For many investors, the next gradual step after mastering the stock markets is venturing into the derivatives segment. Derivatives consist of two key products in India – Futures and Options. However, trading in these can be a tricky business and one can go wrong on many counts. But before we warn you of the pitfalls that you need to be careful of, it is important to know what are futures and options
. Correct understanding of futures and options plays an important role in making the best out of investments in this segment. Read on to understand the nuances of the F&O segment and how to trade in futures and options.
Similarities between futures and options
- Both futures and options belong to the family of derivatives. For the uninitiated, derivatives are financial contracts whose value is derived from an underlying asset (such as securities) or a group of assets (benchmarks such as indexes). Other examples of underlying instruments are bonds, commodities, interest rates, stocks, etc.
- They are trading products which offer the investor a chance to make profits and hedge their current investments
- Both futures and options trading happens in the stock market.
Difference between futures and options
- The major difference between futures and options lies in the obligations or rights of the involved parties. In the case of options, the holder of the contract has the right to purchase (or sell) the underlying financial instrument or asset at the pre-determined price. However, he or she is not obligated to do so. The seller, on the other hand, needs to compulsorily perform their part if the holder chooses to exercise his or her option. In simple words, the holder has an “option”.
- In the case of a futures contract, both parties have an obligation to fulfill their part of the contract on a specified date in the future at a pre-determined price.
- In terms of risk, futures are riskier than options. The holder of the futures contract is obligated to buy on the future date at the fixed price even if the security moves against him or her. However, in an options contract, the holder can choose not to no go through if the security price does not move as per his/her expectation.
- There is an advance payment involved with options contract. The holder of the contract has to pay an amount or premium to get the right to buy or pass in the future. In case the contract holder chooses not to exercise the right, he/she will lose this upfront payment amount. No such charges are there in a futures contract as both the parties need to honor their obligations on a certain date.
- In the case of a futures contract, the transaction takes place on a pre-determined date.
- Futures and options may be conceptually different but their core principle is the same. They provide a chance to make a profit from an index, stock or any other underlying asset without investing the entire sum.
Understanding future and options
Now that you know the difference between futures and options, you might think that you are all set to venture into this segment. However, before you do that it is important to understand some important facts about futures and options
- Futures and options are traded on the stock market. The F&O segment contributes to the maximum trading volume across stock exchanges in the country.
- The calculation of profits (or losses) is done daily till the time of sale or contract expiry.
- Unlike the equity market, derivatives come with an expiration date.
- There are hidden costs involved in the F&O segment. These include brokerage, stamp duty, GST, STT, etc.
- Options contracts are asymmetrical. In case the price of a stock goes down, the buyer's loss is restricted to the amount of premium paid. However, the seller's loss is limitless potentially.
- Trading in options is possible even when one is unsure about the market’s direction. One can combine futures and options to trade markets in such situations. One of the USP of the F&O market is the flexibility to choose a non-directional strategy.
Things to avoid while trading in futures and options
If you wish to trade in futures and options, there are some mistakes you need to steer clear of.
- Use futures as a trading proxy: This is one of the biggest (and most common) mistakes made by investors in the F&0 segment. The power of leveraging works both ways – in your favor and against it. Futures have the potential for unlimited profits as well as losses. So, one should not get lured by the possibility of exponential profits without considering the impact of losses.
- Ignore the stop/loss feature: Many people do not make effective use of this important feature. The stop/loss feature is a great risk management tool. One must remember that leverage is a double-edged weapon. It can help as well as hurt. It is important to maintain a disciplined and rigid stop/loss target at the time of trading. On earning the set or desired profit, one must use this feature to exit from the futures position.
- Sell if another institution is doing so: A big part of the future trading is to create a cash-future arbitrage. Hence, do not start selling your future contracts just because some other institution is doing so. It might be trying to create a position of arbitrage. Following the herd is not a wise way of trading in the F&O segment.
- Get attracted by cheaper-priced options: Naturally one would prefer low-priced options as the advance premium payment would also be lesser. However, in such cases, it is important to assess the intrinsic value of that particular option to determine if it is truly underpriced.
- Holding longs closer to the date of expiration: There are two factors that impact the valuation of options – intrinsic value and time value. As the date of expiry comes nearer, there is a sharp dip in the option price (if it is going to expire at zero value). Hence, timing your exit and setting the target return are crucial aspects to be considered in options trading. Else, one might end up making losses.
How to trade in futures and options
Once you have a thorough understanding of futures and options, it is time to choose an intermediary for your trading purposes. This is a crucial step as the right partner can help you select the right investment opportunities and make the most out of your hard-earned money.
IndiaNivesh is a great choice for all your financial needs. With a rich experience of more than a decade, it offers best-in-class and customized services to its customers. Its in-depth understanding of the market combined with cutting-edge technological tools enables them to support customers holistically. Their long list of recognitions stands testimony to the passion and excellence they display in the financial world.
So, make the right choice of partner and keep it simple. Futures and options are not rocket science once you understand their nuances.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.