DERIVATIVES AND RISK MANAGEMENT

Many understand how the stock market works, but fail to understand what the role of a financial derivative is, which is an incredibly important game that must be played or at least understood to do well in the stock market, as the performance of financial derivatives is synchronous with the performance of stocks and industry groups.

For those who do have math in their senior secondary years, you already know what a derivative is, for those who have not, a derivative is mainly used to figure out the rate of change of a quantity instantaneously. Imagine a car, moving on a highway, while you can figure out how much distance it has covered absolutely, you take an average quantity to find the speed. (In this case, the total distance, covered by the total time). But this is not instantaneous, and gives an average quantity instead of an instantaneous quantity. Derivatives, provide a way to compute this, and give you the average speed, for an infinitely small amount of time, which makes it instantaneous! Pretty cool huh? Financial derivatives are no different, and essentially give you the same thing. An instantaneous measure of the change in rate.

The stock market is mainly meant for buying, selling, and issuance of shares of publicly-held companies. And many felt that they could accurately predict the direction in which a certain non-tradable / broad spectrum field is doing. For example, Mr.X, an expert in the field of pharmaceuticals, may feel that the Pharma industry will pick up immediately after the main blow of COVID-19, due to an increase in the number of health conscious individuals. Of course, Mr.X does not know which companies will do well, and which will not, and he is not an avid investor, who wishes to devote time to researching these companies, or take the risk of investing in a company which may fail. Hence, the power of the derivative comes in here to save him. He can invest in a financial derivative, relating to the performance of the Pharma industry as a whole. Using the moving cars analogy, it is like standing on the side of a highway and saying, “I have no clue which car will speed up or slow down, but I do know that the average speed of all the cars will either increase immediately because I can see a broken-down car being moved”. You’re not betting on one car, you’re betting on the efficiency of the highway as a whole.

One way that you can utilise this effectively, is by betting on what direction the ENTIRE market will move, using financial derivatives based on the Bombay SENSEX / NIFTY 50 (they are market indicators, taken by averaging out the performance of some of the most important companies over a short period of time). If you think that the market will boom in the next 5-6 months, as more and more things open up, you can invest in a financial derivative. Or, if you think that the market will fall, you can short the stock! which basically relies on the stock/index failing to make money. By looking at the entire market, and not investing in one single company, you are wielding a double edged sword. You have essentially diversified your risk, and no longer rely on one company’s success or failure. However, it relies on a lot more factors, and even if a few companies in the industry succeed, and the rest fail, the general index will go down. It depends on your investing style more than anything.