Derivatives Trading - Basics explained

 Derivatives Trading for Beginners

Derivatives - anything "derived out of" something else.

In trading, derivatives can be derived from different underlying assets such stocks, interest rates, commodities, indexes, foreign exchange (currency).

Forms of Derivatives

Originally, derivatives where created with intention of hedging the risk of price movements in the underlying assets. This was initially helpful for companies doing business in international markets and where exposed to Foreign Exchange Rates risks. For example, an Indian company doing most of its accounting in INR but has major clients in US who are paying in USD. The company will have a risk that in case INR becomes stronger compared to USD, its profit margin might reduce in INR terms. The company would like to reduce its exchange rate risk by getting into a contract with someone at an agreed conversion rate on a given date in future.  

Later on these contracts where extended to other underlying assets. For example, oil Seller 'A' who wants to reduce his risk of reduced oil prices later in a month will like to get in a contract will oil Buyer 'B', to sell N quantity of oil at price X on an agreed date D. The buyer 'B' will like to get into this contract as he may expect the oil prices to go further up.

Derivatives can be traded both Over the Counter (OTC) and well as on exchanges. 

            

Pros and Cons

The advantages of derivatives include:

• Leverage - One can buy derivatives by paying only Margin or Premium amounts i.e. one can trade using just fraction of money required in cash trade.
• More options - one can implement different strategies
• Hedging - an instrument to mitigate risk due to unfavorable movements in prices, rates etc.

Like anything else in life derivatives too have its share of disadvantages. Given the complexity of these instruments, one needs to have good understanding before indulging in derivatives trading. As they are derived from other underlying assets, accessing their value is not straight forward. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates. 

Types of Derivatives

Future

Futures are contracts between two entities with one entity agrees to buy and other to deliver an asset at an agreed upon price at a future date. These contracts are regulated and traded on exchanges. The entities involved in the future contracts have the obligation to complete the contract agreements i.e buy/sell the asset at agreed price on agreed date.

These instruments are used by traders to hedge their risk like change in price of  or speculate the price of underlying assets.

Futures can be bought by providing the 'margin' money i.e. leveraged using just the fraction of the total asset cost.

Options

The options buyer has the right but not the obligation to buy or sell an asset at pre-agreed price on agreed date (expiry date).

These are similar to future contracts are traded on exchanges. The buyer of contracts can pay a 'premium' to the option writer for the call/put options. The premium again just a fraction of the total asset cost.

With 'Call Option' the buyer gets the right but not the obligation to buy the underlying asset at a given price before expiry date, 'Put Option' gives the buyer the right but not the obligation to sell the underlying asset at a given price in future.

Forward

They are similar in nature to Future contracts with key difference that these contracts between two counter-parties takes place in private. The involved parties get into agreement for settlement on a specific date in the future at pre-agreed price. 

Forwards carry the intrinsic risks of OTC contracts like default by one of the counter-parties on its side of the agreement. The forward contract may contain customized terms, size and settlement process for the derivative.

Swaps

These are another kind of derivatives in which two parties exchange one kind of cash flow with each other or any variable attached with the assets. For example, Interest Rates Swaps (IRS), currency swaps, commodity swaps.   

Currency swaps is an agreement between two parties doing business/trades in different currency. Party A agrees to repay the loan of party B in currency X, while party B agrees to repay loan of party A in currency Y.