The world of futures and options

Derivatives as the word suggests are those financial instruments whose values are derived from the value of the underlying.

Derivatives were initially traded mainly in the form of “Forward” contracts.

Historically, forwards were mainly used to hedge against fluctuations in the value of commodities and were bi-lateral contracts between two parties.

However, these trades carried huge risk in terms of counter party defaults.

Then came the concept of exchange-based derivatives.

In this case, the counter party is not known to a trader and all settlement related issues were taken care of by the exchanges.

Derivatives instrument are used by three types of market participants viz: speculators, hedgers and arbitrageurs.

A speculator is a trader who speculates on price movements of the underlying stock, commodity, currency or interest rates. A hedger is the guy who uses derivatives for risk management to hedge the price fluctuations of his position in the underlying. Let us consider the example of an exporter expecting to receive dollars in three months.

If he fears that the price of the dollar could fall, he would take a bearish position in the derivative market which expires after three months.

Derivatives are primarily of two kind — futures and options.

A future is similar to underlying wherein a market participant can take both long and short position as per his view.

In India, derivatives settlements are cash settled on the expiry day and the trader has to settle the profit/loss in cash as per the expiry price.

Options are of 2 types: The call option gives the buyer the right and not the obligation to BUY a stock at a particular price on a particular date.

A put option gives the buyer the right and not the obligation to SELL a stock at a particular price on a particular date. Both the calls and puts of different strike prices are traded in the exchanges.

Buying of options involves limited risk and a chance of making unlimited profits. However, the writer/seller of the options has only limited profits and chance of incurring unlimited loss.

This is because, the seller of the option gives right to the buyer to buy/sell the stock (call/put respectively) and has to oblige if the buyer exercises his right.

Trading in derivatives involves great degree of leverage and therefore has higher risks.

A trader takes position depending upon how confident he is of his view on a stock. Let's take a case of Tata Steel. The CMP is Rs 450. Someone who is 100 per cent confident of his view and expects the stock to touch Rs 480 by expiry might take a long position in futures.

On the other side, a person who does not have such confidence or a person with a limited risk appetite would settle by buying 450 strike call at Rs 12. As the saying is “Higher the risk, higher is the return,” the trader holding futures makes bigger profits if Tata Steel starts moving higher. In case of the call buyer , his level for breakeven to start earning profit would start above 462.

Trading in derivatives doesn't end here. There are lot of innovations that can be done with techniques such as Algorithmic trading.

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