Posted on Tuesday, December 30, 2014
Modified on Saturday, October 1, 2016
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'How to start F&O trading?' is the challenge most people faces when they enters in to stock market. In this article I will share the information about how to trade Equity Futures and Options in few easy steps.
Let's begin with few fundamental questions asked about F&O trading. Later I will talk about easy steps to trade in F&O.
Like 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 course 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 adverse, trader incurs losses.
Few fundamental things you should know about F&O trading:
In the Futures and Options segment at NSE and BSE; trading is available in mainly two types of contracts:
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.
Similar way BSE offers trading in future for underlying assets as following indexes:
Stock exchanges offer F&O contracts for individual scripts (i.e. Reliance, TCS 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.
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.
'Square off' means selling a future position.
For example; if you buy 1 lot of NIFTY future on 20th Aug 2014 and decide to sell it on 24th Aug 2014; you actually square off your future position.
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.
The order place to sell square off an open future position is called cover order.
Future contracts are settled in two ways:
The profits/losses are calculated on daily basis at the end of the day. MTM goes 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.
Note: 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 previous day and difference is cash settled.
i.e. For 1 lot of NIFTY Futures (50 shares) if
Net Profit = (7678.00-7629.55)*50 = Rs 2422.50
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 2014; the contracts available for NIFTY Futures are as below:
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.
For example; in the above table; 28th Aug 2014 is the expiry of this month's contract. The contract life of this future contract is from today to 28th Aug 2014.
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.
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.
To start trading in futures contract, you are required 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 in nature.
[Important Note] 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, 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.
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.
Below example demonstrate how to buy and sell one lot of NIFTY 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.
Below screenshot shows that we are placing an order to by 1 lot (50 shares) of NIFTY Futures at the price of Rs 7643.90.
In above 'buy order entry' form some of the important fields are:
You hold the equity future contract until you sell it or it expires on predefined expiry day (in our case its 25th Sept 2014). In this example we will hold the F&O contract for 7 days and then sell it.
For each day we hold the contract, the broker send a 'Future & Options Day Bill' along with few other statements including margin statement, client ledger detail, contract note etc.
The F&O day bill provides the accounting information of the contract on daily basis. Let's go through the F&O day bills for each day and discuss the accounting:
Below is the Future & Options Day Bill for end of day 1, the day when we bought the contract. Let's check few useful fields in this.
Contract Note - Buy NIFTY F&O
For buy and sell transactions of F&O contract, broker send a contract note. Below is the contract note received from broker on Day 1. The next contract note will be send to you on the day you sell the contract.
Brokers also share the ledger detail with the client with a 'client account ledger detail' document. This document provides you detail about all the financial transaction done by broker on day 1.
On day 1 I decided to carry forward the F&O position. But on day 2 the market is closed as its Saturday. Note that the position is now name as 'Brought Forward'.
Note: The above day bill doesn't have any 'Carry Forward' position as the market was closed.
This is the first trading day (Monday) for NIFTY future and it went up around 50 points. Now let's check the accounting for Day 4:
The net profit of Rs 2422 is credited to the account.
Similar to previous day, we decided to carry forward the future contract. The price went up by Rs 103.7 and we made decent profit of Rs 5185.00.
Once again we decided to carry forward the contract. The price remain flat and actually went down by Rs 2.15, loss of Rs 107.50.
On day 7 I decided to sell the contract for Rs 7800.00. Here is my transaction:
Below is the Future & Options Day Bill from day 7, the day when we sold the contract. Let's check it:
|Net Profit / Loss (in Rs)|
|Total Profit / Loss||+7659.18|
|Day 1 (Buy)||Rs 20|
|Day 7 (Sell)||Rs 20|
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