By Atul Parakh
Equity derivatives offer a powerful way for investors to strategically structure their portfolios, going beyond the traditional “buy and hold” approach. By using derivatives, investors can manage their risk not only in volatile market environments but also at times of a sideways and bearish trend market when investors’ portfolios often fail to generate any return for quite a long time. Here, equity derivative instruments like futures and options can play an important role in helping investors generate income.
Often, financially strong companies’ stocks are included in the investor’s portfolio, which move up at their own pace and can even stay sideways for quite a long time. During the range-bound phase, a rational investor can deploy suitable option strategies to generate short-term gains. It may increase the overall returns in the long run, even if the company stock does not perform well in the cash segment.
Hedging with derivatives will minimise the risk. However, strategic portfolio structuring using derivatives may also help to maximise the returns.
Benefits of Derivatives in Portfolio Structuring: Tailored Risk Management: Equity derivatives like options and futures contracts enable targeted hedging against market
Enhanced Diversification: Derivatives access exposure to diverse asset classes or market segments not readily available through direct investment. Futures and options on sectorial indices, commodities and currency derivatives offer better diversification opportunities beyond traditional asset allocation models.
Expressing Market Views:
Derivatives facilitate taking directional calls on specific stocks, sectors, or the broader market. For instance, buying a call option (CE) expresses a bullish view of a particular stock, while buying a put option (PE) reflects a bearish view of the stock. On the other hand, the selling call option expresses a bearish view, and the selling put option reflects a bullish outlook.
Capital Efficiency:
Leverage is an inherent part of derivatives, allowing managing larger exposure with limited capital. This can be beneficial for amplifying returns within an existing portfolio but comes with high risk due to the magnification of both gains and losses. Proper use of leverage and strict risk management is important for better utilisation of capital.
Key Strategies with Derivatives:
1. Hedging with Equity Put option: Buying a put option on existing stock holdings or the overall portfolio offers downside protection, which is particularly pertinent in volatile markets. To buy a put option of a particular stock, investors must pay a premium amount. This premium amount is the cost the investor pays to get protection from the downside in the underlying asset. However, if the stock does not fall, then the premium will decay with the passing of time and might reduce the overall return.
2. Income Generation with Covered Calls: Selling covered call options on owned stocks generates income while capping potential upside within a defined range. This strategy suits investors seeking regular income from their portfolio while accepting limited capital appreciation.
3. Market Exposure with Stock Index Options: Options on major stock indices provide exposure to broad market movements without directly owning individual stocks. Buying call options leverages market rallies while buying puts helps in capitalising the declining markets.
4. Sector Rotation with Sector ETFs and Options: Sector-specific ETFs offer targeted exposure to industries with high growth potential. Combining them with options allows for more nuanced positioning, entering or exiting sectors based on changing market dynamics.
Considerations to be Taken While Dealing in Derivatives
Complexity: Derivatives involve inherent complexities and higher potential risks compared to simpler buy-and-hold strategies. Understanding contract terms, margin requirements, and risk-reward dynamics is crucial before using them.
Transaction Costs: Frequent buying and selling of derivatives incur additional transaction costs, which can erode returns and negate potential benefits, especially for smaller portfolios.
Leverage Risk: The leverage inherent in derivatives magnifies both gains and losses, amplifying portfolio volatility and potential downside. Careful risk management and position sizing are essential.
Regulation: Regulatory requirements and restrictions can limit the use of certain derivatives for specific investor types or portfolios. Understanding these regulations is crucial for compliant usage.
Equity derivatives offer valuable tools for strategic portfolio structuring but require careful consideration and understanding. When used appropriately, they can be helpful in risk management and optimise overall returns within established asset allocations.
However, the complexity, transaction costs, and leverage risks involved necessitate thorough research, application of risk management strategies, and careful alignment with individual investor goals and risk tolerance.
(Atul