Being a developing nation Indian stock market a being very shallow in late ’90s. In early 2000 India introduces the exchange-traded derivatives on NSE and BSE both. With the emergence of futures trading on NSE India witnessed huge spike in trading volumes and major chunk of new participants entered in the market. During 2000-2008 Bull Run Indian traders make a huge amount of money in futures and options trading.
It’s been 20 years since the derivatives have emerged in India and we have seen a lot of informed traders are trading derivatives market as their full-time career and many also based trading systems have been introduced in recent past. ? So why anyone needs to understand the derivatives and how it will going to help in improvising the trading strategies and profit margin we’ll try to understand this in this article.
Let first try to understand what are derivatives??
Derivatives are the financial instrument which derives its value from the performance of some underlying assets. Any assets whose value are uncertain and cannot be determined can be an underlying asset for derivatives.
For example, if we say what will be the value of Nifty in next trading session, intrinsically it is difficult to say where nifty trade will tomorrow at 1 P.M. So two people who hold the opposite view about Nifty can make bet on the moment on nifty and make a contract on this assumption. In derivatives scenario, these types of contracts are known as Futures Contract.
Futures market follows the zero-sum game rule, which means one person loss will be the profit of other, financial assets such as share possess some value they create wealth but profit and loss from the derivatives market is being generated from the pocket of traders who are in a trade.
What is the importance of derivatives markets?
- Derivative makes Market Efficient – Derivative market helps in replicating the underlying asset payoff. The price of underlying and its derivatives will remain in equilibrium which reduces the arbitrage opportunities in the market.
- Price Discovery – Derivative helps in determine the correct price for the shares and commodities. Financial markets are affected by all the major news around the world. How the trades interpret this information the prices of stocks keep on changing and helps in discovering the right price.
- Counterparty Risk – Derivative market reduces the counterparty risk as exchanges are very strict on margin norms, they take upfront margin from both the parties based on the volatility of stock so that counterparty fulfills their obligations.
There are different types of derivative contract such as forward future options, swaps, floor, and collar, etc. However, the most preferred derivative instruments are futures and options.
Most of the traders all over the world trade in options markets. In India, we have also witnessed that a large number of traders are trading in options markets. Although options trading is the most difficult and complex in all the above derivatives.
Let’s try to understand the options market.
Whenever we talk about directional trading, people are more fascinated towards options trading as it required very less capital and can generate a higher return. But as we discussed option trading and understating is not that much easy to implement.
In the option market, there are basically two instruments which trader’s trader – which are known as Call option and Put options.
Call options increase in value when the market goes upside and decrease in value market falls.
On the other side, put options increase in value when the market falls and decrease in value when the market rise.
With these, there are other complications which are attached to options which are known as Option Greeks, such as.
• Delta – shows the rate of change of premium with respect to change in option premium.
For example, if Nifty rises from 11000 to 11100 how much the value of call and put options increase and decrease in value respectively that is determined by delta.
• Theta – show the decrease in value of an option due to passage of time, if the time to expiry is high means the expiry date is for the option value decrease is less but as we approach the expiry value of option started decreasing at an increasing rate.
• Vega – shows the change in option premium with respect to change in volatility of the option. Option premium is also affected by an increase or decrease in the volatility of the market, higher the volatility the option premium will tends to be high and vice versa.
• Gamma – Show the rate of change of Delta with respect to change in the underlying price.
• Rho – Rho signifies the change in option premium with respect to change in interest rate in the economy.
Let’s take an example to understand options working.
Nifty is trading at 11000 and 11100 CE is trading at Rs.55. and the expiry is on 31st Oct.
We are expecting that market will reach 11600 by the end of 31st Oct 2019.
Scenario 1. Nifty reaches at 11600 on 31 Oct 2019.
Instead of buying the future contract we bought the call option of 11100 at 55.00.
So we have paid Rs. 55 from our pocket that’s our outflow [i.e 55*75(75 is the lot size defined by exchange) = Rs.4125. (Total Investment).
First we need to cover out cost to be in profit.
So Strike price + Premium will be our break-even point in this case.
i.e 11100 + 55 = 11155.
We will start making money when the nifty will start trading above 11155.00 in our case.
On 31st Oct Nifty trades above 11155 and closes at 11600 as we expected.
P&L = 11600-11155 = 445 (So we earned 445 point on this trade.
i.e = 445 *75 = Rs. 33,375.00
So with our expectation be right we make profit of 33,375 with just investing only Rs.4125.
Scenario 2. Nifty goes opposite to our view and closes at 10800.
In this case, we didn’t close above 11155 which is our break-even point and we know that if the market goes the price of put options rise and price of call option falls. So, in this case, we’ll lose money.
We will lose amount only equivalent to the amount paid which is equal to Rs.4125.00
Scenario 3. Nifty remains at 11000 only.
In this case, when the market closes at the same price, the theta will play an important role here, as the expiry comes near our option value which we have bought at Rs.55 will start to decay and it will become zero if the market closes to below 11155.
As in our case if stay at 11000 we’ll again loses money as it stays below 11115 and that will again be equal to Rs.4125.
The above calculation shows the simplest working of options trading, there is more and more complex addition to it.