The law of instruments…

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.