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Big Story | What you should know before trading in derivatives

Akhil Nallamuthu BL Research Bureau | Updated on February 13, 2021

It might be luring for new entrants and the uninitiated to increase stake in the markets via derivatives. We list out a few key points you should know before taking the plunge

Trading in derivatives can be a double-edged sword, especially in a volatile market like the one we are witnessing now. Warren Buffet once famously referred to derivatives as “financial weapons of mass destruction.”

While many market participants would strongly disagree with him, one cannot over-emphasise the need for adequate risk management while trading in derivatives. Originally conceived as hedging instruments, they have now evolved into a significant trading instrument representing over 90 per cent of total daily trading volumes on NSE in India.

NSE has maintained its position as the world’s largest derivative exchange for two years in a row now. The Covid-19 lockdown and the increase in trading activity since then gave a further boost to this trend with derivative trading volumes almost trebling from the March 2020 levels.

The surge in derivatives trading has also been driven by the increase in retail participation since the lockdown.

While it might be luring for the new entrants and the uninitiated to increase stakes in the markets via derivatives, they should take due care to understand the details and nuances.

They must also learn adequate risk-management practices so as to not get caught unawares when markets make completely unexpected moves.

Here, we list key points that investors and traders need to keep in mind with respect to derivative trading.

When to buy or sell

Investing wisdom says any stock should be bought at reasonable valuation to extract maximum gain out of the money that we put in. So, valuations are imperative, and this can be a big factor in deciding the ‘when’ part of any investment.

Derivatives, on the other hand, are not investment products. They can either be used as hedging tools for a large investment portfolio or as speculative products that are part of trading strategies.

Hence, the right time to deal with derivatives is when you need to hedge a portfolio or have a well back-tested and validated trading strategy that can be tried out in the markets.

The advantage with derivatives is that irrespective of the market/stock direction, a price movement can be capitalised on and monetised.

This means you can make money by going long or short, depending on your expectations..

Investors with a large equity portfolio in the cash segment can, for example, hedge a part of their portfolio by taking a short position on the index or a few specific stocks. This way, their losses will be lower if the stock prices fall, because the short position would be profitable in such cases.

However, the flip side is that if the stock prices move up, the profits would be lower as the short position in derivatives would be at a loss, thus reducing the profit of the overall portfolio. So, choosing the right derivative products can protect your portfolio from extreme volatility.

Traders, on the other hand, can try to profit by taking positions based on their assessment of the market/stock direction or by adopting trading strategies that are agnostic to the market direction.

For example, a popular trading strategy in developed markets is market neutral trading. Here, traders take positions where their long position is equal to their short position in terms of value, and try to profit from their long position outperforming their short position irrespective of the direction of the stocks.

The margin factor

When you trade in derivatives, you cannot escape the term ‘margin’. Exchanges have stipulated margin requirements that should be maintained by the market participants in order to transact in derivatives contracts. This is called upfront margin.

It varies with each stock depending on volatility.

For instance, the futures contract of Hindustan Unilever has an upfront margin requirement of 20 per cent, while that of Vodafone Idea is 60 per cent — this is because the volatility of the latter is substantially higher.

Remember, this is only to initiate a position; so, you need to have a buffer amount to account for any potential drawdown, ie, the mark-to-market (MTM) margin. Practically, not all trades can be profitable right from the moment we enter it. Most of the time, we could witness some amount of drawdown before the position becomes profitable, and so, one should maintain a margin over and above the upfront margin.

But what is the optimum margin? One way of calculating this is by using the trading range of a security, ie, by using average true range (ATR) indicator. Let’s see how you can do this.

Suppose you are bullish on the Nifty 50 and wish to buy its futures for intraday. Let us see what should be the optimum margin you need to maintain, in the form of cash or in any other acceptable form.

The upfront margin requirement will be approximately ₹1.7 lakh for a contract value of approx ₹11 lakh (margin of around 15 per cent).

To calculate the additional amount required, we will consider the daily ATR of Nifty 50 futures. On Friday, the ATR (average of last 14 trading days) stood at nearly 250 points. So, if you are on the wrong side of the trade, the futures is likely to move against you by 250 points in a day.

For safety, we can assume that the futures can move 1.5 times, ie, 375 points. In this case, you might face a loss of a little over ₹28,000.

Hence, before initiating an intra-day trade in Nifty 50 futures, one should make sure that the available margin in the demat account amounts to nearly ₹2 lakh (about ₹28,000, plus upfront margin of ₹1.7 lakh). This is not a hard-and-fast rule; you can have your own methodology.

Broadly, the margin requirements will vary if you want to hold positions beyond intraday and will also be based on the derivative instrument you use — futures or options.

Futures or options?

While both futures and options can be used to trade or hedge, they exhibit different characteristics. So, whether you should go for futures or options depends mainly on three factors — outlook for underlying security, hedging requirements and your emotional comfort level.

Derivatives help you execute trades that can closely align with your forecast. Let’s say, after analysis, you conclude that a stock is mildly bullish and expect it to go up in the short run, but the rally can exhaust soon. In such situations, covered call (an option strategy) can be an optimum strategy.

Likewise, one can execute a variety of strategies depending on the expectation.

Two, if you are using derivatives for hedging purposes, you can use futures or options or a combination of both depending on the circumstances. Hedging a single stock depends on the number of shares you hold and the lot size (number of shares per contract) of the F&O contract. If the number of shares is higher than the lot size, futures can come in handy. If vice-versa, you might have to hedge using options (with futures, you might end up over-hedging).

But the tricky part is hedging a stock that does not have a derivatives contract on it. Here is where the concept of beta comes in.

Beta of a stock over a period of time can be calculated by comparing its daily returns with that of its benchmark index, say Nifty 50. Beta can be calculated using the ‘SLOPE’ function in excel. Scrips with beta greater than 1 are generally referred to as high-beta stocks and vice-versa.

Suppose you hold a stock whose beta is 2. This means that it can move twice as much as Nifty 50. Here, you can hedge by selling two lots of Nifty 50 futures contract.

But if the beta is 1.5, you may use a combination of futures and options.

But it’s a cumbersome process and it becomes difficult to perfectly hedge every time.

When it comes to hedging a portfolio of stocks, rather than hedging each stock with its own derivatives contract (margin requirements can shoot up in this case), you can calculate the weighted average portfolio beta and take required positions in Nifty 50 futures.

The third factor is your emotional comfort level. If you tend to be more adventurous, trading in futures and selling options may not cause discomfort. But if you are a play-it-safe person, option buying can be more suitable, because the maximum loss will be the premium paid and you can also trade in low-premium options.

In general, rather than buying/selling naked futures or options, you will be better off if trades are executed as a mix of futures and options — this gives you the opportunity to manage risk better and make hedged trades.

While the potential profit can be lower, you can avert huge drawdowns and thus cut down losses.

Once a derivatives trade is executed, one must stay in constant vigil. Importantly, remember that these are leveraged products and if gone wrong without proper checks and balances, can wipe out capital quickly than one can imagine. Having well-defined entry and exit points is a must.

Taxation

The profit/loss incurred by trading F&O contracts are classified under ‘Business Income’ as per the Income Tax Act. Business income is further categorised as speculative and non-speculative income.

While intraday trading in shares is treated as speculative transactions, trading in F&O comes under non-speculative business (even if done intraday) since these contracts are deliverable and the purpose is for hedging.

This means, income from F&O will be taxed as per your income tax slab. You can also claim expenses such as internet charges, brokerage charges and DP (depository participant) charges before calculating the taxable income.

If the non-speculative income is a loss, it can be used to set off taxable income under other headings, except salary and speculative income.

Unutilised loss, if any, can be carried forward for eight years.

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Published on February 13, 2021
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