Nitish is new to the financial market and wants to know more about Derivatives. What exactly does the word Derivatives mean? How does it reduce the risk involved in a transaction? How can a person trade in Derivatives? His friend Naren answer all these questions. The following is a brief conversation between them.
Nitish: What are derivatives?
Naren: Derivatives, are financial contracts which derive their value from a spot price, which is called the “underlying”. Two popular derivatives are: futures and options. The term “contracts” is often applied to denote the specific traded instrument, whether it is a derivative contract in commodities, gold or equity shares. The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange, real estate etc.
Nitish: What is a forward contract and why is it useful?
Naren: In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.
Forward contracting is very valuable in hedging and speculation. If a speculator has information or analysis which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction making a profit.
Nitish: What is a futures contract?
Naren: Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardized, and trading is centralized (on a stock exchange). There is no counterparty in futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Futures markets are highly liquid as compared to the forward markets.
Nitish: What are various types of derivatives instruments traded at exchanges?
Naren: There are two types of derivatives instruments traded on Exchanges; namely Futures and Options:
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.
Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore is obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types – Calls and Puts options:
“Calls” give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
“Puts” give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. All the options contracts are settled in cash.
Further, the Options are classified based on the type of exercise. At present, the exercise style can be European or American.
American Options – American options are options contracts that can be exercised at any time up to the expiration date. Options on individual securities available at NSE are American type of options.
European Options – European options are options that can be exercised only on the expiration date. All index options traded at NSE are European Options.
Nitish: Why should I trade in derivatives?
Naren: Futures trading will be of interest to those who wish to:
- Invest – take a view of the market and buy or sell accordingly.
- Price Risk Transfer (Hedging) – It is buying and selling futures contracts to offset the risks of changing underlying market prices. Thus, it helps in reducing the risk associated with exposures in underlying market by taking a counter- positions in the futures market.
- Leverage- Since the investor is required to pay a small fraction of the value of the total contract as margins, trading in Futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin.
Thus the Leverage enables the traders to make a larger profit (or loss) with a comparatively small amount of capital.
Options trading will be of interest to those who wish to:
- Participate in the market without trading or holding a large quantity of stock.
- Protect their portfolio by paying small premium amount.
Benefits of trading in futures and options:
- Able to transfer the risk to the person who is willing to accept them.
- Incentive to make profits with minimal amount of risk capital.
- Lower transaction costs.
- Provides liquidity, enables price discovery in underlying market
- Derivatives market are lead economic indicators.