What is Futures and Options? - Definition and Types of F&O
Futures and Options (F&O), commonly referred to as F&O or FNO, are types of derivatives that derive their value from underlying assets such as stocks, commodities, indices, or currencies. These financial instruments allow traders to hedge against risks or speculate on the price movements of these underlying assets. Read along to learn about what futures and options are and how they are different from each other. You'll also get to understand how you can get started with F&O trading using the various strategies available.
Types of F&O Contracts
Futures Contracts
Futures contracts are standardized agreements traded on exchanges, where parties agree to buy or sell an asset at a future date for a price agreed upon today. These contracts specify the quantity and quality of the asset, as well as the delivery date. Key characteristics of futures contracts include:
- Standardization: Futures contracts are standardized in terms of quantity, quality, and delivery time, making them highly liquid.
- Leverage: Traders can control large positions with a relatively small amount of capital, known as the margin.
- Hedging and Speculation: Futures are widely used for hedging against price fluctuations and for speculative purposes.
Options Contracts
Options contracts are derivative instruments that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a specified date. They are categorized into two types:
- Call Options: These give the holder the right to buy the underlying asset at a specific price (known as the strike price) before the option expires.
- Put Options: These give the holder the right to sell the underlying asset at the strike price before the option expires.
Options offer several advantages, such as limited risk for buyers (the most they can lose is the premium paid for the option) and the potential for significant profits if the underlying asset's price moves favorably.
What is F&O Trading?
F&O trading involves buying and selling futures and options contracts. This allows investors to trade based on the future price movements of underlying assets without owning them directly. F&O trading is popular in financial markets due to its leverage, flexibility, and risk-hedging capabilities.
Understanding the Basics of F&O
The basics of F&O trading include understanding how these contracts work and their purposes.
People use F&O trading for different reasons:
- Hedging Risks: Protecting against potential losses in other investments.
- Speculating: Betting on future price movements to make a profit.
- Arbitraging: Taking advantage of price differences in various markets to make risk-free profits.
How F&O Trading Works
F&O trading works through standardized contracts traded on exchanges. The process involves these steps and key concepts:
- Opening a Trading Account: To start trading, you need an account with a brokerage that offers F&O services.
- Placing Orders: Based on your market analysis and strategy, you place orders to buy or sell futures or options contracts.
- Margins: You need to deposit a margin, which acts as a security deposit to cover potential losses.
- Settlement: Futures contracts are settled either by delivering the actual asset or by cash payment. Options can either be exercised (used) or allowed to expire without any obligation.
Key Participants in F&O Trading
Several types of participants are involved in F&O trading, each with different goals:
- Hedgers: These are individuals or businesses that use F&O contracts to protect against price fluctuations in the underlying asset. For example, an investor might use futures contracts to hedge against potential losses in their stock portfolio.
- Speculators: Speculators are traders who seek to profit from price changes in the market. They take on higher risks in hopes of achieving higher returns. Speculators typically do not intend to take delivery of the underlying asset.
- Arbitrageurs: Participants who exploit price differences between markets to make risk-free profits. They buy in one market where the price is low and sell in another where the price is higher.
Understanding Margin Requirements
Margins in F&O trading are collateral that traders must deposit with their brokers to cover potential losses. There are two main types of margins:
- Initial Margin: The minimum amount required to open a position in a futures or options contract.
- Maintenance Margin: The minimum balance that must be maintained in the account to keep the position open. If the account balance falls below this level, a margin call is issued, requiring the trader to deposit additional funds.
How to Open an F&O Trading Account with INDmoney
To start trading Futures and Options (F&O) with INDmoney, follow these steps:
- Sign Up on INDmoney: Visit INDmoney's F&O page and click on "Get Started." If you don't have an account, sign up by providing your basic details.
- Complete KYC: Submit necessary documents for KYC (Know Your Customer) verification using your Aadhaar card.
- Open a Trading Account: Once KYC is completed, open an F&O trading account through the platform. This involves filling out an application form and agreeing to the terms and conditions.
- Deposit Initial Margin: Fund your account with the required initial margin to start trading.
- Access Trading Tools: Utilize INDmoney's advanced trading tools and features like live option chains, GTT (Good Till Triggered) orders, and risk management tools to enhance your trading experience.
Steps to Start Trading F&O
Once your account is set up on INDmoney, follow these steps to begin trading:
- Learn the Basics: Understand the core concepts of F&O trading, including how futures and options work, their benefits, and risks.
- Develop a Strategy: Determine your trading strategy based on your financial goals and risk tolerance. Common strategies include hedging, speculation, and arbitrage.
- Use Trading Tools: Leverage INDmoney's tools such as advanced charts, powerful indicators, and profit/loss estimators to inform your trading decisions.
- Place Orders: Execute trades by placing buy or sell orders through the INDmoney trading platform.
- Monitor Your Trades: Continuously track your positions and market movements to make timely decisions.
- Set Targets and Stop Losses: Use GTT and stop-loss features to manage risks and protect your capital.
What is the F&O Ban List?
The F&O Ban List is a regulatory measure enforced by the Securities and Exchange Board of India (SEBI) to control excessive speculation and maintain market stability. When the combined open interest (total number of outstanding contracts) for a stock exceeds 95% of the market-wide position limit, that stock is added to the F&O Ban List. During the ban period, only squaring off of existing positions is permitted, meaning traders cannot take new positions but can only close their existing ones. This measure helps in reducing speculative trading and protecting retail investors from high volatility.
How Stocks End Up on the F&O Ban List
Stocks are placed on the F&O Ban List when the combined open interest for a stock surpasses 95% of the market-wide position limit. The market-wide position limit is a threshold set by SEBI, calculated based on the stock’s free float market capitalization. When a stock crosses this threshold, it is placed under a trading ban to prevent further speculative positions. Once the open interest falls below 80%, the stock is removed from the ban list and normal trading can resume.
Impact of F&O Ban List on Trading
When a stock is included in the F&O Ban List, traders are restricted from taking new positions in that stock. They can only reduce their existing positions. This restriction aims to prevent further speculative trading and reduce volatility in the stock's price. The inclusion of a stock in the ban list can lead to reduced liquidity and wider bid-ask spreads, impacting overall market efficiency. However, this regulatory action ensures market stability and protects retail investors from excessive market manipulation.
Regulatory Aspects of F&O Trading
Role of SEBI in F&O Trading
The Securities and Exchange Board of India (SEBI) sets guidelines for trading practices, margin requirements, and disclosure norms to maintain transparency and reduce systemic risks. It monitors the activities of exchanges and market participants, ensuring compliance with established rules and regulations. SEBI’s regulatory framework is designed to maintain fair and orderly markets, protecting investors from fraudulent practices and ensuring the smooth functioning of the F&O market.
Conclusion
Futures and Options (F&O) trading is a sophisticated financial mechanism that offers investors a way to hedge against risks, speculate on price movements, and potentially achieve significant returns. However, it requires a thorough understanding of the market, strategies, and regulatory frameworks. Proper education, diligent research, and prudent risk management are crucial for success in F&O trading. The regulatory oversight by SEBI ensures that the market operates transparently and efficiently, protecting the interests of all participants.
FAQs
What does FNO mean in trading?
FNO stands for Futures and Options, the most commonly traded equity derivatives. You can trade these to hedge risks from long or short positions or to speculate on the price movements of stocks or indices.
What is an example of F&O trading?
If you buy a futures contract for 100 shares of a company at ₹200 per share, you must buy the shares at ₹200 each, even if the market price rises to ₹250 per share by the expiration date. Conversely, if you sell a futures contract, you must sell at ₹200 even if the market price drops to ₹150.
Do people make money in FNO?
Yes, people can profit from F&O trading without physically buying or selling shares. However, it is risky and can lead to significant losses if the market moves against the trader's position.
How do I start trading in FNO?
- Sign up on INDmoney: Visit the INDmoney website and create an account.
- Complete KYC: Submit required documents for verification, such as PAN card and Aadhaar card.
- Open a Trading Account: Fill out the application form and agree to the terms and conditions.
- Deposit Margin: Fund your account with the necessary initial margin.
- Use Trading Tools: Utilize INDmoney's trading tools to place and manage your trades.
What are the benefits of FNO trading?
Benefits include hedging against market movements, speculating on price changes, using leverage to trade large positions with small capital, profiting from market volatility, accessing liquid markets, diversifying a portfolio, and using sophisticated trading tools.
Is F&O an intraday?
F&O trading can be both intraday and positional. Intraday involves buying and selling within the same trading day, while positional involves holding positions overnight or longer.
Is it mandatory to show F&O loss in ITR?
Yes, it is mandatory to report F&O losses in your Income Tax Return (ITR). If treated as a business loss, report it in ITR-3. If not treated as a business loss or if you file taxes under the presumptive income scheme, report it in ITR-4.