Trading Strategy : DERIVATIVES FOR TRADERS

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DERIVATIVES FOR TRADERS

How can derivatives be used by traders? How do you define traders?

In this context, by traders, we mean those who actively buy and sell in the markets on an intra-day and intra-week basis. Derivatives can be very useful to such traders and could increase their profits manifold.

For example, a typical trader might buy Satyam at Rs 185 on the view that it could go up to Rs 190 but if it goes the other way instead, he could keep a stop loss of Rs 181. Typically, the stock could go down to Rs 181, hit the stop loss and then bounce back to Rs 190 beautifully but after the trader has got out with a loss.

Instead, the trader could buy a call on the stock and pay a premium. He could then not worry about stop losses (mentally be prepared to lose the premium). Thus, even if the stock were to hit Rs 181 he would keep the position open and then liquidate when the stock reaches Rs 190. At that time, the call would have also appreciated automatically.

Thus, calls (and puts) could be used rather than stop losses with a higher efficiency level.

How would traders then project their profits?

When a trader buys Satyam at Rs 185 and wants to sell at Rs 190, he knows clearly that he would make a profit of Rs 5 in the process. In case of calls, he might have to make some more calculations.

First of all he needs to determine what to buy. If he decides to buy a 190 Call, which is available at say Rs 8 at the moment (when Satyam itself is at Rs 185), he can use the Delta to project the Call price. If the delta of the Call is say 0.45, then he could project the call price to be Rs 10.25 when Satyam were to reach Rs 190.

How is that worked out?

A delta of 0.45 implies that the value of the Call would increase by Rs 0.45 for every Re 1.00 increase in the stock. Thus if Satyam were to rise from Rs 185 to Rs 190 (i.e. by Rs 5), then the Call would tend to go up by Rs 2.25 (5 x 0.45). If the Call is currently quoting at Rs 8, then it would go up to Rs 10.25 at that time.

Is that not smaller than the appreciation on the stock? How do I make them comparable or equal?

The reward is only Rs 2.25 as against Rs 5 in the stock. But look at the risks too. The risk in buying the stock is Rs 185 while the risk in buying the Call is only Rs 8. Theoretically, the stock could go down to zero (thought it may never happen), while even if the Call goes down to zero, you still lose only Rs 8.

Nevertheless, if you would like to equate the payoffs, you could buy more Calls. For example, if you wanted to buy 5,000 units of the stock, you could think of buying 10,800 units of the Calls so that the payoff would be equal approximately (5,000 x 5 = 10,800 x 2.25 approx). I have taken 10,800 units because the lot size of Satyam is 1,200 units and this is the nearest lot available.

Does Delta work in real life?

Yes, Delta calculations do work in real life. Indian market does respond to the theoretical Black Scholes model in the sense that option prices change as per the underlying stock prices. However, delta based projections might not be exactly matched. For example, if your projected price is Rs 10.25, you may find in reality that the price ranges between Rs 10 and Rs 10.50. However, these small differences will be found in any market and not only in India.

You could have a bigger problem in some stocks and on some occasions, viz. illiquidity. In stocks where trading volumes are low, you might find that the bid ask numbers are say Rs 9.50 and Rs 11.25. In this case, though the price as per the Black Scholes Model is the around the midpoint of the two prices of bid and ask, as a trader, you might find difficulty in getting your projected price.

So what is the solution?

The answer lies in selecting the right stock options to trade. I would advise that you should observe which are the options where volumes are reasonable and trade only in those stocks.

What else can be done to exit the option position if the option is illiquid?

Another possibility is to neutralize the delta of the position using futures. This would amount to liquidating the position in theory but keeping it open in practice. The payoffs would be very similar and the objective would be achieved in the short run. In the medium term, you would square up both options and futures.

Can you elaborate with an example?

Suppose you bought 10,800 Satyam Calls as discussed. The Delta was 0.45 when Satyam itself was at Rs 185. Then Satyam moved to Rs 190 and Delta moved up to 0.52. Now the portfolio Delta is 10,800 x 0.52 i.e. 5,616. You want to square up as you are making a decent profit. However, because of illiquidity you are unable to get a fair price on the options.

You can alternatively neutralize your Delta. This means you should sell 5,616 futures – Futures have a Delta of 1. When you sell, you generate negative Delta. If you sell 5,616 Futures, you have generated -5,616 Delta. This would make your position Delta neutral (or zero Delta). Practically, you will have to sell in lots of 1,200 and thus you would sell 6,000 Futures.

By doing so, your position will neither gain nor lose with any small movements in Satyam. If Satyam goes up, Calls will generate profit while Futures will generate losses. These two will neutralize each other. If Satyam moves down, Calls will lose and Futures will gain, again neutralizing each other.

You should then wait for a good call price to emerge and at that point square up both simultaneously (most of the time lot by lot slowly).

If I am unable to square up soon, what happens?

If Satyam moves up or down sharply from the current level of Rs 190 before you can square up both the positions, you need not worry. Your profit will actually increase if it moves sharply. Your lowest profit level is the current price of Rs 190. Your Black Scholes payoff is a U shaped curve with the bottom at Rs 190 and highs on both sides of the U. Thus, even if the square up is delayed by a couple of hours or even a day, you need not worry. You stand protected irrespective of any changes in prices in that kind of short term.

If you wait for many days, that strategy would be wrong because Options would lose their Time Value and the profit would deteriorate. The Call will decay day by day and you would lose profit. Futures do not carry Time Value and would generate similar profit or loss even after lapse of time. The Delta of the position which was zero would now change due to Call Delta values changing by elapse of Time.

While within a day, such a change would be negligible, if the position is open for 5 days or more, the change would be significant. Hence, this strategy is applicable for traders who would exit soon but are unable to exit at the moment.

Can you summarise our discussions so far?

We have been discussing how derivatives can be used by traders. We have discussed the importance of Delta in projecting profits. We have also discussed how Delta neutralization could help in exiting positions which are otherwise illiquid.

If a trader is bearish what should he do?

Suppose you are bearish on Infosys, you could short sell in the cash market. However, you will have to square up on the same day. If you do not square up on the same, day, you will have to ensure delivery. If you do not possess the shares, then questions of auctioning etc will emerge which can result into major mishaps without delivery.

How can I use the derivatives market for this purpose?

Hence, you can sell futures if you are bearish. In case of futures, you do not need any delivery. You will need to pay up a margin as per exchange regulations. Further, every day your position is marked to market and accordingly a daily profit or loss is computed by the exchange. All profits will be paid to you and losses recovered from you for each trading day separately.

If you sell futures, you should keep your stop loss limits vigorously in the same manner as you would act in the cash market. The principles of stop losses would be the same as you follow in your regular trading strategy. Some traders keep an ‘x’ % stop loss, some follow a trailing stop loss etc. Some traders might follow an indicator like a moving average or an oscillator to decide their stop losses.

Futures are fairly liquid in the leading counters and you might even find that futures volumes are higher than cash market volumes in some scrips. The Nifty recently recorded a turnover of over Rs 1,000 crores and the total turnover reached over Rs 5,900 crores this month, making it a record till date.

Most experts are fairly confident that turnover levels of Rs 8,000 crores per day are not far off.

Are futures sufficient for bearish trading?

Futures are sufficient for bearish trading if you have the necessary skills, aptitude and patience. However, as options are also available, it will be to your advantage if you can use them skillfully. However, all your trading skills can sometimes be severely tested on overnight basis.

You found your bearish assumption coming true and you have made some profits today evening on a mark to market basis. However, tomorrow morning the scrip opens high and moves up higher resulting in losses for you. What do you do? You can punch in a Good Till Cancelled Buy order at a predetermined (stop loss) price. However, the risk here is that early morning trades are sometimes choppy, irrational and unrelated to the direction taken by the scrip during the rest of the trading hours. In such cases, you sometimes may find you’re your stop loss got hit and you got out, only to find the stock resuming its southward direction again.

In such cases, option usage is far superior.

What should I do using options?

If you are bearish, you could buy put options. In the Indian market, only the current series is active and hence you should buy only current series. In the last week of the month, the next month series also becomes active (especially from Tuesday onwards).

Which strike should I buy?

The strike to buy depends on how bearish you are. For example, you are bearish on Infosys and Infosys is currently trading at Rs 3,590. If you are very bearish, you should buy a lower strike like 3300 or 3200, which will be available cheaper. If you are mildly bearish, you should buy a current strike like 3600 or 3500 which will be more expensive.

If Infosys moves down slightly (say to 3500 or so), you will find that the current strikes respond well and they move up well. The far out strikes like 3300 or 3200 will not move too much. However, if Infosys moves down significantly to say 3300 levels, then the appreciation of the far out strikes will be very attractive, especially when you calculate in percentage terms.

Are there other strategies like bear spreads?

Yes, there are other strategies like bear spreads in which you buy a current strike (say 3600) and sell a far out strike (say 3300). In this case, you pay a high premium for the current strike but recover some of it from the sale of the far out strike. Thus, your net cost is lower.

However, there are three issues associated with such spread trades. One, for each trade, you bear the impact cost and the bid ask difference and secondly, you bear the brokerage. If you increase the number of transactions for each trade, you end up with lesser profits. Thirdly, you will find that the bear spread does not respond well to dropping scrip prices if the number of days to expiry are high. The bear spread creates profits only towards the end of the contract, in most cases. Thus, if Infosys were to move down and then bounce back up and remain up, you might find that you could not book your profits well and ultimately lost because it closed on the upside.

Therefore, I would advise you to be careful with spreads.

How many puts should I buy?

The volume of trading is a matter of personal preference, risk profile and capital available for trading. However, let us create a framework for comparing oranges with apples. Suppose, you would have sold on the cash market 1000 Infosys shares on your bearish assumption. How much is the risk you are taking in this market?

Technically, the risk is measured using a VaR model which indicates the maximum move that Infosys might move up or down in a given time period. Say the daily VaR of Infosys is 3.5% and you are considering one month as the time frame. Then effectively, the risk involved in a month is roughly around 18%. If Infosys is currently at 3590, then you are willing to lose upto 18%of this level in a month’s time, which would come to Rs 6.46 lakhs on the volume of 1,000 shares.

In such a case, you could use your funds to buy puts to the extent of Rs 6.46 lakhs. If the current ATM Put is available for say Rs 180, you could buy 3,600 puts approx for that value.

But I may not suffer that kind of losses!

Yes, that is true. While technically Infosys could move up by 18% during the next month, you might not wait that long. You could for example, stop out your trade at a 3% stop loss level. In that case, your maximum loss is only 3% of 3590, i.e. Rs 1.08 lakhs on the 1,000 shares volume.

You could in this case, invest slightly more than this amount (say 100% more) i.e. Rs 2.16 lakhs on buying puts. If you buy ATM Puts at Rs 180 each, you could get 1,200 puts for this value.

Why 100% more?

This is a subjective addition because even if Infosys were to move up by 3% in this trade, the puts will still trade at some value. The value of the Puts will not go down to zero. Thus, even if Infosys moves up to say Rs 3,698, you will find that the Puts are still trading at say Rs 120 or even higher. Your loss therefore will be relatively smaller as compared to futures.

How do I estimate my profits from trading?

As a day trader, the expiry graph that we normally try to figure out profits from, is not applicable. You will have to apply delta to estimate your profits. Let us continue our same example.

The 3600 Put given Infosys price of 3590 and expiry days as 30 and a current volatility level of 43% provides a price of Rs 180 approx on the Black Scholes calculator. The delta is -0.48. Thus, if you buy 1,200 puts, your position delta will be -576. Puts naturally carry a negative delta. The implication for put buyers is that with Infosys moving down, their Put values will move up and hence puts are negatively correlated with Infosys prices.

Now, if you project that Infosys will move to 3400 in 10 days time, use the Black Scholes calculator and find out the put prices at that time. The put will quote at Rs 262 at that time. Thus, you will make a profit of Rs 82 per put, i.e. Rs 98,400 on your position of 1,200 units.

Can I use Delta for profit projections?

Yes, you can. But Delta projections do not work in this example because, Infosys movement is significant (from 3590 to 3400) and secondly, the time taken is also significant (10 days). In such cases, delta itself will change and hence cannot provide a good answer. For example, Delta math would have told you that if Infosys moves down by 190 points, the Put value would move up by 190 x 0.48 i.e. Rs 91. However, it is expected to move up by Rs 82 (a difference of around 10%). The principal factor here is the passage of 10 days time where Puts would lose their Time Value. The Time Value factor is not captured by the Delta math.

When can I use Delta math?

If you are trying to project the price of the Put within a shorter span of time (say 1 days) and for a smaller movement of Infosys (say from 3590 to 3550), then Delta math would be quite accurate. In this case, the Delta math would indicate that the price of the Put would increase by Rs 18 approx (40 point downward move in Infosys multiplied by 0.48 delta). The calculator also provides the price of the Put to be around Rs 200.

How do I get the Black Scholes calculator as well as the greeks on a continuous basis?

I would suggest that you should have a derivatives trading software with you which would provide you with your greeks on a continuous basis for your positions. It is difficult to work out the greeks on your calculator or on excel. A software is an important tool for an active trader.

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