Some are investors. Some are speculators. Then, you have Derivative traders... like a blend of both! Arguably amongst one of the most complicated asset classes, derivatives are not easy to understand for all. But worry not, we bring to you a simple explanation of this interesting investment avenue.
What is a Derivative?
Derivative is a financial contract whose value is derived from the underlying asset.The value of the underlying assets keeps changing according to market conditions. The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in future. The commonly used assets are stocks, bonds, currencies, commodities and market indices.
What is a Forward contract?
Forward is a type of derivative contract. It is a customised private agreement between two parties; i.e, the buyer and the seller, that commits them to buy or sell an asset at an agreed price on a specific date in the future. Forward contracts are not traded on an exchange.
Sellers and buyers of forward contracts are obligated to fulfil their end of the contract at maturity. Mostly forward contracts are used when there is uncertainty and volatility in an attempt to lock in prices, gain control over costs and give them greater certainty. You have probably heard of farmers and other commodities producers entering into forward contracts. it’s a particularly common practice in the agricultural sector because it helps to hedge against future price fluctuations.
What is a Future contract?
Future contracts are the same as forward contracts, futures are standardized contracts which lets the holder to buy/sell the asset at an agreed price at the specified date. The parties are under an obligation to perform the contract. Future contracts are traded on the stock exchange. And the value is adjusted according to market movements till the expiration date it is also known as marked-to-marketed every day.
Forward vs Future contracts
Forward and Futures contracts are almost the same but there are some key differences in between them:
- Future contracts are traded on an exchange, that is they are standardized. Whereas forward contracts are not traded on an exchange (not standardized) but on OTC; i.e, they are private agreements whose terms are customized to suit both parties.
- In forward contracts, there is counterparty risk involved; i.e, the risk that one of the parties to a contract might default on its terms and there is no clearing house involved that guarantees performance. Whereas in future contracts, exchange clearing house acts as the safeguard to both sides in the agreement.
- In forward contract, settlement occurs at the end that means any profit or loss on a forward contract is only realized on the settlement. Whereas future contracts are settled every day; i.e, they are marked-to-market on a daily basis. This means both parties must have the money to ride the fluctuations in price over the life of the contract.
- Usually in forward contracts, prices include premiums for the added credit risk. In the beginning, both parties are required by the exchange to put beforehand a nominal account as part of the contract known as the Margin. As the futures prices are certain to change every day, the differences in prices are settled on a daily basis from the margin.
What are Options?
Option is a derivative contract that provides the right, but not the obligation, to buy or sell a futures contract at a designated strike price (specified price) for a particular time. The buyer is not under any obligation to exercise the option. Whereas the seller of the options contract is under obligation to buy or sell based on the option contract buyer’s decision. The option seller is known as the option writer.
Options are divided into two types:
- Call options – The purchase of a call option will provide the buyer right but not the obligation to buy the underlying asset specified in the option contract. That means, a call option is a long position, the underlying future prices will move higher.
- Put options – The purchase of a put option will provide the buyer the right, but not the obligation, to sell the underlying asset at the specified price in the contract. A put option is a short position, that the underlying futures price will move lower.
Derivatives, without a doubt, are an interesting and enticing asset class. But with the complexities involved in derivatives trading, it's not actually everyone's cup of tea. So, you can choose to trade in derivatives only if you have the intellect and the risk appetite to invest in speculative asset classes. Otherwise, you'd be better off staying on the sidelines.
As Peter Lynch says -
"Invest in what you know!"