Many years ago, Warren Buffett had described Future and Options (F&O) as “weapons of mass destruction”. While that was largely a generic statement, F&O trading can be profitable and meaningful if done in the right manner. (note the “if”). and it helps you put a small capital to better use. However, to actually make F&O trading a good decision for you, here are five things to remember:
Set your risk goals first before trading
In many ways, F&O trading is similar to equity market trading—since it calls for a lot of discipline to make consistent profits. The only difference is that F&O is slightly more complicated as a product than equities. There is a leverage aspect to it and there is also a risk management aspect to it. The answer lies in managing your risk and putting limits to the risk that you are willing to take. This has to be done at multiple levels. Firstly, put a limit to the amount of capital you can afford to lose on each trade. Secondly, limit the capital you are willing to lose on any particular trading day. And lastly, determine how much of your original capital are you willing to lose. At that point, you must be ready to get back to the drawing board and rethink your F&O trading strategy.
Use leverage smartly, not indiscriminately
People often argue that futures’ trading is smarter because you can increase your Return On Investment (ROI) since you only pay a margin. There is a downside to this argument, since even your losses can multiply. Hence, when you leverage, it is apt to keep strict stop losses and tight profit targets. If you feel that the risk is too high you can look at trading that stock through stock options rather than through stock futures. You must ideally avoid overnight risk, especially in situations like these when the trade war and BREXIT are putting tremendous pressure on global markets.
F&O can be used to hedge your risk
Hedging is one of the primary purposes of F&O and you must start using it as a hedging product. This works in two ways: example, if you have bought shares of Reliance and the stock is up 15% in 3 months, you can lock in the profits by selling futures. You may limit further appreciation but you are now assured that 15% profits are locked in irrespective of how the price moves. You can also protect a falling stock by buying lower put options. Once you understand the hedging aspect of these products, F&O trading is a lot simpler.
F&O hybrids are a smart limited risk strategy
Let us say that ahead of elections, you were expecting huge volatility but were not sure of the direction. How can you play this trend? That is where F&O comes in handy. You can create a strangle by buying a call and put option. Your risk would be limited to the total premium. But on a day like 23rd May (the election results day), you would have probably made money on the call and the put option because the market gyrated substantially both ways. That is the unique feature of using options and it is a very smart way of trading an otherwise directionless markets.
You can test your strategy with options before taking positions
This role of F&O is often underappreciated. For example, if you believe that a stock like SBI would benefit from a turnaround in PSU banking, you can implement your view through call options. If the view goes against you, then all you lose is the premium. If it moves in your favour, then you get almost the same benefits as buying the stock. This approach can really work in your favour and when starting out trading, it is recommended you use a low risk strategy like this.