Futures and options derive their value from an underlying and this underlying could be a stock, index, bond or commodity. For now, let us focus more on futures and options on stocks and indices. A stock future/option derives its value from a stock like RIL or Tata Steel. An index future/option derive its value from an underlying index like the Nifty or the Bank Nifty. In the last few years, the F&O volumes in India have picked up in a big way and account for 90% of the volumes in the market.
However, F&O has its own share of myths and follies. Most rookie traders look at F&O as a cheaper form of trading equities. On the other hand, legendary investors like Warren Buffett have called derivatives as weapons of mass destruction. The truth obviously lies somewhere in between. It is possible to be profitable in online trading for F&O if you get your basics right.
1. Use F&O more as hedge than as a trade
This is the basic philosophy of how to trade in futures and options. One of the reasons retail investors get enthused about F&O is that it is a margin business. For example, you can buy Nifty worth Rs.10 lakhs by paying a margin of just Rs.3 lakhs. That allows you to leverage your capital by 3 times. But that is a slightly dangerous strategy to follow because just as profits can multiply, losses can also multiply in futures. Also, you need to have enough cash to pay mark to market (MTM) margins if the price movement goes against you.
The answer is to look at futures and options more to hedge. Let us understand this better. If you are holding Reliance bought at Rs.1100 and the CMP is Rs.1300, then you can sell the futures at Rs.1305 (futures normally quote at a premium to spot) and lock in profits of Rs.205. Now, whichever way the price goes, you profit of Rs.205 is locked in. Similarly, if you are holding SBI at Rs.350 and you are worried about a downside risk, then you can protect by buying an Rs.340 put option at Rs.2. Now you are protected below Rs.338. If the price of SBI falls to Rs.320, you book profits on the put option and thus reduce the cost of holding the stock. That is how you can make F&O work effectively by getting the philosophy right!
2. Get the trade structure right; strike, premium, expiry, risk
Another reason why traders get their F&O trades wrong is due to bad structuring of the trade. What do we understand by structuring of an F&O trade?
Before buying or selling the futures check for dividends and the see if the cost of carry is favorable or not.
When it comes to trading in futures and options, the expiry matters a lot. You can get near month and far month expiries. While far month contracts can reduce your cost, they are illiquid and exit can be difficult.
Which strike should you prefer in options? Deep OTM (out of the money) options may look cheap but they are normally worthless. Deep ITM (in the money) options are just like futures and don’t add value.
Get a hang of options valuation. Your trading terminal has an interface to check if the option is undervalued or overvalued based on the Black and Scholes model. Ensure that you buy underpriced options and sell overpriced options.
3. Focus on trade management; stop loss, profit targets
The last thing to focus on is how you manage the trade; more so when you are trading in F&O. Here is why!
The first step is to keep a stop loss for all trades in F&O. Remember; this is leveraged business so stop loss is a must. Ideally stop loss must be imputed with the trade and not inserted as an afterthought. Above all, it is a strict discipline in OnlineTrading.
Profit is what you book in F&O; all else is just book profits. Try to churn your money rapidly because in the F&O trading business you can make money if you churn your capital more aggressively.
Keep tabs on maximum capital you are willing to lose and at that point rework your strategy. Never bet more than you can afford to lose. Above all, when markets are beyond your comprehension, stay out.
F&O is a great alternative in online trading. You just need to take care of the 3 building blocks to be profitable in F&O.
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