Sep 09, 2009 08:17 PM
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(Updated Sep 09, 2009 08:27 PM)
Why Derivatives?
To hedge! It's just like the Guest Room in your house - If You fight with your wife you have to sleep there right? So it's hedging towards unfortunate circumstances!
Surprised to see that no one's mentioned anything on derivatives. Maybe the following myths contribute to that fear.
1. Complicated - No it Ain't. People make it complicated so that you pay them when your enlightened. Confession - I've been paid for doing so :D
2. Risky - Maybe....But aren't stocks on their own risky? In fact one should use derivatives to reduce the traditional risk cash investing has.
So to begin with - Derivatives are simple to Understand. Period! Trust me on this
Do I need Derivatives if I invest only in Mutual Funds or only for investment purposes?Yes - For the above investors the most relavent is the PUT option (xplained later)
What are Derivatives?
Instruments whose value is derived from something else. My Value of this post is derived from the ratings you assign! Similarly (Copy pasted the run of the mill definition ) -Don't get scared if it's complicated.
"Derivative is a product whose value is derived from the value of one or more basic variables, called underlying. The underlying asset can be equity, index,foreign exchange (forex), commodity or any other asset."
To the uninitiated, Derivatives in the stock market can be classified into two categories
Futures
Options
Out of the above two would focus only on options as Futures tend to be more riskier initially if some has no experience.
Why Options?
Even if you have investments in Mutual Funds, Equity tax related scheme, Options help you hedge the loss indirectly. So even if you invest in Mutual Funds, Options would help you!
Stock/Cash Market - It's like a marriage! Your stuck with your wife forever! There might be the occasional "dividends" though. Kids are a bonus! Divorce is the "Stock Split" :)
Options - It's like an Engagement! - You don't have to marry your beloved! You only have the "option" to do so. Basically it means that you have no obligation and not bound by anything! You buy her the movie tickets, the coffee, tell her how good she is without meaning it and marry someone else! Get the drift- No obligation is the key here :)
Options - I think Infosys would reach Rs 2000 by the month end. So I pay a "premium" to buy the "option" to buy infosys at it's current price of rs 1500. Please note - I don't have to buy the stock. Only buying the right to buy/sell the stock at Rs 1500 irrespective of how it moves.....
So if the stock crashes to Rs 1000 my loss is limited to the premium amount and not the actual loss in the stock.
Types of option
Put option - You have Reliance stock - You believe the stock would fall! CMP @ Rs 1500. Buy the put option at @ Rs 20. It gives you the right to sell to sell the stock @ Rs 1500. So if the stock falls to Rs 1020 on expiry day...you make Rs 500. See!!! benefit from stock crashes as well
So you protect yourself from the risk of falling stock prices
And if the stock goes up you limit your losses to the premium amount paid to buy the option and not the fall in value of the stock price
Call option - Wanna buy 1000 RNRL at Rs 50 each? Just buy the option at lets say Rs 5, QTY - 1000. If the Stock goes to Rs 65, you make a net profit of Rs 10...See your money just got tripled by paying only 1/10th the cost. If the stock tanked to Rs 40 your loss is only Rs 5000. Else it would have been Rs 10,000
Again you protect yourself from the risk of falling stock prices
There's lot more to be written but this is just a brief on the concepts! It's not Rocket Science!For actual definitions please use sites like Investopedia or NSEINDIA.COM and got to the NCFM section of the site
In a Nutshell -
A - It Ain't complicated - If this doesn't help do let me know! I would clarify
B- At least start buying one Put Option of any stock that u believe would go down! It'll get you at started in the World of Derivatives.
Happy Trading!
