Introduction to Derivatives Markets
Derivatives derive value from an underlying asset, which can be a stock, bond, index, commodity, exchange rates etc. As the name suggests its value is derived from and hence dependent on the underlying. Derivatives are risk management tools used to manage price risk. Consider this illustration.
Illustration 1: Azure Ltd. is a gold producer and Titus Ltd. is a jeweller that sells ready to wear jewellery. Azure and Titus are exposed to price risk. Azure has a price risk if gold prices fall too much and Titus has a price risk if the gold prices rise too much. Let us say, the price of gold is Rs.39,000/10 gram currently. Now both are comfortable at a price of Rrs.39,500 so they enter into a contract. Azure agrees to sell 100 KG of gold to Titus at the end of 3 months (just before festival season) at a price of Rs.39,500/10 grams. This is a most basic form of derivative contract called as forward. At the end of the 3 months, whatever be the price of gold in the market, the gold will be exchanged at Rs.39,500 so both the seller of gold and buyer have certainty. Their risks are managed.
Types of Derivative Products
Broadly, there are 4 classes of derivative products that are available in any derivatives market.
- Forwards: What we saw in the gold illustration above is a forward product. It is a contract to buy or sell an underlying asset at a future date but at a price that is fixed and agreed upon today. A forward contract is a symmetric derivative product where both the buyer and the seller could have unlimited profits and unlimited losses. Forwards are over the counter (OTC) products and executed on telephone.
- Futures: Structurally, the futures contract is similar to forward contracts in that it is also an agreement to buy or sell an underlying asset at a future date at a price fixed today. However, futures are superior in 3 ways. First, they are standardized so they are liquid. Secondly, they are traded on a recognized stock exchange. Finally, futures carry counter guarantee from the clearing corporation of the exchange, so there is default risk.
- Options: While futures and forwards are symmetric (profits and losses are unlimited to buyer and seller), the options are asymmetric. An option is a right but not an obligation to buy or sell an underlying asset for the buyer of the option. For the seller of an option, it is an obligation without the right to buy or sell an underlying asset. For this right, the buyer of the option pays a premium to the seller of the option; called option price.
- Swaps: A swap is an exchange of one set of cash flows for another. You can exchange your fixed interest outflows into variable rate outflows pegged to a benchmark. Similarly, receivables in dollars can be converted into Yen receivables.
Naked Derivatives Position versus Covered Derivatives Position
Derivatives are a tool of risk management and hence they must be predominantly used for covered positions and not for naked positions.
- A steel producer like Tata Steel selling steel futures or a gold user like Titan buying gold futures is a covered position. They have an underlying price risk.
- A trader buying steel futures or gold futures expecting their price to go up in the future is taking a speculative position in the market.
- An arbitrageur in the market buying in the cash market and selling in the futures market for the spread is also a covered position.
- A portfolio manager with an underlying portfolio selling Nifty Futures or Buying Nifty put options is a covered position.
- An importer or exporter buying or selling USDINR futures is again a covered derivative position. A trader buying USDINR futures to bet on dollar strength is a naked position.
A Detailed Look at Options Contracts
An Option is a contract that gives the right, but not obligation, to buy or sell the underlying asset on or before a stated date, at a fixed price, on payment of premium. The party taking a long position is the buyer of the option and the party taking a short position is the seller/ writer of the option. The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. The option will be valuable only when the price is favourable.
Options can be categorized into two main types:‐
Call Options – the right to buy an underlying asset. That means your view is bullish.
Put Options – the right to sell an underlying asset. That means your view is bearish.
Options can be one of the following:
In-the Money (ITM) – when the price / strike price gap is favorable
Out of the Money (OTM) – when the price / strike price gap is unfavourable
At the money (ATM) – when the price / strike gap is neutral
Option price / premium have two key components:
Intrinsic Value – the extent to which the option in in-the-money (ITM)
Time Value – Excess of option price over the intrinsic price. Time value can never be negative. For ATM and OTM options, time value is zero.
A Detailed Look at Options Contracts
Derivatives perform 3 important functions for market participants
When an investor has an open position in the underlying, they can sell futures or buy put options and hedge (protect) the risk.
Speculate on price
Here there is no underlying position it is just a trade in line with the trader’s view on the future prices movement of the underlying asset. Trader is leveraging.
Cash futures arbitrage
Arbitrageurs are specialist traders who buy in cash market and sell in the futures market to lock in the assured returns on the spread between cash and futures.
10 Things to Know About Indian Derivative Markets
- Indian derivative markets are a mix of cash settled and delivery settled. Exchange traded currency futures are by default cash settled. Commodity futures are settled either in cash or by actual delivery. Most equity derivatives are cash settled.
- Equity derivatives are available in 3 monthly contracts expiring on last Thursday of each month. These are the near-month, mid-month and far-month contracts.
- Buying and selling futures entails payment of initial margins and MTM margins if price movement is unfavourable. Option sellers are margined just like futures.
- Options are contracts on specific strike prices fixed at regular intervals. Contracts are standardized and options can only be bought or sold at specified strike prices.
- Futures and options lot sizes are defined in number of shares of a stock or index. The lot value is kept at Rs.7.50 lakhs to Rs.10 lakhs and trades can only be multiples of lot size.
- Apart from monthly options, the Indian exchanges also offer weekly options on the Nifty and the Bank Nifty. These weekly options are settled on every Thursday.
- NSE has one of the highest volumes of stock futures in the world. Futures are similar to the erstwhile Badla (carry forward) on the BSE which makes traders comfortable.
- There is a wide range of derivatives options in India. Equity derivatives offer index futures, index options, stock futures and stock options. In addition, one can also trade VIX futures. Commodity derivatives offer futures on precious metals, industrial metals, hydrocarbons and agricultural products.
- Open interest is measured as the total value of all open contracts. Shifts in OI are an important indicator of the direction of the market.
- The put call ratio (PCR) is the total number of puts to calls. This can be interpreted as the PCR of volumes in the derivatives market or the PCR of open interest.