Derivative securities are an asset class which derives its value from an underlying security. These assets may be securities like bonds, equities, commodities, interest rate, currencies and many more.
The most interesting fact about owning a derivative is that you don’t have to buy an asset, you can take “Long” and “Short” positions in derivatives.
The two major classes of derivatives are “Forward and Futures”. While both of them look very similar, there are some difference which separate the two classes. While forwards and futures both give buyer the right to purchase the “Option”, futures are much more standardised and are traded on exchange. Another important difference between the two classes are the profit/loss calculation methodologies. Futures are “marked to market” every day and gains/ losses are booked on a regular basis, while forwards settle at the end of the agreement.
Options: An option is a derivative contract, which gives the owner the right but not the obligation (unlike owner) to buy or sell the underlying at the exercise price. When an investor takes a “Long” position, he buys the option, while the short position refers to sell the option. There are two major types of options:
- Call Option
- Put Option
Options, which give you a right to buy the underlying asset, are called Call Options. A call option is often bought when an investor expects the market to be bullish, that means they expect the price of an underlying to go up. On the other hand, the Options that give you a right to sell the underlying asset are called Put Options. This option is often bought when an investor feels the market is bearish, that is the price would go down in the nearing future.
Option traders have to do business with more variable factors than the normal stock traders. These are broadly divided into two broad approaches:
- American Option Strategies
- European Option Strategies
In American Option strategies, owners may exercise at any time before the option expires while the owners of European style options may exercise only at expiration.
Often traders bounce into derivatives without much knowledge of strategies. Below mentioned are some option strategies which may help to earn profits with limited risk.
Some technical definitions are mentioned below which might help you to understand these strategies better:
Moneyness: It refers to the relationship between the strike price of an option and current market price of an underlying security.
In the money: A call option is said to be “In the Money” when its strike price is below the current market price whereas the put option is “In the Money” when its strike price is above the current market price.
A long call is the most common option strategy where an investor expects the market price to rise beyond the strike price before maturity. It offers significantly higher profits if the expectations turn out to be correct. Let’s look at one example:
Suppose, A owns 100 shares in a company, which currently trades at $105. A believes that the price would go up due to some profitability scenarios in a company. He wants to buy 100 more shares but doesn’t have enough resources to do that, so he purchases a “Long Call” at an option price of $3, with a strike price of $130. So, he pays $300 (=3*100) to buy 100 shares of the underlying stock. Now at maturity, if the stock price hits $165, he will be buying the shares at $130 and sell in the market for $165, making a gain of 3500 [= (165-135) *100]. Since he paid a premium of $300, therefore his total net profit=$3500-$300=$3200.
If in case the markets don’t meet the expectations and the price falls down to say $120, the investor won’t exercise the option and will book a maximum loss up to the premium paid.
Long Call Options
Covered Call (Long Stock+ Short Call)
This is one of the versatile strategies where an investor Long stock and Short Call. This is often chosen when an investor forecasts the market to be neutral to bullish, but he also protects himself from any downside. This strategy is often created by buying the stock and shorting the call options and is a very popular strategy because it generates income and reduces some risk of having long stock alone.
For Instance, you purchase 100 shares at the $98, with a strike price of $100, 1 call option is simultaneously shorted, for which you earn a premium of say $3.5 per share. This acts as a limited protection against the downside but will have an obligation to sell the stock at an agreed price on the expiration date. The major risk one faces in this strategy is the downside risk because the price can decline sharply.
The market profit you can earn in this strategy is $5.5 (=100-98+3.5), but the risk is substantial if the stock price declines.
Protective Put (Long Stock + Long Put)
This strategy works as an insurance and is often used when an investor forecasts the short term to be bearish but the long term to be bullish. In this strategy, an investor holds the stock which he already owns but long the put option as he believes that the market is bearish in the short term. This strategy has the unlimited upside potential as the owner holds the stock with a limited risk, as the maximum loss he can bear is the premium paid for buying the put option plus the change in the price.
For Instance, an options trader owns 100 shares trading at $100 and at a put option at $3.25. Here the maximum profit is unlimited as the stock price can rise indefinitely. The maximum risk is the difference between stock price and strike price plus the premium paid. In our example, maximum loss is equal to $3.25 (=$100-$100+$3.25).
Collar (Long Stock + Short Call+ Long Put)
This is a hedging strategy wherein an investor is protected from large losses but is also limited to large gains. This strategy is often chosen by the investor when he wants to have some upside profit potential but also wants to leave some upside profit potential when the short-term forecast is bearish, but the long-term forecast is bullish. In this strategy, an investor purchases out of the money put option and short out of the money call option for the same underlying asset and expiration.
For Instance, an investor buys 100 shares at $100, short call at $105 for $1.80 and long put at $95 for $1.60. If the stock price declines, the purchased put provides protection below the strike price and if the stock price increases profit potential is limited to the strike price of the covered call less the premium paid. In our example, maximum profit an investor can earn is $5.2 (=105-100+1.80-1.60) and maximum loss he has to bear is $4.8 (=100-95-0.2).
Collar Option Strategy
Long Straddle (Long Call + Long Put)
It is an option combination where an investor buys both puts and calls on the same underlying asset with same exercise price and same expiration dates. The idea to choose this strategy is to book profit from price change, either when the markets go up or down. Long straddle pays premium on both call and put and thus is an expensive strategy. One can earn unlimited profit as the stock price can rise indefinitely and, on the downside, a substantial profit can be earned as stock price can go up to zero.
The maximum risk an investor can have is limited to the premiums paid. Both options will expire worthless if the stock price is exactly equal to the strike price at expiration.
Likewise, a short straddle can also be created using short call and short put.
Though these strategies provide huge profit opportunities but also come with large risks. Some of them are mentioned below and it is advised to have a look before jumping into any strategy.
- Real Value: It is very difficult to determine the real value of the underlying assets because of their complexity. Most traders avoid using these strategies and derivatives because they are not able to trade them.
- High Leverage: Another big risk investor undertakes is the leverage. For instance, futures are marked to market every day. If the value of the underlying plunges, they have to add money to maintain the margin until the agreement expires.
- Counterparty risk: There is literally no exchange involved in the contract and hence there is a risk that the counterparty does not fulfil their obligations. These may also be named as default risk as there is a high probability that one party may who have the obligation may not able to accomplish it.
The derivative instruments allow investors to hedge, speculate or increase leverage but they must apply caution, seek expert advice and take weigh the risks before taking any exposure.
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