Source: Finkarma
In my early days of trading I used to visit my broker’s office. I noticed that there has always been a shift in trader’s batch after every few months. I never saw some old faces. They were always replaced by new faces after some time. Now the question is, why this happened? Had they made enough money that they stopped trading? No. Had they started online trading? I don’t think so because it was not so popular back then. The correct answer is that most of them lost their entire capital (or a major portion of it) in their brief acquaintance with the markets. I bet online trading these days has made this introduction even more brief for the new traders.
But Why Do Traders Lose Their Entire Capital in The First Few Months of Trading?
Majority of the traders jump into the stock market for making huge money, and that too in a short duration of time. Most of them come with small capital, may be a few thousands. They further divide this capital in small chunks before adding into their trading account. They are never able to withdraw this capital because they always sit on losses. Their desire to make huge money attracts them towards the more slippery floors of the market. Unfortunately, their situation is not like that of a honey bee who is attracted towards flowers for her food rather it’s like a moth who loves the fire so much that he is finally killed by it.
Options Are Lucrative but Destructive
Options are the most attractive derivative instruments for new traders. One of the reasons for this attraction is the minimal cost. The cost of buying options is a just-fit for them, not only for day trading but also for carrying them overnight. With little knowledge at hands, traders are defeated by the Greek God’s trickery sooner than later. The trickery leaves them no option but to kill their trades in loss. Most new traders are not familiar with the smoky ‘Theta’ which blows away a huge part of an option buyer’s capital. As the new traders are unfamiliar with the fact that options are the hedger’s edge over the retail traders, they keep on losing on behest of their false hopes. Theta is a silent killer, let’s understand with the help of a hypothetical example.
Suppose Reliance is trading at 2450 and our new option buyer Mr. X buys an out of the money 2500 strike call option (CE) at Rs.40, on a good news, just three days before expiry. The stock moves down to 2400 and now the CE is at 25. The next day Reliance opens above 2450 but CE price is 35 only. Mr. X decides to hold because he does not want to exit in loss. He thinks that the stock has come back to its level, so the CE is bound to go up. Reliance grinds for the whole day between 2430 and 2450 but the CE at the end of the day is at 31. Now Mr. X is anxious. He could not understand what just happened. He has been told by the broker and the youtubers that as the stock price goes up, CE price also goes up with it. But it is not happening in this case.
Options expire on the last Thursday of each month. Index weekly options do expire every Thursday. The option’s value deteriorates as it approaches the expiry date. A basic generalization would be that if on expiry, the stock closes below the call option’s strike price then the option expires worthless, that is its value becomes zero. But if the stock trends up and close above the call option’s strike price then the option will have some intrinsic value in it, so it won’t expire worthless.
Next day, on expiry, Reliance opens with a gap down below 2400 and the 2500 CE is trading at Rs.10. In the late afternoon, Reliance gets back to 2460 but 2500CE is at 20. By 3 O’clock Reliance is at 2465 but the 2500 CE is at Rs.1. Mr. X is left with no option but to close his positions in a loss of Rs.10,000 at the end of day.
I leave it up to you to think about the hedger who sold Mr. X the 2500CE@40. How much money do you think he made?
Futures Are Not for The Beginners
The next instrument that comes in the queue is the futures segment. This instrument also expires on the last Thursday of every month but there is no ‘Theta’ burn in this case. Then what is the risk involved in this segment? The risk is in its fixed position size. There is a fixed lot size that the trader has to buy or sell if he wants to trade in an equity/index future. For example, A traders has to buy/sell 1 full lot which has 250 shares, if he wants to trade Reliance future. The risk involved in such a trade is that if Reliance drops by Rs.20, you will have a loss of 250 X 20 = 5,000. Of course, the profit will also be multiplied by 250 if the stock goes up.
The advantage is that the trader does not have to pay the entire amount to trade futures. He just has to pay a margin. For example, If Reliance is trading at 2450, then to add 1 lot of 250 shares, the normal margin requirement would be approx. Rs.1,37,000. Various websites provide calculators to find out the margin requirements.
But not all traders can afford to trade in futures because many of them do not have sufficient margin in their trading account. They like to keep a small portion of their capital in their trading account. Less capital means you have less margin. This is also one of the reasons that they got attracted towards index/equity option buying.
Trade Equity and Stay in The Game
The third segment that comes in the list is the equity or cash segment. As the name suggests, you need cash to buy. You can not buy more than what you have in your pocket. In intraday trading yes, you can have the advantage of some leverage but to carry an equity position, you need to have an equal amount of money in your trading account. There is no expiry associated with this segment. Also, there is no theta decay. The trader can keep his position for as many years as he likes.
Let us say Mr. Y buys 50 shares of Reliance at 2450. The stock goes down and Mr. Y has enough capital to hold these shares. He takes delivery of these shares in his demat account and keeps it. Reliance goes down to 2300 but Mr. Y is not much worried as he knows he is carrying a good company’s shares. After three months Reliance gets back to 2800. Mr. Y sells his shares in profit.
In this way, trading or investing in equity is safer, for new traders, compared to F&O. Its just that they need to trade in blue-chip (fundamentally sound) companies. Even if the stock goes down there are chances that after some duration, the stock will recover and the trader will not lose his capital. But yes, his capital will be stuck in that stock for some time.
The second advantage is that unlike futures and options, the trader does not have to buy a fixed quantity or lot. One can even buy 1 share if he wants to. This allows for scaling-in and scaling-out of a trade, which makes trade management easier for a retail trader.
Although equity is the best option for any new trader in the market yet the ‘get-rich-quick’ policy may hurt him. The traders indulge themselves into small cap or penny stocks. They will buy a cheap stock trading at say Rs.5 so that they can buy more number of shares. More shares mean more profits if the stock goes higher. But unfortunately, such a negligent investment may keep the trader’s capital stuck for a very long period of time. Some small cap companies also get delisted from the exchange. In such a case, the trader loses his entire capital. If a trader wants to invest in a small cap company, it should be well researched by a knowledgeable person. To become knowledgeable, one has to stay in the game for a long period of time. And trading/investing in good quality stocks of Nifty50 or Next Nifty50 is a good option for that.
It’s true that the stock market is neutral. It has nothing to do with your profits and losses. The market always throws plenty of opportunities to make money, it’s just that your efforts have to be in the right direction. I do not discourage trading in F&O but, for any new retail trader, the more rational path flows from equity which finally leads to futures and then towards options.