Download Derivatives Market

Simplifying how derivative products
operate in the stock market
(Extended Version)
– By Prof. Simply Simple
TM
Hopefully the last lesson on
‘derivatives in the real world’
helped you get a good idea
about it’s concept.
In this lesson, I will explain to
you how a derivative deal is
practically done in the market
place.
In our previous lesson we
explained how in a market
comprising of several buyers
and sellers, one need not know
who the counter-party is.
As we saw in our earlier lesson,
there are several farmers in the
market, perhaps a few thousands!
And several thousand bread
manufacturers!!
And a market place where there
is free flow of information!!!
So that the expected future stock
price (price of wheat for the sake
of comparison with our previous
examples) is known to every
farmer and bread manufacturer.
Any farmer trying to extract a
higher price will not be able to
do so because for the bread
manufacturer there are several
other farmers to buy from and
vice versa.
This is what we call ‘Price
Discovery’.
Now in the stock market we do not
have farmers and bread
manufacturers, but instead have
investors who are both buyers and
sellers of stocks.
Now lets say there is a stock A listed on
the stock exchange and its “futures” is
quoted at Rs. 120.
Also, let’s assume there are
participants in the market to buy and
sell the futures to each other based on
their contrarian view about the stock.
And let’s say the expiry date for
settlement of the futures contract is
after 5 days.
Now, for the sake of understanding,
suppose you were to buy a ‘futures’
of stock A for Rs 120. In this context,
it is important for you to understand
that in a derivative product what you
actually do is take a view on future
price movements and at the end of
the settlement period, you reconcile
based on whether your view was
right or wrong.
Since at no point in time the
investor has to take delivery of the
stock, he does not have to pay the
entire price of the stock at the time
of the deal. All he has to pay hence
is the margin money which is a
fraction of the price, say, 15% of the
price which is Rs 18 in the above
example.
Now to understand this better,
let’s look at how the prices move
in these 5 days.
Day 1
Closing Price on day “One” – 122
Your buying price day “One” – 120
Your profit – Rs 2
So at the end of the day your account with your
broker would get credited by Rs 2.
Debit
Day 1
Credit
Rs. 2
Day 2
Closing Price on day “two” – 125
Your profit as compared to the previous day is Rs 3
So at the end of day 2, your account with your broker
would get credited by Rs 3.
Debit
Credit
Day 1
Rs. 2
Day 2
Rs 3
Day 3
Closing Price on day “Three” – 124
Your loss as compared to the previous day is Rs.1
So at the end of day 3, your account with your
broker would get debited by Rs 1.
Debit
Credit
Day 1
Rs. 2
Day 2
Rs 3
Day 3
Rs.1
Day 4
Closing Price on day “Four” – 123
Your loss as compared to the previous day is Rs.1
So at the end of day 4, your account with your
broker would get debited by Rs 1.
Debit
Credit
Day 1
Rs. 2
Day 2
Rs 3
Day 3
Rs.1
Day 4
Rs. 1
Day 5 – Settlement Date
Closing Price on day “Five” – 125
Your profit as compared to the previous day is
Rs.2
So at the end of day 5, your account with your
broker would get credited by Rs 2.
Debit
Credit
Day 1
Rs. 2
Day 2
Rs 3
Day 3
Rs.1
Day 4
Rs. 1
Day 5
Rs 2
Day 5 – Settlement Date
Thus the effect of the 5 days leading
to the settlement would be like
this…
Debit
Credit
Day 1
Rs. 2
Day 2
Rs 3
Day 3
Rs.1
Day 4
Rs. 1
Day 5
Total
Rs 2
Rs 2
Rs 7
So in this case the investor gained Rs 5 on settlement date.
However since your investment was only
Rs. 18 (15% margin money), you need to
calculate Rs. 5 as a percentage of Rs. 18.
Thus, the returns earned would be equal to
5/18 x 100 = 27% (approx.)
Please do let me know if I have managed to clear this concept for
you.
Your feedback is very important as it helps me plan my future
lessons.
Hence please give your feedback at
[email protected]