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A future full of options

Since we are in such a choppy market now, it's a good time to examine the relative benefits of options trading, writes Udayan Mukherjee.

business Updated: May 13, 2007 22:37 IST

Last week, a lot of Nifty futures traders would have lost money as the index gyrated wildly, practically everyday.

Only a very disciplined trader would have been able to trade the swings. Most would have got stopped out either way. Trading naked stock or index futures is a dangerous game. It's almost like gambling in a casino.

The market, particularly in the short term, is inherently unpredictable. Yes, sometimes when it trends nicely and continuously, traders can make money riding the trend. The moment it gets into indecisive, uncertain and choppy territory, trading in futures becomes hazardous.

Since we are in such a choppy market now, it's a good time to examine the relative benefits of options trading. Sadly, options haven't taken off in as big a way as futures have which is a reflection of how speculative our market is, intrinsically.

If you don't have a gambler's "all or quits" psyche, options is the place to be. It cuts risk, limits potential losses and helps you capture modest returns by betting against extreme scenarios.

A lot of very smart traders simply write deep out-of-money options every month. The call is simple, the index or stock is unlikely to make a very sharp move, up or down, so you simply sell the option to an essentially greedy buyer who is betting on such a sharp move.

The probabilities are in your favour and against the buyer and at the end of the day, trading is all about probabilities. Sure, once in a way, the stock or Nifty will make that sharp move and you will have a losing trade, but that's part of the game.

The returns from these trades often turn out to be quite substantial in annualised percentage terms. It may not have the excitement of a stock futures doubling, but it's a more conservative way to make your money work.

Once you get deep into the options game, other possibilities will open up. You can learn to milk money out of spikes in volatility in the market, effectively hedge your portfolio against market falls and on a day when you are feeling really greedy, even take that punt without worrying about having to sell your house.

Do remember, option writers make more money. Try and be on the selling side in the options game. Also, since the options market is far less liquid than the futures market, be careful about what you are playing options in.

The Nifty is fine, so are a few liquid large cap stocks. You have to be sure about being able to unwind your trade when the time comes, else you are dead. So don't go about buying options in some midcap only to be stuck later.

Having said this, derivatives trading is a risky game. Both futures and options are like loaded guns, the best you can say is that the options gun at least comes with a safety catch.

E-mail author: marketwatch@hindustantimes.com