What is a Derivative

A derivative is a financial security with a value that is reliant upon or derived from an underlying asset or group of assets. The derivative itself is a contract between two or more parties based upon the asset or assets. These financial instruments help you make profits by betting on the future value of the underlying asset. So, their value is derived from that of the underlying asset. This is why they are called ‘Derivatives’.The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

The value of the underlying assets changes every now and then. For example, a stock’s value may rise or fall, the exchange rate of a pair of currencies may change, indices may fluctuate, commodity prices may increase or decrease. These changes can help an investor make profits. They can also cause losses. This is where derivatives come handy. It could help you make additional profits by correctly guessing the future price, or it could act as a safety net from losses in the spot market, where the underlying assets are traded.

There are many kinds of derivatives available to market participants.

A stock option is a contract to either buy or sell a specific stock at a set price at any time before the contract’s expiration. A “call” option provides the option buyer the right to buy stock at the specified price while a “put” option offers the right to sell stock at a pre-determined price. For example, if a stock with ticker ABC is trading at $100 per share, a call option may provide the buyer the right to purchase shares of ABC at $110 per share at any time between the contract’s purchase and its expiration date. The contract may expire within the month or years from now. The contract has little value to the option holder unless ABC rises in price. But if ABC eventually trades for $120 per share, the call holder can purchase shares at a discount to the market rate. Alternatively, the option-holder can simply sell the contract on the open market for a profit, as the contract is now more valuable.

Futures Contracts
Futures are speculative derivatives where the underlying entity is a stock market index, a commodity or other economic vehicles. The two parties in a futures contract are simply speculating on the future value of the underlying entity and making a wager of sorts based on this opinion. Futures are “cash-settled” derivatives that trade on the open market. While stock options settle in actual shares should the option holder choose to execute the contract, futures do not provide a contractual item or entity as part of the derivative’s terms. Instead, if the holder of a future contract chooses to execute its terms, she simply receives cash if her speculation was correct. Most often, futures traders simply sell the contract itself later for a profit or loss caused by changes in the underlying’s value.

Forwards Contracts
A forward contract is drawn up between two parties who agree to transfer cash between each other based on the outcome of market conditions. Each party has an opposing opinion of how the underlying entity is likely to change in value. The underlying entity can be anything as the contract is entirely customizable. For example, the two parties may structure the forwards contract around the prediction of a price change in a single stock or an entire stock market index. When the stock moves, one of the contract’s members was correct in their prediction while the other was wrong. Thus, the loser pays the winner the cash specified by the contract. But these contracts can be much more complex than this as there is no limit to the creativity the contract’s participants may use when drafting the agreement. Futures are one form of a forward, but they are standardized to facilitate easy trading by the masses.

Why use Derivatives:

  • Earn money on shares that are lying idle: So you don’t want to sell the shares that you bought for long term, but want to take advantage of price fluctuations in the short term. You can use derivative instruments to do so. Derivatives market allows you to conduct transactions without actually selling your shares – also called as physical settlement.
  • Benefit from arbitrage: When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets.
  • Protect your securities against fluctuations in prices The derivative market offers products that allow you to hedge yourself against a fall in the price of shares that you possess. It also offers products that protect you from a rise in the price of shares that you plan to purchase. This is called hedging.
  • Transfer of risk: By far, the most important use of these derivatives is the transfer of market risk from risk-averse investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is transferred. There are a wide variety of products available and strategies that can be constructed, which allow you to pass on your risk.

Trading in the derivatives market :

Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.

  • First do your research. Remember that the strategies need to differ from that of the stock market. For example, you may wish you buy stocks that are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market, this would need you to enter into a sell transaction. So the strategy would differ.
  • Arrange for the requisite margin amount. Stock market rules require you to constantly maintain your margin amount. This means, you cannot withdraw this amount from your trading account at any point in time until the trade is settled. 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.
  • Select your stocks and their contracts on the basis of the amount you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have to pay a small amount to buy the contract.
  • You can wait until the contract is scheduled to expiry to settle the trade. In such a case, you can pay the whole amount outstanding, or you can enter into an opposing trade.