The recent picture shows that derivatives trading is a new form of gambling. To some extent it is true, but if we try to understand the concept behind the invention of derivatives, we will realize that it is not gambling, rather, it is a pure facility of low-cost leverage and hedging of big market risk.

Why do people think that Derivatives are speculation?

Nowadays, most people invest in futures because they can gain a huge profit with just a small margin of investment. But when the market starts moving contrary to their predictions, they start losing their money. Here, they carry out these trades in a very unplanned manner. When they do not have the money to pay the required margin, they end up with a hefty loss.

Similarly, maximum people purchase Call/Put options to gain unlimited profit with limited risk. In this situation, people enter with arrogance and ignorance. They just standby and wait for the market to work in their favour and Options premium start falling due to various factors like time, volatility, rate of interest, etc. At the expiry, if the market does not work in their favour, the premium ceases and they end-up with a loss.

In both, Future and Options, people lose their money due to greed, unplanned investment, and lack of knowledge. Hence, they conclude that Derivatives are speculation instruments. Now we will understand the actual purpose behind the derivatives and how it can benefit us in our investment.

Purpose of Futures

Earlier there were Forward contracts, where two parties agreed to buy or sell some product/asset in the future. The biggest challenge in Forward contracts is counter-party risk. Hence, Exchanges enters and introduces the Futures Contract. Exchanges guarantee settlement between the buyer and seller thereby clearing the counter-party risk.

The biggest motive of the Futures contract is low-cost leverage. An investor can multiply his returns using this leverage. He could grasp substantial exposure by investing the margin money only thereby multiplying his profit. So, let us understand this with an example.

For example, an investor wants to invest Rs.10 Lacs in Nifty50. He can have two options: (1) He can buy Nifty ETFs worth Rs.10 Lacs or (2) he can purchase a Futures Contract. The investor can purchase Futures contact by investing only 10% of margin money, i.e., Rs.1 Lac. Hence, he took the exposure of Rs.10 Lacs by investing Rs.1 Lac only. If the market rise, he will earn on Rs.10 Lacs exposure. This Futures’ forwarding cost for Nifty is around 5% per annum. So, He will pay Rs.50,000 as a forwarding cost in a year. On other hand, he will park the rest Rs.9 Lacs in a debt fund from where he can earn 7% interest. So, he will earn Rs.63,000 as debt interest. Hence, he would save Rs.13,000.

Purpose of Options

The Options were invented to provide hedging in case of risk if the market goes against your expectations. Call Options gives its buyer a right to buy (no obligation) and Put Options gives its buyer a right to sell (Not obligation) an underlying asset. If you want to buy equities or futures, you can buy a put option to hedge the risk of market fall. Similarly, if you want to sell Equities or Futures, you can buy a Call option to hedge the risk of market rise.

For Example, you have bought one lot of Nifty futures worth Rs. 14000. That means you have unlimited risk if Nifty falls below 14000. The 14000 put option for December 2021 is trading at Rs.900 while I am writing this. That means the premium cost is around 6.5% of the underlying value for one year. Now if you purchase Nifty Futures along with Put Option and hold them, you will have a maximum loss of Rs. 900 (6.5%) in the whole year, regardless of any level Nifty falls to.

Conclusion

If we think wisely, Futures and Options are not speculative instruments. Rather, they help us to increase our profitability with protection against our inaccurate views of the market. At Finideas, we have developed a strategy for long term investment with the combination of Equity, Futures & Options. This strategy, named Index Long Term Strategy, has given 18.90% YOY returns with a maximum of 4% drawdown since 2002.

Just click below to know more about this strategy.

Thank You. Happy Investing.