The way markets are turning out to be speaks volumes of the mental makeup of investors. It is like the befuddled deer, which fails to do an inward journey, for that elusive, soothing smell and searches for it in its vicinity despite the fact that the smell emanates from it. Such has been the mental state of investors resulting into losses and the subsequent lull, which has put off investors from the markets.

Though a resurrection of the markets seems bleak, that ray of hope has not yet faded. The reason, just as the sun sets there is always the moon to show you the way. So is it with the markets. A case in point is the derivatives markets, which is so often left unnoticed by investors involved deep in the cash market. Whatever be the reason, there are ways and means by which you can make money with the help of a few derivatives products in the markets, just like a category of investors is minting. Here is the roadmap of that journey for you.

The way

Derivatives, essentially, are products, which derive their value from the underlying asset like commodities, equity, interest rates, currency etc. Derivatives products had gained momentum since 2004 especially in the equity market. However, a lot has changed after 2004. The liquidity in the derivatives markets has increased three times in 2008 as compared to the cash market. Hence, this has increased the importance and focus of the derivatives markets. More so, it has necessitated the understanding and exposure to these markets.

There are two products available in the equity derivatives market-futures and options. Futures functions similar to the cash market with a difference that the price of the futures is derived from the underlying spot index or stocks, while options are different from futures. There are two types of options- put and call. You can buy and sell both the options.

If you buy options the loss is limited and profit is unlimited because the buyer of the option has got the right/option to buy the shares. In this, you don?t need to pay any margin money unlike in futures if the market works against your position, and it?s exactly opposite in case if you sell the options. Also, you don?t need to have extra cash margin in your trading account for exposure in options, unlike futures. ?It depends upon the situation. Options are good when the implied volatility is high and futures are better when the premium is lower,? argues Siddharth Bhamre, Senior derivative analyst, Angel Broking.

How it works

In options, there is a clear-cut pay-off method. This means that the investor needs to be sure of how much they could lose or gain. ?For this, the investor must have a clear view about the market and an understanding of the options and then take positions,? warns Navendra Singh, derivative analyst with a leading broking firm. Here is a simple example to illustrate derivatives option. Suppose you go to the market to buy tomatoes. The price is Rs 8 per kg. If you think that the price of tomatoes will go up to Rs 12 in the next five days then you make a deal with the vendor that you will buy tomato after five days at Rs 9 per kg and for that you will pay a premium of Rs 2 for the right to buy. If the price goes up to Rs 12 on the fifth day you gain Rs 1 per kg as your cost is Rs 9+2=11. However, if the price goes down or remains constant then you will be in loss. And if the price is Rs 11, you will buy (execute the contract) because you are in a no-profit-no-loss position. The vendor in this example is a seller of the options, so he gets the premium for giving the option/right to you.

In options, you can take exposure in stocks as well as the index, unlike the cash market where exposure is only in the individual stock. Practically speaking, even though majority of the investors predict the broader index, they can?t take positions in the cash market. However, this issue has been resolved and you can take positions on the index: for instance, S&P CNX Nifty index options on National Stock Exchange (NSE). And stock options deal with individual stocks: for instance, Reliance Industries, Grasim Industries, etc. Looking at the current market situation one can take a short-term view on the index.

Technical specification

To buy options stocks or index, investors have to take an exposure of at least one lot. Number of shares in a lot differs depending on the stocks and index. Take for instance, one lot of Reliance Industries is equal to 75 shares, Tata Power has 200 shares. In case of Nifty it is 50 shares. A mini nifty option contract started by BSE and NSE has a size of 20 shares in a lot, especially for small investors. There are different terminologies used in options like strike price, premium, expiry date, settlement period, intrinsic value and time value. A strike price is the price at which the buyer of the option wants to exercise the contract on the day of expiry i.e., on the last Thursday of every month. A strike price is also known as exercise price.

A strike rate is said to be in the money when the spot price is higher than the call option strike price. Out of the money is when the call option strike price is higher than the spot price. And at the money is where both the strike price and call option is equal. The same thing can be explained exactly in an opposite manner in put option. When a strike price is in the money, the premium can be divided into two parts, intrinsic value and time value of money. Suppose the Nifty spot price is 5,200 and 5,000 is the strike price, and it has a premium of Rs 250, then Rs 200 is intrinsic value and Rs 50 is time value. There is only time value premium and zero intrinsic value in case of out of the money. Premium is the amount you have to pay when you buy option contract having a specific strike price. The premium varies depending upon the difference between strike price and spot price and time value. Also, there are some terms like in the money, out of the money and at the money. In option contract you will find different strike rates. Currently, you will find 11 strike rates in case of Nifty options. Five are out of the money one is at the money and remaining five are in the money contracts.

The significant difference between in futures and options is strike price intervals. Unlike futures, where there is only one price for any stock or index, options have various strike prices and an investor can choose one of them. Every strike price has a premium attached to it. Premium on the strike price starts reducing as the day of the expiry nears because the time value reduces. In the start of the current month you will see higher premium. Ideally, investors think that a lower premium is cheaper and better but this is not the case.

Lower premium will be available because the gap is much higher between the spot and strike price. It is true that in case of lower premium the risk of loss in terms of value is much less. However, there is a risk of losing the 100% of the premium amount paid and the number of lots bought if the gap doesn?t get narrower over the period of the contract. The same case can happen while selling the options because one gets the premium upfront but the loss of risk is unlimited.

Strategies

Apart from going long and short you can use various other strategies to hedge your position in different market situation. This requires good homework and regular tracking of the derivatives options in the market. These strategies normally involve initiating more than one transaction. Strategies like bull call spread, bear call spread, long and short straddle, strip and strap.

When you think the underlying index i.e., Nifty will go up somewhat or is at least more likely to rise than fall; one should execute bull call spread strategy. A call option is bought with a lower strike price and another call option is sold with a higher strike price, producing a net initial debit. The same thing applies in put option. In this, the upside potential is limited

Derivatives options can be used as an arbitrage apart from hedging. Arbitrage opportunity can be used between two strike prices and various others.

Newer avenues & the other side

Investors can now take exposure in Nifty options for longer term as compared to maximum three-month options contract available currently on the NSE stock exchange. This new product will overcome the disadvantages in the current options where exposure is available for the short-term period. In the long-term nifty options the contract maturity will be every quarter (March, June, September and December). The next three quarters will be covered.

Add to this there will also be five semi annual months expiry (June and December). In case of range in the strike prices in the quarterly instead of 5-1-5 there will 8-1-8 (strikes out of the money, 1 at the money, and 8 strikes in the money). The number of strikes for half yearly is same as the one-month contract. Long-term Nifty option is a step towards ensuring that investors who have not participated yet in options could start investing.

?Theoretically it is good that investors can take long-term position on Nifty option. But, practically speaking, if there is no liquidity in the May 2008 month contract, how can you expect liquidity in the December 2008 month contract?? advises Siddharth Bhamre, derivative analyst, Angel Broking. If one has to take a position then the investor has to find a buyer and fix the deal off market. Hence, it is fraught with many features, which need to be understood.

Derivatives products are risky bets. The ones who are willing to take a risk for the short term and has sufficient knowledge on the markets could start initiating the exposure in options. If one does not have it, it is better to get an idea of options and how it works before entering the market. When there are benefits in any product, it involves a risk of losing money. In case, if the market goes against your position, then the maximum loss can be 100% that is to the extent of premium paid. Hence, it is like chess: once you have chosen a move, you have to adhere by it. And hence better ruminate and choose.