What are Derivatives?

If you are a novice in the stock markets, you may have heard TV anchors or financial websites mentioning the F&O market. F&O stands for futures and options. These are called derivatives. Derivatives are so named because they are “derived” from an underlying asset class which can be equities, currencies, commodities, etc. The common factor between all underlying asset classes, is that they carry the risk of change in value.

A derivative contract is an agreement between a future buyer, and a future seller based on a value that is closely linked to the current market price of the instrument. When you are investing in a derivative you are actually placing a bet on whether the value of the asset will increase or decrease within a certain period of time. The most common of types of derivatives (and the most actively traded) are futures and options.

Derivatives can be used to hedge or protect one’s portfolio against price risk or the risk of the price of the underlying asset going in an unfavorable direction. However, when used without adequate knowledge or recklessly, they can be agonizing. Warren Buffet has thus famously called them “weapons of mass destruction.”

The most popular kind of derivatives and what they mean

Futures

A futures contract is a legally binding agreement between the buyer and seller. In this contract the two parties agree to make the transaction at a future date based on a speculation they are making about the underlying asset. The quantity, delivery time and date of settlement are mentioned in the contract. On the pre-stipulated date, the transaction is settled by taking delivery of the underlying stocks, and you simply pocket the profit or the loss as a result of the sale.

Short selling of a futures contract

If you are absolutely sure that a price of a stock is overvalued, you can “short sell” in the furtures market technique called “short selling”. A short sale can be made when the prices of a stock are expected to drop. Although this is a speculative call, if you have reason to believe that the stock price will definitely fall, you could offset the position with a buy and make a neat profit by this transaction.

Let’s consider an example with you as a short seller. Here is how you go about your short selling transaction step by step

• You sell a lot of 100 shares of company XYZ at a price of Rs 10 each
• As expected by you the price of XYZ drops to Rs 8 per share
• You buy back a lot of 100 shares at Rs 8 each
• You make a profit of Rs 200 by short selling XYZ.

Options

In the case of futures, the buyer and seller is obligated to make the transaction and square off the deal. However there is another type of derivative contract called options. That are a little different from Futures and enhances the chance of the profits of the dealer as well as reduces the chances of his losses.

The buyer of an Option has the right to go through with the sale but is not obligated to make the sale at a pre determined price within the end of a stipulated time period. However, since the seller of the option can use his discretion to exercise his right to sell, he needs to compensate the seller by paying a premium.

Options are of two types

Call Option and Put Option

• Call option gives a right to the holder to buy the asset at a fixed price while Put option gives the right to sell at fixed price. The price at which the holder decides to buy or sell his option is called the strike price or the exercise price.
• At the time of settlement, the seller of the option, must pay the buyer the difference between the strike price and the price of the underlying stock.
• In the Indian context, all options are excercisable on the date of expiry. This method is called the European Option, and is the only one prevalent in India.
• In international markets the holder has the choice of excercising his option on or before the date of delivery. This is called the American option.

Now let us understand this with appropriate examples

An investor buys a call option of stock X at a strike price of Rs 3500 at a premium of Rs 100. If the market price of X is more than Rs 3500 he would like to exercise his option. Suppose the price of X moves up to Rs 3800 (in the spot market) he will exercise his option by buying one share of X from the seller of the option at the 3500 and sell it in the market at Rs 3800. His profits would thus work out to be Rs 200 {Spot price (Rs 3800) - strike price (Rs 3500) – premium (Rs 100) = 200}

An investor buys a put option on stock Y at a strike price of Rs 300 and pays a premium of Rs 25 on it. If the price of Y is less than Rs 300 he would want to exercise his option. Suppose the price of Y falls to Rs 260 in the spot market, he immediately buys Y at a price of Rs 260 in the spot market and sells Y by excercising his option in the derivatives market . He thus makes a profit of Rs 15. { Strike price (Rs300) – Spot Price (Rs 260) – Premium (Rs 25)= Rs 15}

Margin and the contract value

In order to ensure that an investor does not ditch the exchange after having entered into a derivatives contract, the exchange asks for a margin- which is a deposit of safety. The margin is a certain portion of the contract value ( may range from 15 to 50% and is determined by the broker or the exchange). On the day you buy or sell your futures contract you need to pay this margin. On the day your contract gets over (the future date) you get back your margin plus whatever profit you may have made or the loss amount is deducted from your margin amount.

Mark to market

The difference between the spot price and the agreed future price of the underlying stock is called mark to market. You can incur a mark to market profit or a mark to market loss depending upon the price of the spot.

Square off

On the agreed date that a derivatives contract comes to a close the exchange will square it off. This means all buyers and sellers of derivatives contracts will be given their margins back with their profits or minus their losses. For convenience sake, in India there are only three open dates when such transactions can take place. These are the last Thursday of the current month (when a contract has been entered into) the last Thursday of the month after that and the last Thursday of the following month. In trading parlance these are referred to as month, month +1 and month +2.

The risk factors and how to manage derivative trading

Derivatives, as you may have figured by now are great tools to maximize your profits and reduce your risks. But that having said, they do come laced with inherent risks since they are based on speculation. So here are some words of caution for you, before you consider trading in derivatives.

• Firstly, consider derivatives as an avenue of diversifying your portfolio only after your financial needs are taken care of.
• You need to have a thorough understanding of the markets and the financial acumen required to use derivatives as a tool to take advantage of market conditions.
• Conduct thorough research before you decide upon a strategy. Textbook formulas will not work in derivatives market as the market conditions differ and you need to make a judgement call based upon your views of the market at the time you are entering into a derivatives contract.
• Keep the requisite margin amount ready in your trading account at all times. Also bear in mind that due to market conditions that underlying stock may rise or fall drastically, so keep the extra money in your account to deal with such a situation.
• Consult with your broker beforehand if you intend to deal in derivatives. The required services need to be activated for you to deal in them.