Derivatives Trading

Derivatives Trading

1. Basics of a Derivative

A derivative is a financial instrument whose value is derived from an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, or market indexes. Derivatives are often used for hedging risk or for speculative purposes. They include contracts like futures, options, and swaps, allowing investors to speculate on the future price of an asset without having to own it. The value of a derivative fluctuates based on the changes in the value of the underlying asset.

2. Name Some Common Types of Derivatives

The most common types of derivatives include:

• Futures Contracts: Agreements to buy or sell an asset at a predetermined price at a specific future date.
• Options Contracts: Provide the right, but not the obligation, to buy or sell an asset at a predetermined price before or on a specific date.
• Swaps: Contracts that involve the exchange of cash flows between two parties, such as interest rate swaps or currency swaps.
• Forward Contracts: Customized contracts between two parties to buy or sell an asset at a specified future date and price.
• Credit Default Swaps (CDS): A type of swap designed to transfer the credit exposure of fixed income products between parties.

3. 4 Categories of Equity that You Must Know

Equity can be categorized into four main types:

• Common Shares: Represent ownership in a company, providing voting rights and dividends.
• Preferred Shares: Offer fixed dividends and have priority over common shares in the event of liquidation, but typically lack voting rights.
• Equity Mutual Funds: Pooled investment funds that invest in a diversified portfolio of equities, managed by professional fund managers.
• Convertible Bonds: Bonds that can be converted into a predetermined number of the issuing company’s equity shares.

4. Types of Equity Markets and What to Choose From?

Equity markets can be broadly categorized into:

• Primary Market: Where new shares are issued and sold to investors for the first time, such as during an Initial Public Offering (IPO).
• Secondary Market: Where existing shares are traded among investors after they have been issued in the primary market. The Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) in India are examples of secondary markets.

Choosing between these markets depends on your investment goals. For long-term investments, participating in the primary market can be advantageous, while active traders might prefer the liquidity and opportunities offered by the secondary market.

5. 5 Reasons Why You Must Invest in Equity

1. Potential for High Returns: Equities have historically provided higher returns compared to other asset classes like bonds or fixed deposits.
2. Ownership in Companies: Investing in equities gives you a stake in a company, with the potential to benefit from its growth and profits.
3. Dividend Income: Many companies pay dividends to shareholders, providing a regular income stream.
4. Liquidity: Equities are generally highly liquid, allowing investors to buy and sell shares quickly in the stock market.
5. Inflation Hedge: Equities often outperform inflation over the long term, preserving and growing your purchasing power.

6. What to Gain from Equity Trading?

Equity trading offers several potential benefits, including:

• Capital Appreciation: The primary goal of equity trading is to buy low and sell high, profiting from the increase in the stock price.
• Dividend Payments: Shareholders may receive regular dividends, providing a steady income stream.
• Portfolio Diversification: Equities can diversify an investment portfolio, reducing risk by spreading investments across different sectors and industries.
• Active Participation in Company Growth: By investing in equities, you can participate in the growth of companies and the economy.
• Market Liquidity: The stock market’s liquidity allows for quick entry and exit, offering flexibility to traders and investors.

7. Understand Put-Call Parity

Put-Call Parity is a financial principle that defines the relationship between the price of European put and call options with the same strike price and expiration date. It asserts that the difference between the call option price and the put option price equals the difference between the current stock price and the present value of the strike price. This relationship is crucial for ensuring that no arbitrage opportunities exist in the market.

8. What is Trading On Equity?

Trading on equity refers to the use of borrowed funds (debt) to finance the purchase of assets with the aim of increasing the return on equity. When a company uses debt to acquire more assets, it expects the return from these assets to exceed the cost of borrowing. This leverage can amplify profits, but it also increases risk, as the company must meet its debt obligations regardless of its financial performance.

9. Easy Retirement – Equity Funds Versus Debt Funds

When planning for retirement, choosing between equity funds and debt funds is a critical decision.

• Equity Funds: Suitable for long-term growth as they invest in stocks and have the potential to deliver higher returns. However, they come with higher risk due to market volatility.
• Debt Funds: These invest in fixed-income securities like bonds and are generally safer but offer lower returns. They are suitable for risk-averse investors seeking stable income. A balanced approach, combining both equity and debt funds, can provide growth potential with reduced risk, aligning with retirement goals.

10. Systematic Transfer Plan (STP): Meaning, Process, and Much More

A Systematic Transfer Plan (STP) is an investment strategy where an investor systematically transfers a fixed amount from one mutual fund scheme to another, usually from a debt fund to an equity fund. This strategy is used to reduce the risk of market volatility and to benefit from rupee cost averaging. STPs are ideal for investors who want to gradually shift from a low-risk investment to a higher-risk, potentially higher-return investment.

11. How to File Income Tax Return for Futures and Options?

Filing income tax returns for Futures and Options (F&O) trading in India involves reporting gains or losses as business income. The steps include:

• Maintain Proper Records: Keep detailed records of all transactions, including contract notes and ledger accounts.
• Calculate Income: Calculate the net income from F&O trading after deducting related expenses.
• Fill the ITR-3 Form: F&O income must be reported in the ITR-3 form under the “Income from Business or Profession” section.
• Pay Advance Tax: If your F&O income is substantial, ensure that advance tax is paid to avoid interest penalties.
• Claim Deductions: You can claim deductions for expenses incurred in trading, such as brokerage fees, internet charges, etc.

12. Five Popular Derivatives & How They Work

1. Futures Contracts: Agreements to buy or sell an asset at a future date at a price agreed upon today.
2. Options Contracts: Provide the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price.
3. Swaps: Contracts where two parties exchange cash flows or other financial instruments.
4. Forward Contracts: Customized contracts between two parties to buy or sell an asset at a specified future date at an agreed-upon price.
5. Credit Default Swaps: Financial agreements that transfer credit risk from one party to another.

13. Different Types of Derivative Contracts

Derivative contracts can be categorized into:

• Forward Contracts: Customized agreements to buy or sell an asset at a future date.
• Futures Contracts: Standardized forward contracts traded on an exchange.
• Options Contracts: Contracts giving the right, but not the obligation, to buy or sell an asset.
• Swaps: Agreements to exchange financial instruments or cash flows between parties.

14. What are Hedge Funds?

Hedge funds are alternative investment funds that use various strategies, including derivatives, leverage, and short-selling, to generate high returns for their investors. They are typically open to accredited or institutional investors due to their higher risk and complex nature. Hedge funds aim to deliver absolute returns, often independent of market direction, making them an attractive option for sophisticated investors seeking to diversify their portfolios.

15. What is Margin of Safety?

Margin of safety is a principle of investing that involves purchasing securities when they are significantly undervalued compared to their intrinsic value. This concept, popularized by Benjamin Graham, provides a cushion against errors in judgment or market volatility. By buying assets with a margin of safety, investors aim to reduce the risk of loss while maximizing potential gains. The larger the margin, the less the risk of the investment.