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Investing & Trading: Derivatives is a boon if you use it wisely

, April 20, 2018, 0 Comments

derivatives-marketexpress-inThere is a wave of fear which flows in the minds of investors, when ‘Derivatives’ word is mentioned. Whereas Derivatives are such instruments that you will fall in love with them once you know what benefits it entails.

Before explaining you all with the advantages of derivatives, lets first explore the reasons behind these fears:

  1. Past bad encounters with derivatives due to lack of adequate knowledge of Trading and Derivatives:
    Derivatives are complex instruments as compared to regular cash market. A trader needs to have required technical knowledge of derivative products. Further, Traders also need to have good trading strategies ready which has been back tested successfully.
  2. Taking advice from broking relationship managers regarding trades:
    Relationship managers or RM as we commonly call them working in broking companies generally advise their clients on trades. Investors often take their advice blindly before evaluating their qualifications and track of record of their recommended trades. Most RMs just have very basic knowledge about Derivative instruments and Trading. They lack proper educational qualifications required to trade into Derivatives or understand the market so as to profit from it. Secondly, there is no track record maintained for the recommendations given by them and thirdly, they have conflict of interest i.e. they are wired to generate revenues from brokerage so as to achieve their targets in their organisation – leading to over trading.
  3. Highly risk averse nature of the investor:
    Highly risk averse investors with risk profile of just 5% annual volatility may not enter the derivatives segment at all.

Coming on to benefits of Derivatives, especially Options, Options can yield consistent returns in excess of 25%-30%, if used intelligently. Returns from Options can beat the market, mutual funds and individual stocks most of the times and provide stable cashflows without much volatility.

Following are the advantages vs cash market/stock buying:

Trade in any market direction – long, short & sideways: With cash equity, one can only go long which is just 1 of the three phases of the market while using derivatives, one can trade in any direction according to market view.

Design trading strategies that has potential to profit even if market goes in opposite direction compared to what you desired: One can use statistics to arrive at high confidence bands (3 standard deviations) on either side of the market with upto 85% accuracy and sell call or put OTM options at upper or lower band respectively to capture the premium entirely, earning a reasonable 25% returns per annum.

Hedging your portfolio: This is one of the classic use of options wherein one can hedge their long side portfolio by buying puts and short side portfolio by buying calls. The hedge ratio can be altered depending on the riskiness of the portfolio.

Earn profits not only in trending market but also in range bound market as most of the times that is the case: Equity market are believed to be trending only 25-30% of the times with rest of the times being in a range. There are various option strategies which can take advantage of the consolidation phases of the market like strangles, straddles, etc.

Get leverage of 10-12 times: Equity Options in Indian stock exchanges typically give 10-12 times of leverage. For e.g. In Nifty the margin is 50k for selling a option worth transaction value of 7.5 lakhs.

Using options increases your base probability of winning to 67% assuming returns are distributed log-normally: As the markets primarily have 3 scenarios – bull, bear and sideways. As per normal distribution, each case would have equal probability of 1/3. As discussed earlier, options can earn profits even when markets are sideways or go in your favour with the same trade, you stand a chance to make profits 2/3 times. But, as markets do not follow a gaussian distribution, by using quantitative analysis like statistics and machine learning, one can achieve the probability of wining to 65-70% .

Opportunities to take advantage of increased volatility: There are some specific option strategies catered to volatility. One can go short or long on volatility using options in events where volatility increases considerably like elections, results, etc.

The opinions expressed in this article are the author’s own and do not reflect the view of MarketExpress – India’s first Global  Analysis & Sharing Platform or the organization(s) that the author represents in his personal capacity.