In this article, we will discuss
- Derivatives 101: What are They and How to Trade Them?
- The Importance of Derivatives Trading Strategies
- Types of Derivatives Trading Strategies
- Conclusion
Derivatives trading has grown increasingly popular in India in recent years. Both the options and the futures market are abuzz with retail investor activity, facilitated by platforms like Samco Securities and the Samco trading app. It’s possible that you too may have dabbled in the derivatives market and traded using options and futures. As a beginner, you may only be familiar with basic buying and selling strategies.
However, you can improve your trading performance with various derivative trading strategies. This article will discuss derivatives trading in more detail and shed light on some effective strategies that you can use in the derivatives market.
Derivatives 101: What are They and How to Trade Them?
Derivatives are financial securities that derive their values from other underlying assets. These assets can be equity stocks, commodities, currency pairs or even market indices. The two main types of derivative instruments that use these assets as the underlying value-add are framed as contracts, which is why we refer to them as options contracts and futures contracts (or options and futures, respectively).
Futures contracts must be honoured, meaning that the sale or purchase as specified in the contract must be completed. However, with options, you have the flexibility to honour the contract or let it expire, depending on how the price of the underlying asset moves. For instance, if you buy a call option, you have the option (and not the obligation) to purchase the underlying asset at the specified price (strike price) on the expiration date. If the strike price is higher than the asset’s market price at expiry, you can let the option expire. Similarly, if you buy a put option, you have the option to sell the underlying asset at the strike price on the expiration date.
You can trade futures and options on the stock exchanges like the NSE and the BSE if you have a trading account. You should also be aware of the margin money required for your derivatives positions and ensure that you have sufficient balance in your trading account. Most beginners focus on taking a long position in the derivatives market and squaring it off within a short period, or consider writing (i.e. selling) options to profit from the premiums. However, derivatives trading is much more nuanced and varied, as you’ll find out in this article.
The Importance of Derivatives Trading Strategies
Types of Derivatives Trading Strategies
Depending on the goal of the trade and the methods used, derivatives trading strategies can be classified as hedging, income generation, arbitrage, speculation or leverage techniques. Let us take a deep dive into each of these derivatives trading strategies to understand what they entail.
Hedging with Derivatives
Hedging with derivatives can be your go-to strategy if you are looking to protect your other investments from market volatility. Here, you use options and/or futures to offset or minimise potential losses in other existing investments. The primary aim of this derivatives trading strategy is not to maximise profits but to minimise risks. You can use F&O contracts to counter potentially unfavourable movements in the price of the underlying asset — if you already hold that asset.
For example, if you hold a company’s stocks in your portfolio, you could buy put options to protect yourself from a market downturn. Alternatively, if you are a commodity trader, you could use commodity futures to lock in future prices and shield yourself from unfavourable price changes.
To successfully hedge your open positions using derivatives, you should understand the correlation between your primary investment and the derivative you are using. That said, while hedging can limit the downside, it could also cap the upside potential. So, you have to learn to balance the risks and rewards optimally.
Income Generation Strategies
These derivative trading strategies involve using options contracts to generate a stream of additional or alternate income. When you sell or write an options contract, the buyer of the contract pays you a premium. This is the income that you stand to receive from the trade. If the option expires worthless, you get to keep the entire premium (minus any trading charges and costs) as your income.
Call writing, in particular, is generally popular in this category of trading strategies. Here, you sell call options on stocks that you already own. The premium received is your immediate income. If the stock price remains below the strike price at expiry, the options expire worthless and you can keep the premium as well as your shares. So, this is essentially a way to squeeze some additional benefits from your existing portfolio.
You can also sell cash-secured puts. This involves writing options on stocks you may want to hold in your portfolio. However, the value of such stocks should be backed by cash in the bank account linked to your trading account. If the stock price remains above the strike price at expiry, the option expires worthless and you can pocket the premium.
Arbitrage Strategies
Arbitrate strategies in derivatives trading aim to profit from price discrepancies in related securities or markets. The goal here is to buy and sell simultaneously to make risk-free profits, or to limit risk as much as possible. To identify an arbitrage opportunity, you need to look for a scenario where the same asset is priced differently in different markets — or where there is a misalignment between the price of a derivative and its underlying asset.
Index arbitrage is a common arbitrage strategy in derivatives trading, where you may buy undervalued stocks that closely replicate an index in the cash market and simultaneously sell overpriced index futures. The goal here is to profit from the potential price convergence as the expiration date draws closer.
Volatility arbitrage is another effective derivatives trading strategy. Here, you take advantage of the differences between the implied volatility and realised volatility of a security. For instance, if you believe that an options contract is overpriced based on its implied volatility, you can sell it and simultaneously buy the underlying asset to offset the directional risk. With time, if the realised volatility is lower than the implied volatility, the difference could be your profit.
Speculative Derivatives Trading
This is a high-risk derivatives trading strategy that involves taking positions in the options or futures market based on predicted future price movements. Unlike hedging, the goal of speculative trading is to profit from the expected changes — and not just to minimise the risks in other positions.
One advantage of speculative derivatives trading strategies is the potential to earn high returns with relatively small initial investments. However, your losses can also be magnified. To offset this increased risk, stock exchanges require a margin money deposit from traders.
As a speculative trader, you need to make educated estimates about how the market may move in the future. If you expect the price of the underlying asset to rise, for instance, you may buy call options or write put options. If you expect it to fall, you may buy put options or write calls. Futures contracts can also be used for speculation as they allow you to trade based on potential price movements without actually owning the underlying asset.
Leverage-Based Strategies
This type of derivative strategy uses options and futures to control a large position in the market with a relatively small amount of capital. One common leverage-based approach is trading futures contracts. With futures, you only need to put up a fraction of the contract's value as margin money. This allows you to take larger positions than you could in the spot market with the same amount of capital.
Options can also provide leverage, as the premium paid is typically much less than the value of the underlying asset. Another strategy is using CFDs (Contracts for Difference), which allow you to speculate on price movements without owning the underlying asset. With CFDs, you can often trade on margin, further increasing your leverage.
While leverage can potentially magnify your returns, it's crucial to understand the risks too. A small move against your position can lead to significant losses that potentially exceed your initial investment. That's why proper risk management is vital when you are using leverage-based strategies.
Conclusion
The bottom line is that derivatives trading can be done using a diverse range of strategies that each suit varying investment goals and risk appetites. From risk mitigation and hedging to profit-seeking through speculation and arbitrage, these strategies can be powerful tools to navigate the financial markets. Income generation and leverage-based approaches further expand the possibilities for traders.
However, it's crucial to remember that while derivatives can offer significant opportunities, they also come with substantial risks. Success in derivative trading requires a deep understanding of these instruments, careful risk management and continuous market analysis.
Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING. The asset classes and securities quoted in the film are exemplary and are not recommendatory. SAMCO Securities Limited (Formerly known as Samruddhi Stock Brokers Limited): BSE: 935 | NSE: 12135 | MSEI- 31600 | SEBI Reg. No.: INZ000002535 | AMFI Reg. No. 120121 | Depository Participant: CDSL: IN-DP-CDSL-443-2008 CIN No.: U67120MH2004PLC146183 | SAMCO Commodities Limited (Formerly known as Samruddhi Tradecom India Limited) | MCX- 55190 | SEBI Reg. No.: INZ000013932 Registered Address: Samco Securities Limited, 1004 - A, 10th Floor, Naman Midtown - A Wing, Senapati Bapat Marg, Prabhadevi, Mumbai - 400 013, Maharashtra, India. For any complaints Email - grievances@samco.in Research Analysts -SEBI Reg.No.-INHO0O0005847
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