Suppose you hear your favourite band is coming to town. You want to buy tickets, but you think the prices might drop. You find someone who will hold a ticket for you at today’s price for a small fee. This is similar to trading market derivatives. Without owning the ticket, these contracts let you agree on a future price based on today’s value. Let’s discuss the concept of derivates in detail and highlight some derivative trading strategies that can position you as a successful derivative trader.
What are Derivatives?
Derivatives are a category of financial instruments whose value is based on an underlying asset, such as stocks, bonds, commodities, or currencies. These are essentially contracts between two parties that agree to exchange either assets or cash flows contingent on how the underlying asset performs. In India, derivatives play a significant role in the stock market for hedging risks or speculating price movements.
To understand the derivatives market better, let’s consider a simple example.
Suppose you are a farmer engaged in wheat cultivation and harvesting. You supply your crop to different states in India. However, due to better conditions this year, the wheat was harvested in abundance, leading to more supply than demand. You are concerned that the price of wheat might drop by the time you finally supply your crop. To protect yourself, you get into a futures contract with a buyer who is ready to purchase your wheat at a prearranged price at a future date. This contract is a derivative because its value is based on the cost of grain. If the market price of wheat falls, you are protected because you can sell your wheat at the agreed-upon price, thus avoiding a loss.
Understanding Different Types of Derivatives
Here are the definitions and key differences between different derivative contracts.
| Aspect | Futures | Options | Swaps | Forwards |
| Definition | Standardised contracts to trade an asset at a future date at a prearranged price. | Contracts that give the holder the right, but not the mandate, to trade an asset at a prearranged price before or at expiration. | Agreements between two parties to exchange financial instruments or cash flows over a specified period. | Customised contracts between two parties to trade assets at a future date at a prearranged price. |
| Trading Venue | Traded on exchanges like NSE and BSE. | Traded on exchanges (e.g., NSE) or over-the-counter (OTC). | Typically traded over-the-counter (OTC). | Traded over-the-counter (OTC). |
| Standardisation | Highly standardised with specific terms and conditions. | Standardised when traded on exchanges; customisable OTC. | Highly customisable based on the needs of the parties involved. | Highly customisable with flexible terms. |
| Risk and Margin | Requires margin and daily settlement; high risk due to leverage. | Requires premium payment; risk limited to the premium paid. | Risk depends on the terms of the swap; it can be significant. | No margin requirement; risk depends on the counterparty. |
| Settlement | Daily settlement through marking to market; physical or cash settlement at expiration. | Settled by exercising the option or letting it expire; physical or cash settlement. | Periodic settlement based on the terms of the swap. | Settlement occurs at the contract’s expiration date. |
| Use Cases | Hedging against price fluctuations, speculative trading. | Hedging, speculative trading, income generation through premiums. | Managing interest rate risk, currency risk, and other financial risks. | Hedging against price fluctuations, speculative trading. |
How to Trade Derivatives?
You can employ any of the following strategies to become a successful derivative trader.
1. Box Spread
A box spread is a market-neutral equity derivatives strategy that merges a bull call and a bear put spread with identical expiration and strike prices. This strategy aims to secure a risk-free profit by taking advantage of price discrepancies in the options market. Here, you buy a call and a put at one strike price while selling a call and a put at a higher strike price.
Suppose you buy a call and a put at ₹100 and sell both at ₹120. After deducting the initial expenses and commissions, the ₹20 difference between the strike prices will be your profit.
2. Protective Put
A protective put is a way to secure your investments against potential losses. If you hold shares in a company but are concerned about a price fall, purchasing a put option allows you to trade your shares at a strike price. This works as insurance, limiting loss if the stock’s value drops.
For example, if you hold 100 shares of Reliance Industries priced at ₹2,500 each, you can buy a put option for this company with a strike price of ₹2,400. If the stock falls to ₹2,200, you can sell your shares for ₹2,400, reducing your potential loss. This approach allows you to control risk while remaining invested.
3. Butterfly Spread
The butterfly spread is a balanced share market derivative strategy that merges both bull and bear spreads to control risk and cap potential gains. It consists of four options contracts with three strike prices. You buy one call at a lower price, sell two calls at a middle price, and buy one at a higher price, aiming to profit when the asset’s price remains within a certain range.
Suppose you believe the stock will stay close to ₹100. In this case, you can buy a call at ₹90, sell two calls at ₹100, and buy another at ₹110. Your highest profit comes when the stock stays at ₹100.
4. Iron Butterfly
The Iron Butterfly strategy is fit for traders expecting minimal price changes in an asset. It works by selling one at-the-money call and put while purchasing an out-of-the-money call and put, limiting potential profits and losses.
Suppose you expect a stock trading at ₹100 to stay flat. You sell a ₹100 call and put and purchase a ₹110 call and ₹90 put via a derivative app. If the stock price hovers near ₹100 until expiration, your profit from the premiums will be maximised.
5. Long Strangle
A long strangle is an options strategy in which you purchase a call and a put on the same asset, with different strike prices but the same expiry date. This method works well if you anticipate a large price shift but are uncertain of its direction.
For example, if you buy a call option for Reliance Industries at ₹2,500 and a put option at ₹2,300, a sharp price move in either direction will allow you to profit from one of the options. This strategy works well in volatile markets, limiting your risk to the premiums paid.
6. Long Straddle
A long straddle options trading strategy requires you to purchase both a call and a put option for the same underlying asset, sharing the same strike price and expiration date. This approach is perfect when you expect a substantial price shift but are uncertain about the direction.
Let’s say you buy a call option and a put option for Reliance Industries at ₹2,500. You can earn from either movement if the stock price rises to ₹3,000 or falls to ₹2,000. Conversely, if the price remains stable, your loss would equal the combined premiums of both options.
Conclusion
Derivatives are contracts whose value is tied to an underlying asset. When trading in derivatives, it is crucial to take certain precautions. However, when trading in equity or currency derivatives, thoroughly understand the product and its risks. Start with a clear trading plan, including your risk tolerance. Set up stop-loss orders to minimise losses and ensure your investments are within your financial means. Remain aware of market changes and news that could affect asset values.
To begin trading in derivatives, first open Demat account online with a reputed broker like HDFC SKY or use a reliable Demat app to manage your investments efficiently.
