Derivatives are key financial instruments that have gained significant prominence in recent times. The 2 major kinds of derivatives are futures and options. Here’s all you wanted to know about these 2 key derivatives.
A derivative is a financial instrument that derives its value from an underlying asset such as a stock, a market index, or a commodity. The 2 major kinds of derivatives are: options and futures.
What is an option?
An option provides you with the right to purchase or sell theunderlying asset without being obliged to do so. There are 2 kinds of options: ‘put option’ and ‘call option’. With a put option, you get the right to sell, while with the call option you get the right to buy. An option contract states the strike price – the price for which you can purchase or sell the underlying asset. It also clarifies the expiry date – the date after the contract becomes invalid. The default expiry date is the last Thursday of every month for Indian markets.
Options can also be classified as American and European. American options can be used at any time before the expiry of the contract, while European options can be used at the time of expiry of the contract. Options on individual Indian stocks are American type while those on indices such as Nifty are European. For example, RIL option contract CA-50-Feb is an American type call option that gives you the right to buy Reliance shares at US$ 50 with the expiry on last Thursday of February. PE-100-June on Nifty is a European type put option that gives you the authority to sell at US$ 100, with expiry date on the last Thursday of June.
What is a future?
A future is a standard tradable contract that obligates the delivery of the underlying asset at a pre-determined price on a pre-determined date. When you buy a futures contract, you must purchase the underlying asset and hence it is riskier than options. Futures are generally carried out mostly in commodities like gold and silver. Squaring off, delivery, and cash are 3 ways in which the futures deals are settled. Squaring off involves adopting a position contrary to your initial one. So you can square off the buying of cotton futures by selling the same contract. Delivery involves the actual delivery of the underlying asset on the date specified. So if you buy a cotton futures contract, you’ll actually get the delivery of cotton. In cash settlement, you pay the difference between the futures price and current price of the asset. So if you sell cotton futures for 1 kg at US$ 100 and the price when the contract expires is US$ 200, you should pay the buyer US$ 100.
What are derivatives actually used for?
Futures and options let you speculate on price variations. Companies use them to hedge the risks involved in fluctuations in the prices of raw materials. TCS, the leading IT service provider, had hedged the currency risks involved in a stronger rupee in order to protect their bottom-line.
Are derivatives right for individual investors?
Yes, you can do this from the comfort of your home. But you should carry out a thorough study and exercise caution. Spend time researching not only the derivative but also the underlying asset. Understand how the price variation of the underlying asset affects your investment value and study the related market for the asset.
Critics opine that derivatives decrease the transparency of the market and lead to instability and speculation, thereby increasing volatility in the market. The supporters of derivatives claim that they enhance risk management and hike liquidity. However, it is commonly acknowledged that derivatives have a very important role to play in financial markets and the economy. Do you agree?
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