You are trading in the cash market as a short-term investor, placing CNC orders on a daily basis which require you to pay the complete value of the security on the first day itself when you buy it. Usually no limit or leverage is available in case of delivery orders. What if you can invest in short term without having to pay the complete value of the security. Well derivatives are the solution here.
Derivative is a financial instrument in which the value is derived from the value of some underlying asset. Generally, these underlying assets are Stocks, Stock Indices, Currency, Commodities etc., Hence the price of the derivative product fluctuates based on the price of the underlying asset. Forward Contracts, Futures, Options and Swaps are some of the examples of widely used derivative instruments.
These derivative instruments are used to hedge the RISK of the underlying asset. That means if someone has an exposure on some underlying asset and if they want to hedge themselves from the volatility that is present in the asset, they can do the same using these Derivative Products.
1) Futures: - A futures contract is an agreement between multiple investors for the sell and purchase of an asset at an agreed price on a future date. Traders use futures contract to hedge their risk. The investors involved in futures are obligated to fulfill their commitments to buy or sell the underlying asset.
It is not necessary for all future contracts to be settled at expiration. Derivatives can be cash settled, meaning that the profit or loss in the trade accounts for cashflow to the trader’s trading account. Cash settled future contracts include interest rate futures, weather futures and more unusual contracts like stock index futures.
2) Options: - Ab option contract is very similar to a future contract; it is an agreement between two investors for the purchase or delivery of an asset at a future date for a specific price. The main difference between futures and options is that, in case of options, the buyer is not under any obligation to exercise the agreement for purchase or delivery. It is an opportunity and not an obligation, but in case of futures, they are obligations.
Options are also used for hedging or speculation on the price of the underlying asset they are based on. Options may further be classified as put option and call option. In both the cases, the option buyer has the choice to exercise the contract.
These products can be used to hedge the risk associated with stocks /shares. For example, a person is holding the Shares of Reliance Ltd and he is of the opinion that the price will increase substantially in a period of six months and thus wants to hold the stock for six months. At the same time, he is also scared that six months down the line if the price falls drastically he may end up in losses. To hedge this price fall he can enter into a derivative product like “Futures” or “Options” by locking in the price. In futures the price of that particular future date will be locked and he has to sell those shares at that price on that day. Whereas in Options he will have the liberty to sell or not to sell at that price on that particular date. That means, on that future date if market rate of Reliance share is higher than the option agreed price then he can simply ignore this option and sell at the market rate. Similarly if the market rate is lower than the option agreed price then he can sell at that agreed price. As he has the liberty to sell or not to sell they have to pay a price while buying the Option itself which comes at a cost which is called the Option Premium, which is again a market determined factor.
• Derivatives provide the investor a way to hedge against the risk.
• Derivatives can be leveraged and have low initial margins.
• Derivatives are instruments which help investors in diversifying the portfolio.
• Derivatives have fixed lock in prices
• Derivatives are complex to understand compared to the cash market.
• They are very sensitive to demand and supply factors.
• Derivatives are subject to counterparty risks in case of OTC.
• Derivatives are hard to value.
Derivative instruments in most of the cases are leveraged. It means that very minimal amount of capital is requires to invest in a large amount of derivative contract of an underlying asset. It gives the investor a leverage ratio of 8:1. The initial margin requirement for holding a futures or other derivative position varies depending on the market conditions. They provide a risk management strategy to the investor by offering many techniques like hedging and speculation.
There is a huge shift from the cash market to the derivatives market considering the fact that derivatives have low margin requirement. Though trading in derivatives is complex than the equity market. Trading simultaneously in derivatives along with cash market can act as a strong risk management technique, because when you are investing in market, your investment is always at risk. Derivatives can act as a high return objective at very low initial margins if traded with proper research.
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