Important concepts of derivatives tradingSome of the concepts that we are going to use in the coming sections are the following -
Future -It is an agreement between a buyer and a seller of an asset to conduct the transaction on a particular date at a particular price. Once entered, the agreement has to go through.
Option -It is an agreement between a buyer and a seller such that the buyer of the option pays a premium (to the seller of the option) in return for which he gets the right to buy/sell an asset at a particular price on/before a particular date.
Market price -Also known as the spot price, it is the price at which the asset itself is available for sale in real time.
Strike price -The particular price of the asset at which the future or option is to be executed is known as the strike price of the future or option contract.
Cash settlementSettling a derivatives contract basically means executing the final step in the derivative trading process - just like a purchase, it involves the final exchange of the asset and the cash. Once the contract is settled completely, there are zero actions that are mandatorily required to be done by either party in relation to that particular contract. Now, there exist two ways in which a future or an option may get settled - physical settlement or cash settlement. In the case of physical settlement, the underlying asset needs to be actually delivered to the person entitled to it on the specific delivery date. The underlying asset can be anything listed on an exchange like equity, commodity, currency etc. This usually happens in the commodity markets when companies genuinely want the asset at a predetermined price for use in manufacturing or other purposes. In the case of cash settlement, the seller does not actually make the physical delivery of the asset to the buyer. Instead, if the buyer makes a profit, then the seller simply sends the profit amount to the buyer in terms of a cash amount. The exact amount of the profit depends upon the difference between the market price of the underlying asset on the day of expiry and the strike price for the same asset as agreed upon in the derivative contract. Cash settlement is used when the trader has more interest in the profit and little interest in actually holding the asset.
Cash settlement exampleLet us take an example of a future contract on gold that you have decided to be a part of as a seller. As per the contract, you have agreed to sell 100 grams of gold at Rs. 55,000/10 grams. Suppose the price of 10 grams of gold is Rs. 60,000 in the market on the day of expiry of the future contract. Now in the case of physical settlement, you would have to send 100 gm of gold to the buyer at Rs. 5,50,000 in total. However, in case of physical settlement, you can simply pay Rs. 50,000 to the buyer.
Benefits of cash settlementLet us now take a close look at the advantages that arose from cash settlement for both the buyer and the seller in this transaction. Seller side benefits
- • You, the seller, completely avoided the process of sending 100 gm of gold to the buyer.
- • The transaction cost of obtaining the gold from the market, examining it and then securely transferring it to the buyer is now completely removed.
- • The losses that could have occurred in case the gold got stolen or turned out to be of less quality are avoided completely.
- • The exact calculation of profits or losses is also easier.
- • Overall, you save a lot of time and money that you would have lost in addition to your existing losses.
- • The buyer too can avoid the entire process of sending Rs. 5,50,000 to you and then executing a sale of 100 gm of gold at Rs. 600,00 on the same day.
- • Similar to you, the buyer would also have to undertake the transaction costs of securely receiving and then sending off the gold to the other buyer - he would also have to take on the risk of the gold being misplaced, or damaged or turning out to be of lower quality than agreed upon.
- • In order to realise the exact same amount of profit, the buyer is having to undertake far less risk, transaction cost, effort and time spent in the case of cash settlement.
- • These benefits stand even in the case of stock trading. In case of physical settlement in equity derivatives, even after the execution of the option, the trader has to undertake further efforts to buy/sell the stocks in the stock market in order to actually realise the profits. For example, in case of a call option, even if the spot price is higher than the strike price, the profit will come only if person buys the stock at strike price and then goes into the spot market and sells the entire the quantity of stocks at the spot price. The entire process takes a lot of time and effort and puts the trader under stress and risk. Cash settlement spares the trader of the hassle of undertaking the subsequent steps in order to realise the profits.