The basic definition of derivatives goes like this – they are financial contracts whose price is based on the price of the underlying asset which could be a stock, index or commodity. This might be hardly enlightening.
For the uninitiated, they are financial contracts between two parties who agree to an exchange (in the form of cash, stock or commodity) at the end of the contract term.
Derivatives are of two types – futures and options.
What are futures?
Futures is a contract to buy or sell the underlying stock, index or commodity, at a predetermined price and on a predetermined date. You have an obligation to fulfil the contract come what may.
To make it simple, suppose you want to invest in ICICI Bank shares in a month, but you think that by that time share prices would go up. So, you enter into a futures contract to buy the shares of ICICI Bank after one month at today’s price. If the price goes up after a month as you thought, you would have gained by entering into the futures contract.
What are options?
Options are derivative contracts that give you the right but not obligation, to buy or sell the underlying.
In the case of options, there are two types – call and put.
Call option gives you the right to buy and put option gives you the right to sell. You have the choice of exercising and not exercising the contract, depending on the value of the underlying at the time of contract expiry. In the above example, suppose you buy a call option and ICICI Bank share prices do not go up, you can decide not to exercise the contract to buy the shares as they would be available for the same price in the stock market.
What are the components in a futures contract?
The important elements include the strike price and expiry date. Let’s take the above example. You enter into a November 2019 futures contract to either buy or sell ICICI Bank at Rs 490. Here, Rs 490 would be the strike price. Contracts expire on the last Thursday of every month. So, the expiry date would be 28th November.
How are contract prices determined?
According to theory, futures price is the price of the underlying plus the interest rate in the economy. If the stock’s cash price is Rs 100 and interest rate is 12 per cent per annum and time left for expiry is one month then the futures price should be Rs.101. However, the demand and supply for futures would also determine the futures price, which means that the futures price could be a little more or less than the theoretical price. This is seen as the futures contract quoting at either a premium or a discount to the market price of the stock.
Even though futures contracts cannot quote at a high premium (people will buy the stock and sell futures making good money), it can quote at a good discount. Futures contracts can trade at a discount because of dividend expectations and technical reasons like heavy selling in the futures market. Investors can use these opportunities to their advantage.
What are the advantages and risks involved?
For futures, the biggest advantage is leverage. For entering a futures contract, you pay only a percentage of the contract price. This is known as the margin. Margins are usually anywhere between 10 and 30 per cent depending on the stock’s volatility. So, you can buy futures worth Rs 100 for Rs.20-30 (but you need to settle the whole amount at the time of contract expiry).
Another advantage with futures is that the future contracts are cash settled and hence there is no T+2 settlement headache. But leverage is also a big risk. Just like profits get multiplied due to the leverage effect, losses would also be high. Therefore, options are safer. Since options give you a choice of exercising the contract, you would need to pay an upfront cost for buying them this is known as the premium. This is the maximum loss that you could make on an option whereas in case of futures the loss is unlimited and upfront costs are minimal.
How to start trading in futures and options?
It is very important that before trading in futures and options, you gain experience trading in the cash (stock) market. Make sure you trade physical stocks on a day trading basis for at least 12 months. this will give you a keen sense on how good you are with gauging a stock’s direction. Also, start trading in the index like Nifty before you choose to trade in futures and options of individual stocks. Nifty being the market index is usually a lot less volatile and hence safer for first time investors/traders.
What are points to keep in mind?
Never enter the futures and options market with no knowledge or little know how. There are times when theory might be opposite of what happens in market. So, take the help of a futures and options expert. Also, note that there is a cost involved in holding your futures contract. Unlike shares, futures and options instruments have maturity periods and continued exposure will involve recurring costs. So, close your futures positions as soon as you make profits and always use limits and stop losses.
Here are some must dos for beginners
• Read up on futures and options
• Trade in the cash (stock) market for at least a year before trading in futures and options
• Set targets and stop losses for every trade to minimise losses
• Start trading in futures and options with indices like Nifty
• Use a small capital to start with. You could increase the amounts as you make gains
If you are a beginner and don’t want to take risks, you should stick to options where the losses will be limited. If you are keen on investing in stock futures, you could try these simple futures strategies.
• If you anticipate price rise, buy futures
• If you anticipate downside, sell futures
Looking to reduce volatility in your portfolio? Read this article – How To Hedge Your Stock Portfolio Against Volatility