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Why Stock Index Trading?
A stock index describes the performance of the national stock market and uses a weighted average of stock prices. Nifty 50, Heng Sang Index (HSI), the NASDAQ, S&P 500, and Dow Jones Industrial Average are examples of stock indexes.
Index Futures reflect the strength of the major companies constituting the index. You can’t find any equal-weight index, where every company's performance has an equal contribution to the index.
What is Futures?
“Futures’ word tells us that the trading is done by auction on a regulated listed marketplace where prices are transparent and investors of all kinds get same prices and the risk of counterparty defaults is practically nil.
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price.
Unlike a traditional spot market, in a futures market, the trades are not ‘settled’ instantly. By transacting in futures, you are not buying any asset. You are just dealing in contracts or digital agreements to buy or sell assets for the present and settle contracts with cash or delivery of the assets when the contract is exercised.
Why trade future contracts?
The futures were invented to provide:
- Hedging and risk management for assets
- Leverage so that traders can enter positions larger than their account balance. Investors pay much lower fees than buying the mutual funds or even the assets in the cash market.
- "Short” exposure for traders to bet against an asset performance even without owning the asset. It is like you are betting on a loser of a sports game. “Short” is a unique word used by financial traders to describe as selling something that is not owned by them.
Why Options on Futures?
Although both are derivatives, futures and options are entirely different in terms of their potential risk and return and serve different purpose of hedging.
You can buy futures and buy Put options or Sell futures and buy call options at the same time to protect yourself from the effects of adverse asset price movements.
The futures contracts move linearly or proportionally with the spot price, which means for every $1 price movement of the underlying asset, a buyer or a seller makes or loses $1 per unit.
As against this, options have a non-linear payoff. Which means return is not in the same proportion as the capital invested. For an option buyer, the gains are unlimited, but losses limited. But for an option seller, the losses are unlimited and gains are capped.
Futures contracts move more quickly and it is easier to get in and exit and helps the purpose of day trading. Options prices only move in correlation to the futures contracts and they keep fluctuating sometimes wildly too.
Options trading platform has an analytical tool called Delta which measures the movement of the prices between the futures and options. It is worth understanding this tool if you want to trade options profitably.
Visualization of the two derivative instruments will help you take decisions on which instrument to trade and how.
With futures, you can connect increase or decrease in contracts with price rising or falling as happens in any spot market.
In options, it is not so. Because traders have marked different future price levels (called strike prices) and are betting on their forecasts. Sellers will make money if the prices don’t touch those levels or technically speaking remain “out of the money”. It will be sort of a tug-of-war between the buyers and sellers.
There is a contracts volume measurement tool called Open Interest. It is different from volume which denotes contracts sold or bought on any given one day. One key difference is that volume counts all contracts that have been traded, while open interest is a total of contracts that remain open in the market.
Traders can think of open interest as the cash flowing to the market. As open interest increases, more money is moving into the futures contract and as open interest declines money is moving out of the futures contract.
For futures, price increase or decrease affects Open Interest. In Options trading, Open Interest shows increase or decrease at different strike prices with the movement of the market. It is safer to assume that Sellers choose levels at which they hope to make money and that can happen only when those price levels are not touched.
Seller of Calls want the prices to remain lower than their chosen strike prices. Sellers of Puts want the prices to remain above their chosen strike prices.
What is linear and what is nonlinear?
Have you ever watched children building a sand castle on a beach and saw it collapsing suddenly? It may have taken an hour or so for them to complete the dome. Yet, when one of the children suddenly uses the fist or takes a small handful of sand and applies it on the top of the castle to beautify it, the entire structure crumbles.
Seemingly minor or a routine action, a handful of sand brought down the entire structure.
The output (the castle crumbling) was disproportionate to the input (applying the fist or handful of sand). That is non-linear effect.
The non-linear effect means that the output is not in the same proportion as the input.
Futures is considered a linear derivative contract which means for every $1 price movement of the underlying asset, a buyer or a seller makes or loses $1 per unit. The futures contracts move linearly or proportionally with the spot price. Linear derivatives involve futures, forwards and swaps.
Options is a derivative product but with non-linear payoff. Non-linear in the sense that the output (return) is not in the same proportion as the input (investment). For an option buyer, the gains are unlimited, but losses limited.
The flip side of it is that losses are unlimited for a seller, and gains are limited.
Looks like the Option Buying channel is tailor-made for Pareto Principle practitioners like me.
Self-directed investors are not machines. Emotions are always part of the game. Majorly, emotions are the reason why traders have to face losses in their career.
And very often, two of the main reasons for this are the lack of discipline and not taking decisions when it is required.
Please, ask yourself the following questions:
When you plan to enter a trade, how much time do you spend with analyzing charts or fundamental data? In today’s information age, when you can get good and free analysis from youtube, do you really think it is necessary to do this job?
Do you want to be a driver? Or driver-cum-engineer? Stick to one job and that is of taking swift and well-informed decisions. Don’t burden your brain with too many tasks.
And how much time do you use for managing the trade?
It is very likely that you will use – or more precisely, waste – 80 % of the time to initiate the trade and 20 % of the time to manage the trade.
Is this effective? Most likely, not.
Just think about it how much more you could make out of the time you have if you would only use 20 % of it to search for trading opportunities.
How would you feel if you could keep or even improve your level of profits while you are able to reduce your time and efforts in a significant way?
Wouldn’t this be a great change? The time you save will:
- reduce stress,
- improve trading decision making ability
- open new opportunities and
- make trading more effective and more efficient.
Index options buying is an ideal vehicle to practice 80/20 principle.
Index buyers can just focus on Market Open hours (maximum 60 minutes) and Closing time (maximum 60 minutes) .
Index buyers are not subjected to hazards of stock futures trading or after-hours gaps or insider trading.
Weekly trading positions need less capital to buy and buyers face no margin call pressure. But you have to remain on your toes to save the trades from time decay eating your capital.
Options buyers don’t have to deal with emotions during the trading. The trade is being taken after knowing fully well what is going to be the risk.
You can control your unrealistic Hopes or Greed by putting a realistic exit order along with the buying order.
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