The NSE website proudly states that it is the largest derivatives exchange in the world for the fifth consecutive year based on the number of contracts traded. And yet many retail traders prefer to trade in the spot market, not in the derivatives market. This week, we discuss the primary concern of such traders as well as the benefits of trading futures.

Size effect

A cause for concern for retail traders is the size of capital required to trade derivatives. For instance, you need 1.39 lakh to go long on one contract of HDFC Bank. This is because each contract has a permitted lot size of 550 shares. The point is that you do not have to buy 550 shares in the spot market. So, your trading capital is lower. Of course, if you were to compare equivalent positions, then futures requires less trading capital than buying the shares of the underlying. For instance, you need 7.93 lakh to buy 550 shares of HDFC Bank! But as one retail trader noted, it may be, perhaps, better if the permitted lot size were lower in the derivatives market.

True, options require lower trading capital. This is the primary factor that drives many retail traders to dabble in options as their initiation to the derivatives market. Understandable, but risky. The factor that makes options trading difficult is time decay or theta. Simply put, gains from futures will not be significantly different whether your price target is achieved the day after you initiate a long position or at the expiry of the contract, when futures price converges with the spot price. That is not the case with options. The sooner the target is achieved, the greater the gains from options. In some cases, you may even suffer losses on your options position despite the underlying hitting your price target!

Note that the large capital requirement required for futures has two components — the initial margin and the mark-to-market margin. Notwithstanding this, there are some benefits of trading futures.  Trading futures is not very different from trading the underlying. Think of futures as trading the underlying on margins. This provides the leverage to boost your gains. Take HDFC Bank. The gains you can make on one futures contract is almost the same as the gains you make on 550 shares of the stock, but with about 20 per cent of the capital!

Trading futures
Think of futures as trading the underlying on margins; this provides the leverage to boost your gains
Optional reading

The permitted lot size acts as a contract multiplier during the life of a derivatives contract. That is, each one point move in the futures price is magnified by the permitted lot size. This boosts your gains if the underlying moves up but magnifies loses if the underlying declines. So, trading discipline becomes important; you need to trade futures with strict stop loss. Options could prove deceptive if you believe that the maximum loss is only the option premium; for, options expire worthless more often then they expire in-the-money.

The author offers training programmes for individuals for managing their personal investments