An Introduction To Derivatives Trading
As the name suggests, the word derivative signifies a financial instrument
, the value of which has been derived from an underlying asset, like stock, commodity, currency, bullion, market index, etc. Derivative connotes different sorts of contracts (forward, futures, options or hybrid), which have a pre-determined fixed tenure and which are linked to the fulfilment of a certain contract, corresponding to the value of the underlying asset. As per the second amendment in the Securities Laws Act, 1999, derivatives have been incorporated in the definition of Securities.
Derivative trading is conducted in fashion similar to that of stock trading in the financial market, with its valuations altering in accordance to the underlying asset's value. The trading may be done directly through stock exchanges or via the OTC (over the counter) route. The two most popular and widely traded derivatives are
futures and options.
A future is a lawfully binding tradable contact wherein the transacting parties agree upon buying or selling of the underlying security at a mutually acceptable predefined date and price. Regardless of what the price of the security is on that date, the trade must be executed. Thus, futures trading involves the following: buyer, seller, price and an expiry date.
Options trading is a bit more flexible, in the sense that options give involved parties the liberty to execute a trade at a specified price within or at the end of a particular time frame.
Mentioned below are certain terms one should be aware of while dealing in options:
Premium: The consideration that the buyer gives to the seller for getting the right to buy as per his will. The seller has the obligation to carry out the transaction when the buyer decides.
American option: An option that is exercised on or before the expiry date.
European option: An option that is materialised only on the expiry date.
Call option: An option to buy the underlying asset.
Put option: An option to sell the underlying asset.
Exercise price or strike price: The price at which the option is exercised.
The points that go in favour of derivatives trading are:
It is easily tradable and exudes high resilience, thus leading to increased liquidity.
It improvises risk management associated with business and market conditions, as only those transactions are pursued that enhance returns.
However, critics feel that
Transparency is amiss in these type of transactions
Markets get exposed to speculation and instability
It is too complicated for average investors
Regardless of the above shortcomings, derivatives trading is still considered a boon as it has a huge positive trickledown effect on the economy and the financial markets.
by: Mike Smiths
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