Future and option contracts are among the key instruments of derivatives trading. Derivatives, for the beginner, are contracts the value of which depends on underlying assets or sets of assets. These assets could be bonds, stocks, market index, commodities or currencies.
Nature of derivative contracts
There are four key types of derivative contracts including swaps, forwards, futures and options.
– Swaps, as the name suggests, are contracts where two involved parties may exchange their liabilities or cash flows.
– Forward contracts involve over-the-counter trading and are private contracts between a seller and a buyer. Default risk is higher in a forward contract, wherein the settlement is towards the end of the agreement.
– In India, the two most widely recognised derivatives contracts are futures and options.
– Futures contracts are standardised and can be traded in the secondary market. They let you buy/sell underlying assets at a specified price that are delivered in the future.
– Stock futures are those where the individual stock is the asset that’s underlying. Index futures are those where the index is the asset that’s underlying.
– Options are contracts wherein the buyer has the right to sell or buy an underlying asset at a specific price and a set frame of time.
– There are two options contracts: call and put.
|Definition||Buyer has the right, but is not required, to buy an agreed quantity by a certain date for a certain price (the strike price).||Buyer has the right, but is not required, to sell an agreed quantity by a certain date for the strike price.|
|Costs||Premium paid by buyer||Premium paid by buyer|
|Obligations||Seller (writer of the call option) obligated to sell the underlying asset to the option holder if the option is exercised.||Seller (writer of a put option) obligated to buy the underlying asset from the option holder if the option is exercised.|
|Value||Increases as value of the asset increases||Decreases as value of the underlying asset increases|
|Analogies||Security deposit – allowed to take something at a certain price if the investor chooses.||Insurance – protected against a loss in value.|
How to start F&O trading?
Much like shares are traded in the cash market or exchanges, F&Os are also traded in India’s stock exchanges. This option was launched in India’s stock exchanges in the year 2000. You would need a trading account, aka derivative trading account, to start your F&O trading. You can trade in F&O from anywhere with the help of such an account.
– It has to be noted that futures are not available on all stocks but a select set of stocks.
– You would also need to understand the concept of margins when you begin trading in F&O. Your broker collects margins whether you are buying/selling futures contracts. Your account needs to have a funding of margins before you start trading on futures.
– To buy options, you would need to deposit premiums. Premiums are paid to the seller by the buyer.
– Most broking houses also provide an online margin calculator to let you compute margins.
– The margin percentage varies from one stock to another on the basis of risks involved.
– You can buy F&O contracts for one, two or three month periods.
– Contracts can expire only on the last Thursday of each month. In case that Thursday happens to be a holiday, the previous trading day is considered the date of expiry.
– You can sell a contract at any time before the expiry date. In case you don’t do so, the contract expires and the profit or loss is shared.
Advantages of F&O trading?
The biggest advantage of F&O trading is that you can trade without actually investing in the asset – you don’t have to buy gold or any other commodity such as wheat, for instance, and still reap the benefits of fluctuations in the price of such commodities. The same principle applies for futures and options trading in the stock market — you don’t have to invest in the asset per se. Yet another advantage of F&O trading is that the cost of transactions is not very high.
- Able to transfer the risk to the person who is willing to accept them
- Incentive to make profits with minimal amount of risk capital.
- Lower transaction costs
- Provides liquidity, enables price discovery in underlying market
- Derivatives market are lead economic indicators
It is important that you do your research before you set up that trading account. Getting a grip on the concepts and prices help.a great deal. Futures and options trading is ideal for traders who are looking at the short term and have tolerance to risk. Also, many experts suggest that a beginner could start with the equity cash trading segment for a while before moving on to the futures and options segment. That said, trading in derivatives is not rocket science, provided you have the right broking house and access to research and advice.