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What you need to know before Investing Financial Derivatives

Updated on October 1, 2012

Guide for Derivative Investments

The basic requirements are these: I) Demat account, ii) Knowledge of cash market, iii) Margin money deposit with the broker, iv) Knowledge of market to market margin requirement, v) Knowledge of contract specification and expiry date.

Stock markets world over have become highly volatile. With increasing globalisation and interrelation between different countries, the affect of geo –political problems in any region is felt the world over. Hence, regional turmoils make world financial markets increasingly volatile and unstable. In such kind of markets, derivatives play an important role for investors and traders alike.

A derivative instrument is a financial instrument, tradable on the stock markets, which derives its value from the value of some other financial in strument or variable. The derivative's value is determined by fluctuations in the underlying asset. Hence, the value of derivative is dependent upon the price or value of the underlying asset. The most common underlying assets include stocks, commodities, currencies, interest rates and market indexes.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Future and forward contracts are entered between two parties to transact at a future date at predefined price and terms. The difference is that future contacts are standardised exchange trade contracts, whereas forwards are not. Options can be either 'call' options or 'put' options. The option buyer acquires a right, while the option seller takes on an obligation.

For example, Mr A buys 100 TCS @ IR 1,100 in anticipation of target price of IR,200. If the market turns volatile and TCS starts to decline, then he can sell TCS future or buy a 'put' option in TCS of appropriate strike price along with his initial investment. This way, for a small extra investment, he can insure himself against heavy losses.

The underlying asset for option contracts are similar to future and can be stocks, indices, commodity, currency or interest rates. Swaps are agreements between two parties to exchange cash flows in the future, according to a prearranged formula, ego interest rate swaps. Over the counter (OTC) derivatives are contracts that are traded and negotiated directly between two parties, without going through any intermediary or an exchange. Swaps and forward contracts are examples of OTC derivatives . Exchange-traded derivative contracts are traded through recognized stock exchanges.

Derivative contracts are traded in all the three market segments: equity, commodities and currency. Market men are well aware of equity derivative contracts. However, in recent times, commodity and currency derivatives are also fast catching the fancy of retail investors. The most preferred derivative contract in commodities is gold and silver, in that order.

Depending upon the expected direction that the market or underlying asset will take, derivatives can be used for leveraging, hedging or speculating. Contrary to cash market, where an investor has to pay the full cost price of his investment, on derivative exposure one has to pay only the margin money. This margin money is just a fraction of the total cost price as calculated in cash market.

Nowadays derivative segment is gaining increased awareness and popularity among the market men. Due to the ease of their trading (they can be bought and sold in the regular market like stocks), limited risk exposure and the hedging option that they provide, derivative volumes have been increasing manifold in recent times.

Some people use the information on derivatives at any given time to predict the future trend in the underlying asset. The outstanding position in any derivative at a certain market condition can also be analysed for predicting the short term trend. Since derivatives can be sold without having the necessary delivery, a person can have an open sell position as well.

Open interest refers to the total number of derivative contracts both on buy side and on sell side that have not been settled in the immediately previous time period. A derivative with large open interest indicates greater interest either on selling side or on buying side. Hence, if the prices of these instruments are correlated with the increase or decrease in their open interest, a layman can get a rough idea about the perception in the market about the future price trend.

For example, ABC Ltd future trading @ 100 with open interest 10,000, next day ABC trading @ 102 and open interest increased to 15,000-general market expect it to trade even higher, with fresh long positions building in the stock and vice versa.

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