Demystifying Derivatives: Protecting Your Portfolio During Market Turbulence and Enhancing Returns

7 Jan 2025 , 05:33 PM

Investments inherently involve volatility, which is a bleak reality for investors. Yet, it gives the investor an opportunity to generate additional returns if one applies the right strategies. Derivatives, which most people regard as complex and risky can be instrumental in risk management, speculation, and boosting returns. When employed correctly and at the right time, derivatives can help hedge risks and increase returns, especially in volatile market circumstances.

Financial Derivatives Overview:

Derivatives are financial instruments whose values are determined by an underlying asset such as currency, bonds, commodities, Interest rate, equity or Index. Value of such an instrument usually moves with the price movement of the underlying asset.

The types of derivatives include:

• Options: It is a financial contract that authorises an option holder the right (but not an obligation), to buy (call option) or sell (put option) an underlying asset at a pre-agreed-upon price within a particular time frame.
•  Futures: It is an agreement to purchase or sell an underlying security at a later stage for an agreed upon price. They are standardized contracts on listed financial assets.
• Swaps: Contract in which two parties mutually agree to exchange cash flows or other financial instruments in order to mitigate interest & currency rate fluctuations risk.
• Forward: Resemble futures, except that they are private and customized contracts between interested parties to address specific risk management requirements.

Derivatives Usages

• Hedging: Protects from risk exposure in a core asset or portfolio.
• Speculations: It involves earning profit on price movements without owning the underlying securities.
• Arbitrage: It involves buying and selling an asset or its derivatives in different markets to get benefits from short- term price discrepancies between markets.
  Main Advantages of Derivatives
• Risk Mitigation: Derivatives can protect against declines in market, currency, and interest rate fluctuations.
• Capital Efficiency: Derivatives require less capital investment as compared to buying the underlying assets in the cash segment, making it a cost-efficient option in managing large portfolios.
• Income Generation: Management by using covered calls or option writing can generate additional returns.
•  Customization: Offers flexibility to form bespoke strategies with respect to risk tolerance and prevailing market conditions.

Derivatives Protect the Portfolio from Market Turbulence

Asset price volatility during periods of market turbulence impacts even diversified portfolios. Here are some ways in which derivatives can be used to mitigate such risks:

• Put Options for Downside Protection: A put option entitles its holder to sell an asset at a pre-established price. If markets fall, the value of the put option gradually starts to increase; and hence, it serves as a risk mitigator in your portfolio.

Example: If you have 1000 shares valued at Rs. 100 and expect there to be a downturn, then you can buy a put option with a strike price of Rs. 100 for Rs. 5. If the share price decreases to Rs. 80, the value of the put option would rise to Rs. 20, limiting the loss.

• Protective Collar: This involves buying a put and then selling a call at a higher strike price. Thus, one reduces the potential upside and downside on an underlying asset.

Example: If you own a stock at Rs 100, you can buy a put option of 100 strike for Rs 5 and sell a call option of 120 strike for Rs 2. Therefore, the net cost for that hedge comes to Rs. 3, which provides protection against a drop while capping any gains above Rs. 120.

• Future Contracts for Price Locking: This is often used for hedging against the price difference that might prevail at the future date by allowing investors to set their prices against the underlying asset that they wish to purchase later.
• LEAP Options: LEAP (Long-Term Equity Anticipation Securities) options are typically associated with hedging against long-term volatility or downside risks, providing a good deal of time for one’s investment hypothesis to unfold. However, such strategies incur higher premium costs arising from longer expiration dates. December and March expiries carry high volumes, so they can be used for such hedging. Before taking the plunge into LEAP options, carefully evaluate risk appetite, option costs, and the long-term strategy to be protected.
• Beta Portfolio Hedging: This strategy measures the sensitivity of a portfolio against changes in the market level, thereby offering hedges toward market risks. However, highly effective instruments must be identified for hedging exposures such as index futures or index puts.

Example: Consider the portfolio in below table with weighted beta of 1.148. This portfolio can be hedged using a) shorting Nifty futures of Rs. 8,096,967 (portfolio value * portfolio weighted beta) or b) acquiring put options with matching exposure.

Derivatives can be strategically used to enhance returns in many ways:

• Leverage Positions with Limited Capital: Derivatives give notional exposure far larger than what one can take in cash market using the same amount of capital, amplifying potential gains (and losses) due to the inherent leverage. Generally, this is advisable for investors having higher risk appetite and tolerance.

Example: For example, an investor capable of buying only 100 shares of Reliance priced at Rs. 1200 may use futures to get exposure as high as 1000 shares, paying only a fraction of this future value (i.e., the margin requirement).

• Income Generation: Selling options such as covered calls can earn premium income, consistent with agreeing to sell the asset at a specified price. This method works well in flat-to-slightly-rising markets.

Example: For instance, the investor who owns 1000 shares of Reliance at Rs. 1200 could sell call options whose strike price ranges somewhere between Rs. 1300-1350 or, as per the investor’s return appetite, earn a premium while still retaining ownership of those shares if the stock remains below the strike price.

• Speculative Opportunities: With derivatives, speculative trading can happen on price movements, enabling the investor to gain from price changes without having to first own the underlying asset.

Example: An investor anticipating growth in Reliance stock will invest in options or buy futures contracts with apparent price increases in mind.

Risks and Considerations

Derivatives are tools that help in risk management as well as return enhancement. However, derivatives carry inherent risks such as:

• Leverage Risk: Derivatives magnify both gains and losses, which means that small price movements could result in significant profit or loss.
• Counterparty Risk: Some derivatives open the investors to the risk that the counterparty may not fulfil his obligations. This risk is limited for exchange-traded derivatives.
• Complexity and Costs: Derivatives can be complicated and entail transaction fees, margin requirements, as well as premiums. Profits can be eroded by misunderstanding them or overtrading.

General Advice for Investors in Turbulent Markets

• Risk Management: Always assess risk prior to execution of trades and refrain from impulsive actions due to market momentum.
•  Diversification: Spread investments across assets with negative correlations to minimize risk exposure.
• Avoid Loss Aversion Bias: Resist a bothersome holding of investments that has lost value in hopes that it will bounce back sooner or later. Clear profit and loss thresholds should be established.

Conclusion

Derivatives are multi-faceted financial instruments which are available to the investor either for protection of their portfolios, improvement in monetary return, or for dealing with market volatility. They serve very well for hedging positions, speculating, or income generation. However, it is important to exercise care in understanding their workings and the risks involved while dealing in them.

The careful strategic use of derivatives can allow an investor to gain an early competitive advantage in volatile markets and still get the most efficient performance possible from that portfolio. Hence, it is important to invest in it wisely, after carefully assessing one’s own financial goals and risk tolerance

Manish Batwara

Senior Director – Fund Manager