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Things to know before you start trading in futures and options

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Unlike stocks and Mutual Funds, trading in derivative contracts (generally and popularly including derivatives and options) can be really complex.The first thing we need to understand is how are derivatives different from normal investments like stocks. Derivatives are not assets but a form of contract, derivatives like futures and options have a fixed expiry date as per the terms of contract between buyer and seller. The interesting fact about derivatives is that the instruments themselves don't carry any value rather the value is derived from the value of underlying instrument. The underlying instrument can be commodities, currencies, stocks or even precious metals. Due to the peculiarities of Derivative instruments, some of the derivative instruments which are not exchange traded are traded in Over the Counter Markets (OTC) which are customised, flexible, less regulated, private but subject to greater risk in case of default.

If you want to start with futures and options (Derivative forms) of trading, there are a few simple hacks you need to know:

  • To trade in Futures and Options you don't need to open a demat account - For futures and options trading you need to open trading account with your broker but not demat account, demat account is generally required to convert your physical stocks into electronic stocks (as if you are virtually holding them). In case of Derivatives, there is no physical delivery of contract, only the settlement price or price difference is paid in cash, hence there is no hassle of opening a demat account.

  • Investing in futures can bring you down the same way they can bring you up - Futures are leveraged products and they can work both ways. if your agent approaches you and tries to persuade you by saying that you can buy stocks in a future contract of Rs 100,000 by paying a margin of Rs 20,000, making leverage ratio of (100,000/20,000 = 5), and if the price rise by 10%, that makes your profit (10,000 *5 = 50,000), magnifying it by 5 times definitely but he will not tell you that in case the market falls by 10% your losses can be (10,000*5 =50,000) magnifying your losses in same way it can magnify your profits.

  • Options is not a very good deal to make money - Option contracts give you rights but not obligation to buy or sell the security, the risk which a trader has in case of options trading is only limited to the amount of premium paid and not extended to the value of the options.Options have a specific expiry date, before date you can either exercise and sell your option after buying it or let it expire at its expiry date. 90% of the options expire worthless (carry no value at the expiry date), therefore it is reasonable to sell your option and make some profit rather than making it expire valueless. The loss in case of Options is limited to the amount of premium paid, but you can make profits in case the company's share prices rise after you have bought the options. There are call and put options and different risk and rewards associated to the buy and sell side of them. We can discuss that in the later articles since they can be complicated to explain.

  • Futures trading is a square deal - Futures trading is symmetrical, if A buys "RIL" futures at Rs 920 and B sells these futures, if price goes to Rs 940, then the profit for A is Rs 20 and for loss for B is also 20, similar for both the parties. The reverse will hold true in case of losses as well.

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  • Margin on futures can cause troubles in volatile times - Margins on futures can go up during Volatile times, assume that you brought a specific future product at a margin of 15% and you still have additional liquidity of 10% (upto paying for 25% (10%+15%), but due to volatility in market, the margins are revised to 40%, in that case you need to bring in fresh margins otherwise your broker will cut off your positions, which can be quite risky.

  • Your cost of trading in F&O can be quite high - Generally cost of Futures and Options trading can be quite high, you need to pay brokerage, GST, stamp duty, statutory charges and STT on F&O trades. Generally you need to trade in such a way that ensures that your profits to the cost ratio is 3:1(ideally), profits can be less than 3, but definitely not less than 1, otherwise your efforts of trading in F&O will not be justified.

Trading in options and futures can be difficult but can generate profits, when the markets are most volatile and lacking luster. These are innovative financial products and a proper understanding of these instruments can play a major role in generating profits in the market, obviously it can generate losses as well and that is where the high risk factor comes into place. You need to understand the timing and consequences of such trading in order to generate results.

 

Happy Trading!

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