Possible ways of losing money in stock markets – 5

Overview:

Everyone wants to get rich quickly, especially, when it comes to investing and trading in stock markets. People often forget that there is no free lunch, and we can’t get rich gambling in stock markets as if these are counterparts of casinos. I have been investing since 2017 and trading since 2019. Although it has been an informative and smooth journey in investing, trading has been a different story.

Under normal market conditions, trading stocks was easy. But, after the Covid stock market crash, trading stocks has become very strenuous. New traders entering the markets in large numbers and increased volume in trading have certainly helped institutional investors. Since April, finding the support and resistance levels for most of the stocks has been a nightmare. Many new traders are trying their luck in the options since they require less capital and generate more profits.

“Trading Options and Futures without prior knowledge” is the next topic in our series of “Possible ways of losing money in Stock Markets”. I have discussed the first five methods where new retail investors and traders lose money in my previous articles. You can find the links at the end of this article.

1. Following Fake gurus on social media
2. Trading Penny Stocks
3. Falling prey to Value Traps
4. Purchasing high premium stocks
5. Intraday trading with Margin money
6. Trading Options and Futures without prior knowledge
7. Investing in stocks that you don’t understand
8. Taking short term positions against the market move

Trading Options and Futures without prior knowledge:

Options and Futures come under the category of derivatives. Basically, a derivative is a contract that gets its value based on the performance of an underlying asset. Derivatives are like betting against the price of the underlying assets in the upcoming future. There is a clear difference between Options and Futures, the most widely traded derivatives in stock markets.

A Futures contract is an agreement for buying and selling of a particular security or commodity in the future for a specified price. Every contract has an expiry date. I will share an example to make it more understandable.

Suppose you are interested in buying ITC shares. Today, ITC’s share closed around ₹185. A single futures lot of ITC consists of 3200 shares. September futures of ITC closed at ₹185.7; which means the gross value is ₹594,240. In NSE, futures contracts’ total value of any share or index varies between ₹500,000 and ₹1,000,000. Reliance shares futures contract exceeds this limit; it might be adjusted accordingly later.

A new investor or trader would ask himself what’s the point of buying the ITC futures contract for ₹185.7 while the share itself is trading at ₹185. No one likes to pay an extra premium for the same item just because it is trading in a different segment. The best reason for doing so is Margin benefit. We have calculated that the gross value of the ITC futures contract is ₹594,240. But there is no need to pay the full amount for buying that contract. The total margin required for buying is only ₹131,166. The investor gets to buy the futures contract paying only 22% of the gross value. Nevertheless, we should have the total amount on the expiry date (24th September) if we want to take delivery of the shares.

Everything seems so good, what’s the problem trading the futures contracts? Well, I will point out a few:

Let us take the same example of the ITC futures contract. A novice investor or trader has bought the ITC futures contract for ₹185 today; he or she pays the margin required, i.e. ₹131,166. If everything goes well and ITC shares rise to ₹190 on the expiry date, the investor makes ₹5 on each share. Total profit of 5 x 3200 = ₹16000. If the investor had to make the same profit in the cash segment, he or she should have spent ₹594,240 for purchasing 3200 shares.

If the exact opposite happens and the share price drops to ₹180 by the expiry date, the incurred loss would also be the same, i.e. ₹16,000. In case, the share falls to ₹170, the loss would be alarming ₹48,000. Suppose a trader with a capital of ₹150,000 had taken the trade and the share price dropped to ₹170, 32% of the portfolio would be wiped off in a single trade.

The future contract also has a margin adjustment at the end of every day. Trader or Investor should possess the required amount in the account to square the MTM losses every day in case the share price is moving in a negative direction. Usually, the amount would be in multiples of thousands or even more depending on the price movement of the share.

Shorting Futures:

For example, let’s take Reliance share. It closed at ₹2320 today, gaining 7.3% since yesterday’s close. If you expect that reliance may fall by 4% to 5% in the upcoming trading sessions, you can short Reliance futures or call options. Buying put options also come under shorting, but it does not require margin. Most of the brokers provide margin benefits to selling options and futures combined with hedging options at other strike prices.

For shorting Reliance Futures, you need ₹308,268 as of 10/09/20. Both options and futures are to expire on the 24th of this month. Reliance futures and options have 505 shares in a lot.

Suppose you have shorted Reliance Futures at ₹2330. If the Reliance falls to ₹2230 by the expiry; you will get ₹100 per share, which means 100 x 505 = ₹50500. If the converse happens and share rises to ₹2430, the loss will be ₹50500. It the share rises to ₹3030, the loss incurred would be 700 x 505 = ₹353,500. To make it simple for you, shorting futures is the dumbest thing to do if you are a small retail trader with ₹100,000 to ₹200,000 as trading capital.

Even if you set stop-loss to ₹2350, the loss will be 50 x 505 = ₹25250. I seriously doubt any retail trader with small capital would risk that much. There is a very good chance of share price hitting stop-loss and revert back and falling to ₹2250 levels. This is the case where you have predicted the move correctly but setting a stop-loss, which is for safety, has worked in a negative way.

So buying and selling futures is risky for traders. Who will benefit from trading futures, then?

The answer is simple. Someone with ₹5,000,000 capital or more in their account, they are High Net Worth Individuals. Institutional investors deal in thousands of million rupees. For these giants, a loss of ₹50,000 would not be big enough. Anyhow, they hedge the positions buying alternatives like options or taking the delivery of the shares.

So if we get back to ITC futures. You have bought the futures contract for ₹185.7; if the share price falls to ₹180, it should not be of concern if you are willing to take the delivery of the shares on the expiry date. But for that, you should have ₹594,240 in your account including the premium of ₹131,166 paid as margin.

It is simple to understand, if you are only speculating on the price of a share or index, do not buy or sell futures contracts. Options are much better for speculative purposes since there are also many strategies for hedging like call and put spreads, butterfly, condors, etc. Does it mean trading in Options is risk averse and easy? No, Not at all! Let’s discuss that in the next article.

Here’s the link to Opstra Options Analysis, one-stop website for Futures and Options Strategies.

Previous Articles:

1. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 1
2. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 2
3. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 3
4. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 4

Disclaimer:

I provide the information and my views on the website only to educate new investors, stock market enthusiasts, and the common public on equity or stock market investments. Please consult your financial adviser before making any investments in the stock market. In case of any queries, you can contact me via email ID: shivakumar.lachapeta@valueinvesting.online