How to Use Options and Futures for Risk Management?

Trading can be an exciting investment approach.  The potential for high returns and the thrill of timing the market can be an addictive interest. However, with all the excitement comes inherent risk. Implementing the right strategies can help to effectively lessen these risks. Derivatives, such as options and futures, can play an important role in risk management strategy. In this blog, we will explore how options and futures can be an inherent part of a trader’s investment strategy. We will also learn how options trading in India and futures hedging strategies safeguard investments from potential losses.

Understanding Options and Futures

Options and futures are derivative contracts that allow investors to hedge risks or speculate on price movements in financial markets. Let’s understand them in detail.

What are Options?

Options are financial derivatives that give owners the right to trade an underlying asset at a prespecified price on or before a fixed date without making it an obligation. Options trading in India is a beneficial way of trading in stocks without owning them. These instruments allow traders to protect their portfolios from losses by exercising call-and-put options. Using put options allows them to sell an asset at a predetermined price while using call options offers them the right to buy an asset at a specified price. The premium received on the option contract is a form of protection.

What are Futures?

Futures are financial derivatives that make it an obligation for the buyer or seller to purchase or sell an underlying asset at a prespecified price on or before a future date. These instruments help investors hedge the risks, thereby protecting themselves against future price movements of an underlying asset. The underlying holdings of futures contracts mainly consist of commodities, currencies, stocks, and indices. For example, a trader might use a futures contract to lock in the price of any commodity, which will ensure receiving a certain amount irrespective of the price fluctuations observed in the market.

How do Options and Futures Help with Risk Management?

Options and futures play a crucial role in risk management by allowing investors to hedge against price fluctuations and minimise potential losses.

• Portfolio Hedging with Options

Options trading in India can be used to hedge the risks involved with the price movements of an underlying asset. The two ways of doing so are protective puts and covered calls.

1. Protective Puts: Investors holding stocks can buy put options to protect against potential declines in stock prices. These are favourable when an asset’s price is expected to fall.
2. Covered Calls: Investors can sell call options on stocks they own to generate additional income while limiting upside potential. These are favourable when an asset’s price is expected to rise.

• Managing Risks with Futures

Futures hedging strategies are used against price fluctuations in commodities, currencies, and even interest rates in the following ways.

1. Commodity Futures: Traders use these contracts to speculate or hedge on price changes for physical or agricultural goods.
2. Equity Futures: These are contracts on individual stocks or equity indices like the Nifty 50. Equity Futures allow traders to speculate on future stock price movements.
3. Currency Futures: These contracts are a way to hedge against foreign exchange risks, which involve trading in currency pairs.
4. Interest Rate Futures: Traders and institutions often use these contracts to manage risks associated with fluctuations in interest rates.

• Reducing the Effect of Market Volatility

By holding short positions in index futures, traders can use these contracts as a hedge against market-wide downturns.

Pros and Cons of Using Options and Futures

The advantages and disadvantages of using futures and options are as follows:

Benefits

• Risk Management – These contracts allow investors to hedge against market risks. Using this strategy, traders transfer the risk associated with one asset to another party, allowing themselves to reduce their risk exposure when trading in large volumes.
• Leverage – Options and futures allow investors to control large positions with relatively small capital. Hence, they can gain large profits with relatively less capital.
• Speculation – Traders use these instruments to asses an underlying asset and speculate on its future price movements. These contracts can be beneficial for traders who are looking to make quick profits and hedge their existing positions.

Drawbacks

• Leverage – Leverage can be a double-edged sword. While it can increase profits, it can also amplify losses. Traders need to manage their positions carefully.
• Depreciation – Another risk associated with trading options is the risk of premium depreciation. Here option’s price declines over time due to time decay, which means less possibility of using the option, which reduces its value.
• Timing – Another important aspect of trading options and futures is the expiration date. One must act on the anticipated price of an asset before the expiry of the contract.

Risk Management in Options & Futures Trading

It is crucial to manage risks in futures and options trading and minimise potential losses. Effective risk management ensures long-term sustainability by protecting capital and managing volatility. Key strategies include:

• Position sizing – This strategy limits exposure by only risking a small percentage of capital per trade. Traders usually follow what is called the one-percent rule. This rule of thumb recommends not putting more than 1% of the capital into a single trade.
• Stop-loss orders – A stop-loss point is the extent to which a trader is willing to take a loss on the trade by selling a stock. This often happens when a trade does not follow the expected way. These orders are designed to limit losses before they escalate. Stop-loss exit points are set to close trades and limit losses automatically.
• Hedging – Hedging helps to protect your positions from volatile market conditions and reduce potential losses. With the help of counter trade, it preserves your capital with a layer of security. Hedging helps traders to eliminate uncertainty and secure asset prices in the future. This boosts confidence in traders by providing them with a security net.
• Leverage Control – In leveraging, you need to pay a portion of the overall contract value, enabling traders to control large contracts and speculate on price movements with minimal initial investment. However, leverage should be used cautiously as it magnifies the effects of price fluctuations. Here, even little changes in price can produce substantial gains or losses.

Conclusion

Options and futures trading are excellent tools for risk management, but they come with huge risks. They are complex investment tools and need careful execution. For beginners, it is advisable to consult a trusted financial advisor like Torus Digital, who can properly guide you in derivatives trading.