Trading Strategy for derivatives must be based on acceptable risk

It is appropriate for novices and those who have some basic knowledge about derivatives trading.

The second article will be entitled "How to apply implied volatility in options trading", the third "Low trading liquidity of options and the role of options market makers" and the fourth "Pure techniques of options trading".

There are two products - Stock Exchange of Thailand (SET) 50 Index futures and SET 50 Index options - available at the Thailand Futures Exchange (TFEX).

Long futures (those that have a long position that expires months ahead) can make a profit from selling the contract if the SET 50 Index goes up, while short futures (those with a short expiry date) can gain from buying the contract to unwind position if the SET 50 Index goes down, as the underlying price is set at the time the contract was written.

Investors must put an initial trading margin of Bt50,000 per contract. Profit and loss is realised at the end of the trading day through the mark-to-market method. Mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that or similar instruments.

For example, the final value of a futures contract that expires in nine months will not be known until it expires.

If it is designated mark to market for accounting purposes, it is assigned the value that it will fetch in the open market at present. Investors are required to add a deposit equal to Bt50,000 on the following trading day if the contract value is below a maintenance margin of Bt35,000.

In the event of wide fluctuations on the SET 50 Index during a trading period, and the contract value falls below Bt15,000, an additional margin of Bt35,000 is required within one hour after the margin call. On the other hand, investors can withdraw the excess amount if the contract value is higher than Bt50,000 and the whole amount if the contract position is already unwound.

Given a contract multiplier at Bt1,000 per point, you would gain a profit if you bought long SET 50 Index futures at 600.2 points and short at 605.8 points. (605.8 - 600.2 = Bt5,600).

For options, there are two different points: principle and margin.

Investors who buy both "call" (the right to buy at a pre-set price) and "put" (the right to sell at a pre-set price) options are required only to pay a premium first.

For example, on a contract multiplier of Bt200 per point, if they buy long options at 44.4 points, investors must pay 44.4 x 200 = Bt8,800. The sum of Bt8,800 will be transferred to the account of those who short the options as margin, but they cannot withdraw the amount.

There are four trading strategies for options, and which strategy should be traded depends on expectations about the stock market's future movement, whether up or down. Each trading strategy has a different risk level.

If investors expect the SET 50 Index to rally over time, they should buy long "call" options. Investors in this case can gain if the SET 50 Index rises within the expiry date, but their maximum loss exposure is capped at the premium already paid if the SET 50 Index falls or remains static.

If investors expect the SET 50 Index to move lower soon, they should buy short "put" options, because they can make a profit even though the SET 50 Index falls. However, the disadvantages are that investors are required to place a margin deposit before trading, and they risk having

to top this back up to Bt50,000 to replace the loss.

You may think those who buy "short" options are somewhat at a disadvantage and that no

one would want to buy them. However, option prices adjust to a level that makes them attractive, and they reach equilibrium in line with the principle of supply and demand. "Puts" are bought in anticipation that the SET 50 Index will fall, while "calls" are bought on expectations it will rise.

In conclusion, we should select a trading strategy based on expectations of the SET 50 Index's movement and acceptable risk level.

In the next article, we will discuss how to choose options.