Derivative Trading

Derivatives are financial instruments, traded on or off an exchange, the price of which is based on or directly dependent upon i.e., “derived from” the value of one or more underlying asset, reference rate or index. The underlying asset can include securities, commodities, bullion, currency, livestock, etc., the reference rate includes interest rates, exchange rates and index consist of stock market index, consumer price index(CPI). This trading of rights or obligations based on the underlying product, for hedging, speculating or arbitraging purposes is termed Derivatives Trading, Financial Derivatives or Trading Derivatives. The main types of derivatives are,

1. Forwards
2. Futures
3. Options
4. SWAPs

Derivative trading in India can take place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organization (SRO) and SEBI acts as the oversight regulator.

Futures Trading & Pricing

A Futures Contract is a standardized agreement between a buyer and a seller; obligating the seller to deliver a specified asset of specified quality and quantity to the buyer on a specified date at a specified place and the buyer, in turn, is obligated to pay to the seller a pre-negotiated price in exchange of the delivery. The trading in these contracts is termed Futures Trading. In this type of trading, the contracting parties negotiate on, not only the price at which the commodity is to be delivered on a future date but also on what quality and quantity to be delivered and at what place.

Based upon their reason for choosing futures trading, people engaging in it can be typically classified as-

1. Hedgers
2. Speculators & Arbitragers

In case of Hedgers, Future contracts are used a risk minimizing tool. For example, in case of commodity as the underlying asset, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. The farmer agreeing to sell the wheat is said to assume the short position and the wheat miller agreeing to buy it is said to assume the long position. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price and a sure buyer, and for the wheat miller, the availability of wheat. Farmers, manufacturers, importers and exporters, etc, are Example of Hedgers who trade in futures for protection from price risks.

Though it minimizes risk, hedging has a black side to it also, if the wheat prices surge in the near future, the farmer will not be able to increase his prices and will lose the excess profit possible in that case and if the wheat prices fall down the buyer will still have to pay the agreed upon price in the contract, thus paying more than the market price.

Speculators, trade with hedgers and other speculators and consider futures trading as a means to earn profits and not for minimizing risk purposes (like hedgers). They aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they’re investing in, while speculators want to increase their risk and therefore maximize their profits.

They speculate the value of the underlying asset and buy if they feel its value will increase, selling later when it has indeed increased and sell when they feel its value will decrease. As the name indicates, this is pure speculation on their part, based on what they perceive as market conditions. If their speculation is right, it will result in profits, else loss. This is a risk they are willing to take in order to earn quick profits.

Arbitragers are those who attempt to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

Unlike the stock market, where the capital gains or losses from movements in price aren’t realized until the investor decides to sell the stock or cover his or her short position, futures positions are settled on a daily basis, which means that gains and losses from a day’s trading are deducted or credited to a person’s account each day. The profits and losses depend upon the daily movements of the market for that contract and are calculated on a daily basis.

For example, consider the futures contract between a wheat farmer and bread maker of INR 40 per bushel, if in the next day, the price of the futures contract for wheat increases to INR 50 per bushel, the farmer, as the holder of the short position, has lost INR 10 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by INR 10 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer’s account is debited INR 50,000 (INR 10 per bushel X 5,000 bushels) and the bread maker’s account is credited by INR 50,000 (INR 10 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly.

Apart from functioning as a risk reduction tool, Futures contracts are used for Price Discovery. Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today’s and tomorrow’s estimated amount of supply and demand.

Futures Market is fast-paced and its prices depend upon a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. In such a market into which information is continuously being fed, speculators and hedgers bounce off of – and benefit from – each other. The closer it gets to the time of the contract’s expiration, the more solid the information entering the market will be regarding the commodity in question. Thus, all can expect a more accurate reflection of supply and demand and the corresponding price. This process is termed as competitive price discovery or simply price discovery.

Futures prices have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day’s close and the results remain the upper and lower price boundary for the day and can be revised if the exchange feels it is necessary.

Say that the price change limit on silver per ounce is INR 2.50. Yesterday, the price per ounce closed at INR 50. Today’s upper price boundary for silver would be INR 52.25 and the lower boundary would be INR 47.5. If at any moment during the day the price of futures contracts for silver reaches either boundary, the exchange shuts down all trading of silver futures for the day. The next day, the new boundaries are again calculated by adding and subtracting INR 2.50 to the previous day’s close. Each day the silver ounce could increase or decrease by INR 2.50 until an equilibrium price is found. One drawback is that as trading shuts down if prices reach their daily limits, there may be occasions when it is NOT possible to liquidate an existing futures position at will.