In a letter to his shareholders in 2002, Buffet wrote, “In our view…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
And as if that were not enough, the Vatican recently dubbed them as a ticking time bomb.
At their core, derivatives are really not that complicated. A derivative is simply a security (or “piece of paper”) whose value is “derived” from the price of something else. Wikipedia, that repository of wisdom, defines a derivative as a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate. The derivative’s price is determined by fluctuations in the underlying asset. The most common types of derivatives are futures, options, forwards and swaps.
Derivative indicates that the financial instrument derives its value entirely from the asset it represents, whether that is equity, bullion, currency, commodity, realty, rate of interest or even livestock. A feature that is common to all underlying assets is that they carry the risk of change in value. The price of a stock may fall or rise, as will commodity prices and interest rates, while a currency can weaken or strengthen relative to other currencies., Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security.
When you invest in derivatives, you are basically betting on whether the value of the underlying asset will increase or decrease within a set time frame. When you deal in derivatives, you are buying a promise from the original owner of the asset to transfer ownership of the asset rather than the asset itself. This promise affords you great flexibility and is the most important trait that appeals to investors.
A forward contract locks a buyer and a seller of an asset into a price that is payable on a specified date in the future, the expiry date. For instance, you own shares currently trading at Rs 100 each. You perhaps don’t feel too optimistic about the prospects of the company whose shares they are and expect the share to tank. You enter into an agreement with a buyer who, conversely, guesses that the share price will rise. You sell the shares in a months’ time at, say, the price they are today Rs100.
On the expiry date, also known as the settlement date or delivery date, if the share price has dropped to Rs80, you will make a profit of Rs20 a share, and the buyer will be forced to pay Rs20 more than the market price. If the share price has risen to Rs120, you will have lost out in the Rs20 increase in value. After paying you the agreed Rs100 per share, your buyer can immediately sell the shares on the market at Rs20 profit. For you, the seller, this is a simple way of protecting yourself against your shares losing value, which may or may not happen.
But you don’t have to own any shares to begin with. If you want to profit from a drop in a company’s share price, you can enter into such a contract, buy the shares and sell them to the buyer when the contract expires. Under such a scenario, on the expiry date, if the above share’s price has dropped to Rs80, you buy the shares at R80 and sell them to the buyer for R100, making a profit of R20 a share. And if the share price has risen to R120, you will have to buy the shares at R120 and sell them to the buyer at R100, making a loss of R20 a share.
There is a risk associated with Forwarding contracts. In such one-to-one, over-the-counter contracts, each party is vulnerable to the other party, known as the counterparty, backing out of the deal or simply defaulting. This is known as counterparty risk.
The second type of derivatives is Futures.
Futures are standardised forward contracts traded on public exchanges like the BSE. The exchange provides protection against the counterparty risk that we just spoke about. Buyers commit to buying assets and sellers commit to selling assets on a certain date.
When such benefits overshadow the expenses associated with the holding of the asset, the price of the asset in the spot market is more than in the futures market. This situation is called ‘Backwardation’. Backwardation generally happens if the price of the asset is expected to fall. It is not uncommon, as the futures contract approaches maturity, to see the futures price and the spot price close the gap.
The third type of derivative are Options.
Options contracts are instruments that give the holder of this instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a ‘call’ option or a ‘put’ option. We’ve heard those terms before, haven’t we? They’re usually a part of business news.
The buyer of a call option will not exercise his option if, on expiry, the price of the asset in the spot market is less than the strike price of the call. Let’s look at a simple example. Person A bought a call at a strike price of Rs 600. On expiry, the price of the asset is Rs 550. Person A will not exercise his call. Because he can buy the same asset from the market at Rs 550, rather than paying Rs 600 to the seller of the option.
Conversely, a buyer of a put option need not exercise his option to sell if he see that, on expiry, the price of the asset in the spot market is more than the strike price of the call. Let’s assume Person B purchased a put option at a strike price of Rs 500. On expiry the price of the asset is Rs 530. Person B will not exercise his put option, because he can sell the same asset in the market at Rs 530, rather than give it away to the seller of at Rs 500.
The fourth type of derivative contract is the Swap.
A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. Swaps can be used to hedge interest rate risks or to speculate on changes in the underlying prices. Swaps are not used in equity markets in India so we will skip them for now.
Here are 5 things to keep in mind when making your way through the world of derivatives.
- First – do your research. This is all the more important for the derivatives market. Remember that the strategies need to differ from that of the stock market. As an example, say you want to buy stocks that are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market, this would need you to enter into a sell transaction. So, the strategy differs.
- Two, arrange for the required margin amount. Stock market rules require that you constantly maintain your margin amount. This means you cannot withdraw the amount from your trading account at any point in time until the trade is settled. The margin amount also changes as the price of the underlying stock rises or falls. So it s beneficial to keep extra money in your account.
- Conduct the transaction through a trading account. You will have to ensure that your account allows you to trade in derivatives. If not, consult a brokerage or stockbroker.
- Choose stocks and contracts based on the money you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts. You do have to pay a small amount to buy the contract. Ensure all of this falls within the budget you have fixed for yourself.
- Last but not the least, remember that you can wait until the contract’s expiry date to settle the trade. You can pay the entire amount outstanding, or you can enter into an opposing trade. Let’s say you placed a ‘buy trade’ for Reliance futures at Rs 5,000 a week before expiry. To exit the trade before, you can place a ‘sell trade’ future contract. If this amount is higher than Rs 5,000, you book profits. If not, you make a loss.