Derivatives are financial securities whose value or price is derived from an underlying asset or a group of assets, such as stocks, bonds, interest rates, commodities and currencies etc. The value of derivatives keeps on changing depending on the changing market conditions. Derivatives can be traded by predicting the underlying asset&rsquo;s future price movement and can be utilized for a variety of purposes such as access to additional assets, hedging, and more.

There are four main types of derivates that can conveniently be traded on the Indian stock markets and are known as: Future Contracts, Options Contracts, Forward Contracts and Swap Contracts. Each of these is different from each other and has different conditions and risk factors.

Derivatives

To understand derivatives, let us take the example of how farmers and businessman benefit with derivatives, as it provides them with a degree of safety on prices to both. The farmer enters the contract to lock in an acceptable price for the commodity (crop), and the businessman enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the businessman have reduced risk by hedging, both remain exposed to the risks that prices will change.

In this example, the farmer is assured of a specified price for the commodity. But, prices could rise and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop, and the businessman would have to pay more for the commodity than he otherwise would have.

Let us assume that in April 2020 the farmer enters a futures contract with a businessman to sell 5,000 tons of wheat at Rs 440 per bag in July 2020. On the expiration date in July 2020, the market price of wheat falls to Rs 435, but the businessman has to buy at the contract price of Rs 440, which is higher than the prevailing market price of Rs 435. Instead of paying Rs 2,175 (435 x 5,000), the businessman will pay Rs 2,202 (440 x 5,000), while the farmer recoups a higher-than-market price.

Now, if the price had gone up to Rs 500 per bag, the businessman&rsquo;s hedge would have allowed the wheat to be purchased at a Rs 440 contract price versus the Rs 500 prevailing price at the July expiration date. The farmer, on the other hand, would&#39;ve sold the wheat at a lower price than the Rs 500 prevailing market price.

Do not confuse the example as speculation, as both parties hedge to manage risks. Each party has their profit or margin built into their price, and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity. After all, irrespective of the price of commodity going down or up than the futures contract price by expiry, both parties hedged their profits on the transaction by entering into the contract with each other.

Derivative: Breakdown

A forward market is a hedge against fluctuating prices and is a contract entered between a buyer and seller for future delivery of stock or currency or commodity. So, the buyer in a forward contract gains if the price at which he buys is less than the spot price and loses if the price is higher than the spot price. The purpose of the forward contract is to protect the seller or buyer against any fluctuations in the price. If the seller or the buyer incurs loss in a forward contract, they can compensate the same by reversing the contract and selling or buying at lower or higher prices, according to their positions.

Forward Market

Similar to the forward market, it comes under regulated organizations in which members alone are permitted to transact. The futures market has its own rules and regulations and fixes the minimum value for each transaction. The purpose of the futures market is to smooth out the price fluctuation so that neither the buyer nor the seller incurs heavy loss due to price fluctuations.

Example of futures contract

Suppose you expect the stock prices of Reliance Industries (RIL) to increase in the coming months. And you want to make money from this opportunity. The two options available to you are buy shares of RIL in the spot market or buy futures contract of RIL.

Case1

The cost of 1 RIL share is Rs 2,000. You want to buy 100 shares. The cost of 100 shares will be Rs 2 lakh. Suppose you only have Rs 1 lakh to spare, so, you will end up buying 50 shares. As expected, the prices of RIL shares go up to Rs 2,500 after 3 weeks, and you sell your 50 shares and book a profit of Rs 25,000. It is a good 25% gain in 3 weeks.

Case 2

The cost of 1 RIL futures is Rs 2,186 and each RIL futures contract contain 250 shares, so the total value of the contract will be Rs 5,46,500. In derivatives you do not have to pay the full money, you need to pay the initial margin. Assuming this margin is Rs 64,700 and the price goes up from Rs 2,000 to Rs 2,500 in the spot market, which means the price of the derivative will also increase from Rs 2,186 when you entered the contract to Rs 2,558 after 3 weeks and you decide to sell your contract before the expiry, which happens on the last Thursday of the month. In this case, you made Rs 372 per share and as each lot of RIL future has 250 shares, taking your profits to Rs 93,000 or 144% in the same time.

This may seem appealing and easy, but trading in futures, requires skills, ability to spot trends and the appetite to lose money as well as gain.

Futures Market 

Options contract is essentially a type of agreement between two parties, whereby the buyer has the option but not the obligation to buy or sell an underlying asset. In this case, the asset must be bought or sold depending on the type of options contract on the specific date and at a predetermined asset price. One needs to know of a few key terms to understand options, which include lot size, stroke price, premium etc.

Lot size refers to the standard quantity or units of the underlying asset that is included in the options contract. The strike price is the price of the asset at which the two parties agree to buy or sell the underlying asset, in an options contract. The premium is the amount that the buyer pays to the seller of the asset in order to avail the benefits of the options contract and is essentially the market price of the options contract itself. And, the expiration date is the future date by which an options contract must be exercised by the investor. So, beyond the expiration date, the options contract will expire worthlessly.

Options

A call option is a type of options contract that gives the holder the right, but not the obligation to buy the asset at the agreed upon strike price before the expiration date. The call option can be bought by the investor by paying a premium upfront to the seller. The option holder therefore, makes a profit if the value of the asset rises in the future. This is because the call option allows him to buy the asset at a much lower price and then sell in the market for its current higher price.

For instance, if the call option for a stock is purchased at a strike price of Rs 200 and the expiration date is in two months; if within that period, the stock price rises to Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to make a profit of Rs 240-200 = Rs 40.

Call Option

Think of the put option as the opposite of the call option, which means it is a contract that gives the holder the right, but not the obligation to sell the asset at the agreed-upon strike price any time before the expiration date. If the value of the asset falls in the future, the call option gives the choice to sell the asset at the agreed-upon higher price and thereby minimize his risks.

Assuming the same example, assume you purchase a put option for stock at a strike price of Rs 200 and the expiration date is in a month. If within that period, the stock price falls to Rs 180, you can still choose to sell the stock at Rs 200. On the other hand, if the price of the stock rises above Rs 200, you still have no obligation to sell it or can still sell it at the current market price.

Put Option

The relationship between an option&rsquo;s strike price and the underlying stock&rsquo;s spot price determines the financial gain of the option. The relationship between the two is known as in the money (ITM), at the money (ATM) or out of the money (OTM). These terms vary for calls and puts in an option. In case of both Call and Put, the underlying price = strike price means you are at the money (ATM).

<table>
	<tbody>
		<tr>
			<td>&nbsp;</td>
			<td>
			ITM (In the Money)
			</td>
			<td>
			OTM (Out of the Money)&nbsp;
			</td>
		</tr>
		<tr>
			<td>
			For Call
			</td>
			<td>
			underlying price &gt; strike price
			</td>
			<td>
			underlying price &lt; strike price
			</td>
		</tr>
		<tr>
			<td>
			For Put
			</td>
			<td>
			underlying price &lt; strike price
			</td>
			<td>
			underlying price &gt; strike price
			</td>
		</tr>
	</tbody>
</table>

Strike Price and Spot Price

A swap derivative is an agreement that occurs between two parties with the goal to exchange a sequence of cash flows over a certain duration. Typically, at the time at which one initiates the contract, at least one of these cash flows will be determined through an uncertain or random variable, like foreign exchange rate, interest rate, equity price, or a commodity price. On a conceptual basis, one might view the swap as either a long position in a single bond that is coupled with a short position in a separate bond. Alternatively, they may view them as a portfolio of forward contracts.

There are different variations of swap agreements such as currency swaps, debt swaps, commodity swaps, and total return swaps among others. A popular swap is the credit default swap (CDS) which comprises an agreement by a single party to pay the principal amount that is lost as well as the interest on a loan to the CDS buyer, provided the borrower defaults on their loan. Poor risk management and excessive leverage in the CDS market were major contributing causes to the financial crisis of 2008.

Swaps 

Strike price, also known as exercise price is the price at which you can buy the underlying security when exercising a call option, or the price at which you can sell the underlying when exercising a put option. However, spot price means the current market price.

Derivatives Technical Analysis

Options