All About Stock Derivatives

By BankBazaar | September 27, 2018

Stock derivatives can enhance returns from the stock market. We give you a few simple strategies and tell you all about them. 

All About Stock Derivatives

Done with investing in Mutual Funds? Want to try something new? Then try derivatives. You might have heard about stock derivatives. They might seem complicated, but they really aren’t. A stock derivative is a financial instrument whose value is derived from the underlying security, which is a stock.

Derivatives are of two types. One is futures and another is options. Futures is a contract between two parties to buy or sell an underlying stock at a pre-determined price at a pre-determined date in future. Now, how does this work? Let’s say you buy a 3 month Infosys futures contract and the contract involves 200 shares. Today, Infosys is valued at Rs. 1,022 per share. If share prices rise to Rs. 1,100 in 3 months, you will make a profit of Rs. 15,600 (78 x 200).

What about options? Options give you the right, but not the obligation, to buy underlying shares at a pre-determined price at a pre-determined date. So, you have the right to exercise or leave the option. There is a price for the option at which you will be buying it. So, in case you don’t exercise the option, your loss is limited to the price at which you purchased it.

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There are two types of options. One is the call option, which is the option to buy the underlying shares, while the other is the put option, which is the option to sell the underlying shares. Strike price is the price you think the stock will be at when the contract gets over.

Here’s an example. Let’s say you buy a one-month call option on ITC shares for Rs. 9. The strike price is Rs. 300 and the contract will have 200 shares. The present price of ITC is Rs. 288. If it touches Rs. 300 by the time the contract gets over, you will gain Rs. 2,400 (12*200). In case the stock falls by that time, you can decide not to exercise the contract and your loss will be just the Rs. 9 you paid to purchase the contract. That is why options are less risky when compared to futures, where loss can be unlimited. You need to fulfil a futures contract even if it will result in a loss for you.

Got the fundamentals? So, let’s look at how you can create a few strategies using derivatives to profit from them.

Bully Gains?

The markets seem to be on an upside nowadays. But you don’t know if it will sustain for long. Are there any strategies that you can use to make gains? Of course! You can make use of derivatives. Equities are for the long term while derivatives are for the short term. Due to the speculative nature of derivatives, it is best that you consult a stockbroker to trade unless you have knowledge about them. Here are a few strategies that you can ask your stock broker about.

The bull spread derivative strategy is used when you think the stock market is going to rise moderately in the short term. Here, the risks are limited and the returns are limited too. However, remember that by using this strategy, you are foregoing the probability of making a large profit if the underlying stock rallies quite significantly. So it is best to use the strategy only if you are sure of moderate movements in the stock. There are two kinds of bull spread. One is the bull call spread and another is the bull put spread.

Bull Call Spread

What is it: Bull call spreads are where you purchase a call option on a stock while simultaneously writing/selling a call option on the same stock, at a higher strike price. For instance, you buy Axis Bank call options at Rs. 500 and sell a call at Rs. 530. Assuming the present price is Rs. 516, that will be a bull call spread on Axis Bank. You should have the same timeline for both options.

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Pros: When you sell the call, you will receive money on the same. So, you wouldn’t incur much cost for establishing this strategy.

Profit: You achieve maximum profit when the stock price exceeds the higher strike price of both calls. In our example, you will make maximum profits when the share price of Axis Bank moves above Rs. 530. Profit is equal to the difference between the strike prices of the two call options minus the net premium paid.

Loss: If the stock price declines on expiration, a loss is incurred. The maximum loss is limited to the net premium paid.

Break-even: The breakeven point is equal to the strike price of the call option plus the premium paid.

Example: You think that Axis Bank trading at Rs. 516 is going to rally soon and enter a bull call spread by buying a MAY 500 call for Rs.10 and writing a MAY 530 call for Rs. 9. The net investment required to create the spread is a debit of Rs. 1.

The stock price of Axis Bank rallies and closes at Rs. 550 on the expiration date. Both the options would expire in-the-money with the MAY 500 call having an intrinsic value of Rs. 50 and the MAY 530 call having an intrinsic value of Rs. 20. This implies that the spread is now worth Rs. 70 at expiration. Since you had a debit of Rs. 1 when you bought the spread, your net profit is Rs. 69.

If the price of Axis Bank had dropped to Rs. 490 instead, both options would expire, being worthless. You would lose your entire investment of Rs. 1, which is also your maximum possible loss.

Bull Put Spread

What is it: Bull put spreads can be made by purchasing a put option on a stock while simultaneously writing/selling a put option using that stock as underlying, at a higher strike price. For instance, you buy Axis Bank put options at Rs. 514 and sell a put at Rs. 520. Assuming the present price is Rs. 517. That will be a bull put spread on Axis Bank. You should have the same timeline for both the options.

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Pros: The price paid for purchasing the put option will get covered by the premium you will receive from selling a put with a higher strike price.

Profit: You will receive the maximum profit when the stock price exceeds the higher strike price on expiration. Profit is equal to the net premium received.

Loss: If the stock price falls below the lower strike price, then the maximum loss is incurred. Profit is equal to the difference between the strike prices of the two puts minus the net premium received.

Break-even: The breakeven point is equal to the strike price of the short put minus the net premium received.

Derivatives involve high risks. Trade in them only with professional help. If you feel they are too complicated, try investing in stocks first. You can even start with Mutual Funds. They are much easier to understand and invest in. Ready to explore?

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