In today’s world, the desire for quick cash is stronger than ever, especially with the rise of social media and influencers. Millennials and Gen Z investors are drawn to fast profits, often following Finfluencers who promise success in stock market trading, particularly in Futures and Options (F&O). However, the reality paints a different picture. A recent SEBI report revealed that 93% of retail traders in F&O markets face losses, with an average loss of over ₹2 lakh per trader, amounting to a staggering ₹2 lakh crores overall. The influence of social media and the allure of quick gains have led to a boom in F&O trading among retail traders, but the risks are often downplayed by Finfluencers who profit handsomely from their advice. Unfortunately, many of their followers are left with empty pockets. The volatile and risky nature of F&O markets can be overwhelming, especially for new traders, and without a solid understanding of the market, losses are inevitable.

Motilal Oswal Financial Services Ltd has long been committed to promoting responsible investing habits and encouraging long-term investment strategies. The company works closely with certified financial experts to educate investors about the complexities of trading and investing in the stock market, emphasizing the risks, volatility, and crucial factors traders must consider before diving in. To continue this mission, here’s our guide aimed at helping individuals grasp the basics of F&O trading, providing valuable insights into its mechanics, risks, and strategies to help traders make informed decisions and minimize potential losses.

Understanding Futures & Options Trading

Futures and Options are referred to as derivatives because their value is contingent on the performance of an underlying asset, such as a stock or an index. Let’s break this down further with an example: Imagine you inherit a flat from your grandparents. The flat doesn't hold inherent value on its own, as you never invested in it. However, when it comes time to sell, you assess its value based on factors like location, accessibility, and surrounding amenities. In this scenario, the flat's worth is determined by the conditions that make it attractive to buyers. Similarly, Futures and Options contracts lack standalone value. Instead, their value is derived from the associated underlying assets, such as indices like NIFTY, BANKNIFTY, or individual stocks. The market prices of these assets ultimately dictate the worth of the F&O contracts. Just as the flat’s appeal is shaped by external factors, the value of F&O contracts is influenced by the performance and fluctuations of the underlying assets. Understanding this relationship is crucial for anyone looking to trade in the derivatives market, as it emphasizes the importance of market trends and asset performance in determining contract value.

Now, let’s understand each of the contracts in the simplest forms

• What is Futures Contract?

A futures contract is a standardized agreement between two parties to buy or sell an underlying asset at a predetermined price on a specific future date. This contract obligates the buyer to purchase the asset and the seller to sell it, regardless of the market price at the contract's expiration. Futures contracts are commonly used for commodities, currencies, and financial instruments, allowing traders to hedge against price fluctuations or speculate on future price movements. They are traded on exchanges, ensuring transparency and liquidity.

Think of a futures contract like this: You’re a bakery owner, and you need a lot of sugar every month to make cakes. You notice that sugar prices tend to fluctuate—sometimes they go up, sometimes they go down. To protect your business from high future prices, you make a deal today with a supplier to buy sugar at ₹30 per kilo for next month, even if the price changes. This way, you’re “locking in” the current price. That’s what a futures contract does—it lets you buy or sell something in the future at a price you agree upon today.
 In the stock market, you do the same thing but with stocks or indices. You agree to buy or sell them at a specific price later, no matter how the market changes. If the price goes up, you win by paying less. But if the price goes down, you still have to buy at the agreed-upon higher price.

• What is Options contract?

An options contract is a financial agreement that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (known as the strike price) within a specific time period. There are two types of options:

Call Option: Allows the holder to buy the asset &

Put Option: Allows the holder to sell the asset.

Options are often used for hedging against price fluctuations or for speculative purposes in various markets. Unlike futures, the buyer is not obligated to execute the contract.

Simplifying this - Imagine you're at an electronics store, eyeing a sleek new phone priced at ₹30,000. The salesperson offers you a deal: for ₹2,000, you can reserve the right to buy the phone at that price anytime within the next month. By paying ₹2,000, you keep your options open without committing to buy.
This is similar to an options contract. It grants you the choice, or option, to purchase the phone at ₹30,000 (the strike price) within the specified timeframe. If the phone's price rises to ₹35,000, you can exercise your option to buy the phone at the lower price (₹30,000). Conversely, if the price drops to ₹25,000, you can simply let your option (coupon) expire, losing only the ₹2,000 premium you paid.
This flexibility makes options appealing to traders, as they can benefit from favourable price movements while limiting their losses.

Now, let’s understand how to trade in Futures and Options

Firstly, you will need to understand that –
Buying a Futures Contract is committing yourself and your capital to buy or sell an asset (like index or stock) at a future price, whether it is profitable or potential loss.

And, buying an Options Contract is when you gain the right to buy or sell an asset (like an index or a stock) at a strike price without obligation, risking only the premium. In Futures and Options trading, it is important to recognize that one trader's loss often translates into another's profit. Money is not generated within the stock market; instead, it is redistributed among participants based on the strategies employed. Understanding this dynamic is essential for developing effective trading strategies and managing risk.

Continuing with our explanation on how to trade in Futures & Options,

Trading in Futures - When you trade futures, you select a specific price at which you want to buy or sell a stock or index at a future date. For example, suppose you think the price of Nifty will rise from its current level of ₹25,000. You enter a futures contract to buy Nifty at ₹25,200 today (i.e 1st October 2024), agreeing to purchase it at that price in one month (i.e on 1st November 2024). If, at expiration (i.e on 31st October 2024), the Nifty is at ₹26,000, you pocket a profit ₹800 per unit. However, if it falls to ₹24,500, you face a loss of ₹700 per unit. The profit and loss is thus based on the quantity of units that you hold. Which is why, it is important to only hold the capital which you can risk to lose.

Trading in Options - Options work differently. Let’s say you think a certain stock, currently priced at ₹500, will rise in the next month. You buy a call option with a strike price of ₹520, paying a premium of ₹20 per share. If the stock price rises to ₹550, you can exercise your option and buy at ₹520, realizing a profit of ₹30 per share (after subtracting the premium). If the stock price falls below ₹520, you let the option expire, thus forgoing buying the stock, losing only the ₹20 premium.

 What is shorting in Futures & Options Trading?

Shorting in Futures and Options Trading refers to the practice of selling a financial instrument with the expectation that its price will decline. In a short position, a trader borrows shares or contracts and sells them at the current market price, intending to repurchase them later at a lower price. If the price drops, the trader profits from the difference. However, if the price increases, losses can be significant, making shorting a high-risk strategy. Understanding market trends and employing risk management is crucial when shorting in F&O trading.

Let’s understand this with the help of a scenario –

Suppose, you analyse a company. After careful considerations, you pick up the pieces and come to the conclusion that the company has been reporting a slow growth, declining revenue and negative trends. This analysis helps you predict that the stock price of the company share which are currently trading at ₹1,000 will decline in the future. Believing your predictions, you short the company stocks; meaning you borrow the shares of the company to sell. You sell one futures contract at ₹1,000. This means you have committed to selling one unit of the company at this price at a future date. A week later, your prediction comes true, and the stock price drops to ₹800. This decline might be due to poor quarterly results that were worse than expected. You buy back the futures contract at ₹800. Since you initially sold it at ₹1,000, your profit is the difference, i.e

Profit=Selling Price – Buying Price

Profit = ₹1,000 − ₹800

Profit =₹200

Open Demat Account and Start Trading!

7 Key Things Beginners Should Know Before Trading F&O

Now that you have a basic understanding, let’s dive into some important things to keep in mind when trading F&O:

1. Leverage Works Both Ways:

In F&O trading, you only pay a small portion (called a margin) to control a larger value of the asset. For example, if you invest ₹20,000 in futures contracts worth ₹1,00,000, and the stock price goes up by 10%, your profit is amplified—about five times more. But beware: losses are magnified the same way. If the price falls, your losses can pile up quickly.

2. Limited Risk in Buying Options but Limited Chances to Profit:

Buying options feels safer because the most you can lose is the premium you paid upfront. However, about 97% of options expire without making any profit, so while your risk is low, your chances of profit are also low. Option sellers tend to make more money because they take on more risk.

3. Asymmetry in Options:

Options are not equal for buyers and sellers. If you buy an option, your loss is limited to the premium you paid. But if you sell an option, your potential loss can be huge if the stock price rises sharply. For example, if you sell an option at ₹900 and the stock jumps to ₹1,500, your loss could be significant.

4. Margins Can Spike During Volatility:

When the market is volatile (prices changing quickly), brokers might ask for more money (increased margin) to keep your position open. If you can’t pay, they might close your trade. Always have extra funds available during volatile times to cover margin calls.

5. Always Use Stop Loss and Profit Targets:

Risk management is key in F&O trading. A stop loss is a price at which you’ll exit a losing trade to prevent bigger losses. A profit target is a price at which you’ll exit a winning trade to lock in gains. Setting these limits helps you trade based on logic, not emotion.

6. Costs Add Up:

F&O trading often looks cheaper due to lower brokerage fees, but high turnover can increase costs, including taxes and other fees. Always make sure your potential profits are large enough to cover these additional costs.

7. Trade in Any Market Direction:

One of the biggest advantages of F&O is that you can trade even if you think the market will go down. With options, you can use strategies that make money whether the market is rising or falling, or even when it’s not moving much at all.

Learning to trade in Futures and Options is a journey that requires time, understanding, and careful analysis. Just as a swimmer must practice in the water to gauge their ability, traders eager to enter the F&O market should start with a small investment that aligns with their risk appetite. Chasing quick profits can lead to unnecessary risks, so it's crucial to develop skills in chart analysis and market trend evaluation over time.

Patience and discipline are essential; always set clear profit and loss targets, regardless of market conditions. By consistently applying these principles, you can become a skilled trader and establish a reliable secondary income without undue stress.

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