Derivatives: The ❛High Risk, High Return❜ Instrument For The Brave Hearts

Derivatives trading is not for the faint-hearted. Karan Bhojwani helps find out how one can improve the probability of winning by following the best derivative trading practices.

A word synonymous with ‘high risk, high return’ in the Indian equity markets is ‘derivatives’. Most Indian equity participants are short term investors, with individual investors contributing nearly 26 per cent to the total derivative trades, while 60 per cent coming from non-institutional and non-proprietary investors. To add to it, nearly 84 per cent volume in FY17 came from options trading. Derivatives trading stands out from other equity instruments due to its quick and high money character. But hold! The high money is not a myth, provided suitable strategies are put into action by the derivative experts where demographics of the trader are also taken into consideration. The reason being a set of creme de la creme companies having high market cap and liquidity are listed under the F&O category, which lessens the risk in the first place. 

Going back, Indian equity benchmark and broader indices have seen golden days since the start of the reign of the BJP government in May 2014, which was discounted in the prices of these indices since the end of 2013. Markets witnessed a consistent upside with some quick and short hiccups thrown in-between, notwithstanding the major catastrophes the country has gone through. So, we can say that markets have become pro-active from being re-active since last couple of years and have, therefore, become a safe haven for the investors. 

Market buoyancy coupled with SEBI’s intervention to safeguard equity derivative investors has helped derivatives segment supersede equity cash segment in terms of turnover. The ratio of derivatives-to-cash, which was already high at 11.88 times in FY13, has increased to 15.59 times in FY17. 

However, as stated earlier, higher returns attract many investors, most of them belonging to the Tom, Dick and Harry category. Due to this, we have seen a lot of intra-day volatility in the blue-chip stocks in the recent past, although the long-term trend has remained intact. To discourage such wannabe investors, SEBI had taken few steps like doubling the lot sizes of F&O contracts. On the other hand, SEBI is also considering increasing derivatives market trading hours, specifically Index Futures to price in both domestic and global news flows at the same time, rather than waiting for the next session which, many a time, gives gap-up or gap-down openings. With this, the country can also attract more FIIs in the derivatives segment. 

WHAT IS DERIVATIVE? 

The term “derivative” indicates the instrument derives its value entirely from the asset it represents, be it equity, currency or commodity etc. 

DERIVATIVE INSTRUMENTS TRADED WIDELY IN INDIAN MARKETS 

There are two types of derivatives instruments traded widely in Indian markets, namely Futures and Options. 

UNDER OPTIONS DERIVATIVES THERE ARE TWO TYPES: CALL AND PUT OPTIONS 

As Indian markets are experiencing one of their cyclical volatile phases on the back of global jitters, derivatives may seem to some of us a lucrative option as they provide us opportunity to take advantage of volatility.

Kaushlendra Singh Sengar
Founder & CEO, Advisorymandi.com 

Derivatives are weapon of mass destruction,” said Warren Buffet. Is it so? In India, as per the data available, the number of contracts in derivatives in all segments, including stock futures, index futures and stock and index options, since the launch till date has grown at CAGR of 232.99%, whereas turnover has grown up by 188%. Looking on a daily basis, the daily average turnover, including all the segments, escalated by CAGR of 118.41%. 

Equity has shown growth of 109.477% CAGR from 1995-2016, which is great for the economy as it has instilled faith of retail individuals in the market. In turn, it has increased the investment flow into the market, aiding our economy to grow at a faster pace. 

Such tremendous rise in derivatives, which is 6 times that of the cash market, has led to more chances of speculation, hurting retail investors. SEBI is working to protect retail investors. Further, they wish to boost cash market as it will have manifold effect on the securities transaction tax collected by the government. In derivatives, the STT is charged on premium and not on notional values, thus making it unattractive for government. So, we can see measures to boost cash market in times to come.

In this article, we will talk about some of the best practices which will help you to emerge as a successful and a skillful derivatives trader. 

Derivative trading is a leveraged position. One has to deposit a margin amount, which is calculated as a certain percentage of the contract value. With an amount of Rs75,000-1,00,000, a trader can take an exposure of up to Rs5-6 lakh. But before entering into leveraged positions, ensure you have enough support on the off-chance that the market changes course and moves against your expectations. In this case, your broker will deduct the notional loss from the margin and ask you to pay additional margin. In case you are not able to provide additional margin to the broker, you might be compelled to square off your position, which will result in a forced loss. Consequently, as a derivative trader, it is vital to design a proper plan before you initiate a position and keep up adequate margin, just in case there is any shortfall due to adverse movement of the stock price. In many cases, we hear from traders that due to overexposure, they had suffered huge losses which wiped out their entire capital. Hence, it is imperative to draw a Laxman Rekha while trading in the derivatives segment. 

Understanding the IV 

All types of assets that are traded are influenced by volatility to some degree, and this is something an options traders should definitely be familiar with. A financial instrument that has a relatively stable price is said to have low volatility, while an instrument that is inclined to sharp value movements in either direction is said to have high volatility. For a trader initiating a position in an option, it is vital to comprehend the concept of IV (Implied Volatility) or, in other words, anticipated volatility. It is fundamentally a projection of how much and how quick the underlying security is probably going to move in its price. Kishore, a new option trader, was aware about the basic terms of options trading, i.e. strike price and expiry date; however, he was not aware about the concept of IV. Overzealous to makIt has been observed that many options traders bet on the out-of-the-money (OTM) options as the premium for thesee fortune from options trading, Kishore chose to buy call option of company ABC, reckoning that the stock price will rise as the stock was performing well and there were gossipy tidbits that the company may make an announcement of an exciting new product. When he entered the call option, the IV of options of company ABC was very high. However, after a couple of days, company ABC released the news and since there was nothing exciting about the new product, the stock price did not react much. Hence, the stock's IV dropped significantly to the amazement of Kishore, despite the stock price trading near about the same level at which he had bought the call option, but the value of call option decreased as the stock's IV dipped. So, as an option trader, you have to understand the idea of volatility and implied volatility thoroughly. 

When to enter OTM options 

: It has been observed that many options traders bet on the out-of-the-money (OTM) options as the premium for these options are significantly cheaper than at-the-money (ATM) options. Hence, the low premium lures them and often we hear ‘Ek Ka Double’ from option traders as they expect OTM option to be a doubler. However, they fail to comprehend there is a time value attached to the options and if there is no significant price movement in the immediate days, there could be erosion of the premium and they can lose their entire capital. Hence, one should enter into ' out-of-the-money options only if one expects to witness significant moves immediately. 

Using derivatives to one's advantage 

Warren Buffet famously described derivatives as “financial weapons of mass destruction.” However, if derivatives are used properly, they can be pretty much helpful for an investor in some cases. Let us understand how investor can benefit from derivatives. An investor can use “Covered Call Option” strategy. Covered Call Option strategy involves both stock (underlying) and an option contract. An investor who buys or holds a stock and simultaneously writes an equivalent call option in the same stock follows a strategy called as covered call option. Let us assume an investor had bought stocks of ABC Ltd on September 1, 2017, when the share traded at Rs500 in the expectation that the stock will perform well in the long run, but he feels due to lack of triggers or choppy market the stock may move sideways in the short term. So he will sell an out-of-the-money (OTM) call option at a premium of Rs10, expiring on September 28, 2017 with a strike price of Rs520 and lot size of 1,000, so you receive Rs10,000, i.e. premium * lot size (Rs10 * 1000). If the price does not move and the stock price settles below Rs520 at the end of the month, we may pocket the premium we earned. That means a gain of Rs10,000. So an investor can use derivatives to his/her advantage. 

Understanding Open Interest: 

What is Open Interest (OI)? Open Interest (OI) is a number that discloses to you what number of fates or alternative contracts are right now extraordinary (open) in the market. Volume and OI are two unique ideas. Open premium gives us data about what numbers of agreements are open and live in the market, though the volume then again discloses to us the number of exchanges that were executed on the given day. By checking the adjustments in the open interest figures toward the finish of each exchanging day, a few decisions about the day's action can be drawn. Expanding open premium implies that new cash is streaming into that agreement. The outcome will be that the present pattern (up, down or sideways) will proceed. Declining open interest implies that the market is squaring off and suggests that the prevailing price trend is reaching to an end. Understanding of open interest can prove advantageous toward the end of major market moves. A levelling off of open interest following a sustained price advance is often an early cautioning of the end to an upward incline or bull phase. 

Manage Risk 

Derivatives are high-risk instruments, and it is important for traders to recognize how much risk they have at any point of time. What is the maximum downside of the trade? Finding the level which protects against large losses and guarantees gains is what efficient risk management is all about. 

Limiting your positions 

If you are trading derivatives, it is important to have limit on the number of open positions at a given point of time. Because with limited positions, you will be able to keep a close tab on them and managing them will not be as stressful and hectic as attempting to manage dozens of open positions simultaneously. Moreover, limiting your positions will help you to concentrate on the prime opportunities at any given point in time. 

CONCLUSION: Derivatives trading is more skillful than plain vanilla cash trading. While a trader in cash segment follows the market and takes a directional view on the stock, a derivatives trader needs to follow a lot more than that. For example, a derivatives trader keeps track of Greeks and OI information. In the derivatives market, speculative deals carry a lot of hazard. But the higher the hazard, the higher the rewards. In the derivatives market, risk management is your friend, so go get the derivatives edge that yields the highest rewards and least misfortunes.

❝Hedging will fetch better returns in current uncertain global environment❞
Ms. Sneha Seth Derivatives Analyst Angel Broking

It doesn’t matter whether the market is bearish or bullish, derivatives work anyway. Does the statement hold true according to you? 

Yes, one of the best advantages of derivatives segment is that it can be used in both bullish as well as bearish market, unlike the cash segment. Traders can only buy stock and hold the same in case of cash market segment, though only intra-day traders have the privilege to form shorts without holding the underlying stock in their demat accounts. With emergence of derivatives platform, traders can short sell and hold on positional basis to take advantage of a bear market condition. 

How do we bifurcate strategies according to market conditions? Which is the best strategy you suggest in the current market situation? 

There are various strategies for all kinds of markets, whether bullish, bearish, sideways and volatile. In case the overall market is trending northwards and the trader is very bullish, one can simply buy futures or naked call options of the stock; while if the trader is bullish upto certain levels or is mildly bullish, he can adopt bull call spread which will help to keep himself hedged in adverse situation and will lower the cost incurred. Simultaneously, buying At-the-money (ATM) and writing Out-the-money (OTM) call option is known as ‘Bull Call Spread’. Here, loss is limited to the net premium paid and potential profit is restricted to a difference between both strikes minus the net premium paid. 

Similarly, in a bearish market scenario, if one is bearish, he/ she can opt to short futures or buy naked put options. In case the view is slightly bearish, trader can build bear put spread by buying ATM and writing OTM put option. 

Historically, it has been observed that most of the times market likes to remain in a relatively narrow range and most of the traders eventually end up making huge losses due to aggressive positions and, importantly, due to lack of knowledge on how to tackle such market conditions. But with the help of strategies like short straddle and short strangle, traders can overcome losses incurred in the above market conditions. Short straddle is done by selling both call and put option of same strike price and if index/stock expires near the strike price we sold, one can pocket in the entire premium received. But if market heads one side due to any reason, the same strategy may lead to losses. The only difference in strangle is the strike price as it is carried out by using out-the-money strikes of both call and put options. This strangle has the ability to save both money and time for traders operating on a tight budget.

Some events like monetary policy announcement or quarterly results outcome or any global geopolitical news may lead to enhanced volatility. By using options, one can even make money, irrespective of market moving in either direction. Long straddle and long strangle strategies can be used if one expects market to remain volatile in the near term. Here, the only difference is that instead of selling, we buy both call and put options. Maximum loss is limited to the premium paid; while profit depends on the market volatility. Apart from the short term traders, options can also be used by the long term investors to earn some return on money invested or by investors who want to lower the cost of their existing portfolios, by opting for covered call writing. In this case, one can write OTM call option of the stocks you hold, which may give some additional return on investment. 

In calendar year 2017, equity market has given fantastic return so far and the major trend remains bullish going ahead. However, taking into consideration the FIIs outflow last month and the overall F&O activity, we expect market to remain under pressure in the near term. At the current juncture, a strong hurdle for Nifty is seen around 10000-10100. Thus, would suggest long term traders to remained hedged; while short term traders can short index futures with long index call options. 

Would you suggest derivatives trading to a stock market entrant? What instrument would you suggest him/her to begin with?

 Honestly speaking, we would never suggest any newbie to start trading, especially in derivatives segment. New entrants should take tiny steps by first stepping into equities and later with better understanding of the market and the derivatives product, one can start small trades in F&O segment. 

According to you, which technique (arbitrage/hedging) would give better return in this volatile markets? 

We believe the key deliberation behind the derivative instrument is hedging. Hedging is very similar to an insurance product that we commonly buy for protection against a possible eventuality. Every individual trading in stock market is also exposed to a certain risk. In the event of any adverse market movements, hedging simply protects your trading positions from incurring heavy losses. Thus, hedging one’s positions will surely fetch better returns in current uncertain global environment. 

What percentage of savings should be utilised for derivatives trading? Is there any ideal margin percentage a trader should take from a broker? 

Trading in derivatives segment primarily depends on the risk appetite of the client. So, traders with high risk appetite should only prefer trading in F&O segment. 

Despite complexity, turnover in derivatives was 15 times that of cash segment in FY17. Could you please throw a light on traders’ psychology here? 

Nowadays, many traders prefer trading for shorter time horizon like intra-day, 3-7 days or 1-2 months. In such cases, traders are more keen to earn returns at regular intervals with small investment rather than blocking big corpus to take same exposure in the cash market. As we all know, derivatives are highly leveraged product, especially options are very attractive for small pocket traders. 

SEBI is said to be mulling over rules for derivatives trading considering its risky nature for individuals. How would it impact your business? 

Yes, SEBI has been consistently tweaking the regimes in F&O segment, like changing the futures contract size to 5 lakh last year and the most recent addition of ‘Do Not Exercise’ feature to options contract in order to help retail participants. 

There would always be some or the other pros and cons that we come across with revolutionisation coming in. For that matter, increase in the lot size of the F&O contracts has certainly forced traders who religiously want to trade to shift to higher contract value as they have no option left, which may also come with the higher risk factor attached to bigger contract size. At the same time, adding the ‘Do Not Exercise’ feature in options segment has been a relief for the buyers of options who faced imposition of STT of 0.125% if they left an ITM option to expiry. Moreover, the STT in this case were calculated on the notional value of the option and not on the option value which can actually be devastating. However, these changes hardly have any notable impact on the business as traders who want to trade will trade, irrespective of any changes made from the regulatory bodies.