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.

Time is small

brass pocket watches

So I recently accepted a job. Hence the extended absence from the blog. Pretty much whole of the first month went into complaining how hectic this job was, and how I had practically no time to do anything else. Then one day I had to travel with my manager from one site to another. Being coordinator of a large region, he was almost constantly on the phone. Interesting part was that pretty much every single minute he wasn’t on an office call or replying to a work mail, he was on a video call with his daughters. I don’t think he ever got to talk to them for 10 minutes continuously. But a two or three such opportunities during a three hour journey would be enough to refresh his mind.

And then it struck me. If instead of thinking of this journey as one chunk of time of 2 hours, if I thought of it as 24 slots of 5 minutes each, I suddenly seem to have a lot of time. Here are some of the things I could do in one or two slots each:

  1. Check several charts for positional trades.
  2. Read an interesting blog post.
  3. Watch a relaxing video on YT.
  4. Think about a blog post (!)
  5. Write a blog post.
  6. Study a small topic for CFA.

The list will grow as I remember more and more things that I am supposed to do. And granted, not everything can be achieved this way. Playing an instrument comes to mind as an example. But there are other times when we have such slots but we barely utilize them since we do not think of our time at that granular level. Once you train your mind to notice such slots, you will see them everywhere.

And I understand that there is no replacement for long periods of focused work, but when your day ends at 9 in the evening and all you want to do is crash on the bed and submit yourself to sleep, you will have to get your other activities done this way.

Swing trading in particular is for suitable for people like me who have very little time to monitor the positions. All I can do is see the charts once in a while and find out the supports or demand zones. Then simply putting GTT orders at suitable prices would get the job done.

Trading options this way is possible too. But hedging will be the order of the day and one would have to be ready to accept max loss since you may not be able to adjust the position in time if the market moves against you. I recommend sticking to index options only since those are more liquid than the stock options and can be safely exited on a market order. Index options are cash settled as well so positions will be automatically settled upon expiry. Not the case with stock options which will be physically settled. Read You dont know what you dont know for more such things to look after while trading.

Practically everything in life can be gained again except time. So why while it away? Use it as much as you can…

The face down card on social media

playing game card

Have you ever sat through an Multi-level-marketing / pyramid scheme pitch? The person trying to get you on board spends a lot of time on convincing you how this is the best ‘business’ decision of your life. They show you charts and figures of how with a little work you can make 5% per month and when you upgrade to the pro-elite membership you will make about 15% and the people you bring on will make money for you and so on. They make it sound like a business better than selling tea outside a government office. Their motivation is simple; to get you on board and get the commission.

Many insurance and mutual fund distributors specifically push the schemes which pay them highest commissions rather than the one that is best suited for their clients. A car mechanic ‘finds’ several ‘critical’ problems in your car while doing ‘regular’ maintenance. An optician convinces you of how in this age of work from home you need lenses which cost 10 times the regular ones to ‘protect your eyes’. Stock brokers ‘train’ their clients to use leverage and trade in intraday and FnO.

Each of these ‘experts’ put their interest in front of their clients’. It is a good idea to have your car regularly serviced, but most of the parts don’t need very frequent replacing. While you can make good money taking leverage and trading FnO, brokers push it for much higher commissions they get on those products.

Certain ‘star’ traders on social media often claim their strategies as ‘best’ and sometimes the ‘only’ way to make money in the stock markets. You will find that they have their advisory or training link somewhere in their profile. Their primary goal in many cases will be to convince you that to be successful you will have to join their advisory service or take their training.

I will admit that there are some legit trainers out there who can really give you an insight into trading systems. But there are many more who make significantly more money from teaching other people than trading themselves. So every time you see a trader claiming how his is the only system that works in the market, try to figure out his/her motivations. When they show you one card, ask what’s under the card that is face down.

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.

Why context is important

Any piece of information on its own has little significance. If I tell you that in a football match Brazil scored a goal. Would one celebrate upon seeing this? Well, most likely, yes. But let me add some details, or context to this. This goal was scored at 90th minute. The date was 8th July 2014. Football fans already know what I am talking about. Brazil had conceded 7 goals prior to this in what was supposed to be their home turf. It was the semi-final of the FIFA world cup 2014.

What seemed like a simple piece of information was actually the worst nightmare for Brazilians in decades.

Now lets look at another incident that happened a few days ago. A drug manufacturer released a medicine to treat mild to moderate cases of COVID-19. A friend of mine asked me if it was a good idea to invest in that stock since such news often causes the stocks to rally. I asked him to wait out the initial euphoria. Why did I say that?

The piece of news on its own was good. Once again, lets try to add context to this information. This was not the first time a pharma company had claimed to have a drug for COVID-19. In most cases the drug was found to be either not as effective, or working on only select cases, or in a rare case or two completely useless or even harmful. A normal cycle for developing a drug on an average takes somewhere around a decade. All these drugs had gone from conception to release in under a year.

Now before we go any further, let me admit that I am no expert in pharmaceuticals. But after adding the context, what the stock of that pharma company did makes more sense. The horizontal line separating red and the green was when the news of the drug came out. The stock rose about 20% within the day. (30% if you measure from the previous day’s close). Since then, it has given up all the gains. Market, it seems, added context to the information.

Now am I claiming that this stock has no potential for growth? No. I haven’t analyzed the stock from an investment perspective, and hence will not comment on it. But from a swing trading perspective, I did not want to enter into a trade where I had seen similar trades going south very quickly for retailers once the euphoria subsided. Because more often than not, retailers buy near the very top and then are stuck with a scrip which was overbought in the first place.

I am no expert in trading. I would go so far as to admit that while writing this article, I have no significant profit from trading to show for. But over the past two years that I have been watching markets, I have learnt a whole list of things to avoid while trading. And trading on news was one of them. It is not that simple.

There are no free lunches, as they say…

P.S. – Curious ones of you can check the charts of TATASTEEL today. The company reported a loss yesterday but the stock is up today.