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Understanding derivatives and what they mean

We hear or read about them every day. But however much we do read about them, they still seem daunting as ever, don‘t they?

June 06, 2012 / 06:25 PM IST

By Sahaj Agrawal, AVP- Derivatives, Kotak Securities

We hear or read about them every day. But however much we do read about them, they still seem daunting as ever, don’t they?

Welcome to the world of derivatives- a class of instruments that have held the interest of investors over the years. Derivatives are popular given their flexibility, returns and their potential to provide market watchers with indicators of market sentiments.

As Indian markets are experiencing one of their cyclical volatile phases, derivatives, may to some of us, seem a lucrative option. But like every other investment decision, we need to understand them clearly and discover how best to use them to our advantage. Thus, in a series of articles that follow, we will discover and decipher the world of derivatives, the jargon used to communicate and the indicators that define possible successes or profits.

To begin with, let us understand derivatives and what they mean.

Imagine a market where people like you and me have conflicting views regarding the future of stock prices- some of us expect it to rise in the future, while the rest are still sceptical and expect the prices to fall. We trade in a market that allows us complete flow of information and freedom to trade according to our instincts. Given shared knowledge, we would all know how the markets are expected to behave in the coming days and we take our positions- bullish or bearish regards the future price of stocks. This is what forms a typical Derivative Market.

Derivatives are financial instruments that derive their value from other existing asset classes. The term "Derivative" indicates the instrument derives its values entirely from the asset it represents be it equity, bullion, currency, commodity, realty, rate of interest or even livestock. A feature that is common to all underlying assets is that they carry the risk of change in value.

As the value of a stock may rise or fall, an exchange rate may swing in favour of one currency or the other, the price of a commodity may increase or decrease, and so on; it means speculating on forward, future prices, placing an option on possible fluctuations or any other such contract made for the possible realisation of those pre determined values of financial assets or any index of securities. Derivative contracts seek to transfer these risks from an individual who is not comfortable with the risk to the one who is.

Simply put, when you invest in derivatives, you actually place a bet on whether the value of the asset represented will increase or decrease by a certain percentage and within a set period of time. Therefore, derivatives are merely contracts or bets that get their value from existing or future prices of underlying securities. When you deal in derivatives, you are essentially buying a promise from the original owner of the asset to transfer ownership of the asset rather than the asset itself. This promise gives you tremendous flexibility and is by far the most important trait that appeals to investors. 

Derivatives however, are different from equity shares that we hold. Shares are assets while derivatives get their values from the shares being held. The most common types of derivatives that you are likely to come across are futures, options, warrants and convertible bonds.

An options contract gives you the right to buy or sell an asset at a set price on or before a given date. On the other hand, in a futures contract, you are obligated to buy or sell the asset at the end of the contract date.

A futures contract means a legally binding agreement to buy or sell the underlying security at a future date and is an organized contract in terms of quantity, quality, delivery time and place for settlement at a future date. The contract expires on a pre-specified date or on an expiry date and on expiry, futures can be settled by delivery of the underlying asset or cash.

The options contract allows you the right but not the obligation to buy or sell the concerned asset at a predetermined price within or at end of a specified period. The buyer / holder of the option would then purchase the right from the seller / writer for a consideration known as a premium. The seller is then obligated to settle the option as per the terms of the contract or when the buyer exercises his right to buy.
An option to buy is called as a call option and option to sell is called put option. Further, an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date is called European option. This was introduced to increase liquidity volumes in certain segment of options. Currently all the options traded on NSE Exchange are European in nature. The price at which the option is to be exercised is called Strike price or Exercise price.

As in the case of futures contracts, option contracts can also be settled by delivery of the underlying asset or cash. However, unlike futures, cash settlement in option contract includes the difference between the strike price and the price of the underlying asset either at the time of contract expiry or at the time of exercising the option.

As the derivative markets deal in speculation, there is a large amount of risk involved. The Exchanges, however, have a stringent framework for risk control and minimizing loss. But a word of caution to retail investors, invest in derivatives only after taking care of your financial needs and as an avenue of diversifying your portfolio. Derivatives are merely profits that you should earn and not returns that you should bank on.

Derivatives are used to hedge risks and for speculative trades; and active markets need the equal participation of both such investors. By rule of thumb, if you are a cautious investor with limited funds, learn to hedge your bets while if you are ready to take some risk and have ample funds to play the markets, not to mention also possess acumen and understanding of the Indian market trends, play the markets to your advantage.

From the days of badla trading to the more recent foray into the UK equity through the FTSE100 Index, the Indian equity derivative markets have come a long way indeed. However, unless you totally understand the vagaries of this market, proceed with caution to make profits and not losses.

There are three types of participants in a derivatives market: Speculators, Hedgers and Arbitrageurs. Speculators are the high risk takers. They contemplate and bet on the future movement of prices based on their skill and knowledge levels with a higher-than-average risk in return for a higher-than-average profit potential. They take risk to earn profit by buying low and selling high, or by first selling high and later buying low.

Hedgers are cautious players who protect themselves from risk by closely watching price movements and sell as soon as they reaches their optimum price, thus getting an assured price for the stocks. In general, hedgers use futures for protection against adverse future price thereby looking to reduce risk for their holdings and interest. They are extremely important to a derivative market and are primarily responsible for setting future prices.

The person who attempts to profit from inefficiencies in price by making transactions that offset each other is an Arbitrageur. He typically makes his profit by buying low in one market and selling high in another. Arbitrageurs keep market prices stable and reducing possible exploitation of prices. They are typically the most experienced market players who make fast decisions.

We will learn more about these players in our next session. Till then, while dealing in derivatives, do learn to derive- meaning, analysis and profits.

Learning Derivatives: Hedgers, Speculators, Arbitrageurs

Understanding Derivatives: Basics of Futures and Options