What do the smartest people in the world do? They identify and build multiple sources of income for themselves! Similarly, while investing, it makes sense to reduce your risks by increasing the number of investment options. Derivatives are financial instruments that derive their value from the underlying assets that they represent.

Understanding derivatives starts by understanding the concept of risk. Whether you buy essential products, own property, run a business or manage money for some investors, or if you are a Government employee, risk is all around you, 24/7. For some, risk stands between them and their progress. For others, risk is an opportunity to invest. If you have ever bought or sold any asset, you know that there is always a risk that the price of what you buy or sell today could change depending on the market conditions.

Investors use financial instruments such as Derivatives and Futures to hedge risks in the market. These risks can be financial liabilities, commodity prices, or some other unseen factors. Financially savvy companies or share market traders happily accept these risks and use various strategies to make profits out of risks.

Derivatives offer the investors a powerful way to participate in the price action of a particular underlying security. Investors who opt to trade in these financial instruments aspire to transfer certain risks associated with the underlying security to another party.

What is a Derivative?

A derivative is known as a financial security with a value that depends on an underlying asset or a group of assets. The derivative itself is considered as a contract between two or more parties and its price is determined by price variations in the underlying asset. The most common underlying assets are bonds, stocks, commodities, currencies and market indexes. These assets are purchased through a variety of brokerages.

Derivatives can be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of derivatives traded and are not standardized. Derivatives traded on exchanges are standardized and are heavily regulated. OTC derivatives generally have greater counter-party risk than Standardized derivatives.

Top 5 popular Derivatives

  1. Options

Imagine you purchase 100 Nifty 50 futures for Rs 10,724 on January 10. The expiry date is January 31. Your total Investment was Rs 10,72,400. You pay the initial 10% margin of Rs 1,07,240. On Jan 31, you sell all these futures for a price of Rs 10,678.

So your loss is (10,72,400 – 10,67,800) X 100 = Rs 4,60,000.

In this situation your entire initial investment is (i.e. Rs 1,07,240) is lost. And additionally you need to pay Rs 3,52,760 (4,60,000 – 1,07,240).

2.Single Stock Futures

A single stock future (SSF) is contracted to transfer 100 shares of a specified stock on a designated expiration date. The SSF market price of the product is based on the price of the underlying security plus the carrying cost of the interest, and the fewer dividends paid over the term of the contract. For trading SSFs, one requires a lower margin than buying or selling the underlying security, often in the range of 20%, thereby giving investors more leverage.

For example, you purchase 100 TCS futures at a price at Rs 1,740/ share on January 15. The expiry date is January 31. Your total Investment is Rs 1,74,000. You first paid an initial margin of Rs. 17,400. On January 31, the price per share increases to Rs 1,800.

So you gain (1,800 – 1,740) X 100 = Rs 6,000.

  1. Warrants

A stock warrant permits the holder the right to buy a particular stock at a certain price at a pre-determined date.

If TCS issues bonds with warrants attached, each bondholder might get a Rs 1,000 face-value bond and the right to purchase 100 shares of TCS at Rs 20 per share for the next five years. Warrants generally permit the holder to purchase common stock of the issuer, but sometimes they allow the investor to buy the stock or bonds of another entity.

  1. Contract for Difference

A contract for difference (CFD) is an agreement between the buyer and the seller that requires the seller to pay the buyer, the spread between the current stock price and the value at the time of the contract if that price increases. Conversely, the buyer has to pay to the seller if the spread is negative, .i.e. the price falls. The CFD’s main purpose is to allow investors to speculate on price movement without having to own the underlying shares.

5.Index Return Swaps

It is an agreement between two parties to swap two sets of cash flows on pre-specified dates for an agreed number of years.

For example, if one party agrees to pay an interest payment which is usually at a fixed rate based on LIBOR and while the other party agrees to pay the total return on equity or an equity index. Investors try to seek a straightforward way to gain exposure to an asset class in a cost-efficient manner often by using these swaps.

Fund managers can buy into an entire index like the S&P 500, by picking up shares in each component and adjusting the portfolio whenever the index changes.

The equity index swap may give a less expensive alternative, allowing the manager to pay for the swap at a set interest rate while receiving the return for the contracted swap period. They’ll also receive capital gains and income distributions on a monthly basis while paying interest to the counter party at the agreed rate. In addition, these swaps may have tax advantages.

Derivatives also offer an effective method to spread or control risk, hedge against the unexpected events or to build high leverage for a speculative play.

To learn more about derivatives that can help you build multiple streams of income, doing a short term course on derivatives will surely help investors. BSE Institute Limited, a 100% subsidiary of BSE India, offers a short-term course on Advanced Derivatives Trading Strategies, on its online platform bsevarsity.com. One can gain an in-depth understanding of the market strategies used by experienced brokers and traders.