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Why Having Deep Knowledge In Future and Options
Brief Explanation :
Type of instrument we can trade in stock mark:
1.EQUITY- ( popularly known as Shares)
What is Derivative Market :
DEFINITION of 'Derivative'
A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterparty than do standardized derivatives.
The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.
The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different, as well as the way they are traded, though many market participants are active in both.
Imagine a market where people like you and me have conflicting views regarding the future of stock prices- some of us expect it to rise in the future, while the rest are still sceptical and expect the prices to fall. We trade in a market that allows us complete flow of information and freedom to trade according to our instincts. Given shared knowledge, we would all know how the markets are expected to behave in the coming days and we take our positions- bullish or bearish regards the future price of stocks. This is what forms a typical Derivative Market. Derivatives are financial instruments that derive their value from other existing asset classes. The term "Derivative" indicates the instrument derives its values entirely from the asset it represents be it equity, bullion, currency, commodity, realty, rate of interest or even livestock. A feature that is common to all underlying assets is that they carry the risk of change in value. As the value of a stock may rise or fall, an exchange rate may swing in favour of one currency or the other, the price of a commodity may increase or decrease, and so on; it means speculating on forward, future prices, placing an option on possible fluctuations or any other such contract made for the possible realisation of those pre determined values of financial assets or any index of securities. Derivative contracts seek to transfer these risks from an individual who is not comfortable with the risk to the one who is. Simply put, when you invest in derivatives, you actually place a bet on whether the value of the asset represented will increase or decrease by a certain percentage and within a set period of time. Therefore, derivatives are merely contracts or bets that get their value from existing or future prices of underlying securities. When you deal in derivatives, you are essentially buying a promise from the original owner of the asset to transfer ownership of the asset rather than the asset itself. This promise gives you tremendous flexibility and is by far the most important trait that appeals to investors. Derivatives however, are different from equity shares that we hold. Shares are assets while derivatives get their values from the shares being held. The most common types of derivatives that you are likely to come across are futures, options, warrants and convertible bonds. An options contract gives you the right to buy or sell an asset at a set price on or before a given date. On the other hand, in a futures contract, you are obligated to buy or sell the asset at the end of the contract date. A futures contract means a legally binding agreement to buy or sell the underlying security at a future date and is an organized contract in terms of quantity, quality, delivery time and place for settlement at a future date. The contract expires on a pre-specified date or on an expiry date and on expiry, futures can be settled by delivery of the underlying asset or cash. The options contract allows you the right but not the obligation to buy or sell the concerned asset at a predetermined price within or at end of a specified period. The buyer / holder of the option would then purchase the right from the seller / writer for a consideration known as a premium. The seller is then obligated to settle the option as per the terms of the contract or when the buyer exercises his right to buy. An option to buy is called as a call option and option to sell is called put option. Further, an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date is called European option. This was introduced to increase liquidity volumes in certain segment of options. Currently all the options traded on NSE Exchange are European in nature. The price at which the option is to be exercised is called Strike price or Exercise price. As in the case of futures contracts, option contracts can also be settled by delivery of the underlying asset or cash. However, unlike futures, cash settlement in option contract includes the difference between the strike price and the price of the underlying asset either at the time of contract expiry or at the time of exercising the option. As the derivative markets deal in speculation, there is a large amount of risk involved. The Exchanges, however, have a stringent framework for risk control and minimizing loss. But a word of caution to retail investors, invest in derivatives only after taking care of your financial needs and as an avenue of diversifying your portfolio. Derivatives are merely profits that you should earn and not returns that you should bank on. Derivatives are used to hedge risks and for speculative trades; and active markets need the equal participation of both such investors. By rule of thumb, if you are a cautious investor with limited funds, learn to hedge your bets while if you are ready to take some risk and have ample funds to play the markets, not to mention also possess acumen and understanding of the Indian market trends, play the markets to your advantage. From the days of badla trading to the more recent foray into the UK equity through the FTSE100 Index, the Indian equity derivative markets have come a long way indeed. However, unless you totally understand the vagaries of this market, proceed with caution to make profits and not losses. There are three types of participants in a derivatives market: Speculators, Hedgers and Arbitrageurs. Speculators are the high risk takers. They contemplate and bet on the future movement of prices based on their skill and knowledge levels with a higher-than-average risk in return for a higher-than-average profit potential. They take risk to earn profit by buying low and selling high, or by first selling high and later buying low. Hedgers are cautious players who protect themselves from risk by closely watching price movements and sell as soon as they reaches their optimum price, thus getting an assured price for the stocks. In general, hedgers use futures for protection against adverse future price thereby looking to reduce risk for their holdings and interest. They are extremely important to a derivative market and are primarily responsible for setting future prices. The person who attempts to profit from inefficiencies in price by making transactions that offset each other is an Arbitrageur. He typically makes his profit by buying low in one market and selling high in another. Arbitrageurs keep market prices stable and reducing possible exploitation of prices. They are typically the most experienced market players who make fast decisions. We will learn more about these players in our next session. Till then, while dealing in derivatives, do learn to derive- meaning, analysis and profits.
Learning Derivatives: Hedgers, Speculators, Arbitrageurs
As we understood in the last article, Derivatives derive their values from the assets they represent. Given the constant volatility in today’s market environment, there are always variations of price that asset holders have to deal with. In keeping with the demand and supply equation prevailing at the moment, your assets either increases in value or decreases, exposing your holdings to continued financial risk and loss. As this risk is constant and a typical attribute of capital market investing, managing this risk and associated uncertainty is extremely important. Derivatives thus help us manage these risks effectively. As derivatives have no independent value of their own, they are traded at the expected values of the assets they represent. Hence, it is also the trading of expected risk and uncertainties. Thus, trading in derivatives is also a form of insurance against unexpected price movements, volatility of markets, uncertainties of Company performances and profits. Summarizing, derivatives allow you to Trade on price movements Contain risks and uncertainties Profit from short term mispricing However, every market needs participants. As derivative contracts are bought by retail and institutional players with varied needs, market participants are thus defined by the purpose by which they choose to trade in derivatives. The important players in a derivative market as per their specific needs would be: a) Hedgers b) Speculators c) Arbitrageurs In simple terms, hedging would mean the reduction of risk. An investor who is looking at reducing his risk is known as a Hedger. A Hedger would typically look at reducing his asset exposure to price volatility and in a derivative market, would usually take up a position that is opposite to the risk he is otherwise exposed to. For example, an investor has a portfolio of Rs. 1000000 and wants to hedge ahead of an important event (something like elections, policy announcements, or even the Budget!). Depending on the investor’s requirement; hedging can be done by shorting index futures to make his portfolio beta neutral. Alternatively, the investor can buy put options of the index by paying a fixed cost referred to as premium. Hedgers primarily look at limiting their exposure risk. This is done by using derivative tools and “insuring” limited losses in case of unfavourable movements in the underlying asset. That brings us to the next group of derivative market participants the Speculators. As the name suggests, speculators hypothesize expected price movements and take accordant positions that maximize profit. Speculators are extremely high risk takers who are in the Derivative markets merely for the purpose of making profits. They need to effectively forecast market trends to take positions that don’t in any way guarantee safely of invested capital or returns. Speculators rely on fast moving trends to forecast possible market moves these could range from changing consumer tastes to fluctuating rates of interest, economic growth indicators coinciding with market timing etc. Speculators can make huge profits or an equally huge loss and are typically high net investors looking to diversify holding with a view to maximize profits in a short period of time. If a speculator feels the stock price of XYZ Company is expected to fall in the next two days given some upcoming market developments, he would typically short sell these shares in a derivative market without actually buying or owning those shares. Should the stock then fall as expected, he would rake in a sizeable profit depending on his holding. However, should the stock buck expectations, he would make a commensurate loss. The last major participants are the Arbitrageurs. They play in an extremely fast paced environment with decisions being made at a moment’s notice. Sometimes 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. They also play an important role in increasing liquidity in the market thus making it more fluid. There are various arbitrage opportunities that can be explored in the derivatives market. Cash-Futures arbitrage is one of the simplest forms. If the futures price is trading at a premium to its underlying asset; it is referred to as a Contango. If the premium post adjustment for transaction costs gives higher returns than the cost of capital, an arbitrageur will initiate positions to benefit from this opportunity. The opposite scenario (where Futures are at discount) is referred to as Backwardation. Derivative markets also include brokers and dealers who represent customers. Every participant individual or represented place their orders at the derivatives exchanges for execution. This central marketplace then provides a platform for information and matching positions for all participants who remain anonymous to ply their trade. Thus derivatives and its market participants help redistribute risk generated by global and domestic economies. They regulate pricing and protect assets from being excessively over valued or undervalued. Derivative market participants thus keep efficient machinery in place to allow for a smoother and balanced functioning of the equity markets.
Basics of Futures and Options
We have understood Derivatives and their market landscape. We met the key players therein. Now let us introduce ourselves to the instruments that give Derivatives their flexibility and make them lucrative for traders. As we already know, in a Derivative market, we can either deal with Futures or Options contracts. In this chapter, we focus on understanding what do Futures mean and how best to derive the most from trading in them. A Futures Contract is a legally binding agreement to buy or sell any underlying security at a future date at a pre determined price. The Contract is standardised in terms of quantity, quality, delivery time and place for settlement at a future date (In case of equity/index futures, this would mean the lot size). Both parties entering into such an agreement are obligated to complete the contract at the end of the contract period with the delivery of cash/stock. Each Futures Contract is traded on a Futures Exchange that acts as an intermediary to minimize the risk of default by either party. The Exchange is also a centralized marketplace for buyers and sellers to participate in Futures Contracts with ease and with access to all market information, price movements and trends. Bids and offers are usually matched electronically on time-price priority and participants remain anonymous to each other. Indian equity derivative exchanges settle contracts on a cash basis. To avail the benefits and participate in such a contract, traders have to put up an initial deposit of cash in their accounts called as the margin. When the contract is closed, the initial margin is credited with any gains or losses that accrue over the contract period. In addition, should there be changes in the Futures price from the pre agreed price, the difference is also settled daily and the transfer of such differences is monitored by the Exchange which uses the margin money from either party to ensure appropriate daily profit or loss. If the minimum maintenance margin or the lowest amount required is insufficient, then a margin call is made and the concerned party must immediately replenish the shortfall. This process of ensuring daily profit or loss is known as mark to market. However, if and ever a margin call is made, funds have to be delivered immediately as not doing so could result in the liquidation of your position by the Exchange or Broker to recover any losses that may have been incurred. When the delivery date is due, the amount finally exchanged would hence, be the spot differential in value and not the contract price as every gain and loss till the due date has been accounted for and appropriated accordingly. For example, on one hand we have A, who holds equity of XYZ Company, currently trading at Rs 100. A expects the price go down to Rs 90. This ten-rupee differential could result in reduction of investment value.
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