Strategies using Equity Futures and Equity Options — NISM V-D

The applied chapter (9 marks): how the primitives combine into real strategies. Futures hedge, speculate or arbitrage; options build spreads (defined risk/reward), protective puts (insurance) and covered calls (income). Put-call parity ties call, put, spot and strike into a no-arbitrage relationship, and open interest plus the put-call ratio give sentiment. This is the module's "so what" — the toolkit a SIF actually deploys.

Foundation

Spreads combine two options of the same type to define a band. A bull call spread — buy a lower-strike call and sell a higher-strike call (same underlying, same expiry) — profits from a moderate rise, cheaper than a naked call because the sold call funds part of the bought call, but with capped upside. A bear spread is the mirror for a fall. Two classic single-stock hedges: a protective put (own the stock, buy a put) insures the downside; a covered call (own the stock, sell a call) earns premium but caps the upside. Sentiment tools: open interest is the number of outstanding contracts; a rising futures price ALONGSIDE rising open interest signals a strengthening (bullish) trend, because new money is backing the move.

Deep Dive

Put-call parity is the anchor relationship for European options: c + X·e^(−rt) = p + S₀, where c and p are the call and put premiums, X the common strike, S₀ the spot, r the interest rate and t the time to expiry. In words: a call plus the present value of the strike equals a put plus the spot. It holds only for European options with the same strike and maturity. If the market price of one option departs from the value this equation implies, a risk-free arbitrage exists — buy the cheap side, sell the dear side, and lock the difference. Delta-hedging extends the idea to a book of options: hold offsetting positions in the underlying so the portfolio's net Delta is zero and small price moves do not change its value; because Delta drifts (Gamma), the hedge must be rebalanced.

Worked example

Worked example — put-call parity arbitrage (NISM workbook data) A stock trades at ₹1,251. A one-month ₹1,240-strike call is quoted at ₹47.50. The interest rate is 8% p.a. What should a one-month ₹1,240-strike put cost? Put-call parity: c + X·e^(−rt) = p + S₀ ⟹ p = c + X·e^(−rt) − S₀ PV of strike = 1,240 × e^(−0.08 × 1/12) ≈ 1,240 × 0.99336 ≈ 1,231.76 p = 47.50 + 1,231.76 − 1,251 ≈ ₹28.26 (the workbook's fair value). Now suppose the put is actually trading at ₹23.15 — cheaper than its ₹28.26 fair value. The put is under-priced relative to the call, so an arbitrageur buys the cheap put (and the stock) and sells the (relatively dear) call, locking in the ₹5.11 discrepancy as a near risk-free profit until the prices realign. This is exactly how parity is enforced in the market.

Real-world scenario

Real-world scenario — matching the strategy to the client's goal Two investors, same stock, opposite needs. Meera owns 1,000 shares and simply wants to sleep through a noisy quarter: she buys a protective put — a known premium buys full downside insurance. Arjun owns the same 1,000 shares, is mildly bullish, and wants extra income: he writes a covered call above the current price — collecting premium and accepting a capped upside. A distributor who confuses the two — pitching a covered-call "income" fund to someone who actually needs downside protection — has mis-sold. The covered call gives up the upside and only cushions a small fall; it is not insurance. NISM V-D tests this precisely because a SIF may run either behaviour, and matching the fund's option strategy to the investor's objective is the compliance line.

Advanced

The exam rewards precision on strategy names and signals. A bull call spread = long lower-strike call + short higher-strike call; reversing the strikes makes it a bear call spread. A short straddle/strangle (selling both a call and a put) is a naked, unlimited-risk income bet on low volatility — NOT a hedge. A protective put IS a hedge because the long put offsets the owned stock's downside. On sentiment: the four futures-price / open-interest combinations each carry a read — rising price + rising OI = bullish (new longs), rising price + falling OI = short covering (weak), falling price + rising OI = bearish (new shorts), falling price + falling OI = long unwinding (weak). Distributors selling a rules-based or hedged SIF should be able to translate these mechanics into plain language for an investor, without overstating certainty.

Regulatory references

SEBI framework for equity derivatives strategies
Put-call parity (European options) — no-arbitrage relationship
Exchange open-interest and derivatives disclosure

Common mistakes & pitfalls

Calling a short straddle/strangle a "hedge" — selling naked options is an unlimited-risk income bet, not a hedge.
Applying put-call parity to American options — it holds only for European options with the same strike and maturity.
Reading rising price + falling open interest as strongly bullish — that is short covering, a weak signal; rising price + rising OI is the strong one.
Pitching a covered call as downside protection — it only cushions a small fall and caps the upside; a protective put is the insurance.

Frequently asked

What exactly does put-call parity let you do?

It fixes the fair price of a European put (or call) given the other option, the spot, the strike and the interest rate: c + X·e^(−rt) = p + S₀. If a traded price departs from it, you can arbitrage — buy the underpriced side, sell the overpriced side — for a near risk-free profit.

Is a covered call a hedge?

Only loosely. Writing a call against stock you own earns premium and cushions a small fall by that amount, but it caps your upside and leaves most of the downside exposed. A protective put (buying a put against the stock) is the actual downside hedge.

How do I read futures price together with open interest?

Rising price + rising open interest = strengthening bullish trend (new longs). Rising price + falling OI = short covering (weaker). Falling price + rising OI = bearish (new shorts). Falling price + falling OI = long unwinding (weaker).

Practice questions

Click each question to reveal the answer and explanation.

Q 1

An investor buys a call with a lower strike and sells another call with a higher strike, both on the same underlying and same expiry. This strategy is called a ____________.

(a)Bullish spread
(b)Bearish spread
(c)Butterfly spread
(d)Calendar spread

Correct: (a) Bullish spread

Long the lower-strike call + short the higher-strike call = a bull (bullish) call spread — it profits from a moderate rise, cheaper than a naked call but with capped upside. A butterfly uses three strikes; a calendar spread uses different expiries.

Q 2

Which of the following is a hedged position?

(a)Short straddle
(b)Short strangle
(c)Covered call
(d)Protective put

Correct: (d) Protective put

A protective put (own the stock + buy a put) is the clear hedge — the put offsets the stock's downside. Short straddles/strangles are naked, unlimited-risk income bets; a covered call only cushions a small fall and caps upside, so it is an income strategy rather than a downside hedge.

Q 3

Put-call parity refers to the relationship between ____________.

(a)Futures and options on the same stock
(b)Call options on the same stock with the same maturity but different strikes
(c)Put and call options on the same stock with different strikes and different maturity
(d)Call and put options on the same stock with the same strike price and same maturity

Correct: (d) Call and put options on the same stock with the same strike price and same maturity

Put-call parity links a CALL and a PUT on the same stock with the SAME strike and the SAME maturity (European). The other options change the strike, the maturity, or the instruments, which breaks the relationship.

Q 4

Which situation indicates a bullish trend in the underlying?

(a)Rising futures price with falling open interest
(b)Falling futures price with rising open interest
(c)Rising futures price with rising open interest
(d)Falling futures price with falling open interest

Correct: (c) Rising futures price with rising open interest

Rising price + rising open interest = a strengthening bullish trend, because new money (fresh longs) is backing the move. Rising price + falling OI is merely short covering — a weaker signal and the classic bait here.

Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.