Table of Contents
Introduction
Understanding derivatives is crucial when it comes to navigating the stock market. Derivatives are financial instruments that derive their value from an underlying asset. These assets can range from stocks to crude oil, and their prices directly impact the value of the derivative.
Let’s look at an example to better understand the relationship between underlying assets and derivative prices. Imagine that crude oil prices are being derived from the supply between Russia and Ukraine. As the price of crude oil fluctuates, it directly affects the prices of derivatives that are tied to it, such as petrol or diesel.
There are four main types of derivatives: forward contracts, futures contracts, options contracts, and swaps. However, in the stock market, the two most commonly traded derivatives are futures and options. In this video, we will focus on forward and future contracts.
A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price in the future. For example, if the price of cashew nuts is currently $9,000 per square foot, Rohit may want to buy a property at that price. However, the farmer selling the property may have two conditions: first, the payment will be made once the property papers are ready, and second, the price will be given in USD instead of the local currency. In this case, a forward contract would be ideal to ensure that both parties fulfill their obligations without any default.
On the other hand, a futures contract solves the problem of default in a forward contract by involving a third party. Exchanges like the NSC or BSE act as intermediaries between the buyer and the seller, reducing the risk of default. For example, if Rohit and the farmer enter into a futures contract for the property, both parties will be legally bound to fulfill their obligations. This ensures that Rohit doesn’t face any losses due to a default in the contract.
Lastly, options contracts provide flexibility to investors. They give the option to buy or sell an asset at a future date, but not the obligation to do so. For example, if Rohit wants to buy gold but is unsure about its future price, he could enter into an options contract. This would allow him to pay a small percentage of the future price as a margin and decide later whether he wants to exercise the option or not, depending on the movement of the gold price.
Now that we have a basic understanding of how forward, futures and options contracts work, we can explore each type in more detail. If you have any questions or queries, feel free to leave a comment below. Happy learning!
Forward Contracts
Forward contracts are financial agreements between two parties to buy or sell an asset at a predetermined price in the future. These contracts are commonly used to manage risk and uncertainty in various industries, including real estate.
Definition and Purpose of Forward Contracts
The purpose of a forward contract is to provide both parties with a guarantee on the terms of the transaction. In the example mentioned earlier, Rohit wants to buy a property, but the farmer has specific conditions. By entering into a forward contract, both parties can ensure that their obligations are fulfilled without any default.
Example of Buying Property Using a Forward Contract
Let’s delve deeper into the property buying example. Rohit wants to purchase a property at the current price of $9,000 per square foot. However, the farmer selling the property has two conditions: the payment will be made once the property papers are ready, and the price will be given in USD instead of the local currency. In this case, a forward contract can be used to secure the transaction. Both Rohit and the farmer agree on the terms, including the price, currency, and payment date. This contract ensures that both parties are legally bound to fulfill their obligations when the property papers are ready.
Conditions and Risks Associated with Forward Contracts
While forward contracts have their benefits, it’s important to consider the conditions and risks involved. Forward contracts do not involve a third party, which means there is no intermediary to reduce the risk of default. If either party fails to fulfill its obligations, the other party may face financial losses. Additionally, forward contracts are binding, and it may be challenging to make changes or cancel the contract once it is in place. Both parties should carefully assess the terms and conditions before entering into a forward contract.
Comparison with Future Contracts to Highlight Lack of Third-Party Involvement
A key difference between forward contracts and future contracts is the involvement of a third party. In the case of future contracts, exchanges like the NSC or BSE act as intermediaries between the buyer and seller, reducing the risk of default. However, with forward contracts, there is no third-party involvement. This means that the parties involved have a higher level of responsibility and face greater risks if either party fails to fulfill their obligations.
In conclusion, forward contracts provide a way to manage risk and uncertainties in various industries, including real estate. They offer a guarantee on the terms of a transaction, allowing both parties to fulfill their obligations without default. However, it’s important to carefully assess the conditions and risks associated with forward contracts before entering into one. Compared to future contracts, forward contracts lack third-party involvement, which increases the responsibility and risk for the parties involved.
Future Contracts
Future contracts were developed as a solution to some of the problems associated with forward contracts. While forward contracts involve a direct agreement between two parties, future contracts involve the intervention of an exchange, such as the NSC or BSE.
Role of Exchanges in Future Contracts
Exchanges like the NSC and BSE act as intermediaries in future contracts. They provide a platform for buyers and sellers to enter into contracts, ensuring that both parties fulfill their obligations. By involving an exchange, the risk of default is reduced, as both parties are legally bound to fulfill their obligations.
Example: Property Purchase Using a Future Contract
To better understand how future contracts work, let’s consider an example of a property purchase. Rohit wants to buy a property at the current price of $9,000 per square foot. Instead of entering into a forward contract with the farmer, Rohit and the farmer decide to use a future contract through an exchange like the NSC.
Both parties agree on the terms of the contract, including the price, currency, and payment date. The exchange acts as an intermediary, ensuring that both parties fulfill their obligations. This provides security for Rohit, as he does not have to worry about the farmer defaulting on the contract.
Default Risks and Possibility of Loss
While future contracts reduce the risk of default, there is still a possibility of loss. If Rohit enters into a future contract for the property and the price of the property decreases, he may face a loss. For example, if the price of the property drops to $50,000, Rohit would still have to purchase it at the agreed-upon price of $54,000.
It is important for individuals entering into future contracts to carefully consider the potential risks and assess the likelihood of loss. While future contracts provide a level of security, there is always the possibility of facing financial losses.
In conclusion, future contracts provide a solution to some of the problems associated with forward contracts by involving exchanges as intermediaries. They reduce the risk of default and provide security for both parties involved in the contract. However, it is important to remember that future contracts still carry the possibility of loss, and individuals should carefully assess the risks before entering into such contracts.
Options Contracts
Options contracts are financial instruments that provide investors with the flexibility to buy or sell an asset at a future date, without the obligation to do so. They offer a way to speculate on the future movements of an asset’s price while limiting potential losses.
Introduction to Options Contracts and Their Purpose
Options contracts are commonly used in the stock market to hedge against potential losses or to take advantage of market opportunities. They allow investors to control a larger amount of assets with a smaller upfront investment, making them a flexible and cost-effective trading tool.
Condition of Margin Payment and Its Impact on Options Contracts
When entering into an options contract, investors are required to make a margin payment, which is a small percentage of the asset’s future price. This payment serves as collateral and ensures that the investor has the financial capacity to fulfill their obligations if they decide to exercise the option. The margin payment also helps to limit potential losses, as the investor’s exposure is limited to the amount of the margin payment.
Example of Buying Gold Using an Options Contract
Let’s consider an example of how options contracts can be used to buy gold. Rohit wants to buy gold, but he is uncertain about its future price. Instead of purchasing the gold outright, Rohit decides to enter into an options contract. He pays a small percentage, let’s say 10%, of the future price of the gold as a margin payment. With this options contract, Rohit has the flexibility to decide later whether he wants to exercise the option and buy the gold, depending on the movement of the gold price. If the price of gold increases, Rohit can exercise the option and buy the gold at the lower, agreed-upon price. If the price decreases, Rohit can choose not to exercise the option and only lose the margin payment.
Differentiating Between Call and Put Options
There are two types of options contracts: call options and put options. A call option gives the investor the right to buy an asset at a future date, while a put option gives the investor the right to sell an asset at a future date. Call options are typically used when investors expect the price of the asset to rise, while put options are used when investors expect the price to fall. Both types of options contracts provide investors with the opportunity to profit from their predictions about the future movements of an asset’s price.
FAQ
Here are some frequently asked questions about trading derivatives in the stock market:
What are the benefits of trading derivatives in the stock market?
Trading derivatives in the stock market offers several benefits. It allows investors to hedge against potential losses, speculate on price movements, and control larger amounts of assets with a smaller upfront investment.
How can I open a DmiT account for trading derivatives?
To open a DmiT account for trading derivatives, you can follow the link provided in the description box of this video. Simply click on the link and follow the instructions to open an account.
What are the risks associated with derivatives trading?
Derivatives trading carries certain risks. There is a possibility of financial loss if the price of the underlying asset moves against your prediction. It is important to carefully assess the potential risks and make informed decisions when trading derivatives.
Can I trade both futures and options in the stock market?
Yes, you can trade both futures and options in the stock market. Futures contracts involve buying or selling an asset at a predetermined price in the future, while options contracts give you the flexibility to buy or sell an asset at a future date without the obligation to do so.
Are there any minimum requirements or restrictions for trading derivatives?
Yes, there may be minimum requirements or restrictions for trading derivatives. These can vary depending on the platform or brokerage you use. It is important to familiarize yourself with the specific requirements and restrictions before engaging in derivatives trading.