Derivatives are financial agreements whose worth depends on an underlying asset, market index, or interest rate. The assets that underlie derivatives can consist of equities, fixed-income securities, raw materials, foreign currencies, interest rates, and various market indices. They serve multiple functions, such as mitigating risk, betting on price fluctuations, and providing access to difficult-to-trade assets or markets.
The worth of a derivative relies on the price fluctuations of its underlying asset, which makes it very responsive to changes in the market. This responsiveness enables investors to amplify their positions and possibly secure greater profits, but it also heightens the risk of considerable losses.
Key Concepts to Learn Before Trading Derivatives
Before you start trading in the derivative market , here are the key concepts you must learn.
1. Volatility
Volatility measures how much a price of security fluctuates. A high volatility level means the price can shift sharply in a short span, while low volatility signals more stable movements.
You can employ the standard deviation of the asset’s returns to determine volatility. You can then compute the standard deviation by calculating daily returns from monthly closing prices. Here is the formula to calculate the annualised volatility:
Volatility = σ √T​
Where:
- (Sigma) is the standard deviation of returns
- (T) is the number of periods in the time horizon
For example, if the daily standard deviation of daily returns is 2%, the annualised volatility would be:
Volatility = 0.02 × √252​ ≈ 0.32 or 32%
2. Greeks
The Greeks allow you to measure how different factors impact an option’s price. It helps you manage the risks and rewards of your position.
- Delta (Δ): Delta indicates how much the option’s price will change when the underlying asset’s price moves by $1. For instance, if a call option has a delta of 0.5, a $1 gain in the asset results in a $0.50 increase in the option’s price.
- Gamma (Γ): Gamma represents how much the delta of an option changes for every $1 movement in the underlying asset’s price. For instance, if a call option has a gamma of 0.1, a $1 increase in the asset’s price would raise the delta by 0.1.
- Theta (Θ): Theta represents how much the value of an option decreases each day due to time decay. For instance, a theta of -0.05 means the option will lose $0.05 in value daily, assuming other factors remain constant.
- Vega (ν): Vega represents the sensitivity of an option’s value to volatility changes. For example, a vega of 0.2 means a 1% volatility increase raises the option price by $0.20.
3. Technical Analysis
When you engage in technical analysis, you analyse past market data, especially price and volume, to forecast upcoming price changes. Here are some popular chart patterns and indicators to consider before proceeding with derivatives trading:
- Candlestick Charts: These charts illustrate the opening, highest, lowest, and closing prices for a specific time frame. Patterns such as Doji, Hammer, and Engulfing may signal possible market reversals.
- Moving Averages: Moving averages serve to smooth out price data, aiding in trend identification. The Simple Moving Average (SMA) and Exponential Moving Average (EMA) are widely used. For instance, a 50-day SMA represents the average closing price of the last 50 days.
- Relative Strength Index (RSI): The RSI measures the rate and adjustments of price fluctuations. Its values span from 0 to 100, where readings above 70 indicate overbought conditions, and those below 30 denote oversold states.
- Bollinger Bands: These comprise a central band (SMA) and two outer bands (standard deviations from the SMA). They help recognise overbought and oversold conditions.
4. Fundamental Analysis
Fundamental analysis assesses a security’s inherent worth by analysing relevant economic, financial, and qualitative and quantitative factors. Key economic indicators are:
- Gross Domestic Product (GDP): GDP quantifies the overall value of goods and services generated within a country. An increasing GDP signifies a robust economy, which can enhance stock prices.
- Inflation Rates: Inflation reflects how quickly the overall prices of goods and services increase. When inflation is high, it can diminish purchasing power and adversely affect stock prices.
- Interest Rates: Central banks like the RBI determine interest rates. When interest rates rise, it can discourage consumer spending and borrowing, which may result in lower stock prices.
- Employment Data: Reports on employment, such as the unemployment rate, indicate economic health. Generally, a decline in unemployment rates signifies a more robust economy.
Trading Strategies for Market Derivatives
You can employ the following strategies to trade in a derivatives segment.
1. Futures Trading Strategies
- Long and Short Positions: Taking a long position in futures trading means acquiring a futures contract and anticipating the asset’s price to increase. In contrast, a short position involves selling a futures contract, expecting the price to decrease. These approaches allow traders to benefit from market fluctuations in either direction.
- Spread Trading: In this strategy, you buy and sell two associated futures contracts simultaneously to profit from the price difference. Common spreads include calendar spreads (involving the same asset but varying expiration dates) and inter-commodity spreads (involving different yet related assets). Spread trading often results in reduced risk relative to outright positions.
2. Options Trading Strategies
- Covered Calls: In this equity derivatives strategy, you hold a long position in an asset and sell call options against it. This generates revenue from the premiums collected from the calls and protects against asset price declines. Nonetheless, it restricts your potential profits if the asset appreciates significantly.
- Protective Puts: The protective put strategy involves purchasing put options for assets you already hold. This provides a buffer against price drops. If the asset’s value declines, the put option will increase, mitigating the overall loss.
- Straddles and Strangles: Both strategies focus on purchasing options to benefit from large price swings in either direction. A straddle requires buying a call option and a put option that shares the same strike price and expiry date. Conversely, a strangle consists of acquiring a call and a put option with varying strike prices but the same expiration. These tactics are beneficial when expecting significant volatility.
3. Swaps and Forwards
- Interest Rate Swaps: These contracts involve two parties agreeing to swap one set of interest payments for another based on a defined principal amount. Usually, one party pays a fixed interest rate while the other pays a variable rate. Interest rate swaps are commonly used to mitigate the risks of changing interest rates.
- Currency Forwards: A currency derivative (forward) is an agreement to swap a specific amount of one currency for another at a set date in the future based on an agreed-upon exchange rate. These contracts help protect against currency risk by securing the exchange rate, no matter how the market moves.
Guide to Choosing Broker for Derivatives Trading
When choosing a broker for trading in share market derivatives, it’s essential to keep the following factors in mind:
- Regulation and Safety: Confirm that the brokerage is under the oversight of a trustworthy financial regulator, like SEBI in India, to protect your investments.
- Fees: Before you open Demat account, review the various fee structures, which include trading commissions, account upkeep costs, and any additional hidden fees.
- Trading Platform: Assess the functionality and user-friendliness of the trading platform. Look for features like live data feeds, charting capabilities, and a seamless trade execution process.
- Customer Service: Investigate the availability and effectiveness of customer support. A quick-response team can be vital during critical trading situations.
- Educational Tools: Choose brokers that provide valuable educational resources, such as materials, webinars, and tutorials, on their derivatives app to enhance your understanding of derivatives trading.
- Product Variety: Ensure the brokerage offers an extensive selection of derivatives products, including options, futures, and swaps.
- Leverage and Margin Policies: Familiarise yourself with the broker’s leverage options and margin requirements, as these can greatly influence your trading tactics.
Conclusion
Derivatives trading allows investors to capitalise on market shifts and control risks. You can make well-informed decisions by familiarising yourself with vital elements such as volatility, Greeks, and analysis techniques. Consider essential factors when choosing a broker, including regulations, fees, and educational resources. With proper knowledge and strategic planning, trading derivatives can be a valuable inclusion to your investment portfolio, helping you overcome the complexities of financial markets.
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