Playing far month derivatives can be tricky business. One needs to understand the psychology of trade participants and get in the trade at the right price. Day traders should avoid trading in far month derivatives at all costs.
What can be a far month derivative?
A far month derivative is usually matures 2-3 months down line. In India the maximum maturity allowed by exchanges is 3 months. However, in US or other mature markets the far month derivatives can also be more than 6 months. In India currency futures can be 1 year long too. Be aware of the market and instrument you are trading. Please don’t jump straight away as you received your salary yesterday. There are many resources available and would suggest going through them first. One of them is Zerodha Varsity.
Which derivative instruments trade in the far month?
Far month derivatives can include Options as well as Equity/ Currency futures. Both have different payoff models. Futures have a linear payoff model, whereas options have the opposite. Hence, be careful with options as you have to get three things correct viz. Time to maturity of the option contract ( time value ) , price momentum of the underlying equity/index ( volatility ) and appropriate strike price ( ITM, OTM or ATM ). There are other things to consider as well, however the above are the most important.
Role of market depth
Market depth has a key role to play in far month derivative trades. It serves as a barometer and indicates if the trade participants are genuinely interested in the move or manipulation of prices is going on. The market depth in far month derivatives will often show one sided bias due to liquidity issues. Being the far month, participants are generally on the lower side and hence during price consolidation, one side bias in bid or ask may be seen frequently. For example in the below image one can see that there are no buyers in the left side. This is probably due to a downward movement in price for that day, and thus one can only view sellers for the below futures contract.
Watching bid and ask spreads
A far month derivative tends to have large spreads during price consolidations. One can manipulate the prices, when price volatility is on the lower side. This is possible as transactions during this period have subsided. Only when the volatility picks up, we can see high number of transactions. In this scenario the manipulator will deliberately put a bid price lower than the current equity/index price. It is easier to manipulate in groups, wherein the bid prices are deliberately kept low.
Many of the traders operate on a daily basis. Hence, they need to get out by the end of the day. However due to the artificially suppressed bid prices for a certain time duration, such sellers have to offer futures/options at a lower price. The buyer benefits by getting the derivative at a lower price than actual price of the underlying.
In order to avoid the same, it is suggested to have adequate capital, which will allow conversion of a MIS (Margin Intraday Square-Off) trade to CNC ( Cash N Carry ). Having a tight capital base will force you to sell in losses.
Sweet spot to buy
In order to decide a sweet spot for buying once has to consider a long or a short position and zero in on any one. However, there can be both in complex option strategies as well. But that is out of the scope for the purposes of this discussion. In the below image one can see that the top right price is more than the bid and ask prices. How can this be? It is very common in far month derivative market depth section. Here the top right price is high because that is the price where the most recent price has been executed and it is likely that current price of underlying stock has gone side ways or retraced a bit. One can see a stark difference is bid and ask spreads in the lower rows of bid, ask image. It is as high as Rs 53.4. It is huge difference in terms of overall investment amount as 1 lot consists of 625 qty. Hence the potential impact is easily 625 x 53.4 = Rs 33,375 between buy and sell. One may also loose this amount, even if the underlying price has increased, if they are not aware about the intricacies.
Thus one should never buy a far month derivative, if one does not have an intention of holding it till that period or a little less. Till the bid and ask spread are less and are not meaningful.
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