LET’S UNDERSTAND DERIVATIVES
What are derivatives?
A derivative is a contract between two parties interested in doing derivative trading among themselves. These investors bet on the possible future prices of an asset ( Speculation) . The asset can be anything from stocks, currencies, commodities to interest rates as well. So a derivative is a financial instrument which derives its value from an underlying asset on which the bet is placed.
The value of these underlying assets keeps fluctuating. These changes in value can help an investor to earn profits from derivative trading.
Types of Derivative Contracts
Futures contracts are the ones wherein the investor has agreed to buy or sell assets at a specified time in the future for a specified price which is agreed upon the day of the contract. It is like a bet between two parties. For, e.g., There are two parties, A and B. A owns 10,000 shares of a company and fears that the value of the shares might decline. To avoid losses and save the value of the stocks, A decides to arrange for a futures contract. B is a speculator, who thinks that the value of shares held by A will increase. A and B both get into an agreement through the futures contract based on A’s current value of shares.
If the price of shares increases in the future, then A suffers losses and A earns the profit and vice versa.
Futures trading is done on the exchange. The lot size in derivative markets is specified, hence you cannot buy a single share in a futures contract. There is also on expiry date to the contract. People usually prefer to opt for a futures contract to hedge a certain amount of risk.
Options contracts are quite similar to future contracts. In options contract, you get the right to buy or sell an asset at a predetermined price. But there is one important difference. When you buy an options contract, there is no obligation on you to fulfill the contract or adhere to the terms of the agreement. For, example, if you have agreed to buy 200 shares of a company, you have the right to buy them. But it is not compulsory to do so. You can change your mind and chose not to buy or sell. The buyer has to pay a premium amount to get the right to buy the asset. So in case if the prices fall and the buyer loses, the premium paid is the only loss he has to incur.
This right to buy is provided by the ‘Call Option’ and the right to sell feature is provided by the ‘Put Option’.
If you are selling an option contract, then the seller has the obligation ( not Right) to fulfill if the buyer of option decides to exercise it. Options trading is done on both Over-the-counter and in exchanges. This type of trading requires you to have a better understanding of the market and its fluctuations to avoid losses.
Uses of Derivative Trading in India
Transfer of risk
Earn Without Physical Settlement
Protection for Securities
Participants in Derivative Trading
Speculators are the ones who have a healthy appetite for risks. If hedgers are risk aversive, then speculators are the ones who keep looking for opportunities for high risks, hoping to gain high returns. Speculators provide the market a high level of liquidity.
There is a possibility that the price of an asset in the cash market differs from its price in the derivatives market. A trader who makes the most of this inefficiency is known an Arbitrageur. For, e.g., if the value of a share is Rupees 200 per share in the cash market and the same share is quoted at Rupees 210 in the futures market. An Arbitrageur would buy 1000 shares at rupees 200 in the cash market and at the same time sell 1000 shares at Rupees 210 in the future market and earn rupees 10 profit each share.
Why Trade in Derivatives
Higher Chance of Returns
Difference between Futures and Options
Profit or Loss Potential
Options have a limited loss potential and unlimited profit potential.
In options contracts, the buyer gets the right to buy an asset at a decided price. Though there is no obligation to do the purchase. If the buyer purchases the asset, then the seller has an obligation to sell it to the buyer.
In options trading, if the buyer sees a drop in the prices, then he can choose to opt out from the situation and incur minimum losses.
Execution of Contract
In options trading, the contract execution can take place at any time but before the expiry date.
Payments in Advance
In options trading, the buyer pays a premium to get the right to buy the asset.
How Derivatives Can Fit into a Portfolio for a partial or full hedging
Traders can use naked option or option strategies as per the different market view like Bullish, Bearish, Volatile or Range bound. Commonly used option strategies are Bull Call Spread, Bear Put Spread, Covered Call, Covered Put, Put Hedge, Call Hedge, Straddle, Strangle, Iron Condor, Butterfly, Strip, Strap, Ratio Spread, Calendar Spread, etc.
Participants uses different kind of Derivatives indicators like Open Interest, Put Call Ratio, Basis, Cost of Carry, OI Concentration, Rollover, Roll Cost, Volatility, etc. to understand the market movement.