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The optimal route for derivatives trading – BusinessLine

Are you new to trading and do you intend to start trading with derivatives? This week, we discuss why you should first gain some experience in the spot market and then move to the futures segment before trading options.

Trading path

Most of us suffer from loss aversion. That is, we hold-on to our loss-making trades for too long and sell our profitable trades too soon. A disciplined trader would do the reverse- cut exposure to loss-making trades and run profitable trades for a while with appropriate trailing stops.

Loss aversion can hurt your trading performance. The issue is the aversion to taking losses has a greater impact on derivatives trading compared to spot transactions. Why?

Suppose you buy a stock at 100 with a price target of 150 and a stop loss at 85. Further suppose the stock declines to 85. If you do not take your stop-loss and close your position, your capital is locked up in a loss-making investment for a while. You might choose to sell the stock once it reaches your purchase price (100).

Now, suppose you buy a call option on the stock. If the stock declines, the fall in the option price will depend on the strike price in relation to the spot price. But the primary issue arises from the fact that the option (right) you bought is valid for only a finite period. On the NSE, monthly contracts expire on the last Thursday of every month. In addition, the Nifty weekly options expire every Thursday.

One component of the option price is time value. The time value becomes zero at expiry for all options- in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). So, the more you suffer from loss aversion, the longer you are likely to hold an option and more the position will lose from time decay. Therefore, the stock must move significantly within the limited time to offset the loss from time value and generate gains. In contrast, a loss-making stock position does not suffer from time decay.

Futures do not suffer from time decay the way options do. But that does mean you can start trading futures without prior trading experience. The issue with futures is that the permitted lot size acts as a contract multiplier and can hurt your trading performance. For instance, if Reliance futures price declines by 10 points, you would lose 2,500, as the multiplier is 250. It is highly unlikely that would buy 250 shares in the spot market if you are new to trading. You can trade in the spot market with small risk capital, given that you can also buy one share of a stock, a luxury that is unavailable in the futures market because of the permitted lot size.

Optional reading

You have time to moderate your loss aversion bias in the spot market because an underlying does not suffer from time decay. Therefore, it is preferable that you first gain some experience trading the underlying before moving to the derivatives market.

Within the derivatives segment, you should start with futures as they are similar to trading the underlying. For one, your gains on your futures position are not significantly affected whether you take profits a day after you setup the trade or at expiry of the futures contract. For another, futures move in lock step with the underlying. True, the capital required to trade futures is less compared to taking equivalent position in the spot market because you pay only initial margin and mark to market margin. But the multiplier could be a deterrent if you are a new trader.

Finally, when you are confident trading futures, start dabbling in options. Remember, with options, it is important that you get the direction and the speed of the underlying right; for the sooner you take profits, the better.

The author offers training programme for individuals to manage their personal investments.

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)