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NISM-Series-X-A: Investment Adviser (Level 1) · Understanding Derivatives

Trading Strategies Using Derivatives: Hedging, Spreads and Straddles

Updated 11 October 2026 · Fact-checked

Derivative strategies combine futures and options with a position in the underlying to hedge risk, speculate on views or lock arbitrage gains. Identify the view and the existing position, pick the matching strategy, then compute payoff, breakeven, maximum profit and maximum loss at expiry.

Understand Trading Strategies Using Derivatives

Derivatives are used for three purposes. Hedging reduces an existing risk. Speculation takes a risk to profit from a view on price or volatility. Arbitrage earns a risk-free profit from a price gap between two markets, such as spot and futures.

A futures hedge is the simplest. If you hold a stock portfolio and fear a fall, you sell index futures. If the market falls, the loss on the portfolio is offset by the gain on the short futures. The hedge also gives up gains if the market rises. To size it, you use the portfolio's beta: number of contracts = (portfolio value × beta) ÷ (futures price × lot size).

Option strategies shape the payoff. A covered call means you hold the shares and sell a call. You earn the premium but cap your upside above the strike. A protective put means you hold the shares and buy a put. You pay a premium, and your loss is limited below the strike, like insurance, while upside stays open.

A spread combines two options of the same type. A bull call spread buys a lower-strike call and sells a higher-strike call. It costs less than a single call, but profit is capped. A bear put spread buys a higher-strike put and sells a lower-strike put. A long straddle buys a call and a put at the same strike and expiry. It profits from a big move in either direction and loses the total premium if the price stays near the strike.

The key is to link view to strategy. Mildly bullish: bull spread or covered call. Protecting holdings: protective put or short futures. Expecting a large move but unsure of direction: long straddle. Expecting no move: short straddle, which has unlimited risk.

Key formulas to remember

Number of index futures contracts to hedge
Contracts = (Portfolio value × Portfolio beta) ÷ (Index futures price × Lot size)
Round to the nearest whole lot. Sell futures to hedge a long portfolio.
Covered call payoff at expiry
Profit = (Sale price of stock − Purchase price) + Premium received − Max(0, Spot − Strike)
Maximum profit = (Strike − Purchase price) + Premium. Breakeven = Purchase price − Premium.
Protective put
Maximum loss = (Purchase price − Strike) + Premium paid; Breakeven = Purchase price + Premium
Upside is unlimited. Premium is the cost of insurance.
Bull call spread
Max loss = Net premium paid; Max profit = (Higher strike − Lower strike) − Net premium; Breakeven = Lower strike + Net premium
Net premium = premium of bought call − premium of sold call.
Long straddle
Max loss = Call premium + Put premium; Breakevens = Strike ± Total premium
Loss is greatest if spot equals strike at expiry. Profit is unlimited on the upside and large on the downside.
Cash-and-carry arbitrage
Arbitrage exists if Futures price > Spot × (1 + cost of carry) for the period
Buy spot, sell futures, hold to expiry. Reverse the trade if futures are too cheap.

How to solve Trading Strategies Using Derivatives questions

Use this method for any strategy question, whether it asks for a choice of strategy or a number.

  1. 1Read the existing position: does the investor hold shares, a portfolio, or nothing?
  2. 2Read the view: bullish, bearish, mildly directional, big move, or no move.
  3. 3Match the strategy: hedge long holdings with short futures or a put; mild view with a spread; big move with a straddle; price gap with arbitrage.
  4. 4List each leg as bought or sold, call or put, with strike and premium.
  5. 5Compute net premium paid or received, then breakeven.
  6. 6Compute maximum profit and maximum loss. Check which is limited and which is not.
  7. 7Check the answer against the view: a bullish strategy must gain when the price rises.

Quickest way: View-to-strategy shortcut

When to use it: Use for conceptual MCQs that ask which strategy fits a view or which has limited loss.

  1. Buyer of an option: loss limited to premium. Seller of an option: loss can be large, gain limited to premium.
  2. Hedging a long portfolio means selling futures or buying puts.
  3. Covered call: capped upside, small cushion. Protective put: capped downside, open upside.
  4. Spreads cap both profit and loss. Straddle buyer needs a big move.
  5. For breakeven, add or subtract the net premium from the strike.

Common mistakes in Trading Strategies Using Derivatives

  • Buying index futures to hedge a long portfolio.

    Students link a bearish fear with the word buy, or confuse hedging with speculating.

    Fix: A long portfolio loses when the market falls, so you need a position that gains then. Sell futures.

  • Saying a covered call has unlimited profit.

    The long stock has unlimited upside on its own.

    Fix: The short call caps gains at the strike. Maximum profit = (Strike − Purchase price) + Premium.

  • Forgetting the premium in the breakeven.

    Students stop at the strike price.

    Fix: Always add or subtract net premium. Protective put breakeven = Purchase price + Premium.

  • Calling a long straddle a view on direction.

    Both a call and a put are present, which is confusing.

    Fix: It is a view on volatility. You profit from a large move either way and lose if the price stays flat.

  • Ignoring beta when sizing the futures hedge.

    Students divide portfolio value by contract value directly.

    Fix: Multiply portfolio value by beta first, then divide by futures price × lot size.

Worked examples

Example 1

An investor holds a portfolio worth ₹50,00,000 with a beta of 1.2. Nifty futures trade at 25,000 and the lot size is 25. How many futures contracts should be sold to fully hedge the portfolio?

Show the solution
  1. Portfolio value × beta = 50,00,000 × 1.2 = ₹60,00,000.
  2. Value of one futures contract = 25,000 × 25 = ₹6,25,000.
  3. Contracts = 60,00,000 ÷ 6,25,000 = 9.6.
  4. Round to the nearest whole lot: 10. The investor sells futures because the portfolio is long.

Answer: Sell about 10 Nifty futures contracts (9.6 rounded).

Example 2

An investor buys a share at ₹400 and buys a put with strike ₹400 for a premium of ₹15. What is the maximum loss and the breakeven price at expiry?

Show the solution
  1. The put lets the investor sell at ₹400, so the stock loss is limited to zero below ₹400.
  2. Maximum loss = (400 − 400) + premium paid = ₹15 per share.
  3. Breakeven = purchase price + premium = 400 + 15 = ₹415.
  4. Above ₹415 the investor profits, and the upside is unlimited.

Answer: Maximum loss ₹15 per share; breakeven ₹415.

Exam tips

  • Questions often ask which strategy suits a given view. Fix the view first, then eliminate options that have the opposite payoff.
  • Remember who has limited and who has unlimited loss: option buyers risk only the premium; sellers of naked options do not.
  • Check whether the question asks per share or per lot. Multiply by lot size only when asked.
  • With negative marking, skip a numeric question if the hedge ratio or breakeven is unclear rather than guess.
  • Watch for trap options such as buying futures to hedge a long portfolio.

Practice questions from Understanding Derivatives

Trading Strategies Using Derivatives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Trading Strategies Using Derivatives: frequently asked questions

How do I hedge a portfolio with Nifty futures?

You sell Nifty futures. The number of contracts is portfolio value × beta ÷ (futures price × lot size). If the market falls, the futures gain offsets the portfolio loss. If it rises, the futures lose and cancel out your gain.

What is the difference between a covered call and a protective put?

A covered call means holding the stock and selling a call, which earns premium but caps upside. A protective put means holding the stock and buying a put, which costs premium but limits downside. Covered call is income-oriented; protective put is insurance.

When is a long straddle profitable?

It is profitable when the price moves beyond either breakeven, which is the strike plus or minus the total premium paid. It loses most when the price ends at the strike. It suits a view of high volatility without a clear direction.

What is a bull spread?

It is a strategy using two options of the same type and expiry to profit from a rise in price. A bull call spread buys a lower-strike call and sells a higher-strike call. Both profit and loss are limited.