Mastering Derivatives: Trading or Hedging?

Most people immediately think of risk management (hedging) when they talk about derivatives. This refers to the process of creating derivative positions so that a loss on your primary portfolio is offset by gains from your derivative position. However, most market participants do not use exchange-traded derivatives for hedging purposes. Instead, such contracts are used to generate short-term gains. This week we discuss why you should think about trading, not risk management, when considering exchange-traded derivatives.

Trade betting

Index and single stock futures contracts are only available for a maximum period of three months. True, NSE offers long-dated options on Nifty Index. But such contracts have thin liquidity. Even the almost monthly Nifty options have not been actively traded after the introduction of weekly options on the index. This means that the near-week and next-week contracts on the Nifty 50 index and the near-month contracts on stock options, index futures and single stock futures are most actively traded.

Now, even if you only want to hedge your portfolio for the very short term, are you willing to statistically determine the relationship that your portfolio has with the hedging instrument? This is necessary to determine the appropriate number of future contracts to short. The aim is to offset the likely loss on the portfolio with potential gains on short futures. The more stable the ratio, the more accurate the hedge will be. However, the relationship between your portfolio and the hedging instrument may change after you create the hedge. Also, if you short Nifty futures and the index moves up, your short futures (the hedging instrument) will generate losses, detracting from the potential gains on your primary portfolio.

You could argue that put options could be a better hedge than futures. After all, options have asymmetric payoff; for puts, the maximum gain when an underlying frame reaches zero is greater than the maximum loss, the premium option. However, the issue is the passage of time. The premium option contains time value, which becomes zero when the option expires. So the put option you buy as a hedge will work best if the portfolio falls immediately than against the option expiration. However, if you expect the underlying to fall immediately, it is questionable whether taking profit on the portfolio is better than hedging, given that buying the put is an additional cost.

Optional reading

Exchange-traded derivatives are typically used as trading bets. If you have a view that an underlying is likely to move up, you can choose to go long on futures or long on a put or short on a put. Over-the-counter (OTC) derivatives are customized contracts that could work well for risk management. But such products are not available to retail investors. Volatility products, for example. An institutional investor looking to hedge his long-only portfolio against a market crash can go long with volatility or variance swaps (OTC). Because volatility explodes when the market crashes, the investor could have hedged his portfolio against tail risk.

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