What are Derivatives?
You might have heard of financial jargon like Futures and Options, calls, puts, etc. If you have no clue what that is, then this article is for you. All these are a part of a larger class of instruments called derivatives. They trade on exchanges, just like stocks, albeit they have another purpose – risk mitigation (known as hedging in the world of finance). Notice the word derivative comes from the word ‘derive.’ Derivates “derive” their value from some underlying quantity. The question is, what is that quantity? Who decides the value? Let’s understand this using examples, and in the process, we’ll be covering multiple types of derivatives. While reading this article, think about the origin of the name of the derivative, which will help you understand the concept better.
Forwards and Futures
Let’s understand this one with a classic example. Imagine a scenario where there are two parties involved, a farmer selling fruits and a juice-producing company. The farmer sells her fruits to the company, but the price is not constant. It keeps fluctuating every year. When the weather is favorable, supply is greater than demand, driving the prices down. This is beneficial to the company but not to the farmer. If the weather is not favorable, the supply isn’t sufficient to meet the demand, which drives the prices up. This is good for the farmer but bad for the company. It’s a risky bet for both. If they could somehow know the prices in advance, they could prepare themselves for the consequences. No one likes uncertainty. It turns out they can know the prices in advance. Well, not know exactly but at least agree on a price. The farmer and the company enter a contract: next year, the company will buy a fixed amount of fruit at a fixed price from the farmer, irrespective of the market price of fruit. There you have it, a deal has been made, and there is no uncertainty whatsoever. This isn’t to say that this contract would be profitable for both. Even if the market price is lower than the agreed price (exercise price or strike price), the company is legally bound to honor the contract. The same argument applies to the farmer. The only common compensation is the removal of uncertainty. This type of private contract, done over the counter (OTC), is called forwards. Futures are similar but have standardized terms and are traded on exchanges. These contracts (and other contracts, too) are only valid until a particular date, known as the expiry date.
There are more subtle differences, but the idea here is to understand a future contract’s basic concept, so I’ll leave it at that.
You might remember reading that oil prices went sub-zero last year. Well, those weren’t oil prices that crossed zero, but the price of a particular futures contract of oil that was being sold at prices below zero!
What does it mean to have an option? It means you have a choice (not an obligation) to do something.
Recall the farmer and the company from the previous example. Let’s say that the farmer is not satisfied with the futures contract. She thinks that if the market price is higher than the agreed price, she will miss the opportunity of making extra profit. But she is not sure about the future market price. Let’s bring in some numbers at this point. The company is confident that the cost of fruit next year will not go below $100 per unit. The farmer needs to sell it at or above $100; otherwise, she will incur a loss.
The company proposes a contract. It asks the farmer to pay $2, and in return, it will give her the right (but not the obligation) to sell the company 1 unit of fruit at 100$. The company does this to earn some extra cash because it strongly believes that the price will never sink below $100 and the farmer will never exercise her contract. The farmer agrees with this because she is not that sure about the future price. If the price does not go below $100, then she would simply not exercise her contract. It would cost her an extra $2 but remove the risk of incurring a loss. This type of contract is called a put contract. The company is the writer(seller) of the contract, and the farmer is the buyer of the contract. $100 is the exercise price, and $2 is the option premium.
Here put refers to sell (imagine the farmer “putting” the fruit in the companies warehouse). The farmer has the option (the right but not an obligation) to put (sell) fruit at $100.
A call option is the opposite of a put option; it gives the option holder a right but not an obligation (this should make sense now!) to call (buy; imagine the company calling the farmers fruits) at the exercise price.
Initially, this can be confusing but concentrate on the literal meaning of the words ‘option’, ‘call’, and ‘put’, and you’ll see that it starts making sense.
Financial weapons of mass destruction?
There are more types of derivates, but I’ll leave them for another article. The above paragraphs explain the roles of derivatives in risk mitigation, but unfortunately, that is not the primary reason they are traded on exchanges. They are mainly used for speculation. A trader might not be concerned about the underlying quantity (fruit or oil or stock or index or whatever). Traders may write or buy options just because they speculate the underlying price to change in a favorable direction. It’s like tossing a coin and saying, ‘If tails I win if heads you win.’ The difference, in this case, is that the price of commodities and stocks are not entirely random but random enough to make this more like gambling. When you hear of someone trading, more often than not, they write or buy derivatives to earn quick cash. Indians are so obsessed with speculating that the volume of derivatives traded on NSE is higher than any other exchange in the world! The total value of the derivatives market is estimated to be around $1 Quadrillion (1 followed by 15 zeros, equal to 1000 Trillion, or a Million Billion dollars!), and most of this money is not real. This makes derivatives extremely risky. Experts argue derivatives are the reason markets are so volatile. In the words of billionaire investor Warren Buffet, “Derivatives are financial weapons of mass destruction.”