can be executed by just paying the margin amount. For example, consider margin percentage of 10% and stock value of Rs 1 lakh. In this case, A futures contract can be made with just Rs 10,000. This is one of the major benefits of Futures and Options (F&O) trading.
