Did you know that you can be a much more successful trader in futures options if you avoid some basic mistakes? Well, these are not exactly rocket science kind of mistakes but basic mistakes of discipline and mental poise. Let us look at some key options trading mistakes and also some mistakes in futures trading. In the process, let us also look at how to trade futures successfully.
Here are 7 things to avoid if you want to make a success of your futures and options trading:
1. Futures are hedges, don’t use them as proxy for trading
It is one thing to leverage your position and another thing to believe that your margin is akin to your capital. When you trade in futures, your profits can multiply but even your losses can multiply to the extent of your leverage! When you leverage yourself in the futures market, you can feel elated that your profits will multiply if the trade works in your favour. The problem is that the converse also holds true in case of futures. The real problem comes when you are asked to infuse MTM margins.
2. Like in the cash market, you need stop losses in futures and options too..
At the end of the day, futures’ trading is leveraged and therefore you have to keep strict stop losses and profit targets while trading. In fact, the need for stop losses and profit targets is a lot more intense in futures than in cash due to the leverage involved. Always trade futures and options with a risk-return trade off! When stop loss is triggered or profit target is hit, immediately exit the futures position. Don’t ignore the importance of stop losses in the case of options. Not only when you sell options, but even you buy options make it a point to keep stop losses to minimize your losses.
3. Future prices are hit by dividends and that is not a discount
Investors often believe that since the holders of futures do not receive dividends they need not worry about the impact of dividends on futures prices. The truth is that futures are impacted by dividends. If company is quoting in the cash market at Rs.700 and there is a dividend payable of Rs.24, then the futures price for the month will be adjusted downward by that amount. That does not mean that the futures is cheap or that it is underpriced priced due to the discount. Once the dividend ex-date is over, the parity returns. The moral of the story is not to jump in and buy the futures the moment it is at discount to the spot price.
4. Not everyone who is selling futures is negative on the stock
Don’t start selling futures just because you see short side accumulation. The other institution could be creating arbitrage positions where they buy in the spot market and sell in futures. This is a non-directional strategy and is agnostic to market movements. Don’t misconstrue that as a signal to start selling or shorting the futures. You need to realize that a chunk of the trade in the stock futures market is cash-futures arbitrage. Don’t interpret short accumulation in futures as selling in futures and try to go short on the stock. You are likely to end up on the wrong side, as these are non-directional arbitrage strategies. Alternatively, it could be just shifting of positions.
5. Don’t buy or sell futures and options without regard to liquidity..
Have you seen vanishing liquidity in futures and also in certain option strikes? It does not happen in the case of large stocks but many mid cap stocks and especially small caps that are closely held are vulnerable to vanishing liquidity. This trend is more evident in times of market sell-off when the futures can trade at huge tick spreads. Vanishing volumes create a huge spread risk for you. This is where many traders tend to get caught.
6. Low priced options are not necessarily cheap; exactly like penny stocks
Many option traders end up buying deep OTM options just because the premium is low. That is bad strategy because you are paying a small price for a worthless option. You are going to lose money anyways. Rather check the intrinsic value of the option and then buy options that are underpriced. Price does not matter, it is the time value embedded in the option that really matters. Don’t buy options of distant strikes just because they are available at low prices. The option will most likely expire worthless.
7. Avoid holding on to long options when you are too close to expiry
This is a basic reason why traders in options tend to lose money. Any option has two value components viz. time value and intrinsic value. When the call or put option is out of the money then it is very likely to expire worthless at zero. The problem is that an option that is likely to expire worthless will see its value diminishing rapidly in the week to expiry. If you hold these options too close to expiry then you are likely to see your options expire worthless. Time always works against the buyer of the option and hence set your target returns and exit when you sense the opportunity.
If you can focus on these basic rules of options and futures, you stand a good chance of avoiding the typical minefields of trading in F&O.