6 mins read . 23 Jan 2023
The legendary value investor, Warren Buffett, had once described the future and options as weapons of mass destruction. While it is true that F&O trading has been behind a number of crises in the markets, it is actually not about the product but about how discreetly you use the product. F&O trading can be a value addition and also meaningful if done in the right manner, without going overboard. F&O trading is a good decision because it first helps leverage your capital better and secondly, it is one of the most scientific methods of managing stock market risk. Here is how you go about it.
Like in equity market trading, even F&O trading calls for a lot of discipline if you want to sustain yourself as an F&O trader in the long run. Of course, F&O can be a tad more complicated compared to equities, which is the challenge. Since there is a leverage aspect to F&O, risk management becomes critical. It all boils down to how well you manage risk, which can be done at multiple levels. The first idea is to limit the amount of capital that you can lose on each trade. At the next level, you can limit the capital you are willing to lose in a day. Lastly, determine how much of your original capital you are willing to lose.
When people blame derivatives, they often talk about the Barings case. That was a case of the trader taking on too much risk knowingly, just to hide his losses. It was also a failure of the back office and compliance since neither of them could find out what the trader, Nick Leeson, was doing. The idea is to use this leverage discreetly and not indiscriminately. When you leverage it is essential to always keep strict stop losses and tight profit targets. If you feel the risk is too high, look to trade that stock through stock options rather than stock futures. Also, in a globalized F&O market, the overnight risk is something to avoid.
This is, possibly, one of the most important ways of handling risk in the markets. The most common use of futures and options is to hedge risk. For instance, if you have bought a stock and it has gone up 20%, you can lock in profits by selling futures. Now, irrespective of where the stock goes, you are assured of this 20% profit. This limits your upside, but here we are talking about managing risk in volatile markets. The more important aspect of risk is how to use F&O to adopt limited risk strategies. The most simple way is to buy the future with a put option so that your downside risk is limited but the upside potential is huge. Similarly, you can buy lower strike calls and sell higher strike calls and create spreads to lock in profits. That is where the real utility of F&O comes into play. Unlike equities, you can also use options to create strangles so you can benefit from volatile markets or even lackluster markets.
How do you test a call in futures and options? For example, if you are positive on a stock, one way to play the view is to buy futures. However, that entails higher margins and also an unlimited risk on the downside. The other way is to first test your view with call options and once you are sure, you can then implement the strategy with futures. Similarly, if you are having a negative view of a stock, instead of selling futures you can just buy a put option to play the downside. This can be used as a test case to test your view before committing funds to a futures position.
To sum it up, trading in F&O can be a very good idea, if trading is done with a plan rather than indiscriminately. It makes to start small and scale up gradually.