Always have a plan

ITC, the stock that has the butt end of jokes for almost a year now. Since December 2020, except for one occasion, the stock has been in a tight range of 20 odd rupees. Traders long in this stock were at their wits ends since the stock wouldn’t even hit their stop losses for them exit from it justifiably. Traders like me who don’t mind dabbling in options, have made decent money out of this sideways movement from what we call straddles and strangles.

But these strategies are naked. They can produce unlimited loss if not monitored properly. For a stock that was stuck in a range, rangebound strategies made sense. But what if it had broken the range?

A common way to deal with runaway options premiums for option sellers is to make adjustments. There are videos on YT of traders using up to 50 options to manage one sold call that had gone in the money. As dumb as it sounds, deep pocketed among us can do if they fell compelled to do so.

But what if we aren’t one of those? Simply taking an SL and accepting a loss is one. What if the option went so far in the money that it no longer has a reasonable liquidity? Should you bite the bullet exit at any point? Or may be hope for the market to reverse? What if there is literally zero liquidity? Then can you borrow money to somehow physically settle the contract?

There are numerous things that can go wrong in a trade. Best be prepared…

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 are the indices doing

crop ethnic trader using smartphone against laptop at home

The very first watchlist on my trading terminal is made up of major NSE indices. We directly trade only 3 of them directly, NF, BNF and FNF. Out of these, I have never traded FNF, and by looking at the option chain, the liquidity seems pretty low. NF has about 15 lac open contracts. By comparison, FNF has only 3000 for the current weekly expiry.

So let us look at Nifty:

After a mind blowing rally for a year, Nifty seems to be taking a breather. My charts say that the lowest nifty can go is about 13500. That is a roughly 10% correction from current levels. The trendline originating from the March lows of previous year was very steep so it was expected that NF will break below it at some point in time. But shorting the market in anticipation of a trendline breakdown would have proved to be much too costly throughout 2020.

It will be interesting to see which sectors will be leading this correction. RJ in his recent statement said that valuations of the metal stocks are too high for his comfort. I personally think banks can see a good correction. Market will likely be supported by IT stocks. One rationale of this can be found in USDINR chart.

If sectoral rotations take place, a lot of good stocks could be available at a reasonable valuation. The word reasonable might have to be redefined here. With more cash running behind same number of assets, prices of them are likely to rise. In stock market that converts in quality or in demand companies commanding higher and higher multiples.

In terms of trading ideas, I will consider writing hedged 15500 CEs if ATH is tested. I have a long portfolio which roughly equates in value to 50% of notional value of one lot of NF so it wont be all that risky. Though some of the companies have relatively small correlation to NF. Should the markets fall, I will go long in NIFTYBEES or enter into Bull Put Spreads at 13600 levels. I am extremely tempted to do iron condor for 14500-15500 range, but with VIX likely to spike, the NF might break that range, or if nothing else give fakeouts. And since NF is not near the middle of the range the iron condor will have a directional bias.

In BNF I will either wait for ATH of 2020 or the upward sloping trendline to be tested before going long. My go to strategy will be next month FUT long with call writing. If 30000 is tested again, my strategy will be to buy far month ITM call and sell current week OTM call. This will be cheaper than naked long and won’t require EOD cash settlement which comes with a FUT contract.

Markets are showing some signs of exhaustion. If we get a period of sideways movement, I will have a field day with options writing, but the volatility trend doesn’t seem to suggest that.

It will be wait and watch for me till the market picks a direction. What are your thoughts?

What is the ideal size?

person in black pants holding yellow ruler

Apparently professional traders are often asked about the minimum account size one must have to trade in futures. There’s a long answer and a short answer for this. You can find the short answer on twitter somewhere so I will walk you through the long one.

Lets say there are 10 stocks you trade very regularly. You have also done backtesting of your strategy to figure out the idea stop loss that is required.

StockLot SizeCMPStop Loss (%)Stop Loss (Rs)Stop Loss/lot
RELIANCE5051945358.3529,500
HDFC30021953.576.82523,000
HDFCBANK550140045630,800
TCS300270025416,200
INFY60011002.527.516,500
ONGC770080.5021.6112,400
ITC320019447.7624,832
HINDUNILIVR3002125242.512,750
BANKNIFTY252915051457.536,438
NIFTY75128352.5320.87524,066
I have rounded off some numbers for ease of calculations. Lot sizes change over time, so double check the sizes you use from NSE website before calculation.

Stock, Lot size ,and Current Market Price (CMP) are the data columns. Stop loss percentage comes from your backtesting. Then per share loss is simply multiplication of CMP and Stop Loss (%). For example, for RELIANCE, 1945*0.03 = 58.35/- rs per share. Since one lot of RELIANCE is made up of 505 shares. You will lose 505*58.35 = 29,500/- rs per lot.

So let’s look at the maximum loss by amount in the last column of the table. Thanks about 36,500 rs for Banknifty. We will use this for our risk calculations.

Now comes the next question. How much money as a percentage of your capital can you risk per trade? If your answer is 1%, then 35,000 should correspond to 1% of your capital. That comes to 36,50,000 or 36.5 Lakhs.

Let me illustrate why the textbook answer of “About 15-20L is enough to trade in futures” is harmful for your trading journey. Let us say you jump in with 15L to trade in futures. If you are still willing to risk only 1% per trade, you can only take a loss of up to 15,000/-. So if you spotted a trade in Banknifty, you would be forced to either take the trade with half of your normal stop loss or break your rules and take more risk per trade than you have initially decided. If you keep half of the normal stop loss, the accuracy may reduce. If you take more risk per trade then your account can drawdown more than you had anticipated.

In my personal opinion one should only use futures when one wants to take a short position in a scrip. If you want to go long, you can simply buy the stock. You get the freedom of position sizing. You can add more if you want, you can book your partial profits at first target, you get benefits of corporate actions while you are holding the stock, etc.

I know that indices, currencies and commodities are only traded in futures. But the same risk management principles apply there as well.

Take the same approach we Indians take while packing food for the trip. We usually pack enough for us, our co passengers, the conductor, the driver, the cute dog we see at the rest stop and some more for the return journey. Have enough margin in your account before getting into futures so that even if your every single trade goes wrong in the first month, you can still trade once the calendar turns.

Happy trading…

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.

Practicing targets

abstract accuracy accurate aim

If there’s one thing we see consistently across all self help books, it’s setting goals. They talk obsessively about setting goals and breaking them down into sub goals and sub sub goals and planning every hour of your day….

Some goals require that kind of dedication and hard work. But some goals require work with carefully selected targets. Much like a company sets sales targets for its employee to reach the goal of profitability, we need to set ourselves some targets to reach our goal of consistency in trading.

As I wrote previously in my blog post, we must focus on what we can control and hence the targets that we set ourselves must be aligned to the same philosophy.

Most traders set targets for profit, or return on capital. I realized I wasn’t walking the talk. Market doesn’t owe me my target. I can’t force the market to give me the returns I expect or want.

Target setting varies from system to system. An intraday trader can reasonable expect to take several trades in a week. For her it might be statistically correct to check the PnL at the end of the month. For a swing trader there could be months where she doesn’t close any traders and PnL will be zero. Or a month could force her to book 3 losses in that month while several trades end in good profit the next. In such cases, monthly PnL isn’t a right measure.

Setting unrealistic targets can mess with your psychology too. If it looks like you won’t meet your weekly target, which you shouldn’t have set to begin with, you might force the trades and give up any gains that you might have made so far.

Also if you have multiple streams of income, you can set a collective quarterly target across all. I would consider trading in Equities, currency and commodities as three separate streams since required fundamental understanding of markets is quiet different in all three.

So set the targets you can achieve realistically with the capital you have. Follow prudent risk management and work on a trading system that gives you consistent market beating risk adjusted returns.

Happy Trading…

P.S. – Due to some personal reasons I will not be able to publish a post for two weeks.

You dont know what you dont know

white beads on question mark sign

Let me start with example. There is a internet message board called reddit. Communities on it are call subreddits. Among thousands of communities on gaming, cooking, landscaping and other activities, there is one for traders. And I use that word very loosely here. It is called WallStreetBets. Started as a genuine community for traders to share their research, it slowly evolved into a degenerate cacophony of gamblers trying to use derivatives market in america to place all-or-nothing type of bets. One such user was called 1r0nyman. He did some research and found out that there is an options strategy called Box Spread.

Here’s how a box spread works. You enter a bull call spread and enter a bear put spread in such a way that the bought call and sold put are of the same strike price and the bought put and the sold call are at the same strike price. In short, you enter into a long synthetic future at one strike price and enter into a short synthetic future into another. Here’s an example:

You can see in the payoff diagram that no matter where the Nifty moves the profit will be 203. Such strategies are called arbitrage strategies where traders try take advantage of market inefficiencies. But for retail traders the profit is not even enough to cover the cost of the trade. If you trade with a discount broker like Zerodha, you are charged 20 rs per order. Then it could only be economical if you could enter into at least 10 such spreads at a time so make something post charges. Also for 10 spreads you will need about 4 lac of margin. That makes roughly 2000 rs return a half a percent return for the trouble. There are some other problems as well. If you do not enter at the exact prices the arbitrage will not exist. Nifty lot size is 75, which means if you miss entries by as little 2.6 rs there wont be any arbitrage. Only large institutions and HFTs do this since this strategy is only efficient when done with automated systems.

Our trader buddy 1r0nyman had only seen the payoff diagrams. He figured that options on the SPY ETF which is comparable to our NIFTYBEES would work for this trade. He did the calculations and proclaimed that this trade literally can’t go t*ts up because money at risk is zero. Now here’s the catch. In India we trade in European style of options. That’s what the E in CE and PE stands for. European style of options can not be exercised before expiry. There is another flavor of options though called American options. These options can be exercised any time the buyer of options feels like. Now since we are short two options, one call and one put, one of them will always be in the money. Meaning there will always be the risk of one of those two options being exercised and us being forced to either give delivery of or take delivery of the underlying. Box spread is only profitable if held till expiry. But as soon as 1r0nyman entered into his trade, which was several times his account, people started exercising the options. He lost about $60,000 on an account of just $5,000. His broker realized what had happened and immediately closed 1r0nyman’s account. But sometime between getting into the trade and broker force closing the account, 1r0nyman had taken $12,000 worth of profit out from trading account into his bank account. So though his account showed a loss of $60,000, 1r0nyman made over 100% profit before closure. The loss was borne by his broker since 1r0nyman wasn’t supposed to be able to take that much leverage in the first place. Since then that broker has banned box spreads from their platform.

So what’s the lesson here? 1r0nyman didn’t know how bad his trade can go. But what is worse is his broker didn’t know about such catastrophic strategies. That is why it is important to remember that you will not know what you don’t know until the time something like this happens.

In India MCX didn’t know what happens when price of Crude is forced below zero in the international market. On MCX all futures contracts are physically settled. So if you hold a long contract of futures of Crude, you will have to take delivery of 100 barrels of oil. If you hold a long contract of Gold you will have to take delivery of 1 Kg of gold. Yes you read the units right.

Futures contracts on NSE are cash settled on a day to day basis. If you had 10L margin but zero cash in your account, you could enter into a future long in Nifty. About 1.3L of margin will be blocked. Let’s say unfortunately Nifty closes 100 points down and your account shows an MTM loss of 7500 rupees. At the end of the day exchange expects you to pay that 7500 loss in cash. Margin will not work there. So despite having over 8L of margin in your account your broker will raise a margin call against your account. You didn’t know that you don’t know about cash settlement. But you will have to come up with that money somehow.

‘I didn’t know’ excuse doesn’t work in stock market. As a market participant you are expected to do your own due diligence.

So be aware, be prepared, and happy trading.

Monthly Options portfolio October 2020

I did make a simulated options portfolio for October as well. I focused a lot more on some experimental strategies this month as compared to simple delta strategies of September. Also I apologize for not making a sheet as promised for ease of tracking of the positions instead of such screenshots. Hopefully I will get some time this series to make it. This is directly the update post like the last month. Since not all of this portfolio was built at a time, there was no point in writing a ‘Start of the month’ article. Also this time it is difficult to gauge maximum profit on portfolio since some of the strategies did not have a fixed maximum reward. So let’s get into it.

BIG DISCLAIMER - I may not have position in the strategies I post here due to margin reasons. Derivatives are the most risky instruments available to retail traders. Please do your own studies before taking any trades in the stock market. I will not be responsible for outcomes of these trades. I do not own any charts or data I share here. Everything is for educational purposes only. I assume you agree to the disclaimer if you continue reading this article. 

Banknifty Double calendar spread

So what is a double calendar spread? In short, you buy options in far expiry, 26th NOV in this case, and sell options in current expiry. Unique feature of this strategy is that you get positive theta, and positive vega. Meaning, you gain from theta decay AND you gain from rise in volatility. I think this strategy deserves a post of its own. So I will discuss the details separately.


Maruti Bull Put spread

This was a relatively simple strategy. Maruti has a good support around 7000. So when the stock came around that level, I initiated this spread. Since this strategy was initiated just a week before the expiry and 200 points out of the money, the premium was very low. But that also meant that theta decay would be rapid. For about 30 thousand rupees of margin, and about 6-7 days of holding period, this was a decent trade.


Wipro Bull Call Spread

This was one of trades that went horribly wrong both in this portfolio as well as my real money trading account. Results of Wipro were declared after market. A potential buyback was announced at 400rs. So without studying other numbers thoroughly, I took a bullish position in Wipro. Not only did it open gap down, it ended the series about 10 percent down from the results day. I did try to reduce the loss a little by booking profit in 370 CE and selling 360 CE making it into a Bear call spread.


Reliance call condor

This was another one of those experimental strategies I tried out this month. I did the same strategy in Cipla in my real account. I had initiated this strategy at the beginning of the month hoping that 2200 is the lowest RIL would go. It went much lower than that. Just like double calendars, call condors have some unique properties. I will write about it in a separate article. One thing I would like to point out that I booked out on 23rd of October when reliance was at 2100. Despite that the loss I incurred in this strategy was negligible. No it is not a bug or a manipulation, that is a feature of call condors.


Infosys call condor

This was a results day trade. Results trades are designed to take advantage of volatility crash after the results are announced. Traditional results trades are designed around short straddle strategy. I decided to give it a try with a call condor. About a week before expiry I decided to cover 1200 CE short call and short 1150 CE since it didn’t look like IT pack was in the mood to give a rally. This was one of the good trade, not just because of the profit but because the system worked.


Coal India bear call spread

Coal India looked very bearish after breaking and retesting 120. I initiated a bear call spread since I didn’t expect a further sharp down move neither did I expect Coal India to reclaim 120 levels. Those with a keen eye would recognize this trade as similar to the one taken in Eicher motors in the previous month. Entry was decent. But looking back at it, I do not remember why I exited out of this trade. The trade would have ended at maximum profit had I held on to it. This trade was worse than Wipro because I broke my system though the loss is smaller than that in Wipro.


Reliance box spread

Box spread is an arbitrage strategy. You enter into a vertical call spread and a vertical put spread or vice versa. Either one of the call spread or put spread will be a credit spread and the other will be the debit spread. Since the strike prices are same, the difference between credit and debit will be your profit. And theoretically, no matter what happens to the stock your profit will remain constant at expiry. I just wanted to check MTM fluctuation in this strategy. This is another one of those things about trading that looks easy but isn’t. I will write about this separately too.

In total the portfolio made about 17 thousand profit. Applying our deductions of about a thousand rupees per strategy, we still made about 10 thousand rupees on this. Though in this portfolio the capital used would be a lot less than previous month, we would still consider 10L as our investment. That makes the ROI for this month at 1%. This is significantly less than last month’s returns. It is also less than Nifty returns for the month which are around 3%. But we must keep in mind that after continuous reduction for 6 months since April, India VIX rose by almost 27%. That is a crazy increase in volatility. So despite the rise in volatility we managed to make some profit. That is what portfolio approach is all about.

Happy Trading.

P.S. – I had said in my previous monthly portfolio update article that I will post my trades on twitter. But it turned out to be a lot more tedious task than I thought it would be. So I don’t think I will be live tweeting all of my trades from now on. I may post some of the trades some of the times.

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.