Futures & Options

Futures & Options

Like share trading in the cash segment (buy & sell shares), derivative is another kind of trading instrument. A derivative is a type of security or financial instrument, which derives its value from the value of underlying entities such as an asset, index, or interest rate. Futures and Options (F&O) are two types of derivatives available for the trading in Indian stock markets.

Futures:

A future is a contract to buy or sell an asset on or before a future date at a price specified today. The daily movement of the market will determine the profit and loss of any futures contract. If there is an increase in the price of the commodity that is part of a futures contract after the agreement has been made, the seller loses while the buyer profits. On the other hand if there is a decrease in the price of the commodity, the buyer suffers a loss while the seller profits from the transaction.

Options:

This gives the buyer the right to buy/sell the underlying asset at a predetermined price, within, or at end of a specified period. Buyer is, however, not obligated to do so. The seller of an option is obligated to settle it when the buyer exercises his right. As the seller bears the obligation, he is paid a price known as the premium.

Options are of two types:

  • Call option: Call is the right but not the obligation to purchase the underlying asset at the specified price by paying a premium..
  • Put option: Put is the right but not the obligation to sell the underlying asset at the specified price by paying a premium..

Types of settlements for Futures Contracts

  • Daily Mark to Market (MTM) Settlement .
    The profits/losses are calculated on daily basis at the end of the day based on the difference between the previous day and the current day’s settlement price. Every day the settlement of open futures position takes place at the closing price of the day. The base price of today is compared with the closing price of previous day and difference is cash settled.
    After the profit/loss calculated; the future position is Carry Forward to next day. The same process of MTM repeats and profit/losses are calculated again every day until the position is squared off or it expires.
  • Final Settlement .
    On the expiry of the futures contracts; the exchange marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash.

‘Margin’ amount in future trading

To start trading in futures contract, you are required to place a certain percentage of the total contract as margin money. The margin amount usually varies between 5 to 15% and usually decided by the exchange.

This feature (only paying small margin money) makes F&O trading most attractive because of high leverage. You can make a larger profit (or loss) with a comparatively very small amount of capital using F&O trading

Margin % differs from stock to stock based on the risk involved in the stock, which depends upon the liquidity and volatility of the respective share besides the general market conditions.

Should you invest in F&O Contracts

  • Investing in F&O needs less capital as you are required to pay only margin money and take a larger exposure. If you are risk taker and have a good understanding of the market you can earn much more than what you would, by just trading in shares. The reason is limited money to invest.
  • While trading in derivative you can short sell the lot. That means you can sell the first lot at a higher price and then buy that within the stipulated time at a lower price. So, if you are certain that the price of a specific stock will reduce you can earn profit by short selling on the future or option contract.
  • Demat account is not needed for F&O trading. All futures transactions are cash settled. Contract positions are hold by the exchanges until they expire.
  • The F&O positions are carrying forward to next day and can be continued till the expiry of the respective contract and squared off any time during the contract life.

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