A Guide to Futures and Options Trading: Key Concepts & Strategies

This article features opinions and insights from Hariprasad K, a SEBI-registered Research Analyst and seasoned F&O trader who manages a portfolio of over Rs 400 Crores.

This blog will cover the fundamentals of F&O trading, beginner strategies to consider, and common mistakes that can be avoided. 

What Are Derivatives?

To understand F&O trading, let’s start with the fundamentals. At the heart of this lies derivatives, a financial tool that enables traders to navigate and leverage price movements without owning the underlying asset.

Derivatives are financial contracts whose values are derived from an underlying asset such as stocks, bonds, an index, etc. They allow investors to speculate, hedge, and profit from price changes without owning the asset. It was initially designed to manage and reduce financial risks by locking in prices or values. Over time, they have also become tools for speculating on market movements to potentially earn profits.

Two popular types of derivatives traded in India are Futures and Options.

What is a Future?

A future is a financial derivative contract that facilitates the buying or selling of an underlying asset at a predetermined price on a specific date. To explain this in simple terms, let’s consider the following example:

Suppose a consumer wants to purchase a Maruti Suzuki car from Dealer A. The car is priced at ₹5 Lakhs and the delivery date is after a month. The upfront amount is ₹50,000 to confirm the booking.

By paying this upfront amount of ₹50,000, both the Consumer and Dealer have entered into the agreement. In 30 days, the consumer will be paying the amount of ₹5 Lakhs, while Dealer A will be delivering the car to the consumer in exchange. 

Now, let’s say, the price of the car goes up to ₹6 lakhs after 1 month. In this scenario, the consumer is in a position to gain ₹1 lakh as the dealer is under the obligation to deliver the car at ₹5 lakhs only. 

Therefore, entering into a futures contract is a safe haven for both parties as either might feel the price is going to move in an unfavorable direction and it is better to be protected against it. 

Futures can have different expiry dates, but it is more flexible to enter into a contract in the current month as it provides the maximum liquidity to the trader.

Contracts with closer expiry dates minimize slippage, which is the difference between expected trade price and the price at which the trade is actually executed. Trading futures contracts in the current month minimize slippage by ensuring the most liquid contracts, reducing the possible price difference between expected and executed trade prices.

Understanding Key Concepts in Futures Trading

An investor needs to understand the following key concepts before beginning with Futures trading: Initial Margin, Required Margin, and Margin Call.

Take the example of Reliance Industries Limited which has a trading lot size of 500, and a current trading price: ₹1278. Therefore, the contract value will be ₹6.39 lakhs (500*1278). 

Initial Margin: It is the initial locked-in deposit needed to enter into the futures contract, which is determined as a percentage of the contract value. In this case, the initial margin required is ₹1.14 lakhs, almost 17.8% of the contract value. Ideally, the margin requirement varies between 15-20%.

Required Margin: Let’s assume that the price of Reliance Industries falls from ₹1278 to ₹1240. This results in a theoretical loss of ₹19,000 (500 × ₹38). To account for this loss and ensure the margin account remains above the required threshold, the broker may request an additional deposit. For instance, if the loss reduces the margin below the initial ₹1.14 lakhs, the broker might ask for a top-up to restore it to the required level. This extra deposit is known as the required margin.

Margin Call: In cases where the loss incurred exceeds the entire margin in the investor’s account, the broker can either square off the position or ask for a fresh margin, this is called a margin call. For example, if the total losses surpass ₹1.14 lakhs, the broker could either close the position or demand additional funds to maintain the trade.

How are Futures priced?
Futures prices are generally determined by the relationship between the current price of the underlying asset (spot price) and expectations about its future value. This relationship depends on factors like interest rates, dividends, and market sentiment.

1. Forwardation: In most cases, futures prices are higher than the spot price. This occurs because investors factor in the cost of carrying the asset (such as storage or financing costs) until the contract’s expiration. This upward price difference reflects positive market sentiment or expectations of future price increases
2. Backwardation: Conversely, when the spot price is higher than the futures price, the market is said to be in backwardation. This scenario is rare and typically occurs during times of negative sentiment or unusual market conditions, such as supply shortages or panic selling.

By understanding these pricing dynamics, investors can gauge market sentiment and make informed trading decisions.

Beginner Strategies to get into Futures!

As a beginner, an investor could start futures trading as follows:

Start with equity, understand the price action, and get comfortable with stock movements:

It’s best to start with trading in equity first since it teaches price action. In the case of equity, a price movement of ₹1 would expose you to a profit or loss of ₹1 per unit of equity share. However, in the case of futures, a ₹1 price movement exposes the investor to high values of profit or loss depending on the lot size. 

Therefore, to better understand the functioning of futures trading, an investor should first get comfortable with equity trading.

What are Options?

Similar to Futures, Options are derivative instruments that give traders the right, but not the obligation, to buy or sell the underlying asset at a specified price. This distinction opens up a range of strategies that can be tailored to varying risk appetites and market outlooks. Let’s explore the basics of call and put Options to see how they work in practice.

What are Call and Put options? When are they used?

A Call option gives traders the right to buy an underlying asset at a predetermined price and date, by paying a premium today.

For example, an investor can choose to buy a Call option on the Nifty 50 Index (‘underlying”) today by paying a premium of ₹200, for a maturity after 30 days. Suppose, the investor buys the call option at a strike price of ₹25,000, the price that the investor will pay at the time of expiry if they exercise their right to buy Nifty 50. At maturity, if the Nifty 50 is priced at 25,500, investors could exercise the option, and profit ₹300(₹500-₹200) from this transaction.

However, if the Nifty 50 is priced at say, ₹24,000 at the time of maturity, the investor can choose not to exercise the option, and avert loss of ₹800 (1000-200).

Therefore, investors prefer call options when they expect the market to go upwards.

A Put Option gives the investor a right, but not the obligation, to sell or short sell an underlying asset at a predetermined price and date.

Let’s say, an investor buys a put option on Nifty 50 today by paying a premium ₹200, for a 30-day expiry period. Suppose the investor buys the put option at a strike price of ₹25,000. At expiry, suppose the spot price of the Nifty 50 at ₹24,000. Investors can exercise the option to sell at ₹25,000 and gain ₹1000, in net ₹800 ₹1000– premium ₹200). 

However, if Nifty 50 touches ₹25,500 at the time of expiry, the investor would want to sell the underlying at a higher price and would not exercise the option. This would lead to an aversion of loss of ₹500, effectively ₹300 (₹500– premium paid ₹200).

Therefore, put options are ideal for investors expecting a future decline in the market.

Key Concepts in Options Trading

Call options are used when you expect the price of an asset to go up, while put options help protect against price drops or allow you to profit from them.

• In-the-Money (ITM): This means the option could make a profit. The asset’s current price is higher than the strike price for a call option. For a put option, the strike price is higher than the asset’s current price.
• Out-of-the-Money (OTM): This means the option would not make a profit if exercised. For a call option, the asset’s current price is lower than the strike price. For a put option, the strike price is lower than the asset’s current price.
• At-the-Money (ATM): This means the asset’s current price is very close to the strike price, so the option is neither profitable nor unprofitable

Beginner Strategies for Options Trading

Beginner options traders should focus on at-the-money or slightly out-of-the-money options to capture market moves effectively. At-the-money options tend to be safer as they are closer to the strike price. Slightly out-of-the-money options tend to be cheaper and, therefore, potentially strike a balance between risk and reward.

For markets that are not trending up or down (range-bound), the strangle strategy can be useful. This involves buying both a call option (with a strike price above the current market price) and a put option (with a strike price below the current market price) at the same time, both with the same expiration date. This strategy can lead to high profits if the asset price moves significantly in either direction — up or down. The most you can lose is the amount you paid for both options.

Avoiding Common Pitfalls in Futures and Options

Both Futures and Options need to be traded with caution, given the significant risks attached to them.

In Futures, the use of margins increases the potential of multiplying losses, owing to its high leverage quotient. By putting in only a small amount as an initial margin, the investor is essentially borrowing large amounts to enter into an otherwise higher-valued contract, which may be more than what their own capital permits. While this could potentially amplify profits, it also comes with high leverage risk that could lead to magnified losses. Therefore, caution should be exercised while trading in futures. 

Options trading face the risk of time decay, as time passes and an option nears expiration, its value diminishes due to time decay, measured by ‘theta’. To avoid this pitfall, traders can buy longer-term options to minimize the impact.

Delta measures an option’s price sensitivity to the underlying asset’s price changes, helping assess potential gains or losses. Options with strike prices close to the market price have higher delta and more predictability. Options with distant strike prices have lower delta.

Beginners should opt for at-the-money or one-strike, out-of-the-money options to reduce unpredictability.

The Bottom Line

While Futures trading is a slower, more gradual learning process that can be profitable over time, allowing investors to become familiar with trading, Options trading is about making calculated and well-informed choices. In both cases, it is essential to start small, learn the risks involved in the process, and maintain realistic expectations.

Watch the detailed video to learn more

Frequently Asked Questions:

1) What are the Charges in F&O trading?

There are brokerage charges depending on whether the broker is a discount or full-time broker. Discount brokers have fixed charges per order whereas Full-time brokers charge on a per-lot basis. Apart from Brokerage, there are Securities Transaction Tax (STT) charges (usually 0.02%), Turnover charges, GST charges, etc on the entire transaction value.

2) For a beginner investor, which is better Futures or Options?

For beginners, Options are generally more feasible than futures because they offer lower upfront costs and effective strategies like ‘strangle’, and limited downside risk, making them less risky to learn trading without significant losses.