A Beginner's Guide to Futures and Options Trading in Indian Stock Market

F&O trading is one of the major areas of the Indian stock market, making huge opportunities for the traders to win profits. However, it is necessary to know how these complex financial instruments work before proceeding to their trading. The guide to F&O trading in simple terms will be easy for new as well as experienced traders to understand how to trade them effectively.

What Are Futures and Options?

Futures and options are derivatives: They are financial instruments whose value is derived from an underlying asset like a stock, index, commodity, or currency. F&O contracts allow traders to speculate about the future price of these assets without buying them.

1. Futures Contracts

A contract to buy or sell an asset on a given future date at a given price is called a futures contract. The trade should be executed by both parties on that date.

Example: If a perception develops that the price of a particular stock will move up sooner rather than later, one can enter into a futures contract to purchase the stock at the prevailing price. When the stock price increases before the contract is settled, it is sold for profit.

2. Options Contracts

An options contract gives the buyer the right but not the obligation to buy or sell an asset at a fixed price before a specified date. Options occur in two different types:

A call option: it gives the right to purchase an asset at a specified price.

A put option: this gives the right to sell an asset at a fixed price.

Example: If you expect the price of a stock to increase, you can buy a call option. If so, then you can exercise your option to buy the stock at the lower price and sell it at the current, higher price, thereby making a profit. On the other hand, if you anticipate that the stock price falls, you can buy a put option, which gives you the right to sell the stock at a higher price.

If the price of the stock does fall, you can buy it at the lower market value and sell it at the higher price set by the option, thus gaining a profit.

Why Trade Futures and Options?

Trading in F&O gives several advantages to the traders:

1. Leverage

Leverage of F&O contracts means you can control a huge market position with a small amount of investment. An example could be, to initiate a contract, you would require only a fraction of the contract's value as a deposit, known as margin. This jack-ups your potential to earn but increases the associated risk.

2. Hedging

F&O contracts may be used as an instrument to hedge price fluctuations of underlying assets. For example, if you own a stock and fearful of the price declining, you can take the put option as insurance. Once the price declines, the put value will rise to offset your losses.

3. Profit from Market Movements

You can make use of either a rising market or falling market in F&O trading. For example, in a futures contract, you can go long or buy if you expect the price to go up or go short or sell if you think the price is going to come down. Options help you make money by exercising your right to buy or sell at any given time based on the market's need.

How does F&O Trading work in India?

Futures and options are mostly traded on two exchanges in India:

• National Stock Exchange (NSE)
• Bombay Stock Exchange (BSE)

Both of them are governed by the Securities and Exchange Board of India, SEBI, ensuring fair trading practices and investor interest safeguard. Most popular F&O in India are based on stock indices such as Nifty 50 and Sensex and individual stocks.

Important Features of F&O Trading

1. Margin Requirements

Trading in futures necessitates keeping a margin in the account. Margin is a percentage value of the entire contract value. It acts as collateral against potential losses. When trading in options, you only pay the premium, which is the cost of buying the option.

2. Expiry Dates

F&O contracts expire. In India, they expire on the last Thursday of every month. It is again important to note the day of expiry as if you do not square off your position before it expiries it will be auto settled.

3. Lot Size

F&O contracts are traded in lots and not in individual units. The lot size refers to the smallest unit of the underlying asset which you can deal with in an F&O contract. That simply means if the lot size of a stock is 50, you can only trade in multiples of 50 shares.

Risks Involved with F&O Trading

Although F&O trading is profitable, there are huge risks involved:

1. Leverage Risk

Leverage can work both ways-amplify profits as well as losses. If the market goes against your position, you may lose much more than what you provided as margin and be exposed to heavy losses.

2. Market Volatility

F&O prices are particularly volatile. Price movements can be exceedingly sharp, triggering wide fluctuations in the value of contracts.

3. Time Decay (for Options)

Options lose money as they approach the expiry date, primarily due to time decay. Sometimes, if the price of the underlying asset moves as predicted, then the option will expire worthless, and that's where the premium paid goes.

Steps to Get Started with Trading Futures and Options

Step 1: Open a Trading and Demat Account

To trade in F&O you need to have a trading and Demat account opened with a SEBI-registered broker. You should first of all verify that your broker gives you access to trade F&O and all margin and trading tools.

Step 2: Understand the Margins and Premiums

Before you execute an F&O, know how much margins are required for futures and what the premiums are on options. Also, ensure that you have enough amount in your account for your positions.

Step 3: Learn to Read the Market

The absolute basis of trading F&O you learn in the market trend, technical analysis, and movement of price. You must work with candlestick charts, moving averages, and support and resistance levels to make precise trading decisions.

Step 4: Begin Small and Gradually Increase

If you are new to F&O trading, it is always wise to begin small. Trading a few contracts initially, while you gain confidence to start increasing your positions.

Futures vs. Options: Which Should You Trade?

This depends on your risk appetite and style of trading. Futures or options?

If you are so confident about the direction of the market and want to maximise profits using leverage, then futures are excellent. However, they are more dangerous since you carry a settlement obligation on the expiry date.

Options give more flexibility since it is your right to enter the contract, but you are not obligated to do so. They prove valuable in terms of managing risk and hedging since your potential loss is only in the premium paid.

Conclusion

Futures and options trading in the Indian stock market can be a thrilling investment yet highly rewarding and potentially profitable. It offers leverage, flexibility, and opportunities for hedging investments that are achieved directly or indirectly by using a futures contract. However, it involves immense risks, especially for a first-time trader. One needs to understand the basics of F&O contracts, monitor the trends of the market, and practice sensible risk management to have a good chance of success.

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