Derivatives are instruments derived from the securities or physical markets. They include futures, options, warrants and convertible bonds. While shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares as they are assets).
Due to their great flexibility, derivatives allow the investor the full range of investment strategy: speculation,hedgingand arbitrage. Derivatives also offer the sophisticated management of risk.
Derivatives allow for gearing (or leverage). Gearing is the ability of derivatives to soar 100 per cent in a few days, when the underlying security has only risen by a far smaller amount (say 10 per cent). This is possible because derivatives are contracts and not the assets themselves.
One money-making strategy using derivatives revolves around looking for reasonably profitable price differentials in the cash and futures prices of stocks. Once the investor finds such a situation they can buy a company's shares and simultaneously sell its futures and pocket the spread.
For instance, if shares of ABC Ltd can be bought at 3.30 pm on July 16 for Rs 367.15, while the one-month ABC futures can be sold for Rs 370.50, or a premium of 0.91 per cent, the investor can effectively take two exactly opposite positions, which cancel out on the day of settlement of the futures contract, as the cash and futures prices converge.
Regardless of which way the share price moves, the investor makes a profit. This is equal to the difference in prices at the time of buying, minus transaction costs. It is a near risk-free return and it is known at the time of making the trade.
Derivatives can also be used to control large blocks of stocks for a much smaller sum than would be required by outright purchase or sale. Derivatives give people the ability to manage and control risk. Today, in India, fluctuations in the stock market or in the dollar-rupee inevitably expose Indian citizens to greater price risk. Therefore, derivatives are a central part of the reforms process. By giving investors the power to make choices about what risks they are comfortable with and what risks are best hedged away, derivatives make investors more tolerant of price risk.
In addition, from a purely financial sector perspective, derivatives are important as they are part and parcel of market development. Derivatives trading helps improve market liquidity, raises skills and knowledge among market participants, and is a vital ingredient of market reforms such as the transition to rolling settlement.
Invest/Speculate - take a view on the stock (or market) and buy or sell its futures accordingly. One can either go short or take a long position.
Leverage - paying only a small percentage of the contracted value as margins one can take a leveraged position whereby the profits are significantly enhanced if the investor's view turns out to be right.
Hedge - reduce risks associated with market exposure by taking a counter position in the futures market, that is, buy the stock and sell the futures.
Arbitrage - take advantage of the price difference between the futures market and the cash market.