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Chapter 2.1: Introduction to Derivatives Trading
We move on to the world of derivatives – considered one of the most complex financial instruments.
The derivative market in India, like its counterparts abroad, is increasingly gaining significance. Since the time derivatives were introduced in the year 2000, their popularity has grown manifold. This can be seen from the fact that the daily turnover in the derivatives segment on the National Stock Exchange currently stands at Rs. crore, much higher than the turnover clocked in the cash markets on the same exchange.
Here we decode it for you.
What are derivatives:
Derivatives are financial contracts that derive their value from an underlying asset. These could be stocks, indices, commodities, currencies, exchange rates, or the rate of interest. These financial instruments help you make profits by betting on the future value of the underlying asset. So, their value is derived from that of the underlying asset. This is why they are called ‘Derivatives’.
The value of the underlying assets changes every now and then.
For example, a stock’s value may rise or fall, the exchange rate of a pair of currencies may change, indices may fluctuate, commodity prices may increase or decrease. These changes can help an investor make profits. They can also cause losses. This is where derivatives come handy. It could help you make additional profits by correctly guessing the future price, or it could act as a safety net from losses in the spot market, where the underlying assets are traded.
What is the use of derivatives:
In the Indian markets, futures and options are standardized contracts, which can be freely traded on exchanges. These could be employed to meet a variety of needs.
Earn money on shares that are lying idle:
So you don’t want to sell the shares that you bought for long term, but want to take advantage of price fluctuations in the short term. You can use derivative instruments to do so. Derivatives market allows you to conduct transactions without actually selling your shares – also called as physical settlement.
Benefit from arbitrage:
When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets.
Protect your securities against
fluctuations in prices The derivative market offers products that allow you to hedge yourself against a fall in the price of shares that you possess. It also offers products that protect you from a rise in the price of shares that you plan to purchase. This is called hedging.
Transfer of risk:
By far, the most important use of these derivatives is the transfer of market risk from risk-averse investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is transferred. There are a wide variety of products available and strategies that can be constructed, which allow you to pass on your risk.
Who are the participants in derivatives markets:
On the basis of their trading motives, participants in the derivatives markets can be segregated into four categories – hedgers, speculators, margin traders and arbitrageurs. Let's take a look at why these participants trade in derivatives and how their motives are driven by their risk profiles.
Hedgers: Traders, who wish to protect themselves from the risk involved in price movements, participate in the derivatives market. They are called hedgers. This is because they try to hedge the price of their assets by undertaking an exact opposite trade in the derivatives market. Thus, they pass on this risk to those who are willing to bear it. They are so keen to rid themselves of the uncertainty associated with price movements that they may even be ready to do so at a predetermined cost.
For example, let's say that you possess 200 shares of a company – ABC Ltd., and the price of these shares is hovering at around Rs. 110 at present. Your goal is to sell these shares in six months. However, you worry that the price of these shares could fall considerably by then. At the same time, you do not want to liquidate your investment today, as the stock has a possibility of appreciation in the near-term.
You are very clear about the fact that you would like to receive a minimum of Rs. 100 per share and no less. At the same time, in case the price rises above Rs. 100, you would like to benefit by selling them at the higher price. By paying a small price, you can purchase a derivative contract called an 'option' that incorporates all your above requirements. This way, you reduce your losses, and benefit, whether or not the share price falls. You are, thus, hedging your risks, and transferring them to someone who is willing to take these risks.
Derivatives trading participants
Speculators: As a hedger, you passed on your risk to someone who will willingly take on risks from you. But why someone do that? There are all kinds of participants in the market.
Some might be averse to risk, while some people embrace them. This is because, the basic market idea is that risk and return always go hand in hand. Higher the risk, greater is the chance of high returns. Then again, while you believe that the market will go up, there will be people who feel that it will fall. These differences in risk profile and market views distinguish hedgers from speculators. Speculators, unlike hedgers, look for opportunities to take on risk in the hope of making returns.
Let's go back to our example, wherein you were keen to sell the 200 shares of company ABC Ltd. after one month, but feared that the price would fall and eat your profits. In the derivative market, there will be a speculator who expects the market to rise. Accordingly, he will enter into an agreement with you stating that he will buy shares from you at Rs. 100 if the price falls below that amount. In return for giving you relief from this risk, he wants to be paid a small compensation. This way, he earns the compensation even if the price does not fall and you wish to continue holding your stock.
This is only one instance of how a speculator could gain from a derivative product. For every opportunity that the derivative market offers a risk-averse hedger, it offers a counter opportunity to a trader with a healthy appetite for risk.
In the Indian markets, there are two types of speculators – day traders and the position traders.
- A day trader tries to take advantage of intra-day fluctuations in prices. All their trades are settled by by undertaking an opposite trade by the end of the day. They do not have any overnight exposure to the markets.
- On the other hand, position traders greatly rely on news, tips and technical analysis – the science of predicting trends and prices, and take a longer view, say a few weeks or a month in order to realize better profits. They take and carry position for overnight or a long term.
Margin traders: Many speculators trade using of the payment mechanism unique to the derivative markets. This is called margin trading. When you trade in derivative products, you are not required to pay the total value of your position up front. . Instead, you are only required to deposit only a fraction of the total sum called margin. This is why margin trading results in a high leverage factor in derivative trades. With a small deposit, you are able to maintain a large outstanding position. The leverage factor is fixed; there is a limit to how much you can borrow. The speculator to buy three to five times the quantity that his capital investment would otherwise have allowed him to buy in the cash market. For this reason, the conclusion of a trade is called ‘settlement’ – you either pay this outstanding position or conduct an opposing trade that would nullify this amount.
For example, let's say a sum of Rs. 1.8 lakh fetches you 180 shares of ABC Ltd. in the cash market at the rate of Rs. 1,000 per share. Suppose margin trading in the derivatives market allows you to purchase shares with a margin amount of 30% of the value of your outstanding position. Then, you will be able to purchase 600 shares of the same company at the same price with your capital of Rs. 1.8 lakh, even though your total position is Rs. 6 lakh.
If the share price rises by Rs. 100, your 180 shares in the cash market will deliver a profit of Rs. 18,000, which would mean a return of 10% on your investment. However, your payoff in the derivatives market would be much higher. The same rise of Rs. 100 in the derivative market would fetch Rs. 60,000, which translates into a whopping return of over 33% on your investment of Rs. 1.8 lakh. This is how a margin trader, who is basically a speculator, benefits from trading in the derivative markets.
Arbitrageurs: Derivative instruments are valued on the basis of the underlying asset’s value in the spot market. However, there are times when the price of a stock in the cash market is lower or higher than it should be, in comparison to its price in the derivatives market.
Arbitrageurs exploit these imperfections and inefficiencies to their advantage. Arbitrage trade is a low-risk trade, where a simultaneous purchase of securities is done in one market and a corresponding sale is carried out in another market. These are done when the same securities are being quoted at different prices in two markets.
In the earlier example, suppose the cash market price is Rs. 1000 per share, but is quoting at Rs. 1010 in the futures market. An arbitrageur would purchase 100 shares at Rs. 1000 in the cash market and simultaneously, sell 100 shares at Rs. 1010 per share in the futures market, thereby making a profit of Rs. 10 per share.
Speculators, margin traders and arbitrageurs are the lifeline of the capital markets as they provide liquidity to the markets by taking long (purchase) and short (sell) positions. They contribute to the overall efficiency of the markets.
What are the different types of derivative contracts:
There are four types of derivative contracts – forwards, futures, options and swaps. However, for the time being, let us concentrate on the first three. Swaps are complex instruments that are not available for trade in the stock markets.
Futures and forwards: Futures are contracts that represent an agreement to buy or sell a set of assets at a specified time in the future for a specified amount. Forwards are futures, which are not standardized. They are not traded on a stock exchange.
For example, in the derivatives market, you cannot buy a contract for a single share. It is always for a lot of specified shares and expiry date. This does not hold true for forward contracts. They can be tailored to suit your needs.
Options: These contracts are quite similar to futures and forwards. However, there is one key difference. Once you buy an options contract, you are not obligated to hold the terms of the agreement.
This means, even if you hold a contract to buy 100 shares by the expiry date, you are not required to. Options contracts are traded on the stock exchange.
How are derivative contracts linked to stock prices:
Suppose you buy a Futures contract of Infosys shares at Rs 3,000 – the stock price of the IT company currently in the spot market. A month later, the contract is slated to expire. At this time, the stock is trading at Rs 3,500. This means, you make a profit of Rs. 500 per share, as you are getting the stocks at a cheaper rate.
Had the price remained unchanged, you would have received nothing. Similarly, if the stock price fell by Rs. 800, you would have lost Rs. 800. As we can see, the above contract depends upon the price of the underlying asset – Infosys shares. Similarly, derivatives trading can be conducted on the indices also. Nifty Futures is a very commonly traded derivatives contract in the stock markets. The underlying security in the case of a Nifty Futures contract would be the 50-share Nifty index.
How to trade in derivatives market:
Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.
- First do your research. This is more important for the derivatives market. However, remember that the strategies need to differ from that of the stock market. For example, you may wish you buy stocks that are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market, this would need you to enter into a sell transaction. So the strategy would differ.
- Arrange for the requisite margin amount. Stock market rules require you to constantly maintain your margin amount. This means, you cannot withdraw this amount from your trading account at any point in time until the trade is settled. Also remember that the margin amount changes as the price of the underlying stock rises or falls. So, always keep extra money in your account.
- Conduct the transaction through your trading account. You will have to first make sure that your account allows you to trade in derivatives. If not, consult your brokerage or stock broker and get the required services activated. Once you do this, you can place an order online or on phone with your broker.
- Select your stocks and their contracts on the basis of the amount you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have to pay a small amount to buy the contract. Ensure all this fits your budget.
- You can wait until the contract is scheduled to expiry to settle the trade. In such a case, you can pay the whole amount outstanding, or you can enter into an opposing trade. For example, you placed a ‘buy trade’ for Infosys futures at Rs 3,000 a week before expiry. To exit the trade before, you can place a ‘sell trade’ future contract. If this amount is higher than Rs 3,000, you book profits. If not, you will make losses.
Thus, buying stock futures and options contracts is similar to buying shares of the same underlying stock, but without taking delivery of the same. In the case of index futures, the change in the number of index points affects your contract, thus replicating the movement of a stock price. So, you can actually trade in index and stock contracts in just the same way as you would trade in shares.
What are the pre-requisites to invest
As said earlier, trading in the derivatives market is very similar to trading in the cash segment of the stock markets.
This has three key requisites:
- Demat account: This is the account which stores your securities in electronic format. It is unique to every investor and trader.
- Trading account: This is the account through which you conduct trades. The account number can be considered your identity in the markets. This makes the trade unique to you. It is linked to the demat account, and thus ensures that YOUR shares go to your demat account.
- Margin maintenance: This pre-requisite is unique to derivatives trading. While many in the cash segment too use margins to conduct trades, this is predominantly used in the derivatives segment.
Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required to deposit only a percentage of the value of your outstanding position with the stock exchange, irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money, covers an initial margin and an exposure margin. These margins act as a risk containment measure for the exchanges and serve to preserve the integrity of the market.
You are expected to deposit the initial margin upfront. How much you have to deposit is decided by the stock exchange.
It is prescribed as a percentage of the total value of your outstanding position. It varies for different positions as it takes into account the average volatility of a stock over a specified time period and the interest cost. This initial margin is adjusted daily depending upon the market value of your open positions.
- The exposure margin is used to control volatility and excessive speculation in the derivatives markets. This margin is also stipulated by the exchanged and levied on the value of the contract that you buy or sell.
- Besides the initial and exposure margins, you also have to maintain Mark-to-Market (MTM) margins. This covers the daily difference between the cost of the contract and its closing price on the day of purchase. Thereafter, the MTM margin covers the differences in closing price from day to day.
Congrats, now you know about Futures trading. Let’s move on to Options – what are options? What are the types of options and how to trade them? Click here to know more.