BT Insight: What you should know about F&Os

The benchmark Nifty50 may hit its crucial 12,000 level by the expiry of May series futures and options (F&Os) contracts on Thursday. However, the index is expected to stay in a wide range of 11,550-12,100 with a negative bias by the end of June expiry, say analysts. They advise traders to invest in a staggered manner in index and stock F&Os and in case of latter, only put money in heavyweights.

After a strong rally post-exit polls and election verdict, the risk-reward ratio is not favourable, says Chandan Taparia, Analyst-Derivatives at Motilal Oswal Financial Services. He expects limited upside and more downside in the market in June. "Whenever there is a sharp move, some sort of course correction and hedging is always expected," he says.

F&Os are risky propositions for small traders. Sandip Raichura, CEO Retail and Distribution Prabhudas Lilladher says only those with high-risk appetite and a good understanding of market movement and derivatives tools for hedges should participate in F&O markets.

Read on to know what F&Os are and what risks are involved while trading in it:

Derivatives

Before coming to F&Os, you must understand what derivatives are. Derivatives are products, which derive their value from an underlying asset such as stocks, bonds, indices, commodities and currencies. With derivatives, traders can earn profits by speculating on the value of the underlying asset in future. One can also use it to hedge their positions in the spot market by executing an opposite position in the derivatives market. Futures and options are the two most commonly used derivatives.

What are futures?

A futures contract is an agreement between two traders to buy or sell the underlying asset at a specified price in future. The buying or selling price could be lower or higher than the current market price, but the transaction has to happen at the pre-fixed price. Besides, the buyer will be obligated to execute the transaction even if the current market price (CMP) goes below the pre-fixed price.

For example, you buy a futures contract of stock A for Rs 100 on June 5. You expect the price to rise to Rs 150 by June 25. On June 27, stock A hits 130. The seller of the futures contract to you is obliged to sell the underlying stock at Rs 100. You buy the stock at Rs 100, and sell it for Rs 130, earning a profit of Rs 30. If CMP falls to Rs 70 on June 27, you will still have to buy it for Rs 100 and the seller will earn a profit of Rs 30.

So, a futures contract could bring unlimited profit or loss.

What are the options?

An options contract gives you the right to buy (through a Call option) or sell (through a Put option) the asset at a future date at a fixed price. However, you are not under any obligation to do so unlike in futures contracts. Nevertheless, if the buyer chooses to buy the asset, the seller is obliged to sell it. So, an options contract can bring unlimited profit, but it reduces the potential loss.

There are of two types of options: Call (CE) and Put (PE). Buying a Call option means you are buying shares of the underlying scrip at a specified price. If the share price goes up, the value of the Call also rises. Buying a Put option means you are selling the shares at a specified price. If the price of the underlying security falls, the value of the Put rises.

For example, a trader buys an 11,800 Call on Nifty on June 20 for Rs 52 (75 shares make one contract). The call option will expire on June 27. On December 27, Nifty ends at say 11,900. The 11,800 call is Rs 100 'in the money'. So the Call seller pays the trader Rs 100. Call buyer earned the profit of Rs 48 on the Rs 52 per share he paid to the call seller. Had the Nifty closed at 11,700, the 10,800 Call would have ended at Rs 100 'out of the money' and the call buyer would have lost the entire premium (Rs 52) to the seller.

In the case of Put option, the buyer gains if the Nifty falls and the seller gets to keep the premium if Nifty rises or remains flat.

Strike price

The price at which a Put or Call option is exercised is called strike price.

What is the open interest?

Open Interest (OI) is a number that signifies how many futures (or options) contracts are currently outstanding (open) in the market.

"There are always two sides to trade: a buyer and a seller. If the seller sells one contract to the buyer, the buyer is said to be long on the contract and the seller is said to be short on the same contract.  The open interest, in this case, will be 1," explains Nitin Murarka, head-derivatives, SMC Global Securities.

The below table will help you gauge the market trend based on the combination of OI and CMP:

Risks involved:

Although futures trading appears to be an attractive investment option, there are a lot of risks involved.

i) Risk of settlement and delivery: The foremost risk is of settlement and delivery, says Murarka, as all executed trades need to be settled and closed at some point as per expiry date.

ii) Margin game: Raichura of Prabhudas Lilladher explains that F&Os are a leveraged product inherently, which means you only have to invest 15-20 per cent of the entire contract value and yet get an opportunity to participate in the market. So, with leverage benefit, although one ends up in high profits, one may incur huge losses as well. The broker will have no option but to liquidate your position if you fail to pay mark-to-market margins.

Should you go for it?

Murarka advises small traders to follow discipline by keeping strict stop loss intact as one wrong decision can vanish all the capital invested. One should have complete knowledge regarding margins, circulars and other legal things, which are provided by exchanges on a time-to-time basis, he adds.

Raichura shares another caveat: While dealing in Options, one needs to understand the risk associated with commonly referred term such as 'THETA' i.e time value. If one doesn't calculate the premium with time value properly, one may lose the premium paid completely on expiry as well.

Hence, the F&O segment is not for the traders who can't bear elevated risk on their capital. It is always a high-risk and high-reward game, surmises Murarka.