This is the second part of the series of articles on Futures, options and derivatives. I am writing this article on request of Rambodoc.
This is a advanced topic meant for people who know the secondary market in and out and trade in lot size of 100k INR+
Also please remember that Futures is the fastest way a man can go from rags to riches (and reverse) in the stock market and wise men like Warren Buffet call them “financial weapons of mass destruction”.
Why trade in fno market?
1) Typically people make a short term investment in penny stocks, small caps and unknown companies because the stock price is usually low and fluctuations are high. So with a small increase of buying interest, you can make even 10-20% in a single day. However penny stocks exposes one to the risk of unstable management and unsustainable prices. Hence a better option is to bet in the futures of the index/blue chips. Because they are well researched and the chances of nasty surprises are negligible.
2) In secondary, typically people make money only when the market is rising. But in futures all that is required is that you correctly pick the trend and you can make money both in rising as well as falling markets.
3) Even when you have no idea whether the market will rise or fall, you can take opposite positions so that you can make money in volatile market, as well as flat market.
4) Margin/intra day trading requires you to square off the trade by the end of the day. In futures, you can have open positions for upto 3 months.
5) The margin is usually 10-15% of the trade value (lower in case of options) hence it allows you to make big bucks with a small bankroll.
6) You can generate a trading limit against your existing portfolio. (without any charges or interest cost) So effectively you can trade without having any bank roll.
7) You can leverage on market imperfections and place arbitrage and make assured money.
I have just 6 months experience (30 contracts) in trading with derivatives and I usually within a week, I either double my investment, or lose it entirely.
Now lets see how it works:
For the preview of this discussion lets take NIFTY (minifty)
The NIFTY Sensex was trading at 6157/- and has a lot size of 20.
How to make money in FUTURES:
31st Jan futures was trading at 6160/-
28th Feb was trading at 6160/-
27th March was trading at 6150/-
which is very close to the present market value.
1) If you know by those given dates, the market is going to rise/fall… then you can buy/sell accordingly of the respective month. The margin money you need to pay is 12% of the contract value (i.e. with only 14.7k, you can make upto 3 months far transactions worth 123k) and every 1% rise in the NIFTY would deliver 8.3% returns on your portfolio….
So who says Blue Chips and Sensex is boring and you can only make money in small caps?
2) Arbitrage: In this example, the future price is very close to the present price. However if the difference between the future and the present value is more than 2%, then you can buy stocks in the secondary and sell it on the future (or reverse) and make assured money. This is what all the arbitrage funds do.
How to make money in OPTIONS:
The biggest problem with derivatives is that your liability is unlimited. (i.e. going back to previous example, if the NIFTY falls by 1%, you lose 8%) This problem is solved using OPTIONS.
Put at 6200 on 31-Jan-2008 was trading at 133.00
GET at 6200 on 31-Jan-2008 was trading at 170.25
1) So your losses would be capped to 170/- in case of Get and 133/- in case of PUT. (If you buy a PUT Option at 5500, then you can reduce your loss limit significantly, similarly if you buy a GET Option at 6500/- then the price would be much lower)
2) Options which are way off the present price, can be bought at as low as 1% of the trade value. So you can make some really huge trades with just your pocket money.
3) it offers is to make money during volatile/flat market.
If you think that market is not going to change much from the present value then simultaneously write a PUT and GET option. You would make 133 + 170 = 303/- and if the market is within the range of 6200 +/- 303, then you can pocket the difference.
If you think that the market is going to be volatile (go up/down, but do not know in which direction) then buy a simultaneous put and get option. In the above example, if the market goes beyond the bound of 6200 +/-303 then you are poised to gain from the difference.
This post is formed out of the info at the back of my mind. For more details plz go a very good book forwarded by Ruhi.
That link will explain advanced positions like Bull spreads, bear spreads, butterfly spreads etc.