A much bandied about topic in the stock market world yet most of us are not quite aware of what exactly derivatives are all about. This article makes an attempt to clear the concept and get you well-versed with the subject.
As the name itself suggests, a derivative is a product whose value derives from and is dependent on the value of the underlying asset such as commodity, currency, or equity.
Why the hype?
As goes the old saying in the books of success, “more risk, more reward”. Such is commonplace in the case of trading. Derivatives can be used on both sides of the equation, to either shoulder risk or transfer risk with the possibility of calculated profit/gains. The ability to assume risk explains the definition of speculation. This art of speculating through derivatives is one of the reasons why this subject is given such critical remarks.
Contrary to popular opinion, though, derivatives are not fundamentally only risky. In fact, they are a necessity for both traders and investors to ensure risk is reduced in volatile and choppy markets, which in turn can boost their portfolio returns by acting as an investment insurance.
Let us understand the above with a simple example. Anjali, a wheat producer, fears the price of wheat falling in the next six months, whereas, Raj, a cereal manufacturer, predicts a rise in the price of wheat in the same time horizon. Anjali and Raj come into an agreement where Anjali will sell one bushel of wheat at current market price of INR 800 in six months, irrespective of the future market price. By locking in the price of wheat, Anjali, the producer is protecting her produce against an expected decrease in the price of wheat. On the other hand, the manufacturer is protecting his sale against the increase in the price of wheat. The price can either fall or rise, in any case, it can distinctly benefit only one of the parties.
Types of Derivative Products
Mode of Derivatives
1. OTC (Over-the-counter): Contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary
2. ETD (Exchange-traded): Standardized contracts such as futures and options that are traded or transacted on an organized futures exchange. They require payment of an initial deposit or margin settled through a clearing house.
Advantages of Derivatives
1. Hedging and risk management: Most of us would agree that capital protection is equally important as capital appreciation. Capital protection can only be done via hedging. Hedging is similar to an insurance where it attempts to alleviate the risk of adverse price movements in the asset by taking an offsetting position in the related security, such as in futures or options market.
For example, when you buy homeowner’s insurance, you’re hedging yourself against fires, break-ins or other unforeseen disasters. Hedging and risk management walk parallel as risk management is the process of identifying the desired level of risk and the actual level of risk, and altering the latter to equal the former.
2. Lower transaction costs: Derivatives help to reduce market transaction costs as they act as a risk management tool. Hence, the cost of trading in them is comparatively lower than other segments.
3. Rich load of data: Derivatives market brings about rich load of data to understand the market sentiment. Even non-traders can apprehend the signals generated by the F&O (Futures and Options) market to get an insight of the short/long term movement.
4. High leverage: In general, leverage is defined as borrowing funds to make investments. In derivatives, one of the benefits is that it provides high leverage i.e. the capital needed for taking positions in derivative instruments is generally much less than capital needed to actually take the positions in stock markets. In case of Futures, only 20%-40% of the total contract value is required to start trading, whereas, in Options, only the premium amount is required to trade
5. Transfer of Risk: In derivatives, risk can be transferred from one party to another party who is willing to bear it.
Kudos! You have taken the first step to understanding derivatives in all its glory. Next post: Understanding the market participants.
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