Rachana Ranade. Blog

We all have observed “the new normal” during this pandemic. Hand sanitisers have now become one of the irreplaceable items in our bags. Why is that? Because these sanitisers can effectively kill germs and viruses and reduce our chances of getting infected. This practice has become so essential during the current times that there are various kinds of sanitisers being offered in the market. From alcohol-based, alcohol-free, spray, gel-based to fragrant sanitisers, there are numerous options available for us.

Do you think that if we have so many types just for a sanitiser, there won’t be any in derivatives? Of course, we do! And that’s exactly what we will be discussing in today's blog. Before we dig in, if you wish to revise the basics of derivatives discussed in the previous blog, click here.
Now let’s get started!

What is the structure of the Derivatives market?
Before jumping into the types of derivatives, we must understand the structure of the derivatives market. We already know that a derivative is a contract, based on the value of an underlying asset like stocks, bonds, commodities, currencies, interest rates and even indices.

Coming to the markets’ structure, the derivatives market is broadly classified into two categories:

a. OTC derivatives market
In simple words, the OTC market is where derivative instruments are traded informally. An over-the-counter (OTC) derivative is a contract that is tailored as per the needs of the parties involved. These instruments are not listed on any exchange and hence are negotiable between a buyer and a seller to match their risk and return. It is a decentralized dealer market. No intermediaries or exchanges like NSE, BSE, MCX, etc. are involved in the transaction due to which these instruments possess counter-party risk. Popularly known OTC derivatives instruments include forwards and swaps which we shall discuss ahead in this blog.

b. Exchange-traded derivatives market
As the name suggests, these derivatives instruments can be traded on exchanges like NSE, BSE, MCX, etc. These instruments are standardized contracts that have a pre-determined expiration date, price, lot size, etc. and hence are non-negotiable. Here, the exchanges act as an intermediary and thereby eliminates counter-party risk. Unlike the OTC derivatives market, this market is regulated by SEBI. Popularly known exchange-traded derivatives instruments include futures and options which we shall discuss ahead in this blog.

What is the difference between OTC & Exchange-traded derivatives markets?

What are the types of derivatives?
The primary purpose of derivatives is to minimize your risk and earn profits. But how to do that? For that, we have different types of derivatives being traded, in both OTC and exchange-traded markets. So, let’s unfold them one by one.

1. Forwards
Forwards are customized contracts between a buyer and a seller based on an underlying asset at a pre-decided price, quantity, expiration date, etc. I am sure after reading the word customized, you must have guessed that forwards are OTC instruments. You are absolutely right! Hence, forwards being a private transaction, do not trade on exchanges. Investors and businesses use forwards to hedge against the volatility in pricing.

2. Swaps
To put it very simply for you, swaps enable the buyer and the seller to exchange their revenue streams based on an underlying asset. These are again OTC instruments so no exchanges are involved in the transaction. Investors and businesses use swaps to hedge and speculate against the volatility in pricing. The most common types of swaps are interest rate swaps and currency swaps.

3. Futures
Now, the real game starts with Futures and options. Futures are standardized contracts between a buyer and a seller based on an underlying asset at a pre-decided price for a later date. We can say that futures are an advanced version of forwards. They are highly tradable due to the involvement of the exchanges. This also removes the counterparty risk on the traders’ part. Investors and businesses use future contracts to hedge and speculate against the volatility in pricing. The most common types of futures involve stock futures, index futures, currency futures and commodity futures.

4.Options
As the name suggests, options are contracts that give the buyer a right but not the obligation to buy or sell the underlying asset at a pre-decided price. The buyer of the option has to pay a premium to the seller. You must have heard about the call and put options that are widely known amongst traders. These are commonly used to hedge and speculate against portfolio risk.

Bottom Line
Well, the derivatives market is huge and there’s a lot more to learn about all the types of derivatives we discussed today. But don’t worry, we shall understand their basics better in future blogs. It is important to note that even though there’s huge profit potential in derivatives there’s an equal or more probability of losing. It is important to have extremely good knowledge about the stock market , technical analysis and derivatives, to trade in the derivatives market. If you want to learn about Futures and options in the most fun, simplified and practical manner, make sure you check out my course here. I am sure you will love it. Until next time!

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Types of Derivatves

Mirror mirror on the wall, will Nifty jump or have a great fall? If only we had such a mirror that could tell us where a stock or market is headed! But only 2 people can tell where the market is headed. One is God and the other is a liar. We can only build predictions in this regard and take positions accordingly. But how can we do so and earn good money out of it? For that, we have a derivative instrument called Futures. So, let’s understand the world of Futures!

What are Futures?
A futures or futures contract is a financial contract between a buyer and a seller, who enter into the contract based on his/her view on an asset’s future price movement. It is a legally binding derivative contract to buy or sell an asset at a predetermined price on a future date. Hence, the name Futures. Two major features of futures contracts are that they are standardized and exchange-traded. Due to these reasons, they are often preferred over forward contracts by traders. We can say that futures are an extended or a better version of forwards. These important features protect a trader from various risks like liquidity risk, counterparty risk, etc. Futures are usually used by speculators and hedgers. You might recall these terms from our previous blog.

Following the definition of derivatives, even futures contract derives their value from an underlying asset’s spot price. The spot price is nothing but the price at which an asset is currently trading in the cash market. For example, the ACC Ltd. Futures contract will derive its value from the stock price of ACC i.e. its spot price.

How does it work?
Well, in a futures contract, both the buyer and the seller are obliged to fulfil the contract's specifications. The buyer of the contract is of the view that the price of an underlying will rise in near future and the seller has the opposite view. So, when both parties enter into a futures contract, the buyer must buy and accept the underlying asset whereas the seller must sell and deliver it on the expiry of the contract. Therefore, if the spot price of an asset goes up, the buyer wins and if it goes down the seller wins. And that’s how a futures contract work. I hope all of this is crystal clear. Now let’s level up a little and understand some contract specifications about futures.

Futures contract specifications

a. Lot size
By now you already know that futures are standardized contracts as they are exchange-traded. This means that everything in the contract is pre-specified by the exchanges. One such specification is the lot size of the contract. The lot size is nothing but the minimum quantity of the underlying asset you need to buy in order to enter into a futures contract. This minimum quantity is called 1 lot. For example, the lot size for ACC is 500 shares whereas for Gold it is 1 Kg. Lot sizes can vary from asset to asset.

b. Contract value
The contract value is simply the product of the agreed lot size and price. For example, if you agree to buy 3 lots of ACC (500*3= 1500) at say spot price of Rs. 2,400/share, your contract value will be Rs. 36 Lakh.

c. Tick size
Tick size is the minimum difference between the different bids and offer prices. Bid price is buying price whereas offer price is the selling price of an asset. To put it simply, it is the minimum difference between the consecutive bid and offer prices. Right now, the tick size on NSE is Rs. 0.05. So, if we continue with the example of ACC, let’s assume the LTP (Last traded price) of ACC futures was 2410 then the bid prices would be 2409.95, 2409.90, 2409. 85, etc. and offer prices would be 2410.05, 2410.10, 2410.15, etc.

d. Expiry
Just like any other product has an expiry date, even a futures contract has one. Expiry is nothing but the date on which the contract ceases to exist. So, naturally, this is the last trading day of a contract. Any scrip trading in the futures market shall have three different expiries available for trading - the near month expiry (expiry in the current month), the mid-month (expiry in next month) and the far month expiry (expiry in the month after). These contracts expire on the last Thursday of every month. If the last Thursday is a national holiday, then the contract will expire on the previous trading day. On the expiry of the near month contract, the mid-month contract shall become the near month, the far month will become mid-month and the exchange will introduce a new far month contract, this cycle goes on.

Example
So, this is how an actual futures contract for ACC Limited looks like. The screenshot is taken on September 6, 2021, from the NSE website.

I am sure you already have started noticing the terms we discussed but let’s go through it together. First, observe that this is a Stock future under the instrument type heading. After that, you can check the expiry date of the contract i.e. 30th September 2021. On the orange highlighted row, the first price is the LTP of the futures contract- Rs. 2483.35, along with the previous day’s close and OHLC. In the table below that, you can see the market lot/lot size as 500 and the underlying value/ spot price at Rs. 2473.35. In the order book, you can see the best 5 bids and offer prices.

Bottomline
In the end, I would like to say that if you trade in F&O without proper knowledge, you will have no Future and you will be left with no Options. Just to revise quickly what we learned today, futures are standardized agreements wherein the parties to the contract agree to buy/sell the underlying at a pre-determined price on a pre-determined future date. The contract specifications are standardized and are decided by the exchange. Under contract specifications, we understood few key terms like lot size, contract value, tick size, and expiry. There are many other things which you need to know to learn about the Futures and I got you covered. If you want to learn about Futures and Options in the most fun, simplified and practical manner, make sure you check out my course here. I am sure you will love it. Until next time!

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What are futures?

Till now we have learnt about what are derivatives, what are the types of derivatives and what are futures. Let’s revise it quickly. A derivative instrument is a contract between a buyer and a seller based on their views about an underlying assets’ future price movement. An underlying asset can be any financial instrument like stocks, bonds, commodities, currencies, interest rates and even indices. After that, we understood various types of derivatives like- Forwards, Swaps, Futures and Options. Then we took it up a notch with understanding Futures. But, as usual, ye dil mange more! That hunger for knowledge in us has not been fulfilled yet. So, in today’s blog, we will be discussing various types of futures. Let’s begin!

1. Commodity Futures

A commodity is anything that holds commercial value. In India, the various types of commodities being traded are Bullion, Agri, Energy, Base Metals. Commodity futures are contracts that derive their value from a commodity, bought and sold at a predetermined price in future. These contracts are usually preferred by producers or buyers to hedge against future price volatility. Some commodities like gold act as a hedge against inflation due to their low correlation with the stock market. In India, commodity futures are traded on Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX).

2. Currency Futures

As the name suggests, currency futures derive their value from the spot rate of a currency pair. A currency pair indicates the price of one currency that can be exchanged for another currency. These contracts allow you to buy or sell a currency at a fixed exchange rate at a future date. These futures are usually used to hedge against currency risk. For example, an importer importing raw materials from US may purchase USDINR futures to safeguard against rupee depreciation in future. In India, currency futures can be traded on NSE, BSE and MCX SX.

3. Interest Rate Futures

These are futures contracts based on interest-bearing debt instruments. The underlying debt instruments can be T-bills, Government bonds, etc. Interest rate futures is a contract between a buyer and a seller for the future delivery of a debt instrument at a predetermined price. These futures are usually used to hedge against interest rate risk. Due to the inverse relationship between interest rate and bond prices, the interest rate futures are also inversely related to the interest rates. In India, NSE and BSE offer interest rate futures

4. Stock Futures

This is where the real game starts! Stock future is a contract with an individual stock as an underlying. It is a contract to buy or sell a stock at a predetermined price and quantity at a future date. Usually, stock futures are used for speculation and/or hedging purposes. You may trade in stock futures on BSE and NSE. However, they are available only for a specified list of stocks that fulfil certain criteria as stated by the exchanges.

5. Index Futures

Now, what if you don’t want to trade in individual stock futures? No worries! We have Index futures as well. These futures will be contracts based on market indices like Nifty, Sensex, Bank Nifty etc. Traders use these contracts to speculate based on their directional views about the market. Many traders prefer index futures over stock futures, as the underlying index is a basket of stocks the risk is spread out amongst them. You may trade in index futures on BSE and NS

Closing thoughts

I hope now you have a basic introduction to various types of futures. Generally, speculators and hedgers are the participants in these markets. Yes, the profit potential in these instruments is substantial but so is the risk of losses. There are many other things that you need to know about Futures before you take your first trade and as usual, I have got you covered. If you want to learn about Futures and Options in the most fun, simplified and practical manner, check out my detailed course on Futures & Options here. I am sure you will love it. Until next time!

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Types of future contracts

Just imagine, how amazing it would be if we could predict the future. Hold this thought and imagine further how amazing it would be if we could predict the future prices of various financial assets and make money out of them. I am sure my last statement might have created some sort of excitement amongst you all. But the question remains of “How?” Well, there’s something known as derivative instruments in our financial market which can help us do this. But obviously, it’s not as easy as it sounds and as usual, I have got you covered! So, sit back as we unfold the complex world of the Derivatives market in the most simplified manner. Let’s get started!

What are Derivatives?

Derivatives are financial contracts that derive their value from the underlying assets. Confused? Let’s break it down one by one. A derivative instrument is a contract between a buyer and a seller based on their views about an underlying assets’ future price movement. An underlying asset can be any financial instrument like stocks, bonds, commodities, currencies, interest rates and even indices. So, the value at which this contract or derivative instrument is traded is based on the value of its underlying asset. For instance, in the case of a stock derivative say- RIL, the contract/derivative value will increase when RIL’s value increases. Note that you are trading a contract and not the underlying itself. Since its value is derived from an underlying (RIL from our example), this contract is known as a “Derivative instrument”.

History of the Derivatives market

Right from the Greek civilization to the present electronic trading, derivative instruments are believed to be present in the financial markets’ history for a long time. They are said to have existed in the cultures of Mesopotamia during the Greek civilization. Once, one of Aristotle’s followers named Thales, studying meteorology predicted that the olive crops would give a good yield that year. So, he went ahead and purchased all the olive produce around Athens even before they were harvested. As predicted by Thales, the olive produce turned out great and he made profits ahead with the help of derivative instruments.

What about the world’s largest economy, the US? In the 19^th century, American farmers could not find buyers for their commodities. Later, they went ahead and formed the Chicago Board of Trade which evolved into the first-ever derivatives market dealing in standardized contracts. But where was India when the financial market was witnessing this essential change? Well, in the case of India, derivative instrument trading started in 1875 with the establishment of the Bombay Cotton Trading Association. There was a time post-independence when cash settlement and options trading was banned however, later it was uplifted with the creation of the National Electronics Commodities Exchange. And the rest is history.

What is the purpose of Derivatives?

Derivatives are primarily used for hedging and speculation purposes. Now, don’t get scared by these big words, I am here to make it easy for you.

1. Hedging

To put it very simply for you, hedging means taking a position to limit your losses due to price fluctuations in the market. As derivatives are considered to be high-risk instruments, hedging plays an important role in minimizing the losses by taking an opposite position. This proves to be a good cushion for both investors and businesses to protect their portfolios during volatility.

2. Speculating

We all speculate about certain things on a daily basis. For instance, if you observe cloudy weather, you speculate that it will rain soon and hence carry an umbrella. Similarly, in the derivatives market, if you think the markets might go up and take a position accordingly then you are speculating. Speculating purely involves taking a position based on your views about an asset with an intent to generate profit. These are usually hunches or guesses based on the price movement. Unlike hedgers who try to minimize their risk, speculators try to make profits by taking a high risk.

3. Arbitrage

The main aim of arbitrage is to earn profits from the difference in the price of an asset in different market segments. It involves buying an asset from a market (say spot market) where the price is lower and simultaneously selling it on another market (say futures market) where it is trading at a higher price. Arbitrage involves relatively low risk. However, due to market efficiency theory, such opportunities can be hard to find.

Bottom line

Derivatives are often used by businesses that can be largely affected on an operational level due to fluctuating prices of certain commodities. This helps them to reduce their market risk and protects their bottom line. Retail investors must note that even though there’s huge profit potential in derivatives there’s an equal or more probability of losing. It is important to have extremely good knowledge about the stock market, technical analysis and derivatives, to trade in the derivatives market. There’s a lot more to learn about derivatives and their various types, mainly Futures and Options. I am very excited and thrilled to share that my most awaited course on Futures & Options is releasing tomorrow. Make sure you check it out here to learn many more interesting concepts and strategies in the most fun and simplified manner. Until next time!

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What are Derivatives?

Blog

1. Commodity Futures

2. Currency Futures

3. Interest Rate Futures

4. Stock Futures

5. Index Futures

Closing thoughts

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