Cracking the F&O code
This segment attracts more traders due to its potential to give higher returns to the investors than the cash market, writes Ramesh Palan.india Updated: Apr 24, 2008 00:30 IST
Futures and Options are very popular in today’s capital markets as they have the potential to yield huge profit, with any given investment unit. They are also called derivatives instruments as they derive their value from an underlying security – stock or index or commodity.
With the same Rs one lakh of investment one wants to invest in the cash market, an investor can take exposure to stocks worth Rs four to five lakh, depending on the margins imposed. However, one has to understand the process, which is ridden with several pitfalls.
These financial products can also be used to earn money when markets are falling by taking bearish stance, through short-selling the contracts (without even buying or owning them initially) at higher prices and later square them off by buying them at lower price levels in the falling market.
Traders can also manage their risks by using hedging strategies, where they can go long (buy, with a bullish view) and short (sell, with a bearish view) at the same time. Apart from stocks, trader can bet on indices to take advantage of huge movements in them during volatility or when one has a clear bearish or bullish view.
Underlying Stock or Asset
Futures and options prices are ‘derived’ from and dependent on the value of a stock or index in the spot (cash) market. Such stock or index traded in the spot market is referred to as ‘underlying’ instrument for the F&O market.
F&O segments have settlement cycles ranging from one to three months - near month (current), next month (following) and far month (third). The contracts usually expire on the last Thursday of the month, when the new far month contract will come into being. In India, all the contracts are settled in cash, as there will be no physical delivery of shares in F&O segment.
Proper instructions should be passed to your broker, especially when you are communicating via telephone. Note that short-sell orders are different from usual sell orders. A slight negligence may result in a huge monetary loss as commitments multiply in a derivative transaction, when your calculations on trends go awry. F&O investments are considered to be leveraged on this count. If an investor resorts to further loans and invests in this market, there is a possibility of the investor losing his shirt.
It is advised to resort to ‘stop loss’ orders to prevent huge losses in case of unfavourable price movements or reversal of sentiment in the underlying equity shares/indices. Especially, the futures contracts are of high risk-high reward products as there is no circuit filter (daily limits in movement – up or down) applied to them. Proper guidance and precautions should be taken before involving in such trades.
(This article appears in three parts and the second part will appear next Thursday)