Futures and Options – The basics.

Why do derivatives market exist?

As we saw in the introductory articles, derivatives are complex financial instruments and dealing with derivatives is often riskier than dealing with the underlying asset themselves. If they are so complex to deal with, then why do they exist? Why are so many interested in it? What purpose do they serve? We’ll try to find answer all this in this post.

Before that let me clarify a point. There is a common misconception that derivatives would bring  financial ruin. That’s not true. Derivatives by them selves do not bring in any additional risk to the economy. Improper handling of derivatives can cause damage – now, isn’t that true with anything we handle in life? So the root cause of any loss through derivatives is not the problem of derivatives.

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Who plays in this market?

There are at least 5 categories of players in derivatives market. Irrespective of what you intend to do in the market, you would fall in any one of the 5 categories mentioned here.

CATEGORIES OF PARTICIPANTS.

As mentioned above, there are 5 categories:

  1. Hedgers
  2. Arbitrageurs
  3. Speculators
  4. Spreaders
  5. Amateurs

HEDGERS

They are the real users of derivatives. In fact, derivative instruments were invented solely for the purpose of hedging or risk management. Hedgers are investors who want to reduce the risk of price fluctuation on their investments. The meaning of hedging, its uses and the way it’s done would be discussed in another post. Hedgers are basically risk averse investors.

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Types of derivatives 3 – Options contract

We discussed forwards and futures. The next derivative instrument is options.
Before we move on, here are two stock market games for you to play.

TWO GAMES AT YOUR OPTION !

Game 1.

Share price of a company, say Wipro, is at Rs 300 now.  For a small fee of Rs 3 per share, you will be given the right to buy 1000 shares. The condition is that if price moves up and strikes Rs 390, you keep the gain on 1000 shares. If price falls, you need not suffer the loss on 1000 shares. You lose only that small amount you paid for participating in the game.

So, if you win, you make a lot of money. For example – If the price moves up to Rs 390, you gain Rs 90,000 (1000 x 90) less Rs 3,000(3 x 1000). If price falls, you’ll let go a small amount of Rs 3,000 for playing that game.

  • The benefit is- Unlimited gains. Limited loss.

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Types of derivatives 2 – Futures contract

We continue with our discussion on derivatives…

As said in my last article, forward contracts have some de-merits.

  • First, The quantity, the mode of payment, the delivery date, the price, – everything varies from one contract to another and performance of the contract is not guaranteed.
  • Second, to continue the orange juice example, suppose after some days the orange juice company decides to back off since they feel that they don’t need oranges at that price. This would give rise to problems between the buyer and the seller.
  • In short, nothing is regulated in forwards. It’s tailor-made according to circumstances and can be written for any amount and terms.

Quite easy to understand, I guess.

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