What are the Most Common Mistakes to Avoid in Derivatives Trading

Are you new in derivatives trading? Read more about the expected errors traders do in futures and options (F&O), and how to avoid them for wiser and safer investments.

Common Mistakes to Avoid in Derivatives Trading

Trading in derivatives such as futures and options is gaining momentum, in particular among the retail traders in India. Although they could be used in risk-management and to make profits, derivatives are complex and dangerous. Many starters make costly mistakes that could have been prevented with sufficient knowledge and attitude. This article will describe common mistakes in derivatives trading and their causes, and give tips on how to avoid them. Whether you are a beginner or an already experienced trader, this guide will help you to become a more disciplined and successful trader.

1. Lack of Understanding of Derivatives

One of the mistakes that most traders make is that they start derivatives trading without understanding how it operates. Derivatives are the financial tools whose value depends on the price of the primary asset like commodities, shares, stocks or indices. They are not as simple as buying shares.

What to do: 

• Research on the fundamentals of futures and options.
• Learn some key words such as strike price, premium, expiry, margin, leverage, as well as the lot size.
• Take advantage of simulators or paper trading before actual investment is made.

2. Trading Without a Plan

Casual traders tend to be impulsive with their decisions or follow the tips and news without any proper plan, which leads to random trades and undetermined outcomes.

What to do:

• Pick your entry and exit points beforehand.
• Determine your risk-reward ratio.
• Adhere to your strategy in spite of changes in the market without acting impulsively.

3. Overleveraging

Derivatives allow trading large positions at relatively small initial investments with the help of margin, or leverage. Even though leverage can increase profits, it also increases the risks of devastating losses.

What to do: 

• Being careful and wise about leverage.
• Not deploying your whole capital in a single deal.
• Losing only a tiny percentage (like 1 – 2%) of your entire capital on each deal you make.

4. Ignoring Risk Management

Frequently Traders seem to be obsessed with profits and forget about capital protection. Even with one wrong trade, poor risk management can empty your account.

What to do: 

• Utilize stop loss if you like to lessen losses.
• Get diverse in your trades rather than putting all your money in one.
• Make sure you know your loss level before you start trading.

5. Holding Positions Until Expiry Without a Reason

Some traders hold options or futures contracts long, in hopes of the last minute change. This is dangerous, particularly on options which depreciate with time.

What to do: 

• Check your positions often.
• Quit the trade if things are not right.
• Unless there is a good reason, don’t wait until expiry.

6. Not Understanding Time Decay in Options

Time decay (theta) is relevant in options trading. It is the reduction in the option premium as the expiry date nears, especially if the price of the stock remains constant.

What to do: 

• The consequences of time decay apply to both option buyers and sellers.
• Avoid purchasing short-dated options, unless you predict a big price change.
• If you are a seller of options, then use time decay effectively with strategies.

7. Following Tips Without Research

Many new traders are blindly following the advice provided through social media, WhatsApp groups or self styled experts without doing their own research, hence making bad trades and losses.

What to do: 

• Get trust in your analysis or find reliable sources.
• Use technical or basic measures to support trade ideas.
• Do not make trades upon rumors or excitement.

8. Overtrading

The frequent mistake is to trade too much or to attempt reacting to every change in the market. It may lead to higher fees, stress, and wrong decision making.

What to do:

• Trade only if you see the opportunity.
• Prioritize quality trades.
• Take some breaks to avoid trading because of frustration, after losing.

9. Lack of Patience and Discipline

Trade in derivatives requires time and emotional control. Traders exit trades prematurely because of suspicion or hold on to them for too long due to greed.

What to do: 

• Follow your strategy and rules.
• Do not allow fear or greed to control you.
• Maintain a diary of your trades in order to benefit from mistakes and improve.

10. Ignoring the Tax Implications

Profits from the derivatives trading are charged in India. Most traders do not know how to classify F&O income and this can trigger penalties or audits.

What to do: 

• Understand that the F&O trading is not considered as speculative business earnings.
• Maintain proper records and properly file your ITR-3.
• If you are lost over audit rules or filing, consult your tax advisor.

Recommended Read: Combining Derivatives and Margin Trading

Important Tip: Not Practicing Before Trading Live

Most traders fail to practice before trading, and instead, trade with actual money which can be expensive if one does not know the market or platform.

To avoid this:

• Try strategies using demo accounts or paper trading.
• Read up the trading websites and behaviors of trading orders.
• Start with little then increase as you gain confidence.

How to Avoid Mistakes in Derivative Trading in Stock Market

1. Get familiar with Derivatives

• Get knowledge about derivatives such as futures and options before you begin to trade.
• Know important words such as strike price, premium, expiry, Greeks (Delta, Theta, Vega) and margins.
• Explore educational websites or use software to trade virtually.

2. Practice Proper Risk Management

• Always keep your risk on any single trade to 2–5% of your whole capital.
• It is important to use stop-loss orders so as not to risk too much.
• Divide your investments among various trades so the capital is not all held in a single position.

3. Be Careful Not to Borrow Too Much

• Make sure you are well aware of its effects before you use leverage.
• Big leverage means more profits and bigger risks as well.
• While you are new to trading, always go for smaller trades.

4. Set up a Defined Strategy for Trading

• Go over how, when and why you will close a trade before you start trading.
• Keep your emotions out of your trades and don’t trust what other people say about the market.
• Stick with your process and avoid acting on fast decisions.

5. Follow the news to see how the markets behave

• Follow changes in the economy, updates from companies and international trends.
• The VIX (volatility index) is one tool you can use to measure the mood of the market.
• Be careful when markets are very active or change rapidly.

6. Use Margins with Attention

Make sure you keep margin balance in your account.

Remember, you can get a margin call if your trade goes against you.

Use only part of the margin when making one trade.

7. Gain understanding from your successes and failures in trading

• Make a trading journal to keep records of your deals and find ways to improve from slip-ups.
• Go through both your winning and losing trades on a regular basis.
• If traders use these guides, they can cut down risks and gain better control in derivative trading.

Final Thoughts

There is money in derivative trading, but you need to be cautious, disciplined and knowledgeable about it. Good traders are those who prepare their trades, manage risks, avoid traps that other people make, rather than pursue short-term profits. To become better as a trader you have to keep learning. Follow some strategy and stick to it. Don’t let your temporary losses affect your confidence. Avoiding these mistakes will make you a smarter and more consistent derivatives trader.

Recommended Read: Types of Derivatives Market