What are derivatives and how you can make profit out of it?
What are derivatives and how you can make profit out of it?
This post is based on request from Raj Kumar on suggest-a-topic about Derivatives, Futures and Options.
A derivative is a type of security or financial instrument, which derives its value from the value of underlying entities such as an asset, index, or interest rate—it has no intrinsic value in itself. In other words, a derivative is a financial instrument or other contract with all three of these financial characteristics:
- Its value changes in respect to a change in specified interest rate, financial instrument price, commodity price, foreign exchange rates, credit ratings or credit index or other variable (known as underlying items).
- It requires no initial net investment or an initial net investment that is smaller than that would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- It is settled at a future date.
Let me explain this with an example
Pooja Co. Enters into a contract. Under this Pooja Co. Would pay Rs. 1000 if ABC’s share prices increase by Rs. 10 or more during a 3 month period, it will receive Rs. 10000 if the share prices decrease by Rs. 10 or more during the same 3 month period: and no payment will be made if the price swing is less than Rs. 10 up or down.
In this case, the settlement amount changes with the change in prices of share of ABC ltd. Although there is no notional amount to determine the settlement amount, there is a payment provision based on changes. All the above characteristics of a derivative mentioned above I.e. the value of the instrument changes, no initial investment and settlement at a future date are satisfied.
Hence the contract entered to by Pooja Co. is a derivative.
Common derivative contract types
Some of the common variants of derivative contracts are as follows:
A forward contract is a contract between two parties, where payment will take place at a specific time in the future at today's pre-determined price.
A future is a contract 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; the forward contract is a non-standardized contract written by the parties themselves.
An option is a contract that gives the owner the right, but not the obligation, to buy (Call option) or sell (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. Options are of two types:
i) Call option: The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right.
ii) Put option: In put option the seller has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right.
How are Futures & Options contracts different from each other?
The buyer of an option can make unlimited profit and faces limited downside risk. The seller, on the other hand, can make limited profit but faces unlimited downside. In futures contracts, the buyer and the seller have an unlimited loss or profit potential.
Should you invest in F&O contracts?
Investing in F&O needs less capital, as you are required to pay only the margin money (say 10-30 percent of the contract) and take a larger exposure. However, it is meant for high net worth individuals. If you are a risk taker and have a good understanding of the market you can earn much more than what you would, by just trading in shares. The reason is limited money to invest.
For example: If you have Rs. 1,00,000 you can either buy shares worth Rs. 1,00,000 today or play in the derivatives market with a capital of 5,00,000 as you have to pay around 20 % margin money only. There are certain advantages and disadvantages of derivative trading. So while trading in derivatives you have the chance to earn more profit by investing less.
While trading in derivative you can short sell the lot. That means you can sell the first lot at a higher price and then buy that within the stipulated time at a lower price. So if you are certain that the price of a specific stock will reduce you can earn profit by short selling on the future or option contract.
How can I make profits by trading through derivatives?
There are NO guidelines or thumb rules, which when followed would make sure shot profits. But there are certain tips, which may guide you to make limited losses in adverse situations:
Derivatives have to abide a time frame to close the deal irrespective of the fact that you make a profit or loss from the deal. So even if the stock does not rise to a level that you had speculated you have to sell the lot incurring loss. As you are not investing the total amount you will lose a huge amount of money when you are making loss in derivative trading. So you should always keep a stop loss in mind, which refers to the deceased share price beyond which the loss would be unbearable.
The available variety of strategies and available investments have complicated investing. Investors who are looking to protect or take on risk in a portfolio can employ a strategy of being long or short underlying assets while using derivatives to hedge, speculate or increase leverage. There is a big basket of derivatives to choose from, but the key to making a sound investment is to fully understand the risks –
- The underlying asset,
- Its price
- The expiration – associated with the derivative.
The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a portfolio strategy.
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What are derivatives and how you can make profit out of it