The trade of derivatives has gained popularity with the current breed of investors. Future and Options (F&O) help investors express their views on market trends without necessarily having to own the market. However, these instruments are not advisable for everyone. It is imperative to understand the nature and workings of stock options futures, and their benefits and risks, before incorporating them into the portfolio or investment. Let’s understand the extent to which investing in F&O helps in bringing added value or results in assuming useless risk.
Understanding futures and options
Futures are standardised contracts where the buyer and seller are bound by an implicit agreement to trade an underlying asset for a certain price and date in the future. Options, on the other hand, are contracts where the holder has the right, though not the obligation, to buy or sell an underlying asset for a certain price before the date of expiration. Combined in the form of stock options futures, they form an array of trading strategies, some conservative and others highly speculative. They are highly dependent on stocks, indices, and commodities.
Risks and Limitations
Notwithstanding the attractions, there are several risks involved in F&O trading. Leveraging multiplies both the profits and the losses, which, at times, can be much more than the original amount. Market volatilities, option decay, and flash crashes can easily result in the depletion of the portfolio. It has been observed that the majority of individual investors do not assess the risks involved in trading F&O and overtrade, resulting in steady losses. Derivatives, like F&O, require continuous observation, technical analysis, and psychological control. Unchecked, trading stock options futures can be disastrous for an otherwise well-diversified portfolio.
Who Should Consider F&O Investments?
F&O investments will prove most beneficial to investors who already have a fair knowledge of financial markets, as well as an aptitude for taking a relatively high risk. Usually, it is the expert traders, as well as the portfolio managers, who will benefit the most from F&O, as they will have a fair idea of the price movements, as well as the pros of using leverage. They will employ futures, as well as options, not as a form of speculation, but rather as a method to optimize market exposure.
Informed traders also use F&O instruments for making extra earnings using structured strategies such as covered calls, cash-secured puts, and spreads. The strategy here is not only about earning premiums but also controlling risk. The use of derivatives in these investments does not lie in making extra profits. It revolves around risk optimisation.
Before participating in F&O trading, it is imperative that investors educate themselves adequately and learn about contract specifications through back testing or demo trading. This will help prevent losses by ensuring that investments in the Future & Options market improve portfolio performance rather than negatively impacting it.
Conclusion
F&O investments may prove to be quite useful for an investment portfolio. However, this is only possible when used carefully and with a particular intention in mind. F&Os are extremely powerful investment tools used in finance with various objectives such as flexibility, hedging, and enhancement of return on investment. However, they are used only with expertise and in a disciplined fashion and manner. F&Os are quite helpful and useful investment tools for knowledgeable investors seeking to complement their equity investments with stock options futures, and increase their overall risk-adjusted return or may be associated with increased risks and may prove to be counterproductive for some people.
