How to take baby steps in stocks derivatives

Before getting into trading, it is important for an investor/trader to be aware of some basics with regard to trading in the (futures & options) F&O segment. Predicting the future is by no means an easy job. It requires considerable knowledge, creativity and wisdom.

Let’s understand what these derivatives are. These are products that obtain their values from the spot price of a security, called the underlying in market parlance.

In India, F&O contracts are popular derivative instruments traded on the stock exchanges. While in futures, one agrees to buy or sell shares at a certain price on a future date, the option contract gives one the right, but not an obligation, to buy (through a Call option) or sell (through a Put option) on a future date.

How to trade in derivatives market:-

• Do your research: It is very important to do your own research in the derivative market. But, remember the strategies need to differ from that of the spot market. Derivative trading can be done only in the derivative contracts available. NSE’s F&O segment offers contracts for three futures months at a time, and they expire on pre-defined expiry dates, which are usually the last Thursdays of the month. So, traders need to exit before the expiry date, else a contract will get settled automatically on the expiry day. Thus, it requires an accurate and timebound view on the trading bet.

• Arrange requisite margin amount: Derivatives contracts are initiated by paying a small margin and require extra margins in the hand of traders as the stock fluctuates. Remember, the margin amount changes with the change in the price of the underlying stock. So, always keep extra money in your account.

• Trading account: The trading account number is your identity in the market. You will have to first make sure that your account allows you to trade in derivatives. If not, consult your stock broker and get the required services activated. Once you do that, you will be able to place an order online or on phone with your broker.
• Margin maintenance: Select your stocks and their contracts on the basis of the amount you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts.

Choice to make -- Futures or Options: Both futures and option contracts have their own benefits and risks. It may seem that options are a better choice, since your losses can be restricted to the premium paid (in case of options buyer). However in case of short-selling of options, the potential for losses can be unlimited if the movement gets adverse. One more risk in option trading is the time value. One should be sure about the timing before entering an option contract (buy side), as most option contracts expire worthless due to time decay. So compared with futures contracts, the chances of making a profit are much higher in options.

Options may be categorised into two types:
Call Options: Options that give buyer the right to buy the underlying asset on a future date are called Call options.

Put Options: Options that give buyer the right to sell the underlying asset are called Put options.

Conclusion
F&O is certainly risky. Plus, derivative products require a lot of money. So, it is not for you if you have limited funds and low-risk appetite. You should understand that derivative trading carries an element of risk in it. The high leverage enables you to take large positions, and if the market does not turn in your favour, the losses can be huge. F&O is all about betting on future price movements of a security. That’s, when no one is sure about the direction of price movements.

(DK Aggarwal is the CMD of SMC Investment and Advisors)