Do you remember the first time you got on to a cycle? Your parents fitted the bike with side wheels so that you don’t fall. They also equipped you with a helmet and safety pads to avoid any injuries. Similarly, every time you start a new venture, it is best to know the precautions you should take in the currency derivatives segment in order to avoid making mistakes. This principle applies to the derivatives market too. Here are a few precautions you need to keep in mind when you deal in a derivatives segment.
1) Options before futures
In a futures contract of a derivative segment, you are obliged to follow through with a trade on a designated date and a specific price. For example, you may enter a futures contract to buy 100 shares of stock X at Rs 50 per share after three months. If the price of the share goes beyond Rs 50, you stand to benefit but if it lingers below Rs 50, you would be making a loss.
But in an options contract, you can cancel the contract. In other words, you have the right to buy the stock but not the obligation. Your risk is limited to the amount of money you pay to buy the option. That’s why, if you are a novice investor, it may be better to start with options before moving on to futures trading.
2) Avoid illiquid options
In the derivatives segment in stock market, liquidity means that there are active buyers and sellers of a stock at all times. Generally, individual stocks are more liquid than options. This is because traders buy and sell the same stock in the market. But in case of options, there are multiple contracts available in a derivatives segment. You can choose different options with different time limits and strike prices. As a result, a few options can be illiquid as well because there may be little to no trading going on.
When this happens, the spread between the bid price (how much an investor is ready to pay) and the ask price (how much an investor is ready to sell for) can be huge. When you choose an illiquid option, you may either get an unfavourable price when closing a position or may have to hold the option all the way until it expires.
3) Don’t trade without knowing the associated risks
A number of factors can affect your position in the derivatives segment in market when you undertake a future or an option contract. International price movements, macro-economic factors, changes in government policies and market volatility are some of the factors that could impact price movements. Be aware of all these associated risks before you trade any contract in the market.
4) Avoid market rumours
It is very important to take a calculated and informed decision when it comes to trading in the derivatives segment in share market. The internet is full of rumours and unsolicited tips regarding the best contracts that can help you make money. Don’t pay heed to these tips. Conduct your own research and find out the best transactions that fit into your overall investment plan.
5) Use your call options wisely
A call option offers the buyer the right to purchase a stock at a pre-determined price (also known as strike price). However, a big risk of using options is selling shares of a stock if you don’t already own it. This is known as a short call. This means you are selling a call option and you have to buy the stock at a fixed price in the future. This can pose a big problem if the stock price goes beyond the strike price. You would be forced to buy the shares at a market price that is much higher than the strike price; thus resulting in a loss. It is best to avoid short call until you gain experience in the derivatives market.
To sum up
The derivatives field is large and full of potential. There are a lot of different ways you can make money in this field. However, if you are a beginner, it is important to be cautious when you invest through derivatives. The above list highlights some of the precautions you can take in order to invest successfully in futures and options.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.