Derivatives: A boon or bane?

Many people don't know that there exist a financial instrument called "DERIVATIVES". And moreover most of them think that if market crashes, everyone who are into stock market lose their money. JESSE LIVERMORE, the greatest speculator of all times, did most of his money when market crashed in 1929. Most of the people ask these questions and I was also one among them.

How can anyone make money when market crashed?

What is shorting? 

How can anyone sell anything before buying?

The brief understanding of derivatives might answer some of these questions.

A derivative is a financial instrument whose value depends on the value of an underlying asset. If a stock price of company ABC is Rs.500, then the ABC stock derivatives will be dependent on the value of the stock ie Rs.500. These instruments doesn't have their independent values. The value of these derivatives increase or decrease when the value of underlying asset appreciates or depreciates respectively. For example, if stock price of company ABC increases to Rs. 600, then you can see the reflection of appreciation in ABC stock derivatives as well.

As you have understood what a derivative instrument is, you might be eager to know what are those underlying assets. The underlying assets might be equities, commodity (ex.gold, silver, crude oil, copper), currency(ex.Re and dollar), interest rates etc... The list of derivatives changes from country to country. In brief, Derivatives are Risk Management tools. How does derivatives act as risk management tool might be the next question.

For understanding purpose, let us consider a derivative instrument called futures contract. A futures contract is an agreement between 2 parties to buy or sell an underlying asset at certain time in the future at a certain price. In market terms, Buying is also mentioned as "going long" and selling is mentioned as "shorting". So if a speculator is bullish on underlying asset, then  he goes long in futures and if he is bearish, then he short the futures.

This sounds like buying equities and selling equities in stock market. What makes it different from equities then?

2 things makes derivatives a risk management tool. In simple words, these 2 things decide whether its a boon or bane for the trader.

• You can short in derivative market and hold it for more than one day.
• LEVERAGE EFFECT.

Let me explain shorting and going long with an example. A tomato sauce producing company wants tomatoes for production of sauce. But they want the tomatoes in near future, say after 6 months. A farmer who is growing tomatoes needs a buyer after 6 months as well. Farmer will be producing 5 quintal of tomatoes and company also wants 5 quintal of tomatoes. The current price of tomatoes is Rs.2000 per quintal. The company fears that tomato price might increase in future. A farmer on other side fears that price might decrease. Now the company and farmer come to an agreement. The company agrees to pay Rs.2500 for 1 quintal of tomatoes and farmer also agrees for the price, though the real trading of tomatoes hasn't occurred yet. 

Now, company has gone long on tomatoes and farmer has shorted on tomatoes. After 6 months, if price of tomatoes increases above Rs.2500, then company will be profitable because he is tied up with the farmer for Rs.2500 per quintal and farmer will be the loser. So, in this case buyer is profitable and seller is on the losing side. If tomato prices decreases, then buyer will be the loser and seller will be the gainer. Now you can understand how Jesse Livermore made millions by shorting market.

LEVERAGE EFFECT:

This leverage effect of derivatives is what attracts traders the most. Consider NIFTY FUTURES CONTRACT. The unit of trading derivatives is called LOT. 

1 LOT of NIFTY FUTURES = 50 units of Nifty.

Consider present value of NIFTY is 5600. Then 1 unit = Rs.5600. So, 1 lot of NIFTY costs 5600*50 => Rs. 2,80,000. But we are not actually buying Nifty units. We are buying Nifty futures, where we have to pay only 10% of Rs.2,80,000 ie Rs.28,000 per lot. This 10% is called initial margin, according to financial terms.

If a speculator is bullish on NIFTY, he buys 5600 NIFTY FUTURES. For every buyer there should be a seller on other side. So another person would have shorted NIFTY at 5600. If NIFTY goes to 5700 ie 1.7% up move, then profit for bullish speculator will be 100*50 units = Rs.5000 and the bearish person would lose Rs.5000. By investing Rs. 28000, the bullish speculator made 17% returns on his investment and bearish speculator lost 17% capital. 

So, Leverage benefit => 100/(initial margin)

1% movement in NIFTY SPOT is leveraged to 10% movement in NIFTY FUTURES. The initial margins changes from asset to asset and thus changing leverage benefit too. In other words, leverage benefit depends on volatility of assets. More the volatility, lesser the leverage effect and vice-versa.

This is a high risk high reward game. Its on you to decide whether its a boon or bane.