Derivatives Trading is about managing your risk

Novice traders enter the market, discover derivatives and feel like kids in a chocolate shop.

Derivatives provide leverage which can yield more gains than we imagine. Buy an option for Rs 5,000 and maybe it can go all the way to Rs 50,000. Pay a margin of 14% to buy Index futures and if the Index goes up just 2.8%, the trader has made 20% on his investment(margin paid) in just one or two days.

This is how most new entrants view derivatives – a money tree. The trader believes that all he has to do is learn how to pick the fruits from that tree. That looks very easy and traders spend their time and all their money trying to find the way to pick the harvest from the money tree – they can see it, all they have to do is to get it.

Yet, we know that no one has actually taken anything from the tree.

The reason is easy: derivatives are products of leverage. Leverage is high risk. Therefore, the way to make money from derivatives is to manage your risk. This is a boring task for most new traders. what they like is to get ‘picks’ – names that will go up or down! What experienced traders do is to focus almost exclusively on the risk that their trades generate.

So, experienced traders make money, while novice traders lose all their money.

If you are trading in derivatives, here is a simple method to manage your risk: your trading capital should be at least three times the margin that you give to the broker. The investment in options should never be more than 15% of the capital that you set aside for options trading (excluding margin).