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Derivatives are a double-edged sword

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Derivatives are a double-edged sword

Friday, 24 January 2020 | Hima Bindu Kota

Used both for hedging and speculation, the derivatives markets worldwide have grown to a humongous level, reaching about $1.2 quadrillion. However, their use has also brought giant corporations to their knees, hence investors must exercise caution

The term “financial weapons of mass destruction”, coined by billionaire Warren Buffett for derivatives, is not without reason. They can be used both for hedging and speculation and their markets worldwide have grown to a humongous level, reaching about $1.2 quadrillion, almost 10 times that of the world GDP.

However, the use of derivatives has also brought giant corporations to their knees during past global financial meltdowns. One cannot forget the bankruptcy of corporations like Enron and Barings Banks due to wrong speculative moves involving derivatives. Since they are a double-edged sword, one has to be extra cautious while using them. 

What are derivatives anyway? These are instruments that derive their value from any underlying asset, which could be either a stock or a commodity.

Any investor or corporation can put money in any one of the popular derivatives for hedging or speculative purposes. Corporations use them for hedging if they want to reduce an existing risk or protect themselves from any volatility in the price of an underlying asset by taking an offsetting position, whereas speculation is trying to make profit due to any price changes.

Several analysts believe that the Indian stock markets are set to rise further in 2020 and may end higher by at least 13 per cent. It is being predicted that Nifty might end above the 13,000 mark. Similarly, the expectation for the BSE Sensex is that it will go above the 46,000 level. So, if we consider a bullish market for this year, what are the derivative strategies that an investor can use in this type of market where the prices of underlying assets are set to rise? Although the general belief is that stock markets will be bullish, there will certainly be variations as is natural.

In case the markets are extremely bullish, investors should go ahead with a long-call strategy. This is one of the simplest approaches and can be used by beginners in the derivatives market. There is only one transaction involved, i.e., buying call options. It helps investors use the power of leverage and make potentially unlimited profits and at the same time cap their losses. In the worst case scenario, when the markets do not behave as anticipated, loss is limited to the price of buying the call options.

A reverse call ratio spread is also an extremely bullish strategy where an investor can sell an option at a lower price, usually in-the-money or at-the-money and buy more options at the higher strike price, which is out-of-the-money, of the same underlying asset. So if an investor sells one option and buys two options with a higher strike price, a reverse call option strategy is created.

When the market outlook is moderately bullish and the investor is expecting some upward movement in the underlying asset, a long-call ladder strategy could be initiated. This strategy has the potential of earning from time decay if it expires in the range of the strike price. This strategy is created by buying one in-the-money call, selling one at-the-money call and selling one out-of-the money call of the same underlying asset with the same expiry. Experiments can also be made with different strike prices.

Another income-generating strategy that can be initiated in a moderately bullish market is a covered call option which can be created by using a stock and an option. This strategy is created by purchasing a stock and simultaneously selling a call option, which is out-of-the-money, usually on the higher side.

When the markets are becoming more neutral, buying a long-call would not be the best strategy to use. In a moderately bullish market, investors could take a short put option strategy, wherein they go short on a put position, i.e., they are obliged to buy the underlying asset in future at a predetermined price if the buyer wishes to exercise his option. This strategy will be helpful for investors if the price of the underlying asset increases moderately or even remains at the same level. In a flat market, this strategy will be beneficial as it gives investors a chance to earn some upfront money in the form of premium which can be adjusted against some margins.

Another strategy for a more neutral or flat market with a bullish view is bull put spread option, which involves two put options, both short and long. It is created by one short put with a higher strike price and one long put with a lower strike price. But here the expiration date remains the same. This strategy has a higher potential of being profitable as it is beneficial in situations when the prices are steady or are rising.

In case an investor has suffered any losses due to price fall, a stock repair strategy is there and can help the investor recover their losses even if the prices of the underlying asset show slight improvement.

This strategy is created by buying one at-the-money call and at the same time selling two out-of-the money call, of the same underlying asset with the same expiration. The trick here, though, is that the strike price of the sale should be very close to the buying price.

As one can see, there are different derivative strategies for different market outlooks. However, taking a bet with derivatives can be very dangerous as by paying a small premium, investors can end up initiating very large transactions and if the markets do not move the way the investors  anticipated, the losses can be huge. These transactions should only be undertaken by an expert with knowledge about stock markets and in particular, derivatives.

(The writer is Associate Professor, Amity University, Noida)

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