Advanced course on futures and options

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Phew! We’ve finally reached the end of this module. It was a pretty action-packed ride, wasn’t it? We discussed a host of topics and took an in depth look at the way futures and options operate. That’s not all. We also saw how you can effectively earn short-term profits by simply engaging in futures trading and options trading.

While it is true that one of the main advantages of futures and options lies in its ability to generate quick short-term profits, it is far from the only advantage. There are two other benefits that dealing in derivatives offers you - leverage and the ability to hedge.  

So then, what exactly are these two concepts? That’s exactly the question that we’ll hope to answer in this final chapter. Let’s jump right in. 

What is leverage? 

You may not have realised it, but you’ve actually been reading about and using leverage all through this entire module. How, you ask? Well, in the world of derivatives, leverage is essentially known as the power to control a large contract value using just a small amount of investment. Ring any bells yet? Yes. We’re talking about margins and option premiums here. As you’ve already read extensively about it before, by simply depositing a small initial margin or premium amount, you get to either buy or sell futures or options with a much larger contract value. 

For instance, you could buy a ICICIBANK JUL FUT contract with a contract value of around Rs. 5,20,000 by just depositing an initial margin of around Rs. 1,70,000. See how you’re able to enjoy the benefits that a large contract value offers with just a small amount of capital? This is what leverage is all about.          

Leverage: A double edged sword

Well, now that you’re formally introduced to leverage, it’s time we delve a little deeper into it. While high leverage allows you to control contracts with a large value, it may not always be a good idea to utilise it. This is simply because high leverage comes with a much greater amount of risk. Leverage may allow you to enjoy good returns, but only if the market is moving in your favour. If the direction of the market is opposite to your expectations, a high leverage can end up wiping out your capital with significant losses.

Let’s take up an example and see how. Assume that the ICICIBANK JUL FUT contract is currently trading at Rs. 378. The lot size is set at 1,375 shares. So, the contract value comes up to Rs. 5,20,000, right? The initial margin that’s required to purchase this contract is Rs. 1,70,000. Now, let’s look at two scenarios. 

Scenario 1: The market moves in your favour.

Say that the future contract increased in value to Rs. 400 after you bought it. The profit that you would get to enjoy if you square off your position would then be Rs. 30,250 [1,375 shares x (Rs. 400 - Rs. 378)].

A profit of Rs. 30,250 on a single trade is pretty good, wouldn’t you agree? And that too by just investing Rs. 1,70,000 (which you will get back along with the profit once you’ve squared off your position) as opposed to Rs. 5,20,000 (if you buy the 1,375 shares in the spot market).

Scenario 2: The market doesn’t move in your favour. 

Alternatively, let’s say that the price of the future contract fell to Rs. 340. The loss that you would have to bear if you square off your position would then be Rs. 52,250 [1,375 shares x (Rs. 340 - Rs. 378)]. That’s a loss of Rs. 52,250 on a single trade! Once you’ve squared off your position, you would only get back Rs. 1,17,750 as your margin as opposed to Rs. 1,70,000.

So, you see how a high leverage can be both beneficial and detrimental to you? To sum it up, the higher the leverage, the greater the risk. Here’s a tip for you. Since the entire derivative market is leveraged, when you’re dealing in them, always make sure that you assess the market accurately. Even a single wrong move can quickly prove to be very costly.

Let’s now direct our focus to the second concept - hedging. 

What is hedging?

In the financial markets, hedging is a strategy that’s employed to reduce the risk of an investment. It can help limit, or in some cases even prevent, your investments from going into losses. However, simultaneously, hedging also eliminates the possibility to earn huge profits. 

Consider hedging as a method that basically freezes or neutralizes your investments for a certain period of time and makes it immune to any significant losses, and by extension, any significant gains, due to unexpected market movements.

Hedging: A protective shield 

To better understand the concept of hedging, we’ll take up a short example. Assume that you’re a long-term investor looking to make gains from the market. With that view, you buy 100 shares of Maruti Suzuki Limited at Rs. 6,000 per share. So, you end up investing Rs. 6,00,000 (Rs. 6,000 x 100 shares). 

But, after making that investment, you feel that the stock market is going to face tough times due to slow economic growth. Now in this case, what would you do? You can either - 

  1. Let the stock go down in the short-term and hope that it bounces back up sooner or later. 
  2. Or, sell all the shares of Maruti Suzuki now and buy them once again when they’re down.

If you choose the first option, it ends up becoming a huge gamble. The stock price may or may not rise back up to the price at which you bought. If it doesn’t, you’re left with huge losses. And, with respect to stock price movements, the rate at which they fall is almost always faster than the rate at which they rise.

The second option, on the other hand, requires you to time the market perfectly to accurately capture the lower price point. And timing the market is a notoriously hard thing to do.

Okay, so then, what other option do you have? How do you prevent your investment from making losses? Here’s where hedging comes in handy. Hedging can neutralize your investment and prevent unexpected and adverse market movements from affecting it. Here’s how.

There are two primary ways to hedge your investment in the spot market - with futures and with options. We’ll start off by taking a look at hedging using futures trading

Hedging with futures  

Let’s go back to our Maruti Suzuki Limited investment example. Say you’ve bought 100 shares of the stock at Rs. 6,000 per share with a total investment of Rs. 6,00,000, right? To hedge this investment position with futures, all you have to do is short-sell the futures of Maruti Suzuki Limited. Here’s how you do that.

You sell the MARUTI JUL FUT contract, which is currently trading at say Rs. 6,005 in the futures market. The lot size of the contract is set at 100 shares, which is the same as your spot market investment. The total contract value comes up to Rs. 600,500 (Rs. 6,005 x 100 shares). For this contract, assume you pay a margin of 30% on the total contract value, which comes up to Rs. 180,150. 

Now, let’s take a look at what your net profit/loss would be when you hedge your position with futures. Assume that you hold the futures till expiry. For this calculation, we’ll take up different price points of Maruti Suzuki.   

A

B

C

D

Stock price after hedging 

Profit or loss with respect to spot market investment in Maruti Suzuki (per share)

Profit or loss with respect to short-selling of futures of Maruti Suzuki (per share) 

Net profit or loss 

(per share)

Rs. 5,800

-Rs. 200 (loss)


(Rs. 5,800 - Rs. 6,000)

+Rs. 205 (profit) 


(Rs. 6,005 - Rs. 5,800)

+Rs. 5 (profit)


(-Rs. 200 + Rs. 205)

Rs. 6,010

+Rs. 10 (profit) 


(Rs. 6,010 - Rs. 6,000)

-Rs. 5 (loss) 


(Rs. 6,005 - Rs. 6,010)

+Rs. 5 (profit)


(Rs. 10 - Rs. 5)

Rs. 6,200

+Rs. 200 (profit)


(Rs. 6,200 - Rs. 6,000)

-Rs. 195 (loss)


(Rs. 6,005 - Rs. 6,200)

+Rs. 5 (profit)


(Rs. 200 - Rs. 195)

As you can see from this table, by simply hedging using futures, you effectively freeze your investment and shield it from losses irrespective of how the price moves. In order for the hedge to work as outlined above, you’ll need to time your purchases accurately. What this means is, you’ll have to buy the futures contract of Maruti Suzuki at the exact same time as you buy the shares of the company from the spot market. This will help keep the spread (the difference between the spot price and the futures price) to a minimum.  

Hedging with options

When it comes to hedging investments, most traders prefer futures trading. However, you can also make use of options trading to hedge your positions. Again, for the purposes of consistency, we’ll take up the same Maruti Suzuki example. Say you’ve bought 100 shares of the stock at Rs. 6,000 per share with a total investment of Rs. 6,00,000, right? Here’s what you can do to hedge your investment with options trading

You buy the MARUTI JUL 6000 PE option contract, which is currently trading at a premium of Rs. 20 (per share) in the options market. The lot size of the contract is set at 100 shares, which is the same as your spot market investment. Since you’re buying the put option, the total premium that you have to pay comes up to Rs. 2,000 (Rs. 20 x 100 shares).  

Now, let’s take a look at what your net profit/loss would be when you hedge your position by buying a put option. Assume that you hold the option till expiry. For this calculation, we’ll take up different price points of Maruti Suzuki.   

A

B

C

D

E

Stock price after hedging 

Profit or loss with respect to spot market investment in Maruti Suzuki (per share)

Profit or loss with respect to buying the MARUTI JUL 6000 PE (per share) 

Premium paid for purchasing the put option 

Net profit or loss 

(per share)

Rs. 5,800

-Rs. 200 (loss)

(Rs. 5,800 - Rs. 6,000)

+Rs. 200 (profit) 


(Rs. 6,000 - Rs. 5,800)

-Rs. 20 

-Rs. 20 (loss)


(-Rs. 200 + Rs. 200 - Rs. 20)

Rs. 6,010

+Rs. 10 (profit) 


(Rs. 6,010 - Rs. 6,000)

Not applicable 

-Rs. 20

-Rs. 10 (loss)


(Rs. 10 - Rs. 20)

Rs. 6,200

+Rs. 200 (profit)


(Rs. 6,200 - Rs. 6,000)

Not applicable 

-Rs. 20

+Rs. 180 (profit)


(Rs. 200 - Rs. 20)

Here, there are two things that you should note. 

  • The maximum loss that you would suffer when hedging with put options trading is the amount of premium that you pay to purchase the put option. Irrespective of how low the stock price goes, in this case, the maximum loss is restricted to just Rs. 20 per share.
  • When the stock price goes up above the put option’s strike price, you wouldn't exercise the option and would just forego the premium paid to purchase the option. 

Wrapping up

With this, we’ll wrap up this module. It has been quite an interesting learning experience  so far, hasn’t it? The journey doesn’t stop here though. In the next module, we’ll be focusing on two other financial assets - currencies and commodities. As always, stay tuned to learn more.  

A quick recap

  • Leverage is essentially the power to control a large contract value using just a small amount of investment.
  • By simply depositing a small initial margin or premium amount, you get to either buy or sell futures or options with a much larger contract value.
  • While high leverage allows you to control contracts with a large value, it may not always be a good idea to utilise it. 
  • This is simply because high leverage comes with a much greater amount of risk. 
  • Leverage may allow you to enjoy good returns, but only if the market is moving in your favour.
  • If the direction of the market is opposite to your expectations, a high leverage can end up wiping out your capital with significant losses.
  • In the financial markets, hedging is a strategy that’s employed to reduce the risk of an investment. 
  • It can help limit, or in some cases even prevent, your investments from going into losses. However, simultaneously, hedging also eliminates the possibility to earn huge profits.
  • You can use futures and options to hedge your investments.
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