Futures and options trading in India has been growing, but many retail traders face significant losses due to insufficient risk measures and lack of awareness. A report by the Securities and Exchange Board of India showed that 90% of retail traders lost money in F&O trading in FY22.
To minimize losses, it’s essential to understand the risks associated with both futures and options. Let’s explore these critical aspects in detail.
To figure out which is the riskier of the two between futures and options trading, let us take a closer look at the risks in the options market segment. The top downsides include:
1. Leverage and Potential for Total Loss
Options trading involves leverage, which can amplify both gains and losses. Your maximum loss is limited to the premium paid, but if options expire worthless or market conditions are unfavorable, losses can be significant.
2. Time Decay or Theta Risk
Options are wasting assets due to time decay (theta), which erodes value as expiration nears. Buyers face the risk of loss if the asset price doesn’t move favorably quickly, while sellers benefit from time decay but face capped profits and potentially unlimited losses if the market moves against them.
3. Volatility Risk
Options prices are affected by implied volatility (Vega). A decrease in volatility can lower prices, impacting buyers, while sellers benefit but risk losses if volatility unexpectedly spikes. Managing volatility risks is crucial for options trading.
Complexity and Possible Misunderstanding
Options trading is complex, involving intricate terminology and multi-legged strategies that can confuse beginners. Misunderstanding key concepts like Greeks or strategy specifics can lead to unexpected risks.
1. Liquidity Risk
• Low liquidity in futures contracts can lead to wide bid-ask spreads and difficulties in entering or exiting positions, especially during market stress. Assessing a contract’s liquidity is crucial for effective position management.
2. Counterparty Risk
Counterparty risk in futures trading involves the possibility of default by the other party or clearing house. Although rare, it can be significant, especially in unregulated markets, so assessing the financial stability of exchanges and clearing houses is crucial.
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