Back in the old days, stock market was the game of the rich and affluent, and only those who had access to the financial data and understanding of the business could invest. As the businesses started to expand, there was an ever increasing demand for more capital. That is why markets were now opened for smaller investors, and everybody had access to the information necessary to make right financial decision.
However, such liberalization lead to another problem. Till the year 1970, the world had seen multiple recessions, and many rich investors saw their entire wealth being wiped out right in front of their eyes.
There was no mechanism to protect investors from downside risk. It was this reason why an innovative financial product was needed which can be used to protect investors in case of such unforeseeable events, and that is how derivatives came into existence.
What are derivatives:
Derivatives, as the name suggests, derive their value from an underlying asset. The price of the derivative depends and fluctuates with the value of the underlying asset. For example, a derivative of gold will derive its value from the price of gold being traded in the market. Almost every asset, be it equity shares, commodities, or forex have derivatives.
Derivatives are financial instruments that can be bought and sold on the exchange or Over the Counter, by paying a small margin or premium. The “derivative contracts” are valid for a specified period of time and investor entering the contract has to square off his position within that time period.
Derivative instruments are used for hedging the positions of an investor. There are two types of derivatives an investor can use to hedge his position, Futures and Options.
Futures contract in which the broker agrees to lend shares to the investors against margin money(a type of security deposit against lending of shares).
The shares borrowed, can be sold by the investor in the market and bought back later to be returned to the broker. This way, investors are able to hedge their equity investments against downside risk.
To understand it in a better way, let’s take a simple example
Example: Let’s say you have bought shares of company X at a price of Rs. 100 per share and the stock is currently trading at Rs. 120 per share. You are making some profit but are worried that the price may correct and you may lose all your gains.
To protect your investment from risk, you can ask the broker to create a futures contract(where he agrees to lend some shares to you) to sell these borrowed shares, hoping to buy them back later if the price of the stock falls. If the price of the stock falls to Rs. 90 per share, you can buy these shares from the market at Rs. 90 per share and return it to the broker. Thus, you make a Profit of Rs. 30 per share (Profit =sell price-buy price i.e. 120-90=30)
Now, remember that you bought equity shares at Rs. 100, which is now trading at Rs. 90. While you are suffering a loss of Rs. 10 per share on equity (90-100=-10), the profit of Rs. 30 from futures gives you a Net gain of Rs. 20 (Profit of Rs. 30 from futures – loss of Rs. 10 from equity= Net gain of Rs. 20 per share).
Thanks to the futures, despite the decline in price, you still make money instead of suffering loss. Had you not hedged your position, you would have suffered a loss of Rs. 10 per share on equity.
Now let’s look at the other side of the coin. What if the stock price rises after you buy futures. Let us understand using the same example mentioned above.
Let’s say you bought futures contract at Rs 120 per share and price went up to Rs. 140, you lose Rs. 20 per share on the futures.
But since you also have equity shares bought at Rs. 100 per share on which you are making a profit of Rs. 40 per share, so your total gain is Rs. 20 per share(a loss of Rs. 20 from futures(120-140=-20) and profit of Rs. 40 from equity(140-100=40))
By hedging your positions, you not only protect your downside risk, but also ensure that you make some profits irrespective of the direction of the market.
Despite all the positives, futures have a big disadvantage. By its own nature, futures are an obligation to an investor as he has borrowed shares and has to return to the broker before the expiry of the contract. Failing to do so may cost you your entire margin money or even more.
That is why there was a need for another product which instead of being an obligation for an investor, provided them with a right whether he wants to buy back those shares or not. This is how options came into existence.
Options just like futures, are also derivative instruments designed to hedge investors against market uncertainties. However, unlike future, options provide a “right” to the investor if he wants to honour the contract or not, depending upon the market situation.
An options contract can be bought by paying a premium(just like premium you pay against an insurance), to the counterparty(called options writer), which gives you a right whether you want to exercise the contract.
To understand this in a better way let us take the same example which is mentioned previously. Let’s say you have bought equity shares of Company X for Rs, 100 per share. The stock is trading at Rs. 120 per share but you are worried that a market correction may wipe out your entire gains.
In order to protect yourself from such downside risk, you can buy an put option at Rs. 120 per share(a put is an option that gives you the right to buy shares of an underlying asset in the future at a predetermined price). If the price of the stock declines(let’s say to Rs. 90), you can exercise your right to buy the shares.
On the other hand, if the price of the stock rises, you have the option(that’s why the name) to either exercise your right and book loss, or you can simply refuse to do so, in which case, the maximum loss that you suffer is the premium you paid(which is usually very small).
Both futures and options are great instruments to hedge against uncertainties. However, both of them also have their advantages and disadvantages, for example, while futures are great for hedging, they are an obligation for an investor which he has to fulfill.
On the other hand, options provides right to the investor, a choice if he wants to honour the contract or not, but options get “decayed” after sometime(more on that in the next post), In the next post I will discuss about the advantages and disadvantages of both futures and options, and which one should you prefer.