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Home » What are Futures and Options? Understanding Derivative Markets

What are Futures and Options? Understanding Derivative Markets

Futures and options are one kind of derivatives instrument. They are financial instruments whose value increases or decreases on the basis of their underlying asset value. They are available in all three formats of trading: Equity, Currency, and Commodity. In cash trading, people can buy as many numbers of shares as they want but in the derivative market, there are fixed lot sizes per share or commodity or currency. A person can invest only in accordance with that lot size.

Let’s acknowledge these derivatives in a simple format. Like shares are financial instruments, bonds are financial instruments, debentures are financial instruments similarly is the case with derivatives. The way in which one can invest in shares, bonds, etc., in the same way, a person can invest in derivatives as well.

India has the largest volume of derivative contracts volume of exchange. The amount is roughly around 5.96 billion contracts.

What Are Derivative Markets and Derivative Contracts?

The derivative market is a highly leveraged market. It totally depended on the margin. A person who wants to buy x amount of one silver future only has to pay a fraction of the actual future amount. This means that the risk involved for the best discount broker is higher and the return to investors is also significantly high. Derivative Contracts are monthly or weekly or quarterly contracts made.

Derivative Price Changes

Equity

Let’s understand the price changes in equity with an example. Let’s assume the scenario of Reliance industries. If a person has 1 lot of Reliance shares then the price of his portfolio will move in accordance with the price changes in Reliance’s share value. i.e. If the share price of reliance increases the value of derivatives will increase and vice versa.

Commodity

Similarly will be the case for commodities. For instance, I have bought wheat derivatives. The value of my derivative will increase when the price of wheat will increase and the value of my derivative will decrease when the price of wheat will decrease.

Currency

In currency as well the same fundamental applies. Let’s understand it by the U.S. dollar currency. The value of U.S. dollar derivatives will increase when the U.S. dollar becomes stronger or when the price of the U.S. dollar increases. Hence an increase in pricing of U.S. dollars will result in the increase of its derivative value and vice versa.

Index

Also, the same case applies to index value and their derivatives. In Nifty50 or bank nifty, if the value of both of them increases the value of their derivative increases, and if their value decreases the value of their derivative decreases as well.

In a simpler language, the value of these derivatives increases only when the value of their individual underlying asset value increases.

 

Why Invest In Derivatives?

Derivatives are used for hedging and speculation. It helps the person or corporates to take calculated risks on basis of their strategies and assumptions on the market movements. It is not something related to betting or gambling but it is purely based on market trends and global scenarios.

The primary goal behind speculation is to earn more profit and the goal behind hedging is to reduce the losses. Let’s understand it in a simple manner.

Speculation

It is an assumption about the market trend or market movement to take a position for earning profits. Hence if I assume that markets will go down from the current position, I will short sell the NIFTY50 index (derivative) and wait until I get a good return on my position. Hence after getting a good amount of price fall in NIFTY50 I will buy the derivative again to complete the short sell process and book profit from this trade.

Hedging

It is generally done to avoid significant losses in the upcoming future. If the market is in a good position and I buy shares of Rs. 10 Lakh but later on due to market fall, the value of shares I own is constantly degrading. So to cover up my loss I will come into a derivative position for covering my losses. This could be done by short-selling the shares I own in the derivative market. Another way is by getting into a profitable position by selling the index or other shares while the market is in bear movement. This will reduce my losses and let me compensate for my losses that occur in my initial portfolio position. This is the concept of hedging.

Types of Derivatives

  • FORWARDS
  • FUTURES
  • OPTIONS
  • SWAPS

But in the stock market trading forwards and swaps do not form a place. The trading is carried out only in futures and options.

What Are Futures and Options Contracts?

Futures

A futures contract is a pre-decided agreement between 2 parties who have agreed to buy and sell an asset at a certain price at a certain time period in the future. It is done to abolish the uncertain price movements of the asset.

The futures contracts in India have two types of expiry dates: One is weekly expiry and another is monthly expiry. In some cases, the expiry is extended to 3 months as well. The weekly expiry is done every Thursday and Friday is the first day for a new position set up. In the case of monthly expiry, the last Thursday of the month is considered as the expiry date, and the Friday after that day is the day for fresh position buying. In derivatives, the lot size is fixed per index or share.

Options

It is a contract that provides the right to buy or sell an asset but not the obligation to do so at a specified date and a specified time. There are two types of options contracts. One is the Call option and another is the Put option.

Call Option gives the buyer the right to buy the specified asset quantity at a given price on or before the date of expiry. The seller is obligated for selling the asset if exercised by the buyer. The seller here gets the benefit of premium and the buyer gets the asset he wants in his portfolio.

A put option gives the buyer the right to sell the asset at a given price on or before the date of expiry. The seller here is obligated to buy the asset if exercised by the buyer. The seller here gets the benefit of the premium paid by the buyer to exercise the contract and the seller gets the position he wants.

In Options, The option buyer has a possibility of unlimited return and the loss is limited to the premium amount. Whereas for option sellers the loss is unlimited and the profit is limited to the premium amount.

Who Are the Participants of the Derivative Market?

There are three major participants in this derivative market. They are :

  • Speculators
  • Hedgers
  • Arbitrageurs

Speculators

As explained above they predict market movements for earning profits. The entire profit is dependent on the assumptions made by the participant about the market trend.

Hedgers

As explained above they are the ones who create a balancing portfolio for avoiding huge losses in a market trend. They are also big corporates who hedge the raw materials that are imported or bought by them. For example,  X is a  company that makes wheat products, it requires thousands of tons of wheat for production. Supposedly it imports the wheat. The time to reach India is 15 – 20 and the time to reach its destination is approximately 30 days. In the meanwhile, there are chances that the prices of wheat fluctuate heavily affecting the cost structure of the company. To avoid this situation the company hedges the commodity so that the pricing of its raw material is not affected. The profit in hedging position covers losses in raw material pricing and vice versa.

Arbitrageurs

They are the ones who take advantage of the price gap in the market which arises due to imperfections in the market. Arbitrageurs are responsible for changing the demand and supply position of the market and bringing it to equilibrium. They depend on the cost to carry for their profits.

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