Introduction to derivatives trading

What is Derivative Trading?

Derivative trading involves financial instruments whose value is derived from the value of an underlying asset, index, or rate. These instruments can be contracts such as futures, options, forwards, and swaps. The underlying assets could range from stocks, bonds, commodities, currencies, interest rates, and market indexes. In India, the derivatives market is highly active, with the NSE being one of the largest derivatives exchanges globally in terms of contract volumes

Uses of Derivatives

1. Risk Management: Derivatives are extensively used for hedging risks associated with price volatility in financial markets. For example, airlines use derivatives to hedge against fluctuations in fuel prices, while farmers hedge against commodity price changes.
2. Speculation: Traders and investors use derivatives to speculate on price movements, aiming to profit from anticipated changes in asset prices without owning the underlying assets. Speculation adds liquidity and price discovery to markets.
3. Portfolio Diversification: Institutional investors and fund managers use derivatives to diversify portfolios and enhance returns. Derivatives provide exposure to various asset classes and strategies that may not be accessible through direct investments.

Types of Derivatives

In the world of derivatives trading, financial instruments are often classified into linear and non-linear derivatives based on their payoff structures and how their values change to the underlying asset.

Linear Derivatives

Linear derivatives have a straightforward, direct relationship with the price movement of the underlying asset. This means that their value changes proportionally with changes in the underlying asset's price. Types of linear derivatives include:

• Futures Contracts:
  • Structure: Futures contracts are agreements to buy or sell an asset at a future date for a predetermined price. Their value moves linearly with the price of the underlying asset.
  • Payoff: If the price of the underlying asset goes up, the value of a long futures contract increases, and vice versa for a short futures contract.
  • Use Cases: Futures are often used for hedging price risk in commodities and financial markets, as well as for speculative purposes.

• Types of Futures Positions:

Long Futures

A long futures position refers to a scenario where an investor or trader buys futures contracts with the expectation that the price of the underlying asset will increase. Key characteristics include:

• Profit Motive: The holder of a long futures position aims to profit from an increase in the price of the asset underlying the futures contract.
• Obligations: The buyer of a futures contract commits to purchasing the underlying asset at the agreed-upon price (the futures price) upon expiration of the contract.
• Risk: The risk for a long futures position arises if the market price of the asset falls below the futures price, potentially resulting in losses.

Short Futures

A short futures position involves selling futures contracts with the anticipation that the price of the underlying asset will decline. Key aspects include:

• Profit Motive: The seller (short position holder) profits from a decrease in the price of the asset underlying the futures contract.
• Obligations: The seller commits to delivering the underlying asset at the agreed-upon price (futures price) upon contract expiration.
• Risk: The risk for a short futures position arises if the market price of the asset rises above the futures price, leading to potential losses for the seller.

Usage and Strategy

• Speculation: Traders often take long or short futures positions based on their market expectations. For example, a trader might take a long position if they believe the price of a commodity will rise due to supply shortages.
• Hedging: Investors use futures contracts to hedge against adverse price movements in their portfolios. For instance, a producer may take a short futures position to protect against falling prices of their output.

Understanding these positions is crucial for investors and traders to effectively manage risk and capitalize on market opportunities in futures trading.

Forwards Contracts:

• Structure: Similar to futures, forwards are agreements to buy or sell an asset at a future date for a set price, but they are traded over-the-counter (OTC) and are customizable.
• Payoff: The payoff of a forward contract is linearly related to the price movement of the underlying asset.
• Use Cases: Forwards are frequently used in currency markets for hedging foreign exchange risk. In India, forward contracts are commonly used by businesses to hedge against currency fluctuations, especially given the volatility of the INR against major global currencies.

Non-Linear Derivatives

Non-linear derivatives have a more complex relationship with the underlying asset's price. Their value does not change proportionally with the underlying asset's price, leading to more intricate payoff structures. Types of non-linear derivatives include:

1. Options Contracts:

• Structure: Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price before a certain date.
• Payoff: The payoff of an option is non-linear. For instance, a call option becomes more valuable as the underlying asset's price rises, but its rate of change is not constant and is affected by factors like volatility and time decay.
• Use Cases: Options are used for hedging, income generation (through selling options), and speculative strategies, offering more flexibility compared to linear derivatives.

‍The Indian options market has grown significantly, with the NSE's options segment seeing a surge in trading volumes, especially in index options like Nifty 50.

2. Types of Options & Positions

Long Call Option: A long call position involves buying a call option, expecting the price of the underlying asset to rise. Characteristics include:

• Profit: Unlimited potential profit if the underlying asset's price rises significantly.
• Limited Risk: Losses are limited to the premium paid for the option.

Short Call Option (Call Writer): A short call position involves selling a call option, anticipating that the price of the underlying asset will either remain stagnant or decrease. Key features include:

• Profit: Limited to the premium received from selling the call option.
• Unlimited Risk: Losses can theoretically be unlimited if the price of the underlying asset rises significantly.

Long Put Option: A long put position entails buying a put option, expecting the price of the underlying asset to decrease. Characteristics include:

• Profit: Potential profit if the price of the underlying asset falls below the strike price.
• Limited Risk: Losses are limited to the premium paid for the option.

Short Put Option (Put Writer): A short put position involves selling a put option, anticipating that the price of the underlying asset will either remain stagnant or increase. Key aspects include:

• Profit: Limited to the premium received from selling the put option.
• Risk: Limited to potential losses if the price of the underlying asset decreases significantly, resulting in an obligation to buy the asset at a potentially higher price.

3. Swaps

• Structure: Swaps involve the exchange of cash flows or other financial instruments between parties. Common types include interest rate swaps and currency swaps.

• Payoff: The value of swaps can be non-linear, especially in cases where the cash flows depend on variable interest rates or other changing conditions.
• Use Cases: Swaps are used for managing interest rate risk, currency risk, and other financial exposures. In the Indian market, interest rate swaps are commonly used by corporations and financial institutions to manage interest rate risk amidst fluctuating monetary policies.

Key Differences Between Linear and Non-Linear Derivatives

· Payoff Structure:

• Linear derivatives: Have a straightforward, direct relationship with the underlying asset’s price, resulting in a linear payoff structure.
• Non-linear derivatives: Have a more complex relationship, leading to a non-linear payoff structure that can involve factors like volatility, time decay, and strike prices.

· Risk and Reward: Linear Derivatives: Typically involve proportional risk and reward, making them easier to understand and predict.

• Non-Linear Derivatives: Offer potential for asymmetric risk and reward, which can be advantageous for hedging specific risks but  also add complexity.

· Use Cases: Linear Derivatives: Commonly used for straight forward hedging and speculative purposes where direct exposure to the underlying asset’s price is desired.

• Non-Linear Derivatives: Used for more sophisticated strategies, including complex hedging, leveraging specific market views, and generating income through option selling strategies.

Conclusion

Understanding the distinction between linear and non-linear derivatives is crucial for effective derivatives trading. Linear derivatives, like futures and forwards, provide a direct and proportional exposure to the underlying asset's price movements, making them relatively straightforward to use. Non-linear derivatives, such as options and swaps, offer more complex payoff structures that can be leveraged for a variety of strategic purposes, although with increased complexity and risk.

By mastering both types of derivatives, traders and investors can create more versatile and effective strategies tailored to their specific risk management and speculative goals. The Indian derivatives market continues to expand, driven by increasing participation from retail and institutional investors, making it a key component of the overall financial ecosystem.