Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, commodities, currencies, or indices. They are commonly used for trading, hedging risk, and speculative purposes. In this article, we’ll explore the basics of derivatives, with a focus on Futures and Options, and discuss hedging and speculation strategies.
What Are Derivatives?
Definition
Derivatives are contracts between two or more parties whose value depends on the price of an underlying asset.
Common Underlying Assets:
- Stocks: Shares of companies listed on stock exchanges.
- Commodities: Gold, crude oil, agricultural products.
- Currencies: USD, EUR, INR, etc.
- Indices: Nifty 50, Sensex, Nasdaq, etc.
Types of Derivatives:
- Futures
- Options
- Swaps
- Forwards
In the Indian stock market, futures and options are the most commonly traded derivatives.
Futures Trading
What Are Futures?
A futures contract is a standardized agreement to buy or sell an underlying asset at a predetermined price on a specified date in the future.
Key Features:
- Traded on exchanges like the NSE (National Stock Exchange).
- Mark-to-market (MTM) settlement occurs daily.
- Requires margin payments as collateral.
Example:
- Scenario: You enter a futures contract to buy 100 shares of Reliance Industries at ₹2,500 per share in one month.
- If the price rises to ₹2,600, you profit ₹100 per share.
- Conversely, if the price falls to ₹2,400, you incur a loss of ₹100 per share.
Options Trading
What Are Options?
An options contract gives the buyer the right (but not the obligation) to buy or sell an asset at a specified price on or before a specific date.
Types of Options:
- Call Option: Right to buy the underlying asset.
- Put Option: Right to sell the underlying asset.
Key Features:
- Only the buyer has the right to execute the contract; the seller is obligated if the buyer chooses to exercise.
- The buyer pays a premium to the seller for this right.
Example:
- Call Option: You buy a call option for 100 shares of TCS with a strike price of ₹3,000. If the market price rises to ₹3,200, you can buy at ₹3,000 and sell at ₹3,200, pocketing the profit minus the premium paid.
- Put Option: You buy a put option for 100 shares of Infosys with a strike price of ₹1,500. If the market price falls to ₹1,400, you can sell at ₹1,500 and profit from the price difference minus the premium.
Hedging Strategies with Derivatives
Hedging involves using derivatives to reduce the risk of adverse price movements in an asset.
Examples of Hedging:
- Stock Portfolio Hedging with Futures
- If you hold a portfolio of stocks and fear a market decline, you can short (sell) futures on the Nifty 50 to offset potential losses.
- Hedging with Options
- Protective Put: Buy put options for stocks you own to limit downside risk.
- Covered Call: Sell call options on stocks you own to generate additional income.
Advantages of Hedging:
- Reduces risk.
- Helps stabilize returns.
Disadvantages:
- May limit potential gains.
- Involves additional costs, such as premiums for options.
Speculation Strategies with Derivatives
Speculation involves taking high-risk positions to profit from market fluctuations.
Examples of Speculative Strategies:
- Leverage with Futures
- Futures allow traders to take large positions with a small initial investment (margin).
- A small price movement can result in significant profits—or losses.
- Options Speculation
- Buying Call Options: Anticipating a price rise in the underlying asset.
- Buying Put Options: Expecting a price drop in the underlying asset.
- Straddles and Strangles (Options Strategies):
- Straddle: Buy both a call and a put option at the same strike price. Profits are made if the price moves significantly in either direction.
- Strangle: Buy a call and a put option with different strike prices.
Advantages of Speculation:
- High profit potential.
- Flexibility to bet on rising or falling prices.
Risks of Speculation:
- High leverage magnifies losses.
- Requires market timing and analysis.
Comparison of Futures and Options
| Aspect | Futures | Options |
|---|---|---|
| Obligation | Both buyer and seller are obligated | Only the seller has an obligation |
| Risk Level | High | Limited for buyers, unlimited for sellers |
| Upfront Cost | Requires margin | Buyer pays a premium |
| Profit Potential | Unlimited | Depends on premium paid |
Conclusion
Derivatives like futures and options are powerful financial tools for managing risk, maximizing profits, and speculating on market movements. While hedging strategies help mitigate risks, speculative strategies aim for high returns but carry significant risks. Whether you’re a risk-averse investor or a high-risk trader, understanding these instruments and their applications is essential to succeed in the stock market.