What Are Derivatives in Share Markets

Derivatives in Share Markets

In India, share market derivatives have picked up in a big way. Financial derivatives is largely our focus and we look at equity options, equity futures, index options and index futures as the predominant types of financial derivatives. Derivatives in stock markets is basically about future and options in the various permitted stocks and indices. As the name suggests, derivatives are called thus because they derive their value from an underlying asset.

Did you know that you do not invest in derivatives since derivatives are not an asset class. Instead, they are contracts. Broadly, when we talk of derivatives futures and options are the key products that we refer to in the Indian context. These can be on a variety of underlying. One of the big advantages of derivatives is that you can also combine these futures and options in a pre-defined format to arrive at derivative strategies. That makes it flexible.

Before we get into what are derivatives, let us first understand what derivatives are not.

What Derivatives are not

Derivatives are contracts that derive their value from an underlying asset like a stock, bond, commodity, index etc. Firstly, thing you need to know here is that derivative is not an asset but a contract. Hence, derivatives are not held in the demat account, but reside in the trading account only. Unlike what many people believe, derivatives are not an easy road to making money. It is easy to say that profits can be magnified in derivative trading, but remember that losses can also be magnified. Hence you must trade very cautiously.

Derivatives is not for everyone. Don’t attempt trading in futures and options unless you understand these products thoroughly. Most derivatives are not value creating assets but they are value losing assets. For example, futures and options would be worthless after the contracts expire. Keep that in mind when you try to trade in derivatives. Lastly, derivatives are not a trading product. The main purpose of derivatives is to manage your risk and hedge your risk. That is what it should be used for.

What are Derivatives

What exactly are derivatives? Derivatives are financial instruments, but as the name suggests, they derive their value from other existing asset classes. The term "Derivative" means that it derives its value from an underlying asset. This can be stocks, indices, commodities, gold, bonds and just about anything where the value can be agreed upon. 

So, derivatives are basically a play on the change in value of an underlying asset. If the price of the underlying asset is constant all through, then any futures contract or options contract in that asset is pointless. For example, if you have bought futures, you gain when prices rise and if you have sold futures you gain when the prices fall. Similarly, if you have bought a call option, you gain when the price of the stock goes up and if you have bought a put option then you gain when the stock price goes down.

In short, when you trade in derivatives, you are betting either that the price will go up or you bet that the price will go down. You can look at derivatives as contracts or bets on whether the stock price or asset price will go or go down within a certain period. When we talk of derivatives we normally talk of futures and options. But even optionally convertible debentures and warrants are derivative products.

Nuances of Futures and Options

Here we focus on the two most popular derivative contracts in India viz. futures and options. Let us begin with futures. A futures contract is a legally binding standardized exchange traded agreement between two parties to buy or sell the underlying security at a future date at a fixed price for settlement. While futures contracts in India typically expire on the last Thursday of each month, these futures contracts are also traded actively on the F&O segment of the stock exchange. 

Hence, if you are long or short on futures; you can easily close your position by taking the opposite position. You don’t have to wait till the expiry of the contract. Futures are exactly similar in payoffs like a forward contract. The only difference is that futures contract are standardized, liquid and exchange traded. They also carry a counter guarantee from the stock exchange clearing corporation.

Let us now turn to options. Unlike futures (which are symmetric) options are asymmetric. That means; in futures losses and profits for the buyer and seller can be unlimited. However, in an option, the loss for the buyer of the option is limited to the premium while the loss for seller is unlimited. The profit for the option buyer is unlimited but the profit for the seller of the option is limited to the premium received from the buyer of the option.

An option can be a  call option (right to buy) or it can be a put option (right to sell). Why would anybody give such a right to the buyer? They do it to earn the premium. The option premium is the price of the right. That is what is traded in the options market. The options contract gives you the right to buy or sell an asset at a set price on or before a given date.

Illustration to understand options

Assume there are 4 persons A, B, C and D in the options market. There is just 1 contract traded in the market. It is an option contract at a strike price of Rs100. The call premium is Rs12 and the put premium is Rs9. Now let us understand from these 4 persons viewpoint.

• A buys Rs100 strike call option at Rs12. That means he expects the stock price to go above Rs100. However, he has paid premium of Rs12, so profits will only start if the price goes above Rs112.

• B sells Rs100 strike call option at Rs12. That means he expects the stock price will not go above Rs100. At that point, B earns the full premium of Rs12 as income. However, above Rs112, his losses can be unlimited. That is the risk.

• C buys Rs100 strike Put option at Rs9. That means he expects the stock price to go below Rs100. However, he has paid premium of Rs9, so profits will only start if the price goes below Rs91.

• D sells Rs100 strike Put option at Rs9. That means he expects the stock price will not go below Rs100. At that point, D earns the full premium of Rs9 as income. However, below Rs91, his losses can be unlimited. That is the risk.

That sums up the options market for you.

Derivatives – for Speculation or Hedging

That is a debate since derivatives started nearly 100 years ago in an organized manner. One argument traders do make is that if they pay 20% margin on futures then their profits can get magnified by 5 times. The downside is that even losses can get magnified 5 times. One can speculate in derivatives on 2 conditions. Firstly, it must be done with strict losses. Secondly, you cannot allow your trading capital to deplete beyond a point. 

The real purpose of derivatives is to hedge risk. If you have bought a stock, you can hedge the risk by selling futures or by buying a lower put option. Derivatives work best when they are used as a risk management tool.

Participants in the Derivatives Market

Broadly there 3 key participants in the derivatives market. Let us look at them and understand how they operate.

• Speculators are high risk takers. They bet on stock price movements through futures and options. This can work both ways, so strict stop losses and risk management is very critical here.

• Hedgers try to protect risk, typically downside risk when holding stock. While speculators take trading positions, without underlying, a hedger would only buy or sell derivatives with an underlying position in the asset.

• Arbitrageurs are specialized players who create riskless profits based on the spread between the spot market and the futures market. Here the returns are the lowest, but so is the risk. Complicated arbitrage is also done between stock baskets and the index futures.