Why should one not trade in futures and options?

Appetite for leverage is the primary consideration for whether to trade in futures and options.

Aug 18, 2018 03:08 IST India Infoline News Service

At first glance, trading in futures and options appears to be an exciting and lucrative affair. You hear that your friend bought two lots of a ‘call’ option at a premium of Rs4 and sold it for Rs25, pocketing Rs84,000 in less than two days. Unfortunately, even as you celebrate your Reliance long trade, which yielded quite a handsome profit, you realize that your old friend made thrice that with the same outlay through futures trading. However, always remember, if something sounds too good to be true, that is because it usually isn’t. Not that your friend is lying, but because you are seeing just one side of this form of trading.

Therefore, the question that arises now is whether you should trade in futures and options at all, or just stick to good old intraday trading in shares. Without getting into the two extremes of decision-making, it would be more productive to focus on why one should not go overboard with trading in futures and options.

Why one should not trade in futures and options

1. When you do not have the appetite for leverage

Whether you trade in futures or in options, the story essentially deals with leverage. In futures, you pay a proportionate margin, and in options, you pay a premium for getting the right without the obligation. One can argue that in options you only lose the premium paid, but then if you consistently take large positions in options and frequently lose your premium, options too can be equally destructive. The first question to ask is whether you have the appetite and the capacity to take on that kind of leverage. Remember, appetite and capacities are two different things altogether. A retired person may have an appetite for risk but may not have the capacity for such risks. Appetite for leverage is the primary consideration for whether to trade in futures and options.

2. Do you panic in the face of volatility?

This will surely work against you in case of futures and options. Whether you are long or short in futures or in options, if you panic, you are bound to lose money in trading. This is because the total volume of profits in any trade is finite. When you panic, you subsidize the other trader who does not panic and profits flow to the other trade, which means losses will flow to you. The risk of panic becomes more pronounced in futures and options since you are taking a leveraged position and your panic has an exponentially negative impact on your trading performance.

3. When you are an option buyer, theta works against you

Theta is a risk when you have purchased options (calls or puts). When you buy an option, you pay for the price and you also pay for the time. The only problem is that the time keeps reducing as the monthly expiry approaches, and therefore, the time value becomes zero around the expiry date. This works against you. Say, you bought near-month Reliance 1,100 Call option at Rs35 when the market price of Reliance was Rs1,110. That means, out of the call premium of Rs35, Rs10 reflects the intrinsic value of the option (1,110-1,100) and the balance Rs25 represents the time value. If RIL stays around this price, then this Rs25 time value will trend towards zero by the expiry date. This is your biggest risk when you are buying options.

4. When you are the option seller, the volatility works against you

Selling an option is a bit like trading in futures because your losses can be unlimited. But the bigger risk for selling options is that your profits will be limited to the premium. Higher volatility indicates higher time value for an option. While this will benefit you if you are an option buyer, it will work against you if you are an option seller. And for those who do not believe in the volatility risk of selling options, you can always read up on how Nick Leeson bankrupted the 200-year Barings Bank by selling more options than the bank could afford.

5. It is a derivative on a derivative

Finally, there is an interesting argument against trading in futures and options. These are derivative instruments in the way as they derive value from an underlying asset. For example, Reliance call option derives its value from the spot price of Reliance and SBI future derives its value from the spot price of SBI. Now is the interesting argument! The equity share itself is a derivative product and is nothing but an option on the value of the company’s assets and liabilities. Effectively, when you are trading futures and options, it is like trading derivatives on derivatives, which makes it a lot more complicated.

There is nothing wrong in trading futures and options. Know the risks and then take your call!

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