A derivative is a financial instrument. It is a contract between two parties. The value or price of a derivative is based upon the fluctuations in the underlying asset or a group of assets. Underlying assets are generally stocks, commodities, bonds, currencies, indexes or interest rates.
These derivatives are traded through Futures or Options contracts and have an expiry date. Derivatives expiry is what keeps investors on their toes. The last Thursday of each month is considered to be the expiration date for the derivatives.
Here we help you understand a few key points such as Futures and Options trading, derivatives expiry and how it affects the stock market, derivative settlement and arbitrage on derivative trading. This will help you understand how derivative trading works and how you should tread carefully during its expiry.
Futures & Options
Futures and options Trading also known as fno trading is how derivatives are traded in the exchange. A futures contract is a contract wherein an investor can buy or sell assets at a pre-decided price in the future. An options contract is a contract wherein the investor can buy a stock at the ‘Call’ option and sell the stock at the ‘Put’ option. In an options contract, there is no obligation on the investor to buy or sell the contract at the expiry. The investor is not bound to the terms of the agreement.
Derivatives Expiry & Settlement
The derivatives expiry is the date at which the contracts have to be fulfilled. As mentioned before, the last Thursday of each month is designated as the expiry date for all contracts. This is to avoid any confusion regarding the derivative expiry dates.
On the date of expiry, if it is a futures contract, then the trade is settled, and if it is an options contract, then the trade simply gets expired. The settlement is done in two ways. One way is to settle for cash, and the other way is to buy another contract which in turn nullifies your current contract.
If you have a current contract of buying 200 shares of a company, and if you want to nullify it then you need to buy another contract which allows you to sell the 200 shares. You need to pay the difference in the price as each contract is traded at pre-decided value. The settlement price of each contract is dependent o the closing price of the stock for the last day.
How Derivatives Affect Stock Prices
Futures and options derive their value from the underlying asset. These derivatives contracts can also affect stock prices for short periods. If the investors feel that the stock will do well and are optimistic about the future, then the number of ‘Buy’ contracts rises than ‘Sell’ contracts. In anticipation of higher prices, the investors then start buying the shares. When this quantity of buying increases then the stock prices increase too.
As the derivative expiry date nears, the investors take stock of the positions of their derivatives. They see if these are profitable or not. Based on the analysis, the investors may buy the stocks from the stock market and sell them in the derivatives market to earn profits. The can only do this if they hold shares in both secondary as derivatives market. This is called arbitrage trading.
To avoid losses investors might want to cancel their position and sell the stocks in the secondary market itself. Some investors might do vice versa. This causes fluctuations in the prices and increases volatility in the secondary market. This only happens for a short period, and the market recovers from its losses.