TRADING IN DERIVATIVES

In finance, a security whose price is dependent upon or derived from one or more underlying assets is a derivative .The derivative itself is merely a contract between two or more parties. 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.

There are many kinds of derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative investment.

A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of derivatives have been traded on markets before their expiration date as if they were assets. Most derivatives are characterized by high leverage.

There is a general feeling that derivatives are highly complicated instruments and can be traded by only highly qualified individuals. This might be true to a certain extent but with good understanding of the concepts & appreciating the risks associated we all could be traders in derivatives.

All derivative contracts are legal contracts & all the terms and conditions of the contract is pre-defined . Futures, options are most common derivative instruments across the world and also in India.

There are three major classes of derivatives:

1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of aEuropean option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

For example, a gold derivative’s value depends on the price of gold. There are various types of derivatives such as, futures, forwards, options, and swaps.

Futures

Futures are the most common type of derivatives. In a futures contract, the investor agrees to buy or sell an asset at a predetermined price on a particular date in the future. The investor gets profit or loss from that derivative based on the difference between the bought price and actual price of the underlying commodity on the actual date of contract.

Forwards

Forwards also work in a similar way to futures. A forward contract is also an agreement to buy or sell an asset at a predetermined price in the future. The profit or loss from the contract will depend on the spot price at the time of contract expiry. Not Let’s see some of the differences between futures and forwards

Futures contracts are traded on an exchange, whereas forwards are traded over the counter. As a result, futures contracts are standardized and more regulated, whereas forward contracts are customizable and less regulated.

Options - Call Options & Put Options

An option contract gives the investor the right (but not the obligation) to buy or sell a particular asset on a particular date. There are two types of options - Call options and Put options. Call options give you the right to buy, and put options give you the right to sell.

n view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.

A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.

The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.

Today, equity and commodity derivative markets are rapidly gaining in size in India. In terms of popularity too, these markets are catching on like a forest fire.

Structure of Derivative Markets

Derivative trading in India takes place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organization (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.

The participants in a derivative market are:

Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.

Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.

Arbitragers are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Jayati Goel

{Technical Analyst)