F&O: The Financial Instruments Of Mass Destruction

Jul 27, 2017 | 06:21 PM IST

F&O: The Financial Instruments Of Mass Destruction

Is the stock investment risky? The answer is yes, but there are means to minimise risk and maximise profit. The biggest attraction of stock market is that it gives better returns than any other investment instrument, however, at the expense of higher risk. Those who enter the market are well aware that if they don't play their cards right they stand to lose a lot of money. In the same line, if you think equity investment is risky, then future and options trading is 10 times riskier than equity. Future & options (F&O) is a contract-bound trading type where the trade is carried out on the underlying asset, which is either a stock or an index (Nifty).

Warren Buffett calls F&O trading the financial instruments of mass destruction. Buffett summons harshest words for this instruments simply because F&O has the potential to cause massive financial losses to the traders. And over the years, more traders have lost money than earned money from F&O.

However, as it is one of the most popular tradings instruments, it is a subject worth exploring. Let's try to understand what one stands to gain and LOSE from the Futures & Options trading.

What Is Futures & Options?

Both Futures and Options are two different types of trading instruments.

Future Contract

A future contract simply means two parties agree to enter a contract to buy or sell something at a predetermined price at a future date. The future contract is on the underlying asset. It derives its value from the underlying assets hence it is also called derivatives. So if the price of the underlying asset goes up the buyer gets profit and when the price goes down the buyer loses money. Also, the contract has a certain time frame. In Indian stock market, the duration of a future contract is one month, it expires on the last Thursday of the month.

Short Selling Of The Future Contract

When you are buying a future contract, you are basically expecting the market to go up. The contract where you are expecting the market (the price of the underlying asset) to go up, this type of future trading is called going long. However, there is also the other dimension to the future contract which is called short selling. Contrary to going long, if you think the value of the underlying asset will fall in the future, you can sell the forward contract. Now you would be wondering - if you don't own anything how are you going to sell it? In futures, you can do it.

Option Contract

In options, you have two types - Call and Put. In the call option, the trader is expecting the price of the underlying asset to go up while in the put option the trader expects it to go down. An option contract is basically price probabilities of any future event. Let's take a general example of how it works. Suppose you buy call option of ABC company at the strike price of Rs. 250 with the expiry of 3 months. Now as the price of the stock moves towards the strike price you start to gain profit. However, the timeframe is a crucial factor here. If you buy a 1-month contract it will be cheaper as the chances of ABC reaching 250 are greater in 3 months than in 1 month.

What Makes F&O So Risky?

As mentioned above, the stock market is extremely risky, to begin with. This quantum of risk gets multiplied in the F&O trading. Amongst various reasons that make it very risky, one is that it is a contractual trading. All the F&O scrips have a certain time-frame. For example, if you enter a contract on 1st June for the June scrip, your contract will expire on the last Thursday of the June. Unlike equity, where you can hold the position till the desired target is reached, in F&O you have the obligation to square off your position on the stipulated time.

Why Should Retail Investors Stay Away From F&O?

Risk Factor - First and foremost reason for avoiding F&O is that it carries extreme risk. And like equity, it is not a reasonable risk. In F&O, there are many factors which sometimes defy logic. For example, in an option contract, suppose you have entered a call option on Nifty with a strike price of 9800. Now the index, after moving in your favour starts to consolidate. If you hold such position long, even if the index is at the same level, the value of your contract starts to decrease with time. This concept is called 'Decay of time'.

Lack Of Experience - F&O is essentially an instrument for traders. To gain from it, one has to have its full working knowledge. As traders deal with it on the everyday basis, they develop skills to infer from the behaviour of the market. However, if a new investor tries his/her hand at F&O, without any assistance from experienced traders, he/she is bound to lose a lot of money. Unlike equity where you have indefinite time, in F&O your trade gets limited and time and if you don't make up for your losses in the stipulated time you incur more losses.

F&O Is Not Investment - Yes, it's not an investment, it's trading. And like margin trading and intraday trading, very few people make money in F&O. Many investors start F&O with the noble idea that they will increase their capital via F&O and then invest it in equity. It doesn't work that way. Either they lose the money outright or when they earn money they go for more trades and eventually lose it all. F&O trading tests your mental and emotional balance with enticing prospects and most of the investors/traders fall for it.

 

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Niveza Editorial Desk : We are a team of stock market nerds trying to stay ahead of the herd. We spend our grey cells everyday to pave a smooth road for our clients in the shaky world of stock market. While...
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