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

Derivatives and Their Use in Portfolios: Futures and Options

Updated 11 October 2026 · Fact-checked

A derivative is a contract whose value depends on an underlying asset such as an index or stock. Futures bind both sides to trade at a fixed price. Options give the buyer a right, not an obligation. In portfolios, you use them to hedge risk or enhance returns. Solve questions by identifying position, direction and payoff.

Understand Derivatives and Their Use in Portfolios

A derivative is a contract whose value is derived from an underlying, such as a share, an index, a currency or a commodity. You do not own the underlying. You hold a contract linked to its price.

A futures contract is a standardised, exchange-traded agreement to buy or sell the underlying at a fixed price on a fixed future date. Both buyer and seller are obligated. Gains and losses can be unlimited in either direction. Futures are marked to market daily, and margin is paid by both sides.

An option gives the buyer a right but not an obligation. A call option gives the right to buy at the strike price. A put option gives the right to sell at the strike price. The buyer pays a premium to the seller (writer). The buyer's maximum loss is the premium. The writer's maximum profit is the premium, but the writer's loss can be large (unlimited for a short call).

In portfolios, derivatives have two main uses. Hedging reduces risk. For example, if you hold a diversified equity portfolio and fear a fall, you can sell index futures or buy index puts. Losses on the portfolio are offset by gains on the derivative. Return enhancement means taking a view or earning extra income, for example by writing calls against shares you hold (a covered call) to collect premium.

Hedging does not add return. It cuts risk, and it costs money (premium, or giving up gains when markets rise). Derivatives can also add leverage and risk if used for speculation. SEBI's rules for portfolio managers set limits on derivatives use, so for the exam remember that a PMS manager must use them only as per the client agreement and the regulations.

Key formulas to remember

Long call payoff at expiry: Payoff = max(Spot − Strike, 0); Profit = Payoff − Premium; Buyer's maximum loss is the premium. Profit is unlimited as spot rises.
Long put payoff at expiry: Payoff = max(Strike − Spot, 0); Profit = Payoff − Premium; Buyer's maximum loss is the premium. Maximum gain occurs if spot falls to zero.
Breakeven of a long call: Strike + Premium; Spot must rise above this for the buyer to profit.
Breakeven of a long put: Strike − Premium; Spot must fall below this for the buyer to profit.
Long futures profit: Profit = Spot at close − Futures price (× lot size); Short futures profit is the reverse: Futures price − Spot at close.
Writer's position: Writer's profit = Premium − buyer's payoff; The writer's profit is capped at the premium.
Index futures hedge (beta-adjusted): Value to sell = Portfolio value × Portfolio beta; Number of lots = Value to sell ÷ (Futures price × lot size). Beta of 1 means hedge the full value.

How to solve Derivatives and Their Use in Portfolios questions

Use the same sequence for any derivatives question, whether it is a definition, payoff or hedge.

1Identify the instrument: futures, call or put.
2Identify the position: long (buyer) or short (seller or writer).
3Note the key numbers: strike, premium, futures price, spot at expiry, lot size.
4Check the purpose: hedging, speculation or return enhancement.
5Apply the payoff rule for that position and subtract the premium if the position is a bought option.
6For hedges, compare the loss on the portfolio with the gain on the derivative, and use beta if given.
7Check the answer against the limits: option buyer loses only the premium, writer's gain is capped at the premium.

Quickest way: Right or obligation, then direction

When to use it: Use for conceptual and payoff MCQs when time is short.

Ask: right or obligation? Options buyer has the right. Futures and option writers have obligations.
Ask: who gets the premium? The writer.
Hedger of a stock portfolio sells futures or buys puts.
Call profits when the market rises. Put profits when the market falls.
Eliminate options that say the buyer's loss is unlimited or the writer's gain is unlimited.

Common mistakes in Derivatives and Their Use in Portfolios

Thinking an option buyer has an obligation to buy or sell.
Students mix up futures and options.
Fix: Remember: option buyer has a right. Only the writer is obligated if the buyer exercises.
Forgetting to subtract the premium when computing profit of a bought option.
Payoff and profit are treated as the same thing.
Fix: Payoff is the exercise value. Profit = payoff − premium paid.
Buying index futures to hedge a long equity portfolio.
Direction of hedge is confused with direction of the view.
Fix: A long portfolio is hedged by taking an opposite position: sell futures or buy puts.
Assuming a hedge gives extra return.
Hedging is confused with return enhancement.
Fix: A hedge reduces risk and may reduce gains. Extra income comes from strategies like covered calls.
Ignoring portfolio beta when sizing a hedge.
Students hedge the rupee value one for one.
Fix: If beta is given, multiply portfolio value by beta to get the value of futures to sell.
Saying the writer of a call has limited loss.
Students apply the buyer's limited-loss rule to both sides.
Fix: A short call has capped profit (premium) and potentially unlimited loss.

Worked examples

Example 1

An investor buys a call option on a stock with a strike of ₹500 for a premium of ₹20. At expiry the stock is at ₹540. What is the investor's net profit per share, and what is the breakeven?

Show the solution

Payoff = max(540 − 500, 0) = ₹40.
Profit = Payoff − Premium = 40 − 20 = ₹20.
Breakeven = Strike + Premium = 500 + 20 = ₹520.

Answer: Net profit is ₹20 per share and the breakeven is ₹520.

Example 2

A portfolio manager holds an equity portfolio worth ₹5,00,00,000 with a beta of 1. The Nifty futures price is ₹25,000 and the lot size is 50. How many lots of Nifty futures should be sold to hedge the whole portfolio?

Show the solution

Beta is 1, so value to hedge = ₹5,00,00,000 × 1 = ₹5,00,00,000.
Value of one lot = 25,000 × 50 = ₹12,50,000.
Number of lots = 5,00,00,000 ÷ 12,50,000 = 40.
The hedge is a short position, as the portfolio is long.

Answer: Sell 40 lots of Nifty futures.

Exam tips

Expect direct questions on rights and obligations, who pays the premium and who has limited loss.
For hedging questions, first decide the direction: a long portfolio needs a short hedge.
Read whether the question asks for payoff or profit. The premium changes the answer.
Watch for trap options claiming that hedging guarantees a profit or that the option buyer faces unlimited loss.
Remember that derivatives use by a portfolio manager must be consistent with the client agreement and SEBI regulations.

Practice questions from Investments

Derivatives and Their Use in Portfolios: frequently asked questions

What is the main difference between futures and options?

A futures contract obliges both parties to trade at the agreed price on the expiry date. An option gives the buyer a right but no obligation, and the buyer pays a premium for it. Futures have no premium but require margin.

How do you hedge a portfolio using index futures?

You sell index futures when you hold a long equity portfolio. If the market falls, the loss on the portfolio is offset by a gain on the short futures. If beta is given, multiply the portfolio value by beta to find the value to sell.

What is the maximum loss for a call or put buyer?

The maximum loss is the premium paid. The loss occurs if the option expires without value.

Are derivatives used for hedging only?

No. They are also used for return enhancement, such as earning premium by writing calls on held shares, and for speculation. The hedging use reduces risk, while the other uses can increase it.