What are index derivatives?
A stock index is a statistical measure of the value of a particular group of stocks. Indices are used to assess changes in the stock market by evaluating the performance of a given set of stocks. A derivative is an instrument whose value depends on something else. To delve into indices trading, you must first understand options and futures.
An option gives a trader the right but not an obligation to buy or sell an underlying asset at a specified price on or before a specific date. At the same time, Futures contracts are typically transacted between parties to trade an asset at a defined price for a future date, which makes them more suited for hedging than options because they involve obligation rather than just a right.
Significance of Stock indices
Stock indices are used extensively to compare groups of stocks or markets worldwide. For example, suppose you want to see how your portfolio performs compared to a significant market index. In that case, you could look at the MSCI World Index (world stock market index), available from many providers. The MSCI World Index tracks companies in 23 developed markets across North America, Europe, Asia Pacific and Latin America. If you wanted to see how that portfolio compares to another region like the Asia Pacific, then you could use an ETF such as VAS (which represents Asian equities).
Using Options and Futures
Options and futures contracts can both be used to hedge against risk or speculate on price movements. If you own a physical asset like gold or crude oil, you might use an option or future contract to hedge your risk of price changes in those commodities.
In addition to hedging, you can speculatively make money on the movement in the price of an underlying asset without having to buy or sell it. The term “speculation” tends to have a negative connotation because it’s often associated with gambling behavior. But true speculation involves taking calculated risks while minimising losses through careful planning and diversification across many different asset classes when possible.
Options trading strategies
Options are traded as if they were stocks, meaning they can be bought and sold in any quantity, at any time during the day. The buyer of this contract is paid cash when they exercise their right (also called “exercising”). If you think the price will go up between now and your expiration date, buying calls makes sense because you have locked in that profit before it could disappear if prices dropped instead.
Suppose you buy 100 shares of Apple Inc for $1000 each on September 1st, 2021 ($100m) with an expiration date set for August 31st, 2022 ($1b). The share price has dropped from $1000 to $900 since then. But there is still time left before expiry when it might recover again. So, instead of selling them now for a loss ($10m), you could wait until expiry hits on August 31st, 2022, whereupon you can sell your shares in the market at their current value without losing anything due to depreciation.
Futures are better for hedging
Futures contracts were developed to hedge risk and speculate on price movements in assets like gold, oil and other commodities. A farmer who wants to lock in his profits may sell some of his crop’s future production via futures contracts. Likewise, for a manufacturer who wants protection against rising costs of raw materials by buying them through futures.
To summarise, options and futures have many similarities and critical differences. These financial instruments are derivatives of the underlying asset, and their usage varies on the asset type. Indices trading is most suitable for traders with an in-depth knowledge of financial markets.