NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors · Derivatives

Trading Strategies Using Derivatives: Hedging, Spreads and Straddles

Updated 11 October 2026 · Fact-checked

Derivative strategies combine futures and options to hedge a portfolio or take a view on price or volatility. Hedging uses short index futures sized by beta. Covered calls and protective puts pair options with shares. Spreads, straddles and strangles trade direction or volatility. Solve by drawing the payoff and finding the breakeven.

Understand Trading Strategies Using Derivatives

A derivative strategy is a planned position in futures or options, usually held along with a portfolio. Portfolio managers use it for three reasons: to hedge (reduce risk), to enhance income, or to express a view on direction or volatility.

Hedging with futures. If you hold a diversified equity portfolio and fear a fall, you can sell index futures. Gains on the short futures offset losses on the shares. A diversified portfolio moves with the market, so the index is a good hedge. For a single stock, you can sell stock futures. A hedge cuts risk but also cuts the gain if the market rises.

Covered call and protective put. In a covered call, you hold the shares and sell a call option against them. You earn the premium, but your upside is capped at the strike price. It suits a neutral to mildly bullish view. In a protective put, you hold the shares and buy a put. You pay a premium, but your loss is limited below the strike. It works like insurance.

Spreads. A spread combines two options of the same type. A bull call spread is buying a lower-strike call and selling a higher-strike call. Cost and risk are lower, and so is the maximum profit. A bear put spread is buying a higher-strike put and selling a lower-strike put.

Straddle and strangle. These are volatility trades. A long straddle is buying a call and a put with the same strike and expiry. A long strangle is buying an out-of-the-money call and an out-of-the-money put. You profit from a big move in either direction. You lose the premium paid if the market stays quiet. Strangles cost less but need a bigger move.

Key formulas to remember

Hedge ratio using beta: Number of futures contracts = β × Portfolio value ÷ (Futures price × Lot size); Sell (go short) this many contracts to hedge. For a full hedge, use the portfolio beta against the index.
Covered call: maximum profit: (Strike − Purchase price of share) + Premium received; Per share. Applies when the share ends at or above the strike. It assumes the strike is at or above the purchase price. If the strike is below the purchase price, the same expression still gives the capped result, but it can be small or negative.
Covered call: breakeven: Purchase price of share − Premium received; Below this price the position makes a loss.
Protective put: maximum loss: (Purchase price − Strike) + Premium paid; Per share. Valid for a strike at or below the purchase price (an OTM or ATM put). If the strike equals the purchase price, the maximum loss is only the premium. If the strike is above the purchase price, the expression is smaller and can turn negative, which means a locked-in floor above cost. Profit is unlimited as the share rises.
Protective put: breakeven: Purchase price + Premium paid; The share must rise above this for a profit.
Long straddle breakevens: Strike + Total premium and Strike − Total premium; Total premium = call premium + put premium. Maximum loss is the total premium.
Long strangle breakevens: Call strike + Total premium and Put strike − Total premium; Maximum loss is the total premium paid.
Bull call spread: Maximum profit = (Higher strike − Lower strike) − Net premium paid; Maximum loss = Net premium paid; Breakeven = Lower strike + Net premium paid.

How to solve Trading Strategies Using Derivatives questions

Use this method for any strategy question, whether it asks about purpose, payoff, breakeven or hedge size.

1Identify the goal: hedge, income, or view on direction or volatility.
2List each leg: buy or sell, call or put, strike, and premium paid or received.
3Decide the market view the legs imply (bullish, bearish, neutral, or expecting a big move).
4Work out the maximum profit, maximum loss and breakeven using the formulas above.
5For hedging with futures, compute the contracts as β × portfolio value ÷ contract value, and round to a whole lot.
6Check each answer option against your result and drop the options that reverse buy and sell or call and put.

Quickest way: Match the strategy to its view and risk shape

When to use it: Use it for theory-style MCQs that ask which strategy suits a view, or which has limited or unlimited profit or loss.

Own shares and fear a fall: protective put (pay premium, floor on loss).
Own shares and expect little movement: covered call (earn premium, upside capped).
Expect a big move, direction unknown: long straddle or strangle (loss limited to premium).
Expect a moderate rise or fall with lower cost: bull call spread or bear put spread (profit and loss both limited).
Hedging a whole portfolio: sell index futures, sized by beta.

Common mistakes in Trading Strategies Using Derivatives

Saying a covered call has unlimited profit.
Students confuse it with simply holding the shares, where upside is open.
Fix: Remember the call you sold caps your gain at the strike plus the premium.
Thinking a protective put costs nothing.
Students focus on the loss protection and forget the premium.
Fix: The premium paid is a cost. It raises the breakeven above the purchase price.
Buying futures to hedge a long portfolio.
Students link a hedge with buying instead of offsetting the exposure.
Fix: To offset a long position, take the opposite side: sell index futures.
Using only one premium to find straddle breakevens.
Students forget both the call and the put are bought.
Fix: Add call and put premiums together, then add and subtract from the strike.
Ignoring beta when sizing a hedge.
Students divide portfolio value by contract value directly.
Fix: Multiply by beta first. A beta above 1 needs more contracts than the plain ratio.
Calling a strangle and a straddle the same.
Both use a call and a put, so they look alike.
Fix: Straddle: same strike. Strangle: different, out-of-the-money strikes, cheaper, needs a bigger move.

Worked examples

Example 1

A PMS portfolio worth ₹6,00,00,000 has a beta of 1.2 against the Nifty. Nifty futures trade at 24,000 and the lot size is 50. How many contracts must be sold to fully hedge the portfolio?

Show the solution

Contract value = 24,000 × 50 = ₹12,00,000.
Beta-adjusted exposure = 1.2 × ₹6,00,00,000 = ₹7,20,00,000.
Number of contracts = ₹7,20,00,000 ÷ ₹12,00,000 = 60.
The hedge is a short position, since the portfolio is long.

Answer: Sell 60 Nifty futures contracts.

Example 2

An investor buys a share at ₹500 and buys a put with strike ₹480 for a premium of ₹15. What is the maximum loss per share and the breakeven?

Show the solution

Maximum loss = (Purchase price − Strike) + Premium = (500 − 480) + 15.
Maximum loss = 20 + 15 = ₹35 per share.
Breakeven = Purchase price + Premium = 500 + 15 = ₹515.

Answer: Maximum loss is ₹35 per share and breakeven is ₹515.

Exam tips

Read whether each leg is bought or sold. Many wrong options just flip one leg.
Know the limited and unlimited profit or loss of each strategy. This is a common MCQ pattern.
For hedge questions, always check whether beta is given. Multiply by it before dividing.
Negative marking applies in this exam, so eliminate options with the wrong view before guessing.
Remember that hedging reduces risk and also reduces gains. Options that claim a free hedge are wrong.

Practice questions from 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.

CFA Level IIssuer Uses of Derivatives

Trading Strategies Using Derivatives: frequently asked questions

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

A covered call means holding shares and selling a call, which earns premium but caps upside. A protective put means holding shares and buying a put, which costs premium but limits downside. One earns income, the other buys insurance.

How do I calculate the hedge ratio for a beta portfolio?

Multiply portfolio value by its beta. Divide the result by the value of one futures contract, which is futures price times lot size. Sell that many contracts, rounded to whole lots.

When should a portfolio manager use a straddle or a strangle?

Use them when you expect a large price move but are unsure of the direction, such as around major events. A strangle costs less than a straddle but needs a bigger move to profit. Both lose the premium if the market stays flat.

Why does a spread have limited profit?

In a spread you sell one option to lower the cost of the one you buy. The option you sold limits how much you can gain. The loss is also limited to the net premium paid, in both a bull call spread and a bear put spread (both are debit spreads).