Futures, options and derivatives: Watch any movie about the financial markets and you are bound to hear these words. Traders in good looking suits rush around the trading floor spouting these terms at the top of their voices. It all sounds rather important and complicated. But what are these words exactly? And how do you invest in derivatives? Let’s find out.
What are derivatives?
Derivatives are financial contracts between investors. They derive their value from another asset such as stocks, bonds or other commodities. That’s why they are known as ‘derivatives’. Based on the change in price of the underlying asset, the price of the derivative is determined.
How to trade in derivatives?
Future contracts and options are two of the most common types of derivatives. Here is how you can invest or trade in these avenues.
As the name suggests, a futures contract is a contract between two investors to conduct the sale of an asset for a specific price and a pre-determined point of time in the future.
Here is how a futures contract takes place. Imagine there are two investors: Santosh and Meera.
Santosh has 100 shares of company X. The value of each share at the moment is Rs 50.
Santosh wants to sell the shares after six months. However, he fears that the market could take a downturn by then. He wants to ensure that he gets a good return on the sale of his stocks.
He tells his broker to find a buyer for his shares.
Meera is an investor who wishes to buy the shares of company X. She is confident that the market is poised for a boom in six months. She decides to enter a futures contract with Santosh.
As per the contract, she is willing to buy 100 shares of company X at Rs 80 per share after six months.
In reality, two things could happen: the market could go up as Meera expects or go down as Santosh expects.
Imagine the market goes up. The stock price of company X rises to Rs 120 per share.
This means that Meera earns a profit of Rs 50/share.
As for Santosh, it doesn’t really matter whether the market goes up or down because he has already booked his profits at Rs 30 per share.
Imagine the market goes down. Let’s assume the prices of company X falls to Rs 20 per share.
This means Meera makes a loss of Rs 30 per share.
In order to avoid such losses, Meera could instruct her broker to create a stop loss. For example, if she creates a stop loss at Rs 40, the broker immediately sells her shares when the stock hits the specified price.
In this way, Meera can ensure that her losses are minimized.
An option is like a futures contract. Here too, two investors enter into an agreement to trade a security at a particular price on a pre-determined date in the future. But in the case of options, the buyer or seller is not obligated to go through with the transaction. He has the ‘option’ to conduct the transaction. This allows the investor to gain a leveraged position on the stock while at the same time he can avoid the risk of a total purchase. Options are commonly used by traders to hedge their positions in the market.
Derivatives offer investors the opportunity to hedge their bets in the market and maximize their returns. If you have the appetite for some risk and if you possess an understanding of the Indian markets, investing through derivatives can be largely beneficial. And the next time you hear someone talking about derivatives on the TV, you know exactly what they are talking about.
Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.