Common Trading Errors

When stock futures were first introduced in India in 2001, they became quite popular as futures were structurally similar to the Badla system on the BSE. However, the regulator has been worried (and rightly so) that losses on futures could multiply if retail investors do not understand the finer points. Why do we see so many cases of traders losing money trading in futures? Here are some common mistakes that traders commit when they trade in futures. This typically applies to stock futures and to index futures.

Using futures as a proxy for equities

People find it quite simple to buy in futures. After all you only have to only pay a margin in futures. Let us consider the instance of Reliance Industries spot versus Jun-18 futures.

This is where most futures traders get it wrong! For example, if you have Rs.10 lakhs available, you can buy 1000 shares in the cash market. Alternatively you can buy 8 lots (based on margin payable on futures). The problem is over-leverage. You have bought 8000 shares in futures having the capacity to buy 1000 shares. If price goes up it is fine. But, if the price falls by Rs.100, then there is a huge Mark to market (MTM) loss you will have to bring in. Else your position will be cut at a loss.

Overleveraging and stretching your finances

This is an extension of the previous argument. Most traders look at the positive side of leveraging with futures. In the case of RIL, traders tend to believe that with 8 times leverage, you can actually make 8 times the profit. What traders tend to ignore is that it can also mean 8 times the losses. That happens very often when you stretch your affordability based on the initial margin you have to pay.

Not preparing for MTM Margins

The above example of Reliance only shows you the initial margin that you have to pay. If the price goes up from that level then you are absolutely comfortable. Let us assume that the price of RIL falls by Rs.80 overnight due to weak guidance post market. In that case, your MTM loss in a single day will be Rs.80,000 and your broker will immediately call upon you to replenish the loss. If you cannot bring in that cash, the broker will be forced to terminate the position resulting in losses. Always keep a provision up to 25% of initial margin for MTM losses.

Not keeping strict stop losses and profit targets

At the end of the day, futures trading is leveraged trading and hence you need to keep strict stop losses and profit targets while trading. In fact, more so because it is leveraged and the risk multiplies! When the stop loss is triggered or the profit target is hit, you must exit the futures position. Ideas like rethinking your original strategy, averaging your position can all lead to losses.

Ignoring the impact of dividends

Quite a few investors wonder; holders of futures do not receive dividends, then why should dividends impact future prices. That is exactly why futures are impacted by dividends. For example if company is currently quoting in the cash market at Rs.275 and there is a dividend payable of Rs.7 during June, then the June futures will be adjusted downward by that amount. That does not mean that the future is attractively priced due to the discount. Once the dividend ex-date is done and dusted, then the parity returns. Don’t buy a future just because it is at a discount to the spot price. More often, it is purely due to dividends.

Interpreting short futures as selling

That sounds strange. When you see selling in futures that has to be selling; what is wrong in that argument. You need to realize that a big chunk of the trade in the stock futures market is cash-futures arbitrage. Here, large institutions buy in the cash and sell in the futures to capture the spread and lock in the profit. When you see aggressive selling in futures, it could be institutional arbitrage. Don’t interpret that as selling futures and try to go short on the stock. You are likely to end up on the wrong side.

Ignoring the impact of vanishing liquidity

Have you seen vanishing liquidity in futures? It does not happen in the case of large stocks but many mid cap stocks are vulnerable to vanishing liquidity. This trend was specifically visible in times of market sell-off when the futures can trade at huge tick spreads. Ideally, don’t try to trade aggressively in futures in volatile markets. Vanishing volumes can create a huge spread risk for you. This is where many traders tend to get caught.