DERIVATIVES SEGMENT IN INDIAN MARKETS

The Indian Markets basically comprises of two segments –
1. Cash/Spot Markets
2. Derivatives markets.

Derivatives as the name suggests, are financial instruments whose value is derived based on its underlying asset class. Change in value of asset can lead to a change in derivative value. The underlying security in the case of equity derivatives is equity share. An equity share can only provide an unhedged position whether long or short, and the entire risk lies with trader or investor, whereas in case of derivatives positions taken by a trader can be hedged with proper strategies.

The derivatives are primarily used for two purposes –

Speculation- Speculation is many times misinterpreted as gambling. Speculation done through derivatives is more of a trading on movements in prices or stocks but using various real time information or data. Trading is either going long or short on certain stock, index etc using derivative instruments, but with adequate risk mitigating factors in place which is a mandatory aspect in trading i.e. keeping adequate stoploss, position sizing, money management etc.

Hedging – To clarify, hedging means protecting. The idea of hedging is again a very important aspect of trading or investing. Hedging is important in commodity markets and currency markets and many companies hedge the raw materials using derivates to keep the raw material prices which are exposed to significant risk of price changes under control and companies should not incur burden of rising or decline of raw material prices. In case of equity markets hedging can be a bit expensive but it holds importance as far as risk management is concerned. Predominantly mutual funds using hedging in equity since they have invested in stocks at a large scale. In order to avoid the risk of significant fall in prices, fund managers hedge their equity exposure using similar derivatives.Derivatives are divided into two parts –
a) Futures
b) Options.
Popularly called as FNO in markets. But here we will explain Futures and the method I personally use to trade in futures.

FUTURES- Introducing Futures, an equity futures product is a derivative of either an underlying stock or a stock index. In other words, the value of futures depends on that of its underlying stock or index, as the case maybe. To differentiate a futures contract from underlying stock- When we buy stock in cash market, we have to pay full value of transaction (i.e.no of shares x Market price per share). There is no time component involved, we own such stock for all times to come depends on our will. No positions can be taken on Index in cash Markets. Cash market has market lot of one i.e. one can buy stocks in multiple of 1 share. One can short in cash market only for intraday i.e. if shorted (sold) in morning it has to be squared off in the afternoon before end of trading session i.e. End of Day.

In case of Futures- One can go long by entering into futures contract by buying futures contract and can square off by selling such contract before expiry of the series (which is every month’s last Thursday for stocks and every Thursday for indices). Here one can keep their short positions open until the expiry of such contract which can be more than one day. It is not mandatory to pay the whole amount upfront in order to buy the contract , only margin amount is required to be paid and such percentages are decided by the exchanges from time to time depending on risk in certain to such stocks. Futures can be done in lots i.e. certain lot size is decided for certain stocks for instance Lot size for Reliance Industries Futures is 505 shares per lot i.e. a trader in order to trade its future or to go long in it has to buy a lot containing 505 shares but not mandatory to pay full value of 505 shares, but only margin amount is required to be paid to exchange to take the trade. Theoretically, Future Prices = Cash Price + (Monthly/Weekly) Cost of Carry. In case of overall derivatives concept the factor ‘TIME’ holds great importance. This time is Time Value of Money (TVM). Here the cost of carry is dependant entirely on Time Value of Money. As the time goes by the cost of carry starts declining in order to expire the futures at cash price. Futures are sometimes in discount i.e. the Futures value of the asset is less than the current prevailing cash price of such asset, or in premium i.e. the futures value of the asset is more than the current prevailing cash price of such asset. Cash Future Arbitrage is a strategy which can do wonders and can generate approximately 2-3% returns every month using the concept of Time Value of Money. In India, current month futures are highly liquid and most of the trading is done in the current month series. To sum up the concepts in simple words Futures is a contract entered by a person to either buy or sell in future but at a price decided today irrespective of what its market price will be in future.

HOW I TRADE FUTURES IN MARKETS –
Firstly, let us understand what the term Open Interest means. Open Interest is the total number of contracts held outstanding by traders at certain price level. For instance, if a trader places buy order for a stock futures and another trader places a sell order for similar stock futures, the Open Interest is 1. If one trader places bought 5 contracts and the other trader bought 6 contracts and one trader sold 11 contracts the Open Interest here is 11. But in case the seller squared off his sold contracts i.e. bought back 5 contracts then the Open Interest will fall to 11 -5 = 6 contracts.
Again in order to trade we have to analyse the behaivour of futures based on Open Interest created i.e. what changes have been occurred in Open Interest and the reasons behind such changes. If there is rise in open Interest and the price also rises , it is because of buyers buying more contracts of futures, if there is rise in Open Interest and a fall in prices which means there are more short positions created in by the traders . Whereas, in case if the Open Interest is falling and the price is rising ,then it means that earlier short positions created are being covered i.e short sellers are squaring off their position and if there is fall in Open Interest and fall in prices mean the longs created earlier are being unwinded i.e. previous longs are being squared off.
Okay coming back to trading method I follow to trade Futures . I personally use Technical Analysis for getting entry , stoploss and exits but for selection of futures I use Futures Open Interest data to understand where is the position created and to understand the change in Open Interest . I personally do trade more in Index futures than stock futures because 1) Lack of capital , 2) Less volatile moves , and 3) Low Lot size . Being a student I have less money to trade so I prefer Index over stock futures . But yes Stock Futures also generate good profits if done well .
I use derivavtives data like change in OI as a tool to understand what are big players doing and their view of markets. For instance If- 1) OI is decreasing and 2) Prices are rising hence there is short covering done by various traders in the markets. So this is the primary data analysis I do and viceversa. Later on I check with the charts to decide whethert to trade this and if yes at what levels to enter and what stoploss should we follow. Being an Intraday Futures trader I use intraday charts using a free software like – tradingview.com or investing.com Taking a 15 min Intraday chart of Nifty Futures and generally, I wait for first fewhours to take a trade and I draw two horizontal lines of the first candle of 15 mins and then wait for price to break in the direction where Open Interest is indicating . For instance -if there was short covering taking place my view was to go long . Hence I wait for the candle to give a breakout of the channel and give me a buying opportunity but I don’t enter immediately on breakoutand wait for a pullback or retracement .I also use Moving averages for trend analysis and also an Indicator named Average True Range (ATR) for stoploss.

Thank you.

Regards,

Atharva Joshi,

Kautilya,

IBS Mumbai.