Concepts to Know Before Futures and Options Trading| Espresso

Concepts to Know Before Futures and Options Trading

Trading in derivatives has attained momentum in current years. It gives an opportunity to evade investment against market risks and losses. Futures and Options are derivatives that derive their value from assets like equity shares, bonds, interest rates, commodities,  share market, indices, and others. Futures and Options have fixed contracts with a fixed expiry date.  

 

Published on 11 March 2024

The derivatives market is a critical segment of the equity market and is comparatively more complex than equity investments because of leverage and the associated risks.

In Futures trading platforms, it is mandatory for both the buyer and the seller to trade at the predetermined value of the underlying asset under the ordinary circumstances. Futures contracts are traded in lots restricting the number of units that form the part of 1 futures contract. The stock exchange has also levied initial margins (Span+Exposure) on futures contracts to minimize the risk of defaults. On the other hand, in options trading, premiums are based on the underlying asset's strike price, which is actually the rate to buy or sell until the contract expires. Both the concepts require deep knowledge and experience before making a trade. Here are the concepts you must know before you trade in Futures and Options.  

Challenges in Selling

Futures and options are leveraged assets. Futures are more formidable to sell than options. There are more chances that the future profit traders may earn by negotiating it at a lower price. Traders may be forced to sell for less or acquire more than the market price.

Here, the possibilities of making a profit are ideally the same as the chances of making a loss. Options may appear as a safer bet but traders are more likely to put off trades and lose its high value, which results in a net loss.

Maintaining your risk tolerance

Risk tolerance is defined as the level of risk that traders are willing to undertake to accomplish their goals. Traders trade in derivatives to reduce risk by fixing the price beforehand. A trader must consistently try to find a price to generate substantial profits. The financial maxims that apply here are: the higher the profit, the higher the risk. Traders must think about how much danger they’re prepared to take while complying at any cost.

Increasing returns via call writing

One of the best strategies for reducing holding costs and increasing the return on an existing stock is writing. In order to accomplish this, investors should select stocks for F&O trading for writing based on stock-specific cash flow while keeping a safety margin while writing strikes. Here, a buffer or a sufficient premium yield can demarcate the strike price. Traders must keep an eye on the position by establishing alerts in the system to determine whether to track the position or leave it.

Call writing delivers some flow of money as a premium, but any larger spike in stock price beyond the writing strike may not create a preferable real return.

Trading in long and short

Pair trading offers an added benefit in the market conditions. They deliver the opportunity when traders deviate from their average. Pair trading offers a low risk because both stocks have both Long and Short visibility in the supply chain. If traders possess stock in a firm and expect it to grow in value in the future, then they have a long position in the market. However, if traders are pessimistic about their future and sell them before the trade is transferred into their name, they have a short position.

Consider the costs

Derivative trading does not require a Demat account. It is typically a less expensive option. However, traders should not be deceived by the cheaper stock broker. When the underlying cost rises, after the increase in frequency. Derivative trading is instantaneous, where transactions occur in a short amount of time, which increases the aggregate cost of the trade. Therefore, it is invariably smart to balance the volume of transactions with the earnings.

Psychology of Trading in Futures and Options

Trading in derivatives involves understanding of charts, technical indicators, market sentiments, and many other external factors. However, the major aspect of trading which is consistently ignored is Psychology which involves human-driven emotions like fear, greed, hope, and regret. These emotions greatly dictate the success and failure of any trade. 

For example, when traders have a surplus capital of ₹1,00,000 and try to make profits in futures trading, one of the first emotions that they might encounter is “fear” which begins when the market moves in the opposite of the anticipated direction. Because of this, traders may square off the positions without a plan. But, when the market moves in the anticipated direction, then they experience the emotion of “greed”. Traders may hold winning positions way longer than their targets and make losses or reduced profits.

Conclusion:

Options and Futures trading strategies are conceptually different, but they do offer an opportunity to protect capital against market volatility by locking a transaction at a predetermined price and date. Futures and Options trading is not easy, it is an in-depth understanding of the financial products. Only the best futures trading platform can help you to perform on time in the market.

Chandresh Khona
Team Espresso

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