The National Stock Exchange of India (NSE) has become the world’s largest exchange by trading volumes, outpacing US-based CME group, the world’s largest derivatives market place, Futures Industry Association (FIA) data show.

One wonders, how is derivative related to trading in stock markets? Trade in the stock markets takes in the form of Equity shares, right? Profits made by the way of speculation and/or value investing?

To burst that misapprehension, I would use this space to share that more than 90% of the volume traded in a day is in Derivatives. If you are worrying that this is related to the “dy/dx” that maths enthusiasts get fascinated about, fret not! Derivatives, in Finance, essentially mean “a financial instrument that derives its value from an underlying asset”.

As such, the so-called “underlying asset” is often simply referred to as the underlying, whose value is the source of risk. The underlying asset could be a stock, bond, commodity or even a stock market index. The parties dealing in such contracts range from speculators to hedgers to arbitrageurs.

As you likely know, equities trade on organized exchanges as well as in over-the-counter (OTC) markets. These exchange-traded equity markets—such as the National Stock Exchange, the Dow, and the New York Stock Exchange and its Eurex affiliate—are formal organizational structures that bring buyers and sellers together through market makers, or dealers, to facilitate transactions. Exchanges have formal rule structures and are required to comply with all securities laws.

To understand this concept further, I’d like to explain the two of the four types of Derivatives, namely, Futures and Forwards.

Put simply, the distinction between Futures and Forwards derivatives is the same as the one between any other Exchange traded and OTC transaction, respectively. For the ones requiring more details, let us understand the distinction by formally defining the two,

A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree on when the contract is signed.*

Let us understand the working of this concept with the help of an example. Consider a rice farmer who expects his crop to be ready in 4 months. The going price of 1 kg of rice is Rs 40. Now, there are three possibilities, the price of rice may rise, fall or stay the same. Suppose, that our farmer expects that the price might fall in the future, due to which he would incur losses. He surely finds it profitable to fix the sale of his rice at the current price, also called the Strike Price. Consider a counterparty, a wholesaler, who banks on the price of rice to rise, whereby he will have to pay more per kilogram of rice, which would reduce his profit. The solution to such a conflict is that these two parties enter into a contract.

This is called a forward contract, where the rice farmer and the wholesaler agree that they would trade after 4 months at the price prevailing today. Now the price of rice after 4 months, also called the Spot Price may rise, in which case he would have to sell his crop at the agreed lower price; however, if the prices fall, the farmer makes a profit. In either case, the farmer is at a little ease since he wanted to ‘hedge’ or reduce risk, which essentially requires reducing profitable opportunities too. It works similarly for the wholesaler.

Consider the same situation again, however in this case, our farmer does not find the wholesaler. To solve his problem, he now needs to find a party to strike a deal. Thankfully, he finds out about the exchange where not only is he able to strike a deal, he is able to eliminate the possibility of default of payment in case he makes profit. This is a futures contract.

A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initi- ated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.*

Something a lot more interesting is to see their actual valuation. I mean how do these regulated futures actually work? Consider the futures of Facebook in the month of January trading at $213. It is clear from above that these futures would derive their value from the share of Facebook trading at $209.78. The prices are not the same and the reason behind is another talk altogether. The price of Facebook has seen a dip in the past month December 2019 from $202 on December 11 to $194 on December 13.

This fall is a consequence of something known as The January Effect. Let me explain, The January Effect is a perceived seasonal increase in stock prices during the month of January. This rally is generally due to an increase in buying in the month of December, followed by a drop in price due to tax-loss harvesting to offset realized gains, prompting a sell-off. Another possible explanation is that investors use year-end cash bonuses to purchase investments the following month (December marks the year end in the US).

Now, I see this as an opportunity to invest in Facebook for some quick gains. So, I purchase the futures of Facebook which trade in lots of 100. Now, (luckily) the share price of Facebook soars to $230 which in turn leads to rise in its futures price to $242.09 on January 25. Another merit of futures is that I can sell them off in the “opportune moment” before expiry to realise gains. By selling them I mean that I am entitled to buy 100 shares of Facebook at $213 each and sell them at $242.09 each. Now, if I calculate correctly, my gains would be $29.09*100 i.e $2909.

This was a quick glance on derivatives and their valuations. I hope it added some value. Happy Investing!(I meant “Trading” :p).

*© CFA Institute.

Written by- Litika Punjwani

(Litika is a student of B.Com. (Hons) at Shri Ram College of Commerce)

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