Derivatives, as the name suggests, derive their value from an underlying asset. Let us take the example of a tomato farmer and a ketchup factory. The farmer grows tomatoes in his farm and supplies it to the ketchup factory on a regular basis. However, the ketchup factor and the farmer want more predictability and stability in their price and their costs and revenues. Let us assume that tomatoes are currently being supplied at Rs.20/kg to the ketchup factor. But there are sharp seasonal variations in these prices. The farmer will be happy if he can get a price of Rs.19-22 per kilogram for his tomatoes while the ketchup factor is open to a price of Rs.20-23 per kilogram in the ideal case scenario.
Now the farmer and the ketchup factory can enter into an agreement wherein the farmer supplies tomatoes to the ketchup factor at Rs.21/kg. This suits the interests of the farmer and the ketchup factory. At the end of 3 months, the farmer agrees to supply 2 tonnes of tomatoes at Rs.21/kg to the ketchup factory and the ketchup factory, in turn, commits to buy the said quantity at Rs.21/kg. What we have seen here is a basic derivative contract come into existence. This called a forward contract. The underlying in this case is the tomatoes and the farmer and the ketchup factory are bound by the agreement.
But what if the market price of tomatoes turns volatile in the next 3 months?
That is perfectly possible. For example, the crop may have been hit by bad weather and the price of tomatoes would have gone up to Rs.26/kg. The farmer ends up with a notional loss because he has to sell 2 tonnes at Rs.21 as against the market price of Rs.26/kg. This 5 rupee loss will be the gain for the ketchup factory. On the other hand, if there is a glut of tomatoes in the market and the price falls to Rs.16/kg then what happens? The tomatoes will still be supplied at Rs.21/kg. In this case, the farmer will gain Rs.5 and the ketchup factory will lose Rs.5.
The question is why are the factory and the farmer getting into a forward contract where one of them could lose. That is because both want certainty. Both are going to be profitable at a price of Rs.21/kg and that is what matters in business. They are not traders who are looking to profit from price movements. They are just looking at protection from price volatility. Forward contract is the most basic form of derivative.
Forwards, futures, options and swaps
While there are many more permutations and combinations in derivatives, these are the four most popular categories of derivative contracts in the market. Let us look at each of them in some detail.
A forward contract, as explained above is an agreement to buy or sell an underlying asset at a future date at a fixed price. The price and the date of delivery are decided in advance. Such contracts are not regulated by any exchange and are only governed by the Indian Contacts Act.
Futures are exactly like a forward contract in structure but there are 2 key differences. Firstly, futures are standardized in terms of lot sizes, strike prices etc. This makes them a lot more liquid compared to forwards. Secondly, futures are traded on a stock exchange and cleared through the clearing corporations. Thus all trades are guaranteed by the clearing corporation and hence there is no risk of default.
Options are slightly different from futures and forwards. Both futures and forwards are symmetrical contracts; meaning losses and profits for the buyer and the seller can be unlimited. But in case of options, the contract is asymmetric. For the buyer, the returns are unlimited but the risk is limited. In the case of seller of option, the return is limited to the premium but the risk is unlimited.
Swaps entail an exchange of one set of flows for another. You can swap the cash flows of fixed rate bond for floating rate bond and vice versa or dollar flows for Yen flows. Swaps are not as popular as the other three in India.
Understanding derivative strategies
Derivative strategies refer to the combination of futures and options positions to created limited loss strategies. Here are four such popular derivative strategies.
In a protective put, a future on a stock is purchased and it is protected by buying a put option of lower strike.
In a covered call, the higher call option on a stock is sold to reduce the cost of your holdings either in the stock or in the stock futures.
A bull call spread is created by buying a lower strike call option and selling a higher strike call option. The trader is moderately bullish on the stock and uses the premium on the higher call to reduce the price of the lower call option.
A strangle is a volatile strategy where a call of a higher strike and a put option of a lower strike are simultaneously purchased. Once the premium costs are covered, the trader makes profits either ways as long as there is volatile movement.