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TABLE OF CONTENTS

Page No.

Introduction 3

Why We Need Derivatives 4

Why Indian Markets have the Best Trading Opportunities 6

How to Trade Options 8

Using Options to Generate Income 11

What Moves the Currency Markets? 13

The Carry Trade 15

The Difference Between Gold and Silver 17

Why Leverage is Good for You 20

Disclaimer 22

Index | 2
 Introduction

Dear Reader,

Congratulations on taking your first step to becoming a profitable derivatives trader!

We thank you for downloading this guide. This guide consists of following eight
articles, all covering the ins and outs of derivatives trading:

Why We Need Derivatives

Why Indian Markets have the Best Trading Opportunities

How to Trade Options

Using Options to Generate Income

What Moves the Currency Markets?

The Carry Trade

The Difference Between Gold and Silver

Why Leverage is Good for You

Once you are done, dont forget to give us your feedback. Heres to a lifetime of
success in trading the derivatives markets!

Kind Regards,

Asad Dossani
Editor, Daily Profit Hunter

3 | Introduction
 Why We Need Derivatives

"Speculators caused the financial crisis"

"Derivative contracts to blame for financial meltdown"

"Soaring commodity prices caused by excessive speculation"

Do these headlines sound familiar to you? Chances are you've heard these more than
just a few times. I certainly have. For many in the media and the general public,
'derivatives' is a dirty word. Throw in the words 'speculators', and now you have
villains too.

The negative attitudes toward to derivative stems in large part from misinformation.
Most people don't know the social purpose of derivative contracts. Most of us under-
stand why equity markets are important. They are useful for companies to raise cap-
ital for investment. But why are derivatives important? And why do we need them?

The main purpose of derivatives is to reduce and hedge risk. Many businesses
and individuals are exposed to financial risk that they would like to get rid of. For
example, an airline needs to buy fuel to power its planes. As a result, the airline is
exposed to oil prices. If oil prices unexpectedly increase, the airline loses out.

How can derivative help here? An airline could purchase oil futures contracts to mit-
igate their risk. Effectively, they can lock in their oil price. Derivative contracts allow
them to get rid of their risk.

Let's take another example. Suppose a farmer sells potatoes. They have a harvest
due in 6 months time. Between now and then, the price of potatoes could fall, and
hurt the farmer. What the farmer can do is use a derivative contract to lock in their
price of potatoes, and get rid of their risk.

Why We Need Derivatives | 4

Let's consider a third example. Consider an Indian multinational corporation that
earns revenues in different currencies. They need to convert their revenues into ru-
pees, and are exposed to risk as a result. They can use a derivatives contract to lock
in their exchange rate. This gets rid of the risk they face from changes in the value of
the rupee.

These examples make it clear why derivatives are important. They allow users to get
rid of risk. But of course, there is a flip side to this. Suppose the hedger takes a de-
rivative position to get rid of their risk. Who takes the other side of the trade? This is
where speculators and traders come in.

As traders, we take the other side of the trade. We take on the risk that hedgers
want to get rid of. And we take on the risk with the expectation of making a profit.
This is why traders and speculators are needed for the market to function properly.
Without us, the market is not liquid, and hedgers can't reduce their risk. Just like long
term investing serves a social purpose, so does trading. Trading ensures that mar-
kets are liquid.

As traders, we are out to make money. But then so are long-term investors. And so
are businessmen and employees. Even savers putting their money in fixed deposits
are looking to make money. Next time anyone asks you why derivatives are useful,
you now have an answer.

5 | Why We Need Derivatives

 Why Indian Markets have the
Best Trading Opportunities

Derivatives trading is a zero sum game. This means that for every winner, there is a
loser. Whenever we enter into a futures contract, one person has the long side and
the other has the short side. And so one man's gain is another man's loss.

Now the derivatives market is full of different players. There are day traders, swing
traders, hedgers, market makers, central banks, etc. And each of these players has
a different objective. If you are either a day trader or a swing trader, your goal is to
make money speculating on which way the market will move. As simple as that.

And while you are trading, you are competing against other traders. What are some
factors that increase your chances of winning any competition? First, you need a good
strategy that is better than other people's strategies. This is something we spend a lot
of time working on, i.e. finding good trading strategies.

But there is another critical factor to winning this competition. And it is not some-
thing you can control. The critical factor is the number of traders you are com-
peting against. It makes perfect sense. The more competition there is, the harder it
is to win, and vice versa.

When it comes to Indian derivatives markets, this factor works heavily in your favor.
I'll give you an example of something I've been working on to illustrate this point.

Our derivatives trading product Alpha Trader uses algorithms to find patterns and
predict market movements. Over the last year, I've developed an algorithm specifical-
ly for currency trading. And I've tested this algorithm on the Indian currency market
(where all currencies trade against the rupee), and the global currency market (where
all currencies trade against the dollar).

Which do you think was more profitable? Keep in mind that I tested the same algo-

Why Indian Markets have the Best Trading Opportunities | 6

rithm for both markets. In both sets of markets, the algorithm was profitable. But the
Indian currency market was significantly more profitable than the global currency
market.

The global currency market is the largest financial market in the world, with a daily
trading volume of over 4 trillion dollars. And behind this is a huge number of traders.
A lot more traders as compared with the Indian currency market.

The Indian currency market has fewer traders, and as a result there are greater profit
opportunities. In fact, the entire Indian derivatives market has more profit op-
portunities than the corresponding global or US markets.

This is entirely because the Indian markets are newer and there are fewer people
trading them. We don't know for sure how long this will last. But what we do know is
that right now there is an excellent opportunity to make money.

7 | Why Indian Markets have the Best Trading Opportunities

 How to Trade Options

Rs. 4,02,091 crores. The average daily turnover in the Nifty futures and options seg-
ment as of February 2013.

Limited risk and unlimited reward.

This is a sentence any trader or investor likes to hear. And it is exactly what options
trading offers you. When we trade a futures contract, or an underlying asset, we have
two options. We can go long (buy) or we can go short (sell). That's it.

Things are simple when we trade futures. There are only two possible things we can
do, and our goal is simply to predict the direction of the market.

When it comes to options trading, the possibilities are endless. If you want to trade
options, then keep reading. We'll devote the next few articles exclusively to options
trading.

What is an option?

An option contract gives the holder the right to buy (or to sell) the underlying asset at
a particular price on a particular date.

Let's walk through an example of a call option. Suppose we have a 1 month Nifty call
option with a strike price of 8,000. How does it work?

Let's break this down piece by piece.

First, we have a call option. This gives us the right to buy the Nifty index.

Second, our option is valid for 1 month. This means we can exercise our option when

How to Trade Options | 8

it expires a month from now. Or we can sell it any time until then.

Third, the strike price is 8,000. This means we have the right to buy the Nifty at a price
of 8,000.

Now let us think through the possible outcomes from buying this call option.

First, the Nifty could end up falling below 8,000 by the time the option expires. At this
point, what should you do?

You could exercise your right to buy the Nifty at 8,000. But this would be a bad idea if
the Nifty is trading below that level. Why use your option when you can buy the Nifty
cheaper in the marketplace?

So if the Nifty closes below 8,000 when the option expires, the option becomes worth-
less. But what happens if the Nifty closes above 8,000? This is where you start making
money. Now, your option is valuable because you can buy the Nifty at a cheaper price
than what it costs in the market. If the Nifty closed at 8,100, you could exercise your
option and make a profit of 100.

How do we get unlimited reward and limited risk with an option? Well, when you buy
this call option, you pay a one off fee to do so. Once you own the option, you can't
lose any more than what you paid for it initially. If the option expires worthless, you
get nothing. If the option expires a profit, you can make that profit.

As you can see, options trading provides us with opportunities that aren't pos-
sible just by trading the underlying or the future. And this is why options trad-
ing is so lucrative.

But of course, there are caveats.

Trading options is more difficult than trading futures. Let's see why this is.

Go back to our Nifty call option. Remember that the option expires in 1 month. And
we make money of the Nifty index is above 8,000 by the time the option expires.

9 | How to Trade Options

Notice that for your option to make money, you need to correctly predict the direc-
tion of the Nifty and you need to correctly predict the time it will take to make its
move. This option is useless if the Nifty goes up but only after two months.

And so, you are predicting both direction and timing when trading an option.
With a future or underlying asset, you only need to predict direction. And this is what
makes options trading more complex than futures trading.

But of course, just because it's more complex, doesn't mean that you can't learn to
trade options. A little effort to learn about options can go a long way in helping your
portfolio.

How to Trade Options | 10

 Using Options to Generate Income

Most investment strategies aim to do one of two things. The first is to protect and
grow wealth. When we invest in long term assets like stocks, our goal is to increase
wealth over time. At the same time, we diversify our portfolios into other assets like
gold to also protect our wealth when time are bad. Or we can use put options to pro-
tect our portfolios.

The second type of investment strategy aims to do something quite different. And
that is to generate income. Generating income means our investment strategy
gives us positive cash flows on a regular basis. And there is an excellent options
trading strategy that does just this.

Suppose you own a stock trading at 100.And since you own the stock, you naturally
think it is going to rise over time. But now further suppose that you think the stock
will rise, but you don't expect it to rise very much.

Let's say that over the next three months, you don't expect the stock to rise beyond
105.This could be for many reasons. Perhaps bad macroeconomic news is affect-
ing stocks negatively. Or perhaps the company is going through a temporary rough
patch.

Is there any way in which we can take advantage of this view? Well, if all you could
trade was the stock itself, then you can't take advantage. But if you can trade options
on the stock, it's a different story. With options, you can make money based on your
view.

How do we do this? We implement a Covered Call strategy. This strategy sells an out
of the money call option on a stock that we own. In our example, suppose there is a
call option with a strike price of 105 that expires three months from now. And sup-
pose that this call costs 3.What do we do?

11 | Using Options to Generate Income

We sell the call option for an instant premium of 3. And then we wait for the option to
expire in three months. Our profit and loss at the end of three months depends on
where the stock price ends up, and what the option is worth at expiry.

The best case scenario is that the stock rises to 105, but not more than that. If the
stock expires between 100 and 105, we make a profit form the stock. The call option
that we sold expires worthless if the stock is below 105.And so we pocket the premi-
um of 3 that we collected earlier.

If the stock closes above 105, we lose money on the call option and simultaneously
make money on the stock. And beyond 105, the profit from the stock exactly offsets
the losses from the call. In fact, it does not matter how far beyond 105 the stock ends
up. We make profits of 0 once the stock goes beyond 105.

If the stock price falls below 100, then we lose money on the stock. But we do keep
the option premium that we earned, so the losses are not as bad.

Can you see what is going on here? When we implement a covered call, we lose the
upside of the stock. That means that if the stock rises very high, we don't earn profits
from this. But what we gain in return is the option premium.So we are giving up po-
tential upside in exchange for current income.

And this is how we can use options to generate income. By writing covered calls, we
can earn additional income at the expense of giving up the upside to the stock.

When is this a good strategy to implement? Precisely when you think the stock isn't
going up very much. If the upside is unlikely to occur, then a covered call will make
you money. It will give you additional income now that you can use to reinvest, or
save in your bank account. And with record breaking volumes hitting the options
markets, now is a great time to learn more.

Using Options to Generate Income | 12

 What Moves the Currency Markets?

The global currency market is the largest financial market in the world, with a daily
turnover that exceeds five trillion dollars. Each day, exchange rates change. Some-
times quite dramatically. Why? What exactly moves the currency markets?

We can break this down into two components. The first is macroeconomic news. The
second is trading behavior.

Macroeconomic news can have dramatic impacts. Interest rates are by far the
most important macroeconomic indicator that drives currencies. What do you
think happens to currencies when interest rates change?

Suppose the rupee interest rate went up while the dollar rate stayed the same. What
currency would you prefer to hold? Well, you want your deposits to earn as high an
interest rate as possible. So you'll buy the currency when the interest rate goes up.
Likewise, if the rupee interest rate fell, this would reduce your incentive to hold ru-
pees.

And so, news about higher interest rates will cause an appreciation in the currency.
And news about lower interest rates will do the opposite. How about other macro-
economic variables? Most of the time, positive macroeconomic news will cause an
appreciation in the currency.

For example, if Indian GDP growth turns out to be higher than expected, the rupee
will appreciate. Or if the Eurozone debt crisis worsens, the euro will depreciate. Sim-
ple, right?

Just because we know how macroeconomic news affects currencies, it does not
mean that it is easy to predict exchange rates. Predicting the currency movement
comes down to predicting macroeconomic news. And in my experience, this is more
difficult than it appears.

13 | What Moves the Currency Markets?

The second component that drives currency markets is trading behavior. This is es-
pecially true for short term market movements. Suppose for example that bad news
leads to a depreciation in the rupee. Now, there may be many traders that had long
positions in the rupee, and the bad news means their stop losses get hit.

So they close out their long positions by selling the rupee. The additional selling of
the rupee can lead to a further fall in the price. The opposite effect can occur when
traders take profits.

Understand how trading behavior impacts markets involves analyzing historical price
data and patterns. It is the foundation for technical analysis and algorithmic trading.

In my experience, trading behavior leads to predictable patterns in the data.

My approach to trading is to exploit these patterns and profit from them. I work on
algorithmic strategies to predict movements in currency markets. And I do the same
for commodity markets.

What Moves the Currency Markets? | 14

 The Carry Trade

Imagine you could borrow money at a low interest rate, and simultaneously lend it at
a high interest rate. For example, you borrow money at 3% interest, and then lend it
out at 6% interest. That would give you a handsome profit, right? This is exactly how
banks make money, when they take deposits at a low interest rate and make loans
at a high interest rate.

You're probably thinking that you can't do this yourself since you're not a bank. But it
turns out you can do this if you are a currency trader. And lots of currency traders do
this already. Let me introduce you to a very popular currency trading strategy called
the 'Carry Trade'.

The Carry Trade seeks to make money from something called the Carry. This is simply
the interest rate differential between two currencies. Suppose you have a currency
pair, and one country's interest rate is higher than the other's. USDINR is a good ex-
ample of this. The short term interest rate in India is 8%, while the same is 0.25% in
the US.

A Carry Trade takes a long position in the currency with a higher interest rate,
and a simultaneous short position in the currency with a lower interest rate.
This effectively allows you to earn the interest rate on the currency you have a long
position in, and pay the interest rate on the currency you have a short position in.

If you went short the dollar and long the rupee, (i.e. short USDINR), you would have
exactly this scenario. You would earn 8% interest on the rupee, and pay 0.25% inter-
est on the dollar. This would net you 7.75% return from the interest rate differential.

This is what happens if you a trading the spot currency pair. If you are trading the fu-
tures contract, it works a little differently. Since you don't earn interest on the futures
contract, you get compensated in a different way.

15 | The Carry Trade

You may have noticed that the USDINR futures prices are always above the spot price
(the RBI reference rate). And the further the maturity, the greater the difference. This
is essentially a result of the interest rate differential. You get to sell USDINR at a high-
er rate than the current spot price, and you can think of it as the compensation you
get from owning a high interest rate currency and selling a low interest rate currency.

Is this strategy too good to be true? Like anything in finance, there is no free lunch.
The Carry Trade comes with risk. The risk is that the exchange rate moves against you
even though you earn the interest rate differential.

Suppose you are Short USDINR. You earn an interest rate differential of 7.75%
per year. But if the rupee falls by more than this amount over the year, you end up
losing money. Even though the Carry Trade gives you an initial advantage, this can be
wiped out if the rupee falls a lot relative to the dollar.

The risk of the Carry Trade is particularly important in times of market turmoil. When
there is panic in markets, Carry Trades lose a lot of money. This is because safe haven
currencies (that typically have low interest rates) rise significantly.

But during normal market conditions, the Carry Trade makes money. In fact, over
long periods of time, the Carry Trade makes money even taking into account the cri-
ses periods. Even though the strategy has considerable risk, it can be very profitable
over long term periods.

The Carry Trade | 16

 The Difference Between Gold and Silver

Here is a graph of the gold to silver price ratio in dollars over the last twenty years,
courtesy of goldprice.org.

Gold to Silver price ratio

Source: goldprice.org

This is what happens if you a trading the spot currency pair. If you are trading the fu-
tures contract, it works a little differently. Since you don't earn interest on the futures
contract, you get compensated in a different way.

The gold to silver price ratio is simply the price of gold divided by the price of silver.
When this ratio is high, gold is relatively expensive as compared with silver, and vice
versa.

When I first started trading commodities, I was fascinated by this ratio. Why do gold
and silver move around so much relative to one another? When is the ratio lower or

17 | The Difference Between Gold and Silver

higher, and why? What is the fundamental link between these two commodities? My
interest in this topic remains as strong as ever; and now I'll share some of what I've
learned about this ratio.

Over the long run, we should expect this ratio to be stable. Why is that? Well, gold and
silver are substitutes for one another. Not perfect substitutes, but substitutes none-
theless. Particularly when it comes to investing, gold and silver often move together,
and tend to represent safe haven demand.

But from this chart, we can learn about some of the key differences between gold
and silver. And if you are buying one of these assets to protect your portfolio, this is
going to be important.

First note that this ratio does not stay above 80 for very long. So when the price
ratio is close to that level, we can expect silver to outperform gold. Right now, we are
above 70, indicating that gold is a little overpriced.

But take a look at what this ratio does in different market conditions. In the early
2000s, during the dot come bubble burst, this ratio goes higher. During the financial
crisis in 2008, this ratio skyrockets. And in the last couple of years, gold has once
again outperformed silver.

Silver tends to do well when market conditions are good. Whenever this ratio drops,
it is usually during times of market increases. The exception has been the most re-
cent data, where silver has been falling alongside most other commodities.

What can we learn from this? Second, gold is a better safe haven asset than silver.
So if you are truly interested in portfolio protection, then gold is the way to go. Silver
on the other hand provides less protection, but is more likely to hold its value when
markets go up.

The reason for this is that silver is also an industrial metal. Demand for silver is driven
in part by industrial needs, and this is positively correlated to the overall market.

Second, gold can protect you during a market crash, but can hurt you afterwards.

The Difference Between Gold and Silver | 18

When the gold price ratio reaches high levels, particularly following a crash, the ratio
then falls dramatically afterwards.

This is one of the major drawbacks of gold. Even if it protects you during a crash, it
hurts you once markets recover.

Third, you can make money trading the gold silver ratio. Keep in mind that this ratio
is stable over the long term only. We can't make money doing this as a short term
strategy. Based on the chart, a good strategy would be to buy this ratio when it is be-
low 50, and sell it when it is above 70. Note that buying this ratio means taking a long
position in gold and a short position in silver.

This type of trade is known as a pairs trade. A pairs trading strategy takes a long
position in one asset and a simultaneous short position in another asset. It makes
or loses money depending on the ratio between the prices of the two assets. In this
case, we are examining gold and silver. But this strategy can be applied to any two
assets that are fundamentally related to one another.

19 | The Difference Between Gold and Silver

 Why Leverage is Good for You

Yes you read that correctly. When most people talk about leverage, they talk about
the dangers. They talk about how you can lose a lot of money very quickly. And they
aren't wrong. But today I'm going to convince you that leverage is an opportunity
rather than a danger. Provided of course you use it properly.

First off, what is leverage? When we trade a futures contract, we typically need to
invest only a fraction of the contract value to enter the trade. For example, the Gold
mini contract on MCX has an initial margin of 5%. This means you need to deposit 5%
of the contract value with your broker to place the trade.

In practice, leverage multiplies your gains and losses. If your margin requirement is
5%, your leverage is 20 to 1. Suppose you take a long position in gold. When the gold
prices increases by 1%, your return on margin is 20%. When gold falls by 1%, your
loss on margin is 20%.

What leverage allows you to do is allocate your trading capital efficiently. Because
you need less money for each trade, you can make more trades. This increases your
returns and lowers your risk via diversification.

In practice, I don't expect the gold price to fall by 100%. So there is no need to allocate
the full contract value when I buy gold. I only need to allocate enough money such
that I can cover whatever losses might occur.

If you are day trading, this amount is going to be small, since you will rarely get moves
greater that 2-3% in a single day. If you are swing trading, you still shouldn't expect
moves greater than 10% over a week or two.

The most important thing is to use leverage correctly. Too much leverage and you'll
be wiped out. Too little leverage and you'll miss out on trading opportunities. How

Why Leverage is Good for You | 20

can you determine the right amount? The best thing to do is follow the 1% rule of
position sizing. Put 1% of your total trading capital at risk for each trade. This ensures
you can get the full benefits of leverage, while keeping your trading capital intact
when you make losses.

Think of leverage as an opportunity. It is an opportunity to allocate only as much as

capital as you need for a particular trade. Remember that you always have the option
of not using leverage. Even if you are trading gold futures, you can always keep the
full contract value in your account. So you should never become worse off by using
leverage. If leverage makes you worse off, just don't use it.

I have seen many traders undone due to leverage. They've suffered large losses on
their account that they've not recovered from. This is a consequence of using too
much leverage. And it is important to keep in mind that leverage is dangerous if you
don't know what you're doing.

But if you do know what you're doing, leverage is a fantastic opportunity. In the long
run, it will significantly improve the performance of your trading portfolio.

21 | Why Leverage is Good for You

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