Trading Strategy – Derivatives Strategies

Derivatives Strategies

What are Strategies?

Strategies are specific game plans created by you based on your idea of how the market will move. Strategies are generally combinations of various products – futures, calls and puts and enable you to realize unlimited profits, limited profits, unlimited losses or limited losses depending on your profit appetite and risk appetite.

How are Strategies formulated?

The simplest starting point of a Strategy could be having a clear view about the market or a scrip. There could be strategies of an advanced nature that are independent of views, but it would be correct to say that most investors create strategies based on views.

What views could be handled through Strategies?

There could be four simple views:  bullish view, bearish view, volatile view and neutral view. Bullish and bearish views are simple enough to comprehend. Volatile view is where you believe that the market or scrip could move rapidly, but you are not clear of the direction (whether up or down). You are however sure that the movement will be significant in one direction or the other. Neutral view is the reverse of the Volatile view where you believe that the market or scrip in question will not move much in any direction.

What strategies are possible if I have a bullish view?

The following strategies are possible:

  •  Buy a Future
  •  Buy a Call Option
  • Sell a Put Option
  • Create a Bull Spread using Calls
  • Create a Bull Spread using Puts

Let us discuss each of these using some examples.

What if a Buy a Futures Contract?

If you buy a Futures Contract, you will need to invest a small margin (generally 15 to 30% of the Contract value). If the underlying index or scrip moves up, the associated Futures will also move up. You can then gain the entire upward movement at the investment of a small margin. For example, if you buy Nifty Futures at a price of 1,100 which moves up to 1,150 in say 10 days time, you gain 50 points. Now if you have invested only 20%, i.e. 220, your gain is over 22% in 10 days time, which works out an annualized return of over 700%.

The danger of the Futures value falling is very important. You should have a clear stop loss strategy and if your Nifty Futures in the above example were to fall from 1,100 to say 1,080, you should sell out and book your losses before they mount.

The graph of a Buy Futures Strategy appears below:

forex Strategies

What if a Buy a Call Option?

If you buy a Call Option, your Option Premium is your cost which you will pay on the day of entering into the transaction. This is also the maximum loss that you can ever incur. If you buy a Satyam May 260 Call Option for Rs 21, the maximum loss is Rs 21. If Satyam closes above Rs 260 on the expiry day, you will be paid the difference between the closing price and the strike price of Rs 260. For example, if Satyam closes at Rs 300, you will get Rs 40. After setting off the cost of Rs 21, your net profit is Rs 19.

The Call buyer has a limited loss, unlimited profit profile. No margins are applicable on the buyer. The premium will be paid in cash upfront. If the Satyam scrip moves nowhere, the buyer is adversely impacted. As time passes, the value of the Option will fall. Thus if Satyam is currently at around Rs 260 and remains around that price till the end of May, the value of the Option which is currently Rs 21 would have fallen to nearly zero by that time. Thus time affects the Call buyer adversely.

The graph of a Buy Call position appears below:

trading strategy

What if I sell a Put Option?

Another bullish strategy is to sell a Put Option. As a Put Seller, you will receive Premium. For example, if you sell a Reliance May 300 Put Option for Rs 18, you will earn an Income of Rs 18 on the day of the transaction. You will however face a risk that you might have to pay the difference between 300 and the closing price of Reliance scrip on the last Thursday of May. For example, if Reliance were to close on that day at Rs 275, you will be asked to pay Rs 25. After setting of the Premium received of Rs 18, the net loss will be Rs 7. If on the other hand, Reliance closes above Rs 300 (as per your bullish view), the entire income of Rs 18 would belong to you.

As a Put Seller, you are required to put up Margins. These margins are calculated by the exchange using a software program called Span. The margins are likely to be between 20 to 35% of the Contract Value. As a Put Seller, you have a limited profit, unlimited loss profile which is a high risk strategy. If time passes and Reliance remains wherever it is (say Rs 300), you will be very happy. Passage of time helps the Sellers as value of the Option declines over time.

The profile of the Put Seller would appear as under:

trading strategy

What are Bull Spreads?

First of all, Spreads are strategies which combine two or more Calls (or alternatively two or more Puts). Another series of Strategies goes by the name Combinations where Calls and Puts are combined.

Bull Spreads are those class of strategies that enable you benefit from a bullish phase on the index or scrip in question. Bull spreads allow you to create a limited profit limited loss model of payoff, which you might be very comfortable with.

How many types of Bull Spreads can be created?

Bull spreads can be created using Calls or using Puts. You need to buy one Call with a lower strike price and sell another Call with a higher strike price and a spread position is created. Interestingly, you can also buy a Put with a lower strike price and sell another with a higher strike price to achieve a similar payoff profile.

In the next article, we will see some examples of Bull Spreads along with other strategies.

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