top of page

Basic of Futures & Options - Risk and Rewards of Trading in F&O

Updated: Dec 7, 2023


Futures and Options both are financial contracts to buy or sell an underlying asset at a predetermined price on a predetermined future date. However, there is a major difference between the two, Future contract is an obligation where an option contract as the name interprets itself, is an option, not an obligation. In simple words, the Future is an obligation to buy or sell the asset whereas in the case of option, it is a choice. Here, the underlying asset refers to real financial assets such as stocks, debt securities, currencies, commodities, market indices ad exchange-traded funds. Futures and options were primarily used for Hedging (the objective is to reduce risk), however, they are also used for Speculation (the objective is to earn profit) as well.


What is Spot Price and Strike Price in Future & Option

The predetermined price mentioned in the Future and Option is known as Strike Price and the price at which the asset is being traded in the market is known as Spot Price. For example, if a future contract is made to buy equity shares of Jio Financial Services at Rs 250 and currently the share is being traded in the market at Rs 220 then the Spot Price will be Rs 220 and the Strike Price will be Rs 250.


How to Trade in F&O

In order to trade in Futures and Options, the first & foremost step is to open a trading account with a broker for buying or selling Futures and Options. After opening the account, log on to the portal and browse through the different F&O available for trading and choose the best suitable contract. Finally, put in the order details and buy the future or option contract. One important thing to keep in mind, the investor needs to maintain a margin requirement with the broker in order to continue trading in Futures and Options.


Different Types of F&O

There are different types of Future and Option contracts that are available for different purposes.


Future Contracts:

1. Stock Futures: In these Futures, underlying asset is stock. These are used to hedge against the volatility of stock prices.

2. Index Futures: In these Futures, underlying asset is Index. These are used to hedge against the volatility of Index prices such as S&P 500, NASDAQ, Sensex, NIFTY and so on.

3. Commodity Futures: In these Futures, underlying asset is commodity. For example, Oil, Wheat, Gold, Silver and so on. These are used to hedge against the volatility of commodity prices.

4. Interest Rate Futures: These contracts are based on the expected future interest rates to hedge against interest rate fluctuations.

5. Currency Futures: In these Futures, underlying asset is currency. These are used to hedge against the volatility of exchange rates.


Option Contracts:

The above mentioned 5 types are also available in option contracts along with some more types.

1. Call Option: These options give the investor an option to buy the underlying asset at strike at a predetermined future date.

2. Put Option: These options give the investor an option to sell the underlying asset at strike at a predetermined future date.

3. American Options: These options can be exercised at any time from the date of purchase to the expiration date.

4. European Options: These options can be exercised only at the expiration date.


Risks associated with F&O Trading

Future and Option trading is quite popular; however, it is important to understand all the risks associated with futures and options before investing money in them. Risks associated with F&O Trading are:

1. If the price of the underlying asset does not move in the expected direction, it can lead to huge losses in future contracts. In case of Option contracts, losses will be limited to the premium paid (price that the trader has paid for the contract).

2. Buy or sell position in the contract can have their margin requirements increased which may cause margin shortfalls. This shortfall needs to be paid to the broker else the broker will stop the F&O trading and the investor will lose money.

3. There is physical settlement risk (Delivery Risk) for future and options which refers to taking delivery of the underlying shares without sufficient funds or short delivery risk (delivering less than the agreed quantity of asset due to shortage of asset)

4. Higher leverage (trading through broker while maintaining margin) may lead to increased cost of trading and higher losses.


It may seem that futures are riskier than options as they are an obligation, hence, options reduce the risk of loss, but that may not be the realty as in practice most of the options expire without trade. It can be concluded that future offers more risk and return than option contracts.


Brokerage for Future and Options

Brokerage for Future and Options trading tend to vary as per brokerage firm and terms of trading account. Brokerage fee can be structured as per

1. Per contract fee: Broker may charge a fixed fee per contract. For example, if investor pays an amount for one contract, then the investor will pay ten times of that amount for ten contracts.

2. Percentage of Transaction Value: A percentage of transaction value is paid as brokerage fee. Transaction fee is calculated by multiplying the contract size by its current market price.

3. Fixed fee: Investor needs to pay a fixed amount as per the fee structure regardless of number of contracts or transaction value.

4. Discounted brokerage: Discounted rates for frequent or high-volume traders.

Investor needs to carefully review and evaluate the brokerage fee structure before initiating trade to avoid any higher or unanticipated additional cost.


Key Considerations for NRIs

In addition to what has been discussed, there are certain other considerations for Non-Resident Indians.

1. NRIs need to appoint a Custodian and a Custodian Participant (CP) Code is required.

2. NRIs can invest in equity delivery and trade in F&O, however intraday trading in equity is not allowed.

3. Intraday trading in F&O is allowed if client has a CP code.

4. For NRE, only equity trading is allowed.

5. For NRO, equity delivery and F&O is allowed

6. NRIs cannot pledge securities as collateral to trade in F&O

7. NRIs can invest in Mutual Funds (except from USA & Canada), if they have a nON-PIS account.

8. Buy Today Sell Tomorrow is also not allowed


Expiry of Option Contracts

Option contracts have expiry dates based on different timelines such as daily, weekly, monthly and even longer-term options known as LEAPS. For example, NIFTY 50 weekly contracts expire on Tuesday, Nifty Midcap Select weekly contract expires on Wednesday and so on. Generally, the date is clearly mentioned in the option contract. In addition to that, last Thursday of every month is considered as the expiry date of F&O Contracts. Expiry is quite important for an investor as it impacts the option’s value and the profit or loss that the investor may suffer.


Who should Invest in Futures and Options?

Investment in F&O are suitable for those investors who has:

1. The objective of trading rather than investing which means making profits in short term.

2. Knowledge of Future and Option Contracts for trading in them.

3. Risk Tolerance as F&O can be highly volatile which may lead to higher losses as well.

4. Adequate Capital: For leveraging and trading frequently or in large amount, adequate capital is required.

5. Time commitment: F&O trading requires time and active monitoring of market conditions.


Overall, F&O trading can be really beneficial for a trader if done carefully with knowledge, strategy and time commitment.


For other interesting conceptual topics please visit our other contents:

How to hedge Foreign Exposure:

Why Rupee has depreciated over time?:


Comments


bottom of page