Know the meaning of derivatives and the types of derivatives.

Introduction

An investor always puts their money into the financial markets with the aim of getting better returns. But your money gets lost with the volatility in the stock market and price fluctuations. Therefore, you might be thinking of trading or investing in an instrument which can minimize your risk, then derivatives are the best options to consider. So, let’s dive in to understand the meaning of a derivative and its types.

The topics covered in this article are:

• Meaning of Derivatives
• Different types of Derivatives

1. Options
2. Forwards
3. Futures 
4. Swaps

• Participants in the Derivatives Market

1. Hedgers
2. Speculators
3. Margin Traders
4. Arbitrageurs

• Prerequisites for trading in Derivatives

Meaning of Derivatives 

Derivatives or financial derivatives are the contracts which derive its value from the underlying assets which can be assets or any benchmark. These instruments are traded on the OTC (over-the-counter) market or an recognized stock exchange between two or more parties.

The underlying assets can be stocks, bonds, currencies, interest rates, commodities, gold or market indices and their value fluctuates accordingly based on the market conditions. Therefore, these fluctuations provide an investor a potential to earn profits in the future and speculate on them. Suppose you have purchased an equity share of any company and the prices of these shares may fall in the future. Therefore, to hedge the risk you can enter into the derivative instrument.

Apart from hedging the risk of price fluctuations there are several other benefits of trading in derivatives such as low transaction costs, helps in achieving market equilibrium and correct asset pricing. As far as earning potential profits, there is also a risk of high losses too, default risk by any party and they are highly speculative.

There are two types of derivatives market or modes to trade in derivatives which are over-the-counter (OTC) market and exchange traded. The OTC market is highly unregulated and forms a major part of derivatives trading in instruments such as forwards, swaps and other instruments. In another way, exchange traded markets have standardized contracts that also offer derivatives such as futures, options, etc. and require an initial margin from both parties to reduce the counterparty risk.

Different types of Derivatives 

There are four derivatives types wherein you can trade having different conditions, risk and analysis.

Options

Options contracts are the type of derivatives contracts where the buyer of the contracts has the right but not the obligation to exercise the contract at the expiration date. The price at which the contract is exercised is called the strike price and the seller of the contract is called the writer. The buyer pays the premium amount to the writer or seller to get the right.

The US options contracts can be exercised anytime on or before the expiration date whereas European options contracts are exercised only at the time of expiration date. In India, we trade only on US options. 

There are two types of options contracts: call options and put options. A call option gives the buyer the right but not the obligation to buy the underlying asset on the expiration date at the strike price. A put option gives the buyer of the contract the right but not the obligation to sell the underlying asset on the expiration date at the strike price. 

• Illustration of a Call Option 

Suppose the current price of an equity share of ABC Limited is ₹1000 on 22nd December 2022 which is also called the spot price. The option contract for ABC Limited shares is available at the strike price of ₹1200 with an expiration date of 15th January 2023 at the option premium of ₹25. You have to buy the call option (or sell the put option) if you expect that the ABC Limited share price will rise to ₹1200.

When the share price of ABC Limited rises to ₹1200 or more, you have the right to buy the shares but not the obligation and the seller (or writer) has to exercise the contract as he has already been paid the extra premium amount by the buyer. If the ABC Limited share price does not rise to ₹1,200 before 15th January 2023, then you can cancel the contract and you lose the premium amount of ₹25. You will cancel the contract because you can buy the shares from the open market at a lower price. 

The potential profits and losses on the expiration date to both the buyer and seller of the call option contract in the example are -

• Illustration of a Put Option 

Suppose the current price of an equity share of ABC Limited is ₹1200 on 22nd December 2022 which is also called the spot price. The option contract for ABC Limited shares is available at the strike price of ₹1000 with an expiration date of 15th January 2023 at the option premium of ₹25. You have to buy the put option (or sell the call option) if you expect that the ABC Limited share price will fall to ₹1000.

When the share price of ABC Limited falls to ₹1000 or less, you have the right to sell the shares but not the obligation and the seller (or writer) has to exercise the contract as he has already been paid the extra premium amount by the buyer. If the ABC Limited share price does not fall to ₹1,000 before 15th January 2023, then you can cancel the contract and you lose the premium amount of ₹25. You will cancel the contract because you can sell the shares in the open market at a higher price. 

The potential profits and losses on the expiration date to both the buyer and seller of the put option contract in the example are - 

• Pros and Cons of Options Contracts - The advantages of trading in options are cost efficiency, high return potential, a low risk profile and multiple strategies. The disadvantages of trading in options are less liquidity, high commissions, a loss in premium amount and the non-availability of some stocks.

Forwards

Forward contracts are the unstandardized contracts where two parties enter into an agreement to buy or sell an underlying asset at a fixed price on a pre-decided date. 

Both the parties are obligated to exercise the contract on the expiry date. There is a high counterparty risk, which means that any party can default on exercising the contract because they are not standardized. They are available on the OTC market and can be customized on terms, size and process based on the two parties' needs. The different types of forward contracts are closed outright forward, flexible forward, long-dated forward and non- deliverable forward.

For example, assume you are a farmer who wants to hedge against market uncertainty about your wheat crop's lower future prices and the current rate of ₹18 per kg. You can enter into a futures contract simply by meeting with wholesalers with an expiry after two months to purchase your wheat crop at a price of ₹18 per kg. If the wheat price falls after two months, you are safe. If the price rises, you are at loss. But as these contracts are not regulated, you might think of defaulting on the contract, which is not a good idea because if the price falls in the future, the wholesaler can also default on the contract. Therefore, it is a situation where you have to be very sure.

• Pros and Cons of Forwards Contracts - The advantages of trading in forwards are guaranteed future price to be paid, flexibility in conditions and helps in forecasting cash flows by the owners. The disadvantages of trading in forwards are risk of loss, counterparty risk of default and long duration.

Futures 

Futures are similar to forwards in terms of their features but differ in terms of their regulations. Futures contracts are traded on the stock exchange and therefore are highly standardized. These contracts have less counterparty risk and the deal is regulated through the stock exchanges. These contracts are backed by collateral and are also settled on a daily basis. Therefore, trading on them becomes very easy and offers high liquidity to the traders. The different types of futures are equity futures, index futures, commodity futures, currency futures, interest rate futures and volatility index futures.

Suppose ABC Limited buys futures contracts on December 22, 2022, for crude oil at a price of $70 per barrel with an expiry date of January 20, 2023. The company has purchased these contracts because of a fear of rising prices in the future of crude oil. The company has minimized the risk because a seller will be obligated to sell crude oil to ABC Limited, whatever the price may be on the expiration date.

The crude oil price rises to $85 per barrel by January 20, 2023. ABC Limited will accept the delivery at a much lower price than the current market price. If they are not in need of oil in between the duration, then they can also sell the contract before expiration through the stock exchange. Therefore, the buyer of the future contracts, ABC Limited, will earn a profit of $15 per barrel and the seller of crude oil will be at a loss of $15 per barrel because they can sell the oil at a higher price in the market. 

As both parties are obligated to exercise the contract, one party will be at a loss and the other will gain the same potential profits, but there is a certain sense of satisfaction among both parties that the contract will be exercised.

• Pros and Cons of Futures Contracts - The advantages of trading in futures are less commission, higher liquidity, helps in converting your position and high leverage. The disadvantages of trading in futures are rigid conditions and over trading.

Swaps

These types of financial derivatives are traded on the OTC market and are highly complicated to manage. It helps the parties to swap their financial cash flow or liabilities and where one is fixed and other depends on the current rate. The different types of swaps agreements are interest rate swaps, commodity swaps, currency swaps, debt equity swaps, total return swaps and credit default swaps. The most used swaps are interest rate swaps used by the companies. 

Suppose that ABC Limited borrows a loan amount of ₹10,00,000 and pays a current interest rate of 7%, which can be changed based on the current rate. Then, ABC Limited will be thinking of paying a higher amount if the interest rate rises in the market. To offset this risk, ABC enters into a swap agreement with XYZ Limited where they agree to pay the changing interest rate and ABC Limited agrees to pay a fixed interest rate of 8% on the loan amount. It means that ABC will now pay 8% and XYZ will pay 7% on the same amount. Therefore, ABC has reduced their risk by entering into a swap agreement with XYZ, as they have a fixed interest rate of 8% of whatever the interest rate in the market is in the future.

• Pros and Cons of Swaps Contracts - The advantages of trading in swaps are that they are less costly, have a longer duration to hedge the risk, provide flexibility and let companies easily manage the balance between revenues and liabilities. The disadvantages of trading in swaps is call risk which leads to a loss in brokerage costs, a lack of liquidity and default risk.

Participants in the Derivatives Market

There are generally four types of participants who trade in derivative instruments, which are called the lifelines of the capital markets as they provide liquidity, facilitate price discovery and contribute to the overall efficiency of the markets.

Hedgers

These participants or hedgers are risk-averse individuals who want to reduce the risk of price movements in their stocks. They take the opposite position in the derivative market as compared to their holding asset or a stock. They are so risk-averse that they are even ready to pay the premium amount to the person who can bear the risk. 

For example, if you are holding 50 shares of any company whose current market price is ₹130. You are thinking of selling it after two months and do not want a single penny of loss on that, as well as being keen on earning the potential profits. In that scenario, you will take the opposite position and buy a put option, paying a premium to the seller of the contract to get the right to not exercise it.

If the share price rises, you will not exercise the contract and sell the shares in the open market, thereby earning the profits. If the share price falls, you will exercise the contract and sell the stocks to the writer of the contract at a predetermined price. You have taken the advantage of both the situation of reducing the risk of a drop and earning a profit in the event of a rise.

Speculators 

Day traders and position traders are risk takers who seek to maximize profits by taking risks. They are the opposite of hedgers and take risks from them to earn the profits. In the earlier example, the hedger may have purchased a put option to reduce the risk of a decline in share price, but speculators believe that the stock price will not fall. If the stock price doesn't fall at the time of expiry, you will not exercise the contract and the speculator will earn the profit equal to the premium amount. Therefore, higher risk takers can only earn the highest profits as proved by the speculators.

Margin Traders 

Margin is the small amount that a trader in the derivative market has to pay to the clearing house or the broker to participate in the market. You can easily take the average in derivatives by trading on a high amount as compared to your capabilities. Many speculators do this and buy three times the quantity more than their spending capacity with the help of a margin amount. 

For example, to buy 200 shares of a company in cash or on the open market, you needed a sum of ₹2 lakh. But with the help of margin in the derivatives market, you can purchase the same number of shares for less than 30% of their value, which is only ₹60,000 and your total position is ₹2 lakh only.

If the share price rises by  ₹80, then your 200 shares in the cash market will give you a profit of ₹16,000 in the open market. But with derivatives, the profits are much higher as compared to the open market. Keep in mind that losses will also be at the same level or higher.

Arbitrageurs 

These traders are low-risk takers and use the inefficiencies of the market for their advantage. They buy the stock at a lower price in one market and sell it to another at a high price if they are listed on different markets. For example, suppose you buy the share at ₹750 in the open market and are quoted on the futures market at ₹765. Then, you can buy it in the cash market and sell the same in the futures market, thereby earning a profit of ₹15.

Prerequisites for trading in derivatives

1. Firstly, to begin trading in standardized derivatives instruments, you need to have a trading account or you can place your order through a broker over the phone or online.

         2. You are required to submit an initial margin amount in your account before you start trading in different types of derivative instruments. The              amount cannot be withdrawn until and unless the contract is exercised. If, due to fluctuations, your margin accounts fall below the pre-                     specified level, then you have to submit them before the day closes to your broker.
 

          3. For the selection of any underlying asset, consider different factors like the cash you have, the margin requirement, the price of the               contract and an asset that should fit into your budget.

          4. You have two options: either wait for the contract to expire and pay the amount or enter into an opposite trade.

Conclusion

As a result, the advantages of trading in different types of derivatives are numerous, as they reduce or transfer risk and provide arbitrage and speculation opportunities. All instruments have different features and are used for different purposes by all market participants. But keep in mind that proper knowledge of these instruments is essential before you begin trading, which can give you both thorns in the form of losses and roses in the form of profits if traded correctly.