Derivatives refers to the financial instruments which derive their value from an underlying security or financial instrument. The underlying products can be equity, commodity, currency, etc.
Futures and Options, or commonly called as F&O segment, are an essential part of the derivatives segment of the securities market. Futures and options are two different types of derivatives.
A futures contract is a standardized exchange traded contract to buy or sell an underlying product at a predetermined price on a future date.
An options contract refers to the financial instrument which gives the buyer of the option the right but not the obligation to exercise the option at a pre-determined date and price. A call option gives one the right to buy the underlying security and a put option gives one the right to sell the underlying security. Investors are charged a premium when they buy an options contract
Derivatives are primarily used by investors for hedging their position and minimizing the price risk. Hedging is basically a risk management strategy in which the investors invest in the instruments strategically to offset the risk of any adverse price movements.
For example, when a farmer sows some crop, he is not sure of how much price the crop would fetch
in future, or even whether the crop would fail due to some reason. In such a case, the farmer may enter into a contract with a merchant, in which case both agree to settle the contract at a particular future date at a particular price. Thus, if the farmer is able to deliver the crop, he is assured of the price. The risk of uncertainty of price is hedged.
However, these days, derivatives are used extensively for two other uses, viz., speculation and arbitrage.
Speculation: When one wants to take a view on direction of the price of some underlying, one can simply buy a derivative rather than buying the underlying as lower amounts are involved.
Arbitrage:There is often difference between the prices of (i) the underlying in regular market (called the cash market) and (ii) the price of the futures contract on the same underlying. In such a case, buying in one market and selling simultaneously in another can yield some profits, though mostly these are small profits.
Bonds carry some risks that you should be aware of, including:
Market risk: refers to the potential decline in the value of the underlying asset, which can lead to losses if the market conditions change
Credit risk: arises from the possibility of the counterparty defaulting on their obligations.
Liquidity risk: refers to the difficulty of exiting a position quickly or at a fair price.
Operational risk: involves losses due to errors, system failures, or inadequate controls.
Additional risk of derivatives trading is that the amount payable for the same is reasonably small in comparison to the market price of the underlying. This could lead to the profits or the losses getting multiplied. If the investor is speculating and gets the decision wrong, derivatives have the potential to wipe out one’s net worth. Being aware of these risks is important for making informed decisions in derivatives trading.
Derivatives are zero sum game unlike some of the other investments like stocks where the stock price is related to the profit growth of the company and the investors can also earn dividends, or debentures where the investor is entitled to earning interest. In case of derivatives, for one party making profits, the other is losing. In such a case, one must be extra cautious as the risk of being on the losing side is high, especially for the less knowledgeable persons.
Note: As per the SEBI study 9 out of 10 individual traders in the equity F&O segment incurred net losses during both the years FY 2018-19 and FY 2021-22.