If you trade derivatives on the NSE, you will be familiar with the concept of permitted lot size. This week, we discuss permitted lot size in relation to scalping trades.

Contract multiplier

Scalping trades refers to trades that are set up to take advantage of small price changes in the underlying. To scalp, a trader engages in several trades during the day and/or scales the quantity for each trade. The latter is important for our discussion. In the spot (cash) market, you can scale your trading quantity by buying (or shorting) more shares. In the F&O segment, you can be tempted to choose contracts that have larger permitted lot size.

A permitted lot size of any futures and options contract is fixed in such a way that the value of the contract is not less than five lakh at the time the contract is introduced on the NSE. Suppose a stock closes at 500 on Thursday and NSE introduces futures and options on the stock for the first time on Friday. Then, the permitted lot size could be 1000 (5 lakh divided by 500).

The permitted lot size indicates the number of shares that you are obligated to buy if you hold long futures position till contract expiry. Or the number of the shares you are obligated to deliver if you have short futures position till expiry. It could also mean the number of shares you must buy or deliver if you are exercising in-the-money (ITM) calls or puts at expiry. Finally, it refers to the number of shares you are obligated to buy or sell if you are short an ITM put or call.

But what if you do not hold your position till expiry? As most derivatives traders, you might just as well decide to close your position before expiry. In such cases, the permitted lot size acts as a contract multiplier. Suppose you bought a call option for 50 points and the price rises to 75 points as the underlying moves up. If the permitted lot size of the contract is 1000, your profit will be 25,000 (1000 times 25 points) less transaction costs. Of course, if the position suffers loses, the contract multiplier will magnify the amount. This argument is especially important for futures as they have symmetrical payoffs.

You may be tempted to set up scalping trades on derivatives with higher contract multiplier to capture decent profit. For instance, setting up trades on Indian Hotels and LIC Housing Finance, which have a contract multiplier of 4022 and 2000 respectively. The issue is that options on these stocks are not actively traded. So, it is moot if you can close your long positions quickly at an appropriate price.

If you have just started trading derivatives, then it is optimal to focus on the Nifty Index and the Bank Nifty. If you are comfortable trading equity options, then price breakouts on the underlying for long positions or sideways movement in the underlying for short option positions must be the primary reason to set up trades, not large contract multipliers.

Mind it
Avoid the temptation to set up scalping trades on derivatives with higher contract multiplier to capture decent profit
Optional reading

The permitted lot size is revised when the underlying price changes significantly from the time the lot size is fixed. For instance, NSE revised the permitted lot size on the Nifty Index from 75 to 50 last July.

You must be careful not to set up calendar spreads till the time all contracts change to the revised permitted lot size. For instance, the June 2021 Nifty contract had a permitted lot size of 75 and the July 2021 contract had 50. So, long July and short June options strategy would have exposed you to positional risk.

Note that choosing contracts with large, permitted lot size would require larger outlay when you are setting up delta-neutral trades, say, going long on the underlying and shorting the ATM call.

The author offers training programmes for individuals to manage their personal investments