Derivatives: Meaning, Types and Benefits

Welcome to the world of derivatives, where fortunes are made not only every single day but perhaps even hour or minute! In this world of constant risk, definitely much higher than the previously discussed chapters on stocks and debt, we shall cover some of the key concepts that every derivative trader must know!

What Are Derivatives?

Derivatives are financial instruments that derive their value from an underlying asset, like stocks, commodities, or currencies. You may think of them as contracts betting on the future performance of these assets. They're not the asset itself but a bet on the direction and degree of the price movement.

Types of Underlying Assets in Derivatives

Derivatives can be based on the following underlying assets:

1. Individual stocks e.g. major stocks like Tata Motors may have futures and options being traded on them.
2. Market indices e.g. major market indices like Nifty and BankNifty have futures and options being traded on them. In such cases, the Nifty is not technically an asset, but its value acts as the value of an underlying asset.
3. Currencies e.g. there can be futures on the US dollar valued in terms of the Indian currency. 
4. Commodities e.g. gold and silver have futures traded on it in commodity exchanges.

This level of flexibility in terms of the underlying asset creates a vast scope for speculation and risk management.

Types of Derivatives

There can be various types of derivatives. In India, there are a few types that are particularly used often i.e. options, futures and forwards. We will read about the different types of derivatives in detail in the coming chapters.

What Are Forwards?

Forwards are customised agreements between two parties to buy or sell an asset at a predetermined price on a specific future date. They are often used by businesses for hedging, i.e. to lock in prices for future needs, reducing uncertainty and mitigating price fluctuations.

Example of Forward 

Suppose an oil company worried about falling oil prices agrees to sell 7,000 litres of oil to a buyer exactly 6 months later at a fixed price of ₹55 per litre. Once the contract is signed, the buyer in the contract must buy exactly 7,000 litres of oil at ₹55 per litre, regardless of the market price of oil in the spot market. This forward contract protects the oil producer from potential price drops, ensuring a stable income.

What Are Futures?

While the structure of a future is exactly the same as a forward, futures are standardised contracts traded on exchanges. In contrast, forwards are independently settled and cannot be bought and sold on an exchange. Futures offer greater liquidity and transparency but lack the customisation of forwards. 

Example of Future Trading 

Assume that an investor expects oil prices to rise. He buys a futures contract, agreeing to buy 5,000 litres of oil at a set price of  ₹55 per litre 3 months down the line. If oil prices increase as predicted, say up to ₹65 per litre, the buyer in the contract can sell the contract for a profit of  ₹10 per litre. In that case, the seller will lose out as he could have sold the 5,000 litres at a higher price of  ₹65 per litre in the spot market. However, if during the run-up to the date of expiry, the price of oil in the spot market falls,  the opposite happens and the buyer will lose out. If the buyer senses this early on, they can sell the future at an exchange.

What Are Options?

Unlike futures, options give the buyer the right, but not the obligation, to buy or sell an asset at a specific price by a certain date. They offer flexibility and limited risk compared to buying the asset outright.

Types of Options 

There are two main types i.e. calls and puts. Calls give the right to buy, while puts give the right to sell. Each has various subcategories depending on the exercise price and expiry date. 

Example of Option 

Suppose you're bullish on the stock of XYZ Corporation, which is currently trading at ₹40 per share. You believe the price will rise in the coming months. You decide to buy a call option with the following details:

Option type - Call option
Underlying asset - 100 shares of XYZ Corporation stock
Strike price - ₹45 per share i.e. the price you have the right to buy the shares at
Expiration date - -3 months from now
Option premium - ₹2 per share i.e. the price you pay for the option contract
Total cost of the option - ₹200 (i.e. 100 shares x ₹2 premium per share)

Here are two possible scenarios at expiration:

Scenario 1: The stock price rises to ₹55 per share

You exercise your option to buy 100 shares of XYZ at the strike price of ₹45 per share.

You immediately sell the shares at the current market price of ₹55 per share.

Your profit is ₹1,000 (100 shares x ₹10 profit per share) minus the ₹200 option premium you paid, for a net profit of ₹800.

Scenario 2: The stock price falls to ₹35 per share

You let the option expire worthless because it would not be profitable to exercise it. Your loss is limited to the ₹200 option premium you paid.

What Are Swaps?

Swaps are agreements between two parties to exchange cash flows based on different interest rates or currencies. They're often used by institutions to manage their exposure to interest rates or currency fluctuations.

Example of Swap 

A company with a fixed-rate loan swaps its payments with another company holding a variable-rate loan, potentially benefiting from more favourable interest rates at certain times.

Benefits of Trading Derivatives 

1. Leverage: Derivatives help the average trader to trade in large asset value with smaller investments compared to buying the underlying asset directly, magnifying potential gains/losses e.g., control ₹10,000 stock with ₹1,000 option premium.
2. Hedging: Derivatives can help limit potential losses in existing holdings by taking an opposite position in a derivative against an anticipated price movement. (e.g., buy puts on stocks to protect against a market downturn.)
3. Income Generation: As options gain or lose value with time, you can earn high amounts from options trading, even though the price of the underlying asset does not change much.
4. Market Access: Gain exposure to diverse assets or niche markets that might be difficult or expensive to access directly through derivatives. 

Risks of Trading Derivatives 

• High Leverage: High leverage amplifies losses as well as gains, leading to a significant financial burden if market movements go against your position.
• Complexity: Understanding the diverse types and nuances of derivatives requires significant financial knowledge, increasing error potential for inexperienced traders.
• Unlimited Loss Potential: Unlike owning underlying assets, some derivatives, like options, can result in unlimited losses exceeding the initial investment.
• Margin Calls: Derivatives often require maintaining a minimum equity level (margin) with the broker. Falling asset prices can trigger margin calls, forcing additional deposits or liquidation of positions at a loss.

Which Types of Traders Should Trade in Derivatives?

Derivatives are best suited for experienced traders with a deep understanding of the underlying assets and market dynamics. They require careful risk management strategies and substantial financial resources to handle potential losses. Novice investors should approach derivatives with caution and seek professional guidance.

Final Words 

Derivatives are a powerful tool, but understanding their complexities and risks is crucial. Approach them with caution, prioritise risk management, and seek professional advice if needed. With responsible use, they can unlock unique opportunities and enhance your financial strategies.

It is time now to move on to the next chapter on bonds, a unique investment instrument that holds more risk and volatility than you might have!