Derivatives Made Easy

Apurva Sheth

I was in my last year of graduation in 2007. Markets were in the middle of a euphoric bull run unmatched by any other market rally since.

Stocks were flying high every day. Making money from the markets seemed a piece of cake. It was common to make 8-10% on one investment in just a few days.

But a quick 10% gain wasn't enough for some. The rally got to the point where some investors weren't happy unless a stock doubled in less than a month!

This was when derivatives became a buzzword. I heard of people doubling and tripling their investments in just days using derivatives. I was excited and wanted to learn more.

But derivatives are like a deep dark jungle - difficult to navigate through. A friend was trading derivatives with half-baked knowledge. He made good money in short time...but lost it all just as quickly and never really understood why.

So I was skeptical from the beginning and didn't want to jump in to anything without knowing what it was. I never missed a chance to question anyone with a finance or broking background about derivatives.

Nobody could answer in any detail - at least not in language I could understand. Then I came across a book on derivatives published by the stock exchanges for brokers. This book was the compass that helped me navigate the jungle.

But it took a very long time. At least six months to go from complete novice to still just an intermediate beginner. Unfortunately, this was just the start of a long way to go...

My learning curve plateaued. It took even longer to go from the beginner to the advanced level.

And that, dear reader, is why I envy you!

You don't have to spend that much time. You already know derivatives provide big opportunities. That you can double your money with derivatives. Now, it used to be that people kept away from derivatives because they knew how time consuming they would be to understand.

But that's no longer the case...

Asad Dossani has designed a course on derivatives. Forget the map; this is GPS device that will help you navigate the jungle of derivatives with ease.

Asad designed the course to take you from beginner to advanced to expert in no time. It's divided into three modules:

  1. Introduction to Derivative and Derivatives Pricing

    This module gives you a solid foundational understanding of futures and options. You will learn about calls and puts. When to buy them. Who sells options and why? What does he get out of it? You will also learn about different pricing models, exotic derivatives, and much more.

  2. Understanding Financial Markets and Picking Out Market Cues

    Derivatives are all about analysing the markets and reading between the headlines to understand which way the market could turn next. In this module, Asad covers various markets including currencies, commodities, equities. And he shows you the factors that decide how the market will react to certain situations.

  3. Creating Your Own Trading Strategy

    Building on the knowledge you gained from the first two modules, Asad will then teach you various tools and techniques you can use to create your own trading strategy. Topics to be covered include investor psychology, fundamental and technical analysis, risk management, and quantitative analysis. Using real-life examples, he will show you how to build your own derivatives trading strategies.

Now, I've reviewed the course and can tell you it's far superior to the book for brokers I used to navigate the dark jungle of derivatives. You can become a master derivatives trader in a fraction of the time it took me.

Click here to learn more and sign up for the course.

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Market Notes

Bank Nifty Might Lose Steam...

The banking sector went through a terrible phase in 2015. Non-performing assets (NPAs) were mounting. Sentiment was extremely negative. And bank stocks were plunging.

The Bank Nifty Index, which tracks the top twelve banks, tanked 35% from its January 2015 high to the February 2016 bottom. During the same time, the Nifty 50 Index fell only 22%. This showed huge underperformance by the banking stocks.

But now, the situation is the reverse. The sector has been in the limelight after the government's restructuring efforts. And from the February 2016 bottom, the Bank Nifty Index soared 73% while the Nifty Index rose only 38%.

Active equity traders usually keep a close watch on both indices. The indices usually closely track each other. That is, they are positively correlated. But at times, one outperforms or underperforms the other by a huge margin.

A popular method to track this outperformance or underperformance is through the ratio charts.

We have divided the price of the Nifty by the price of Bank Nifty to create a simple ratio chart (refer to the top panel in the chart below). A rising ratio indicates the Nifty is outperforming the Bank Nifty. A falling ratio means the Bank Nifty is outperforming the Nifty Index.

Nifty-Bank Nifty Ratio at a 13-Year Low
Nifty-Bank Nifty Ratio at a 13-Year Low

Currently, the ratio is at a thirteen-year low, indicating the Bank Nifty is outperforming the Nifty Index.

Since the indices are positively correlated, any wide discrepancy between them is usually temporary.

In other words, whenever the ratio gets too far from its mean (that is, when one dramatically outperforms or underperforms the other), it is only a matter of time before it reverts to the mean. We can see this mean reversion by plotting stretch indicator on the chart (refer to the bottom panel).

The stretch indicator shows the difference between the ratio line and its 200-day moving average divided by the ratio line. In the chart above, the zero line (blue horizontal line) is the mean and the green line is the ratio line, which revolves around the mean.

So when the stretch indicator rises, the Nifty Index outperforms. But as the indicator goes far above its zero line (mean), it tends to revert to its mean. This indicates that the Nifty will underperform while the indicator reverts back to its mean.

In November 2016, during demonetisation, the stretch indicator bottomed out and rose to revert to its mean in January 2017. The Nifty outperformed the Bank Nifty during this period.

But now, the indicator is again far below its mean. We can also spot a bullish divergence between the stretch indicator and the ratio line. Meaning the ratio made a new low, but the stretch indicator didn't. This indicates the ratio might soon revert to its mean.

But remember a rising ratio only indicates the Nifty is outperforming the Bank Nifty. It doesn't necessarily mean that the Nifty will rise and the Bank Nifty will fall. It can also mean the Bank Nifty will fall faster than the Nifty or that the Nifty will rise faster than the Bank Nifty.

Whatever the case may be, with the ratio near a thirteen-year low and with bullish divergence set up, as seen in the stretch indicator, we can expect the ratio to revert to the mean and the Bank Nifty to underperform the Nifty going forward.

From The Market Wizards...

"It is far more difficult... to know when to sell a stock than when to buy." - Bernard Baruch

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