Understanding Derivatives
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The terms derivatives and speculation are almost synonymous. Some even call it as a sophisticated form of gambling. After all these years, the most famous investor in the world, Warren Buffet, still believes that derivatives are “financial weapons of mass destruction”. When people hear the word derivatives, they tend to tune out because it somehow implies complexity. Yes, derivatives are complicated as compared to cash stock trading and this is because the only thing that matters in cash market trading is direction in the stock. Buy the stock if you think it will go up and sell it if you think it will come down. With derivatives, there’s a lot more to think and analyze.
In addition to trading the trend, we need to think about the implied volatility, premium, discount, lot size and last but not the least, expiry. And without a shade of doubt, derivatives can be a tough nut to crack. However, in the Indian market, in the past six-seven years the charm of derivative trading has seen a sharp spurt and it has been a major contributor to the daily turnover of the exchanges. The fact is that a large chunk of the volumes in the derivative market are driven by small individual speculators and retail traders. The reason is that derivative trading allows traders to put up a small amount of money to bet on the direction of a stock or the index, though this may be complex and risky.
However, the small traders or retail investors with bits and pieces of knowledge start trading in the derivatives markets with high expectation of turning them from rags to riches in a quick span of time. And the truth is that the greed to become rich overnight using the path of derivatives has done so much destruction to retail investors’ wealth that it has forced the Securities and Exchange Board of India (SEBI) to restrict retail investors from participation in the derivatives’ segment with an amendment in the minimum contract size in the equity derivatives segment pushed to Rs 5 lakhs from the present limit of Rs 2 lakhs. This change will come into effect from the next trading day after expiry of the October 2015 contract.
According to SEBI, this move will protect the small and retail investors from these highly volatile products and will shift their focus on long-term investment. This is a sincere and a noble thought. However, DSIJ believes that the roots of these sophisticated products are so strong that it’s not easy to keep the small and retail investor at bay. Rather than keeping at bay, it’s important to provide them ample education, valuable insight and fine-tune their skills on how to use these sophisticated trading instruments effectively. It must take heed of the proverb: “Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime”.
Therefore, we have taken the initiative to provide the much-needed education, valuable insights and moreover some of the best strategies which work in different phases of the market to help the retail or small investors. Presented below are a few important trading strategies for derivatives along with the risks and rewards associated with them and a detailed pay-off chart.
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Directional Move Strategy
- Bull Call Spread: Bullish Strategy.
- Bear Put Spread: Bearish Strategy.
What is a Bull Call Spread?
A Bull Call Spread option strategy is employed when the trader thinks that the price of the underlying asset will go up moderately but he wants to reduce his risk and so he initiates this strategy. This strategy involves buying a lower strike call option while simultaneously selling a higher strike call. For example, assume that ICICI Bank is trading near the 290 levels and a trader is moderately bullish and believes that the stock price will surge higher up to the 310 levels Considering this, he will buy ICICI Bank’s call option with strike price of 280 and simultaneously will sell the ICICI Bank call option with the strike price of 300.
In this strategy the investor will pay a total premium of Rs 12,400 i.e. 1,000x12.40 where 1,000 is the lot size of ICICI Bank and Rs 12.40 is the premium of 280 call option and at the same time the investor will receive total premium of Rs 3,800 i.e. 1,000x3.80, where 1,000 is the lot size of ICICI Bank and Rs 3.80 is the premium of 300 call option. In this strategy the trader would receive premium of Rs 3,800 and on the other hand pay a premium of Rs 12,400 so that the net cost of trade would be Rs 8,600 (12,400-3,800).
In this strategy the maximum loss is limited. The worst that can happen is for the stock prices to trade below the lower strike price at expiration i.e. below 280. In that case, both the call options expire worthless, and the loss incurred is simply the net cost of trade i.e. Rs 8,600. This strategy will be profitable if the stock price is at 280 or above the higher (short call) strike price i.e. 300.
Who Should use the Bull Call Spread? It makes sense to use Bull Call Spread during a moderate bullish phase or during an up-move. If a trader believes a stock or an asset is likely to move in an upward direction at least until the options expire, then utilizing this strategy makes sense.
Risk and Reward
Risk: In Bull Call Spread the risk factor is limited; the maximum potential loss would be net premium paid at the outset i.e. Rs 8,600.
Reward: In this strategy the reward is limited; maximum reward is difference in the strike price less net premium paid. The difference in strike price is Rs 20 i.e. 300-280 and lot size is of 1,000, so 20x1,000 – 8600 = 11,400. Therefore, maximum profit form this strategy would be Rs 11,400.
What is a Bear Put Spread?
A Bear Put Spread option strategy is a bearish strategy when a trader is moderately bearish and he thinks that the price of the underlying asset is likely to correct in the near term, but simply shorting a stock or buying a put may seem too risky. In that case he will buy a put option with higher strike rate and simultaneously sell a put option with lower strike rate. For example, assume that Wipro is trading near 590 levels and the investor think that Wipro will slide till Rs 580 levels or lower. In this case, the trader will buy a Wipro put option with the strike price of 600 and simultaneously sell Wipro put with strike rate of 580.
In this strategy the investor will pay a total premium of Rs 11,150 i.e. 500x 22.3 where 500 is the lot size of Wipro and Rs 22.3 is the premium of 600 put option and at the same time he will receive total premium of Rs 6, 575 i.e. 500x13.10 while selling 580 put option. In this strategy the trader would receive premium of Rs 6,575 and on other hand he is paying premium of Rs 11,150 so that the net cost of trade would be Rs 4,575 (11,150-6,575).
In this strategy the maximum loss is limited. The worst that can happen is for the stock to trade at or above the higher strike price at expiration i.e. above 600. In that case, both the call options expire worthless, and the loss incurred is simply the net cost of trade i.e. Rs 4,575.This strategy will be profitable if the stock price is at 580 or below the lower (short put) strike price i.e. 580.
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Who Should Use the Bear Put Spread?
It makes sense to use Bear Put Spread during a moderate bearish phase or during a down-move. If a trader believes a stock or an underlying asset is likely to move in the downward direction at least until the options expire, then utilizing this strategy makes sense.
Risk and Reward
Risk: In the Bear Put Spread the risk is limited; the maximum potential loss would be net premium paid at the outset i.e. Rs 4,575.
Reward: In this strategy the reward is limited; maximum reward is difference in the strike price less net premium paid. The difference in strike price is Rs 20 i.e. 600-580 and lot size is of 500, so 20x500–4,575= 5,425. So maximum profit from this strategy would be Rs 5,425.
Strategy Used in Neutral Market
- Long Call Butterfly
- Long Put Butterfly
What is Long Call Butterfly?
Long Call Butterfly: Sell 2 ATM (at the money) call Buy 1 OTM (out of the money) call and buy 1 ITM (in the money) call.
A Long Call Butterfly option strategy is used when we expect that the price of the underlying security will not move much in either direction. Preferably we want the underlying security to be exactly at the middle (ATM) strike in order to achieve maximum profit, which is limited. According to this strategy, a trader will sell two call options with the same strike rate i.e. ATM (at the money call) and buy a call option with higher strike rate OTM (out of money call) and buy a call option with lower strike rate ITM (in the money call). For example, if LT is now trading near the 1,550 levels and a trader thinks that LT will trade in the range of 1,600 on the higher side and 1,500 on the lower side, he will sell 2 ATM call option i.e. 1,550 call option and simultaneously will buy ITM 1,400 call option and OTM Call option of strike price 1,700.
In this strategy, a trader will pay premium of 2 call options; one would be OTM 1,700 call option i.e. 4x125=500 where 125 is the lot size of LT and Rs 4 is the premium of 1,700 call. In addition to this will be one more call option of ITM 1,400 call option i.e. 166.65x125=20,831.25; so the total premium paid is 500+20,831= 21,331.25 and at the same time he will receive total premium of Rs 10,225 i.e. 2x125x40.9 while selling 2 lots of ATM 1,500 call option. So the net cost of trade would be Rs 11,106.3 i.e. 21,331.25-10,225.
In this strategy, maximum loss is limited. The worst that can happen is for the stock price to be below the ITM call option strike price or go higher above the OTM call option strike price. In that case the loss would be Rs 11,106.30. This strategy will be profitable if the stock price is between Rs 1,500-1,600. Maximum profit can be obtained if it expires near the cost i.e. 1,550.
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Who Should Use the Long Call Butterfly?
It makes sense to use Long Call Butterfly during range-bound movement in the price of the underlying asset. If a trader believes a stock or an asset is likely to move in a narrow range due to lack of cues or triggers then utilizing this strategy makes sense.
Risk and Reward
Risk: In Long Call Butterfly the risk factor is limited; the maximum potential loss would be net premium paid at the outset i.e. 11,106.30.
Reward: In this strategy the reward is also limited; maximum reward would be Rs 7,643.75 if the price of the underlying at expiration is exactly at 1,550.
What is Long Put Butterfly?
Long Put Butterfly: Sell 2 ATM (at the money) Put Buy 1 OTM (out of the money) Put and Buy 1 ITM (in the money) Put.
A Long Put Butterfly option strategy is almost identical to the Long Call Butterfly. The only difference in Long Put Butterfly is that we use Put options instead of Call options. This strategy is used when we expect that the price of the underlying asset will not move much in either direction. Preferably a trader expects the underlying asset to be exactly at the middle (ATM) strike in order to achieve maximum profit. According to this strategy, a trader sells two put option with same strike price (at the money put) and buys a put option with higher strike price (out of the money put) and buy out option with lower strike price (in the money call).
For example, consider that SBI is trading near the Rs 245 levels and a trader thinks that SBI will trade in the range of Rs 255 on the higher side and on the lower side at Rs 235. Given this, he will sell 2 lots with strike price of 245 (ATM) and simultaneously will buy one lot put of 235 (ITM) and one lot of put 255 (OTM). In this strategy a trader will pay Rs 18,800 i.e. 1,000x(14.4+4.4) where 1,000 is the lot size of SBI and Rs 14.4 is premium for 255 put option and Rs 4.4 is premium for 235 put option. On the other hand, a trader will receive premium of Rs 17,500 i.e. 2x1,000x8.75, where 1,000 is the lot size of SBI and Rs 8.75 is premium of 245 (ITM) put option. In this trade the net cost would be Rs 1,300 i.e. 18,800-17,500.
In this strategy the maximum loss is limited. The maximum loss is up to Rs 1,300 if the stock price is at or below 235 on the lower side or if the stock price is at or above 255. This strategy would be profitable if the stock price moves in the range of 240-250 and maximum profit can be obtained if the stock price is at Rs 245.
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Who Should Use the Long Put Butterfly?
It makes sense to use Long Put Butterfly during range-bound movement in the price of the underlying asset. If a trader believes a stock or an asset is likely to move in a narrow range with negative bias due to lack of cues or trigger in the underlying asset then utilizing this strategy makes sense.
Risk and Reward
Risk: In Long Put Butterfly the risk is limited; the maximum loss would be net premium paid at the outset i.e. Rs 1,300.
Reward: In this strategy the reward is also limited; maximum reward would be Rs 8,700 if the price of the stock at expiration is exactly at Rs 245. The reward will reduce if the stock at the expiration is at Rs 240 on the lower side and on the higher side at Rs 250.
Strategy Used in Times of High Volatility
- Long Straddle
- Long Strangle
What is a Long Straddle Strategy?
Long straddle option strategy is also known as a buy straddle strategy. It is a delta neutral strategy employed by a trader when he is expecting a big move to take place in the price of the underlying asset but is not sure about the direction of the movement. This strategy involves buying of one lot of ‘at the money’ (ATM) put option and one lot of ‘at the money’ (ATM) call option. For example, consider that AMBUJACEM is trading near the 210 levels and the trader is expecting that the stock will see a major move in the coming trading sessions on the back of some announcement in the stock. Considering this he will buy one lot of (ATM) 210 call option of Ambuja Cement and simultaneously will buy one lot of (ATM) 210 put option of Ambuja Cement.
In this strategy a trader will pay total premium of Rs 12,250 i.e. (5.20+7.35)x1,000, where Rs 5.20 is premium of 210 call option of Ambuja Cement and Rs 7.35 is premium of 210 put option of Ambuja Cement and 1,000 is lot size of the stock. So the net cost of the trade would be Rs 12,250. In this strategy the maximum loss is limited. The worst that can happen is for the stock price to hold steady and move in a narrow range. If at expiration the stock price is exactly same or nearby, than both options will expire at zero. The gains in this strategy are unlimited. The best that can happen is that the stock makes a big move in either direction i.e. if the stock price moves at or below Rs 195 on the lower side and on the higher side if the stock trades at or above Rs 225.
Who Should use the Long Straddle? It makes sense to use Long Straddle when one expects huge volatility in the price of the underlined asset but the direction of the move is not certain. If a trader believes that the stock is likely to witness a sharp move either on upside or downside then utilizing this strategy makes sense.
Risk and Reward
Risk: In Long Straddle strategy the risk is limited; the maximum potential loss would be net premium paid at the outset i.e. Rs 12,250.
Reward: In this strategy the reward is unlimited; a large move in the stock price will result in higher profits. Maximum profit in this strategy would be obtained if the stock price moves higher up to levels of Rs 230 and on the downside the stock corrects up to levels of Rs 190.
What is a Long Strangle Strategy?
Long Strangle option strategy is also known as a buy strangle strategy. This is a delta neutral strategy employed by a trader when he is expecting a big move to take place in the price of the underlined asset but is not sure about the direction of the movement. In this strategy a trader buys 1 lot of call option (out of money) and 1 lot of put option (out of money). For example, consider YESBANK trading near 730 levels and a trader is expecting a big move in the stock i.e. on the higher side the stock will move up to Rs 800 and on the lower side it is likely to come down to levels of Rs 640. Considering this, he buys 1 lot of Yes Bank call option of 780 strike price and one lot of put option with strike price of 680.
In this strategy a trader will pay total premium of Rs 4,937.5 i.e. 1 lot of 780 call option at Rs 9.05x250= 2,262.15 where 250 is the lot size of Yes Bank and Rs 9.05 is the premium of 780 strike price call option. Similarly, if we calculate for 680 put option the amount comes to Rs 2,675. So by adding the premium of both the options we get 4,937.5. In this strategy maximum loss is limited. The maximum loss occurs if the underlying stock remains between the strike prices until expiration. Maximum loss would occur if the stock moves in the range of 680 to 780. This strategy will be profitable if the stock price moves at or below Rs 660 on the lower side and on the higher side if the stock price moves at 800 or above.
Who Should Use the Long Strangle?
It makes sense to use Long Strangle when one expects huge volatility in the price of the underlined asset but the direction of the move is not certain. If a trader believes that the stock is likely to witness a sharp move either on upside or downside then utilizing this strategy makes sense.
Risk and Reward
Risk: In Long Strangle strategy the risk is limited; the maximum potential loss would be net premium paid at the outset i.e. Rs 4,937.50.
Reward: In this strategy the reward is unlimited; a larger move in the stock price will result in higher profits. Maximum profit in this strategy would be obtained if the stock price moves higher up to levels of Rs 830 and on the downside the stock corrects up to levels of Rs 630.
Disclaimer: Futures, Stocks and Options trading involve substantial risk of loss and are not suitable for every investor. All ideas, opinion, forecasts, charts or examples contained above are for informational and education purposes only and should not be construed as a recommendation to trader or speculate in the markets.