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Case Study: The Derivative Disaster of Rohan
Rohan, a young and ambitious investor, had been trading in the derivative market for a few years. He had made some successful trades and had built a reputation among his peers as a savvy investor.
In 2020, Rohan decided to invest in a call option contract for a popular tech stock, expecting the price to rise. He bought 100 call option contracts with a strike price of $50, expiring in three months. The premium paid for each contract was $5.
Initially, the stock price did rise, and Rohan’s investment seemed to be paying off. However, in the second month, the company announced a surprise dividend payout, which led to a sharp increase in the stock price. The price skyrocketed to $80, far exceeding Rohan’s expectations.
While this might seem like a good thing, Rohan’s call option contract had a limited upside. Since he had paid a premium of $5 per contract, his profit was capped at $25 per contract ($80 – $50 – $5). However, he had to pay a massive margin call to maintain his position, as the broker required him to deposit more funds to cover the increased value of the contract.
Rohan was caught off guard and didn’t have sufficient funds to meet the margin call. He was forced to liquidate his position at a huge loss, losing $30,000 in a single day.
*The Turning Point*
Devastated by his loss, Rohan realized that he needed to learn from his mistake. He began to study hedging strategies and soon discovered the concept of delta hedging.
Rohan understood that by buying a call option, he had taken a bullish view on the stock. However, he had not hedged his position, leaving himself exposed to unlimited losses.
To mitigate such risks in the future, Rohan decided to implement a delta hedging strategy. He started by buying a call option and simultaneously selling a portion of the underlying stock.
By doing so, Rohan reduced his exposure to the stock’s price movement, limiting his potential losses. He continued to monitor the market and adjust his hedge accordingly, ensuring that his delta remained neutral.
*The Comeback*
A few months later, Rohan spotted another trading opportunity. He bought a call option contract for a different stock, but this time, he implemented his delta hedging strategy.
As the stock price moved, Rohan adjusted his hedge, buying and selling the underlying stock to maintain a neutral delta. When the option expired, Rohan closed his position, having made a modest profit.
Although the profit was not spectacular, Rohan was thrilled to have recovered from his previous loss. He had learned a valuable lesson about the importance of hedging in the derivative market.
*Conclusion*
Rohan’s story serves as a cautionary tale about the risks of trading in the derivative market without proper hedging. However, it also highlights the importance of learning from mistakes and adapting to new strategies.
By implementing a delta hedging strategy, Rohan was able to mitigate his risks and eventually make a profit. His story encourages traders to be mindful of their exposure to market volatility and to explore hedging strategies to manage their risk.
*Discussion Questions:*
1. What are the risks associated with trading in the derivative market?
2. How can delta hedging help mitigate these risks?
3. What are some common mistakes that traders make when using derivatives?
4. How can traders adapt to changing market conditions and adjust their hedging strategies accordingly?
*Share Your Thoughts!*
We’d love to hear from you! Share your comments, questions, or experiences with hedging strategies in the derivative market.
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