What is Derivatives Trading? It must have struck your minds. Risk is inherent in commodity & financial markets. All investment instruments in the financial markets associated with risks in terms of the regular fluctuation in prices, which increases the Investor's exposure to such risks.
Financial derivatives came into the spotlight in the post-1970 period because of increasing instability in the financial markets. After their emergence, they became very popular and by the 1990 s, they constituted about 2/3rd of the total transactions in derivative products.
A derivative is a contract or product that derives its value from an underlying asset. Derivatives may include various assets including indices, currencies, exchange rates, commodities, stocks, or the rate of interest. The seller and buyer of these contracts have opposite estimations of the future trading price. Both buyer & seller bet on the future value of the underlying assets to make a profit. Derivative trading is equivalent to a regular selling and buying process. But rather than paying the whole amount up front, a trader generally pays only an initial margin to a stockbroker.
To get a head-start in this field we first should know what is derivatives trading and its intricacies. We discuss derivative trading and simplify the same for our readers. Let's begin!
Different Types of Derivatives
According to the conditions of a contract, derivatives can be divided into the following types,
1. Futures – A futures contract is a legal agreement between two parties to sell or buy the underlying asset at a predetermined future price and date. The contract is directly executed with a regulated and organized exchange.
2. Forwards – Forward contracts are equivalent to futures. The only difference is that the deal is not regulated or organized exchange. As these are Over-The-Counter (OTC) contracts, it carries more counterparty risk for both parties involved in the contract.
3. Options – An options contract provides rights but not an obligation to traders, to sell or buy an underlying asset at a predetermined future price and date.
4. Swaps – A swap is a contractual agreement between two parties. Swab allows an exchange of cash flows at a future date, using pre-planned formula.
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Participants in a Derivatives Market
Four participants involve in derivative trading. They are as given below,
1. Hedgers – These types of participants invest in the derivatives market to abolish the risks associated with future price changes.
2. Traders and speculators – These participants predict future changes in the price of an underlying asset. Based on their predictions, they take a certain position either long term or short term in a derivative contract.
3. Arbitrageurs- Arbitrage is a practice frequently used to exploit the price differences in two or more markets. . For instance, a trader purchases stock in one market and simultaneously sells it off at a higher price in another market. It is a very common practice in financial markets.
4. Margin traders – In derivative trading, the Investor pays an initial amount to the stockbroker. This amount is Margin. It is generally a percentage of the total value of the investor’s position. Margin traders often use this distinct payment method to buy more stocks than they can afford.
Advantages of Derivative Trading
1. Low transaction costs – Derivative contracts are important in reducing market transaction costs as they work as efficient risk management tools. Hence, the c transaction cost in derivative stock trading is lower than other securities like shares & debentures.
2. Used in risk management – The value of a derivative contract is directly related to the price of its underlying asset Thus, derivatives used to hedge the risks associated with varying price levels of the underlying asset. For Instance, Mr. Ghosh buys a derivative contract, the value of the contract moves in the opposite direction to the price of the asset he possesses. Mr. Ghosh would be able to use the profits in the derivatives to offset losses in the underlying asset.
3. Market efficiency: Derivative trading involves the practice of arbitrage which plays a very important role to make sure that the market reaches equilibrium and the prices of the underlying assets are correct.
4. Determines the price of an underlying asset – Derivative contracts are frequently useful in ensuring the cost of an underlying asset
5. Risk is transferable- Derivatives allow businesses, investors, and others to transfer the risk to another party.
Disadvantages of Derivative Trading
Let us have a look at the disadvantages of Derivative Trading,
1. Involves high risk – Firstly, Derivative contracts are extremely volatile since the value of underlying assets like shares keeps fluctuating rapidly. Hence, there is a risk of incurring huge losses for traders.
2. Counterparty risk- Secondly, Derivative contracts like futures that traded on the exchanges like NSE and BSE are regulated and very organized. However, OTC derivative contracts like forwards, and not standardized. Thus, there’s always a significant risk of counterparty default.
3. Speculative in nature- Lastly, Derivative contracts are the tools for speculation. Moreover, it can lead to huge losses owing to the numerous complexities associated with it.
Derivative trading thus needs in-depth knowledge about the products and a great deal of expertise. Moreover, all investors required to conduct thorough research related this process and formulate effective strategies to minimize losses and maximize profits.
Derivative Trading Example
Derivative Trading is thus of various types and every type has its own set of rules for trade execution.
Let us take an example of future trading for this type of investment so that you can easily grasp the concept.
For example, let’s say the Indian government proposed a policy to subsidize the power sector in terms of their imports. This policy will have a direct impact on the manufacturing of Petroproducts as the producer is now able to import more raw material within the same cost.
It will increase the revenue of the businesses, Hence, increasing the overall profitability of the companies within that sector. So, you select one such stock, for instance, “ Relco Petro” which is now trading at a market price of INR 660. You are completely bullish for this industry and the stock. You may predict that the stock would hit 900 by the end of the next month. With this on your end, you go into a future contract with the selling party at INR 750. This means that if the stock goes beyond 750 from the current market price of INR 660, you will earn profits. To get into such a contract, you need to pay a specific premium amount. It works as an incentive for the sellers and also shows your commitment to the contract. For instance, this non-refundable premium amount of INR 2000.
So, there can be 3 situations:
1) Relco Petro stays approximately INR 660
2) Relco Petro drops by INR 600
3) Relco Petro jumps to INR 820
If either case 1 or case 2 is true, then you would not exercise the contract and let it expire. In simple language, you will not ask the seller to sell the contract at INR 660 as it's already available in the market at a fair price.
In this case, your premium of Rs. 2000 would be kept by the seller.
But, if case 3 comes out to be true, then you will definitely want to exercise the contract by buying the stock at Rs. 660 and sell it at a price of Rs. 820. Hence making a huge profit on the trade.
In this manner derivative trading works. You can be a buyer or seller depending on your expectation from stock or market.
Derivative Trading Strategies
We subsequently have multiple strategies to deploy for derivative trading. The strategy depends upon whether you are using futures or options forms of derivative trading or whether you are going for call options, put options.
Followings are some of the most commonly used derivative trading strategies:
1) Covered Call: This strategy works best when the trader is mildly bullish toward the market. Traders are aware that by only holding the underlying asset, he would not able to make a handsome profit.
2) Protective Call: It’s a hedging option strategy. It is used for minimizing the risks. The strategy combines an existing short position on an underlying asset along with buying of call options, to protect against the price rise against the expectations.
3) Long Call: Long call is buying call options. This implies that the trader has the right to buy a security at a future date at a predefined price.
4) Bull Call Spread: It subsequently consists of one long call with a lower price and one short call with a higher price strike.
5) Long Strangle: It is an options trading strategy and includes buying an out-of-the-money put option, both with the same underlying asset and options expiration date.
6) Short Strangle: It’s a superb strategy to deploy when the investor is expecting very little to no volatility in the market.
Furthermore, Derivatives are securities that derive their value from an underlying asset or benchmark. Common derivatives are futures contracts, forwards, swaps, and options. Also, most derivatives are not on exchanges and are utilized by institutions frequently to hedge risk or speculate on price changes in the underlying asset. Exchange-traded derivatives like futures or stock options are standardized. It also removes or decreases a lot of the risks of over-the-counter derivatives. Derivatives are commonly leveraged instruments. Consequently, it raises their potential risks and rewards.
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