In this article, let us focus on an interesting segment of trading called Derivatives. Advanced traders and experienced investors are mostly involved in this segment because of its huge potential for wealth creation and portfolio safeguarding opportunities.
Let us understand the basic overview of the Derivative market
A definition of Derivatives will look as below.
Derivatives are legal contracts, risk-shifting instruments with all the specifications pre-determined. - Important keywords are "Contracts" and "Pre-determined Specifications."
There are two types of Derivatives markets
Over the Counter
Exchange-Traded
OTC (Over The Counter Trade)
These are derivatives contracts, where financial instruments are traded directly between two parties, a buyer and a seller, through a dealer network. The contracts' specifications are based on mutual consent between the parties (Buyer and Seller). The contracts are tailor-made and customized based on the requirements of both parties. OTC is traded for smaller companies that do not meet the listing criteria in the Stock market and for different commodities outside the formal stock exchanges.
For example, consider a company that buys raw materials from farmers and produces the finished goods to sell in the market. At a certain point in time, the company expects a huge increase in the demand for the product it produces in the coming few months. And also, it is anticipated that the price of raw materials might increase. And hence it wanted to secure the price of the raw materials. It cannot buy the raw materials right now because the company needs raw materials in the future, and buying right now will make the possibility of raw materials to damage in the future, so it decided to go into contract with farmers.
The company approaches a Broker who arranges a meeting with the farmers and decides on a contract based on the mutual agreement of the farmer and the company. The contract says that the company will buy a certain quantity of raw materials after a certain fixed time at a fixed amount. Here the company asks the farmer to deliver the raw material at a future date with the price of the raw materials fixed right now mentioned in the contract.
The price, quantity, and time are fixed upon discussion between the farmer and the company. After both of them agree, both will finalize the contract. Once they both agree, they both sign the contract. The farmer is happy here because he is getting a fixed price for his produce even before he produces. This makes him secure the price and chance to reduce the loss. In direct, the farmer gets a seller before he harvests the farm.
For the company, the contract benefits as it expects increasing demand for raw materials and hence the difficulty in finding raw materials. Now because of the contract, it can handle the non-availability of raw materials and secure the price at which those are available. During this contract, the company usually pays a certain advance to the farmers as it is the Buyer and paid to the farmer who is the seller. This advance is popularly called a PREMIUM amount paid to the seller by the Buyer of the contract.
Always remember that the Buyer of the contract has to pay a premium, and the seller of the contract will receive the premium. Remember that we are talking about buying and selling the contract, not an asset. Always in derivatives, focus on buying and selling of contract when deciding about premium but not the actual asset.
After that time, the company has to buy the raw from the farmer irrespective of whether it needs it or not and also has to buy at a price fixed in the contract.
There exist no formal rules and mechanisms for risk management in OTC instruments. And market stability and integrity cannot be ensured as these are not usually legal. The risk involved in trading these instruments is considerably high as there is no guarantee or safeguard if the counterparty defaults on the contract. Hence higher risk and the volume is low because of the huge risk.
Exchange-traded contracts:
These are the Derivatives contracts between two parties via recognized exchanges (Like Stock Exchanges) in a Regulated fashion. These are the most popular type of derivative contracts.
The advantage of Exchange-traded contracts over OTC is that they have less risk and high liquidity. And also, there exists Standardization and Minimizing the risks. Exchanges set the standards for the quantity of the assets allowed to trade and the quality of the assets before allowing to trade. They make it easy for investors or traders to decide the quantity to be traded and minimize the risk.
Default risk from both counterparties is eliminated. Exchange Will, itself, acts as a counterparty for each of the Trader and hence ensures no defaulter exists. That is, the Exchange act as a buyer for a seller of the contract, and it acts as a seller for a buyer of derivates contracts.
Another important feature is the Mark to Market feature of Exchange Traded Contracts. Profit and loss are calculated daily for each of the contracts, ensuring sufficient funds are blocked from the counterparty to reduce the default probability. The risk is eliminated to the maximum extent by ensuring funds availability promptly. And also, in case the party fails to respect the contract to deliver the contract terms, the exchange at the cost of the defaulted counterparty will arrange for an auction and make sure that the one counterparty default will not create a loss to another party.
Because of these precautions from exchanges, high liquidity and Low risk exist. And hence a high volume of trades are executed daily in these instruments.
Derivates are a type of Instrument that are traded on the stock market/stock exchanges. Our focus will be completely on Derivatives trading on Stock exchanges, as trading contracts outside stock exchanges is risky.
These derivative derive their value from an underlying asset. These assets can be anything from Stocks, Bonds, Commodities, and currency. When we say they derive their value from the asset, we mean that when the price of the underlying asset changes, the value of derivatives changes.
The value of the derivate depends on other market products (Stocks, Bonds, Commodities, currency), as we said earlier. The value of the derivate changes concerning the change of those assets on which the particular derivate depends. Now, this may be an advanced Definition for you to understand. Just remember that a Derivative is like any other asset whose price changes according to another asset.
The following are the most popular types of derivatives. These interns include thousands of individual derivatives which investors can trade.
Forward Contracts
Futures Contracts
Options Contracts
Now to make you understand, let's analyze a simple example. Now consider company "A," a public company whose shares are trading in the stock market. The current market price of each share is 550 Indian rupees. Recently the company announced its financial results, and you are impressed by its performance on seeing the financial results surprising. And also, in the notification company has announced some new projects that may be coming in the future, say the next few months. Now seeing all this positive news, you are of the view that the stock price will move to around 900 rupees within four months.
But you need to determine how the market responds to the price change. And you are planning to buy the company's shares after three months. But what if the price share increases after three months? You will lose the option to buy the shares at the current price.
You want a situation where you can buy the shares of Company A at the current price of 550 rupees but after three months. The Futures contract provides this option. In a futures contract, you come into contact with a seller of shares of company A. The contract is that you will buy the shares of Company A after three months from the seller for rupees 550 rupees.
You want to buy a future contract of that stock. The current stock price is 550 rupees, and you expect to increase it to 900 rupees in 3 months, and you want to keep this option. So you decided to buy a futures contract for three months. In future contracts, you enter into a contract with the seller who is ready to sell the shares of company A.
This means that after three months, if you want to buy the shares of the company, the seller has to sell you the share at rupees 550, whatever may be the price of the shares after three months. Because you have entered into a contract with the seller, you can buy the shares at 550 rupees. So if the price moves above 550 to, let's say, around 800 rupees, then you will use the contract and buy shares from the seller at 550 and sell them at the increased current market price of 800 and make a profit. But if the price falls below 550 after three months, for some reason, you incur losses as you buy the shares at 550 rupees, but the market price is less than 550 rupees.
Now, why does each party, the Buyer and Seller, come into a contract? The Buyer of the Futures contract believes that the price will increase, safeguarding the price he comes into contact with. But the seller believes that the price will go down, so he wants to secure the price at which he can sell the shares, so he comes into contact with the buyers.
These contracts are called Futures contracts, where you enter a contract to trade the underlying asset at a fixed price after a pre-determined expiry period. The following are the mandatory specifications of a Futures contract
The underlying asset which both parties will trade
Price of the asset at which parties will trade the asset
quantity of the assets that parties will trade.
Time for Expiry of Contract. (the date on which parties will trade the asset)
Different types of Derivative Participants
Hedgers – The main of these participants is No profit, no loss. A situation where no profit and no loss is expected only to safeguard the entire portfolio's value from adverse price movement. This is also termed the Locked position by combining different positions and strategies. We will learn these strategies in the coming lessons. Hedger faces risk with the price of an underlying asset and hence uses derivatives to reduce market exposure. Financial institutions, large Institutions, and others use these contracts to reduce exposure due to fluctuations in inflation, interest rates, exchange rates, etc.
Speculators- They predict the future price, and based on the view, they take a position in the derivative contracts. They buy low and sell high or sell high and buy low. They take a large risk for a quick profit. These participants mainly aim to gain quick profit at the high-risk cost. They take positions based on many key factors and take positions. It is less expensive to take a position in the derivatives market than to take a position in the underlying asset market.
Arbitrageurs: Buying and selling simultaneously to make the risk of fewer profits. The deal makes a profit by exploiting price differences in two different markets. For example, buying in NSE and selling in BSE. Buying in the Cash market and selling in the Futures market and similar.
Now you might know what derivatives are in the stock market. There are far more advanced concepts in derivates segments. Let's dive in one by one and understand every concept in detail.