Derivatives are financial contracts that derive their value from an underlying asset. These underlying could be stocks, indices, commodities, currencies, exchange rates, or the rate of interest. Over the last few decades, derivatives market has seen a phenomenal growth. Many derivative contracts were launched at exchanges across the world. The reason of the growth was mainly because of increased fluctuations in underlying asset prices, Integration of financial markets globally, Enhanced understanding of market participants, sophisticated risk management tools to manage the risk and frequent innovations in derivatives markets.
There are mainly four kind of Derivatives products
Forwards : It is a contractual agreement between two parties to buy or sell an underlying asset at a certain future date for a particular price that is predecided on the date of contract. Both the parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of expiry of the contract. Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over-the-counter (OTC) contracts.
Futures : It is a contract which is similar to a forward, except that the transaction is made through an organized and regulated exchange rather than being negotiated directly between two Parties.
Options : It is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, if the buyer exercises his right.
Swaps : It is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula. Swaps help market participants to manage risk associated with volatile interest rates and currency exchange rates.
There are broadly three types of participants in the derivatives market - hedgers, traders and arbitrageurs. An individual may play different roles in different market circumstances.
Hedgers : One who uses derivatives to reduce their risk.
Speculators / Traders : Those who trade in market based on their view to take positions in desired contracts. Derivatives are preferred over underlying asset for trading purpose, as they offer more leverage, more liquidity and less expenses as generally transaction cost is lower compare to spot market.
Arbitrageurs : In this process traders purchase an asset cheaply in one exchange and simultaneously sell it at a higher price in another exchange. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to these transactions, thus closing the price gap at different locations.
Why to use Derivatives
Leverage- As it requires some percentage of margins compare to entire value of trade.
Liquidity- More liquid because of its leverage and low cost nature. Higher the liquidity, lesser will be impact cost for trades.
Hedging- To protect against short term fluctuation in prices
How the Derivatives trading is being conducted
Suppose a person buys a Futures contract of Reliance at Rs. 1250 which has the lot size of 500. A month later, the stock is trading at Rs 1300. This means, He makes a profit of Rs. 50 per share and in total Rs. 25,000 per lot. Similarly, if the stock price falls by Rs. 50, he will loss Rs. 50 per share and in total Rs. 25,000 per lot. Similarly, derivatives trading can be conducted on the indices also. Nifty and Bank Nifty Futures are very commonly traded derivatives contract in the stock markets. The underlying security in the case of a Nifty Futures contract would be the 50 share Nifty index. As per the rule of SEBI, value of Derivatives contract should be more than five lakh rupees and all these stocks can be traded in their assigned lot size and multiple of that.
How to trade in Derivatives Market
1. First do your research or take the expert advice : This is more important for the derivatives market. Derivatives trading can be done only in available Derivatives contracts. In NSE F&O segment we have three contract months at a time which expires in their respective expiry date which is usually last Thursday of the month. So traders need to exit before the expiry else it will auto settle on the expiry day. So it requires more accurate and time bound view compare to the buying shares in delivery.
2. Arrange for the requisite margin amount : Derivatives contracts are initiated by just paying the small margin and requires extra margin in the hand of traders as per the stock fluctuation. Also remember that the margin amount changes as the price of the underlying stock rises or falls. So, always keep extra money in your account.
What are the pre requisites for Derivatives trading
1. Trading account : You can conduct your trades through online trading account. The account number can be considered your identity in the markets. This makes the trade unique to you and needs to open with reputed and well known broker like “Motilal Oswal” who can provide you research support, better and personalised services.
2. Margin maintenance : This pre-requisite is unique to derivatives trading, when you purchase futures contracts you are required to deposit only a percentage of the value of your outstanding position, irrespective of whether you buy or sell futures. This mandatory deposit is called an initial margin. You are expected to deposit the initial margin upfront. How much you have to deposit is decided by the stock exchange as per the volatility of particular derivatives contract.
The exposure margin is used to control volatility and excessive speculation in the derivatives markets. This margin is also stipulated by the exchanged and levied on the value of the contract that you buy or sell. Besides the initial and exposure margins, one has to maintain Mark-to-Market (MTM) margins. This covers the daily difference between the cost of the contract and its closing price on the day of purchase. Thereafter, the MTM margin covers the differences in closing price from day to day.
Forward/futures contract is a commitment to buy/sell the underlying and has a linear pay off, which indicates unlimited losses and profits. Some market participants desired to ride upside and restrict the losses. Accordingly, options emerged as a financial instrument, which restricted the losses with a provision of unlimited profits on buy or sell of underlying asset. An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset on or before a stated date/day, at a stated price, for a price. The party taking a long position i.e. buying the option is called buyer/ holder of the option and the party taking a short position i.e. selling the option is called the seller/writer of the option.
The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, option buyer/holder will exercise his option only when the situation is favourable to him, but, when he decides to exercise, option writer would be legally bound to honour the contract.
Options may be categorized into two main types :
Call Options : Option, which gives buyer a right to buy the underlying asset, is called Call option
Put Options : Option which gives buyer a right to sell the underlying asset, is called Put option.
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.