If you are new to trading and investments, you might only be aware of common stock trading or government avenues like PPF and NPS. You may also only know that making money from market-linked instruments is possible only if the stock market is bullish, which means favourable economic conditions are driving stock and securities prices up. But what if we told you making a profit is also possible in a falling market? Surprised, isn’t it? Well, out of the many instruments available in the market, derivatives are the ones that allow you to do this.
What are Derivatives?
Derivatives are financial contracts that assume value from the performance of an underlying index, stocks, commodities, currency, or debt instrument.
These are agreements between parties, and their value fluctuates in line with changes in the underlying asset. Traders use derivatives to manage risk associated with their portfolio or for speculative trading.
How does the Derivatives Market work?
The derivatives segment functions with two primary roles. The first is the buyer’s commitment to acquire an asset at a predetermined price. The second is the seller’s commitment to deliver the asset at that price.
Let’s take a layman’s example to describe this better.
Suppose you are a cotton farmer, and you are concerned that the market price of cotton may decline by the time you harvest. To protect yourself, you sign a futures contract with a buyer who acknowledges to purchase your cotton at a fixed price at a future date. This way, you lock in a guaranteed price and protect yourself from price swings. The buyer could be a textile manufacturer looking to stabilise raw material costs.
History of Derivatives
The history of derivatives is rich and far-reaching, going back to ancient civilisations. In ancient Greece, philosopher Thales used options on olive presses to profit from his harvest forecast.
In Mesopotamia, around the second millennium BC, futures contracts were introduced to manage agricultural risks. They helped farmers secure crop prices and gain financial stability amid unpredictable weather and market fluctuations. Over time, derivatives evolved further. By the 16th century, derivatives on securities were traded in the Low Countries, especially in Amsterdam, eventually spreading to England, France, and Germany by the 17th, 18th, and early 19th centuries.
The 19th century marked a turning point, with the Chicago Board of Trade (CBOT) setting in 1848. This was a crucial development in derivatives history, as it introduced standardised contracts and formal trading methods. The CBOT further led to the creation of the Chicago Mercantile Exchange (CME), which is now one of the world’s most prominent derivatives markets.
Later, the scope of derivatives has grown from commodities to financial assets. The 1970s saw the development of advanced pricing techniques. Stock market derivatives are vital tools for risk management and speculation worldwide in financial markets.
Types of Derivatives
Derivative contracts are of the following four types:
1. Futures
Futures contracts are executed on futures exchanges. They standardise the terms for all transactions. When you buy a contract, you commit to acquiring the underlying asset upon expiration, regardless of the market price at that moment. Conversely, as a seller, you are bound to provide the asset at the agreed price on the designated date. Futures contracts are available for many asset types, including commodities like oil, gold, and crops and financial instruments such as stock indices and currencies.
For example, purchasing an oil futures contract means you will buy a defined quantity of oil at a pre-decided price on an explicitly mentioned date in the future. Similarly, a stock index futures contract permits speculation on the future value of a stock market index, like the S&P 500.
In India, the Multi Commodity Exchange (MCX) and the National Stock Exchange (NSE) are prominent platforms where futures contracts are traded actively. These exchanges provide a regulated environment for trading various futures contracts, ensuring transparency and reducing counterparty risk.
2. Options
An options contract is a financial derivative in the stock market or other market that provides you with the right, but not the duty, to transact an underlying asset at a set value, known as the strike price, before or on an explicit expiration date.
There are two options on the market: call options, which allow you to purchase the underlying asset, and put options, which allow you to sell it. The price you pay for this right is known as the premium. They are affected by factors like the asset’s current price, the strike price, the time left until expiration, and market volatility.
For example, if you believe a company’s stock will increase in value, you might consider purchasing a call option through a derivatives app. This gives you the right to purchase the stock today, regardless of future price hikes. For example, if you buy a call option for a stock priced at Rs 150 with a strike price of Rs 160, and the stock rises to Rs 180, exercising your option allows you to buy at Rs 160 and sell at Rs 180, netting a profit.
3. Forwards
A forward contract is a personalised contract between two parties that allows them to trade an asset at an agreed price on a stipulated date in the future. Unlike standard futures contracts, forwards can be adjusted to fit the specific requirements of the contracting parties, making them highly flexible. Businesses often use such agreements for hedging to secure prices and minimise exposure to price variations in the asset.
Forwards are negotiated directly between parties in an over-the-counter (OTC) market rather than being listed on central exchanges. This OTC structure allows for customised agreements but increases counterparty risk, as no clearinghouse oversees the contract.
For example, consider you a tea exporter expecting to ship 1,000 kilograms of tea in three months. To protect against possible price drops in the international market, you enter into a forward contract to sell your tea at Rs 300 per kilogram. This agreement guarantees you a fixed price, providing stability for your earnings.
4. Swaps
Swaps are derivative contracts in which two parties agree to exchange cash flows or other financial assets for a defined period. Swaps are not traded on standard exchanges; they are tailored agreements negotiated between private entities. Common swap types include interest rate, currency, and commodity swaps.
Examples of Swaps Contracts:
- Interest Rate Swaps: Consider a corporation holding a loan with fluctuating interest rates. To mitigate the risk of rising rates, it enters a swap agreement, exchanging its variable payments for fixed ones with another party. This move ensures the corporation can better manage its interest costs.
- Currency Swaps: Consider an Indian company that borrowed money in US dollars but earns revenue in rupees. To reduce currency risk, it enters into a currency derivatives swap with a US firm needing rupees, agreeing to swap their principal and interest payments in their own currencies.
- Commodity Swaps: A grain producer that relies on wheat might enter into a commodity swap to stabilise wheat prices. By doing this, the company swaps cash flows based on current market rates for those based on a fixed price, reducing its exposure to price swings.
Benefits of Derivatives
The five key benefits of derivatives trading are:
Risk Management
Derivatives can provide you with a safety net as an investor. For instance, if you are a small business owner anticipating that raw material costs will rise, you can use options to set a maximum price today. This way, you protect yourself from potential price hikes, keeping your budget stable even when prices fluctuate.
Speculation:
With derivatives, you can make predictions about future asset prices. For example, if you believe oil prices will increase, you can buy an oil futures contract. If the price rises as expected, you can sell the contract for a profit.
Leverage:
Derivatives do not require you to pay the full value of the asset upfront. This leverage allows you to manage larger investments with less cash. For instance, you might use futures contracts to trade commodities without needing to purchase the physical goods.
Access to Otherwise Inaccessible Markets:
Derivatives provide a means for you to invest in markets or assets that are not easily accessible. For example, a total return swap allows you to benefit from the price movements of a stock without actually owning it, giving you exposure to the stock market.
Price Discovery:
The share market derivatives play a crucial role in assessing future asset prices. For example, bond futures prices can indicate market expectations about future interest rates, helping you to time your bond purchases or sales effectively.
Conclusion
Derivatives are powerful financial tools that can enhance your trading and investment strategies. Whether you want to manage risk, speculate on future prices, or access markets that might otherwise be out of reach, derivatives provide valuable opportunities. Understanding their types—futures, options, forwards, and swaps—along with their benefits can help you benefit from both the rising and the falling markets.
To begin trading in derivatives, you must first open Demat account online with a reputed broker like HDFC SKY.