How not to blow up your capital with trading

For every rag to riches story there are hundreds of people who tried but failed. And that is true for any profession. So how could trading be any different? People need to believe that trading is a profession and it needs to be treated like one. Those who don’t consider trading as a business are gambling. In this article, I will talk about the common mistakes in trading (specially futures and options) which one needs to avoid to not end up blowing their trading capital.

F&O a leveraged product

Most people who come to trade F&O at the start don’t appreciate that F&O are a leveraged product. Say you are bullish on Reliance Industries and buy 100 shares at ₹2,500 a piece. That means you have to pay ₹2.5 lakh for it upfront. The risk in this trade is if the stock drops to zero tomorrow, you tend to lose ₹2.5 lakh which is your initial investment and no more.

However, instead of buying shares, you trade in F&O and you buy 1 lot in futures. Lot size of Reliance Industries is 250. So, essentially you have bought 250 shares of Reliance at ₹2,500 which means your exposure in Reliance is ₹2,500*250 or ₹6.25 lakh and the margin required for this is just ₹1.5 lakh. So, here you have taken an exposure worth ₹6.25 lakh with a capital ₹1.5 lakh and that means a leverage of about 4 times. For budding traders, leverage is one important concept they cannot afford to miss for trading F&O.

Option buying vs selling

“Kharidne wale ki jeb khaali aur bechne wale ki tijori khaali” said Rakesh Jhunjhunwala about trading options. Those who try to make money from buying options will lose money slowly and those who sell options will although make small profits but would give away everything one day. Both require different sets of expertise, have different margin requirements and risk reward i.e., option buying requires less margin and has potentially unlimited profit with less at risk and option selling requires huge margin with limited profit potential and unlimited risk if not hedged.

Most newbies think that option buying is easy but in reality, it requires a good understanding of option greeks and you need to have three things in your favour - direction, volatility and time. You might be right on direction but still not make money if you do not understand the volatility and time aspect of options. In option selling though, you can generate consistent small returns but if you are not properly hedged or have messed up your position sizing, it is not difficult to lose a large chunk of your capital one fine day.

Trading without any system

The first thing required for profitable trading is to have a proven system. I am not debating about being systematic or discretionary. You could be anyone but having defined trading rules is an absolute must.

For a systematic trader, make sure you have back tested your system and trade only if you have positive expectancy. For a discretionary trader, go through all of your trades in the past and identify the biggest losers. Imagine being in the same situation of taking big hits one after another and will you be able to trade despite those losses? Having a proven system and developing a conviction on the same system is needed to trade profitably.

Setting right expectations

Just like with anything else, setting the right expectation in trading will help you in the long run. Only one out of thousands are able to make big in trading. Social media these days has a big role to play in making trading look like a cakewalk. While on the contrary it is the exact opposite. A lot of people flaunt big Mark-To-Market (MTM) screenshots that suggest making lakhs and crores from trading is easy. Do not get mesmerized by what you see on social media as everyone makes insane returns. Going for higher reward naturally means taking higher risk - ask yourself are you prepared for that?

Right position sizing

It does not matter what trading style you adopt; position sizing is important for all of them. When you trade in F&O, it is important to understand that they are a leveraged product, and one should always look at notional exposure before taking a position. Notional exposure = Value of underlying times the contract size, so for Reliance Industries trading at ₹2,500 and a lot size of 250, notional exposure becomes ₹2,500* 250 or ₹6.25 lakh. It is important to understand risk in any given trade based on notional exposure before taking one.

There are many position sizing techniques used in trading - fixed monetary risk, fixed percent risk, leverage based, etc. which you can read about and go with one that suits you.

The author is a derivatives market expert

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