A derivative is a financial instrument whose price is based on the value derived from one or more underlying assets. These underlying assets can be stocks, gold, bonds, commodities, market indexes and interest rates etc. The derivative is a contract between two or more parties based upon an asset or several assets. The fluctuation of an underlying asset determines the value of derivatives, which implies that it is always changing.
Derivatives include Exchange Traded Derivatives and Over The Counter Derivatives.
Exchange traded derivatives are traded through established exchanges all over the world. These exchanges operate just like stock exchanges. The most common Exchange Traded Derivatives are Futures and Options.
Over The Counter or OTC derivatives are not traded in exchanges and do not have any mode of standardization. Some OTC derivatives are swaps, forward contracts etc.
Futures Contracts are exchange traded derivatives where an investor buys or sells an underlying asset or assets on a particular price in a pre-decided time. If one buys a futures contract, he promises to pay a specific sum on a specific date. Similarly, if one enters into a futures selling contract, he promises to transfer the assets for a given price on a given date. Equity stocks, commodities, indices and currency make a part of the most commonly traded futures contracts.
There are 4 features in a futures contract, they are:
- The Buyer
- The Seller
- The Determined Price
- Expiry of contract
Pricing of Futures:
The pricing of a futures contract is calculated on a term called “Basis”. Basis is the difference in pricing between the underlying asset and the spot market. The Basis is usually negative and is referred to as “Contango”. This means that the asset in the futures market cost more than the same in a spot market. The costs of insurance premiums, storage and interest are not required to be borne in the case of a futures contract purchase. Such costs have to be paid only at the spot market.
The basis turns positive at times and is referred to as “Backwardation”. This happens mostly when the prices of the assets are about to fall. A positive Basis means that the price of an asset is higher in the spot market than in the futures market. A basis turns positive when the benefits outweigh the costs of holding assets in the spot market.
The drawback of investing in futures contract is that it better to hold physical assets instead of their futures form. It would be certainly be more profitable to earn dividend by holding a company’s equity shares while a futures contract holder would not be entitled to dividend.
As the contract comes inches towards its end, it is common to see the future price and spot price closing in on each other. This leads to the Basis reaching zero and is a common occurrence
An options contract gives its holder the right to purchase or sell the underlying asset at a pre-determined price. Notably, the size of the underlying position in an options contract is smaller than in a futures contract.
The option can be either a Call option or a Put option. To read our descriptive article on Call and Put option, click here.
A Call option entitles a buyer the right to buy an asset at a particular price known as ‘strike price’. While the buyer has the right to demand sale of an asset from a seller, the seller has only an obligation to sell and no right. A buyer will not exercise his right to buy if the price of an asset in the spot market is lesser than its strike price on expiry of the contract. For example Mr C will not exercise his right to buy his asset at strike price of Rupees 1000, if the spot market lists the asset at rupees 850.
A Put Option gives the holder a right to sell the asset at the strike price to the buyer. Here the buyer of the contract has the right to sell and the seller of the contract has the obligation to buy. A buyer will not exercise his right to sell if the price of an asset in the spot market is higher than its strike price on expiry of the contract. For example Mr C will not exercise his right to sell his asset at strike price of Rupees 1000, if the spot market lists the asset at rupees 1100.
From the above it can be inferred that in any given options contract the right to buy or sell rests in the hands of the buyer of the contract. The seller only has an obligation to follow through the orders of the buyer. The seller is paid a “Premium” to fulfil his obligation, hence making premium the price of an option.
Futures and Options, commonly known as F&O are very popular methods of investing in the derivatives market. When an investor has already participated in Equity Trading and wants to diversify his portfolio, derivatives are a good option to choose. To read more about stock market strategies that work and become a better trader, visit Indira Trade Blog. We are a website that provides investment advices and several articles to enhance your trading knowledge.