8 basic principles to follow while trading equities and derivatives - Motilal Oswal
8 basic principles to follow while trading equities and derivatives - Motilal Oswal

8 basic principles to follow while trading equities and derivatives

Most of us believe, and rightly so, that trading in equities and trading in derivatives are two different ball games altogether. While the products may different in terms of returns and risk, the underlying principle is the same. More often than not, the principles that you apply to trading equities can be applied to trading futures and options also. Here are 8 such principles that form the cornerstone of trading in equities and derivatives..

Be realistic in your expectations

This applies to all walks of life but more so to trading. There are occasions when you buy a stock and the stock nearly doubles in 10 days time. Don’t get carried away by such performances. These are just the exceptions that prove the rule. The rule is that the market is really going to extract high levels of skills and discipline before it allows you to take big profits. Similarly, when you buy a deep OTM call option, don’t expect to wake up next day morning to find yourself a dollar millionaire. It does not work that way. Typically, your big profits will not come to you without imposing big costs on you. That is true of equities and derivatives.

Equity or derivatives, first focus on managing risk

We have spoken of this factor umpteen times but it still remains the core of trading. After all, trading is all about managing risk. If you are trading on equity, you need to worry about your capital and your stop losses. If you are long on calls or puts then you need to worry about how best you can reduce your option sunk cost. If you have sold options then you need to focus on how much risk you are willing to take beyond your option premium. Focus on the risk aspect and the returns will be taken care of.

It is all in the mind, so never panic

Whether it is equities or derivatives, it is ultimately all in the mind. Are you able to keep your cool in the midst of a volatile market? Can you avoid panicking in a falling market and identify opportunities? Can you have the discipline to avoid the market at the peak of a bull rally and sit on cash? How do you avoid the herd mentality when the entire flock is chasing a particular line of thinking? All these are questions of how well you play the mental game. One of the golden rules of trading equities and derivatives is never to panic. The total quantum of returns in the market is fixed. When you panic you subsidize the other trader who does not panic.

Costs and taxes matter a lot in trading

Whether you are trading equities or derivatives always think like a miser not like a millionaire. Squeeze your costs to the bare minimum. Don’t overtrade as it only adds to the brokerage costs. Get the best possible deal on the rates of brokerage. Keep an eye on taxes because each trading action of yours has a tax implication. When you are able to look at your trading performance in post-tax terms, you have truly arrived as a trader.

Apply the laws of motion to your trading activity

When we talk of motion we are talking of market momentum. Newton’s law says that a body in motion continues to be in motion till an external force acts upon it. The same applies to markets. When you find a certain underlying motion driving the market, try to understand the motion rather than trying to bet against. As a trader, you are always better trading on the same side of momentum. It is not your job to predict when the momentum will shift or when the trend will change. That is for the market to tell you!

Think like an analyst but act like a trader

Many rookie traders erroneously believe that in-depth reading and grasp of news and events is the job of a fundamental analyst. A trader needs to be able to grasp the news and its implications to be able to really understand the trading ecosystem in the right perspective. The idea is to think like an analyst and act like a trader. But, there is really no substitute to doing your home work, keeping abreast of the news and events and an uncanny ability to interpret the data flows.

Focus more on factors within your control

When you are a trader what should you worry about? Should you worry about where the stock will trade at the end of 1 month? Should you worry about how the option price will turn out? Should you worry about whether the Fed will hike rates? Should you worry about whether the US will trigger a trade war with China? The answer to all these questions is “No”, because you do not have control of any of these outcomes. Focus on what you can either control or influence. You cannot predict the price of the stock but you can manage your risk with stop losses. You cannot control the Fed rate decision but you can decide your strategy. You do not know how the trade war will pan out, but you can surely sectors and stocks that are likely to lose from a possible trade war. Focus on what you can control only!

As a trader, the buck stops with you 

Whether you trade equities or derivatives, always remember that the buck stops with you. When you lose money, there is no point in blaming the monetary policy or the Budget. You may not control the outcome of the Budget or the monetary policy but you surely can influence your trading positions. You could have either closed positions or hedged with a put option. Don’t blame losses on market volatility. That is the way markets have been always. Don’t spend time on justifying your losses, rather focus on the learnings.

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