Understanding Risk Management in Trading

CA Manish Singh: Hello everyone. 
In the last chapter, we discussed option buyers, option sellers, who might buy an option, who might sell an option, and how each position behaves. There was one thing that remained common across all those scenarios: there is never a guaranteed profit. A loss can always occur. 

Losses are extremely common in trading. Even the best traders in the world have a success ratio of only about fifty percent. What protects them during the remaining fifty percent is risk management. 

What Risk Management Really Means 

CA Manish Singh: 
When we are trading in the market, our biggest risk is losing our trading capital. 
If we fear losing our capital, we must manage risk in a way that keeps that capital protected. Even if there is a dent in the capital, we should be able to close the trade at a point where we can still think of taking the next trade. It should not happen that a single trade wipes out the entire capital. 

It is very common for traders to blow up their entire capital, but with proper discipline and risk management, this situation does not need to arise. Our intention here is to help you follow risk-management principles so you can protect your capital. 

Let me simplify this with an example. 

One View, Three Possible Approaches 

Suppose someone says: “One can go long on Nifty.” 
This statement simply means there is a probability that Nifty may move upwards from the current level. However, the probability of it going up or not going up is still fifty-fifty. 

But the trader who hears this statement has three different ways to take the same bullish view: 

1. Buy a Futures contract (go long on Futures)
2. Sell a Put option
3. Buy a Call option 

For each of these, three outcomes are possible: 
• The market may go up 
• The market may remain sideways 
• The market may go down 

Let us understand how each reacts. 

1. Buying a Futures Contract 

If my view is bullish and I buy a Futures contract: 

• If the market goes up, I gain.
• If the market stays sideways, losses are negligible since only charges apply.
• If the market goes down, I incur a loss. My stop-loss and target define how much. 

2. Selling a Put Option 

Suppose the market is at 25,000 and someone sells a Put option at the 25,000 strikes. 

Here again, three outcomes: 

• If the market goes up, the seller gains automatically.
• If the market stays sideways, the seller still gains due to time-value decay (Theta).
• If the market goes down, the seller may lose.
• If it drops slightly, Theta decay can offset the loss.
• If it drops significantly, a stop-loss must be triggered. 

So, Put selling benefits from both upside and sideways markets. 

3. Buying a Call Option 

If I buy a Call option: 

• If the market goes up sharply, I may gain.
• If the market goes slightly up, I may still lose due to time decay.
• If the market stays sideways, I lose due to time decay.
• If the market goes down, I lose. 

So Call buying requires strong and fast movement on the bullish side. 

Which Instrument Fits Which Market Condition? 

CA Manish Singh: 
You must decide which instrument suits the current market environment. 

• If the market is highly volatile with big movements, option buying can be effective.
• If the market is dull or range-bound, buying options usually loses money because Theta decay erodes premium quickly. Option selling may make more sense.
• If the market has taken a clear direction (up or down), and you have enough capital, Futures trading may be appropriate. 

The reason there are so many approaches is because of something called Option Greeks. 

Introduction to Option Greeks 

Option Greeks help you understand: 

• How much the option premium may decay (Theta)
• How much the option premium may move with price (Delta)
• How quickly Delta may change (Gamma) 

Greeks tell us how an option may behave in different market conditions. 

In the next chapter, we will discuss Option Greeks in detail. 

Disclaimer: Investments in securities markets are subject to market risks. Read all related documents carefully before investing.