Investment in equities is considered to be a riskier affair. But it is rewarding as well. There is a famous saying that the lower the risk, the lower will be the returns, while with high returns comes high risk. To generate high returns, one has to make investments carefully to generate good income.
There are different ways through which a person can make a good profit from the stock market. Apart from buying and selling stocks in cash, there are several other ways by which one can make money. One of these ways is called derivatives. The derivatives are traded on the price based on their underlying asset. This underlying asset can be a stock or commodity. There are two types of derivative contracts: Futures and Options.
A trade is executed only when two people, a buyer, and seller, enter into a derivative contract where they agree to sell or buy or vice-versa the underlying asset at a certain price target within a time range.
Earlier this year, capital market regulator SEBI had said that 9 out of 10 individual traders were making losses in the F&O segment.
Notably, India is the world’s largest market for trading in equity F&O. According to a SEBI report, F&O trading has seen a stupendous five-fold growth in less than four years between FY19 and FY22.
Future Trading
Arun Singh Tanwar, founder and CEO, Get Together Finance (GTF), said that a person can buy the options or future of a stock or index for a certain expiry. Ina F&O trade, at the time price target is achieved, a person makes good profits, whereas, not reaching the strike price or target price can vanish all capital.
Future contract obliges the trader to buy or sell the underlying asset at a specified price at a specified time. The futures are purchased in the form of lots and one has to pay a margin set by the brokers to enter into the contract.
He said that F&O can also be used for hedging or can also be directly traded. Hedging is nothing but a risk management strategy by taking an opposite position in a related asset.
"The reduction in risk provided by hedging also typically results in a reduction in potential profits," Arun said.
Options Trading
In an option trade, unlike the futures, options give the right but do not oblige you to sell or buy the contract at a certain price. In other words, when a person enters into an options contract for a certain strike or target price, then he/she can exit from the contract before reaching the target.
"Options contracts are also purchased or sold in form lots, but they can be bought at a very nominal premium price compared to the futures," Arun said.
There are two types of Options: Call and Put. A person buys a Call option when he aims for the price to reach that certain target experiencing an up move. As the price of the stock reaches near the strike price, the premium’s value increases. Whereas in the sell option, as the price of the stock goes away from the strike price, the premium price decreases.
A Put option is traded when a trader aims for the price of the stock to fall and reach a certain target.
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