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.
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.