Derivatives: Examples & Market Correction

Many investors and newbie traders are facing losses for the last couple of months. They haven’t fully understood how the stock market works. Also, they aren’t aware of factors affecting the market. Importantly, derivatives play an important role in market conditions. Investors also need to know the difference between a market dip, correction & crash to sustain in this type of volatile market.

1) Derivatives

According to America’s great investor, business magnate & philanthropist Warren Buffet – ‘Derivatives are financial weapons of mass destruction. In the stock market, Futures and Options are derivatives that are also referred to as ‘F&O’. These derivatives are mostly used by Traders, Speculators, Hedgers, Mutual Fund companies & Arbitrators to make a profit or to hedge their positions. It is said that ‘High Returns comes with High Risk’ & derivatives are the riskiest assets. It can give you significant profit as well it can also wipe out your capital.

Futures

Futures are the type of derivatives trading in the stock market. It is a contract to buy or sell an underlying stock or asset at a pre-determined price on a specific date. It has expiry on the last Thursday of every month. Futures trade in a lot size and it includes factors like risk-free rate & dividend. So, many times stocks’ future price is higher than the spot price.  

Example: Reliance June Future has an expiry of 30th June and its lot size is 250. Suppose Reliance futures are trading at Rs.2500. So if you want to buy it, the amount of capital will need is Rs.250 × 2,500 = 6,25,000. But there is a concept called SPAN margin and Exposure margin. With both margins, you can buy Reliance June Futures at Rs.1,40,000. You need not to pay the full amount of Rs.6,25,000 at the time of buying. But if you don’t sell futures before the expiration date, you have to pay the full amount i.e., Rs.6,25,000 and you will get delivery of Reliance’s 250 shares.

Advantage: Traders / Speculators can benefit from very small movements in stock prices with a decent profit. For e.g., If Reliance stock gains only 1% i.e. Rs. 25, the profit will be Rs.25 × 250 = 6,250.

Disadvantage: Futures requires huge capital as mentioned above Rs.1,40,000 is a huge amount for most people. Like profit, if there is bad news or the market is down and Reliance stock is down it will result in losses.

Options

Options are also the type of derivatives trading in the stock market. It gives you the right to buy or sell the underlying security on a specific date at a specific price. There are 2 types of options – Call & Put. Premium is the option price that buyer has to pay the seller. Options also have expiry on weekly and monthly. Index options have weekly expiry and stock-specific options have monthly expiry. Options trading also depends upon many factors such as Option Chain, In The Money (ITM), Out of The Money (OTM), Strike Price, Intrinsic Value, Time Value, Volume, Open Interest, etc. Options doesn’t require huge capital as only a premium price has to be paid. Options also trade in lots like futures & are highly volatile than futures.

Example: Reliance 2500 CE Option is trading as Rs.40, so if you want to buy it you have to pay only 250 × 40 = 10,000. So, if Reliance’s stock price increases, the option price also increases. If it increases from Rs.40 to 50, it will result into 10 × 250 = Rs,2,500 profit. The profit is 25% of your capital. But if you hold it till expiry, you have to exercise it and can get physical delivery of Reliance stock.

Advantages: Options trading doesn’t require huge capital as it only has a premium which is affordable. It has lower risk and higher return potential.

Disadvantages: Options are very complicated and have less liquidity. It has time decay which means it loses its time value if you hold them.

Disclaimer: We have explained F&O in very short & simple language with examples. There are many technical terms that we have not mentioned. Trading in derivatives carries a high level of risk and is not suitable for all investors/traders.

2) Long Unwinding / Short Covering

We are often confused within the terms Buy, Sell, Long, Short, Long Unwinding, Short Covering, etc. The main difference is that in the equity market the terms ‘Buy’ & ‘Sell’ is used, while in the F&O market, ‘Long’ & ‘Short’ is used. For e.g., If you are buying or selling stocks it is ‘Buy’& ‘Sell’ but if you are buying or selling a Futures contract it is called ‘Long’ & ‘Short’. In simple words, Long means Buy, and Short means Sell.

Long Unwinding

Long Unwinding means squaring off your stock or index F&O if you have earlier bought with a view to profit from it or by hitting stop loss. 

Example: If Prashant bought (Long) Reliance June Futures for Rs.2,500 & its price increases to Rs.2,600 or decreases to Rs.2,400, you can square off it by selling (Unwinding) it.

Short Covering

In the F&O market, you can sell stocks for a longer period. If you short futures means, you will profit from it if the stock price goes down. Short Covering means squaring off your stock or index F&O if you earlier sold with a view to profit from it or by hitting stop loss.

Example: If Prashant sold (Short) Reliance June Futures for Rs.2,500 & its price decreased to Rs.2,400 or increased to Rs.2,600, you can square off it by buying (Covering) it.

Short Squeeze

The stock market trades most of the time on sentiments. Many traders or speculators short F&O stocks thinking the stock will go down & they will make a profit out of it. But sometimes these stocks’ price shoots up and traders have to cover their shorts, it is called ‘Short Squeeze’. The word ‘Bear Trap’ is also used to express this.

Example: Today, Prashant has sold Reliance Futures thinking that Reliance will declare average results & stock will go down. But Reliance announces great results and the stock price goes up. So, Prashant has to square off his position to avoid loss.

3) Dip VS Correction VS Crash

Many investors don’t know the difference between Dip, Correction, and Crash. If the market declines 1-2% in a day, they consider it a market crash. But an investor who has invested & still investing for more than 5 years experiences the up, down & volatility of the market.

a) Dip: If the market declines less than 10%, it will be considered a Dip.

b) Correction: If the market declines more than 10% but less than 20%, it will be considered a Correction.

c) Crash: If the market declines more than 20%, it will be considered a Crash.