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How derivatives can be used to add value to HNI portfolios?

Derivatives are instruments that derive their value from an underlying and can be used to hedge portfolio risk, generate recurring income and/or generate portfolio returns.

November 13, 2021 / 10:53 AM IST

Sameer Kaul, MD and CEO at TrustPlutus Wealth (India)

What Warren Buffett described as a 52-year-old love affair, the insurance model is one of the businesses that has significantly contributed to the net worth of Berkshire Hathaway.

In the insurance business model, cash comes upfront and is invested; claims are paid as and when they arise. By underwriting risk, collecting a premium, and investing the same to generate income, an insurance company can make an underwriting profit over and above the investment income as long as the premiums collected are higher than the claims paid and expenses incurred.

Akin to an insurance company, investors can also seek to generate investment income on a recurring basis through judicious use of derivatives. These are instruments that derive their value from an underlying and can be used to hedge portfolio risk, generate recurring income and/or portfolio returns.

Investors can hedge their portfolio risk by buying protection through purchase of Put options. These options gain in value when there is a fall in the value of the underlying or expire worthless in case the underlying rises in value or does not fall in value beyond a threshold below which protection has been purchased.

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Investors can also purchase Put or Call options to generate investment returns as long as they have a view on the underlying and the underlying performs in line with expectations.

Last but not the least, and this is relatively an unexplored area for investors in India, is the idea of using options to generate a recurring income. Income can be generated by selling options on an underlying which can be an index or a single stock or a basket of securities. The investor is essentially taking in a view that either the underlying will not rise in value or the underlying will not fall in value above or below the threshold strike price at which the investor sells the options. The investor earns a premium for taking such a risk which can become the source of a recurring income.

While selling options entail taking risk, such risk can be mitigated when the investor trades with adequate stock or cash as margin and does not trade for a notional value that is larger than the total amount of margin available at the disposal of the investor. Also, risk involved in selling options is mitigated since investors have the option to either purchase the underlying stock or basket of stocks in case the investor has sold put option(s) or the investor can deliver the underlying shares in case they have sold call options and the option expires in the money (price of the underlying is lower or higher than the strike price at which the call option was sold).

With a demat account, one can sell options by using existing investments as margins or cash can be used as margin. One needs to decide the contours of the option trade like what will be the underlying (an index or specific stocks), what will be duration of the contract (typically monthly), at which strike price to assume risk (can be near or far from the current spot) and whether to sell only Calls or only Puts or both Calls and Puts.

Options are exchange traded and can be executed seamlessly through a broker. Exchange traded options carry lower settlement risk since the exchange has a settlement and margin monitoring mechanism that ensures that such trades are executed with limited counterparty risks. While the options trade on a daily basis, the typical settlement cycle is monthly on the last working Thursday of every month.

Selling options can be an effective way to generate high absolute return as well as a recurring income if executed in a judicious way. Unlike an ordinary investment that necessarily needs to rise in value, income from selling options is earned as long as the underlying trades in a range and risk mitigants are in place as discussed above in terms of the margin as well as control over leverage. As more and more participants enter the derivatives space, the liquidity of such instruments should improve and the basket of underlying that are eligible for writing options will also expand and provide investors with an expanded set of products to choose from.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

 
Sameer Kaul is the CEO & MD at TrustPlutus Wealth (India) Pvt Ltd.
first published: Nov 13, 2021 10:53 am

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