Futures and options (F&O) trading has been in the news ever since SEBI’s (Securities and Exchange Board of India) report highlighted the losses that it may result in. As per the study conducted by SEBI in 2022, 9 out of 10 equity F&O traders incurred a loss of Rs 1.1 lakh on an average.
The complexity and risks involved in F&O trading are often underestimated. So, why does this trading format result in losses for many? What should you do to protect your investments? You will find answers to these and also learn about some important tips to keep in mind while F&O trading.
Futures and options are derivative contracts, which means their value is derived from an underlying asset, such as stocks, commodities, or currencies. These can be traded on stock exchanges. A future is a contract where you agree to buy or sell an asset at a predetermined price on a specific future date. An option gives you the right, but not the obligation, to buy or sell an asset at a set price before or at the expiration date.
F&O involves complex contracts and high leverage. Leverage means you can control a large position with a relatively small amount of money. This can amplify your profits, but it also significantly increases your risk of losses. In traditional stock investing, you simply buy and hold shares. Let’s take a look at this table to further understand the top differences between F&O and traditional stock investing:
|
Aspect |
Traditional Stock Investing |
Futures Trading |
Options Trading |
|
Ownership |
When you invest in a stock, you own a share of the company, making you a part-owner. |
Futures trading doesn't give you ownership of the underlying asset; you only have a contract to buy or sell it in the future. |
Here, too, you don't own the underlying asset; you only have the right to buy or sell it. |
|
Profit Mechanism |
You profit from the rise in stock value and receive dividends if the company pays them. |
You profit from the price movements of the underlying asset. If the price moves in your favour, you make money. |
You profit from the price movements of the underlying asset. If the price moves in your favour, you make money. |
|
Risk Level |
In case the share price moves against your favour, you only lose the money you invested in the shares. |
There’s a higher risk due to leverage, which means small price changes can lead to larger losses. |
This, too, carries high risk, but your maximum loss is limited to the premium paid for the option. |
|
Investment Requirement |
You need to pay the full price of the stock to own it. |
You need to pay a margin, which is a fraction of the total value of the asset, to control a large position. |
You need to pay a premium, which is usually lower than the full value of the asset, to buy the option. |
|
Time Horizon |
You can hold the stock indefinitely, as long as you want or as per your investment goal. |
There is a fixed expiration date by which you must buy or sell the asset. |
There is an expiration date by which you must decide to exercise the option or let it expire. |
|
Realisation of Profits/Losses |
Profits or losses are realised when you sell the stock. |
Positions are marked to market daily, meaning gains and losses are calculated and credited or debited to your account daily. Final profits or losses are realised at expiration or when you close the position. |
Profits or losses are realised when you exercise the option, when you let it expire worthless, or when you sell the option contract before expiration. |
|
Settlement |
The transaction is settled by the transfer of shares and cash between the buyer and seller. |
Settled in cash or by physical delivery of the underlying asset at contract expiration. |
Settled in cash or by buying/selling the underlying asset if you exercise the option. |
Now, coming to the question of why so many investors lose money in futures and options trading. Here are some common reasons:
1. Lack of Knowledge:
Many investors jump into futures and options trading without fully understanding how these markets work. This lack of knowledge can lead you to make poor decisions and experience significant losses.
2. High Leverage:
Futures and options trading often involve high leverage, meaning you can control a large position with a relatively small amount of money. While this can amplify profits, it also magnifies losses. A small adverse price movement can wipe out your entire investment.
3. Market Volatility:
Futures and options markets are highly volatile. Prices can change rapidly, and if you happen to be on the wrong side of the trade, you may lose significant capital very quickly.
4. Emotional Trading:
Fear and greed can drive you to make irrational decisions. Panic selling or overtrading in hopes of recovering losses can lead to even larger financial setbacks.
5. Complex Strategies:
Some investors use complex trading strategies without fully understanding them. There are multiple strategies to use while trading futures and options. Each of these has unique features and benefits. However, you must thoroughly know how to use them before applying them on your trading activities.
6. Overpaying for Options (High Premiums):
Options premiums can be influenced by factors such as volatility, time to expiration, and the difference between the current asset price and the strike price. If you pay a high premium for an option, you will need a larger price movement in the underlying asset to offset the premium cost and achieve profitability. This can be challenging and lead to losses if the expected price movement does not occur.
Successful futures and options trading requires a well-thought-out strategy. Without a clear plan, you are more likely to make impulsive decisions that lead to losses.
Also Read: How to Choose The Best F&O Stocks?
SEBI's study on Futures & Options (F&O) trading reveals some serious truths you should know. The analysis, covering FY19 to FY22, highlights some stark realities. The participation of individual traders surged by 500%, increasing from 7.1 lakhs in FY19 to 45.2 lakhs in FY22. SEBI has highlighted that despite this growth, F&O trading is predominantly loss-making. In FY22, 89% of traders incurred losses, with active traders faring slightly worse at 90%.
Only 11% of traders made a profit, averaging Rs. 1.5 lakh. Profitability further diminishes when you consider transaction costs, which consumed 28% of the losses for active traders. These costs, including brokerage and other fees, significantly impact your net gains. Even among profit-makers, transaction costs ranged from 15% to 50% of their profits.
Despite the enthusiasm of more people looking to enter the F&O trading space, the skewed nature of profits indicates that only a small fraction of traders capture substantial profits. This highlights the high-risk nature of F&O trading.
SEBI has recently announced tightening of rules for individual stock to be included in the derivatives segment. This announcement comes amid an exponential rise in trading volumes and concerns about heightened speculation. While entering the F&O trading space, you must keep all these aspects in mind and tread with utmost caution to avoid financial losses.
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