Derivatives Explained: Futures, Options, and Hedging
An introduction to advanced financial instruments.
For Advanced Investors Only
Derivatives are complex financial instruments and involve a very high degree of risk. They are not suitable for all investors. This guide is for educational purposes only and should not be considered investment advice. Trading in derivatives can lead to substantial losses.
What is a Derivative?
A derivative is a financial contract whose value is derived from an underlying asset, group of assets, or benchmark. The underlying asset can be a stock, bond, commodity (like gold or oil), or a market index (like the Nifty 50).
Instead of trading the asset itself, investors trade a contract based on that asset. Derivatives are commonly used for two main purposes: **speculation** (betting on the future price direction of an asset) and **hedging** (protecting against potential losses in an existing position).
Futures Contracts
An agreement to buy or sell an asset at a predetermined price at a specified time in the future.
When you buy a futures contract, you are obligated to buy the underlying asset at the agreed-upon price on the expiration date. When you sell a futures contract, you are obligated to sell it.
- Example: An investor believes the Nifty 50 index will rise next month. They buy a Nifty futures contract today at 22,000, expiring at the end of next month. If the Nifty is at 22,500 on the expiration date, they make a profit. If it's at 21,500, they make a loss.
- Key Feature: Futures involve leverage, meaning you can control a large amount of the underlying asset with a small amount of capital (called margin). This magnifies both potential profits and potential losses.
Options Contracts
A contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a set price on or before a given date.
Call Option
Gives the holder the right to **buy** an asset at a certain price (the "strike price"). You buy a call option when you are bullish and expect the price of the underlying asset to rise.
Put Option
Gives the holder the right to **sell** an asset at a certain price (the "strike price"). You buy a put option when you are bearish and expect the price of the underlying asset to fall.
The price you pay for this "right" is called the **premium**. For an options buyer, the maximum loss is limited to the premium paid. For an options seller (writer), the potential loss can be unlimited, making it a much riskier strategy.
Hedging: Using Derivatives for Risk Management
Hedging is like buying insurance for your investment portfolio. It's a strategy used to reduce the risk of adverse price movements in an asset.
Example: Imagine you own a large portfolio of stocks that closely tracks the Nifty 50, and you're worried about a potential market downturn in the near future. Instead of selling your stocks (which could trigger capital gains tax), you could buy Nifty **Put Options**.
- If the market falls as you predicted, the value of your stock portfolio will decrease, but the value of your put options will increase, offsetting some or all of your losses.
- If the market goes up instead, you lose the premium you paid for the options, but your main stock portfolio gains in value.
In this way, hedging allows you to protect your portfolio from downside risk for a small cost (the option premium).