How to Manage Risk While Trading in Derivatives
Are you looking to upgrade your stock market portfolio? Here’s one way to bump up your trading game: enter the derivatives market. Just do the due diligence first - get to know the basics of managing risk in derivatives trading.
What are derivatives?
A derivative is a financial contract whose value is based on—that is, ‘derived’ from—that of an underlying asset. The underlying asset could be a stock or bond, a commodity like oil or gold, or a market index like Nifty50. It could even be a currency or an exchange rate.
Derivatives traders in India deal in four types of derivatives contracts.
- Futures: Two parties—a buyer and a seller—enter into a contract to buy or sell the underlying asset by a specified future date. Both parties are obliged to honour the terms of the contract by the stated expiration date. Futures trades take place through a regulated exchange.
- Forwards: A forwards contract is similar to a futures contract, except that the two parties negotiate directly. That allows for greater customisation in terms of the contract. Forwards are also known as over-the-counter (OTC) contracts.
- Options: In a futures transaction, both parties must honour the contract terms by the expiry date. However, an options contract works a little differently. It offers one of the parties the choice—or ‘option’—to execute the contract.
- Call option: Here, the buyer has the right, but not the obligation, to buy the underlying asset by the date of expiry.
- Put option: In this case, the seller has the right, but not the obligation, to sell the underlying asset by the date of expiry.
- Swaps: Swaps are between two parties that want to exchange liabilities or cash flows. A typical example is the interest rate swap. However, retail investors usually do not use swaps, and these transactions do not take place on the exchange.
Derivatives and risk management
As you enter the derivatives market, take note of the key players. They have their own way of managing risk.
- Hedgers are focused on reducing their risk. Suppose a trader holds shares in a company where the share price is dipping. They may use hedging to protect their portfolio from adverse share price movements.
- Speculators aim to gain from price fluctuations in the market. Derivatives offer more leverage than trading directly in the underlying asset. So, the trader can take a more prominent position at a lower upfront cost, multiplying the potential for profits.
- Arbitrageurs zoom in on price inefficiencies in the market. They usually take simultaneous trading positions that offset each other to gain profits in a relatively risk-free manner. Suppose a particular stock is undervalued on an exchange. The arbitrageur might buy it cheap on one exchange and sell it at a higher price on another.
To understand how derivatives traders manage risk, consider this simple example:
Trader-A holds 1,000 shares in Company-Q. But the company is performing below par. Trader-A worries that this could push the share prices down from the current level of Rs 530 per share. What should Trader-A do?
She could hedge to protect herself against a potential share price decline. For instance, she could take out ten put options with a strike price of Rs 520. Trader-A could cut her losses by executing the contract if the share price dips below Rs 520 by the expiration date.
Tips for trading derivatives
Keep these pointers in mind while setting up your trading plan:
- Note the market risks: This is the general risk associated with any trade. Always consider the possible impact of market fluctuations when taking a position.
- Factor in the counterparty: There is always the chance that one party might default on the contract. This risk is higher in OTC transactions, as there is no exchange to ensure that both parties maintain sufficient margins.
- Watch your margins: Derivatives trades are leveraged trades. When all goes well, this allows you to multiply your gains. But if the trade moves adversely, there could be a margin call, and you could face huge losses. So, track the margin requirements at every step.
- Time your trades: Note the expiration date while setting up trades. If you fail to exit a derivatives trade before expiry, it could get auto-settled—and the results may not be in your favour.
Thorough research and an adaptable trading plan are essential for derivatives traders to manage their risk. It helps to have an account with a broker like ICICIdirect that offers timely alerts, in-depth research, and seamless trading platforms. With the right support in place, you can make better decisions while trading on the derivatives market.
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