Strategies using futures and options

An SIF strategy document describes positions in the language of this chapter: "hedged with index futures", "protective puts", "spread positions". The exam asks you to compute the number of contracts for a hedge, the maximum profit and loss of a spread, and the breakeven of a combination. Every strategy below is worked with Nifty numbers and a lot size of 75.

Hedging a portfolio with index futures

A fund manager who expects a short-term fall but does not want to sell stocks (transaction costs, tax, conviction in the names) sells index futures. The number of contracts depends on the portfolio's beta to the index: a beta of 1.2 means the portfolio moves 20% more than the Nifty, so it needs 20% more futures cover.

If the market rises instead, the futures lose what the portfolio gains. A hedge removes market risk in both directions; it is not a free put. To add exposure rather than remove it, the manager buys futures; the same formula gives the number of lots. A partial hedge (say, half the contracts) reduces beta rather than eliminating it, and in an SIF the net short exposure after hedging must respect the 25% unhedged cap.

Speculating and spreading with futures

A trader bullish on the index buys futures (long futures): profit = (exit − entry) × lot. Bearish, she sells (short futures). A calendar spread buys one month and sells another on the same underlying, betting on the gap between the two prices rather than on direction; margins are lower because the two legs offset. Stock futures also allow pair trades: long one stock's futures and short another's in the same sector, a classic long-short position.

Protective put and covered call

A protective put is a long position in the stock or index plus a long put. The put caps the downside at (strike − premium) while leaving the upside open, less the premium. It is insurance, and like insurance it costs money every period. An investor holding Nifty exposure at 24,300 who buys a 24,000 put at 120 has a floor: below 24,000 the put pays, so the worst outcome is a loss of 300 points plus the 120 premium.

A covered call is a long stock position plus a short call. The investor collects the premium, which cushions a small fall, but gives up gains above the strike. It suits a holder who expects a flat or mildly rising market. The call is "covered" because the stock is there to deliver, so the writer's loss is limited to the stock falling, not unlimited.

Bull call spread

Buy a call at a lower strike and sell a call at a higher strike, same expiry. The sold call reduces the net cost but caps the gain. The position is moderately bullish and defined-risk on both sides, which is why it appears often in long-short strategy documents.

The mirror image is the bear put spread: buy a higher-strike put, sell a lower-strike put, for a moderately bearish view. Max profit = difference in strikes − net debit; max loss = net debit; breakeven = higher strike − net debit. A bear call spread and bull put spread do the same with a net credit, where max profit is the credit and max loss is the difference in strikes minus the credit.

Straddle and strangle: trading volatility

A long straddle buys a call and a put at the same strike and expiry. It profits from a large move in either direction and loses the combined premium if the market stays put. With Nifty at 24,000, buying the 24,000 call at 250 and the 24,000 put at 230 costs 480; breakevens are 24,480 and 23,520; maximum loss is 480 × 75 = ₹36,000 if Nifty closes exactly at 24,000. A long strangle uses an OTM call and an OTM put, which is cheaper but needs a bigger move. Selling a straddle or strangle earns the premium in a quiet market but exposes the writer to large losses on a sharp move; that is the short-volatility trade an SIF must disclose in its scenario analysis.

Picking the right strategy

Match the view to the tool. Strongly bullish: long futures or long call. Moderately bullish with a budget: bull call spread. Hold stock, want income, expect sideways: covered call. Hold stock, fear a crash: protective put. Expect a big move but unsure of direction: straddle. Expect calm: short strangle, with the capital to survive being wrong. The exam frames these as client scenarios; identify the view, then the position.