Trading in futures and options (F&O) can be approached in two ways.
Firstly, you can look at trading in F&O as a proxy for cash market trading. In the case of futures, you can trade by paying a margin, and in the case of options, by paying a premium. Trading in futures can also be approached as a defensive hedge. But futures and options are nothing like the “Weapons of Mass Destruction” as described by Warren Buffet.
Here are 7 things you must keep in mind if you are trading in F&O.
Ideally, use future as a hedge, and not as a proxy for your cash market trading
Trading in futures is in many ways like margin trading, but there is a difference in the risk involved. In the case of trading on margin in cash, you only trade intraday. On the other hand, futures can be carried forward until the expiry date (which is the last Thursday of the month). That makes futures positions vulnerable to overnight risks. Also, there is 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 rather than using it as a proxy for cash markets.
Putting stop losses and profits targets is a must in F&O
Futures are leveraged products and you need to keep strict stop losses and profit targets while trading. When a stop loss is triggered or if the profit target is hit, immediately exit the position. Stop losses are non-negotiable in case the of long futures, short futures, and short options. But what should you do when you buy options? If you bought an SBI 300 call at Rs5, then your maximum loss is limited to Rs5. But if you are nearing the end of the expiry and you are getting Rs3, then as well book the loss of Rs2 and exit. Why let go of Rs5 when you don’t see any chance of making a profit.
Always check for liquidity before entering F&O positions
A lot of the volumes in futures and options trading are algorithmic in nature, and they can vanish just as fast as they come. You may not face a problem of liquidity in frontline stocks or in Nifty futures and options. But in many mid-cap stocks, the F&O volumes can be notoriously slippery. In fact, when markets sell off at a rapid pace, you can see the volumes and liquidity evaporating in front of your own eyes.
A low priced options is not necessarily an attractive option
This is a classic myth. Buying deep out-of-the-money (OTM) options (calls or put) just because it is very affordable is a bad idea. Such options are cheap because that is what they are worth. They only have the time value and markets assign them a low price because the probability of scaling the price is quite low. If you keep losing your options money, it can add up to quite a bit.
If possible, 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.
Elegant and multi-layered options strategies entail a huge cost
One of the basic conditions of options trading is 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. The danger is two-fold. Firstly, you are not too sure whether you are net long or net short. Then there is the cost aspect. Each leg of the options trade has to be closed and you have transaction costs and statutory costs for each leg. This makes a big difference to the overall economics of your options trade.
Finally, keep an options scrapbook and constantly revisit your strategy
We all trade with the assumption that we are on the right track. But quite often, our options strategy may be out of sync with reality. You are bound to go wrong in your calls, but if you consistently trigger stop losses, then you need to get back to the drawing board and revisit your strategy. This is the final and key measure to long-term trading success in futures and options.