Why Derivative Trading is Complicated?

The factors that influence success in derivative trading

Trading derivatives has often been described as one of the quickest ways to go bankrupt. Yet, people continue to engage in it, believing they will be the exception. They follow the few individuals who have made significant profits from derivatives without understanding the mindset and discipline that led to their success.

What Makes Derivatives So Rewarding Yet Dangerous?

The answer lies in leverage. Derivatives allow traders to control large positions with a relatively small amount of capital. This mechanism, where a small investment can yield disproportionately large rewards, is called leverage. In the world of product creation, for instance, you invest a small, one-time effort that could potentially bring you many years of reward, like building an app or writing a compelling book. This is positive leverage—if things go wrong, you can always pivot. You only need to succeed once.

However, in financial markets, leverage doesn't serve you in the same way. It often destroys you. It asks you to invest a small amount to gain the benefits of large quantities. We tend to forget that with larger quantities come significantly higher risks—risks that our modest capital can't withstand. More often than not, a trader’s overconfidence becomes their downfall, and they end up losing their entire account.

A simple way to calculate leverage is to multiply the price of the underlying asset by the minimum contract size. For example, if the Nifty 50 is at 24,000 and the lot size is 75, the required capital is 24,000 x 75 = 1,800,000. But the cost of one futures contract might only be 210,000. This means you're trading with 9x leverage, which comes with both 9 times the risk and 9 times the potential profit.

Before you ask, yes, leverage is even worse in options. You are buying 1,800,000 worth of goods for a fraction of that cost—that’s the essence of leverage. With option buying, you may reduce your risk and leverage, but theta (time decay) works against you, eroding much of your potential profits, making the situation even worse.

No matter the strategy you deploy, you cannot create a buffer to tolerate 9 times the risk. When dealing with high-leverage instruments, demand and supply also behave erratically, as the traders in these markets are highly sensitive to fluctuations. On top of that, you are competing with high-frequency trading systems and institutional investors who are always looking for inefficiencies in option pricing.

If you’re an option buyer, your win rate naturally remains lower because time works against you. You can only succeed in option buying when there’s enough momentum, which means you must exercise restraint on most trading days. A 25% average win rate, coupled with the need to compete against the “big boys,” is not for the faint-hearted. It's not a strategy for the inexperienced, nor is it a wise approach for anyone not fully prepared.

How Do Some People Succeed Then?

Those who succeed in trading derivatives fall into two categories: those who use leverage to their advantage and those who use it to hedge their portfolios, like hedge funds. If you can mitigate the adverse effects of leverage, trading derivatives can be like trading any other stock—though this also means the profit potential decreases, and the edge in derivatives may diminish.

Successful traders take fewer trades, to begin with. They don’t trade every day or react to every market event like an addict. They approach the market systematically, understanding the nuances of the instruments they trade. More importantly, they know what can go wrong with each trade they place. To suggest that they use less leverage would be an oversimplification of their disciplined trading approach.

Should You Trade Derivatives?

There is no straightforward answer, but I will attempt to make it clearer. If you plan to use derivatives as a hedging instrument, you need to establish clear ground rules and test the efficacy of your options. If you aren’t comfortable with the Greeks, option pricing, or the mathematical impact on your portfolio, you should stay away from derivatives altogether. In that case, you should focus on prudent stop-loss management.

For trading, you must develop a viable strategy that has stood the test of time. Whether it's a trend-following strategy or any other approach, backtest your strategy on at least five years of data for the instruments you intend to trade. Run a Monte Carlo simulation to understand the worst-case scenario based on your backtest data.

If you're looking to generate monthly income through “safe” option strategies, you must have a solid understanding of option Greeks. I highly recommend that you save yourself from future misery and avoid other forms of derivative trading unless you’re truly committed to mastering these complex strategies. With fixed-income options like straddles, strangles, and iron condors, you need to analyze current market conditions and assess the potential risks. You’ll get the maximum risk and reward in simulators, but you also need to consider what else could go wrong—and this is where studying option Greeks becomes crucial.

How Do I Use It?

I use a trend-following option strategy on Nifty 50, which is our primary index. 85% of my capital is invested in stocks. When I’m not in stocks, I sit on cash. I do not touch that 85% for anything else. The remaining 15% is used for my mechanical strategy to hedge against bearish phases of the market. This helps me limit my drawdown to a single digit, or sometimes even less.

The strategy has been tested for over 7 years now. I initially tested it over 5 years, followed by 2 years of forward testing. I’ve also run a Monte Carlo simulation for my worst-case scenario, covering up to the 99th percentile. The only reason I use derivatives is to limit my drawdown and preserve my capital using the strategy I’ve personally worked hard to develop and test.

Conclusion

Much of your behavior in the stock market reflects your mindset, which is evident in your trading actions. The clearer your thinking, the more prosperous you will become—regardless of the strategies you employ. If you stick with it, you will generate profits. Spend enough time in the markets with a profitable strategy, and you will eventually make a lot of money.

Derivative trading is extremely risky because of its high leverage, which disrupts the balance of demand and supply. Additionally, you are competing with the major players who can easily wipe you out if you make even the smallest mistake.

Whether you succeed or fail depends on how you handle these challenges. One of the ways to navigate this is by building a mechanical trading system that keeps you disciplined and consistent.