Futures and Options are a major type of stock derivative. Trading in derivatives also allow you to hedge or speculate to protect yourself against the unexpected movements in the market. This can be done with the help of the hundreds of possible Option strategies available to a trader. Consequently, the traders are also have an advantage to use various metrics to measure the theoretical exposure of an option or option strategy to the various risks. Futures and options have a wide range of advantages and drawbacks.
The basic myth of options trading is to build complex and unusual strategies. The mantra should be to keep it as simple as possible. Traders tend to create complex strategies with multiple layers of calls and puts on the long and short side. Any Investor learns from his failures, mistakes and only by constant analysis and somewhat by following expert traders. People venture into F&O trading without getting the information necessary to understand how trades in this market segment differ from trades in the spot market. But, undoubtedly there are some key points that each investor should keep in his mind before futures and Options trading to ensure successful profit making trades.
Let’s discuss the major 5 things you must keep in mind if you are trading in F&O.
1. Losses are not limited to the margin money
You can look at trading in F&O as an alternate option for cash market trading. Futures offers a biggest advantage of trading by paying a nominal amount to book your trade, called as margin, and in the case of options, by paying a premium. In spot market trades, the risk is generally limited to the amount of capital you put in. However, in futures trading and options trading, you pay margins that are much less than the actual capital you’re risking. This makes it easier to lose sight of the true magnitude of your potential loss. Before entering into F&O trading, it helps if you keep this in mind.
2. Do not overlook liquidity
Beginners or budding investors who are new to F & O often do not realize the importance of liquidity. So, it is very important that you do not forget to measure the liquidity of the trade you are entering into as it’s necessary to ensure that the derivatives you’re trading in are liquid enough to support an exit.
3. Using future for hedging
Trading in futures is quite similar like margin trading, but there is a difference in the risk involved. F&O trading comes with its own set of risks as it’s not any news. This is why it’s always advisable for beginners to execute a future trading strategy or an options trading strategy in combination with a regular trade, so the F&O trade can be a hedge for your regular trade. This way, you can minimize the risk while simultaneously getting a better idea of how the derivative market works. Another benefit to hedge your risk is since, positions in futures can be carry forwarded until the expiry date and this makes futures vulnerable to overnight risks and the risk of mark-to-market (MTM) margins which you pay in futures. That is why, it is always preferable to use futures for hedging your risk.
4. Adding Stop losses and profits targets
Just like we discussed in the first point, Futures are leveraged products, you need to set a point where your losses stop and also a point to target your profits while trading. Maintaining strict stop loss points and profit target points helps you monitor and execute a trade efficiently. This way you can keep a leash over your profit and losses. The moment the stop loss point is reached and if the profit target is hit, you can immediately exit the position.
While trading in options if you bought a Reliance Industries 300 call at Rs50, then your maximum loss is limited to Rs50. But if you are nearing the end of the expiry and you are getting Rs30, then it is more likely recommended to book the loss of Rs20 and exit. Why would any investor let go off Rs50 when they don’t see any chance of making a profit.
5. Don’t hold long options too close to expiry
This is a common reason why options traders lose money. Any option has two components viz. time value and intrinsic value. When the call or put option is out-of-the-money, then it is very likely that it will expire worthless. If you hold these options too close to expiry then you will see the time value erode rapidly in the last few days. Time always works against the buyer of the option, so exit when you sense the opportunity.