Derivative Trading and its Terminologies

Derivative Trading and its Terminologies

Benefits of Derivative trading


Derivatives are the standardized financial contract between two or more parties whose value is derived based on their underlying assets. Derivative trading in the share market is better than buying the underlying asset since the gains can be substantially inflated.

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Derivatives provide a significant impact on finance because they provide numerous advantages to the financial markets:

  1. Hedging risk exposure

  2. Price determination of an underlying asset

  3. Market efficiency

  4. Low transaction costs

  5. Used in risk management

  6. Transfers risk

 

What is open interest in FNO?

Open interest is the total number of outstanding contracts that are held by market participants at the end of each trading day. Alternatively, it is the total number of FNO contracts that haven't been executed (squared off).

The open interest provides a more accurate picture of the FNO trading and whether the fluctuation is involved in it. Increasing open interest represents market has money inflow. While decreasing open interest indicates money outflow of the market.


For your better understanding, refer to the table given below:




How to hedge portfolio risk using Derivative trades

Hedging portfolio risk through derivatives is the easiest and most efficient way of trading, which allows you to minimize the negative impact of adverse price swings in the market and reduces the price risk involved. For how to hedge portfolio risk by using derivatives, let's put it in a way of an example, there is an investor who's worried about short-term price rise in XYZ stock, where he can hedge his stock portfolio against short-term losses by purchasing the same number of XYZ put option. A difference between the portfolio and profit from the put options would be considered as the hedging portfolio risk or an offset.

So generally, for hedging, you can buy an XYZ stock contract from NSE and sell the same XYZ stock contract on BSE. The price difference/mispricing will be your risk-free profit and a hedge against your portfolio risk.

Put/Call Ratio (PCR)

 

Put/Call ratio (PCR) is a popular derivative indicator, specifically designed to enable traders to determine the sentiment of the options market effectively. The ratio is calculated either based on options trading volumes or on the basis of the open interest for a particular period.

If traders are buying more puts than calls, it signals a rise in bearish sentiment. If they are buying more calls than puts, it suggests that they see a bull market ahead.

 

PCR is calculated by two methods which are as follows:


i) Based on Open Interests of a specific day

PCR is computed by dividing the current open interest in a Put contract on a specific day by the open Call interest on the very same day.
PCR (OI) = Put open interest/Call open interest

ii) Based on the volume of Options trading

Here, PCR is computed by dividing the total Put trading volume by the total call trading volume on a specific day
PCR (Volume) = put trading volume/Call trading volume