You may find the term Derivative a completely new one. Even if you are already in the Stock market, there are chances that you have never come across derivatives. Whatever the case is, whether you know or not, after reading this page, you will know what Derivative is and why people are making a shift towards it from traditional stock market trading.
In this article today, we shall start with understanding the financial derivatives market, then we shall discuss how it works, after that, the usage or purpose of the derivatives in the market, and lastly, we shall check if they are safe enough to trade.
Let's begin with the first thing, understanding what a derivative market is. To understand why people are getting attracted towards it, you must be completely aware of the term.
Derivatives are contracts that derive their values from the underlying asset, index or ROI. This is mostly seen in stocks or commodities with high volatility. Because the derivatives act as insurance to protect the stock against any uncertainties. Many farmers make use of derivatives to protect their products against any price risk. As they can be helpful in the volatile market and have the capacity to protect against market risk, they are sometimes also referred to as "shock absorbents".
The derivative segment in the financial market has been continuously growing since 2016 every year. There has always been a debate on the total value in the rise of the derivative segment, as some consider the face value while others consider the actual market value. Looking at the data, the Derivatives market rose to $640 Trillion in June 2019.
We shall move to understand the type of derivatives. There are 4 significant types of derivative contracts: Forwards, Futures, Options and Swaps. Traders can make use of any type of derivative contract to protect themselves from the adverse impact of price fluctuations in the market.
This price fluctuation is not caused by internal factors only, but there are external factors too that can create an impact on the pricing of the underlying asset. Factors such as global crisis, changes in the currency conversion rates, interest rates, political change, changes in foreign policies, etc., could be anything.
Forwards are contracts between two parties or entities to buy or sell the underlying asset at a predetermined price. While dealing in forward contracts, both parties are obliged to honour the terms mentioned in the contract and execute accordingly, that is, to buy or sell on the expiry date. Those dealing in the forwards have one benefit of negotiating. Contracts between two parties can be negotiated and customized to create a win-win situation for both, and thus they are called over-the-counter (OTC) contracts.
Forwards are being exchanged on the futures exchanges so that a proper record can be maintained of the complete transaction.
One of the risks involved in these over-the-counter (OTC) contracts is exposure to counter-party risk. This is the credit risk, in which one of the parties involved in the agreement, either seller or buyer, may not honour the transactions and may not fulfil his part of the obligation. In this situation, the other party has no choice but to save himself from this position.
Options are also types of the contract made between the two parties. One of the exciting things in the options contracts is the contract holder has the right to buy/sell the underlying asset at a specific strike price and expiry date, but at the same time, he is not obliged to do so. It means if the contract holder does not find the position profitable, he may not execute the contract. Then what happens to the contract? Those which are not executed are called expired worthless. Few traders roll them for the next expiry date. To enter into this type of contract, the buyer has to pay the seller a small amount known as a premium. There are two types of options contracts: Call options and Put options.
Call options: The call options give the right to buy the underlying asset at the strike price on some future date.
Put options: The put options give the right to sell the underlying asset at the mentioned strike price on some future date.
Futures are also the contracts between two parties to sell or buy the standard quantity of a specific underlying asset on the same date, but the delivery of the asset and the payment against it will be made on some future date. These contracts are more regulated and well organized, unlike those directly negotiated between the two parties. In futures contracts, the buyer takes a long position, and the seller is said to have a short position. The record of these types of contracts is maintained on the future exchange.
Swap is also one type of contract between two parties wherein they exchange the underlying asset. The transaction takes place on a specific date. The most commonly used swaps are Interest rate, commodity, currency, and default credit swaps. You will get through this once you are clear with the above three types of derivatives.
We have seen the types of derivatives; now, we shall move to understand how they work in the stock market.
How do the derivatives work?
Let's start with some history. How derivatives came into existence? It started in the 12th Century in Europe between the farmers and traders to protect the monetary value of their produce. The main purpose of the derivative market is to transfer the risk due to any uncertainties. There are two major role players in the derivative market: one who hedges mean protect; they are called hedgers in the market. The other ones are speculators or traders. They play bets on different prices under different circumstances; based on those, they execute the trade. Their price prediction is mainly based on historical data and analyzing various current parameters.
Let us understand them differently and a little more deeply.
Hedgers: These are generally the ones who are producers and manufacturers of some agricultural goods. They want to ensure that they will get a predetermined price of their produce at some later date and should not fall in the loss if the price of that product goes down in the market. They enter the derivative market to protect their produce and mitigate any risk.
Speculators: We can call these people actual traders because they predict the future movements of the underlying stock based on many factors and keep a constant eye on their fluctuations. When they realize the price may increase, they enter the trade and exit before expiry by taking their profit chunk.
There is one more major player in the derivative market known as Arbitrageurs. These are said to be the risk-takers in the market. They buy one asset from one market at a lower price and sell the same in the other market at a high price.
So, these were the major players in the derivative market. We shall now see the ways or methods of how derivatives are traded.
You will find two methods using which the derivatives are traded:
Over the counter
On the exchange board.
Those derivatives which are unregulated by any authority come under the category of over-the-counter. There is a tremendous amount of risk involved in trading via this method as they are not regulated, but still, many traders prefer to trade this way. Trading in this way carries many risks, like the counter-party risk, which we discussed earlier, price movements, and expiry date, and may not be good if you are not good at negotiating.
The next are those being traded on the exchange boards. As the regulatory bodies regulate them, it feels safe and less risky. Though the Financial derivatives market is said to be risk-free, it still has a risk up to a certain level.
This information was to let you know how they work and what risk they have, so once you are clear with all such information, you can decide the best options strategies for trade. We must move ahead with understanding for what reasons Derivatives are used in the market.
The use of Derivatives in the stock market:
Derivatives are the best used for risk management in the stock market. The stock market cannot always be predictable, it will always be uncertain, and thus derivatives play a significant role in mitigating the risk. We have seen various types of derivative contracts that are useful in different situations. We have seen above forwards, futures, options and swaps; each one has its value based on your risk management strategy.
Now, suppose you are in a highly volatile stock; then, you can make use of hedging to protect your investment from any risk. You can use the derivative contracts to mitigate the potential risk in your position. An investor may choose any contract, from Forwards, swaps, and options, to safeguard his investment from the financial uncertainties prevailing in the market. We shall understand with an example. Suppose. You are a trader, and you feel that the price of stock A is going to rise till the next month, but on the other hand, you also don't want to risk your capital against any unforeseen events.
Here, you can invest in B company's stock having the same value as stock A. Instead of directly investing in the stock, you bought the derivative contracts and agreed to buy the same at the current price but at some future date. Suppose the price of stock B increases; you will profit as you buy the stocks at the old, lower price. Suppose the A company stock price falls; B's stock profit will offset your loss.
You can also have two different assets or two different markets, and using the various derivative contracts, you can offset or balance the potential profit and loss.
How safe is it to trade using Derivatives:
Here, we shall see how safe it is to use the Derivative contracts and whether any risks are involved. There are a few risks attached that can be eliminated using the derivative contracts. Well, there are a few risks that demand proper prediction, your accuracy to trade, and validation from the other involved parties.
The risk in the Derivatives market can be related to any of the following:
Let us understand them one by one in detail:
Leverage: suppose you are trading in the derivatives with leveraged money or borrowed money. Then you must know several risks attached to it. You may get high earnings if everything works in your favour, but there are also examples who lost massively by investing the borrowed money. Price fluctuations in the price of underlying assets can lead to such types of losses.
Risk due to a third party: As we have already discussed this point above, let me brush it up again. Suppose you enter the contract privately without involving any exchange; in this case, your risk will be much higher. When the exchange platform is involved, traders have to deposit some amount to ensure that they are capable of handling the risk, and thus you get extra security. Further, if you are into the Swaps, the exchange does the credit check for both the parties involved, and if it is a success, only then does the transaction happen, but that is not the case with privately done contracts. So, to prevent yourself from such threats, try to use those contracts that involve the exchange.
Excessive Investment: This is where you need to understand the difference between confidence and overconfidence. When you have invested an excessive amount, the risk of losing it is also high. You may likely end up losing all your investments. Or you might lose the amount which cannot be compensated even by your high earnings. Thus, derivatives are a tool for risk management. They can also play a role in mass destruction here; financial loss. Instead of helping you in mitigating the risk, they can be the cause of generating more risk in your position. Thus, it is mandatory to perform accurate analysis before investing in derivative contracts.
Illusional Safety: As the name suggests, illusional safety means the trader is under the illusion that his investment is safe enough in any of the derivative’s contracts, but due to a major crisis, it may not be the scenario. Thus, none of the stock will be profitable to cover the losses.
Here, we have seen how derivatives work and what are the limitations of their working, but are they worth using? Can I trust the usage of the derivative contracts, so the answer is if you (the trader) are well aware of the proper steps and how to make optimum use of them, they can use them.
So, in this article today, we saw the derivatives, their types, usage, and risk associated with them. Hope you are clear with the concept of derivatives, and now you know why people are moving towards derivatives. If you have any questions, kindly drop them in the comment section below.