Understanding Derivatives Trading

We listen to or hear about them every day. Financial planners spurn them. Some have associated them with a number of high-profile corporate events that have tossed the global financial market over the years. And market professionals like Warren Buffett even viewed them as time bombs for the economic system and called them financial weapons of mass destruction. Yet, the equity derivative instruments have become the universal symbol of trading on Dalal Street even if they still appear intimidating as always, don’t they?

Welcome to the domain of derivatives - a class of instruments that has gained fame and is now a chunk of every trader and investor’s trading arsenal. Derivatives are popular given their liquidity, quick returns, and their prospective to provide market participants a hedge to their portfolios. After staging a strong rally and scaling to lifetime high levels in March 2015, the Indian equity markets have been on a rollercoaster ride as several concerns one after another have triggered sell-offs – concerns like slower-than-expected recovery in the economy, tepid corporate earnings, tax-related issues like demand notices to foreign institutional investors (FIIs) levying the minimum alternate tax (MAT), etc. have haunted the market and kept every investor on his toes due to high volatility.
 
Going forward, the general question every equity investor or trader has on his mind is about the direction in which the markets are headed. Is there a clear outlook emerging from the current scenario? We expect the Indian equity market to continue with its volatile phase based on global uncertainty and lacklustre corporate earnings. Thus, in this article we will discuss and decode the world of derivatives, the jargon used to communicate the indicators that explain likely success or profits in this popular instrument of trading. To begin with, let us understand how these sophisticated financial instruments work and what they mean.
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The key objective of every trader or investor is to get the most out of his investment and minimise risks when the markets are tentative and volatile. And this resulted in the birth of a new security for trading i.e. derivatives. The word is used to refer to financial instruments which derive their value from some underlying assets. The ‘Investopedia’ defines derivative as “a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuation in the underlying asset.”

For example, a derivative of the shares of Reliance (underlying security) will derive its value from the share price of Reliance. In simple terms, it’s similar to share trading in the cash segment, i.e. buying and selling of shares but with a specified contract size whose value is derived from an underlying security. The major types of derivatives in the Indian equity market are futures and options.

Futures

As the name suggests, futures are derivative contracts that give the holder the opportunity to buy or sell the underlying at a pre-specified price sometime in the future.  Futures come in standardised form with fixed expiry time, contract size and price. In the Indian equity market, futures are available for index as well as selected stock which meet the criteria on liquidity and volume.

Options

An option contract gives the holder the option to buy or sell the underlying at a pre-specified price sometime in the future. An option to buy the underlying is known as a ‘call’ option. On the other hand, an option to sell the underlying at a specified price in the future is known as ‘put’ option. In the case of an option contract, the buyer of the contract is not obligated to exercise the option contract. In the Indian equity market, options are available for index as well as select stock which are listed in the derivative category.

Every trade that a market participant executes is based on firm rationale and in-depth analysis. The analysis in turn is based on interpretation of data, trends and indicators that provide us clues as to what is expected in the future. Thus, we come to the most important part of derivative investing i.e. understanding the derivative indicators. Indicators play an important role in identifying market sentiments leading to possible movement of price. Both futures and options contracts have different set of indicators that are carefully tracked to understand the sentiment of the market. A common parameter across a derivative contract is the ‘open interest (OI)’.

What is OI?

Open interest, also known as ‘open contracts’ or ‘open commitments’ refers to the number of active or open contracts for any given security. It applies to the futures and options markets but not to the stocks which are trading only in the cash segment. In simple terms, OI means the total number of contracts in the futures and options segment that are still open i.e. they have not been closed on a particular trading day. It is the total number of outstanding contracts that are held by participants at the end of each day. The open interest position that is reported end of the day shows the increase or decrease in the number of contracts for that day in the form of a positive or negative versus the previous day.
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Forecasting Market Sentiments with Options

Though most of the options traders are used to the proceeds and flexibility that options offer, not everyone is mindful of their significance as a predictive indicator. Options contracts tend to consider two major indicators for forecasting the market direction. These are Put-Call Ratio (PCR) and Implied Volatility (IV).

What is PCR?

The PC Ratio i.e. Put Call Ratio measures how many put options are bought versus call options. The formula is very simple: the number of put options traded divided by the number of call options traded in a given period. For example, in a bullish market sentiment, it is considered that there is one put option per every two call options; therefore, according to the calculation, the PCR stands at 0.5. While typically the trading volume is used to compute the Put-Call Ratio, it is sometimes calculated using open interest volume.

The values that help to forecast market sentiments include:

• Ratio of less than 0.6 indicates bullish sentiments
• Ratio in the range of 0.6 to 0.9 indicates normal sentiments
• Ratio of above 0.9 indicates bearish sentiments.

What is Implied Volatility?

Implied volatility of an options contract represents the expected volatility of a stock over the life of the option. As outlooks change, the options premiums react appropriately. Implied volatility is directly influenced by the supply and demand of the underlying options and by the market’s anticipation of the share price’s direction. As expectation rise or demand for the options increases, implied volatility will rise. On the other hand, as the market’s expectations trim or demand vanishes, implied volatility will decrease.

The salient features of forecasting market direction with implied volatility are:

• When implied volatility is high it indicates market will move with high volatility
• When implied volatility is low it indicates a trending move in the market, usually a bullish sentiment. 

The above mentioned are some of the processes that will provide an edge to the market participant to predict the futures movement of the market and spot potential trading opportunities and maximise accordingly. These indicators are used in several variations and combinations to successfully provide expertise to control the financial weapons of mass destruction i.e. derivatives trading.