In this article we will learn how futures contracts are used for hedging, trading and arbitrage, And along with this we will also understand about different option strategies. We will learn about hedging strategies and its benefits.
Futures Contracts for Hedging, Speculation And Arbitrage
Futures and options contracts were created to reduce the risk of trading in the derivatives market. Index futures are used to hedge the risk of a single stock or a portfolio of stocks. Investors create long hedge and short hedge positions using futures contracts.
Hedging A Portfolio Using Index Futures:–
Index futures are used to mitigate the risk from portfolio stocks. Let’s assume you have a portfolio of 20 stocks which is a well-diversified portfolio, in which our maximum risk can be zero. Our investments are still subject to market risks. To reduce market risks, we can adopt the following strategies. To reduce the loss in portfolio due to market risk, we can hedge by selling index futures, so that even if the market crashes and your portfolio suffers a loss, on the other hand, you make a profit in the short position of index futures.
Using Futures For Trading Or Speculation:–
Futures contracts were specifically designed to reduce the risk that comes from price changes, they use it for trading. Investors who expect a bullish trend in index futures or individual stocks expect the stock price or index futures to rise. Such investors take long positions in stock futures and index futures, Investors who have a bearish expectation on index futures or individual stocks expect that the stock price or index futures will fall. Such investors take short positions in stock futures and index futures.
Using Futures For Arbitrage:–
Arbitrage is the creation of positions in two different markets simultaneously such as undertaking stock and index options, futures and cash markets. It does this to minimize its risk. It works on the cash and carry model. Basically, it compares the fair future price and the traded price with each other.
Trading Strategies
- Calendar spread
Calendar spread is a strategy in which the trader takes a position in the futures market with two different expiry months. The trader buys and sells contracts of different months. To follow this strategy, the arbitrageur has to see which contract to buy and sell. The rule of this strategy is that you have to buy a contract of lower price and sell a contract of higher price. For which the arbitrageur needs the price so that he can decide which contract is of lower price and which is of higher price.
Use of Options For Trading And Hedging
1.Trading strategies using options:
The most commonly used strategies in option trading are straddle, strangle and spread. A spread is formed by option combinations where in similar call puts on a same underlying but different expiries and strike prices. This is a position of limited loss and limited profit. These are divided into three sections.
- Vertical Spreads
- Horizontal Spreads
- Diagonal Spreads
2.Vertical Spreads
Vertical spread is created by using options with the same expiry date and different strikes, also it is made by combination of calls or puts. It can be grouped like this.
- Bullish Vertical Spread
Using Calls
Using Puts
- Bearish Vertical Spread
Using Calls
Using Puts
. Bullish Vertical Spread using Calls
A Bull call spread is created when the market view is positive, in this the investor wants to minimize his cost. So he goes long the call at the lower strike price and sells the call option at the higher strike price.
.Bullish Vertical Spread using Puts
A bearish put spread is created when the market view is negative, in this the investor wants to minimize his cost and reduce the Market risk. So they go long the put at the lower strike price and sells the put option at the higher strike price
.Bearish Vertical Spread using calls
When the trader expects a fall in the market, he shorts a call option with a high premium. If the market falls, the risk in a naked call is unlimited. To avoid loss, he buys a call option at a higher strike price.
.Bearish Vertical Spread using puts
When the trader expects a bearish view in the market, he long a put option with a high premium. If the market falls, the risk in a naked put is unlimited. To avoid loss, short low strike put option and receive a premium.
Horizontal Spread
In horizontal spread, positions are created in options of the same underlying but with different expiries at the same strike price. This is also called time spread and calendar spread.
Diagonal spread
Diagonal spread is a combination of different strike prices with different expiries on the same underlying. These strategies are more useful in over the counter markets than in exchange traded markets.
Straddles
This strategy combines two different options call/put. Which has same strike price and same expiry. To create a long straddle position, a call long and a put option are placed at the same strike price and same expiry. To create a short straddle position, a call short and a put option are placed at the same strike price and same expiry.
Strangles
Strangle strategy looks similar to straddle strategy but is different in execution and cost.
In Long Strong Strategy both the options are of different strike prices i.e. call and put. Both the options are out of the money and the premium paid for the same is also low.
This is exactly the opposite of the long strategy and involves two out of the money short positions call/put.
Covered call
This strategy is used to earn extra income or to take advantage of market movement in which profit is taken by creating a position in the future market without selling the cash stocks held.
Butterfly Spread
Butterfly spread is an extension of long straddle. Butterfly spread is formed by only calls and only puts or a combination of both.
Hedging with options:
Options are known to provide protection against sudden price fluctuations in the underlying asset. If an investor is thinking of buying a stock in the future, then buying a call option on the stock helps him lock in the position. This protects the investor from sudden rise. Therefore, buying a call option provides protection from sudden fluctuations.
Protective Put
This is a hedge position, in which the investor has bought a call in the future market. He is always exposed to sudden fall in the market and the rate of mark to market margin also remains the same. To protect this, the investor buys a call option so that if there is a fall in the market and he suffers a loss in the future market, on the other hand he gets a profit in the put option.
3.Interpreting open interest and put-call ratio for trading strategies
Let us understand some basic terms used for futures and options and how does this help us in choosing a trading strategy.
.Open interest: – These are the contracts and numbers that are open to market participants and are not closed
.Call-put ratio: – This is the ratio that indicates the volume or number of call options and put options to be traded. This is calculated using option trading volume and option trading open interest.
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