Most people immediately think of risk management (hedging) when they talk about derivatives. This refers to the process of setting up derivatives positions such that a loss on your primary portfolio is offset by gains from your derivatives position. Yet, most market participants do not use exchange-traded derivatives for hedging purposes. Rather, such contracts are used for generating short-term gains. This week, we discuss why you should think of trading, not risk management, when you consider exchange-traded derivatives.

Trading bets

Index and single-stock futures contracts are available for a maximum period of three months only. True, the NSE does offer long-dated options on the Nifty Index. But such contracts have thin liquidity. Even the near-month Nifty options have not been actively traded after the introduction of weekly options on the index. This means the near-week and the next-week contracts on the Nifty 50 Index and the near-month contracts on equity options, index futures and single-stock futures are most actively traded. 

Now, even if you want to hedge your portfolio only for a very short term, are you willing to statistically determine the relationship that your portfolio has with the hedging instrument? This is required to determine the appropriate number of futures contracts to short. The objective is to offset the likely loss on the portfolio with potential gains on short futures. The more stable the relationship is, the more accurate the hedge will be. But the relationship between your portfolio and the hedging instrument could change after you set up the hedge. Also, if you short Nifty futures and the index moves up, your short futures (the hedging instrument) will generate losses, dragging the potential gains on your primary portfolio. 

You could argue that put options could make a better hedge than futures. After all, options have asymmetric payoff; for puts, the maximum gain, when an underlying hits zero, is greater than the maximum loss, the option premium. The issue, however, is time decay. The option premium contains time value, which becomes zero at option expiry. So, the put option that you buy as a hedge will work best if the portfolio declines immediately than towards option expiry. But if you expect the underlying to decline immediately, it is moot if taking profits on the portfolio is better than hedging, considering that buying puts is an additional cost. 

For better gains
The put option that you buy as a hedge will work best if the portfolio declines immediately than towards option expiry
Optional reading

Exchange-traded derivatives are typically used as trading bets. If you have a view that an underlying is likely to move up, you may choose to go long on futures or long on call or short on put. Over-the-counter derivatives (OTC) are custom-tailored contracts that could work well for risk management. But such products are unavailable for retail investors. Volatility products, for instance. An institutional investor wanting to hedge its long-only portfolio from a market crash could go long on volatility or variance swaps (OTC). Because volatility explodes when market crashes, the investor could have hedged its portfolio against tail risk.

The author offers training programmes for individuals to manage their personal investments