Why is derivative trading popular but not profitable?

Derivatives, as the name suggests, are financial assets that derive value from underlying stocks like currencies, indices, stocks, commodities, etc. Options are the most popular among derivatives driven by Index options.

While many reasons fuel the popularity of derivative trading in the stock market, here are the three prime reasons for the raging demand for options trading.

Low Capital Investment
Most people are enticed to trade in options because they can start at as low as Rs 100.

Traders turn to options trading as the investment required is small, but the potential reward is large. However, the chances of retail investors making money in the options market are slim.

Plethora of Social Media Content and Influence
The pandemic has led to a surge of social media content promoting options trading as an easy way to supplement income. The increased awareness has attracted many gullible & first-time people to turn traders with surface-level information

Lure of Quick Money
There are plenty of success stories on social media doing the rounds where people have talked about how they converted a few thousand rupees to a few lakhs in a very short period of trading options. These traders often reap huge profits in a brief period rather than the usual traders. People are fascinated and get caught up in the allure of such get-rich-quick stories and want to try their luck as well. However, Options trading is more science than luck.Why is derivative trading not Profitable?
According to the Jan 2023 report shared by Sebi, 9 out of 10 individuals suffered losses by trading in the equity F&O segment. But why is this happening?
Read on to learn the aspects leading to the loss of traders in the derivative market.

Lack of Knowledge, Understanding & Practical Applicability
Most new options traders believe that the price of Options is impacted by the price of underlying, which is true. But there are additional factors that impact the price of options of which there is little knowledge, understanding and practical applicability.

For eg: Option prices can fall even if the underlying price remains the same or even goes up.

This can happen if you buy an option when volatility is high and then volatility drastically reduces. So, you end up paying a very high price for future expected volatility. However, the price of the underlying has not changed, just the expectation of future volatility, and this can reduce the price of options even when the underlying price is the same or even slightly gone up.

The time value of an option also tends to fall more as Options near the expiry. So, here again, the option price can decrease even when the underlying price is the same or even slightly gone up. The finer relationship between underlying asset price and Option prices is not practically understood and interpreted by traders even though the data is available.

Choosing the Wrong Strike Price
If you ask an option buyer what the target price of the option is buy trade, most often than not, the trader will tell his target price for the underlying. Again there is a lack of understanding of how exactly option prices are affected by the change in underlying assets based primarily on time and future expected volatility.

The determinant of which strike price to use is also very important to the varying degree that impacts the option price vis-à-vis the underlying. However, most traders choose strikes based on only one consideration – The capital that they have, and this is not a scientific way of choosing strike prices.

Knowing when not to Trade
Options trading is not without risks, and it is important for traders to exercise caution in certain scenarios. For example, when volatility is high, the price of an option may be inflated, which can lead to losses. Similarly, taking overnight positions closer to expiry can also be risky, as the time value of the option decreases, making it more challenging to profit from it.

Options trading requires a solid understanding of market dynamics, risks, and strategies to succeed. Blindly following tips, social media trends or peer pressure can lead to losses.

(The author of the article is S K Hozefa, CEO for Tradeplus)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)



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