Derivatives-Beginner's Guide
Why Should I Read this Guide?
If you were one of those people who watched Squid Game after it became all the hype, then fret not, because I was also one. There was one scene in particular that made me consider financial literacy levels and how arcane the topic of derivatives is to the general public.
(In the translated Hindi Version, Sangwoo (Park Hae-soo) says “Mutual Funds” instead of “Futures”, which only exacerbates the efforts of those attempting to spread financial literacy.)
This guide would cover the basic 5 W's and 2 H's of Derivatives:
In later guides, I will also show you how you can apply the knowledge you’ve gained in a practical way and make monetary returns off of it.
and here is a live example of me more than doubling my small investment with a derivative position. Would’ve made more, but greed is a big NO in the market.
With a mere 2% move in Nifty (350+Points) I was able to make 138%+ returns off of my investment. We will discuss about Live Derivatives trade in the next guide.
Derivatives can also give you margin or Leverage. Which means the ability to employ more resources than you have. Leverage is a double edged sword, it has a huge payoff and equally huge loss potential.
Why should you know about Derivatives?
Warren Buffet has called Derivatives the financial weapons of mass destruction.
However, this is only half of the truth.
Derivatives when used in a wrong way can be detrimental to one’s financial health.
but, when used rightly and responsibly, can multiply your money in a single day.
Derivatives are powerful financial instruments, and there is no way one does not fall in love with them after learning about them. For anyone interested in knowing how the stock market works, just knowing about equity is no longer enough.
Total turnover and volume (Contracts) of derivatives traded on the exchange is more than 3 times that of equity (Hit a high of over 15 in 2019). They have the potential to multiply your investments by more than a hundred times within seconds, and I think this is reason enough to be interested in learning about this.
Who works in the derivatives market?
● Hedging: (keeping your losses capped or limited) is a form of risk transfer. (Farmers, Importers, Exporters, and Commodity Traders)
● Speculation: Intraday Traders, who buy and sell these financial instruments on the same day itself, make money by betting on price fluctuations. (Traders, Asset Management Companies and Short-Term Investors)
● Arbitrage: Making the best out of market inefficiencies. (Asset Management Companies and High-Frequency Trading Bots)
We will further discuss this in guide 2.
What are Derivatives?
Cliché? Let’s do away with this definition
Derivatives refer to contracts (Contracts are agreements and agreements are legally enforceable, basically agreements with extra steps. ).
This contract, as the name suggests “Derives” its value from an underlying asset or is simply called underlying.
The Price of a derivative contract depends ‘mainly’ on
• Terms of Contract
• Price of Underlying
• Quantity of Underlying
• Price Fluctuation Level of Underlying (Implied Volatility)
• Days remaining for Expiry
For Instance
During the summer, when you take out your favourite cotton shirt to wear, keep in mind that cotton is the underlying asset and cotton shirt prices are the derivatives. Market forces act upon the underlying, and it impacts the price of the derivative as well.
Scenario 1)
Bad Harvest of Cotton- Failing cotton crops-Supply to fall down- Cost of cotton goes up
This would result in an increase in cotton prices, making your favourite shirt again more expensive.
Scenario 2)
Bumper Harvest of Cotton- Supply to increase- Cost of cotton goes down
This would result in a decrease in cotton prices, and voila! You can buy two shirts for the same price this year!
To sum up the instance given above, prices of Cotton Shirts are the derivatives of Cotton prices.
More Derivative Examples
• Milk and Cheese
• Rubber and Car Tyres
• Wheat and Bread
• Cheese and Pizza (Yes, Derivatives themselves can also be the Underlying)
In fact, one might say that wheat prices are themselves a derivative of Seed Prices or Fertiliser Prices. This just emphasises my point that we see derivatives and their application on a daily basis, but we don’t truly acknowledge it.
How Many Types of Derivatives are there?
There are 4 Types of Derivatives
1. Forward
2. Futures (s at the end is very important)
3. Option
4. Swaps
Stay with me, everything will make sense. I will cover terms like Expiry, Obligation, MTM, Speculation,customised and Hedging super soon.
How do Derivatives work?
Forwards are customized contracts between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although it is primarily used for Hedging against the risk of price fluctuation of the underlying. (Boring? I think so too)
Here goes my attempt to simplify it.
Mr. Biryani owns a restaurant that specializes in, yes, you guessed it right, Biryani. The best thing about their biryani is the supreme quality of the rice they use. Mr. Biryani is worried that the price of rice may rise (nice wordplay?) in the near future. He worries that increased cost of rice would impact his costs and thus, the price at which he sells his biryani.
Mr. Biryani cares about his customers and knows about the power of derivatives. We’ll let Mr. Biryani have his lunch for the time being and talk about his childhood friend Mr. Kissan now.
Mr. Kissan is a (wow, you guessed it right again) paddy farmer from whom Mr. Biryani buys his rice. Mr. Kissan worries that rice prices might fall this year and he would have to compromise on his profit margin.
Mr. Biryani wants to safeguard himself against this fluctuation and invites Mr. Kissan to his home to draw up a contract. (A contract is an agreement, and an agreement is a promise with extra steps.)
In that contract, Mr. Biryani agreed to buy 2000 kg of Rice from Mr. Kissan at Rupees 40 per kg on 3rd October, 2021 (near future).
Now might be the best time to mention the 4 characteristics of this contract.
• Predetermined Quantity
• Predetermined Price
• Predetermined Date
• No Intermediary Involved
This type of contract which allows you to reduce or transfer your risk is known as a “Forward” Contract.
Not everyone is fortunate enough to do business with friends. What if Mr. Biryani and Mr. Kissan don’t trust each other. Then they’ll have to go for “Futures”. Futures are forward contracts which are traded in the stock exchange. Hence, they are regulated and standardized and the only difference being that they are not O-T-C (Over the counter) like forwards. They have a stock exchange as an intermediary. OTC transactions are basically transactions which take place outside the stock exchange. Read this paragraph again word by word and you would totally understand this.
Options are a bit tricky to explain but super easy to work with.
Mr. Kissan goes to Mr. Biryani and says “You can pay me a certain amount of money (Premium) and I would give you the right to buy my rice at a predetermined price on a predetermined date). It is worth mentioning here that an Option is a Right, not an Obligation. Exercising rights is optional but obligation is something that has to be done irrespective of anything. There can be two situations now.
Situation 1: The price of Rice goes up
Mr. Biryani can exercise his "Option" and buy the rice at a lower predetermined price. Mr. Kissan is happy as well, because he got to sell his rice at the price he wanted and he wouldn’t be incurring any losses because the value of his underlying (rice) is going up as well. So, he is not complaining. (In advance terms, this strategy is known as a "covered call." We’ll cover this in later guides.)
Situation 2: The price of Rice goes down
Mr. Biryani sees that the price of rice has fallen and he buys rice at cheap rates now. Mr. Biryani remembers his Option and thinks that instead of exercising his option, he can buy it for cheap market rates. Mr. Biryani is happy because he got the rice cheaply and the Option Premium was the only cost he incurred.
Premium refers to the amount Mr. Biryani paid Mr. Kissan to get the Option.
Swaps are not traded on the Stock Exchange and hence, they are (YES! You got it right again) traded O-T-C (Over the counter), i.e., not under the jurisdiction of the exchange. Swaps, as the name suggests, mean swapping of financial responsibilities.
Mr. Kissan has a friend named Mr. Tamatar. He is not financially reliable as he might have a bumper harvest one year and failing crops the next. Mr. Kissan has a high credit rating. Mr. Kissan got a loan with 5% p.a. interest, and Mr. Tamatar takes the loan of equal amount but gets it with a floating interest rate. A Floating Interest Rate refers to the rate of interest charged on loans that differs frequently according to market scenarios and policy changes. The floating interest rate could be as low as 0.5% or as high as 20%. It totally depends on the market scenario.
Mr. Kissan trusts his friend as well as his own gut feeling and thinks that Mr. Tamatar would be more than happy to pay 5% p.a. and that he might benefit from the floating exchange rate as he thinks that the floating interest rate might benefit him as he thinks the floating rate might remain low for the time being. Mr. Kissan and Mr. Tamatar entered into a contract which "Swaps" their financial obligations. Swaps can also be bought as a right instead of an obligation. Swaps are customisable.
Where are Derivatives traded?
Derivatives are traded on Stock Exchange or OTC (Over the Counter).
Derivatives traded on the Stock Exchange are settled via the M-T-M system, which stands for the Mark-to-Market System. In its simplest terms, it means valuing something by its most recent price and settling accordingly.
For instance,
Mr. Karobaar knows about the price action and market movements. He can use this knowledge to make huge profits with small market fluctuations. The thing with derivatives is that they are a Zero-Sum Game. For every penny someone gains in a derivative position, someone loses that penny. Mr. Karobaar takes a derivative position, and that position appreciates. Following the M-T-M system, the stock exchange would ensure that Mr. Karobaar receives his profit amount on the same day, or at the very least the following day, in his account. M-T-M is just a spicy word for quick settlement of profit and loss.
Over-The-Exchange (OTC)
When I was a child I used to think that the black market is a shady place where people wear face masks and set up their small shady shops in front of their shanties. Over-The-Counter (OTC) gives the same impression but that is not true. Any unregulated derivative transaction (They are legal and enforceable though) is a part of Over-The-Counter (OTC).). It is a decentralized exchange. Customizable derivative contracts are only available Over-The-Counter (OTC) where we can get into the derivative position on our own terms.
Another term which has to be covered is "Expiry". Expiry refers to the day on which the derivative position has to be fulfilled or the day on which an obligation has to be fulfilled. In the case of options, expiry refers to the day after which you cannot exercise your right to buy or sell the underlying at the predetermined price. If the right is not exercised, then the contract is rendered worthless.
Why do we need Expiry?
That’s a very good question. Let us go back to Mr. Biryani’s situation. All of us know what inflation is. It is the rise in the price of commodities over time. It would be unfair if Mr. Biryani shackled Mr. Kissan into a derivative contract for life. Mr. Kissan’s expenses would increase over time, and being paid the same amount of money for years doesn’t make any sense. Therefore, an Expiry is needed so that the values are ascertained efficiently.
When should we use Derivatives?
Derivatives are supremely nifty financial instruments. They are wartime as well as peacetime weapons. By the former line, I mean that derivatives can be used to draw a positive return when markets are showing aggressive movement as well as when markets are stable and not moving much at all.
Many smart people who knew about the impact of COVID took a derivative position prior to the market crash and made 100x or more on their investments.
I’ll explain derivatives further and strategies in later guides.
Derivatives is a super wide topic and if I say that I’ve scratched the surface of this topic, I would be lying. I’ve tried my best to walk you through the basics of derivatives so that you now have a vague knowledge of them.
Now instead of feeling lost and unaware, you can listen to your stock market nerd friends and understand the lingo they’re using and actually understand and, more importantly, enjoy the conversation.