Imagine you have some savings and want to invest them wisely. With countless investment options available, you might stumble upon terms like equity derivatives or currency derivatives. But what do they mean, and how can they work in your favour? While the term “derivatives” might sound intimidating at first, it essentially refers to financial contracts whose value is based on an underlying asset. This guide aims to demystify market derivatives, breaking them down into simple concepts while offering effective strategies for derivatives trading. Additionally, using a Demat app can simplify managing your investments and tracking your derivative trades in real time.
A Brief History of Derivatives
The concept of derivatives dates back centuries. The earliest records point to ancient Mesopotamia, where farmers used basic contracts to safeguard against crop failures. Fast forward to the 16th century, the Italian city of Venice saw the creation of agreements similar to options, which protected merchants from losses due to fluctuating prices.
In the modern era, the derivatives market began to flourish in the 19th century with the establishment of the Chicago Board of Trade (CBOT) in 1848. The CBOT introduced standardised futures contracts primarily for agricultural commodities, marking a significant milestone in derivatives trading. Over time, platforms like the Chicago Mercantile Exchange (CME) emerged, expanding the reach and complexity of derivatives.
What Exactly Are Derivatives?
At its core, a derivative is a financial instrument that derives its value from an underlying asset. This can include stocks, bonds, currencies, commodities, or market indices. The beauty of derivatives lies in their versatility; they can be traded on exchanges or over-the-counter (OTC), offering a way to hedge risks, speculate on price movements, or access hard-to-trade assets. Common types of derivatives include futures, options, forwards, and swaps.
How Do Derivatives Work?
Let’s explore a straightforward example involving a futures contract to grasp the mechanics of derivatives. Suppose you are a trader who believes that the price of oil will rise in the next few months. You decide to enter into a futures contract to buy oil at ₹4,000 per barrel, with a delivery date set for three months ahead.
Scenario 1: Price Increase
If, at the contract’s expiration, the price of oil has risen to ₹4,500 per barrel, you can sell your contract to another trader at this higher rate, pocketing a profit of ₹500 per barrel.
Scenario 2: Price Decrease
Conversely, if the price falls to ₹3,500 per barrel, you would incur a loss of ₹500 per barrel when selling your contract, as you would have to sell it for less than your purchase price.
Strategies to Profit from Derivatives Trading
When it comes to futures and options trading, understanding various strategies can significantly enhance your potential for profit. Below are some effective approaches:
1. Options Trading Strategies
Covered Call
In a covered call strategy, you own shares of a stock and sell call options against those shares. If the stock price remains below the strike price, the options will expire worthless, allowing you to keep the premium. However, if the price exceeds the strike price, you may miss out on further gains as you must sell your shares.
Imagine you own 200 shares of ABC Ltd. at ₹100 each. You sell call options with a ₹110 strike price for ₹5 per share. If the stock stays below ₹110, you keep the ₹1,000 premium. But if it rises above ₹110, you have to sell the shares at that price, albeit with a profit.
Protective Put
A protective put is a strategy to safeguard your investment in a stock. If you hold shares and purchase a put option, this allows you to sell your shares at the strike price if the market price falls. This strategy limits your potential loss.
Suppose you bought 150 shares of DEF Corp at ₹200 each and purchased a put option with a ₹190 strike price for ₹10 per share. If the stock drops to ₹180, you can still sell it at ₹190, effectively capping your loss.
Bull Call Spread
The Bull Call Spread is ideal for those anticipating a moderate price increase. You buy a call option at a lower strike price and sell another at a higher strike price, both expiring simultaneously.
For instance, if GHI Ltd.’s stock is trading at ₹500, you could buy a call option with a ₹480 strike price for ₹20 and sell a call option with a ₹520 strike price for ₹10. Your net investment would be ₹10 per share, with potential profits if the stock exceeds ₹520 by expiry.
2. Futures Trading Strategies
Straddle Strategy
A straddle involves buying both a call and a put option on the same underlying asset with the same strike price and expiration date. This strategy is beneficial if you anticipate significant volatility but are uncertain about the direction of the price movement.
Imagine you expect XYZ stock, currently priced at ₹1,000, to experience a big move, but you are unsure which way it will go. You buy both a call and a put option with a strike price of ₹1,000 for ₹30 each. If the stock rises to ₹1,100, your call option will be profitable, and if it drops to ₹900, your put will generate gains.
Calendar Spread
This strategy involves buying a longer-term futures contract and selling a shorter-term one with the same strike price. This tactic lets you capitalise on time decay, as the shorter-term contract loses value more quickly.
For example, if you believe the price of a specific commodity will remain stable, you might buy a contract expiring in December while selling one expiring in October. The October contract will likely lose value faster, potentially allowing you to profit from the difference.
Breakout Strategy
This strategy aims to take advantage of a security moving out of a defined price range. You would identify a key resistance or support level, wait for a breakout, and enter a trade in the direction of the breakout.
For instance, if a stock is consistently trading between ₹300 and ₹350, a breakout above ₹350 might signal a buying opportunity, while a drop below ₹300 could indicate a selling point.
The Importance of Risk Management
When engaging in derivatives trading, effective risk management is crucial. The derivatives market can be volatile, and without proper strategies, investors can face significant losses. Here are some essential risk management tips:
- Set Stop-Loss Orders: Use stop-loss orders to automatically sell your position if it falls below a certain price, limiting your losses.
- Diversify Your Portfolio: Don’t put all your eggs in one basket. Spread your investments across various asset classes to reduce risk.
- Understand Market Conditions: Keep an eye on market trends and economic indicators that may affect the price movements of your derivatives.
- Avoid Over-Leveraging: While leveraging can amplify profits, it can also increase risk. Always use leverage wisely.
Conclusion
In summary, derivatives can provide excellent opportunities for hedging and speculation. You can confidently navigate this complex market by understanding the various types of derivatives and implementing sound trading strategies. Always ensure you conduct thorough research before diving into derivative trading.
If you’re eager to explore the derivatives market, consider downloading a derivative app to access real-time data, manage your trades, and stay informed. To kick-start your investment journey, don’t forget to open Demat account with a reliable broker like HDFC SKY today!