What are Derivatives?
Financial derivatives have changed the world of finance through the creation of innovative ways to comprehend, measure, and manage risks. Derivatives are meant to facilitate the hedging of price risks of inventory holdings or a financial/commercial transaction over a certain period. By locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors, and thereby, serve as instruments of risk management. The derivative market was introduced in India in the year 2000 and since then it’s gaining great significance like its counterpart abroad.
“Derivatives are financial securities and are financial contracts that obtain value from something else, known as underlying securities. Underlying securities may be stocks, currency, commodities or bonds, etc.”
By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets,
increasing market liquidity and efficiency, and have facilitated the flow of trade and finance.
Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation/trading, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps.
Derivatives can either be exchange-traded or traded over the counter (OTC)
Exchange refers to the formally established stock exchange wherein securities are traded and they have a defined set of rules for the participants. Whereas OTC is a dealer oriented market of securities, which is an unorganized market where trading happens by way of phone, emails, etc.
Why should you invest in the Derivatives Market?
A derivative product can be structured to enable a pay-off and make good some or all of the losses if gold prices go up as feared.
Physical Settlement - Earn money on shares that are lying idle
Benefit from arbitrage
Hedging - Protect your securities against fluctuations in prices
Transfer of risk
Trading
Trading in the Derivatives Market
If you are new to Derivatives and have some prior knowledge of the stock market, then follow these simple steps before you start trading in derivatives. Hence you can also join the Stock Market Institute In Delhi for the proper guidance of the stock market under the well-experienced faculty, including the derivatives market
Do your Research
Select stocks and Contracts as per your budget
Get Margin amount
Conduct Trade
Settlement
Note: Trading in the derivatives market is very similar to trading in the cash segment of the stock markets. This has 3 key prerequisites –
Demat Account
Trading Account
Margin Maintenance
What are the Types Of Derivatives?
The main instruments for derivatives trading in India are future contracts, options contracts, swaps, etc. These instruments are originally meant for hedging purposes. However, their use for speculation can’t be ruled out.
A forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at an amount agreed upon today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.
Example :
Suppose you need to buy some gold ornaments say from a local jewelry manufacturer XYZ Gold Inc. Further, assume you need these gold ornaments some 3 months later in the month of December. You agree to buy the gold ornaments at INR 54000 per 10 gram on 15 March 2020. The current price, however, is INR 53600 per gram.
This will be the forward rate or the delivery price four months from now on the delivery date from the XYZ Gold Inc.
This illustrates a forward contract. Please note that during the agreement there is no money transaction between you and XYZ Gold Inc. Thus during the time of the creation of the forward contract no monetary transaction takes place. The profit or loss to the XYZ Gold Inc. depends rather, on the spot price on the delivery date.
Now assume that the spot price on delivery day becomes INR 54100 per 10 gram. In this situation, XYZ Gold Inc will lose INR 100 per 10 gram and you will benefit the same on your forward contract. Thus, the difference between the spot and forward prices on the delivery day is the profit/loss to the buyer/seller.
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Future Contract |
Forward Contract |
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Traded on Organized Stock Exchange |
Over the Counter (OTC) in nature |
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Standardized contract terms, hence more liquid |
Customized contract terms, hence less liquid |
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Required margin payments |
No margin payments |
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Follow Daily Settlement |
Settlement happens at the end of the period |
Along with some exceptions to forward contracts, there are future contracts. What makes future different forward contracts is that we trade futures on stock exchanges while forward on the OTC market. OTC or the over the counter market is a marketplace for typically forward contracts.
An option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction—that is to sell or buy—if the buyer (owner) "exercises" the option. The buyer pays a premium to the seller for this right. An option that conveys to the owner the right to buy something at a certain price is a "call option"; an option that conveys the right of the owner to sell something at a certain price is a "put option".
Example:
Consider the same example. Let us now suppose that the seller XYZ Gold Inc. believes that the spot price may rise above INR 54000 per 10 gram during the forward contract agreement with you. So to limit loss, XYZ Gold Inc. purchases a call option for Rs. 1050 at the exercise price of INR 54000 per 10 gram with the three months expiration date.
The exercise price is technically known as a strike price. Similarly, the price of the call option is technically known as the option price or the premium.
Actually, the call option gives the buyer the right to buy the gold at the strike price on the expiration date. However, there is no obligation to buy on the expiration date. He may or may not exercise his right on the expiration date. If the price is in the favor of the buyer he will exercise his rights and will receive the intrinsic value from the writer of the option.
For instance, if the spot price decline below INR 53600 our XYZ Gold Inc will choose not to exercise the option. In this way, his loss would be limited to the premium of INR 1050 per 10 gram.
In an alternative situation, when you expect the price to fall below the spot price in the future, you have the option to purchase put options. Buying a put option provides you the advantage to sell at the strike price on the expiration date. Here also you have no obligation to exercise your right.
The swap contract involves an exchange of cash flows over time. Swaps are typically done between two parties. One party makes a payment to the other. This depends on whether a price is above or below a reference price. This reference price is the basis of the swap contract and is there is mention regarding it in the contract.
Some Rules of investing/trading in the Derivatives market
Always have a stop loss - if not, it would be like driving a car without the brakes
Always have a cap on your losses
Always have a definite profit target in your mind
Never believe what people say as most of them aren’t qualified for it
Always go with the trend
Who are the participants in derivatives markets?
This investor buys an asset at a cheaper rate from one market and sells it at a higher price in another market, where the investor is taking the minimum risk. This price gap is very brief and it narrows down quickly, and the arbitrageurs might lose the opportunity.
Hedging is minimizing risk or loss. In the market, an investor who protects his investment from unfavorable price movements is called a hedger. Hedger tries to limit the risk by buying put options by paying a fixed amount known as premiums.
They are the risk-taker, they take high risk expecting higher gains in the short-term. They buy stock with an expectation of price rise and sell them at a high price level. This situation can make high gains for an investor though it also has a very high risk of losing your money.
Start with a demonstration class.
