In this ar­ti­cle, we will talk about some of the best prac­tices which will help you to emerge as a suc­cess­ful and a skill­ful deriva­tives trader.

Dalal Street Investment Journal - - SPECIAL REPORT -

1 Al­ways keep your ex­po­sure in check

Deriva­tive trad­ing is a lever­aged po­si­tion. One has to deposit a mar­gin amount, which is cal­cu­lated as a cer­tain per­cent­age of the con­tract value. With an amount of ₹75,000-1,00,000, a trader can take an ex­po­sure of up to ₹5-6 lakh. But be­fore en­ter­ing into lever­aged po­si­tions, en­sure you have enough sup­port on the off-chance that the mar­ket changes course and moves against your ex­pec­ta­tions. In this case, your bro­ker will deduct the no­tional loss from the mar­gin and ask you to pay ad­di­tional mar­gin. In case you are not able to pro­vide ad­di­tional mar­gin to the bro­ker, you might be com­pelled to square off your po­si­tion, which will re­sult in a forced loss. Con­se­quently, as a deriva­tive trader, it is vi­tal to de­sign a proper plan be­fore you ini­ti­ate a po­si­tion and keep up ad­e­quate mar­gin, just in case there is any short­fall due to ad­verse move­ment of the stock price. In many cases, we hear from traders that due to over­ex­po­sure, they had suf­fered huge losses which wiped out their en­tire cap­i­tal. Hence, it is im­per­a­tive to draw a Lax­man Rekha while trad­ing in the deriva­tives seg­ment.

2 Un­der­stand­ing the IV

All types of as­sets that are traded are in­flu­enced by volatil­ity to some de­gree, and this is some­thing an op­tions traders should def­i­nitely be fa­mil­iar with. A fi­nan­cial in­stru­ment that has a rel­a­tively sta­ble price is said to have low volatil­ity, while an in­stru­ment that is in­clined to sharp value move­ments in ei­ther di­rec­tion is said to have high volatil­ity. For a trader ini­ti­at­ing a po­si­tion in an op­tion, it is vi­tal to com­pre­hend the con­cept of IV (Im­plied Volatil­ity) or, in other words, an­tic­i­pated volatil­ity. It is fun­da­men­tally a pro­jec­tion of how much and how quick the un­der­ly­ing se­cu­rity is prob­a­bly go­ing to move in its price. Kishore, a new op­tion trader, was aware about the ba­sic terms of op­tions trad­ing, i.e. strike price and ex­piry date; how­ever, he was not aware about the con­cept of IV. Overzeal­ous to make for­tune from op­tions trad­ing, Kishore chose to buy call op­tion of com­pany ABC, reck­on­ing that the stock price will rise as the stock was per­form­ing well and there were gos­sipy tid­bits that the com­pany may make an an­nounce­ment of an ex­cit­ing new prod­uct. When he en­tered the call op­tion, the IV of op­tions of com­pany ABC was very high. How­ever, after a cou­ple of days, com­pany ABC re­leased the news and since there was noth­ing ex­cit­ing about the new prod­uct, the stock price did not re­act much. Hence, the stock's IV dropped sig­nif­i­cantly to the amaze­ment of Kishore, de­spite the stock price trad­ing near about the same level at which he had bought the call op­tion, but the value of call op­tion de­creased as the stock's IV dipped. So, as an op­tion trader, you have to un­der­stand the idea of volatil­ity and im­plied volatil­ity thoroughly.

3 When to en­ter OTM op­tions

: It has been ob­served that many op­tions traders bet on the out-of-the-money (OTM) op­tions as the pre­mium for th­ese op­tions are sig­nif­i­cantly cheaper than at-the-money (ATM) op­tions. Hence, the low pre­mium lures them and of­ten we hear ‘Ek Ka Dou­ble’ from op­tion traders as they ex­pect OTM op­tion to be a dou­bler. How­ever, they fail to com­pre­hend there is a time value at­tached to the op­tions and if there is no sig­nif­i­cant price move­ment in the im­me­di­ate days, there could be ero­sion of the pre­mium and they can lose their en­tire cap­i­tal. Hence, one should en­ter into ' out-of-the-money op­tions only if one ex­pects to wit­ness sig­nif­i­cant moves im­me­di­ately.

4 Us­ing deriva­tives to one's ad­van­tage

War­ren Buf­fet fa­mously de­scribed deriva­tives as “fi­nan­cial weapons of mass de­struc­tion.” How­ever, if deriva­tives are used prop­erly, they can be pretty much help­ful for an in­vestor in some cases. Let us un­der­stand how in­vestor can ben­e­fit from deriva­tives. An in­vestor can use “Cov­ered Call Op­tion” strat­egy. Cov­ered Call Op­tion strat­egy in­volves both stock (un­der­ly­ing) and an op­tion con­tract. An in­vestor who buys or holds a stock and si­mul­ta­ne­ously writes an equiv­a­lent call op­tion in the same stock fol­lows a strat­egy called as cov­ered call op­tion. Let us as­sume an in­vestor had bought stocks of ABC Ltd on Septem­ber 1, 2017, when the share traded at ₹500 in the ex­pec­ta­tion that the stock will per­form well in the long run, but he feels due to lack of trig­gers or choppy mar­ket the stock may move side­ways in the short term. So he will sell an out-of-the-money (OTM) call op­tion at a pre­mium of ₹10, ex­pir­ing on Septem­ber 28, 2017 with a strike price of ₹520 and lot size of 1,000, so you re­ceive ₹10,000, i.e. pre­mium * lot size (₹10 * 1000). If the price does not move and the stock price set­tles be­low ₹520 at the end of the month, we may pocket the pre­mium we earned. That means a gain of ₹10,000. So an in­vestor can use deriva­tives to his/her ad­van­tage.

5 Un­der­stand­ing Open In­ter­est:

What is Open In­ter­est (OI)? Open In­ter­est (OI) is a num­ber that dis­closes to you what num­ber of fates or al­ter­na­tive con­tracts are right now ex­tra­or­di­nary (open) in the mar­ket. Vol­ume and OI are two unique ideas. Open pre­mium gives us data about what num­bers of agree­ments are open and live in the mar­ket, though the vol­ume then again dis­closes to us the num­ber of ex­changes that were ex­e­cuted on the given day. By checking the ad­just­ments in the open in­ter­est fig­ures to­ward the fin­ish of each ex­chang­ing day, a few de­ci­sions about the day's ac­tion can be drawn. Ex­pand­ing open pre­mium im­plies that new cash is stream­ing into that agree­ment. The out­come will be that the present pat­tern (up, down or side­ways) will pro­ceed. De­clin­ing open in­ter­est im­plies that the mar­ket is squar­ing off and sug­gests that the pre­vail­ing price trend is reach­ing to an end. Un­der­stand­ing of open in­ter­est can prove ad­van­ta­geous to­ward the end of ma­jor mar­ket moves. A lev­el­ling off of open in­ter­est fol­low­ing a sus­tained price ad­vance is of­ten an early cau­tion­ing of the end to an up­ward in­cline or bull phase.

6 Man­age Risk

Deriva­tives are high-risk in­stru­ments, and it is im­por­tant for traders to rec­og­nize how much risk they have at any point of time. What is the max­i­mum downside of the trade? Find­ing the level which pro­tects against large losses and guar­an­tees gains is what ef­fi­cient risk man­age­ment is all about.

7 Lim­it­ing your po­si­tions

If you are trad­ing deriva­tives, it is im­por­tant to have limit on the num­ber of open po­si­tions at a given point of time. Be­cause with lim­ited po­si­tions, you will be able to keep a close tab on them and man­ag­ing them will not be as stress­ful and hec­tic as at­tempt­ing to man­age dozens of open po­si­tions si­mul­ta­ne­ously. More­over, lim­it­ing your po­si­tions will help you to con­cen­trate on the prime op­por­tu­ni­ties at any given point in time.

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