Things to Know Before Trading in Futures and Options.

Have you ever thought of trading in futures and Options? As an aspiring derivatives trader, what are the things that you should know before trading in futures and Options?

Well, trading in derivatives has gained momentum in recent years. It has been identified as an opportunity to hedge investment against market risks and losses. Futures and Options are derivatives that derive value from underlying assets like equity shares, commodities, bonds, interest rates, share market indices, and others. Futures and Options have fixed contracts like one month, two months, or three months, and these contracts have a fixed expiry date. For instance, stock futures and options expire on the last Thursday of the month.  

The derivatives market is a crucial segment of the equity market. It is comparatively more complex than equity investments because of leverage and the associated risks.

A Quick Insight on What Exactly Are Futures and Options.

A futures contract is an agreement between two parties (buyer and seller) to buy or sell an underlying asset (equity shares, commodities, bonds) at a pre-determined price and on a pre-determined date in the future. Futures are obligatory for both the buyer and the seller, meaning they must trade at the pre-determined value of the underlying asset under normal circumstances. Futures contracts are traded in lots specifying the number of units that forms part of 1 futures contract. To minimize the risk of defaults, the stock exchange has levied initial margins (SPAN+Exposure) on futures contracts. Check out FYERS Margin Calculator for reference.

For instance, A is expecting that the share price of X Ltd will rise soon. A buys 1 lot (10000 shares) of X futures currently priced at ₹70, and the margin amount is ₹100000. So, if the share price rises to ₹100, then A makes a profit of ₹3,00,000 per lot {(100-70)*10000}. However, if the share price falls to ₹50, then A makes a loss of ₹2,00,000 per lot {(70-50)*10000}.

Interestingly, in Options contracts, a buyer of the contract has the right (not an obligation) to purchase or sell a stock (underlying asset) at an agreed-upon specific price (strike price) and date. Buyers of the contract pay a premium to trade in Options. Premiums are based on the underlying asset's strike price, which is actually the rate to buy or sell until the contract expires. Think of this like an insurance premium to protect against risks. For instance, if you are a farmer who wants to sell produce at a minimum price of 100 per kg, you will have to buy a put option at a strike price of 100. If the price of the produce goes below 100, you will be protected against the downside.

There are two basic option types, i.e., the Call option and the Put Option. A call option enables the buyer of the contract a right (not an obligation) to buy stocks or any underlying asset at a specific fixed price and date. Alternatively, the Put Option enables the buyer of the contract a right (not an obligation) to sell stocks or any underlying asset at a specific fixed price and date.

Now, Look at the Things You Should Know Before Trading in Futures and Options.

1. The Power of Leverage in Futures and Options Trading.

Stock market leveraging has attained prominence and has become a common practice amongst investors. The basic idea of leverage in the stock market is to enhance exposure to the underlying asset (stocks) and amplify returns on investment by using a deposit (margin money). In layman's language, you are putting down a fraction of the total trade value to initiate the trade at the exchange.

In Futures trading, you only pay a percentage of the total contract value to buy or sell futures. It is very important to understand that leverage works both ways; it can generate profits as well as result in losses. For example, Reliance futures is trading at ₹2,600, and the lot size is 250 shares. So the contract value is ₹6,50,000. This is where the leverage facility steps in and allows you to trade by paying the margin amount (SPAN+Exposure). For taking a position in reliance futures, you are required to pay ₹1,51,000 per lot, which is approximately one-fourth of the total trade value specified by the stock exchange. If the price of the Reliance futures increases to ₹2700, the profit would be ₹25,000 per lot. If the price of the Reliance futures decreases to ₹2400, then the loss would be ₹50,000 per lot.

In Options trading, you also get the opportunity to make more significant gains with a smaller amount of capital. For example, you wish to buy 250 shares of Reliance industries in September, which is currently trading at ₹2500, but do not have the required capital amount of ₹6,25,000. In this case, you can enter into the options market and choose an appropriate option in proximity to the stock, with a strike price of ₹2500, for ₹123. This would bring down your investment to ₹30750. However, it is advisable to note that the time value of options deteriorates significantly throughout the contract period. Hence, the timing makes all the difference.

2. Risk Management Involved in Futures and Options Trading.

Risk management is a crucial aspect of futures and Options trading. It should be strictly adhered to stay afloat in volatile market scenarios. With a good risk management strategy, you are well-placed to control losses and continue with active participation in the stock market.

To protect your capital, it is advisable to trade in futures and options with stop losses as the risk is significantly higher than trading or investing in stocks. Stop loss acts like an insurance cover to your trading position. It helps in terminating the trading position with the maximum loss that can be undertaken. Stop loss gets triggered automatically and helps manage losses effectively without monitoring the market closely.

Interestingly, hedging against risk is also an important tactic to stand strong against market risks. You can easily use Futures and Options to mitigate or hedge against market risks. For instance, if you're holding Reliance, then hedging can be done by selling futures at a higher price, or you can protect your position by buying put options.  

3. Understand the Psychology of Trading in Futures and Options.

Trading in stock markets involves understanding stock charts, technical indicators, market sentiments, and other external factors. However, one of the critical aspects of trading which are consistently ignored is Psychology. Human-driven emotions like fear, greed, hope, regret and others act as catalysts to trading. These emotions largely dictate the success and failure of any trading action. But how?

For instance, you had surplus capital of ₹1,00,000 and tried to make profits by trading in futures. One of the first emotions that you might encounter is FEAR. It starts once the market starts moving opposite of the anticipated direction. The probability of potential loss instills a fear of losing out, and you might square off the positions without a plan. Now, if the market moves in the anticipated direction, then you might experience the emotion of GREED driving your mind. You might hold winning positions way longer than your targets and make losses or reduced profits.

Interestingly, there is another scenario wherein you buy a share based on your analysis that the price will increase during the day. But suddenly, the price starts falling, and in the hope of a price rise, you tend to hold your position a little longer and could incur more significant losses. The emotion of 'HOPE' is positive but can lead to devastating results. On the other hand, you are expecting the price to rise, and at the last moment, you decide to hold back. Suddenly, if the prices rise and this is the point wherein you start experiencing 'REGRET'.

A stock market is characterized by high volatility, and it is crucial to have an emotional balance before taking a step forward to trading in the markets.

Conclusion:

Futures and options might differ conceptually, but they offer an opportunity to protect capital against market volatility by locking a transaction at a pre-determined price and date. Although Futures and Options trading is not rocket science, an in-depth understanding of these financial products is essential before you start trading.

FYERS, a reliable and easy-to-use trading platform, provides you with an opportunity to trade in futures and Options seamlessly. Additionally, you can also refer to the FYERS School of Stocks to get a full-fledged understanding of derivatives.