Derivatives or financial derivatives, as the name suggests, are financial contracts that “derive” their value from an underlying asset. Simply put, derivatives help you make profits by taking a call on the future value of its underlying asset. There are many types of financial derivatives of many assets such as commodities, currency, indices and stocks. For the sake of simplicity however, we will delve into equity financial derivatives for better understanding.
How does an equity derivative work?
Suppose you buy a derivatives contract on stock A that is trading at Rs 2,000 in the spot market. The expiry date of the contract is a month later. At this time the stock trades at Rs 2,500 in the spot market, but you can still purchase it at Rs 2,000, thereby making a profit of Rs 500 per share. The same holds true if the stock price were to fall by Rs 500. In that case you would incur a loss of Rs 500 per share.
What are derivatives used for?
To know the uses of financial derivatives let’s look into the below terms:
Derivatives offer you the opportunity to protect yourself against price fluctuations. You can use a derivative strategy to protect yourself against a price rise or a price fall. This is called hedging.
Every investor in the market has a different risk appetite or tolerance to bear losses. Derivatives can be used effectively to transfer risks from risk-averse investors who want to protect themselves against price fluctuations to risk-tolerant investors such as speculators who take contrarian trade positions to enhance profits.
Different types of derivatives contracts
Futures and forwards:
As explained earlier, future contracts are agreements coined to buy or sell a specified number of shares at a pre-stipulated time in the future. Forwards can be called a variant of futures but ones that can be customised to a certain extent. Unlike futures, these are non-standardised in nature and cannot be traded on the exchange.
Options are similar agreements like futures, but one in which you can exercise a choice or an option to meet the obligation. For example, if you have an option contract to buy 50 shares on the expiry date, you can choose whether or not you wish to do so. Options too can be traded on the stock exchange.
What do you need to invest in derivatives?
To understand how to trade derivatives here are the following factors you need to consider:
A demat account- Just like trading in shares, a demat account is a pre-requisite for dealing in derivatives.
Trading account- A trading account is linked to your demat account and serves as your unique identity in the market.
Initial margin- When you decide to deal in derivatives, you need to deposit an initial margin, that is decided by the stock exchange. It is a risk containment measure on behalf of the exchange, and depends upon the total value of your outstanding position as well as the average volatility of the stock and interest cost over a stipulated time period. This margin is adjusted daily depending upon the market value of the open positions you hold.
Exposure margin- This margin is also levied by the exchange and is used to control excessive speculation and volatility.
Mark to market margin- Apart from the two margins mentioned above, you also need to maintain a Mark to Market (MTM) margin. This margin covers the difference between the cost and the closing price of the contract on a day to day basis.
Derivatives trading must do’s
Research- This is the most important aspect of derivatives trading. Derivatives trading is far more complex than stock trading, so do not make a trade unless you are completely sure of the position you are taking, the purpose of the same and the possible consequences.
Maintaining the margin amount- Margin maintenance plays a big role in derivatives trading. It is always prudent to maintain some extra amount in your account as the margin amount changes with the rise and fall in the underlying stocks.
Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
Characteristics of the Types of Investor in Stock Market The key to successful investing is chalking out an investment strategy that is in sync with your risk appetite. Simply put, your risk appetite is your tolerance to bear losses. Your risk appetite may be low, medium or high. Therefore, to begin investing, you need to understand your risk appetite first to understand what type of an investor you are. This is what will determine your investment profile and help you achieve your financial goals.There are different types of investor profiles hence, while each individual has a different investment profile and investment preferences, it is easy to classify investors into three broad categories based on the amount of risk they are willing to take. Here are the three types of investors based on their risk tolerance: The conservative investorThe first and foremost concern of this type of investor is the protection of his capital. He is unable to bear any erosion of the principal amount he has invested. This makes him a low-risk investor who will probably get sleepless nights during a volatile period in the markets. What he prefersA low-risk investor is therefore likely to be happy investing in debt instruments. Since he is not aggressive in his expectations, he does not mind the likelihood of moderate capital growth with steady returns.The balanced investorThis is someone who is willing to take a little more risk to enhance the value of his portfolio. He will thus have more tolerance for volatility than a conservative investor, but will not be willing to invest in high-risk instruments for greater returns. What he prefersA medium-risk investor seeks a balance between stability and growth. His portfolio will consist a mix of debt for stability and equity-oriented instruments that invest in stable companies. The aggressive investorAs the name suggests, this is an investor who can take the market’s short-term volatility in his stride. He is not afraid to expose his portfolio to high risk in pursuit of higher growth. The essential difference between an aggressive investor and low and medium risk investors is that he is willing to take greater risk. What he prefersAn aggressive investor is willing to expose his portfolio to high risk instruments in the equity markets and may even bet on unknown companies to further enhance the value of his portfolio. Such investors with a competitive investor profile are also willing to opt for leveraged products such as derivatives of equities and other asset classes. ConclusionTo identify your investor profile it is important to determine what kind of an investor you are before you embark on your investment journey. It is important to bear in mind that wealth creation is a time-consuming process and staying invested will bear fruit if you have time on your side. Thus, it is wise to invest according to your own risk profile. This is what will take you closer to your financial goals. The best part about different investor types is that every individual begins as a novice and gradually progresses to the next consecutive level of investment accomplishment through training and knowledge. Irrespective of the type of investor you are currently, moving on to the next level is not too far, and can be easily done with a little practice and education.What is the key to being an experienced investor? As can be seen from various examples around us, the most successful investors have excellent temperament that has helped them consistently outperform the market. They can do this not because of perfect timing or hordes of cash. They do it by distinguishing their instinctive tendencies, established methods, doctrines, and laying down a disciplined plan of action.Taking a cue from Warren Buffett, he says, "Success in investing is not associated with one's I.Q." At the end of the day, what one needs is the temperament to restrain impulses that usually get most people into trouble. Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
When it comes to investing, a key ingredient to success is diversification. Simply put, it is the act of reducing risk by distributing resources among various financial instruments. Diversification can happen not only within a single asset class such as equity, but can also be achieved among various asset classes. For instance, retail investors may consider investing commodity besides equity and debt. Unlike popular perception, investing commodity is not as complicated or risky and offer immense potential for market-savvy investors. Basics of investing commodity To understand what are commodities investments, let’s look at how commodities are classified into five broad sectors: ● Agriculture● Metals and materials● Energy ● Services● Precious metals Each of these categories have different commodities under their heads as explained below: Where does trading happen? Now that you know what are commodities investments, it is a good idea to know there are three main exchanges where you can trade in commodities. These are the National Commodity and Derivatives Exchange (NCDEX), Multi Commodity Exchange of India (MCX) and the National Multi Commodity Exchange of India. All the three exchanges have a national presence and electronic trading and settlement systems and can offer benefits of investing in commodities. Investing in commodities made easyThere are a host of equity traders who have a well established presence in commodities as well, and offer trading facilities through the internet platform. If you are new to trading, you can also check the list of brokers registered with the above exchanges to make a final choice. You can begin trade by entering into an agreement with the broker and undergo the normal Know Your Customer (KYC) procedure. Besides a bank account, you will need a commodity demat account from National Securities Depository Ltd. You will need to pay your broker a percentage of the contract value. For different commodities there will be different brokerages. It will also differ on the basis of transaction type meaning trading or delivery. However, it cannot exceed the maximum limit as specified by the commodity exchanges. Pricing and contracts in commodity trading There are two types of prices in commodity trading: spot and future. ● Spot price is the price in which one buys and sells a commodity on the spot ● Future price is the price of the same commodity at a future date. A futures contract is thus an agreement to buy or sell a stipulated amount of a commodity of your choice at a certain price on a future date. On this date, the commodity being traded (type and quantity) must be delivered at the contracted price, irrespective of a rise of fall in the market price. Trading in commodity futures is done on margin. This means, as an investor you have deposit only a fraction of the futures contract with the broker. This provides higher leverage and the option to reap higher returns. Cash or delivery settlement mechanism A contract may be settled through a cash or a delivery mechanism. If you want a cash settlement, you must indicate so at the time of placing an order. Else, if you wish to make a delivery, you need to have the required warehouse receipts. You have the option of changing this mechanism as many times till the expiry of the contract date. How does a transaction take place? A transaction is made electronically between the brokers of both the buyer and seller of a commodity. Both parties enter into respective obligations. While one party decides to purchase, the other decides to sell. The buyer is obliged to take delivery and pay for the commodity for the ascertained price, while the seller has the obligation to deliver the commodity on the said date. Both the buyer and seller can however absolve themselves can absolve themselves of this obligation by offsetting their trade before contract expiry. This is what most speculators do to make gains by speculating on the direction of the price of the commodity. How is commodity trading advantageous? The right mix of commodities in your portfolio can help your portfolio as they are an excellent means of diversification. For instance, gold has a low co-relation to equities and will typically provide gains when equities are down. You could also consider mutual funds investing in commodities to add to your portfolio. Further, as commodity prices determine inflation, investing in commodity futures may be used as a hedge against inflation. However, it is imperative to understand the risks involved in commodity trading before taking a leap. Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
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