You have saved up some money and want to invest it wisely. You have heard of various investment options but are curious about something called equity or currency derivatives. What are they, and how can they benefit you? Derivatives can initially seem complex, but they are simply financial contracts whose value is derived from an underlying asset. This guide will break down share market derivatives into easy-to-understand concepts and provide some strategies to trade derivatives.

History of Derivatives

The history of derivatives goes back to ancient civilisations, with some of the earliest known contracts emerging in Mesopotamia around the second millennium BC. These contracts aimed to mitigate agricultural risks. A famous historical figure, Thales, an ancient Greek philosopher, cleverly utilised an ancient form of an options contract to secure rights to olive presses, expecting a fruitful harvest.

The derivatives market began to take shape in the 19th century with the founding of the Chicago Board of Trade (CBOT) in 1848. This milestone introduced standardised futures contracts for agricultural goods and laid the foundation for modern derivatives trading. The Chicago Mercantile Exchange (CME), established in 1898, expanded this market further. 

What are Derivatives?

Derivatives are financial instruments whose values revolve around the price movement of underlying securities like stocks, interest rates, commodities, indexes, or currencies. These financial contracts can have two or more parties and are tradable on exchanges or via over-the-counter (OTC) methods. They are used for multiple reasons, such as hedging against market price shifts, speculating on future price changes, and accessing markets or assets that are otherwise hard to trade. Popular types of financial derivatives include futures contracts, options, forwards, and swaps.

How Derivatives Work

Let’s consider a simple example of a futures contract to understand how market derivatives work. Suppose you are a trader who believes the price of wheat will rise. You choose to buy a futures contract for wheat at ₹1,000 per tonne, with a delivery date set for three months from now.

Scenario 1: Price Increase

If wheat prices rise to ₹1,200 per tonne at the contract’s expiration, you can sell your contract to another trader for this higher price, resulting in a profit of ₹200 per tonne.

Scenario 2: Price Decrease

Conversely, if the price drops to ₹800 per tonne, you will lose ₹200 per tonne when selling your contract, as you would have to sell it for less than your purchase price.

How to Make Money Trading Derivatives

To profit from derivatives trading, you must be aware of different strategies for derivatives in the stock market.

1. Options Trading Strategies

Covered Call

When executing a covered call, you sell call options on the shares  you own. If the stock stands below the strike price, the options will expire without value, and you keep the premium as your profit. However, if the stock surpasses the strike price, you will have to sell at that level, potentially losing out on further gains.

Let’s say you have 100 shares of XYZ Corp at ₹50 each. You sell a call option with a ₹55 strike price, expiring in one month, for a Rs 2 per share premium. If XYZ stays under ₹55, you get to keep the Rs 200 premium. If it exceeds ₹55, you sell the shares at ₹55 and keep the premium.

Married Put

In a married put, if you own a stock and buy an at-the-money put option, you can trade the stock at the strike price even if the market price plummets. This strategy caps your loss to the option’s premium and the stock’s decline to the strike price.

Let’s say you purchase 100 shares for ₹1,200 each and simultaneously buy a put option with a ₹1,100 strike price for ₹40 per share. Your maximum loss is capped at ₹140 per share (₹100 drop + ₹40 premium). If the stock appreciates, you benefit minus the premium paid.

Bull Call Spread

If you expect a moderate rise in an asset’s value, the Bull Call Spread might be your go-to strategy. You acquire a call option at a lower strike price and sell a higher strike call option, both expiring simultaneously.

Suppose you expect XYZ Corp’s stock, currently trading at ₹1,000, to rise. You buy a call option with a ₹980 strike price (in-the-money) for ₹60 and sell a call with a ₹1,020 strike price (out-of-the-money) for ₹20. Your net cost is ₹40. If the stock rises to ₹1,020 or higher by expiry, your profit is capped at ₹40 per share, minus the initial cost.

Bear Put Spread

If you expect the price of an asset will fall, you might opt for a Bear Put Spread. This involves buying a higher strike price put and selling a lower strike price put, both with the same expiry date, allowing you to profit from the decline while capping losses.

For instance, imagine a stock is trading at ₹1,200. You could buy a put option through a derivative app with a ₹1,250 strike price for ₹80 per share and sell a put option with a ₹1,200 strike price for ₹30 per share. Your net cost for this strategy is ₹50 per share (₹80 – ₹30). If the stock price drops to ₹1,200 or lower by expiration, your maximum profit is ₹70 per share (₹80 – ₹50).

Protective Collar

This strategy involves three key components: owning the underlying stock, purchasing a put option, and selling a call option.

Here’s how it works:

• Hold the Shares: You begin by maintaining a long position in the shares whose equity derivatives you want to trade.
• Purchase a Put Option: This allows you to trade the shares at a specific price (strike price), giving you downside protection.
• Sell a Call Option: By doing this, you commit to selling the shares at a higher strike price if the stock price increases, which helps cover the put option’s cost.

Suppose you own 150 shares of a stock that is currently valued at ₹300. You acquire a put option with a strike price of ₹290 and sell a call option with a strike price of ₹310. If the stock price falls below ₹290, the put option safeguards you from further losses. If the price climbs above ₹310, the call option limits your earnings.

2. Futures Trading Strategies

Calendar Spread

Here, you buy a longer-term futures contract while selling a shorter-term contract with the same strike price. This approach allows you to benefit from the fact that the shorter-term contract will lose value more quickly over time, which could lead to a profit from the difference.

For example, if you anticipate that crude oil prices will not fluctuate much, consider buying a December futures contract and selling an October one. The October contract will experience faster time decay as it approaches expiration, potentially allowing you to profit if prices hold steady.

Pullback Strategy

To execute this strategy, identify a strong trend using technical tools like moving averages or trendlines. After confirming the trend, watch for a pullback, a brief reversal against the prevailing trend. You will typically enter the trade at a support level during an uptrend or a resistance level in a downtrend.

For example, a stock is in a solid uptrend but has retraced to its 50-day moving average. At this point, you may initiate a long position, predicting that the price will bounce back and continue rising. 

Volatility Harvesting

The fundamental concept behind volatility harvesting is to spot futures contracts that show significant volatility and make trades to capitalise on these price fluctuations. For example, you may purchase a futures contract when you expect a rise in volatility and sell it once it reaches its peak to profit from the price difference.

Suppose you identify that the Bank Nifty futures contract is experiencing heightened volatility due to recent policy changes. You can purchase the contract at a lower rate and sell it at a higher rate as volatility increases, thus profiting from the price shifts without trying to forecast the market direction.

Quantitative Order Flow Analysis

This approach involves examining buy and sell order patterns to forecast price changes. You can use tools like footprint charts and cumulative delta to understand market sentiment better.

For example, footprint charts illustrate the volume of orders across various price points, allowing you to pinpoint key support and resistance levels. Conversely, cumulative delta shows the net difference between buying and selling orders, offering insights into the supply-demand balance.

Conclusion

Derivatives play a vital role in today’s financial markets, offering numerous opportunities for hedging and speculation. However, conducting comprehensive research on the underlying assets and market conditions is crucial when proceeding with futures and options trading. Implement risk management techniques, such as setting stop-loss orders to protect your capital. Avoid over-leveraging and spread your investments to mitigate risks. Keep yourself aware of market trends and economic factors, and maintain discipline to prevent emotional trading decisions, ensuring a strategic approach.

To start your derivatives journey today, open Demat account through a platform like HDFC SKY.