A Guide to Derivatives

June 8, 2012   ·   0 Comments



Lesson 5: A Guide to


The word ‘Derivatives’ brings into one’s mind the affluent investors taking high risks and earning .That’s not always true. We give you a clear picture of ‘Derivatives’ – a term that has always seemed to be mind – boggling.Derivatives as the word indicates, derives its value from the underlying asset, which can include shares, commodities, interest rates, market indexes, currencies etc. In simple words, we can consider it as a technique of allowing traders to hedge their bets.  Derivatives have always attracted investors due to the flexibility and returns that they are capable of granting. While it might seem to be a remunerative and gainful option, it involves infinite risks and requires you to have the . Considering the present in the market, one can capitalize more with the right understanding of market sentiment.

http://stockssavvy.comWhile hedging is popular in the stock market today, it has its origin from the future contracts signed by farmers and traders who use to sign future contracts in order to protect themselves from and other adversities.

According to the Securities Contract (Regulations) Act, Derivatives include:

  1. A contract where value is based on the prices or index of prices of underlying assets.
  2. Security that is derived from debts, share, loan, contracts for differences, risk tools or any other kind of security.


The Significance of Derivatives:

always play a and act as an indicator while trading. We all have our own and judgment about the of the . Markets have many uncertainties where the value of a stock may rise or fall anytime and the value of a currency may increase or decrease. Derivatives allow one to capitalize from their speculation and judgment. The intention of Derivatives is to transfer risk from individuals who are not willing to take risks to people who are keen on taking risks.

Dealing with Derivatives:

Investing in derivatives is predetermining the value of the asset and the margin of increase or decrease over a given period. It involves signing of a contract between a buyer and a seller where the buyer is promised a transfer of ownership of the asset.

Dealing with Derivatives is different from dealing with the equity market and investing in shares. The basic difference between derivatives and shares is that derivative is a contract and not an asset as in the case of shares. However, warrants and convertible bonds are an exception to this rule.

Types of Derivatives:

There are different types of contract that adhere to different conditions. Some of the common types of derivatives are:

Future Contract: It is an organized contract with specific terms and conditions inflicted regarding time, quantity, place for the resolution of the contract, quality, etc. It is a legal agreement that compels one to buy or sell the underlying asset on a fixed date at a predetermined price. The contract mentions an expiry date where one can settle the future by the delivery of the underlying asset or cash.


Option contract:This type of derivative contract gives the buyer/ holder of the contract the flexibility or option to buy or sell the underlying asset within or at the end of the mentioned period according to the contract.  The premium is the consideration amount that a buyer has to pay to the seller to purchase the right.

The two types of option that this contract dealswith are the call option and the put option

The call option:This option gives one the right to buy the underlying asset at the predetermined price on or before the specified date. One will choose this option when one anticipates the price to rise before the expiry date.

The put option: This option gives one the right to sell the underlying asset at the predetermined price on or before the specified date. One will choose this option when one anticipates the price to fall before the expiry date.

If an option can be exercised on or before its expiry date, it is knows as an American option. On the other hand, the European option gives the right to exercise the option only on or after the maturity date. The options that are traded on the NSE exchange are considered European in nature.

The strike price is the price that one has to pay for buying or selling the underlying asset according to the contract.

Option contract can be settled by the delivery of the underlying asset or cash. However, this contract also makes it necessary for one to pay the difference between the strike price and the price of the underlying asset. It can be paid either at the time of the exercising of the option or on the expiry date.


Derivatives: Pros and Cons

Dealing with derivatives is often considered difficult. With the high dosage of risk involved, it is necessary for one to comprehend with sophisticated risk management and watch the market more closely. However, the flexibility that derivatives offer enables one with a good insight to earn increased income.

The derivative market witnesses three most important types of participants:

Speculators:Speculators are risk takers who expect to earn profits by taking a derivative position. They will beton the future movement of the prices as they buy from one side and sell in on the other end.  The profit earned and the risks taken both are high as one is expected to invest only the margin.

Hedgers:  Hedgers play carefully and use the market as a means to lessen the risk caused by adverse conditions. The hedger takes the opposite position to the risk exposure. He keeps a close watch on the market and sells the future contract immediately when the optimal price is attained.

Arbitrageur:Arbitrageurs trade to earn profit by taking advantage of the price differential in two different markets. They deal in two markets at the same time and hence attain profit by buying low in a market and selling high in another.

With the right strategies, one can dive into the derivative market enjoying the flexibility of buying or selling in the market without possessing the asset where the absolute objective of one is to earn profit by making a smart move at the right time. Besides, there is more room for earning, as you only need to pay the marginal amount to acquire the right to buy or sell.

Kotak Securities

Kotak Securities is one of India’s leading stock broking firm offering stock trading, mutual fund and IPO investing service’s along with a research division specializing in Sectoral research and Company Specific Equity Research.Express your views on their Facebook Page and Twitter Handle (@KotakSecurities) or you can also browse through their various videos on YouTube and Slide Share.

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