F&O Trading – A Temptation to Leverage on Trading Limits
Normally to buy shares, you need to have sufficient limit to provide for 100% of the order value, while to sell shares, you need to have shares in your demat account. However, in F&O Trading, funds are blocked only to the extent of some % of the order value allowing you to leverage on your trading limits. Investors generally use F&O to increase their purchasing power so that they can own more stock without fully paying for it. But F&O exposes you to the potential for higher losses. Here's what you need to know about F&O.
How Does Leveraging Works
Let's say you buy a stock for Rs. 60 and the price of the stock rises to Rs. 75. If you bought the stock in ‘Cash" Segment and paid for it in full, you'll earn a 25 percent return on your investment. But if you bought the stock on futures (say 33.33%) paying only Rs. 20 in cash – you'll earn a 75 percent return on the money you invested.
The downside of using F&O is that if the stock price moves unfavorably, losses can mount quickly. For example, let's say the stock you bought for Rs. 60 falls to Rs. 39. If you fully paid for the stock, you'll lose 35 percent of your money. But if you bought on futures, you'll lose more than 100 percent.
Beware of Additional Margin requirements – You Can Lose Your Money Fast
Your positions are continuously monitored and additional margin call is made as per the defined rules.
If the limit is not sufficient to meet the call for additional margins, the broker may close out your position.
Always remember that the broker may not be required to make a margin call or otherwise tell you that your margin has fallen below the required level. The broker has the legitimate right to close out the open position at any time (without consulting you) in case you do not satisfy the additional margin requirements. Therefore, once you buy/sell stock on F&O, do not exhaust your trading limit in full. Maintain sufficient free limit to provide for additional margin as and when required.
Recognize the Risks Beforehand
F&O Trading carries risk and therefore may not suit every investor. Before trading on F&O, you should ensure that:
- You have understood the trading and settlement
mechanism of the exchange and your compulsion to follow the F&O Trading
- You can lose more money than you have invested
- You have to keep sufficient trading limits as cushion
to fund additional margin as and when called for.
- You would not be tempted to over leverage your positions.
Last but not the least
You can protect yourself by knowing how F&O Trading works. Judge for yourself whether it is prudent for you to trade on F&O in light of your financial resources, investment objectives, and tolerance for risk.