The different types of derivatives and options, their flexibility and usefulness for managing risk and pursuing profits in the financial markets. A simple example is provided to illustrate how options work.
A derivative is a financial security that derives its value from an underlying asset. The underlying asset could be anything from bonds, equity, commodities, currencies, interest rates, and market indices, to name a few. If you go back in time, you will find that derivatives started as a means to manage the risk associated with fluctuations in agricultural commodity prices. For example, in the case of agriculture, farmers who held crops would enter into a contract to sell their crops at a set price on a set date to mitigate the risk of prices crashing.
There are different types of derivatives, including forwards, futures, options, swaps, and swaptions. This article will focus on options and why they may be the missing ingredient in your recipe for success. However, before we step into that, let us quickly define the derivatives types we mentioned.
Types of Derivatives
Forwards are customised contractual agreements between two parties where they agree to trade a particular asset at an agreed-upon price and at a particular time in the future. Forwards are often traded over-the-counter (OTC), such as on electronic media or telephone, rather than on exchanges. This means they are not traded on a centralised exchange.
A major drawback of forward contracts is that they have counterparty risk and don’t provide a competitive arena for different market participants. This is where futures come into play. These are the standardised versions of the forward contract, which take place between two parties where they agree to trade a particular contract at a specified time and an agreed-upon price traded on the exchange like BSE or NSE.
It is an agreement between a buyer and a seller which gives the buyer the right but not the obligation to buy or sell a particular asset at a later date at an agreed-upon price.
They are the most complex derivatives in the market. They enable the market participants to exchange their cash flows or liabilities from two different financial instruments. A notable feature of swaps is that they are not traded on exchanges, and small investors cannot participate. The most common swap is an interest rate swap.
This phrase swaption is a combination of swap and option, and it is also an over-the-counter contract. It allows but doesn’t put one under obligation to enter into an interest rate swap deal at a predetermined strike and future date.
Using Options for Success in the Markets
To understand options better, let us draw a parallel between a futures contract and an options contract in the case of food grains. In a futures contract, the buyer and the seller agree to buy or sell food grains at a set price on a set date. If the price of food grains goes above the set price, the buyer loses money, and if the price of food grains goes below the set price, the seller loses money. In a neutral scenario, both the buyer and the seller make a profit equal to the difference between the predetermined price and the current price.
In an options contract, the buyer has the option to exercise the contract, meaning they have the right but not the obligation to buy or sell the underlying asset at a set price on a set date. However, this flexibility comes at a cost, as the buyer pays a fee for entering the contract, known as a premium.
Now let’s revisit the question we posed earlier – why might options be the missing ingredient in your recipe for success? The flexibility that options provide is what sets them apart from other derivatives. With options, the buyer has the option to exercise the contract, which means they can take advantage of favourable market conditions. For example, if the price of food grains rises above the predetermined price, the buyer can exercise the contract, buy the food grains at the set price, and sell them in the market for a profit. On the other hand, if food grain prices fall below the set price, the buyer can choose not to exercise the contract and avoid making a loss.
Let us also take an example of the markets. Here, we have two positions in options trading, i.e., a call option and a put option. A call option gives the owner the right to purchase an asset at a predetermined price but not an obligation to sell, while a put option gives the owner the right to sell the asset without any obligation. A call option is used when you expect the share prices to go up, and a put option is used when you expect the prices to go down.
Suppose you purchase a long call option for ten shares of Company A at ₹1100 per share for July 1. You are entitled to purchase ten shares at ₹1100 per share, regardless of the actual price of the share, on July 1. So on that day, if the company shares are trading at a price of more than ₹1100, you have the right to purchase them at a lower price and hence, make profits. On the flip side, if the shares are trading at a price lower than ₹1100, you can choose not to exercise the option, and the loss will be equal to the premium because you don’t have any obligation to buy.
Therefore, it can be seen that each type of derivative has its own characteristics, but options stand out for their flexibility and can be utilised well even by novices in the market. They play a significant role in the financial markets and provide a means for market participants to manage risk and pursue profits.
Derivatives are financial instruments whose value is derived from an underlying asset or security.
The most common types of derivatives are futures, options, and swaps.
Options are particularly useful for managing risk and pursuing profits in the financial markets due to their flexibility.
With options, the buyer has the right but not the obligation to buy or sell the underlying asset at a predetermined price and time.