How to Make Money Trading Derivatives

1. Master the Art of Trend Identification with ADX

The ADX can tell the strength of the move that a market may be in and thus help you keep you out of a whipsawing market and by keeping you in long enough during a trending market to make huge profits.

ADX Decoded. The Average Directional Movement Index (ADX) is your compass in the market wilderness, revealing whether the market is trending or range-bound. Developed by Welles Wilder, the ADX doesn't tell you the direction, but the strength of the trend. A high ADX signals a strong trend (up or down), while a low ADX indicates consolidation, a time to tread carefully.

Interpreting ADX Values. An ADX below 20 suggests a weak trend, favoring oscillators like RSI. A rising ADX from 15 to 25 signals a strengthening trend, perfect for trend-following systems. An ADX above 30 confirms a strong trend, while an ADX exceeding 45 suggests the trend is nearing exhaustion. Think of ADX as the market's heartbeat: a strong, steady beat means a healthy trend, while a weak, erratic beat calls for caution.

Practical Application. Use ADX to filter signals from other indicators. In trending markets (high ADX), trust trend-following indicators like MACD. In range-bound markets (low ADX), rely on oscillators like RSI and stochastics. This strategic approach prevents whipsaws and maximizes profit potential. ADX works on all timeframes, from intraday to weekly charts, making it a versatile tool for any trader.

2. Combine Technical Tools for High-Probability Trades

Profitable trading does not depend on the knowledge of a large number of theories, rather it depends on successfully implementation of a few.

Confluence is Key. Don't rely on a single indicator; instead, seek confluence, where multiple indicators confirm the same signal. Combine trend-following indicators (MACD, moving averages) with oscillators (RSI, stochastics) and chart patterns (trendlines, flags) for robust trading decisions. This approach increases the probability of success by validating signals from multiple angles.

Trend Following vs. Oscillators. Use trend-following indicators like MACD and moving averages in trending markets (high ADX). Oscillators like RSI and stochastics excel in range-bound markets (low ADX), identifying overbought and oversold conditions. Applying the right tool for the market condition is crucial.

Trendlines as Guides. Trendlines are simple yet powerful tools for identifying and trading trends. Connect at least three non-consecutive points to form a valid trendline. Breakouts or breakdowns of flatter, longer trendlines are more significant. Use trendlines to place stops and scale into positions.

3. Swing Trading: Capitalizing on Market Swings

Swing trading is the most consistently profitable strategy that you can use in the futures market.

Capture Short-Term Moves. Swing trading involves holding positions for a few days to a couple of weeks, capitalizing on short-term market swings. The key is to identify the trend in a higher timeframe (e.g., weekly) and then look for low-risk entries in the direction of that trend on a lower timeframe (e.g., daily). This approach allows you to ride the dominant trend while minimizing risk.

Entry Techniques. Three primary methods for entering trends on reactions are:

• 20-day Moving Average (DMA): Enter when the price corrects below the 20 DMA and then moves back above it.
• RSI (7): Enter when the RSI (7) moves below 40 (oversold) and then turns back upwards in an uptrend.
• Stochastics (7,10): Enter when stochastics (7,10) go below 20 (oversold) and then turn upward in an uptrend.

Support and Resistance. Draw support and resistance lines on your charts to create a roadmap for your trades. These levels act as potential entry and exit points, helping you manage risk and maximize profit. Remember, swing trading is about catching the meat of the move, not necessarily predicting the ultimate top or bottom.

4. Day Trading: Guerrilla Warfare in the Stock Market

Day trading is about discipline and training of the mind.

Preparation is Paramount. Day trading is akin to a military operation, requiring meticulous planning and discipline. Conduct thorough research outside market hours, identifying potential trading stocks and derivatives. Review their behavior from the previous day and formulate a trading plan.

Rules of Engagement. Stick to a schedule, arriving before the market opens and staying focused throughout the day. Manage losses aggressively, limiting the rupee value loss per trade to no more than 2% of your trading capital. Avoid overtrading, restricting yourself to a maximum of five trades per day.

Exploit Intraday Patterns. Focus on trading during the most active periods of the day, typically before 11:00 a.m. and after 2:00 p.m. Wait for the best entry setups, such as trendline breakouts, flag patterns, and news-based gaps. Use stops and targets to manage risk and reward, aiming for a risk/reward ratio of at least 1:2.

5. Arbitrage: Generate Risk-Free Returns

The cash and futures arbitrage is a strategy which often offers risk free returns at rates better than savings accounts deposits and most other risk free liquid asset classes.

Exploit Price Discrepancies. Cash and futures arbitrage involves exploiting price differences between the cash market and the futures market. When the futures price is higher than the cash price, buy the stock and sell the futures. When the cash price is higher than the futures price, sell the stock and buy the futures. This strategy aims to capture the cost of carry, the difference between the futures price and the cash price.

Understanding Cost of Carry. The cost of carry should theoretically be positive, reflecting the financing cost of holding the underlying asset. However, in the Indian market, sentiment can drive the cost of carry negative, creating arbitrage opportunities. High costs of carry often signal overbought markets, while negative costs of carry suggest oversold conditions.

Benefits of Arbitrage. Cash and futures arbitrage offers risk-free returns, especially during periods of market consolidation. It provides a reasonable return when no other trades are visible, allowing you to deploy idle cash. It also reduces the market risk of a portfolio by hedging against market declines.

6. Options: Control Risk and Amplify Returns

The huge benefit of options, on the other hand, is that they are non-linear products with only limited downside but unlimited upside for the buyer.

Non-Linear Power. Options are non-linear instruments, offering limited downside and unlimited upside for buyers. Calls give the right to buy, while puts give the right to sell. Options can be used for speculation (trading) or hedging (risk management).

Key Concepts. Understand market lots, strike prices (in-the-money, out-of-the-money, at-the-money), and expiration dates. Option value comprises intrinsic value (the amount an option is in-the-money) and time value (the portion of the premium exceeding intrinsic value).

Volatility is Key. Volatility, a measure of price fluctuation, is crucial in options trading. Historical volatility reflects past price changes, while implied volatility reflects the market's expectation of future price movements. Buy options with low implied volatility and sell options with high implied volatility.

7. Covered Calls: Generate Consistent Income

Gujral's book is heavily under-priced for the great ideas it offers so liberally.

Rent from Your Stocks. Covered call writing involves selling call options on stocks you already own. This strategy generates income from the option premium while maintaining ownership of the underlying stock. It's ideal for sideways or mildly bullish markets.

How it Works. You own a stock and sell a call option with a strike price above the current market price. If the stock price stays below the strike price, you keep the premium. If the stock price rises above the strike price, your stock is called away, but you still profit from the premium and the stock's appreciation up to the strike price.

Choosing the Right Stocks. Select stable, large-cap stocks with good liquidity and limited downside risk. Avoid stocks with speculative bubbles or questionable fundamentals. The goal is to generate consistent income, not to chase high-risk, high-reward opportunities.

8. Special Situations: Profit from Predictable Events

The key here is not to speculate on what announcements the budget might contain but to see if the implied volatility of the option premium is high enough to sell.

Capitalize on Market Expectations. Certain events, like budget announcements, company results, and election results, create predictable volatility spikes. Sell options before these events to capture the inflated premiums, as the market often overestimates the impact of the news.

Budget Trading. The budget, once a major market driver, now has a limited impact. Focus on selling straddles (selling both calls and puts) when implied volatility is high, regardless of the expected direction.

Company Results. Write covered calls on fundamentally strong companies before their earnings announcements. The key is to assess the implied volatility and the stock's technical position, ensuring it's not overbought.

9. Discipline: The Bedrock of Trading Success

The market takes away money from indisciplined traders and gives it to the disciplined ones.

Discipline Over Knowledge. While technical analysis is important, discipline is paramount. A disciplined trader follows a trading plan, manages risk, and controls emotions. They avoid overtrading, stick to their strategy, and learn from their mistakes.

Qualities of a Disciplined Trader. A disciplined trader is organized, patient, and self-controlled. They have a trading plan, do their homework, and avoid emotional decision-making. They treat trading as a business, not a gamble.

Traits of an Indisciplined Trader. Indisciplined traders jump into trades impulsively, ignore market signals, and chase emotional highs. They overtrade, blame the market for their losses, and fail to learn from their mistakes.

10. Money Management: Protect Your Capital

The size of Your Trading Positions should be Based on the Size of Your Trading Capital

Preserve Your Capital. Money management is about protecting your trading capital and ensuring long-term sustainability. It's not about maximizing profits on every trade, but about surviving the inevitable drawdowns and staying in the game.

Position Sizing. Determine the appropriate size of your trading positions based on your account equity. A conservative approach involves trading one Nifty futures contract for every Ͳ2 lakh in your account. A more aggressive approach may involve trading one contract for every Ͳ1 lakh.

Stops and Exits. Use stops to limit your losses and protect your capital. Place stops at logical levels based on chart patterns and market volatility. Have a clear exit strategy before entering a trade, and stick to it.

Last updated: February 21, 2025