Derivatives are among the most complex financial instruments and also one of the most controversial. While they are as old as commerce itself, they have become prominent only in the last few decades.

Their critics claim that they make markets less transparent and more prone to instability and speculation. Their supporters say that derivatives improve risk management and increase liquidity.

Both sides would agree that derivatives are extremely important and have a big impact on other financial markets and the economy. So even if the average investor doesn't invest directly in derivatives it's important that he or she knows what they are.

What is a derivative instrument?

A derivative, as the name suggests, is a financial instrument whose value is derived from another asset (known as the underlying). The underlying can be a stock, a commodity, and a market index among other things. The two main types of derivatives are options and futures.

Options

An option gives you the right to buy or sell the underlying asset but not any obligation.

A call option gives you right to buy the underlying asset while a put option gives you the right to sell.

An option contract specifies the strike price, that is, the price at which you can buy or sell the underlying and the expiry date after which the option is no longer valid. In other words, the expiry is the last day on which a contract expires or ends. In Inidan markets, expiry is the last Thursday of every month.

• A mutual fund with a difference  

Options are also classified into American, which can be exercised at any time prior to the expiry date and European which can only be exercised at the expiry date.

In India options on individual stocks are American-style while options on indices like the Nifty are European.

So in the newspaper if you read, say, a Ranbaxy option contract: CA-330-Mar, it means that this is an American-style call option which gives you the right to buy Ranbaxy shares at Rs 330 and which expires in March (the last Thursday).

Similarly a PE-4300-April Nifty contract is a European-style put option, which gives you the right to sell at Rs 4,300 and expires in April.

Futures

A futures contract is a standardised, tradable contract, which requires the delivery of the underlying asset (commodity, stock etc.) at a specified price and specified future date.

Unlike options, buying a futures contract gives you the obligation to buy the underlying and thus involves greater risk. Another difference is that commodities like gold, cotton, crude oil etc are especially prominent in futures markets.

Futures transactions can be settled in three ways: squaring off, delivery and cash settlement.

• How to trade in futures 

Squaring off means taking a position opposite your initial one. For example, you square off the purchase of a gold futures contract by selling the identical contract.

Delivery means physically delivering the underlying asset on the agreed date. If you sell a gold futures contract of say 1 kilogram then you will have to give real gold to the buyer on the mutually agreed date.

Cash settlement involves paying the difference between the futures price and the spot price of the underlying asset.

For example, if you sell a gold futures contract worth one kilogram for say Rs 1.2 lakh and the price of the contract on expiry day is Rs 1.3 lakh then you will have to pay the buyer the difference of Rs 10,000.

Speculation and hedging

So what are derivatives actually used for?

At the simplest level both options and futures can be used to speculate on price movements. For example you can obtain a profit if you purchase Nifty futures at 3700 and the Nifty goes up to 4000. In this case your profit is 300.

Similarly let us say you purchase a call option with a strike price of 3000. The option itself will have a cost of, say, 100 rupees. If the price goes above 3000 the option is said to be "in the money" which means that you can exercise the option, buy the underlying share for 3000 and make a profit. However that won't cover the cost of the option.

For that the share price will have to rise above 3100 after which you can make profit net of the cost of the option. In practice you will usually be able to book a profit by squaring off your position without having to exercise the option. (In a real situation you will also have to consider trading costs and taxes but the general idea still applies).

• Use options to make money

It's also possible to make money in a falling share by buying a put option. Let's say that for 100 you buy a put option with a strike price of 2000. Now if the price falls below 1900, the option gives you the right to sell at 2000 even though the market price is below that. Once again you will make a profit even after considering the cost of the option.

Speculation means deliberately taking a risk but derivatives can also be used to hedge risk.

For instance a textile manufacturer who is afraid of increases in cotton prices may buy cotton futures to hedge (protect or minimise) that risk. At a broader level multiple derivatives can be combined to execute complex trading strategies, which allow you to manage very specific types of risk.

Should ordinary investors invest in derivatives?

It is possible to do this from the comfort of your home through online trading platforms.

However derivatives trading require extra preparation and caution. At their simplest, options and futures are calculated bets on the movements of the underlying asset.

If you guess right you could earn a multiple of your initial investment in days but if you guess wrong your investment can be wiped out equally quickly.

So if you do invest in derivatives make sure you are especially diligent in researching both the derivative and the underlying asset.

You should understand precisely how changes in the price of the underlying would affect the value of your investment and also study the underlying market whether it's stocks or commodities.