by Manshu on April 12, 2012

The topic of Futures and Options has come up quite frequently in comments and emails but Ive never done a post on them till now because the posts got too long. I can remember deleting at least two drafts because they got too unwieldy, and complex.

Ive tried to give it another shot, and simplify it by breaking it into parts. Here is the first part with some very basic and easily digestible information on futures and options.

Two Types of Derivatives

There are two types of Derivatives commonly traded in the market Futures and Options, and within Options there is further a Call option and a Put option.

The price of these derivatives is based on an underlying asset, and the price of the derivative usually moves in tandem with the price of the underlying. The underlying is usually a stock or an index in the context of investing in a stock market.

Derivatives: Futures and Options

So, that means the price of Infosys futures or Infosys options will depend on the price of the Infosys shares. But if thats the case then why dont people simply buy the stock or the index fund?

Why Buy Futures or Options?

While there are other reasons, I think two big reasons are leverage and taking short positions. Options and Futures give you a lot of leverage and you can make (or blow up) a large amount of money in a short period of time with the same amount of capital than you can with a regular cash position.

The second reason is to take short positions, or profit from declines in the price of a share or commodity. If you want to take a bet that a particular company will do badly, and then profit from it then you cant do it very easily in the cash market.

But you can sell a future, call option or buy a put option to take a short position in the stock or index.

The third common reason I hear is hedging risk, and while I agree that it is a big reason for institutional investors, I just cant see how retail investors can efficiently hedge with derivatives. The notional values of derivatives is often too high, and the expiry periods too short to act as an efficient hedge for small investors.

Who should buy Derivatives?

I think the big difference between buying derivatives and buying a share in the cash market is that your investment can go to zero a lot more frequently in the derivatives market than in the cash market, and only those people who have a high risk appetite and who can stomach losing a lot of money should invest in derivatives.

I think you should also be fairly clued in on the market to make these kind of leveraged bets, but if you asked me what fairly clued in on the market means I would find it very difficult to define that.

That being said, they can be quite profitable as well because they give you the ability to profit from short positions and add leverage.

I think the bottom line is that you should only invest that amount of money in derivatives that you are comfortable in losing. They arent for everyone, and not everyone should dabble in them.

Ill stop this post here, and in the next part of this series build on what it means when  you say the price of a derivative depends on the underlying.

This post is from the Suggest a Topic page.