ABOUT DERIVATIVES

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

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Futures Contract

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.

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Forwards Contract

If, in a futures contract the price is agreed upon and the buying and selling take place in the future, then in the forwards contract the date for buying or selling is pre-decided, and the assets are sold or bought based on the price on the day of transaction. Forward contracts are traded over-the-counter.

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Options Contract

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.

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Swaps

Swap Contract is a very complex derivative. In Swaps, you can change your cash flow from uncertain to certain. This is most commonly done in regards to interest rates and currency. You can swap your fixed interest rate to a floating interest rate. These contracts are not traded on the exchange but are private agreements between two parties. In India, the swap market does not see many takers as the market is highly illiquid.

Uses of Derivative Trading in India

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Transfer of risk

As the derivative markets have takers who are highly motivated to take up risks, a trader who does not want to take risks can transfer it to these risk takers in the market.

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Arbitrage Benefits

This is where you can earn profits dues to the inefficiencies in the market. Derivatives trading involves good returns because of the arbitrage strategy.

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Earn Without Physical Settlement

In any trading to get the final income, you need to settle the trade. In derivatives trading, you don’t need actually to sell your shares, but you can earn profits through contracts in case of price fluctuations.

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Protection for Securities

Depending on your hedging strategy, you can protect your security from a high rate of losses.

Participants in Derivative Trading

Derivatives trading in India involves the following participants. These participants are the financial intermediaries who provide enough liquidity in the market.

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Hedgers

Investors who want to save themselves from the risks of price movements are called hedgers. They partake the process of hedging their investments by doing an opposite trade in the derivatives market to reduce the impact of such fluctuations. The risk is then transferred to somebody who is agreeing to bear it.

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Speculators

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.

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Margin traders

Margin traders are the ones who do margin trading. Margin trading is when you only have to pay a fraction of the total sum. The fraction paid is called margin. This process involves high leverage. There is a fixed limit to how much you can borrow from the broker.

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Arbitrageurs

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

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High Leverage

Derivative trading opens avenues for a high trading exposure. The low rate of margins involved in trading helps you to leverage on high levels and incur minimum losses.

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Liquidity

Derivative trading brings in more liquidity because of high leverage. Liquidity is what attracts investors to invest in derivatives.

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Hedging

Hedging is common in derivative markets. When you hedge position you protect yourself from potential losses.

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Flexible Risks

Every investment involves risks. In derivatives trading, you get to choose between a high risk and a conservative risk strategy which is based on the predicted rise or fall of stock price.

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Higher Chance of Returns

No matter which way the market moves, there are chances that you might incur good returns in derivative trading, given that your strategy is perfect.

Difference between Futures and Options

In India futures and options trading is preferred by investors as a go-to option to trade in the derivatives market. Listed below are the various difference between f&o trading.

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Profit or Loss Potential

Futures have an unlimited potential for both, profits and losses.
Options have a limited loss potential and unlimited profit potential.

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Obligation

In a futures contracts if a buyer agrees to buy or sell an asset on a specified date in the future, then he is obligated to do so.
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.

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Risk Factor

Even if there is a drop in the agreed price, the buyer will have to buy the asset and incur losses in futures trading.
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.

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Execution of Contract

In futures trading, the contract execution takes place on the specified date. That date is when the buyer purchases the underlying asset.
In options trading, the contract execution can take place at any time but before the expiry date.

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Payments in Advance

There are no advance payments in futures contract except the eventual payment for the asset.
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

Investors typically use derivatives for three reasons, to hedge a position, to take the advantage of high leverage or to speculate on an asset’s movement. Hedging a position is usually done to protect against or insure the risk of an asset. For example if you own shares of a stock and you want to protect against the chance that the stock’s price will fall, then you may buy a put option. In this case, if the stock price rises you gain because you own the shares and if the stock price falls, your risk is limited because your Put option will gain you against the losses which you will make in stock.

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.