How to start F&O trading? This is one of the first quetions most people ask when they enter in to stock market. In this article We will share the information about how to trade Equity Futures and Options in few easy steps.
Let’s start with few fundamental questions asked about F&O trading. Later I will discuss about easy steps to trade in F&O.
What is DerivativeTrading (Futures and Options)?
Similar to share trading in the cash segment (buy & sell shares), derivative is another kind of trading instrument. They are special contracts whose value derives from an underlying security.
Futures and Options (F&O) are two types of derivatives available for the trading in India stock markets.
In futures trading, trader takes the buy/sell positions in an index (i.e. NIFTY) or a stock (i.e. Reliance) contract. If, during the period of the contract life, the price moves in traders favor (rises in case you have a buy position or falls in case you have a sell position), trader makes profit. In case the price movement is opposite to the traders position, trader incurs losses.
Few fundamental things about F&O trading
The F&O segment is responsbile for most trading across stock exchanges in India. They are the most popular trading instruments worldwide.
To take the buy/sell position on index/stock futures, a trader has to place certain % of order value as margin. Which mean if a trader buy future contract worth of Rs 4 Lakhs, he pays just around 10% cash to broker (known as margin money) which is Rs 40,000. This gives the opportunity to trade more with little cash.
Profit or losses are calculated every day until the trader sells the contract or it expires.
Margin money is calculated every day. It means if the trader doesn’t have enough cash (margin money) in his account (on any day when trader is holding the position), he has to deposit the margin money to broker or broker can sell his F&O contract and recover the money.
Unlike stocks; derivative has an expiry. Which means if trader do not sell until a pre-decided expiry date, the contract is expired and profit or loss is shared with you by the broker.
Future Trading can be done on the indices (Nifty, Sensex etc). NIFTY Futures are among the most traded futures contracts in India.
Why to trade in F&O?
With futures trading, trader can leverage on trading limit by taking buy/sell positions much more than what you could have taken in cash segment. However, the risk profile of your transactions goes up. Settlements are done on daily basis (MTM) until the contract expires.
Profits/losses are calculated (and credited/debited in traders account) on end of the day every day. Demat account is not needed for F&O trading. All futures transactions are cash settled. Contract positions are hold by the exchanges until they expire.
The F&O positions are carrying forward to next day and can be continued till the expiry of the respective contract and squared off any time during the contract life. This is different from ‘Margin Trading’ where trader has to close the position the same day.
What are different types of Equity Futures & Options available in India?
In the Futures and Options segment at NSE and BSE; trading is available in mainly two types of contracts:
Index Futures & Options
At NSE; Index F&O are available for 6 indices. This includes; CNX Nifty Index, CNX IT index, Bank Nifty Index and Nifty Midcap 50 index.
- CNX Nifty Index (based on the Nifty index.)
- BANK Nifty Index (based on the BANK NIFTY index)
- CNXIT Index (based on the CNX IT index)
- Nifty Midcap 50 Index ( based on the Nifty Midcap 50 index)
- CNX Infrastructure Index (based on the CNX Infrastructure index)
- CNX PSE Index (based on the CNX PSE index)
Similar way BSE offers trading in future for underlying assets as following indexes:
Futures & Options on Individual Securities
Stock exchanges offer F&O contracts for individual scripts (i.e. Reliance, Infosys etc.); which are traded in the Capital Market segment of the Exchange.
NSE offers F&O trading in 135 securities stipulated by the SEBI. The stock exchange defines the characteristics of the futures contract such as the underlying security, market lot, and the maturity date of the contract.
Why all stocks are not available for F&O trading?
F&O contracts of individual companies are not available for all the companies listed in stock exchanges. Only those stocks, which meet the criteria on liquidity and volume, have been considered for futures trading. Or companies whose shares have high liquidity and volume of trades at stock exchanges are eligible for F&O trading.
Stock exchange decides which company’s F&O contracts can be traded at the exchange.
What does ‘Square off’ means in future trading?
‘Square off’ means selling a future position. For example; if you buy 1 lot of NIFTY future on 20th Aug 2020 and decide to sell it on 24th Aug 2020, you square off your future position.
Can I sell F&O Contract before expiry date?
Yes, you can sell the contract (or square off the open position) anytime before the expiry date. If you do not sell the contract by expiry date; the contract get expired and profit / loss is shared with you.
What does Cover Order’ mean?
The order placed to sell square off an open future position is called cover order.
What are different types are settlements for Futures?
Future contracts are settled in two ways:
Daily Mark to Market (MTM) Settlement
The profits/losses are calculated on daily basis at the end of the day. MTM is applied until the open position is closed (square off or sell). The next question and an example in the later part of this article will explain you MTM process in detail.
On the expiry of the futures contracts; the exchange marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash.
What is Mark to Market in Future Trading (MTM)?
MTM is the most important process in F&O trading and very little difficult to understand for conventional stock market investors who buy and sell shares for long term.
At the end of every trading day; the open future contracts are automatically ‘marked to market’ to the daily settlement price. This means; the profits or losses are calculated based on the difference between the previous day and the current day’s settlement price.
In other words; MTM means every day the settlement of open futures position takes place at the closing price of the day. The base price of today is compared with the closing price of the previous day and difference is cash settled.
i.e. For 1 lot of NIFTY Futures (50 shares) if
Previous Day Last Price (Brought Forward Price) = Rs 7600
Today Last Price (Carry Forward Price) = Rs 7700.00
Net Profit = (7700-7600)*50 = Rs 5000
After the profit/loss calculated; the future position is Carry Forward to next day.
The same process of MTM repeats and profit/losses are calculated again every day until the position is squared off or it expires.
Every day works like a fresh position until contract is sold or expires.
Through the profit/loss are credited/debited on daily basis in traders account; the brokerages / fees / taxes are only charged at the time of buying and selling future contract.
MTM is an important concept and very important to understand for future stock traders.
End of Day EOD MTM is mandatory for future contracts.
Why different contracts are available for same index or stock? Explain the F&O Trading Cycle? What is F&O Contract life?
Equity futures & options are traded in 3 ‘trading cycles’. The 3 month trading cycle includes the near month (one), the next month (two) and the far month (three).
i.e. If current month is Aug 2020; the contracts available for NIFTY Futures are as below:
Buy Order Entry – NSE Future (NIFTY)
The contract life of the F&O contract is until the last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day.
New contracts are introduced on the trading day following the expiry of the near month contracts. The new contracts are introduced for three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market (for each security) i.e., one near month, one mid month and one far month duration respectively.
What is ‘Expiry day’ for F&O contract?
Futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
What is ‘Margin’ amount in future trading?
To start trading in futures contract, you are needed to place a certain percentage of the total contract as margin money.
Margin is also known as a minimum down-payment or collateral for trading in future. The margin amount usually varies between 5 to 15% and usually decided by the exchange.
Note: This feature (only paying small margin money) makes F&O trading most attractive because of high leverage. You can make a larger profit (or loss) with a comparatively very small amount of capital using F&O trading.
Margin % differs from stock to stock based on the risk involved in the stock, which depends upon the liquidity and volatility of the respective share besides the general market conditions.
Normally index futures have less margin than the stock futures due to comparatively less volatile.
The margin amount usually recalculated daily and may change during the life of the contract. It depends on the volatility in the market, script price and volume of trade. It is possible that when bought the future position; the margin was 10%; but later on due to the increased volatility in the prices, the margin percentage is increased to 15%.
In that scenario, the trader will have to allocate additional funds to continue with open position. Otherwise, broker can sell (square off) the future contract because of insufficient margin. Thus It is advisable to keep higher allocation to safeguard the open position from such events.
How is futures trading different from margin trading?
While buy/sell transactions in margin segment have to be squared off on the same day, buy/sell position in the futures segment can be continued till the expiry of the respective contract and squared off any time during the contract life.
Margin positions can even be converted to delivery if you have the requisite trading limits in case of buy positions and required number of shares in your demat in case of sell position. There is no such facility available in case of futures position, since all futures transactions are cash settled as per the current regulations. If you wish to convert your future positions into delivery position, you will have to first square off your transaction in future market and then take cash position in cash market.
Another important difference is the availability of even index contracts in futures trading. You can even buy/sell indices like NIFTY in case of futures in NSE, whereas in case of margin, you can take positions only in stocks.
Trade in Equity Futures in 3 Easy Steps:
Below example demonstrate how to buy and sell one lot of NIFTY Future.
Step 1: Buy Equity Future
Assuming that you have an account with a share broker in India to trade in F&O segment; the first step is to buy (or sell in case of short-selling futures) a future contract. You can visit NSE or BSE websites to check the available future contracts for indexes as well as securities.
In this example; we will buy 1 lot of NIFTY ( 50 shares). Note that you can buy/sell the F&O contracts only in lots. The lot size is different from contract to contract.
Placing a buy order is pretty simple and similar to buying shares for delivery.
Suppose that we are placing an order to by 1 lot (50 shares) of NIFTY Futures at the price of Rs 7500.
Buy Order Entry – NSE Future (NIFTY)
In above ‘buy order entry’ form some of the important fields are:
Exchange segment = NFO (NSE F&O segment)
Inst Name (Instrument Name) = FUTIDX (Future Index)
Symbol = NIFTY
Expiry = 25Sep2020