Derivatives – Dutch Uncles

Understanding India’s Derivatives Market: All you Need to Know Before Investing

Shalmoli Sarkar — Sun, 19 Sep 2021 03:35:08 +0000

The origin of India’s derivative market dates back to 1875 when the Bombay Cotton Trading Association first began trading and by 1900, India became the world’s largest derivatives market.

But what is a derivative market?

A derivative is a financial contract between one or more sellers where the trading amount is dependent on the value of assets such as stocks, bonds, commodities, currencies, and market indices. Stocks, bonds, and market indices are known as financial derivatives, and gold, silver, food grains, and crude oil are commodities. The value of the financial contract or derivative is derived from the value of its underlying asset.

Let us understand this with an example.

Suppose a person named B, wants to book an IPL ticket for the front row. But on reaching the booking counter, he finds that all the front row tickets are sold. Moreover, other tickets were expensive now. His friend who works with the Cricket Board, on learning the situation, assures him of the availability of a middle row ticket for which booking will begin after four days. B’s friend hands him a letter that promises B to purchase the ticket at Rs 2000 irrespective of the ticket’s price at that time which may increase due to high demand.

As expected, the demand causes the ticket value to rise to the price of Rs 4000, but due to the letter, B can purchase the ticket at Rs 2000, giving him 50 percent profit. This also means that the value of the letter is Rs 2000, which is the profit.

Now, due to some reason B met with a small fracture due to which he cannot collect the ticket at the said date. The catch here is that since the said date has passed, he will not get the ticket priced at Rs 2000, and the letter provided by his friend holds no value now.

In this case, the letter was the derivative or in simpler terms a contract whose value was dependent on the ticket. So, the ticket is the underlying asset and the derivative is the ticket.

Similarly, in real life, petrol and diesel are derived from crude oil. Crude oil is the underlying asset and petrol and diesel are derivatives. A price change in crude oil will simultaneously impact the price of petrol and diesel.

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A derivative is a financial contract between one or more sellers where the trading amount is dependent on the value of assets such as stocks, bonds, commodities, currencies, and market indices.

What are the types of derivatives?

Derivatives can be classified into four types :

Option: It is a financial contract that allows the buyer to buy or sell an asset at a specific price during a specific period. However, in an option contract, the advantage lies in its flexibility that allows the trader to decide whether to purchase the asset or not at the said time. For instance, in the above example – Had B signed an option contract with his friend, then he could have avoided purchasing the IPL ticket at that date since he met with a fracture.
Future: Future is a financial contract that allows the trader to buy or sell an underlying asset at the agreed price mentioned in the contract at the said time. Here, the only difference that lies between future and option is that the trader cannot step down to purchase the assets. He has to purchase, irrespective of favourable market prices. Taking the same example, had B signed a futures contract with his friend then he would have to purchase the ticket for Rs 2000, even if he is not able to attend the IPL finale due to his broken leg. He is obliged to carry out the contract as agreed. Sadly, B in this has made a loss of Rs 2000.
Forwards: Similar to future derivatives, the trader is obliged to perform the contract with the only difference being that forwards are not standardised and not traded on stock or derivative exchanges. In this type, the chances of sellers or traders turning down the contract become high when the market price does not favour them. Had this been a future contract, and by chance, the seller or trader does not perform the contract then the risk is borne by the derivative exchange. As the contracts are not bound by a regulatory body’s rules and regulations, they are customisable to suit the requirements of both parties involved.
Swaps: Involves two parties where the exchange of cash flows or liabilities takes place from two different financial instruments. Most swaps involve cash flows based on a principal amount such as a loan or bond. Interest rate swaps are the common swaps contract that takes place. They are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.

What is the difference between capital and derivatives markets?

Though in both capital and derivative markets both small and big businesses intend to raise capital, few know about the difference between the two.

Which body regulates the derivatives market?

In India different derivative instruments are regulated by various bodies such as commodity derivative market in India is regulated by Securities and Exchange Board of India (SEBI), and RBI regulates the interest rate derivatives, foreign currency derivatives and credit derivatives.

The post Understanding India’s Derivatives Market: All you Need to Know Before Investing appeared first on Dutch Uncles.

Options and Futures: How are they Different from Each Other?

Shalmoli Sarkar — Sat, 18 Sep 2021 08:35:08 +0000

Options and Futures are the tools used by investors when trading in the derivatives market. Derivative here refers to a financial contract whose value is dependent on underlying assets or stocks.

In both these tools, a financial contract between the buyers and the seller is involved that allows the buyers to derive profits from an underlying asset such as shares, stock market indices, electronic trading funds (ETFs), etc. Here are some of the key differences between the tools.

What is Future?

A Future is a financial contract that allows the buyer to bet on the future price of an underlying stock or commodity. Traders, after betting, have to buy that stock at the time of delivery. There are many types of futures contracts available, on assets such as oil, stock market indices, currencies, and agricultural products.

Let us understand this with an example.

Say a trader wants to speculate in the price of crude oil by entering into a futures contract in January with the anticipation that its value will surge in December. Currently, the December crude oil futures contract is trading at $40 a barrel. Oil is traded in the quantity of 1000 barrels which means the total amount traded will become $40000 ( 1000 X $40), but first, the trader will only pay the initial margin. Suppose the oil prices at the end of the year increase and now the new price per barrel is $ 50 and the trader sells the future contract to exit. Now, the difference between the previous and current oil barrel price is $10 ( $50-$40) where the trader earns $10000 ( 1000 X $10) as profit. Had the price of an oil barrel fallen to $20, then the loss would have been – $20000 ( 1000 X $20 {$20-$40}) in which the trader has no other option to buy the oil, thus giving losses.

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IOptions and Futures are the tools used by investors when trading in the derivatives market. Derivative here refers to a financial contract whose value is dependent on underlying assets or stocks.

What is Option?

An option is a financial contract that offers buyers the opportunity to buy or sell an underlying asset at a specific price on or before a certain date. Here, the buyer is not obligated to buy or sell the asset if they decide against it. Within option, there are two alternatives:

Call: It gives the holder the right to buy a stock

Put: It gives the holder the right to sell a stock

Let us understand option with an example-

Suppose we are interested to invest in stocks whose price is Rs 2000, and after a month we bet the stock’s price to be Rs 2150, for that, the company asks to pay a margin of 10% i.e. Rs 200. But, let us say after a month when stocks are issued, the price becomes Rs 2500. So, the buyer who earlier paid the margin amount of Rs 200 and bet the stock price to be Rs 2150 will now buy it at Rs 2350 (2150+200). Therefore, a stock priced at Rs 2500 will be available at Rs 2350. But, in case if price falls the buyer can choose not to purchase the stocks as it will attract losses but will have to bear a small loss of Rs 200 which is the margin amount paid.

The Difference – Options vs Futures

Things to keep in mind for investors before investing in options and futures

Here are some of the tips to keep in mind for investors, as trading in options and futures (or in the derivatives market) is similar to trading in the stock market.

Maintain a margin amount

The margin amount while trading in options and futures markets should always be kept in store. As per the stock market rules, investors need to continuously maintain a margin amount i.e. one cannot withdraw this amount from trading account at any point in time till the trade gets settled.

Tab on budgets

While trading in options and futures market, a trader must pick stock and their contracts based on four things:

Amount in hand
Margin requirement
Price of underlying assets or stocks
Price of contracts

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