In the stock market, derivatives are financial contracts whose value is based on the price of an underlying asset, such as a stock, bond, or commodity. They are often used for hedging, speculation, and increasing leverage in investments. Derivatives do not represent ownership of the asset itself but rather derive their value from it. They are used to manage risks or to make profits based on price changes.
Types of Derivatives:
There are mainly four types of derivatives in the stock market:
- Futures: A futures contract obligates the buyer to purchase, and the seller to sell, an asset at a predetermined future date and price. These are often used by traders who want to lock in prices or protect themselves against price fluctuations.
- Options: Options give the holder the right (but not the obligation) to buy or sell an asset at a set price within a specified period. There are two types:
- Call options allow buying the asset.
- Put options allow selling the asset.
- Swaps: Swaps involve the exchange of cash flows or financial instruments between two parties. Common swaps include interest rate swaps, where one party agrees to exchange fixed interest payments for floating ones.
- Forwards: Similar to futures, forwards are agreements to buy or sell an asset at a future date for a price agreed upon today. However, unlike futures, forwards are customized contracts traded over-the-counter (OTC) and are not standardized.
Example: Using Options to Hedge
Let’s consider an investor, Raj, who owns 100 shares of a company called XYZ Ltd., currently trading at ₹100 each. Raj is concerned that the stock might fall in value. So he decides to buy a put option for ₹5 per share. This option gives him the right to sell his shares at ₹95 each in the next month, even if the price drops below that.
A month later, the stock price falls to ₹80 per share. Because Raj purchased the put option, he can sell his shares for ₹95 each, even though the market price is lower. This limits his loss to ₹5 per share (the cost of the option), instead of losing ₹20 per share if he sold them at the market price.
Why Use Derivatives?
- Hedging: Investors use derivatives to protect themselves against price changes. In Raj’s case, the put option served as a hedge against the falling stock price.
- Speculation: Traders can use derivatives to speculate on the future price of assets without owning them, hoping to profit from market movements.
- Leverage: Derivatives allow traders to control a large amount of an asset with a smaller initial investment, increasing both potential gains and risks.
Conclusion:
Derivatives are powerful tools in the stock market, offering opportunities to manage risk and amplify returns. However, they are not without their risks, and understanding how they work is essential for anyone considering their use. Whether hedging against market volatility or speculating on price movements, derivatives can play an important role in an investor’s strategy.
– Ketaki Dandekar (Team Arthology)
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