Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

Understanding Derivatives – Lies, Lies and Damn Lies -5

8 min read

Previous Chapter : The Holy Grail – LIES, LIES AND DAMN LIES-4


 
Derivatives are derived from some other asset; they can take many forms. Risks occur in several forms. When we buy stocks the prices can go up or down in future. When we buy a car, accidents can occur in future. When we have receivables in foreign exchange at a future date its value can change in future. Prices of commodities can fall at the time of harvests. This is a risk a farmer faces. Prices of commodities may go up upsetting the budgets when actual purchases are made. Change in weather patterns can affect the profitability of companies that depend on weather. Thus there are risks in every investment. All these risks are related to events that may occur in future. Derivative instruments are concerned with future and have a future date of expiry. As there are thousands of investment avenues there are thousands of derivative products that are designed to reduce the risks associated with them. Some derivative products are traded in derivative exchanges. Some of the products are custom made and traded between two parties. Exchange- traded derivatives have some contract specifications. Exchange will specify contract sizes, quality specifications, and date of expiry and margin requirements. Only bargaining will be on the prices. In an exchange buyers and sellers are not known to each other. The exchange will have a clearinghouse that stands between the buyer and seller. From the buyer the clearinghouse buys the asset and sells it to the seller. The clearinghouse collects margins from the parties depending on the risk associated with their positions, and guarantees against defaults. Margins collected will be changed depending on the risks due to change in volatility in prices. Losses and profits will be made mark to market every day. ( Explain Mark to Market) But contracts made between two parties are designed to suit the requirements of both parties. For example a trader needs 1550 tons of rubber of certain quality on 22nd September 2010. A rubber farmer agrees to supply the rubber at an agreed price on that day. Here it is a private agreement. This contract is a future contract. The delivery is at a future date. The quantity is the actual requirement and is not a standard size. Had this contract been made in a commodity exchange the quantity would have been 1550 tons instead of 1551.50 tons. There are no margin payments between parties. There is no central place to execute such contracts. Large numbers of such contracts are executed between private parties everywhere every day especially in commodities and foreign exchange. These are called forward contracts. These contracts are also known as OTC contracts (Over The Counter contracts). These contracts have many defects.
1 As there are no margin requirements defaults could arise
2 As there is no central place to trade finding counter parties are not easy
3 As there are only two parties involved, agreeing to a mutually agreeable price is not easy.
4 There is no liquidity for such contracts. Bid and ask prices can vary widely increasing the cost of transaction.

These contracts reduce risks as follows.
A US exporter is to receive one million Euros after three months. He has no clue about the Euro/Dollar rate after three months. He is satisfied by the existing rate. He wants to sell his one million Euros in the forward market. He approaches his bank with this request. His banker finds a buyer of dollars (probably an importer from Germany) who requires them after three months. The US exporter sells one million Euros to the German exporter near the then current rates. Both will have the money only after three months. Both parties make a forward contract immediately. Now, suppose Euro goes down with respect to dollar. It means that one needs to pay more Euros to get one dollar. This also means that the US exporter gets fewer dollars if Euro depreciates with respect to dollar. Due to his forward contract the US exporter still gets the same number of contracted dollars after three months. In the case of the German importer, he needs to pay the same contracted dollars to get his 1 million Euros. He could have paid fewer dollars to get his 1 million Euros had he not made a forward contract. It may look that the German importer lost. But it is not so. Exchange rate movement could have been in the reverse too. Then the US exporter would have been a loser. Both these parties have removed the variability of their returns by entering into a forward contract.

By selling their receivables in the forward markets both parties removed their risks..

FUTURES CONTRACTS HAVE A GREAT FUTURE
While forward contracts are traded between two parties or two firms, futures contracts are traded in exchanges with counter parties remaining unknown to each other. Here the term exchange is introduced. Exchanges are independent institutions regulated by Government- appointed bodies with rules and regulations enforceable by law. These are places where stocks, commodities and their derivatives could be bought or sold. Companies that have public share holding must enlist their shares in these exchanges so that shareholders get a chance to trade their shares without the intervention of the companies concerned. These institutions are highly essential because without these shareholders have to find counter parties by themselves or approach directly the companies for selling the shares. Both these methods of trading are time consuming and costly and hence act as inhibiting factors for fund raising and investments.

These exchanges provide a central place to trade. They guarantee trades avoiding defaults by taking margins depending on risk. They design sensible contracts with clear specifications so that the only variable is price and they enable smooth trading. All exchanges have a Clearing House that acts as intermediary between buyers and sellers.

Therefore forward contracts when traded in exchanges have very few drawbacks. In exchanges there will be thousands of participants buying and selling. These traders have information about the assets they are trading on. Therefore they have some idea about the worth of an asset at a future point of time. This creates liquidity and price recovery. Exchanges and clearing houses collect margins I order to prevent default. However there is a problem with exchange-designed contracts. Contracts are stream lined and quantity, quality, expiration and other variables are fixed, except price. Therefore one individual cannot create a contract with a specific quantity to hedge his specific position. (This is not clear to me)

Availability of futures contracts on stocks, commodities and indices is very convenient for investors to hedge their positions in the spot market or the cash markets. These can be used for reducing risks in derivative markets too. Here a new term indices is introduced. A stock index is a number based on stock prices. A commodity index is computed using commodity prices. These have a Base Year and a Present Value. The index figure shows how many times the present value has gone up or down when compared to base year. Indices too are derivatives because their values are derived from other assets like stock or commodity prices. Dow Jones Industrial Average is derived from 30 stocks. S&P 500 is derived from 500 stocks. Russell2000 has 2000 shares and Nasdaq Composite includes more than 3000 shares listed on Nasdaq. Dow is a very old index of American stocks whose value is based on the prices of 30 major companies in the US. The base value is adjusted to compensate for the effects of stock splits and other adjustments. Dow is a minor representative of the US markets. Buying Dow Jones futures (DJX) is equivalent to buying 30 shares in the Dow for a future delivery. Similarly when an investor buys S&P 500 futures(SPX) he is buying an equivalent of 500 shares included in that index. Because of this useful role buying and selling of index futures are allowed in many US derivative exchanges. After 2000, individual stock futures are also allowed to be traded in the US. Thus US investors have hundreds of futures contracts on indices and stock futures to hedge against spot or derivative positions. As each index represents a particular group of shares these could be utilized to hedge a specific sector. In addition to all these index -based derivatives, many exchange- traded funds (ETFs) are floated by many institutions. ETFs on indices are mainly miniature indices that can be bought instead of an index. For example SPY is an ETF that has one tenth the value of S&P500. Instead of buying 500 shares in S&P500, an investor can buy SPY and own the shares in S&P500. As the basic unit is only 1/10 of the S&P500 it requires less money to own a unit of SPY.

As S&P500 has 500 shares, it is a widely diversified index. Therefore company specific risks are totally eliminated in this index due to negative correlations among various companies. Thus S&P 500 has only risks related to market as a whole. Hence S&P500 derivatives can be used to hedge against systematic risks.

There are serial methods by which futures contracts could be used to hedge risks in stock markets and commodity markets. (The last Part about indices is not easy to understand)

Before discussing these methods it is pertinent to find out the type of participants who operate in these futures markets.

FUTURES CONTRACTS HAVE A GREAT FUTURE

There are four types of traders in futures exchanges.
1.Producers
2.Consumers
3.Speculators
4.Arbitragers

Farmers are producers of farm products. Oil drilling companies are producers of oil. Food product companies are consumers of farm products. Oil refineries are consumers of crude oil. But speculators and arbitragers are two different groups. Among the four groups speculators are in the majority. These people assess the likely prices of assets in the future and take positions on them to buy or sell them at a future date. Suppose crude oil is trading at $80 per barrel in the spot markets. A group of people having information on oil may feel that oil prices may go up after 3 months. There may be another group who feels that oil prices may fall after three months. The first category might push up the oil prices with huge demands while others might sell oil to this group. One of these groups is definitely in the wrong. As oil does not get transferred immediately and both these two groups have no other interest in oil other than taking profit from their guess work they are called speculators. As transfer of assets does not take place immediately futures exchanges charge the traders only the risk margins. The maximum risk in the positions is determined every day using computer soft ware and margin money collected through brokers. As fluctuations in prices are not a very big risk, margins normally come below 25% of asset prices. Therefore speculators need to raise only a maximum of 25% of asset prices to take positions in the futures exchanges.

When the producer of an asset like wheat wants to sell his future wheat production (produce or product?), there will be plenty of speculators ready to bid for the production (?). Consumers may also bid for the asset. Apart from producers, speculators will also try to buy and sell futures on wheat depending on their perceptions. A speculator who feels that the future prices will fall, will sell future contracts while a speculator who feels that prices will go up, will buy them. Here producers and consumers are transferring their price risks to speculators. Arbitragers are a group of traders who watch the price difference of an asset in different exchanges. Price difference is a rare occurrence due to efficient communicational facilities. However if such a thing happens, this group will buy from where the asset is priced less and sell to where the asset is priced higher. Most often cost of transactions and other levies nullify any advantages in arbitrage trades.

In the case of financial assets like stocks, investors can reduce risk by using futures. Suppose a mutual fund has $2 billion assets in stocks. Suppose the portfolio has one to one correlation to SPX. This means that if S&P 500 falls by one percent, the portfolio will also lose 1% in value. Asset managers of the mutual fund fear greater volatility in the markets due to political events abroad. As this risk is systemic in nature they will sell $2 billion worth of SPX in the futures markets. If markets crash by 2%, the portfolio will lose 0.04billion in value. At the same time SPX will also lose $0.04 billion in value. As the portfolio managers have short positions in SPX any fall in portfolio value will be compensated by the profit from SPX short positions.
Suppose an investor or a mutual fund will receive some funds after three months. However markets had a big crash and price earning ratios fell considerably before the receipt of funds. These investors can then choose the futures market to accumulate their preferred stock by paying margin to stock exchanges. Suppose a mutual fund receive $2 billion after three months from sale of units. If the price earning ratios fall considerably, the stocks will become very cheap. The mutual fund can buy the required portfolio in the futures market by paying a small margin. If prices go up by the time the fund gets money from sale of units it can sell the futures. It can buy the shares from spot markets at current prices and their sale of futures will provide them profits to compensate for the rise in spot prices.

Speculators in futures markets play altogether a different game. They buy and sell huge quantities with thin spreads paying small amounts of margins. They may not even hold their positions to the next trading day. It is speculators who create most of the volume in the derivative markets. As they are ultimately the carriers of someone else’s risks, most of them end up with huge losses. Broker’s charges and other levies are very heavy for them due to their huge trading volumes. Even though speculators do a useful job of creating volumes, price recovery and liquidity, buying and selling futures as a speculative activity is sheer foolishness. Most often individuals take speculative positions without knowing the direction of the markets. Their risks are unlimited and ultimately Murphy’s Law will catch up with them unless of course they are blessed by the goddess of Luck.

To be continued
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

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