In the world of Finance, the better you understand each term, the better you learn and the better you learn, the more you earn. The stock markets provide 2 major components available for trading i.e. Equity & Derivatives
Equity shares are that where you become a shareholder by purchasing the shares or the lender by purchasing the corporate bonds or other debt instruments like Fixed deposits. Fundamentally, your money grows as the company grows and its stock price. Here, you are investing by becoming a shareholder in the company. This is why deliverable quantity numbers matter so much that how many are investing and how many are just trading.
Derivatives is an arrangement or product (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security. Focus Focus! It is not an investment instrument, it is either of the following but not an investment instrument like equities:
- Risk hedging instrument
- Gambling / Betting / Lottery.
A real-life example: Tomorrow, there is a match between India & Australia. You are positive for India’s performance but your friend is positive on Australia’s performance. Practically, you can’t invest in Virat Kohli or Aaron Finch now, they are big players now. 15 years back, they might need training support, some financial support and if you have provided them support in those tough times, they might repay you today in 1 form or another. So, you would be reaping the investment in multi-fold returns. That opportunity is gone.
We have a match (underlying asset) tomorrow and on the basis of past performance, India has a winning factor of 40% while Australia has 60%. You entered into an (arrangement or contract) with your friend that if Australia wins, you’ll pay him 100 bucks or if India wins, he will pay you 100 bucks.
TIP: This real-life example is actually betting, gambling or lottery view of the derivatives. I strongly advise you to save your money and never enter into naked contracts or options. Here, you don’t own the underlying asset and hence it’s a pure luck game.
Before I explain derivatives as a risk-hedging instrument, let me take you on a small ride of statistics so that YOU NEVER RISK YOUR MONEY on dreams, false hopes, intuition, poor advice, gut feeling, or poor calculation or lack of knowledge.
Statistics #1: 90% of the options buyers lose their invested money every month in every stock market of this world.
Statistics #2: Options sellers lose their (invested money + home + jewellery + life) everything when they enter naked into an option.
So, use derivatives to hedge your risk and not investment.
Risk Hedging (Worst Scenario) – 7.5% monthly return with 67% probability on bell curve gives monthly 5.02% return which means that perseverance will double your money in 15 months.
Gambling/Betting (Best Scenario) – 40% monthly return with 10% probability gives 4.00% return which means that roller coaster ride of emotions in the best case scenario may double your money in 18 months which is earning 20% less than worst case scenario of risk hedging in that moment of time.
In these statistics, I am explaining through plain English and Simple mathematics that Worst Case Scenario of Risk Hedging is better than Best Case scenario of Gambling.
Risk Hedging Examples (Correct Use of Derivatives):
- Hedging your equity portfolio against an Index
- Hedging the risk associated with a specific equity share
- Hedging the risk of future contract with an options contract
- Hedging strategies in options contract.