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F&O Trading: High Returns At The Cost Of High Risk

If you are a stock investor, the temptation of trying your hand at F&O trading must have brushed you sometime or other. Future & Options trading also known as derivatives is the big attraction for all the new investors/traders. Unlike equity, to make money in derivatives you don't have to wait for years, you make big bucks in a short time, sometimes as little as hours. But if it is so good then why celebrity investors call it the financial instruments of mass destruction? To understand this you will have to take a closer look at F&O market and in no time you will realise that all is not glossy and shiny underneath. F&O trading is a game designed for professional traders. It's a high-risk proposition where you can bag big profits and also lose it all. Sounds exciting, doesn't it? Let's explore the subject and try to understand why and how to use futures and options.

What Is Futures & Options Trading?

Future Contract

A future contract is where two parties agree to enter a contract to buy or sell something at a decided price at a future date. The futures contract is on the underlying asset (stock or index). As the contract derives its value from the underlying assets a future and options contract is also called derivatives. Let's try to understand the concept of F&O with an example.

If you have developed an opinion that Nifty will rally in the next few week as most of the companies in Nifty 50 are doing well. This means you are bullish about Nifty, you buy a future contract of Nifty (long position). Now that you have taken a long position and if your directional view turns out to be true, you will gain from Nifty's upward movement. In case it goes against you, you will lose money. Also, the contract has a certain time frame, so it is important that your directional view realises during the contract period.

In Indian stock market, the duration of a future contract is one month, it expires on the last Thursday of the month.

Short Selling Of The Future Contract

When you buy a futures contract, you are basically anticipating the market to go up. The contract where you are expecting the market (the price of the underlying asset) and you are seeking to gain from the upward movement, this type of future trading is called going long. However, if you the think the index or the particular stock is going to fall in future, you can still make money out of that movement. It's called short selling. Opposite of going long, in short selling, you can sell the future contract and take a short position and buy it when your target is reached. Naturally, you must be wondering - how can you sell something that you don’t own? In futures, it is possible. Just like in the long position you have to sell the contract to square off your position, in short selling, you have to buy the same contact to square off the position.

Option Contract

Just like futures, there is long and short, in options, you have two types - Call and Put. In the call option, the trader is anticipating the price of the underlying asset to go up while in the put option the trader expects it to drop. An option contract is essentially price probabilities of any future event. For example, you buy call option of ABC company at the strike price of Rs.500 with the expiry of 3 months. Now if the price of the stock moves towards the strike price (In this case Rs.500) and you start to gain profit and when it moves against you, you lose money. The time plays a crucial factor in options. If you buy a 1-month contract it will be cheaper as the probabilities of ABC reaching 500 are greater in 3 months than in 1 month.

Should Retail Investor Try Their Hand At Derivative Trading?

If you ask this above question to any experienced investor they would advise you against it. There is a reason why experienced investors spell a cautionary note for traders because they know the quantum of harm derivatives can cause. However, there are some smart ways you can use the F&O. Using it for hedging is one of the best ways. Hedging simply means safeguarding your equity holding. In a way, it works as an insurance. For example, if you are holding 500 shares of Tata Motors and there is a possibility that the share value is going to drop in the coming days, then you can short the future contract of Tata Motors. By doing this, if the stock goes down, as you had expected, you will gain from the futures contract. This process of securing equity holdings is called hedging.

Final Word

As we learned that hedging is the best use of derivatives, and if used wisely, one can gain a lot from it. But we have also learned that derivative trading can turn out to be a beast which has the potential to wipe off all your capital. Over the year, traders have reduced F&O trading to gambling. Hence, the retail investors are better off not using derivative. It's better to focus on your long-term investment goals and stay invested in equity.

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Wednesday, 16 October 2019

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