Paterson | Pioneers in Financial Services since 1892

DERIVATIVES
Derivatives are essentially a collection of a broad class of financial instruments that derive their value from other financial instruments (‘the underlying’), conditions or events. Thus, in a derivative contract between two parties the value of the contract is linked to the price of another financial instrument, condition or event.

Broad Classification of Derivatives can be done based on:

Relationship between underlying and derivative, such as futures and options
Type of underlying, such as equity derivatives, forex derivatives, commodity derivatives, etc.
Market in which they are traded, such as ETF or OTC

Benefits of Derivatives:

Provide leverage or gearing
Speculate and make profit
Mitigate risk in the underlying
Obtain exposure to underlying in case it is not possible to trade in the underlying
Create options where the value of the derivative is linked to a specific condition or event

STRATEGIES
The commonly used derivative strategies are:

Hedging
Aims to reduce risk in existing positions in the current portfolio
Speculation
Aims to take advantage if the value of the underlying asset moves as per expectations (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level)
Arbitrage
Aims to provide arbitrage opportunities in cases where the movements are not as per expectations, for example when the current buying price of an asset falls below the price specified in a futures contract to sell the asset

We at Paterson employ all these, depending upon the circumstances.

PATERSON: DERIVATIVES STRATEGIES
Our speculative strategies are based on the key information from Market players, where in we have an idea about the market swing on the either side in a particular month.

Given below are some of the Futures and Option strategies that have proven to be quite profitable in the present range bound market.

I] Vertical Bull Call Spread

This options strategy is used when the outlook on the index or stock in moderately bullish.
This is done by purchasing Call options at a specific strike price while also selling the same number of Calls of the same asset and expiration date but at a higher strike.
The maximum profit in this strategy is the difference between the strike prices of the long and short options.
Let's assume that Nifty is trading at 5100, and the market information suggests that in the current month settlement, Nifty is likely to settle around 5300.
Then using a Vertical Bull Call spread, we can buy the April 5100 strike Nifty Call Option for Rs.150 and sell the April 5300 strike Nifty Call option for Rs. 50.
The idea behind this strategy is that Nifty will hover around 5300 levels so that the 5100 Call will be worth around Rs.200, while the 5300 Call sold will become worthless.
Normally we don’t wait till the settlement and so try to square off the positions when the spread between our Call positions narrow.

II] Straddle

This option strategy is based on buying both a call and put of the index or stock.
To initiate an Option Straddle, we would buy a Call and Put of a stock / index with the same expiration date and strike price.
For example, we would initiate a Straddle for Nifty by buying Nifty 5200 April Call as well as Nifty 5200 April Put.
The idea behind buying a straddle is to capture the sudden upsurge in the market volatility.
The best time to use this strategy is when the market awaits news or results of a particular company or event like budget / election which can move the index as a whole on either side.

Another way to use the Straddle strategy is to Sell it, instead of Buying it – which is selling a Nifty 5200 April Call as well as Nifty 5200 April Put.
By selling a Straddle we are anticipating a range bound or flat market, where the Nifty remains around 5200 without a possibility of crossing the range within the settlement period.
As value of options erodes with time, what has been sold by us loses its value if the index remains range bound.
At the same time selling a Straddle can be very risky and lead to unlimited losses, if there is violent move in the market due to unforeseen events.

III] Synthetic Positions:

Involves creating a replica of one instrument by buying or selling several other instruments which can include the stock/index or derivatives on stocks / index.
These several instruments have the same payoff as investing in a stock or index.
For example, a position which is long a 5200 strike Call and short a 5200 strike Put is equivalent to purchasing the underlying i.e. Index for 5200 at exercise or expiration.

Under similar lines we replicate a Short Put position by buying the index futures and selling the Call with a strike near to the index position.
Going short in a Put essentially means that we have a bullish view on the market.
The point in using a synthetic strategy here is to take advantage of the high volatility in the Call options, due to which the call option price will erode faster even if there is going to be a rise in the underlying index.
This position has a cushion on the downside (if the index falls) up to the net credit of the value of Call option sold and the upside risk arising out of selling the call is mitigated by a long futures position in the index.

CONTACT US
These are just a few of the strategies that we have used in the past and continue to use based on market conditions. However, the right derivatives strategy for you would depend on your business needs and requirements. For structuring the right strategy for your company, you can e-mail us at contact@paterson.co.in or call us.