By Atul P.M.Derivatives are contracts that derive values from underlying assets or securities.
The underlying asset or assets from which these contracts derive values can be stocks, bonds, indices, currencies or commodities like gold, silver, oil, natural gas, electricity, wheat, sugar, coffee and cotton etc.Derivatives serve the purpose of risk management.
Derivative futures contracts originated with farmers and traders hedging their produce against future price fluctuation risks in 12th Century Europe.
Derivatives work on the principle of risk transfer, depending upon the roles donned by different market players.Two prominent market players in derivatives are hedgers and speculators/traders.
Hedgers are the underlying asset owners, who wish to transfer the future price fluctuation risk, while speculators are the risk consumers, who take positions in derivative contracts based on the predictions of future movement of prices of the underlying asset.
Speculators hold derivative positions with or without owning the underlying assets.Traders take this risk as they have the opportunity to take positions in larger volume of stocks in terms of lots that is available on leverage and cheaper cost of transaction against owning the underlying assets.
Speculators usually pay a certain percentage of the contract size as margin to get into a contract and must maintain the percentage ratio margin throughout the contract period.Arbitrageurs are the third category market participants, whose approach is to risk-proof themselves.
They take advantage of the price difference in a product in two different market locations.
This trade takes place where the buyer purchases an asset for a cheaper price in one market/location and arranges to sell the same simultaneously in a different market/location at a higher price.Opportunities from such pricing mismatches do not last long, as arbitrageurs rush in to take advantage of them and kill the pricing gap in no time.
Major derivative products traded are forwards, futures, options and swaps .Forwards are contracts signed between two parties to buy or sell the underlying asset on any future date for a price agreed upon on the date of signing of the contract.
Forwards are decentralised and customisable contracts based on the requirements of the parties involved and are traded over-the-counter (OTC) and not on any exchanges.Futures are standardised forward contracts which are traded through any regulated exchanges.
Forwards and futures are a commitments to buy or sell the assets during or at the time of expiry of the contract.
This exposes forwards and futures contract holders to unlimited gain or loss.Traders take positions in option contracts to gain unlimited gains but restricted losses.
Options give the right to buy or sell the underlying asset, but not the obligation to do so on or before a specific date mentioned for an agreed upon price.
These option contract rights are bought by paying a premium.The Option buyer pays the premium and buys the right, but has no obligation to buy or sell the underlying asset.
The Option writer is the counterparty, who receives the premium and has the obligation to buy or sell when the Option buyer exercises his right.Option buyers have the opportunity for unlimited profits, but limit their loss to the premium they pay to option writers.
On the other hand, option writers have the scope for unlimited losses but a limited gain in the premium they receive.Options can be categorised into two main types; Call Option, Put Option.
The former gives the buyer a right to buy an underlying asset and the latter gives the buyer a right to sell an underlying asset.