How to start F&O trading?

How to start F&O trading Is the challenge most people face when they enter the 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.

What is Derivative (Futures and Options) Trading?

Like share trading in the cash segment (buy & sell shares), the 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 trading in Indian stock markets. In futures trading, the 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), the trader makes a profit. In case the price movement is adverse, the trader incurs losses. Few fundamental things you should know about F&O trading:

The F&O segment accounts 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 a certain % of order value as a margin. This means if a trader buys a future contract worth Rs 4 Lakhs, he pays just around 10% cash to the 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. This means if the trader doesn’t have enough cash (margin money) in his account (on any day when a trader is holding the position), he has to deposit the margin money to the broker, or the broker can sell his F&O contract and recover the money.

Unlike stocks; a derivative has an expiry. This means if the trader does not sell until the 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 should I 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) at end of the day every day.

Demat account is not or 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 & OptionsAt 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:

SENSEX

BSE100

BSETECK

BANKEX

Futures & Options on Individual SecuritiesStock 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.

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 actually square off your future position.

Can I sell (or square off) the F&O contract before the 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 the expiry date; the contract get expired and profit/loss is shared with you.

What does Cover Order’ mean?

The order place 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) SettlementThe 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.

Final SettlementOn 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 (MTM) in Future Trading?

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 the 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 the difference is cash-settled. i.e. For 1 lot of NIFTY Futures (50 shares) if

Previous Day Last Price (Brought Forward Price) = Rs 7629.55

Today Last Price (Carry Forward Price) = Rs 7678.00Net Profit = (7678.00-7629.55)*50 = Rs 2422.50Note:

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 is 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 a very important concept and very important to understand for future stock traders.

End of Day EOD MTM is mandatory for future contracts.

The sample F&O Day Bills for couple of days to understand this concept.

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 2020 is the expiry of this month’s contract. The contract life of this future contract is from today to the 28th. New contracts are introduced on the trading day following the expiry of the near-month contracts. The new contracts are introduced for a 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 the ‘Margin’ amount in future trading?

To start trading in the 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 the future. The margin amount usually varies between 5 to 15% and is 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 stock futures due to comparatively less volatility.

The margin amount is 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 the open position. Otherwise, the 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 the margin segment have to be squared off on the same day, the 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 the required number of shares in your Demat in case of sell position. There is no such facility available in case of a futures position since all futures transactions are cash-settled as per the current regulations.

If you wish to convert your future positions into delivery positions, you will have to first square off your transaction in the future market and then take a cash position in the cash market. Another important difference is the availability of even index contracts in futures trading. You can even buy/sell indices like NIFTY in the case of futures in NSE, whereas in the case of margin, you can take positions only in stocks

3 Easy Steps of Trade in Equity Futures

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.

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:

• Exchange segment = NFO (NSE F&O segment)
• Inst Name (Instrument Name) = FUTIDX (Future Index)
• Symbol = NIFTY
• Expiry = 25Sep2020

Step 2: Hold Equity Future

You hold the equity future contract until you sell it or it expires on a predefined expiry day (in our case it’s 25th Sept 2020). 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 sends 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:

Day 1:

• Buy Price (NIFTY): 7643.90
• Close Price (NIFTY): 7629.55

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.

• Brokerage: The Rs 20 (as I placed this order through UPSTOX, The flat fee discount broker) is debited by the broker as a brokerage charge. Brokerage is charged on the day when we buy the F&O contract and the day when we sell it.
• Regular Trade: This is used for buy & sell transactions. It shows which F&O script you bought, its expiry date, quantity, Rate at which you bought it, and the total amount (Rs 3,82,195).
  Note: Though the total debit amount is Rs 3.82 Lakhs; it doesn’t mean you have to pay this much amount. It’s just for accounting. You pay only the margin amount to the broker for this trade, which is around 10% of the total amount (i.e. Rs 38,219).
• Carry Forward: As we decided to hold the position for the next few days; our F&O contract will be carried forward. The ‘Carry Forward’ value of the contract is decided by the exchange at the end of the trading day. In our case, it’s Rs 7629.55 (NIFTY actually falls on day 1). Based on this rate; the total credit to our account is Rs 381477.50.
• Net (Profit / Loss): Day 1 accounting shows the loss of Rs 717.50. Various taxes and charges (applicable on buy transaction) are added to our losses and the net due to us is now Rs 787.97. This is the amount broker will take from our account by end of the day.

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.

Step 3: Sell Equity Future

On day 7 I decided to sell the contract for Rs 7800.00. Here is my transaction:

Day 7

• Brought Forward Price (NIFTY): Rs 7779.55
• Sell Price (NIFTY): Rs 7800.00

Below is the Future & Options Day Bill from day 7, the day when we sold the contract. Let’s check it:

• Brokerage: Rs 20 is charged by the broker as a brokerage charge. This is similar to how we paid brokerage on day 1 when we buy the F&O Contract.
• Regular Trade: The sell transaction is captured here.
• Net (Profit / Loss): Day 7 accounting shows the profit of Rs 1022.50. After deducting taxes and brokerage; we made a net profit of Rs 947.15. This is the amount broker will pay us on Day 7.