What? F&O?

If you have ever joined a telegram group, chances are you have seen a message like this:

Both calls ended in loss that day. The messages with the fire emojis stopped the minute it went into loss.

Curious why they only selectively post their winning trades?

Stock market seems simple. You buy low and sell high. That is like saying batting in a world cup final easy, just hit the ball with the bat. Both statements oversimplify the complexities massively. If you are trading in cash delivery markets, 9 out of 10 times you will not need to know about technical complexities besides the T+2 settlement cycle and the new rule of margin requirement for selling your shares. If you are trading intraday you have to learn how leverage works, and what happens when your MTM loss at the end of the day is more than the money you had in your account in the morning.

But these are still trivially simple compared to what you need to know to tread into derivatives market of equity, currency and commodities (pun intended!). If you jump in directly, you will realize that you did not know what you did not know.

I thought I will give you a small checklist of things you will need to know by heart to be safe in the market.

  1. Expiry time – Know the expiry time and date for the contract you are trading. Equities expire on Thursdays at the end of the day. Currencies expire on Fridays at noon. Recheck the details yourselves. I may be wrong, or rules might have changed since publishing this article.
  2. Type of settlement – Nifty and Banknifty contracts are cash settled, meaning you receive the gains or pay the losses and the contract is considered settled. Stock futures and in the money stock options are physically settled. Meaning, depending upon the side of the contract you hold, you must either take delivery or give delivery equal to the number of lots you hold. An ITM Reliance contract would be settled with 505 shares of Reliance. That requires full value of contract i.e. 505 x CMP of Reliance and not just 2.5L margin that the broker takes.
  3. Margin Maintenance – Unlike cash trades where once you buy the shares and pay for them, you do not need to maintain any money in the account, derivatives need cash or margin. (Cash can be given as margin but margin cannot be paid as cash!). If you go long in a futures contract and market goes down a little, resulting in an MTM loss of 5000 Rs. Then you must pay 5000 Rs cash at the end of the day. If you are holding an option position however, just some margin will be blocked. So, you can get a margin call if you run out of cash to pay for the futures MTM settlement EOD even if you have plenty of non-cash margin left. Some brokers require additional margin two days prior to the expiry of physically settled contracts. If you are carrying the position throughout the month for about 1.5L margin, you will need about 3L margin to keep the position open on the last two days of expiry. Your trade could very well have ended in profit had you been able to keep it open till expiry. But if you get a margin call on Wednesday, you might be forced to close the position at a loss.
  4. Liquidity – F&O market is much more illiquid than stock. It might be quite easy for a seasoned trader to enter and exit from a 10,000-share position of GODREJCP. But it will be difficult for her to square off 10 call options at slightly OTM strike of the same stock since the liquidity is much less. So, your position might show 2000 rupees profit, but by the time you exit fully, you might have paid 400-500 rupees to slippages. That is 20-25% less than the profit you were expecting. This is especially true for multi leg option strategies.

There are many more factors you need to look out for while trading in F&O market, but hope this post gets you started on at least some of them…

Also read my article on starting to trade in FnO market: What is the ideal size?

Black Swan Events

two black ducks on grass lawn

This is the catch phrase every single news channel likes to throw around. It is an event that is beyond what is normally expected. The word ‘normally’ is a bit subjective. When you start trading, for the first few months upper or lower circuits would seem like abnormal events. Soon you would get used to extreme volatility where 8% up and 9% down happens one day after another. You will see a stock tanking 10% after a historically bumper result. And through all this if you manage to keep your account afloat, you will see the shortest bear market in the history lasting about a month from peak to trough.

But let us see some events that would have surely caught many ‘professional’ traders off guard too.

There is one event I would like to talk about. One where the value of crude oil contracts went negative.

No, it did not mean that you could go to petrol pump and get paid to fill the tank of your car. It was a time where world was locked down due to COVID-19. There was little demand for crude. People holding long futures of crude would have to take delivery of oil on expiry of their contract. It is worth mentioning here that crude contracts are physically settled in US unlike on MCX where they are cash settled. So long traders would have been stuck with barrels upon barrels of crude which had no demand in the market or any economically viable place to store. So, traders started selling the contracts. Selling did not stop. Eventually the ask side of the orders started working in negative. Traders were ready to pay money to close their long positions because taking a delivery would have meant an astronomical loss.

At least in the US the exchanges could process negative orders and the market kept running. In India last traded price of April month future contact was 965 rupees but the final settlement price was assigned as negative 2884 rupees.

A lot of traders and brokers have moved to various courts of appeal. Traders and brokers claim that MCX had no system to submit negative price in spreads and hence it cannot assign a negative price for settlement.

The cases are still in the court. The difference between LTP and settlement price was over 3500 Rs. Multiply that by 100 barrels per contract and a long trader could have potentially lost 3.5 lakhs per contract that day. That is more than the margin requirement for the same contract at that time.

Results from the court are still awaited. The traders who lost big that day might get some of their money back. But that will take time. And they would have lost precious opportunities that presented themselves from April till today.

Nobody, not even our exchanges had anticipated negative prices before this event. Since then the margin requirement on crude oil has increased a lot. Currently it is more than even the notional value of the contract.

Black swan events are unexpected. So naturally there are little safeguards in place against them. But there is always a way to prevent large losses. Here I mean losses large enough to mess with your psychology, make you lose confidence. It might reduce your capital so much that it is no longer viable for you to trade.

Remember, in trading, not losing money is more important than making a lot of money. It is prudent to hope for the best but prepare for the worst.

What is risk management?

This is the first article of a 4-part series of articles on risk. I often hear people saying stock markets are risky. I am going to try and classify and quantify the risks that they perceive. Once they know what to and what not to be afraid of, may be the fear will subside a little.

We all have heard the following;

‘MutualFundsAreSubjectedToMarketRiskReadAllSchemeRelatedDocumentsCarefully’

Not just the adverts, but you all will have at least one each from the following categories in your friends and family:

The one who is terrified of the thought of stock market and actively advises everyone against it.

The one who has tried and burnt her hands in stock market.

The one who’s doing it for a long time but has neither made nor lost too much money.

The one who knows what she is doing and makes consistent money from the market.

The last one is very rare and usually flies under the radar. Except the one who has lost a lot of money, everyone else of the above have done a decent job of managing their risk. And yes, I am including the person who stays away from the market, since she has already made sure she never makes a loss in the market. (There are other ways she will lose her money but we will talk about it in subsequent articles).

If you look up the definition of risk management, you will find something along the lines of identifying and mitigating threats. That is a generic definition. Let us rephrase it to suit our profession. The overarching risk in securities market is losing money. And why do we lose money? Usually because our view of the market is wrong or the tool that we used to express our view of the market is wrong.

You can have 7 views for the market:

  1. Up
  2. Down
  3. Sideways
  4. Up or sideways
  5. Down or sideways
  6. Up or down.
  7. Arbitrage – This is not a feasible stance for most retail investors so we will ignore that.

For example, if your view is that the market might stay sideways, but market makes a directional move beyond your expected range you will lose. Your risk management principles will dictate how much you lose when your trade goes wrong.

I would like to give an example of picking the wrong tool for your directional view as well. Let us say your view was that Reliance will move up in the next 30 days. Instead of buying shares you thought you’ll receive higher ROI if you take a position using options. You buy an OTM call. For half the month Reliance doesn’t move up very much. Due to theta decay, your option loses premium and the stop loss on the option’s premium is hit. You exit the position and a couple of days later Reliance Starts an explosive rally on the back of some good news. You could have held on to the position if you had made a spread with options or simply taken a cash position.

We will talk about many factors that are often overlooked while taking a position in the next article.

Understand the purpose

colorful cutouts of the word purpose

Everything you do in in the markets must have a purpose. And no, I don’t mean it in the philosophical sense.

If you are investing in mutual funds, usual purpose is to meet future financial goals. If you are trading, you are trying to profit off of market inefficiencies.

No matter what instrument you use, making money is your end goal. If you can make it without ever touching futures, options and intraday trading, how does it matter? Attempts to catch bottoms to buy or tops to sell are done for bragging rights more than making money. You could have caught bottom of Coal India at Rs. 110 mid-October and be up about 10%. Someone who simply bought Kotak Mahindra Bank on the same day because it looked like it would resume its uptrend would be 45% up today. Catching bottom means nothing if you can’t make money from it.

Understand the purpose of FnO as well. One of which is the leverage. You can trade in several hundred shares while paying for only a part of them upfront. Another one is expressing market views which can’t be expressed in any other way. For example, extended sideways movement can be cashed in effectively by option selling. Shorting can’t be done in cash market, and hence must be done using futures or options. Decide instruments based on your strategy and not the other way around.

Make perfectly clear to yourself why you are in the markets. If it is to sound smart by saying words like Iron Condor, long unwinding, head and shoulders, there are a million other ways of sounding smart without risking your capital. If you are in it to make money, take the simplest route available to you. There are no points for taking a tough path and failing.

The law of instruments…

handheld tools hang on workbench

If all you have is a hammer, everything looks like a nail

Abraham Maslow (Rephrased)

You often see traders with profile descriptions like, ‘Options trader’, ‘Futures trader’, ‘Crude trader’. It sounds cool doesn’t it. Makes you want to pull out your credit card and pay tens of thousands, sometimes hundreds of thousands of rupees to go learn how to do some complicated hedging strategy. But do you really need to?

But what we often forget is all these are tools to achieve your end goal. In this case to express your views about the market. Nobody says they are a mutual funds investor proudly. Why? Because it doesn’t sound cool. It doesn’t involve showing your expiry day profits. But for a mutual fund investor, it expresses her view. It serves her purpose of creating wealth for her financial goals.

Let’s take an example.

You can have very simple view of a stock. ‘From current market price, it will go up’. Now how do you pick a tool? If you have a small account (read: less than a few lacs) it is best to stick to cash market. But lets say you have enough money in your account to play around. If you still want to keep the risk low, you can simply buy the stock. If you want to use some leverage to make more money on the same trade and in return can afford to lose a little more money if the trade goes wrong, then you can buy a futures contract. Options are a little more complicated. You can buy a call or sell a put. You can create vertical, horizontal, diagonal or ratio spreads to create suitable risk reward profile. These are all tools.

We don’t decide what furniture we want in our living room by looking at our toolkit first. Which in this case would contain only hammer and severely limit your options (pun intended).

In my case I prefer to express my views in terms of support-resistance or supply-demand levels. One of my views is that we wont see 9000 on the downside or 12500 on the upside for a couple of months in NIFTY. Then the simplest tool would be a short strangle or an iron condor. Another example is ‘NESTLE would be a good pick for a long term portfolio at current price’. Since its a long term bet, venturing into derivatives would be too risky so simply buying a stock would be better. I won’t have to check the movement everyday and no matter what happens I wont lose more than I have put into the stock. Which, by-the-way, can happen in derivatives.

So design your sofa first. Then go pick your hammers and chisels.

The perspective

Every time a stock hits its lifetime high, the social media starts buzzing with lines such as ‘Just 3 Lac invested in XYZ-MULTIBAGGER company in the year LISTEDDATE would have been equal to YOUCOULDHAVEBEENRICHB*TCH today!’.

When I was a newbie in the markets and came across such tweets, I felt my parents (and by extension me) missed their opportunity of being filthy rich. But once I became a little used to the stocks and their erratic behavior, I realized how smart, albeit unknowingly, my parents were. Let us talk about one of the poster children of such multibagger returns; MRF. Since its listing in the year 1999, it has increased by approximately 4500%. I will throw one line as well. Just one lac invested in this stock back then would have been 45 lac today. But here’s the detail I missed. back then access to markets was not as straight forward as it is today. The maze of brokers, sub brokers and market operators would have been very difficult to navigate for someone like my parents. Not being savvy about financial world, they would have relied on the recommendations of their broker. And we all know how shady that business was for small investors back then.

And looking at MRF today and talking about how great that investment would have been is the epitome of hindsight bias. What if you had invested the same one lac in reliance power? It would have been equal to one thousand. Yes that’s right. 99% of your capital would have been lost in ether. There are countless other stocks which were trading at 1600 once and now quote at 1.6 rs. Many have completely vanished altogether.

There were some logistical issues as well. Shares were issued in physical format, the settlement period was long, minimum margin requirement with the broker was high, etc.

Many can’t afford MRF today. At the CMP of almost 64000 rs, it remains the most expensive stock listed in the Indian markets. When it was listed, it traded at around 2000 rs. But remember in the year ’99, 2000 rs was more than what many people earned in a month.

We all revere Warren Buffet as one of the greatest investors of all time. One of his commandment clearly states that you should only invest within your circle of competence. Tech companies were out of his. Stock market was out of my parents’ and of many contemporary of theirs. So they did what they understood; LIC, PPF, real estate and gold. Is it the optimum portfolio allocation by modern portfolio constructions standards? Not by a mile. But at least they didn’t lose their sleep over what market did…

Disclaimer – The names of the companies are for illustration purposes only.