EQUITY INVESTING: Why F&O trading isn’t meant for retail investors

June 16, 2021 1:45 AM

Futures & Options is not really investing but punting. The retail trader hardly has the nimbleness and might to exploit the ephemeral opportunities flashing for a nanosecond on charts

The retail trader hardly has the nimbleness and might to exploit the ephemeral opportunities flashing for a nanosecond on charts.

By Pankaj K Agarwal
For all its sad fallouts, the pandemic seems to have worked wonders for retail activity in capital markets around the world. Closer home, the retail participation—on the rise for the last few years—now commands an unprecedented 45% market share in the cash segment. Even more interestingly, in the Futures and Options (F&O) segment, retail’s share has galloped to about 30% (turnover), in Index Futures as well as Options. Sensing the mood (and opportunity), many brokerages are offering attractive margin trades and complex strategy plays to the retail investor.

However, the derivatives, once dubbed “weapons of mass destruction” by none other than Warren Buffet, are inherently way riskier than stocks. Rising retail participation has got even the regulator worried for some time now as it may deal a double whammy of posing grave financial risk to the unsophisticated investors while making the markets overly speculative, too.

That said, if you have joined the party or have been considering giving F&O a shot lately, here is some useful advice.
Derivatives to hedge risks

The derivatives were invented to hedge risks of loss on an existing exposure. In other words, they are essentially loss-prevention tools and not profit-making ones. Of course, speculation does have an economic point, yet it is not everyone’s cup of tea.

Even in the retail space, these are strictly recommended for those who have built sufficient financial cushions to withstand severe blows to trading capital which could very well happen in the F & O segment.

F&O require forecasts of prices/index levels over a short horizon of three months maximum. This requires a great deal of skill and ability to form directional views from technical charts and derivative analytics. If you are not familiar with technicals, consider educating yourself first or stay away.

The lure of derivatives in part comes from the leverage. Simply put, leverage allows you to take exposure to a larger value by committing only a fraction of it. Leverage is like a kitchen knife which a professional cook uses to create a gourmet while a kid hurts himself grievously with. It multiplies gains manifold once things move favourably but compounds your losses too with equal ferocity if they don’t. Never lose sight of this.

Writing options are only for pros. The lure of upfront cash inflow and the theoretically superior chances of winning by options sellers can blind you to the risks which could potentially wipe out your entire capital.

Keep losses small
Do not forget the timeless wisdom of the professional trader: It is not the towering gains which ensure trading success in the long run; it is your ability to keep losses small instead. Having a reasonable risk-reward ratio and sticking to it come hell or high water will keep you going for a long time.

In fact, F&O is not really investing but punting or trading. Most amateur traders crash out of the market very soon. Plus, it is a full-time profession, requiring considerable skill and temperament. As the trading gets increasingly tech-based, it is becoming tougher except for sophisticated players. The retail trader hardly has the nimbleness and might to exploit the ephemeral opportunities flashing for a nanosecond on charts.

I have always maintained that retail investors would do well to stick to goal-based investing in long-term avenues like mutual funds. Investing for the long haul may not be as exciting as the roller-coaster world of F&O trading, but it surely is durable and healthier.

The writer is associate professor (Finance & Accounting), Indian Institute of Management, Jammu

RISKS IN F&O TRADING
Derivatives trading is for those who have built sufficient financial cushions to withstand severe blows to trading capital which could very well happen in the F&O segment
As F&O trading gets increasingly tech-based, it is becoming tougher except for sophisticated players
Retail investors should stick to goal-based investing in long-term avenues like mutual funds. Investing for the long haul may not be very exciting, but it surely is durable and healthier

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