What are Derivatives?
In simple terms, derivatives are those products derived from their underlying assets. Let’s break down this into a simple example that you can relate to. You all have tried refreshing sugarcane juice in summer or any season. Sugarcane is the raw material that goes into the machine, and we get juice from it. So relate to this from a company say Reliance its price on Nifty or Sensex is Underlying asset or raw material like sugarcane.
Future and options are like machines used to make derivative contracts. The price of contracts in the future and options are like the price of juice, it varies according to supply and demand. If you see in summer, juice prices are comparatively higher than in the winter season. In the same way, derivative prices also work. If the Price of Sugar Cane goes up, the price of Sugarcane Juice also goes up.
History of derivative Trading
That was the definition, but if you had come across this word and thought that this is something fancy and an advanced concept that was introduced in recent years, you are wrong. Derivative trading was practiced from historical times but a breakthrough started from Japan in the 18th century.
They were using something called rice vouchers that could be settled in cash in rice trading as derivatives. At that time, it was all over a counter product without any regulations but now all derivative instruments are regulated by the government to protect investors from any kind of fraud.
Purpose of derivative trading
Originally derivatives were introduced as an instrument for hedging. Let’s get this with a simple example. Suppose you are a farmer and produce rice. Now you are fearful that due to some reason, it’s price may fall in the upcoming future. You want to make sure that you get the right price for your rice.
There is a company which deals with the rice business. They are fearful that rice prices may increase in the future, and because of that, they may incur a loss. So both farmer and company made a contract that the farmer will sell a decided quantity of rice to that company at a specific date at a predetermined price, say Rs. 100 per kg. This strategy is called hedging, which means protection from any risk.
Now three situations may happen :
Price of Rice goes up: In this case, the price of rice in the market went up to 200 Rs. Per kg. But due to contract agreements, the farmer is obliged to supply rice at 100 Rs. to the company according to the contract. He had to face 100 Rs. Per kg loss due to this contract.
Remains the same: In this case, none of the parties have to face loss as the market price and contract price are the same.
Price of Rice goes down: Suppose the rice price went down to 50 Rs. per kg. In this situation, the company has to face 50 Rs. loss. Because he is obliged to fulfill the contract and buy it from the farmer at 100 Rs. even if the market price is 50 Rs.
Types of Derivative Trading
There are four types of derivative tradings Forwards, Futures, Options, Swaps.
Forwards: These are the contracts that I explained with the Rice farmer example. These are over-the-counter (OTC) contracts. What does it mean that there is a counterparty risk of default. No central or regulatory entity can protect them from such defaults. Yes, there are courts where they can file a case but we all know how much time it takes in the Indian judicial system.
Futures: To overcome issues in Forwards, Futures were introduced. It is regulated by SEBI in India, to protect investors from any defaults. Nou you can buy or sell a contract using your smartphone, laptop from any place. An option is also a similar type of contract but with a little advanced concept such as premium, time decay, etc.
Swaps: These are a little bit different from all the other derivatives contracts, it deals with interest rates.
What are the options?
Let’s get the option concept with a basic example of Buying a house. Suppose you liked the house and showed interest to buy it which has a price of 1 Cr. But you are not willing to buy now but after 6 months. For this, you paid 1 Lakh token amount to the broker, so that he won’t sell this house to someone else for the next 6 months. After this only three things can happen, either the price of the house will increase, decrease, or remain the same.
These can be three scenarios:
Price of the house goes up: Suppose the price of the house went up to 1.5 Cr. in 6 months. In this case, buyers of the house will get a profit of 49 Lakh by subtracting a 1 lakh token amount. They will buy the house at the contract price of 1 Cr.
The price of the house remains the same: In this case, there will be a situation of no profit & no loss for buyers removing the token amount. So they have the option either to buy it or look for another house.
Price of the house drops: Suppose the market price of a house drops to 50 lakhs. Now the house buyers will let go of the contract agreement by losing the token amount. In this case, brokers faced a loss of 49 lakhs. This is why people prefer to trade options. Here buyers of the contract are not obliged to fulfill the contract but, the sellers are. The downside risk gets restricted for option buyers but, the profit probability is unlimited.
Option Terminologies with compared to the above example
- Token of 1 Lakh = Option premium
- Agreement price/ Initial price of 1 Cr = Strike price
- Price of the house at the end of the contract = Option price at expiry
- Duration of contract ( 6 months) = Contract duration ( Mid, near, far ) months.
- Type of contract 6 months fixed = European/American contract
Why should I trade derivatives?
There will be a query in your mind that why should you trade or take a position in derivatives. Its answer depends on two questions, whether you are an investor or a trader.
Derivative for Investors:
Let’s begin with the first situation, suppose you are an investor and had bought 1000 shares of Reliance at 1000 rupees. Due to some incidents like Covid 19 market fell drastically, as you all have seen in March 2020. So you can do two things either you see your share price drop continuously or take a hedge position in the future or option to protect against such uncertain events.
Derivatives for traders:
If you are a trader with deep pockets then future and options are a much better place to trade than the cash segment. There are 2 reasons for that one is high liquidity and the other is high profit/ loss depending on your experience. Due to digitalization, many people are trying their hands on derivative tradings. Some are making fortunes while others are burning their hands. It all comes down to knowledge and experience. If you trade with proper knowledge and techniques there is a high probability you will make a profit.
Pros and Cons of derivatives
- High liquidity
- Good for hedging purpose
- Good for trading due to high liquidity
- High-profit margin
- Can do short selling
- High Risk due to large capital requirement
- High volatility
- A little bit complex to master