Chapter 5: Strategies using Equity Futures & Options
NISM Series VIII — Equity Derivatives | 10% weightage | ~10 exam questions
What this chapter is about
This is where theory meets real trading. You've learned what futures and options are — now you learn how to combine them to express specific market views, hedge portfolios, and exploit arbitrage. The exam tests whether you can identify the right strategy for a given scenario. No heavy calculations here — it's mostly about understanding which strategy suits which market view.
Key concepts
Three types of strategies:
- Hedging — reducing an existing risk
- Speculation — taking a directional view for profit
- Arbitrage — exploiting price inefficiency for risk-free profit
Futures strategies
Long Hedge — you PLAN to BUY something in future and fear prices will RISE. Buy futures now to lock in price. Example: Mutual fund manager has collected ₹300 crore in NFO and will buy stocks over next month. Fears market will rise before he can invest. Buys index futures now → if market rises, futures profit offsets higher stock purchase price.
Short Hedge — you OWN something and fear prices will FALL. Sell futures now to lock in price. Example: Portfolio manager holds ₹500 crore in equities. Expects market volatility before RBI policy. Sells index futures → if market falls, futures profit offsets portfolio loss.
Beta Hedging — hedging a portfolio using index futures, accounting for the portfolio's beta.
Number of contracts to sell = (Portfolio Value × Portfolio Beta) / (Index Value × Lot Size)Speculative strategies using futures:
- Bullish view → Buy index futures
- Bearish view → Sell index futures
- Bullish on market but bearish on specific stocks → Buy index futures + Sell stock futures
Cash and Carry Arbitrage — when futures are overpriced vs fair value. Buy in cash market, sell futures simultaneously. Profit = mispricing (risk-free).
Reverse Cash and Carry — when futures are underpriced. Sell in cash market (short sell), buy futures. Requires securities lending facility.
Options strategies
Covered Call — you OWN the stock + SELL a call option on the same stock.
- View: mildly bullish or neutral
- Max profit: premium received + (strike − purchase price)
- Max loss: stock falls to zero − premium received
- Best for: generating income on existing holdings
Protective Put — you OWN the stock + BUY a put option.
- View: bullish but want downside protection
- Acts like insurance on your portfolio
- Cost: put premium paid
Naked Call — SELL a call without owning the underlying.
- View: bearish or neutral
- Max profit: premium received
- Max loss: UNLIMITED (stock can rise indefinitely)
- High risk strategy
Option Spreads — combine two options of the SAME type (both calls or both puts) on the SAME underlying but with DIFFERENT strikes or different expiries. Always limited profit AND limited loss.
Vertical Spreads — same expiry, different strikes:
- Bull Call Spread: Buy lower strike call + Sell higher strike call. Net cash OUTFLOW. Bullish view.
- Bear Call Spread: Sell lower strike call + Buy higher strike call. Net cash INFLOW. Bearish view.
- Bull Put Spread: Sell higher strike put + Buy lower strike put. Net cash INFLOW. Bullish view.
- Bear Put Spread: Buy higher strike put + Sell lower strike put. Net cash OUTFLOW. Bearish view.
Calendar Spreads (options) — same strike, different expiries.
Straddle — Buy BOTH a call AND a put at the SAME strike, SAME expiry.
- View: big move expected, don't know direction (pre-results, pre-budget)
- Profits when underlying moves significantly in EITHER direction
- Short Straddle: sell both — profits when market is RANGE-BOUND, LOW volatility
Strangle — Buy an OTM call + OTM put at DIFFERENT strikes.
- Cheaper than straddle (both options are OTM)
- Needs a bigger move to profit
Butterfly — Combination of spreads. Limited risk, limited reward. Profits when market stays near middle strike.
Put-Call Parity — fundamental relationship between call and put prices with same strike and expiry. If violated, arbitrage opportunity exists.
Real market example — Short Hedge
It's January. Kiran manages a ₹50 crore equity portfolio with a beta of 1.2. Union Budget is in February and he's worried about volatility.
Nifty is at 25,000. Lot size = 75.
Contracts to sell = (50,00,00,000 × 1.2) / (25,000 × 75) = 6,00,00,000 / 18,75,000 = 32 contractsHe sells 32 Nifty futures contracts. If budget disappoints and Nifty falls 5%:
- Portfolio loss ≈ ₹50 crore × 1.2 × 5% = ₹3 crore
- Futures profit = 32 × 75 × (25,000 × 5%) = 32 × 75 × 1,250 = ₹30 lakh per 1% = ₹3 crore
The hedge works — portfolio loss is offset by futures gain.
Trap Alert
Trap 1: "Buying an OTM index call and selling an OTM index put is a hedge" → FALSE This is a SPECULATIVE strategy (synthetic long), not a hedge. A hedge offsets an EXISTING position. If you have no underlying exposure, it's speculation.
Trap 2: "Bull call spread results in cash inflow" → FALSE Bull call spread = buy lower strike call (pay) + sell higher strike call (receive). Net = OUTFLOW (you pay more than you receive because the lower strike call is more expensive).
Trap 3: "Bear call spread results in cash outflow" → FALSE Bear call spread = sell lower strike call (receive more) + buy higher strike call (pay less). Net = INFLOW.
Trap 4: "Short straddle profits from high volatility" → FALSE SHORT straddle profits from LOW volatility and range-bound markets. LONG straddle profits from HIGH volatility and big moves.
Trap 5: "Calendar spread = same underlying, same expiry, different strikes" → FALSE That's a vertical spread. Calendar spread = same underlying, DIFFERENT expiry months, same strike.
Must-remember rules
- Hedging = reducing existing risk | Speculation = taking new risk | Arbitrage = risk-free profit
- Long hedge = plan to buy, fear price rise → buy futures
- Short hedge = own asset, fear price fall → sell futures
- Covered call = own stock + sell call (income strategy)
- Protective put = own stock + buy put (insurance strategy)
- Naked call = sell call without ownership = UNLIMITED risk
- Option spreads = same type (call/call or put/put) = limited profit + limited loss
- Vertical spread = same expiry, different strikes
- Calendar spread = same strike, different expiry
- Long straddle = buy call + buy put same strike = big move expected
- Short straddle = sell call + sell put same strike = low volatility expected
- Bull call spread = net outflow | Bear call spread = net inflow
- Bull put spread = net inflow | Bear put spread = net outflow
Weightage note
10% of exam = ~10 questions. Mix of scenario-based questions ("what strategy should Mr X adopt") and true/false on spread mechanics. The cash inflow/outflow on spreads is frequently tested and frequently wrong. Straddle vs strangle is another common topic.
Quick revision — 60 second scan
- Long hedge: buy futures to lock purchase price
- Short hedge: sell futures to protect portfolio from fall
- Covered call: own stock + sell call = income generation
- Protective put: own stock + buy put = insurance
- Naked call: sell call without stock = unlimited risk
- Spreads: same type, limited risk + limited reward
- Vertical: diff strikes, same expiry
- Straddle: same strike call + put, big move expected
- Bull call spread = outflow | Bear call spread = inflow
- Short straddle = profits in low volatility