Risks in Derivatives Trading
Participation in derivatives exposes a trader to five broad risk categories — market (price) risk, liquidity risk, credit (counterparty) risk, legal/regulatory ...
The Five Risks of F&O
Participation in derivatives exposes a trader to five broad risk categories — market (price) risk, liquidity risk, credit (counterparty) risk, legal/regulatory risk and operational risk. Every trader must read the Model Risk Disclosure Document before opening an F&O account.
(1) Market risk — the price of the underlying moves against the position; because derivatives are leveraged, a 2% move can wipe out the margin. (2) Liquidity risk — inability to exit a position at a fair price, typical in far-month or deep out-of-the-money contracts. (3) Counterparty/credit risk — the other side defaults; almost eliminated on exchanges by the clearing corporation but very real in OTC. (4) Legal/regulatory risk — a contract turns out to be unenforceable, or regulations change mid-trade (e.g., position limit cuts). (5) Operational risk — fraud, mis-punching, inadequate documentation, system failures. SEBI therefore requires every broker to issue a Model Risk Disclosure Document that the client must sign before opening an F&O account.
Price moves kill the position — amplified by leverage
You can't get out even at a deep discount — no buyers
Counterparty vanishes — OTC pain, not exchange pain
Court finds the contract invalid, or SEBI changes rules overnight
A Practical Example
Sandip sells 10 lots of deep-OTM BankNifty puts 3 weeks before expiry collecting ₹15,000 premium. That Tuesday, US CPI surprises upward and BankNifty gaps down 4% overnight — the puts go ITM, exposing Sandip to ₹12 Lakh MTM loss. He rushes to exit but the bid-ask has widened from ₹2 to ₹18, and he can sell only at a premium of ₹95. Two risks fired at once: market risk (gap down) amplified losses 80x vs credit taken; liquidity risk made exit 9x more expensive than normal. Lesson from the NISM workbook: derivatives are not suitable for someone with limited experience or low risk tolerance.
What Makes This Important
Frequently Asked Questions
A SEBI-mandated standard disclosure every exchange member must give to a new F&O client. It explains leverage, market, liquidity, credit, legal and operational risks in plain language. The client must sign it before the first F&O trade.
🧠 Quick Quiz
2 questions to check your understanding