Understanding Derivatives Trading
As the name suggests, a derivative is a financial instrument that derives its value from another financial asset.
For example,
a gold derivative’s value depends on the price of gold.
There are various types of derivatives such as futures, forwards, options, and swaps.
Futures
Futures are the most common type of derivatives.
In a futures contract, the investor agrees to buy or sell an asset at a predetermined price on a particular date in the future.
The investor gets profit or loss from that derivative based on the difference between the bought price and actual price of the underlying commodity on the actual date of the contract.
For example,
assume, on July 1st the spot price of gold is $1000.
A three-month gold future expiring October 1st is trading at $1050.
Assume an investor buys long futures contract at the current futures price of US$ 1050/oz.
If on 1st October if the gold spot price hikes say to US$1100, the investor who agreed to buy the gold on this date at $1050 will get a profit of $50.
Likewise, he might incur a loss if the price drops below $1050.
Forwards
Forwards also work in a similar way to futures.
A forward contract is also an agreement to buy or sell an asset at a predetermined price in the future.
The profit or loss from the contract will depend on the spot price at the time of contract expiry. Not Let’s see some of the differences between futures and forwards
Futures contracts are traded on an exchange, whereas forwards are traded over the counter.
As a result, futures contracts are standardized and more regulated, whereas forward contracts are customizable and less regulated.
Forward contracts are generally not available to trade for retail investors.
These contracts tend to trade between banks and large companies.
Whereas futures can be traded by almost anyone.
Futures also have the added advantage that they can be bought and sold prior to expiry, whereas forwards are more difficult to terminate.
Options - Call Options & Put Options
An option contract gives the investor the right (but not the obligation) to buy or sell a particular asset on a particular date.
There are two types of options - Call options and Put options.
Call options give you the right to buy, and put options give you the right to sell.
For example,
today is 1st July, and like before, the spot price of gold is US$1000.
A call option that gives the holder the right to purchase gold for US$1000 on 1st October is trading at US$30.
As an investor, I believe the price of gold is going to rise over the next three months, so I spend US$30 and purchase this call option.
Fast forward to 1st October, and the price of gold is now US$ 1,100.
I exercise (use) the option, purchase gold for US$ 1,000, and have made US$ 100 profit.
My net profit is US$ 70 after considering the option price.
If the market price at expiry was below US$ 1000, I would not have exercised the option and my profit would be US$ 0.
Once we factor in the cost of the option, we have a net loss of US$ 30.
The beauty of an option is that if in the example above, gold were to fall, no matter how much it fell, my maximum loss is always US$ 30, the price I paid for the option, whereas my maximum gain is infinite. You can see why options are so popular
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