How to Trade in Options with Small Capital

Many investors find trading in derivatives attractive as the avenue tends to provide the potential for good returns. Futures and options are two main types of derivatives that investors can trade-in.

Both these contracts promise the buying or selling of an instrument at a future date at a predefined price. While the futures contract mandates the trade, the options contract allows the buyer or seller to back out if the trade is not in their favour. 

Since options contracts are flexible, they are quite popular. Traders can trade in options with different amounts of capital. However, an investment of less than Rs.2 lakhs is usually considered small capital.

Usually, budding traders or traders who want limited exposure to options trading opt for small capital to minimize exposure to risk in the overall portfolio.

While you can do option trading with a small capital, there are certain rules that you should follow to ensure that your trade is profitable. 

Here is a quick guide to the rules –

Rules for Options Trading With Small Capital

• Understand the Options Market Before You Venture Into It

The options market is a technical market. Unlike the cash market, wherein you can buy stocks immediately, options involve trading in the future. With the markets being volatile, no one knows what the future might bring.

While you might enter the trade with the expectation of profit, the party at the other end of the trade has also entered the contract with profit expectations. Only one of your expectations can come true, so you need to have the right set of expectations.

Understand how the options market works and then identify profitable trades before investing.

• Start Small

Although your capital is limited, you should not invest all of it at once. Start small by investing 10% or 20% of your capital, or lesser/more, depending on your risk appetite. Do not open multiple trades simultaneously. Enter one or two contracts at a time. Before signing on a new contract, wait for the previous ones to close.

Remember, some consider options as wasting assets, and they have a small shelf life too. So, when investing in such assets, you need to keep your exposure limited. 

• Choose the Right Holding Period

The holding period is crucial in determining the profit that you can earn from an options trade. Many investors stay invested for too long and risk losing out on the trade.

Since options have a short shelf life, opt for a shorter holding period. This would allow you to participate in breakout or breakdown zones so that you can immediately move out of the trade if needed. 

• Predefine the Stop and Target Amounts

There are online calculators for options trading that help you prefix the stop and target range. Align your options trade to these calculated and analyzed stops and targets to minimize losses and maximize gains.

• Avoid Impulsive Buys and ‘Hot Tips’

Just because your friend or a neighbour benefited greatly from an options contract doesn’t mean you would too. Avoid impulsive trades or buying options that are in the news.

If a stock is expected to surge, it doesn’t mean that the options contract of the stock would have the same favourable outcome. Price expectations in stocks don’t apply to options trading, given their short-term nature.

Also, do not believe in the so-called ‘hot tips’ shared by self-proclaimed analysts and experts. Always research the trade that you venture into and make a judgment call rather than being swayed by the alluring tips.

• Steer Clear of the Unknown

There is always the fear of the unknown when it comes to stock and derivatives markets. There might be events that have an unknown impact on the market. Trading during such events is a mistake.

Avoid entering into a trade during such unknown events. Plan your trades after the events pass so that any impact on the market is already made away with.

You may also want to know How to Trade in Futures and Options