February 2011 Summary

   This month, the Nifty pretty much traded in a range from 5200 to 5600. FII's (or FITs as I like to call them), sold around 7200 crores worth of stock in the cash segment. But, thanks to some support from the DIIs, the fall wasn't as severe as it was in January month. However, the F&O expiry day saw the Nifty fall by a massive 3%.
   Well, that was about the markets. My trading account finally showed some hints that it broke out of a range and made some decent profits. I must admit though, that there were 5-6 very small profit trades and 1 big trade. Had I been unemotional and let the winner run just for a day more, I would have raked in bigger profits in that one too. 
   But the highlight of the month for me, "No large losses in this month."

As always, my list of learnings for this month, hopefully might be useful for others too.

• Watch out for the gap between the 10DMA and the 30 EMA lines. The bigger the gap, the better the chances of making a profitable trade. The more closer the body of the candlestick to the 30 EMA line, the better. When you run your scans, give more preference to results that match this criteria.
• Use INDIAVIX in conjunction with the Williams%R (3 day period) for a better market timing criteria.
• Money management : I'd like to explain this with an example, as shown below.

I buy 100 shares of company A at Rs.100. Before entering the trade, I determine the maximum loss that I can take in this trade is 2%, and place the stop loss order at Rs.98.
Now the order moves in my favor in 2 days time and touches Rs.104. I sell half of my shares and lock in some profits. So,effectively now I cannot make a loss in this trade unless the stock touches Rs.96.  And since I use trailing stop methods, even if I get stopped out now, I exit the trade at a price around my entry price.


Though this is an extremely conservative way of trading it helps with me with 2 things.
1. Protect my capital, as I have not made any loss in the trade. Though there is some disappointment that the trade wasn't a great one, atleast it wont dent my confidence, something that's important for amateur beginners like me.
2. This prevents any major losses in any case, in case of extremely volatile market conditions. Something which I has been the case in the last month or so.

Next is What?
   Today the budget was announced. Somewhere deep inside of me, I get this feeling that the worst is over.
The market could be heading for a reversal.Maybe, its time to start slowly focusing on long side trades.
   But as a technical trader, I must learn to let go of my emotions and only respond to what appears on the charts.

That's all for now. Happy Trading!

Futures and Options (Part 1)

   This post is for some of the followers of my blog, who may want to trade in Futures and Options, but don't have much idea about it. The big problem that I faced that there's a lot of information in the internet, but not all of it in one place.


So here are some of the basics about Futures and Options trading.



Both of them are derivatives. As in, they are instruments which can be used to negotiate the price or value of an underlying stock(say L&T,TCS) or index(say Nifty,Bank Nifty).

And this is primarily a trading and hedging tool. I shall tell more about hedging a bit later.

Futures trading :


Say on the 1st of March, I find that the share price of L&T is quoting at Rs.1600. I figure, that this is a good price to buy 1 lot of L&T. But I don't have all the money needed to buy 1 lot(125 shares of L&T).

Lot sizes are defined by the exchanges(NSE, BSE). As a standard, the value of a derivatives contract as stipulated by the exchanges is Rs.2 lakhs or thereabouts.
So if you calculate, I'd need Rs.2 lakhs to take 1 lot of L&T.

So I decide to take a Futures contract, by putting an upfront guarantee money. The guarantee money is defined for the stock by the broker(ICICIDirect, Kotak, HDFC Securities) based on its stock category and traded volumes (and many other factors which we will ignore for now).

My broker decides that I need to put 1/6th of the contract value as guarantee money for L&T. So I need to initially roughly set aside Rs. 33333 for this trade. This is known as initial margin.

On the other side, there might be a trader Chaman Patel who believes that Rs. 1600 is already a very high price for the L&T and he believes that by the end of the month it might fall further. So he decides to sell me the 1 lot of L&T at Rs.1600.

So a formal agreement is entered between me and Chaman Patel, all happening through the NSE, and facilitated by the broker. This is just an example, as in real life I don't know the true identity of the seller on the other side, as the NSE comes in between.

Bear in mind, a Futures contract is an obligation. I am obligated to buy 1 lot of L&T and Chaman Patel is obligated to sell that lot to me on the settlement date. In NSE, the settlement(also called F&O expiry day) date happens to be the last Thursday of the month, of course considering that its not an exchange holiday on that day.

So how is money made in this?
As told earlier, I enter a Futures contract to buy 1 lot of L&T at Rs. 1600 with March 31 as settlement date.Usually there is a slight difference between the Futures price and the stock price, a premium or discount based on the prevailing market conditions.

Say, on the 2nd, L&T rallies by 2% or 32 rupees. Due to this, the value of my contract also increases, because I already have Chaman Patel who has committed to selling me 1 lot Rs.1600 even though the market price is Rs.1632.
Theoretically, I can buy these shares at Rs.1600 from Chaman bhai and sell in the open market at Rs.1632.
So my broker credits Rs.32 * 125 = Rs 4000 into my  trading account.
On the other side, Chaman Patel's broker debits Rs. 4000 from his trading account.

Say, on the 3rd, L&T falls by 1% or 16 rupees. Due to this, the value of my contract decreases by 1%(roughly).
Now my broker debits Rs.2000 from my account, and similarly credits Rs. 2000 into Chaman bhai's account.

This whole thing keeps going in a while() loop as long as the contract is open, at most till the expiry day of the contract.

Say on the 7th, the price of L&T has reached Rs.1760, a nice rally of 10%. I figure that this is the maximum that L&T might go. I decide to close my contract with Chaman bhai by placing an offsetting sell order.

In other words, I exit this trade by selling my contract to some other trader through the NSE. Only now I sell this contract at a notional value of 125*Rs.1760.

So in effect,  I made a cool profit of 125*( 1760 - 1600) which comes to Rs.20000.

In the whole story till now  no shares were actually bought, or sold. And its not even necessary that Chaman bhai actually has these shares, should I choose to keep my contract open till final settlement day.

But, for some reason I keep this contract open till the end of the month. On expiry day, the futures price and the stock price converge. And on that day L&T closes at Rs.1650, and my contract is settled at this price.

My net profit in that case will be just 50*125 = Rs.6250. Even now, no shares are actually bought or sold.

How is money lost in this?
Look at the case of Chaman bhai. He entered into a contract to sell L&T at Rs.1600. On the day of final settlement, he ends up  losing 50*125 = Rs.6250. That's assuming that he has still not closed his contract till then.He could have also chosen to close his contract at any point of time before the expiry day, by taking an offset buy order on his contract.

Why is this risky?
A lot of traders go bankrupt in trying to make money quickly in futures. Due to the leveraging aspect coming in here, money is also lost pretty quickly in futures.

If my analysis of the market and the stock itself is wrong, and there is a major selloff and L&T falls by 10%, then  I make a loss of 160*125 = Rs.20000.  I could also be a subject of margin calls.

What is a margin call?
If you remember, I initially had blocked Rs.33333 as margin money with my broker . If L&T stock falls by  a lot very quickly, then my broker will want me to bring more money as margin, failing which he can choose to sell my contract.By this, he can limit any further losses and also initiate procedures to recover the losses from me.

Not all traders keep cash for margin(guarantee). They keep stocks as collateral with the broker. In case the trader is unable to meet the margin requirements, the broker starts to sell these shares kept as collateral and recover the losses. If this happens on a large scale with thousands of traders facing margin calls, something that's seen during times of major selloffs, then margin calls will add considerably to the selling pressure in the markets, and bring it down very quickly.

Futures hedging:
Say, in 2006 you bought some 125 shares of L&T at Rs.500 as long term investment, maybe with a 5 year perspective in mind. So far its been a good investment where you are seeing decent profit on the money that you put in.

But you figure that markets are entering into a short term correction, or maybe even a bear market, and you want to mitigate your risk.

So you decide to enter into a futures contract to sell 1 lot(125 shares) of L&T at the prevailing market price i.e. Rs.1600. In this case, you can choose to keep your L&T shares as margin.


Your guess is right and L&T falls by a 10% within a few days. You can choose to close your contract by taking an offsetting buy contract. By this you make a decent profit of Rs.20000.
By this, you achieve a few things. One,  your average price on each share reduces drastically. Two, you have additional money with you, which you can deploy in order to buy more shares of L&T (or any other stocks for that matter). Three, you still have valuable stock with you, which you can confidently keep with you for more years to come.

Large financial institutions, especially the FIIs employ hedging extensively in order to mitigate risks. But they use options more that futures to do this.

What are options?
Well , that's going to be another post, as this one has been a very long one. That shall be posted shortly.