DERIVATIVES

DERIVATIVES BRIEF SUMMARY:

• Derivative is a product/contract whose value is derived from the value of one or more basic variables called bases(underlying assets, Index or reference rate).
• The underlying Assets can be Equity, Forex or Commodity.
• This underlying has a marketable value and hence has market risk.(Example Price of Quoted equity shares has market value and changes as per market conditions i.e has market risk).
• Derives value from underlying assets means that all derivative instruments are dependent on an underlying asset's value. Like value of a stock Equity backed derivative is dependent on the market value of the Equity shares.
• The change in the value of the forward contract is broadly equal to the change in the underlying.
• The position of Profit/Loss on the date of maturity is determined by the price of underlying

Cash and derivative market market differences:

• Even a single share can be purchased in a cash market for example if you have electronic account(Demat) you can purchase any number of shares from the stock market through your broker however In derivative market (Futures and options especially) minimum lots are fixed.
• Tangible Assets are traded in Cash Market example you can purchase 100 quintal of wheat, However contracts are traded which are based on underlying Tangible or Intangible Assets.
• Generally Trading in Cash market is done for the purpose of consumption or investment however trading in derivatives is done for the purpose of Hedging, Arbitrage or Speculation.
• Customer is required to open securities trading account with the Securities depositories to trade in Cash market whereas to trade futures customer must open a future trading account with the derivative broker.
• Buying securities in Cash market requires putting up all money upfront whereas buying futures involves putting up the margin money.
• Buyer of shares of the company in the cash market is the part owner of the company whose shares are bought however buyer of futures is not the owner of the company.

The Most Important Derivatives are Forward, futures and Options

Forward:

Example: There is a farmer who grows the crops harvest it and sell it in the spot market after harvesting. Now suppose due to  over production/supply or for any other reason the prices of the crops  decline sharply at the time of selling i.e after harvesting, there is a possibility that he even cannot realise his cost. So are there any way by which he can save himself from such  loss. The answer is yes , he can enter into the forward contract today, i.e he can enter into a contract today at the agreed upon price to deliver the asset(here crops)at pre-determined date in Future. This will at least ensure to the farmer the input cost and a reasonable profit.( however there is always a possibility of foreclosing a bumper profit if the price of crop increases above the contracted price). The transaction that the farmer has entered is called forward transaction and the contract is forward contract.( i.e Contract entered into today to deliver asset at pre-determined date in future for a fixed price).

Definition:

A forward Contract is an Agreement between the buyer and seller obligating the seller to deliver a specified asset of specified quality and quantity to the buyer on a specified date at a specified place and the buyer in turn is obligated to pay to the seller a pre-negotiated price in exchange of the delivery.

However it should be noted to understand that no part of the contract is standardised and the two parties sit across and work out every detail before signing the contract.

Future Contract:

Trading in future can be done in both Stock Futures or Index Futures.  In Either Case both Buyer and Seller of the contract has to Deposit an initial margin with their brokers based on the value of contract entered , the rules for the margin to be deposited with brokers is framed by Exchanges. It is to be noted that the margin requirement is continuous.Every business day the broker will calculate the margin requirement for each position. The investor is required to deposit additional fund as margin deposit if the account does not meet minimum margin requirement. The investor can square off its position before expiry otherwise it gets automatically squared off at the end of expiry at the closing price existing on such expiry date. If the price of underlying say Infosys goes down and the investor has long position(Buyer) then the account of such investor is debited and if it goes up the account is credited and reverse in case of Short Position(Seller).

Purpose of trading in Future:

There are mainly two Purpose, the first one is Speculation ( on the expectation that the market will go same as the investor has expected and thereby making profits example can be: if investor expects the price of underlying will increase he will take long future position and vice versa)  in and second one is hedging ( It is like protecting itself from any downfall in the value of the investors asset by taking short future Positions , here any downfall in the asset will be compensated by profit earned on future positions, this can also be understood as fixing the profit now irrespective of market conditions that will exist in future whether favorable or unfavorable).

Few Advantages of Future Index Trading over Stock futures Trading:

• Stock Index Futures cannot be easily manipulated whereas individual stock prices can be exploited easily.
• Stock Index Futures being the Average stock price is much less volatile than individual stock price hence less risky proposal.This implies risk diversification is possible under stock index futures.Stock index futures are highly marketable and liquid.
• In Stock futures normally future position is settled by physical delivery of stocks.However in case of Stock Index futures settlement is done through cash.
• Also it has been observed that regulatory complexity is less in case of  Index Futures.
• Index future can act as a hedging tool for stock portfolio in the falling markets.

Options:

Options can be understood as a privilege given by one party to another, that gives the buyer the right but not the obligation to buy(call) or put(sell) any underlying (Equity, Forex, Commodity, Index, Interest Rate, etc.) at an agreed upon price within a certain period on a specific date regardless of changes in underlying's market price during that period.

Example:

Suppose you are given an option to buy (call option) 1 ounce of Gold at $1500 at some specified date in future irrespective of changes in market price of Gold. suppose price of gold has increased to $1550/oz . what will you do ?

The price for you  is fixed i.e $1500/oz and currently in the market you will get it for $1550, Here you will of course exercise the option. i.e you will buy the Gold.

The Important thing here is you should be able to anticipate the price of Gold at that particular date, In case in the above case if price has gone down to $1450/oz you will probably not exercise the option, here by not exercising the option your loss will be only the premium paid at the time of buying the option.(say let's premium be $20) Your loss if price falls to $1450 Is $20 Only).

The various kinds of stock options include put and call options, which may be purchased in anticipation of changes in stock prices, as means of speculation or hedging.

Important Terminology that are used in Options:

1. Strike Price
1. In the money
2. At the money
3. Out of the money
2. Buyer and Writer of the option(also called seller of the option): when Individual sells option, they effectively create security that didn't exist before.thus is called writing an option and explains one of the main source of options, since neither the associated company nor the options exchange issues options.When you write the option i.e when you sell the option you might be obliged to sell the shares at the strike price anytime before expiration.
3. Premium: the price of the option is called premium( that is what you pay to buy the option) and the buyer of the option cannot loose more than the premium. hence the risk of the buyer of the option is no more than the amount paid for the option.And the profit potential on the other hand is theoretically unlimited , In the above example suppose market price of Gold will reach to $1600/oz, in such case cost for the buyer is only the premium amount of $20 and the agreed upon amount i.e $1500/oz. His profit will be $1600-($1500+$20)=$80.

Let's understand each and every term from above example of Gold.

In the above example $1500/oz is strike price you purchased the option for rs.$20 i.e premium i.e value of option.Assuming market price of $1550 it's intrinsic value is $50(I.e $1550-$1500) and the difference of intrinsic value and Premium (i.e $50-$20=$30) is attributable to time value. which declines as the option approaches the expiration. At the expiration all the worth comes from the intrinsic value since there is no time value left on expiration.