Derivatives P & C
Options & Spreads
This blog provides an introduction to the concept of derivatives and their functions. Using simple examples and lucid language, futures and options are explained in a way that will be clear to amateurs. The blog provides a future and options tutorial to provide amateurs with the opportunity to take advantage of these instruments.
The word “derivative” is something we are all familiar with. According to the dictionary, the word “derivative” means something that is based on another source. In other words, anything that has been derived from some other idea or concept is termed as “derivative”.
In the world of finance however, the answer to the question “what is a derivative” has a whole other meaning. In financial jargon, derivative refers to any instrument which derives its value from an underlying asset. While we all know the derivative definition, few people understand what these instruments are and how they function.
The derivatives market in India is becoming more and more popular with every passing day. Although derivatives have been around for a while, they have recently stolen the spotlight as one of the hottest new methods of investment. This market has the potential to earn you more money than you could have imagined. If you do not know the basic principles on which these instruments function however, you could lose money just as easily.
In simple terms, a derivative is a contract of sorts, which is based on an underlying asset like equity, commodities or even currency. The price of the derivative is obtained from the value of the underlying asset.
Derivatives can be traded through exchanges, and in some cases, even over the counter (OTC). They are primarily used to hedge or reduce risks associated with any investment strategy.
There are a number of derivative instruments traded in stock exchanges around the world. The two main instruments on the basis of use and popularity are futures and options.
A future derivative is essentially a contract between two individuals or institutions. It is an agreement to buy or sell the underlying asset on which the contract is based, at some future date at an aforementioned price. Such contracts are generally traded through exchanges.
Let us now consider an example to make things more clear.
Imagine a world in which you are an agricultural land-owner. In the present year, you plan to cultivate rice in your fields, and then sell that rice in the market. There is some scope for ambiguity here because there is a certain unavoidable lag period between deciding to cultivate rice and the actual harvest.
You have two options in front of you. You could either grow the rice, harvest it or then sell it normally in the market at whatever the price is at that point of time. Alternatively, you could take out a futures contract and predetermine the price you get for the rice.
Now, as we all know, speculation is not an exact science. In fact, it is hard to find any financial instrument without any implicit risks. Futures, too, are nothing different.
The disadvantage of taking out a futures contract and locking in the price at which you sell your rice is quite obvious. You have no way of knowing what the market price will be after the harvest. If, for some reason, there is inadequate supply in the market, the price of rice would increase considerably. In such situations, the predetermined price on your futures contract would actually be lower than the market price and you would lose out on higher profits.
It is, however, just as easy to argue for the other side. The advantage of futures contracts and predetermined prices come in mainly when the market price falls. If, for instance, there is a harvest boom this year and lots of rice is produced, the market price of rice would fall. You, however, would still be able to sell your produce at the higher price and thus make a profit.
An option is a contract between two people or parties. The buyer of the option buys the right to buy or sell the underlying asset at a predetermined price within a certain time period. It is important to note here, that the buyer of the option can choose whether to buy or sell the security.
The option contracts which concern the purchase of the security are called call options while those which concern the sale of the security are called put options.
Let us look at an example now.
Imagine you are an investor in the stock market. After perusing through the available stocks from the companies, you have suddenly realised that the value of the stock of Company A will rise in the next month. If the value is currently at Rs. 100, it is expected to rise up to Rs. 200 in the following month.
You have two options at this point. You can either buy the stock now, at Rs. 100, wait for it to increase in value and then sell it off again once it reaches Rs. 200. This would leave you with a net profit of Rs. 100 per share.
Alternatively, you can buy an options contract for a month. Let us assume that the contract is priced at Rs. 5. The strike price or exercise price on the options contract is Rs. 150. This means, even if the price of the share increases or decreases, you can exercise the option and buy the stock at Rs. 150.
So you would probably wait for the stock price to rise. Just before the expiration of the contract, you could exercise the option and buy the share for Rs. 150. You would then sell the share in the market for Rs. 200 and still make a net profit.
What would be the point of such an exercise?
Like with futures, the heart of the matter comes down to the limitations of speculation. You see, you can never be absolutely certain that the price of the stock is going to rise. The company could just as easy run into an unexpected obstacle in its trajectory and then fumble and fall.
What, then, would happen to the value of your stock?
The main advantage of options trading, is that it will nullify the risks of such sudden downward movements in the price of the stock. If you chose to buy the options contract instead of the share, you would have completely averted any similar sort of risk. If the value of the stock suddenly takes the downward tumble, you would simply not exercise the option and buy the stock. Your loss, in this case, would be limited to the price of the options contract.
It is almost as though such an options contract gives you the opportunity to take a sneak peek at the price of the stock. If you are satisfied that the price has increased, only then would you buy the stock.
Derivatives allow you to have a certain amount of leeway that is absent in the root assets. They enable you to get higher exposure to trading. At the same time, they do away with the need for upfront capital which shares and other assets require.
Derivatives have become increasingly popular because of their myriad applications and uses in various forms of hedging and risk management. They are generally used to offset the risk of sudden movements in the stock price. They are considered to be levered instruments.
This blog provides a glimpse into the world of a few other financial derivatives, namely forwards and swaps. Using mundane everyday examples, these concepts are examined and their functions explained. The purpose of this blog is to demystify the complications surrounding financial derivatives, so that they may be used by all potential investors to create the optimum investment portfolio.
The term “derivatives” is one none of us are unfamiliar with. After all, derivatives and the derivatives market in India are hardly ever out of the news.
A derivative is a security or a financial instrument, which derives its value from the underlying asset on which the instrument is based. The price of a derivative depends on the fluctuations in the price of the underlying asset.
Well, among other uses, the main use for these derived financial instruments are to manage risk. It is almost as though derivatives were the next obvious creation in financial markets for managing the risk generated by the original or underlying assets.
The more complicated and more convoluted a market structure gets, more is the possibility of generating risk. If the financial market consisted of only one metaphorical layer of the simple instruments like shares and bonds, offsetting the risk would be a piece of cake.
However, it is not quite that simple.
The multifaceted character of the stock market brings with its labyrinth-like map, equal opportunities of generating risk and offsetting it, too. As derivatives derive their value or price based on the fluctuations in the price of the underlying asset, they can be used to offset any risk from market fluctuations on the underlying asset.
The benefits of derivatives are large in number and they find applications in hedging, risk management. These instruments are vitally important, and their importance is increasing with every passing day. It is paramount to understand the different kinds of derivatives in order to stay ahead and be fully informed.
Forward contract or a forward, is a contract between two individuals or two groups of individuals to buy or sell an asset or a security at a predetermined price on a predetermined date. These contracts are non-standardised, in the sense they are traded over the counter and not through exchanges.
You may have noticed, forwards sound somewhat similar to another type of financial instrument, namely, future derivatives. Futures and forwards are very similar indeed. They are both agreements and contracts between two people which specify the sale or purchase of an asset at a previously agreed upon price.
There are a few basic differences though. While futures are standardised instruments which are traded through exchanges, forwards are more informal agreements between two parties and are traded in over-the-counter or OTC markets. Also, forwards are settled only on the maturity or expiration date. Futures, on the other hand, are settled on a daily basis.
The fact that forwards are traded in OTC markets and futures are traded through exchanges, gives rise to advantages and disadvantages in equal measure. As forwards are essentially private agreements between two individuals, they are more flexible in their terms and conditions.
This flexibility, unfortunately, comes at the cost of a high risk of counter-party default. As forwards are not traded through exchanges, there is an absence of an enforcing mechanism which would prevent either party from defaulting. As a result, such contracts are more unpredictable and unregulated, and are associated with more risk.
Let us now attempt to clarify the concept further with an example.
Imagine a world where you want to buy a house. You have your eye on a particular beauty down the road. Let us assume the current market valuation of the house is at Rs. 50 lakhs. The owner tells you that she will vacate the house in six months and you can buy it after that.
You have two courses of action available at this juncture. You could either wait the six months and then buy the house. Alternatively, you could enter into a forward contract with the owner, which would enable you to buy the house six months later, at a predetermined price of Rs. 55 lakhs.
Let us now fast forward six months. The market valuation of the house is now at Rs. 60 lakhs. Assuming you chose the latter option of the forward contract, you would still be able to buy the house for Rs. 55 lakhs. This would give you a potential profit of Rs. 5 lakhs. If you hadn’t entered into the forward contract, you would have had to pay the market price of Rs. 60 lakhs.
There is however, a downside to this story. In the unlikely event that the real estate market suddenly takes a tumble, and the price of the house falls down to Rs. 40 lakhs, you would still have to pay the higher price of Rs. 55 lakhs as specified by the contract.
As we see, forward contracts protect you from sudden price movements in one direction. They are widely used in trades involving interest rate movements and currency transactions.
A swap is a contract or an agreement where two individuals or two groups of individuals exchange the cash flows or liabilities associated with each individual’s financial instrument. The benefits and the value associated with it, all depend upon the underlying financial instruments involved.
Swaps are generally based on interest rates, exchange rates, stock indices and other similar instruments. The different types of swaps are interest rate swaps, currency swaps, commodity swaps and others.
Essentially, what happens is the two parties exchange the cash flow associated with one particular financial instrument with another. Each cash flow makes up one leg of the swap. One of the cash flows is generally fixed, while the other is of a variable nature.
The cash flows are calculated on the basis of a notional principal amount. Swaps are different from the other main derivatives, namely, forwards, futures and options, in the sense that the principal amount is not directly exchanged by the individuals involved in the contract.
How then, does it work?
Let us consider an example.
Imagine a world where there are two companies, Company A and Company B. A and B enter into a simple interest rate swap for a period of two years. The nominal value of the swap is at $2 million. Let us assume that Company A has a bond which pays the London Interbank Offered Rate or LIBOR while Company B has a bond which yields a fixed return at 5%. Both bonds, therefore, have a principal amount of $2 million.
Assuming that the London Interbank Offered Rate or LIBOR is expected be around 3%, Company B would offer Company A an assured return of 5% in exchange for a payment of the LIBOR plus 2%.
The two companies here, are essentially switching or swapping the bonds that they each hold. Except, instead of actually exchanging the bond, they are simply exchanging the payoffs generated by the bond.
An interesting thing to be noted at this point is that even though A’s bond is expected to pay 3%, A actually has to pay 5%. The reason behind this rationale, is rooted in the core principle of interest rate swaps.
The idea is that the party which holds the security offering a floating interest rate hedges the risk from the floating interest rate by swapping the payoff with that of a more conservative security. Reverting to the example, A has to pay a higher rate because the interest rate swap is also doing away with any uncertainty associated with the floating interest rate. The higher price is a reward for the lower risk.
At the end of the two year period, if the LIBOR was at 3% as expected, neither company would gain or lose. If the LIBOR had been higher than 3%, A would end up making a net loss. If the LIBOR had been lower than 3%, B would have been the unlucky one.
Swaps have become fiercely popular in recent years because of their wide-spread applications in financial markets across the world. Interest rate swaps are one of the most widely used forms of swaps. They offset any risk associated with a floating interest rate.
However, as swaps are traded over-the-counter and not through exchanges, they do bring with them some risk of counter-party default. Much like forwards, while they offset a certain class of risk, they also bring with them an additional risk.
The derivative market in India has expanded like wildfire over the last couple of decades. These financial instruments are very useful indeed. However, they bring with them advantages and disadvantages galore. This blog provides a comparison of the benefits of derivatives and their down side.
Financial derivatives are instruments which derive their value from the underlying asset or security on which they are based.
Aside from being one of the most talked about methods of investing, derivatives and their myriad uses and applications creep into news segments and snippets quite often. In fact, to not know everything about the derivatives market and why it is considered so important, would put you at a disadvantage in any conversation.
I am going to break down this intricate subject into advantages and disadvantages, so as to give you a clear idea about the different aspects of derivatives.
1. Risk Management
Derivatives are widely used by investors as a method of managing or diluting the risk associated with portfolios. The reason is simple, really. Because derivatives derive their value from the underlying asset, they can be used to hedge against sudden fluctuations in the price of the underlying asset.
Just like normal people use umbrellas during the monsoons to shield or protect them from the rain, investors use derivatives to shield themselves from sudden and unexpected movements in the price of their asset of choice.
For example, imagine a situation where you have bought the stock of a company because you expect the company to do well and the price of the stock to rise. It would be very naive of you, however, to not have a contingency plan for the unlikely event when the market does not perform as expected.
A smart investor would also buy a put option along with the share. This would in effect, perform the same task the umbrella does, albeit metaphorically. A put option would enable you to sell the stock at a specified price if the market performance is anything less than satisfactory. It would act as a failsafe and protect you if the price of the stock suddenly fell.
2. Price Discovery
Price discovery, as the name suggests, is the process by which the correct price of a commodity is determined in the market. To go into the economics of it, the correct price is determined at the point where the demand curve and the supply curve intersect each other.
Price discovery is a process of utmost importance. However, the problem lies in the fact that the demand and supply curves are, for all intents and purposes, invisible. Humans thus have to play a guessing game of sorts to determine what the price of a commodity should be.
Derivatives are very useful in this process. Most derivative instruments like futures, forwards and options, deal with future transactions and prices. Companies use them to predict the future prices of raw materials and investors use them to predict the future prices of shares.
The derivatives markets are affected by any changes or fluctuations in the world economies. Their volatility and sensitivity actually helps determine what the price of a product should be.
3. Market Efficiency
This advantage is two-fold. Firstly, companies can lock in the future prices of raw materials and hedge against unexpected risks in the market. This increases their efficiency and overall performance.
Secondly, trading in derivatives is rooted in arbitrage. This helps maintain price efficiency and lowers transaction costs across the markets.
Thus, as we see, financial derivatives bring with them multiple game-changing advantages. However, as with all good things, there is also the bad. In fact, Warren Buffet was of the opinion “derivatives are financial weapons of mass destruction”.
1. Market Risk
Market risk is that risk which is generated by factors which affect the overall performance of the market on the whole. Also known as systematic risk, this has plagued all sources of investment, probably since the beginning of time itself. Market risk is caused by factors such as recession or depression, natural disasters and political turmoil.
Derivatives too, fall prey to market risk. They are, of course, used as instruments of risk management, but market risk can never be avoided.
For example, with instruments such as futures and options, investors can allow for a certain amount of price movements in either direction. However, if a tsunami or an earthquake ravages a part of the earth, or if the world is suddenly hit by a global recession of a tremendous magnitude, there can be drastic and unforeseen movements in price which derivatives cannot protect from.
2. Counter Party Risk
Counter party risk, as the name suggests, is the possibility in which one of the parties in the contract is unable to meet its contractual obligations. Simply put, one of the parties defaults.
This risk is higher in over-the-counter or OTC markets which are not as regulated as exchanges are. Therefore, financial derivatives like swaps and forwards, which are primarily traded in OTC markets are affected by counter party risk.
For example, a forward contract is an agreement between two parties to buy or sell a security or an asset at some predetermined date in the future, at a fixed price. If, however, one of the parties is unable to either make the payment or deliver the product, there is little the other party can do in terms of enforcing the agreement. In fact, in some cases, one of the parties could even abscond, leaving the other party with the short end of the stick.
3. Liquidity Risk
Financial derivatives are very powerful instruments in the sense that they are more sensitive to price fluctuations than other normal assets or securities. This means that if there is any inaccuracy in a trade involving a derivative, it holds the potential of generating huge losses for the investor.
Liquidity issues may arise if investors plan to back out of a derivatives trade prior to its expiration date. In fact, if business owners wrongly predict the future prices of commodities or securities, it could result in tremendous losses which lead to financial distress.
This blog deals with the different trading strategies that can be created using financial derivatives. While these instruments are complicated and can be overwhelming on their own, trading strategies provide an easy option to budding investors to make use of them and fully take advantage of the benefits of derivatives.
Derivatives are one of the most popular methods of investment in the financial world right now. Fast and volatile, these instruments hold the potential for large capital gains. Options trading, in particular, has stolen the limelight like no other.
However?, in the immortal words of Stan Lee, “With great power comes great responsibility”.
This is a lesson we all must remember when dealing with the derivatives market. This is because the potential for capital gains is right on the flip side of shocking losses. Volatility is both a pro and a con here. That is why it is so important to be fully informed before you start investing and maneuvering your way through the quagmire that is the world of derivatives.
Options are contracts between two individuals where the right to buy or sell an asset is traded. Essentially, one person sells to the other, the right to buy or sell the asset, for example a stock, at a fixed price within a fixed period of time.
Call options are the ones where the investor buys the right to buy the underlying asset and put options are the ones where the investor buys the right to sell the underlying asset.
There are a number of strategies using call and put options that traders have developed to take advantage of the myriad moods of the market.
A covered call is one of the most popular strategies used by traders. The basic idea is that you offset the potential risk of any downside movement in the value of the stock by combining it with a suitable option. It generates income for the investor while reducing the exposure to any risk.
How does it work?
A covered call is created by combining a long position in the underlying stock with a short call option on the same stock. Simply put, you buy the share, and simultaneously sell a call option on that share.
The risk of buying the stock alone without any option is that the stock markets are about just as predictable as the forces of Mother Nature herself. Speculation can only go so far. If the price of the stock does decline, and you have no mechanism in place to protect you, the potential for losses is huge.
A short call is where you sell the right to buy the share. What this means in effect is that when the stock price reaches a certain predetermined strike price, the share will get sold to the buyer of the call option at the strike price.
The falling of a stock price is similar to driving down a really steep mountain slope without any end in sight. The covered call comes into play as a really effective braking mechanism which stops the car from hurling down towards impending doom.
Covered calls have gained popularity among traders in the derivatives market in India primarily because of their simplicity and effectiveness. They are primarily used in situations where the investor ranges from a neutral to bullish disposition. So if you are looking to start using options for hedging and to manage the risks associated with the stock market, you need to look no further.
A protective put, also known as a married put, is used primarily in situations where investors expect the prices in the market to rise, but also want to protect themselves from any sudden downward movements in price.
Like a covered call, a protective put is created by combining a share with a suitable option. In this case, a long position in the underlying share is combined with another long position in a put option.
What does this mean?
The first step here is to buy the share. Simply buying the share is not enough for a prudent investor. In order to protect oneself from the vicissitudes of the stock market, it is necessary to also buy a put option in the same share.
A long put option gives the investor the right to sell the share once it reaches a certain strike price. What this translates to, is an insurance policy of sorts, which ensures that the investor can sell off the stock once it falls to a certain threshold value.
There are a number of similarities that can be spotted between a covered call and a protective put. There are a few minor differences though.
For the protective put, there is a minor downside for the investor when the market stays bullish. This happens because the buyer of the option always has to pay a price or premium to the seller of the option, in exchange for the right to buy or sell the share. In this case, because the investor buys the put option, he/she has to pay a price to the seller of the put option.
If the market performs well and stock prices keep rising, the investor incurs an additional cost in terms of the price of the put option. Of course, one can interpret it as a premium for the insurance provided by the option. However, when the option does not need to be exercised, the price payed can seem redundant.
The covered call does not impose any additional cost on the investor. As the seller of the call option, the investor does not have to pay any premium to the buyer. On the contrary, the investor actually gets an additional premium from the buyer of the option in exchange for the right to buy the share. Covered calls therefore provide a constant positive profit to the investor. Both these strategies help amateurs and budding investors by offering an easy way of trading correctly in the derivatives market and making use of the benefits of derivatives.
This blog introduces a particularly popular subject in the derivatives market in India. Option spread strategies are a very clever method of taking advantage of the benefits of derivatives while also doing away with some of the disadvantages of derivatives, namely the volatility risk.
Derivatives have shot across the metaphorical sky of the finance world much like a meteor, dazzling and blinding everyone in their wake. We all know they are powerful instruments. However, more often than not, people do not really understand how to correctly approach options trading so as to harness their power in an optimum manner.
Option spread strategies, as the name suggests, are tried and tested methods of investing. For amateur investors, trading strategies offer a guidebook of sorts, which is absolutely essential to start off in the world of investing.
There are several kinds of trading strategies involving options, in varying levels of complication. In this article, we are going to talk about spreads.
Spread strategies in financial derivatives are created by buying and selling options based on the same underlying assets, but with different maturity dates or strike prices. They are used widely in the derivatives market in India.
Spread strategies in financial derivatives are created by buying and selling options based on the same underlying assets, but with different maturity dates or strike prices. They are used widely in the derivatives market in India.
Let us use an example to simplify the matter further.
Imagine you are a potential trader, scouring the stock market for your next golden goose. You narrow in on one company, ABC, which is currently trading at Rs. 1,000 per share. You expect the price of this company’s stock to go up in the following month and reach a level of at least Rs. 1,300 per share.
You have several options available at this juncture.
The first option is to directly buy 100 shares of ABC, which would lead to an initial cash outflow of Rs. 1,00,000. If the market performs as expected and stays bullish, the stock price will rise and reach the expected value. At this point, you can sell off the shares and earn Rs. 1,30,000. This will give you a profit of Rs. 30,000.
If however, the market does not perform as expected, and the value of the stock falls instead, you will have to sell the shares at a lower price and incur considerable personal losses.
The second option is to create an option spread strategy with call options derived from the stock of the company ABC. You can buy a call option with a strike price of Rs. 1,000 and sell another call option with a strike price of Rs. 1,300. Let us assume both the options have the same period of maturity. This means, in the period of one month, if the market does stay bullish and the stock price rises, you can buy the stock at Rs. 1,000 and sell it off again at Rs. 1,300. This, too, will give you a net profit of Rs. 30,000.
The advantage to the latter option is, if the market does not stay bullish as expected, you can simply choose to not exercise the option and not buy the stock. In effect, you are hedging the risk associated with any downside movement of prices by buying and selling call options simultaneously.
Spreads find use and application in investments and portfolios around the world. They are indeed a useful subject to know about.
One of the most popular and well-known trading strategies across the world, bull spreads are almost defiantly clever in the way they combine simplicity with functionality. In fact, the strategy used in the example above is the perfect answer to the question “what is bull spread” i.e. it takes about a spread created by call options.
As the name suggests, bull spreads are primarily devised for investors who are bullish in their outlook. The main rationale behind this idea is to hedge the risk associated with options by buying and selling two options on the same underlying security. In essence, the investor moderates his/her range of possible outcomes to a very specific window which is provided by the difference in strike prices.
Theoretically, bull spreads can be created using both call options and put options. However, the spreads created by combining two call options are more popular than the ones created using two put options.
Functionally, bear spreads are similar to bull spreads in the sense that they serve a similar purpose. Bear spreads, just like their bull counterparts, limit the risk exposure to the investor by restricting his/her range of possibilities to a specific window.
The main difference between the two is in the targeted group of investors. While bull calls are meant for investors who are of a bullish disposition and expect the market to rise, bear spreads are for the more pessimistic half, the ones who expect the market to fall.
Let us now consider an example to further simplify the clouds of mystery surrounding the bear spread.
Imagine again, that you are a potential trader in the stock market. To keep things simple, let us assume that your company of choice is once again Company ABC. However, this time, you are have a bearish disposition. You expect the market to decline in the upcoming month.
ABC is trading at Rs.1,000 per share. You expect the price of the share to fall to Rs. 700 by the end of the following month. In order to take advantage of the volatility of the market, you create a bear spread using put options.
What does this mean?
You buy a put option with a strike price of Rs. 1,000 and sell another put option with a strike price of Rs. 700. Both options, of course, have the same period of maturity.
If your intuitions bear fruit and the market continues in a bearish trajectory, the stock price will fall to Rs. 700. When this happens, your short put option will come in to play and you will have to purchase the share at the price of Rs. 700. At this point, you can take advantage of your long put option and sell the share again at the higher price of Rs. 1,000. Assuming the entire contract is for 100 shares, this little transaction will earn you a net profit of Rs. 30,000.
Even if your intuitions had proven false and the market had risen instead, you could simply not exercise the option. Bear puts therefore enable you to take advantage of the volatility in stock prices while limiting the exposure to any risk.
Bear spreads, too, can be created using both call options and put options. However, bear puts are more popular and more commonly used than bear calls are.
There are, of course, other variations and other methods of creating spreads. However, these two are the most simple as well as the most widely used. Calendar spreads, which are created using options with different maturity periods, comes in at a close third.