Sunday, December 19, 2010

F&O investing: High risk and high gain option

The future and option (F&O) market is a good investing or trading option for investors with a high risk appetite. The volatility in the markets creates many opportunities for speculative trading in the F&O market. The F&O market offers high returns as it is similar to leveraged investments. On the other hand, it comes with a high risk of loss of capital. Investments in derivative instruments magnify the returns and risk many times. Therefore, investors with a high risk appetite , good understanding and reach of stock markets only should look at investing in derivative instruments. 


A 'future' is an agreement to buy or sell a certain underlying asset at a fixed price and at a certain future date. The seller of a future has an obligation to deliver the underlying asset to the buyer, and the buyer has an obligation to pay the agreed price to the seller at a future date. A transaction involving the sale of stock futures is called 'short future position' and a transaction involving the purchase of stock futures is called 'long future position'. 


An 'option' is a special type of future contract where the buyer has an option to buy or not to buy the underlying asset from the seller at a fixed price up to a certain date called 'options expiry date'. However, the option seller (writer) has an obligation to deliver the underlying asset to the buyer. The buyer of the option pays an upfront fee/premium to the seller of the option. If the buyer does not exercise the option by the option expiry date, the option expires and has no value. 

Call and put options 

Options are of two types - call option and put option. In a call option, the buyer has an option to buy an underlying 
asset at a predetermined price. In a put option the buyer has an option to sell an underlying asset to the seller of the put option at a predetermined price. 

Derivatives trading in market indices 

F&O trading in market indices are the most-traded derivatives in the markets. These derivatives move based on the market indices such as the Nifty, Bankex etc. Investors can take positions based on the market outlook or sectoral outlook in the short term. Investors can also initiate various trading strategies with a mix of positions in the derivatives segment. 

Derivatives trading in stocks 

The stock-specific derivative trading is more difficult due to liquidity concerns and hence requires extra care. Usually, derivatives of blue-chip companies have good amount of trading and liquidity in the market. Investments in stock-specific derivatives yield good returns due to higher volatility and sharp movements. However, investors should remain cautious with stockspecific derivatives as they come with liquidity issues at times. 

Derivatives trading in commodities 

Derivatives in commodities are attractive options due to high volatility in commodity prices. However, care should be taken in commodity trading as it is important to have good understanding of the underlying commodity and factors that may impact price movements in the commodity. 

Trading cycles 
Usually, derivates are traded in three trading cycles - current month, next month and the month after next. Current month derivatives are the most-traded in the market. Therefore, it is advisable for investors to trade in current month derivatives. 

Track market movements 

Trading in derivates comes with a high risk element. Investors looking at trading in the F&O segment should track market movements closely, apart from the developments that might impact the market movements. 

Stop-loss trigger 

Investors should trade in the F&O segment keeping a tight 'stop loss' and 'book profit' trigger defined for their open positions. Open positions in the derivative segment can be very risky in certain volatile market conditions.
It is also important to keep in mind that all positions in trading may not end in profits. Hence, investors should 
be ready to incur losses in some trades. Typically, experts in trading target profits in 60 to 70 per cent of 
their trading positions. 

Factor in brokerage amount 

Most of the F&O positions settlements happen on thin margins. Hence, brokerage becomes quite significant when it comes to net profits of investors. Stock brokers offer a variety of plans for trading in derivatives for their regular clients. Investors should choose their brokerage plan carefully based on their trading quantum and profile.

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