Derivatives Market - 5 things you must know about derivatives

Derivatives are products that derive their value from an underlying asset or index. Derivatives markets in India trade a plethora of contracts on equities, indices, interest rates, currencies and commodities.

Jun 27, 2019 03:06 IST India Infoline News Service

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Derivatives trading in India began officially in 2001 when futures and options on equities were permitted. Derivatives are products that derive their value from an underlying asset or index. Derivatives markets in India trade a plethora of contracts on equities, indices, interest rates, currencies and commodities. In the equity markets, derivatives account for ~95% of the total volumes on a daily basis. Here are five things you must know about derivatives.
 
Derivatives are leveraged and can work both ways
 
Leverage is borrowing. How do you borrow and buy shares? You put in a margin of 20% and the bank funds 80%. So, you take a 100% position by putting just 20% of your own money, although you pay interest on the balance 80%. This is what derivatives do. You pay a margin (depends on stock volatility) and take position in a stock. For example, you can buy RIL shares worth Rs10 lakhs by paying a margin of around Rs3 lakhs in futures. This leverage works both ways. Just as it magnifies the profit, it can also magnify the loss. That is why derivatives are preferred more for hedging (protecting risk) than for trading.
 
Derivatives necessarily have lot sizes and an expiry date
 
Derivatives can be in the form of forwards, futures or options. Forwards and futures are the same except that futures are standardized and are traded on a recognized stock exchange. Forwards are neither standardized nor are they traded on an exchange. Standardization of futures and options happen in two simple ways. Firstly, the minimum lot sizes for each stock and index is fixed and traders can only buy and sell in multiples of these lots. Secondly, expiries are also fixed; for example, equity derivatives expire on the last Thursday of each month and there are 3 contracts that get traded.
 
Derivatives are contracts that may or may not result in delivery
 
Derivatives can be cash settled or settled against delivery. For example, currency derivatives and equity index derivatives are necessarily settled only in cash (profit / loss is adjusted). However, in case of commodity futures, the traders have a choice to either take delivery of the physical commodity or just square off and adjust the profit or loss.
 
Derivatives can behave like debt and insurance too
 
Futures on a stock can be made to look like a debt instrument. How does that work? Stock futures will typically quote at a premium to the spot price. If you buy the stock in spot and sell it in futures, you lock in assured profits. This is called arbitrage. For example, if you bought RIL spot at Rs1200 and sold July futures at Rs1209, then the spread of 0.75% (9/1200) is locked in as assured profit for the month. When continued through the year, it is akin to a debt instrument. Insurance is for protection and you can protect your stocks with options. For example, if you buy a stock and also buy a lower put option (right to sell), the losses on the stock are compensated by the profit on the put option. Sounds interesting!
 
Futures are symmetric and options are asymmetric
 
This is a lot more interesting! A future is an agreement to buy or sell at a future date. If you buy Nifty futures and another trader sells Nifty futures then both can have unlimited profits or unlimited losses. Thus futures are symmetric. The option is a right to buy or sell without an obligation to buy or sell.  The buyer of the call option has the right to buy without the obligation while the seller of the call option has the obligation without the right. This makes options asymmetric and at the same time also makes it extremely flexible for managing risk and creating low risk strategies.
 
In the last few years, derivatives have emerged as a distinct trading class with their own unique sets of advantages.

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