The lure of financial markets is hard to resist. Yet, there are many complex financial products you need to understand before investing and earning from the market. One such complicated product is derivatives.
Intricate trading strategies, lots of jargon and arcane pricing formulae are what make derivatives' trading difficult to understand. It's easier to grasp the fundamentals of a derivative trade if stocks are used to illustrate. The concept can easily be generalised to other financial instruments.
Consider the simplest transaction in the stock market. When you want to buy a particular stock, you place an order with your broker and he does it for you in what is known as the cash market. You will need to make the payment in the next two working days.
However, say you wish to buy it a month later - maybe because you don't have the cash right now. You could wait a month before buying it in the cash market. But if you are worried the price may rise in that time, you might want to fix the purchase price today but pay for it later.
That can be done under a futures contract. For instance, assume the price fixed today is Rs 1,700. Under a futures contract, you will agree to buy the stock at Rs 1,700 a month from now. In derivative parlance, it is called a 'one month future on the stock'.
The future price of the stock is dependent on two things: 1) Price of the stock today 2) One-month interest rate, as you will be paying a month later. Now, suppose on the decided date, a month later, the stock price rises to Rs 1,750.
You will buy it cheaper at Rs 1,700, as mentioned in your contract. But, if the stock price falls to Rs 1,650, you can buy the stock at that price or market price. This is called using an option.
So, the buyer has a choice of buying the stock at Rs 1,700, but is not forced to. If the market price is below Rs 1,700, he can buy it at the lower price. Hence, he has an option.
The person selling the option to you will charge a fee called premium. It is the price of the option. You get the flexibility of ensuring your purchase price for the stock does not exceed the price decided by you. And, in case, the price goes down, you can buy at the lower price from the market.
That is the beauty of an option contract. It limits your losses to the premium paid, but your profits can be unlimited.
Large financial institutions and high networth individuals trade in futures and options (F&O). Retail investors, ideally, should stay away from this market because it is not an investment tool but a trader's delight. Also, you need to have a strong understanding of this subject and be constantly on your toes for best result.
The writer is director learnwithflip.com.
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